Gold rallies over 80 dollars off recent lows (8/21/2015)

It has been a while since my last post, and a lot has changed.

Where we last left off, I had discussed how playing gold from the short side on a short term basis was simply too difficult given the velocity at which upmoves tend to take place compared to down moves. I suggested that longer term players would be better off playing the market from the short side, and that 1150 was a clear place at which to stop out of your shorts. If you sold 1105-1125 as I suggested, you got stopped out for a ~40 handle loss, approximately a 4% loss.

The short gold concept was based around a combination of technicals and the general of a deflationary environment, which has historically been negative for gold. In addition, gold was holding in much better than its precious metal counterparts (silver and platinum) on a historical basis. Given the ferocity of the potential down-move should gold have consistently settled below 1080 made the risk/reward of the downside more appealing.

So now what. And why are we here?

I was recently asked by a reader about how gold would fair in a particular type of economic environment. My answer? I have no idea. Gold’s price is not tied to its utility. Most of the arguments made about what drives gold’s price seem rather incomplete. Why is gold a hedge against inflation? Imagine a hyper inflationary environment. What would you prefer to own? 1 ounce of gold or 400 gallons of gasoline for your car? Most utilitarians would prefer the gas. What are you going to do with that ounce of gold if no one will buy it for you? The gas at least might help you get somewhere. Incidentally, the cost of an ounce of gold and the cost of 400 gallons of gasoline are pretty close right now.

The value of most financial instruments at any given point in time is the price at which it can be bought or sold. In the case of gold, that price has very little to do with what it might do for us on a given day. So let us just accept the fact that fundamental research on gold is kind of a waste of time. It’s price is dictated by perception and money flows.

The Stock market has started to look rather shaky. The money has to go somewhere, and we have begun to see money allocated back into bonds. The general consensus was that bonds could not rally because an interest rate hike was coming. Now people are doubting whether it will happen at all. The Fed, to its own detriment, is being vague in its message. Markets are a bit uncomfortable. China’s recent currency devaluation, questions about the strength of the economy among other things have led to some jitters. We are beginning to see gold have a strong inverse correlation with the stock market. As I write, the S&P has sold off nearly 100 handles in just the last few days. So money is flowing into bonds, and the correlation between gold and the bonds is picking up. So, gold rallies. The stop out point I mentioned from the short trade was 1150, and “prudent longs” all bailed by the Friday afternoon gold settled below 1140. As such,  we should be careful not to take some levels that were significant in the past and assume they will be again. Perhaps 1180 will serve as resistance simply because it has been so significant for so long. But be careful not to assume that gold will behave as it did once before if it reaches the 1180-1220 range.

For now, gold is the anti- stock market. It appears that it has regained some safe haven status. One of the tip offs that gold was in trouble last time we were here (near 1155) was that the Greek turmoil caused the S&P to sell off, but did not cause gold to rally. This time appears different, at least for now. If the S&P were to recover, we might soon refer to this rally in gold as a massive bout of short covering before retesting the new base of 1080. But should equities remain unstable I expect gold to continue to rally. Logically, we can reason that gold is a safe haven against world turmoil. But who really knows. At this point, all we can say is that there has been a strong inverse correlation between gold and the S&P in the short term. This is not the spot to make big bets. Realized volatility has performed well, so if you want to take a stance, owning straddles probably makes more sense than buying or selling futures here. We simply don’t have enough information and need to watch how this plays out before putting significant capital at risk.

If this rally were to have legs there would likely be significant selling coming in around 1230. The level has proven formidable before, and at this point in time, it is where the multi year down trend line comes into play. Please reference past posts to see the charts that illustrate this downtrend.

Now is not the time to be dogmatic. Volatility in these markets remains historically low, so buying options creates a max-loss defined bet that will not force you to exit a trade too soon should the price action be choppy.