Gold has officially entered a bear market, declining more than 20% from the September 2011 peak of US$1,924/oz. I warned in December last year and in March this year that gold was likely to fall further, even though I was optimistic on the long-term outlook. The reasoning was that gold had gone up every year for 12 straight years, a feat achieved by few assets, and that a sharper correction seemed inevitable at some point. After all, most bull markets have several corrections of +30% and gold had only experienced one steep fall of 29% in 2008. Also, the March-July period is traditionally weakest for gold prices as seasonal demand slows.
Now that gold is falling, what should you do? Well, the technical picture suggests that gold will move to US$1,300-1,400/oz. At these levels, gold would have fallen 27-32% from its peak. Remember that during the 1970s bull market, gold fell 47%, before rising 8x to peak in 1980. So no-one can rule out gold declining a lot more. But there are still good reasons to believe that the gold bull market is far from over. If you think that’s right, accumulating gold below US$1,400/oz makes sense.
But we’re getting ahead of ourselves. Let’s go through Friday’s events and what to expect from here.
What triggered gold’s steep fall on Friday?
Gold was smashed on Friday, down 4.7%. It wasn’t alone as silver finished down 5.3% and other commodities were also sharply lower.
Gold’s fall was largely technical. It breached May 2011 lows of US$1,536/oz. This triggered stop losses. Then the psychological US$1,500/oz was breached and further selling kicked in.
Silver hasn’t yet broken through its key technical support level of US$26/oz. But it should do soon enough.
Beyond technicals, are there other reasons for the sharp fall in gold?
Some have pointed to the European Central bank forcing Cyprus to sell its gold. This is nonsense though given Cyprus’ gold holdings were tiny.
The fact is that gold’s price action has been a concern for the past six months. Despite QE4 and Japan’s monstrous stimulus package, gold has shown few signs of moving higher. Prior to this, stimulus had always stimulated the gold price too.
So what gives? Well, I think supply and demand for gold may offer a more plausible explanation for the recent price weakness. In 2012, gold demand fell 4%, the first decline since 2009. This was driven by a 12% decline in demand from India, the world’s largest consumer of gold. A rising rupee, making gold more expensive, as well as higher import tariffs, took a toll on Indian demand.
The decrease in gold demand was all the more remarkable given that central bank gold buying reached 48-year highs.
With India imposing higher tariffs on gold this year, there are good reasons to believe that Indian demand will continue to remain soft. Also, retail demand for gold exchange-traded funds has clearly been in sharp decline of late. Lastly, seasonal demand for gold is weakest in the second quarter of the year. It only ramps up in the second half in the lead-up to India’s festival of lights, Diwali.
The decline in gold demand has come while gold supply remains muted. While gold demand is likely to pick up in the second half of the year, supply should stay relatively flat. This is because it takes at least five years to get a gold mine up-and-running, and the 2008 financial crisis delayed a lot of investment into new mines.
Long-term, the supply picture looks poor as gold companies are cutting back investment spend, after it got out of control in the lead-up to 2008. More than a quarter of CEOs at the world’s top 25 gold companies have been replaced over the past 18 months as boards demand better returns on capital.
Therefore, though the near-term outlook is challenging, the picture beyond 2013 appears brighter.
How much further could gold fall?
The truth is that no-one knows. You can monitor supply and demand, the technical and so on, but putting a bottom on the price is impossible.
The 1970s can offer insights, though history never repeats. The gold price from 1974-1976 corrected 47% before it rose 8x to peak at US$887/oz in 1980. Extraordinarily, the price increased 4x in the 13 months before the peak.
All bull markets have sharp corrections. You should expect them and that way there’s not much to panic about when they do happen.
Does gold’s fall signal anything about the broader economic environment?
The different markets are sending mixed signals. Strengthening in bonds and the commodities sell-off would seem to indicate investor caution, or so-called risk off. But stocks are still at or near record highs in most markets, which indicates risk-on.
What’s clear is that economic data have deteriorated of late. In the U.S., poor retail sales numbers were the latest in a line of data which were below expectations. In Asia, export figures from countries dependent on global trade such as South Korea, Taiwan and Singapore have been abysmal.
My take on this is that stocks are the odd man out due to printed money flowing through to them. What I’m seeing is that deflation appears to be defeating central banks’ best efforts to produce inflation to reduce their debt loads. The prices of gold and copper (Dr Copper is used as a sign of economic strength or weakness) indicate that inflation isn’t on the horizon.
Whether these commodity price decline indicate a larger deflationary event is on the way is an open question. Let’s wait and see.
Is the gold bull market over?
Ah, the key question. I think there is a strong likelihood that the bull market isn’t over. History is my guide on this. Commodity bull markets have averaged 18 years over the past century, with 14 years as a minimum. We’re into year 13 of this gold bull market. If the bull market is over, it would be the shortest one in recent history.
More importantly, all bull markets have a so-called parabolic stage, where prices go up in a straight line. You see that in the gold chart of the 1970s. Same for the Nasdaq in the 1990s and so on. We just haven’t seen such a spike in this gold bull market.
Moreover, bull markets require significant public participation. I certainly don’t see the average person in most countries having participated in the gold bull market. It certainly isn’t reflected in the fund allocations of fund managers either. In the U.S. for instance, gold represents less than 1% of institutional fund portfolios.
Finally, history suggests that global currency devaluations favour precious metals. And as mentioned in my newsletter last week, the current expansion of central bank balance sheets is unprecedented.
What about gold stocks, which have been obliterated of late?
Gold stocks are at more than 10-year lows versus the gold price, as measured by the HUI index in the U.S.. They have been significantly underperforming gold for some time.
One key reason is that gold companies have seen mine cost blowouts, investment overspend and silly merger and acquisitions prior to this year. Shareholders did not get the benefits of higher gold prices through better company earnings and dividends.
As mentioned above, the cowboy culture of many gold companies is now changing. Boards are holding managements to account. CEOs are being more disciplined about investment spend, focusing on returns rather than getting bigger just for the sake of it.
In the end, gold stocks are leveraged plays on gold prices. But you need to be able to pick the right companies.
This post was originally published at Asia Confidential: http://asiaconf.com/