For the last three years, we have accepted by and large the risk on trade (equities, and gold as a hedge against fiat currency and any implied inflation), versus the risk off trade (bonds and cash, in the event that world markets become unstable and equity prices fall. This basically becomes the disinflation trade. This sort of of thing, risk on-risk off, wax-on, wax-off, in rapid succession is sort of the same thing that confused even the Karate Kid. In 2011, we began to see the intense correlation between the value of the U.S. Dollar and Euro become the central focus of that risk-on, risk-off trading motif, as wild fluctuations in the Euro based on the Eurozone’s problems with Greece, Italy, Portugal and Spain (the first two being the most critical for now) being played out. It was not a fun time to hold gold during those periods, and it seems now that we are at a crossroads. Is gold still in the midst of a bull market? Should an investor sell his or her gold now?
Let us look at gold from the perspective of the GLD exchange traded fund.
Those are huge questions, and I am going to attempt to answer them in as concise an answer as possible. We are, I think, at a pivotal moment for precious metal investment, but I think gold bulls and gold bears are both ultimately going to be surprised at what will be perhaps THE most volatile year in gold in the last 30 years perhaps. Its not guaranteed, but odds, I think, favor it. It is entirely possible that a bull shakeout occurs that could leave most of the bulls crying after they sell their positions in panic. I think it is possible in 2012 for GLD to hit BOTH 127.80 AND as high as 230.82 (that means gold could trade as high as $2300/oz).
What factors will lead to the inevitable correction in gold and GLD?
1) The U.S. Dollar is likely to strengthen for awhile against the Euro. Why? It is likely because there is no real resolution to the Eurozone debt crisis that will release the weaker economies (Greece being number 1) from the strongest members, and Italy is probably on the ropes as well in terms of its ability to repay debt. As one can see in this chart, it is entirely possible to see the EURUSD trade at 1.1215 if a three-drives-to-a-bottom pattern completes. Any overshoot of that to a 0.786 retracement could take it as low as 0.9901, which is below parity, sometime in 2012. I realize that it is not any linear equation to figure the gold price, but a 29% strengthening of the dollar would mean a 29% decrease in the GLD price, which would put it close to 107.91 (see later how closely that correlates to one key area of support on the chart).
2) Italy has the world’s 4th largest gold reserve on earth. What do you think Italy’s government will do to cover at least some of their debts? You got it. They will likely sell it, depressing prices further.
3) At some point demand in Asia (particularly India, but also China) should a deeper slowdown begin to hit the nations in that region. That should also begin to have a negative effect on gold and GLD prices.
As economic pressures continue to build on the Eurozone, I think there is a good possibility of selling of gold reserves by governments,investors, and institutions (Dennis Gartman has tempered his bullish on gold just recently, as has George Soros).
And what happens after that? Well, I am indeed pessimistic on one point. I think the Euro will die eventually (and in 2012 quite frankly) and that the Eurozone will break up. (I agree strongly with John Mauldin’s position here. Time is definitely UP for the EU). That event should have two primary effects:
1) It will create the mother of all volatility cycles in world currencies for the remaining sovereigns and the ‘new’ old currencies like the French Franc, Deutsche Mark, and Swiss Franc, among others, as they re-emerge.
2) That action will refocus the world’s scorn on the most profligate spender on the face of the earth, The United States of America. As our debt spirals above 100% of GDP, there will be even more concerns as 2012 passes and 2013 arrives regarding out inability to sustain our “nanny state”. We already know that Social Security is running out of cash sooner than expected and that Medicare costs continue to spiral out of control. What has yet to be seen is the economic impact of single-payer healthcare on the cost of doing business in the United States, and it will be the job of the next President (or the one in office now) to deal with that mess. I cannot begin to write out all the negative implications of that or this post will become a novel. The key point is that our debt growth is totally unsustainable, and it will probably cause our currency to weaken once again, which will AGAIN cause a spiral in all commodity prices including gold, silver, and other industrial and agricultural commodities. Consumers may see cheaper gasoline at the beginning of 2012, but they might indeed be feeling a real pinch as 2013 arrives. Prices of this and other commodities may rise again by the end of the year.
While we might see a breather in commodity prices going into the election (which will be a boon to all incumbents who will use as an excuse to call for another term in office), what will likely happen is a quick boomerang in costs as the U.S. Dollar weakens again in the midst of this mess. How quickly that happens will be hard to tell, but that is likely to happen in the next cycle. It is not going to be pretty. John Mauldin has done a good job of describing it in this article, The Years Ahead. I would read that if I were you.
What does that mean for GLD?
Look at the Fibonacci targets for extensions should a major rally ensue. It still puts GLD at any where from 201.26 to 230.82.
The corrective price action happens in separate options in all likelihood. Lets call them option 1 and option 2. The target outcomes of slingshot rallies for option 1 and option 2 are here.
That brings up an even bigger question than the last.
What would I do if I have ridden gold up to the 1900 area and now see myself with a 400 dollar negative reversal in value? If one is a position holder, I would consider put option or collar strategies that would allow one to be taken out below the 1070 area (actually below that 1000 area where resistance first hit), and if you are taken out, you still have your 1500 dollar gold if you had held since 2001 (I have friends who have held it that long). If that is taken out, then you could re-enter again with some kind of bullish option spread to await a breakout to the other side of the slingshot bullish trade back above 2000. I realize that is a bit risky, but I think the odds of that happening are probably much better than a coin flip. I personally think we are going to see volatility in 2012 and 2013 that will make 2011 look tame (and 2011 wasn’t). When politicians kick cans down the road, they cannot stop until there is no more road. Even an optimist in this environment realizes there is not much road left with which to kick cans.
I still believe there is enough fear to cause people around the world to run to gold for protection, not so much from inflation, but from damaged fiat currencies. The break-up of the Eurozone, even though I think it is inevitable, will not change the problem of worthless fiat currencies. When we see that the break-up causes even more uncertainty, investors will face the choice between the U.S. dollar and gold. In the short run, people will run to the U.S. dollar in all likelihood. In the long run, I think there will be one last rush to gold, and that will likely be the slingshot heard around the world.
Conclusion: I think the new year will bring a short burst of optimism both for the U.S. dollar and for a rescue of the Eurozone that could drive GLD prices down from 141.28 to as low as 127.80 in one scenario and perhaps as low as 113.57 ( a 0.618 retracement of the swing from 11/1/2008 to 9/1/2011.). Sometime in late 2012 into 2013, I still believe GLD will top out somewhere from 201.26 to 230.82 late in 2012 or early 2013. At the outside, it could be as high as 258.18.
Now, I know I sound rather pessimistic, but a lot of it is built upon the chart patterns I see. Many forecasts are awkward and wrong, as Barry Ritholz describes, but I will stick with what I see for now. I would tend to hedge any portfolio position in gold, and not really sell all of it. Remember, my forecast is a bit gloomy, but not quite this gloomy.
Happy New Year everyone! I will post my forecasts for the $SPX tomorrow and likely announce a couple of things I am working on with regard to the neural nets also.
