Gold Prices Reach New Lows

Are you a gold trader looking for a silver lining around gold’s stunning collapse? Better still, let me give you a golden lining. It comes in the shape of a number… 25.

But first, let’s have a little cry and get all this misery out of our system.

Since its September 2011 peak of ~$1,925 an ounce, gold has fallen nearly $700 to yesterday’s close of ~$1,230, over 36% in the span of just 21 months.

Gold has fallen $136 in 5 trading days since last week’s FOMC press conference, $162 so far in June, $365 so far this quarter, and $450 so far this year. Yesterday, it hit a 34-month low. That’s gotta hurt!

But if you stick with me past the explanation, you just might find some relief in that number 25.

The Causes

The current selling spree began back in early October of last year, when gold failed to jump over $1,800 for the third time. It was strike 3, and gold was out.

This started the flight from commodities into equities, with month after month of bleak reports on slowing global commodity demand and upbeat reports on U.S. housing, employment, and consumer spending.

Then came the blow that pushed gold off the cliff in April, with talk of gold sales from Cyprus to Spain and other stops in between. Gold ETFs started seeing record liquidations, short contracts outnumbered long contracts, and mining operations became unprofitable as the gold price fell to or below operating costs.

The tumbling down the mountainside gained further momentum just last week when Federal Reserve Chairman Bernanke hinted at plans to begin the reduction phase of the central bank’s monthly bond purchases later this year.

Gold was seen as a protection against stimulus’ negative side-effects of currency devaluation and inflation. But the Fed’s announcement indicated to everyone that we’re reaching the end of the tunnel and there’s no inflation in sight.

Add all these up and we have very little reason to own gold. The economy is improving, inflation is benign at 1%, stimulus unwinding is about to begin, and equities just won’t quit.

Safe haven? Don’t need it.

Further to Fall

For all the reasons noted above, you will find it extremely difficult to locate anyone defending gold.

There has been “a change in investor sentiment towards gold in response to indications that the U.S. Federal Reserve may end its quantitative-easing program earlier than expected,” Australia’s Bureau of Resources and Energy Economics revealed in its recently released Q2 report.

With gold ETFs already losing over 400 tons through liquidations this year, Mark Keenan, commodity strategist at Societe Generale in Singapore, expects to see another 400 tons sold by year’s end.

“The outflows are very much driven by the positive stream of economic data and Bernanke clearly outlining the fact that if the economy continued to recover, QE is going to end,” Keenan informed Bloomberg.

What is more troubling is that Chinese and Indian gold buyers are not coming to the rescue as they did back in April, leaving many to expect the slide to continue through the summer.

“It has been a turbulent past few weeks for the yellow metal and there seems little to suggest any let-up in the months ahead,” Ishaq Siddiqi, market strategist with ETX Capital, warned in a note to clients cited by CNN Money. “We could see gold prices test the $1,000 mark in the run-up to Fed tapering of stimulus,” [which is expected this September].

Alternative Evaluation

However (here we begin to see the first rays of that golden lining), something happened almost exactly one year ago that has already been called a game-changer by many: on July 25^th, 2012, the U.S. 10-year Treasury note reached its lowest yield ever, prompting many to call the bond bull run over.

Since then, the 10-year government bond has been falling in value, its yield rising. Trading Economics gives some insight into what that means:

“United States Government Bond Yield for 10 Year Notes rallied 41 basis points during the last 30 days which means it became more expensive for United States to borrow money from investors.”

“The yield required by investors to loan funds to governments reflects inflation expectations and the likelihood that the debt will be repaid.”

“Moreover, unless governments issue inflation-indexed bonds, there is inflation risk, in that the principal repaid at maturity will have less purchasing power than anticipated if the inflation outturn is higher than expected.”

For a year now, bond investors have been demanding more interest on their money. 1.4% is no longer acceptable to them. They now want 2.53%. They smell inflation.

The Federal Reserve has been adamant that “inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable,” and “inflation over the medium term likely will run at or below its 2 percent objective,” as stated in June’s press release.

The Fed is willing to allow the 1 to 2 year inflation rate to overshoot its 2% target by a half percent before changing its easing policy. The above noted yield rise to 2.53% is on the 10-year, far enough into the future to pre-empt any policy change for the time being. However, the Fed’s foot is letting up on the stimulus accelerator pedal right now.

So while a reduction in Fed stimulus is negative for the gold price going forward, the reason for the reduction might be positive – inflation is on its way, gold’s very own stimulus provider.

Another consideration is timing. Has the Fed waited too long? Is inflation approaching faster than anyone realizes? Bond yields have already been rising for a year now. With the Fed’s lending rates expected to remain unchanged until 2015, inflation will have had a 3-year head start [from 2012 to 2015] by the time of the first rise in interest rates and a 6-year head start on rate normalization by 2018.

We just have to wait for the reports to keep rolling in month after month to get a clearer picture.

Trading the Number 25

In the meantime, though (here we see that golden lining in all its splendor), there is a way to trade gold profitably regardless of what it does, whether it goes up or down from here.

The graph below shows the SPDR Gold Trust ETF (NYSE: GLD) over the past three years, the daily closing prices in black.

Source: BigCharts.com

The fainter beige line weaving in and out of the black plotline is the 25-day moving average. This is our magic number 25.

A simple trading rule – which can be applied to any other stock or commodity – is to buy when the price crosses above the 25-day average (green dots) and sell when the price crosses below the 25-day average (red dots).

Of course, other moving averages can be used, whether higher (50, 100) or lower (20, 15). Just keep in mind that the lower the moving average is, the more frequently the price will cross it, issuing copious amounts of buy and sell signals that may be more troublesome than advantageous. By the same token, the higher the moving average is, the fewer the crossings and the sparser the signals will be, possibly causing you to miss important reversals due to the delay.

Gold’s notorious volatility works to our advantage when trading on a moving average. The longer the run up – or down – without crossing the average, the more profit we will generate.

There are, however, several points where the market moves sideways, hopping the moving average several times in tight succession, as in those clusters of dots overlapping one another. In these tight swings, you will not make money; you may, in fact, lose a little.

But the longer runs (blue and orange lines) can more than make up for those short criss-crosses.

When trading a moving average, an investor needs to choose the instruments he or she is most comfortable with. One method is to use call and put options, where a green-buy is met by a long call, and a red-sell is met by a long put.

One may also long a standard ETF when buying and long an inverse ETF when selling. [Word of caution: avoid shorting, as being wrong can be costly.]

The easiest way of trading a moving average is to simply long an ETF on the buys and close or reduce that position on the sells, only to reopen it or add to it on the next buy signal.

As a final beam from that golden lining, the longest span between green and red signals is never more than 3.5 months (at least, in the last 3 years). The latest span – which is a sell-span – is nearing the end of its third month now.

Might we be nearing the end of this correction?

Joseph Cafariello

If you liked this article, you may also enjoy:

• Gold Panic Selling
• Where Gold Goes from Here