The gold price has endured significant setbacks over the past fortnight, signalling that the correction and consolidation phase from the previous March high of over US$1000 an ounce will be deeper and more prolonged than we had expected. The gold and energy sectors have clearly been unable to evade the ongoing bear market, which has now spread to all areas of the stock market. We don’t believe the downturn in gold and oil is sustainable however, as the Chinese and Indian juggernauts will continue their relentless advance – a situation convenient ignored by the commodity bears.
For those that have ridden the bull market in precious metals over the years, sharp price reversals and ongoing volatility are essential characteristics of the market. Nevertheless, it’s fair to say that we have been surprised by the latest sharp falls in the prices of crude oil and precious metals, which needless to say, have undergone severe reversals over the past week or more.
From a technical perspective, this week's break below the May low of US$846 indicates a break in the longer-term upward trend. Encouragingly, the case can be made that we are simply witnessing an Elliot Wave "ABC correction" of the longer-term upward trend.
While initial attempts to rally from the US$802.34 low support this view, we recommend viewing the rebound with caution while below the US$875 region. Until prices post a sustained return above here, we cannot rule out further probes to the downside folowed by an extended period of consolidation.
While these situations are never pleasant experiences, it is important to take into account where the financial markets are at today in order to put developments into their proper perspective. Over the past few weeks we have witnessed one of the sharpest sell offs in the Australian stock market in nearly three decades: over the past few days alone, the Australian dollar has suffered its biggest decline in nearly 25 years.
Volatility is currently the mainstay for the market, and the gold and energy sectors have become the latest casualty of a lack of confidence in financial markets stemming from the world credit crisis. Making the situation worse is the fact that the US dollar has amazingly reversed direction and rallied against all major currencies.
However, despite all of this volatility and angst, we believe it is essential to remain focused. We do not believe that the bull market in gold and gold equities is over; far from it. We do however believe that the correction could be potentially more protracted and now that the US dollar has displayed signs of strength.
We do not for one second believe that the longer-term decline of the US dollar is over. After all, this is the same currency that hit record lows earlier this year. The poor fundamentals of the US economy have not changed overnight, nor are they likely to change; in fact, they are likely to deteriorate further in the short-term. But speculators seem to be punting on a US revival and their weight of buying could sustain a rally over the next six to twelve months.
Turning our attention back to gold, the long consolidation phase after the metal’s extended rise during early 2006 is a case in point. During this period, gold equities were not sold off sharply – a very different situation to what we see today. The difference between then and now however is that the broader Australian equity market is currently in the worst bear market since the 1970s. In our opinion, this is clearly having an exaggerated negative impact on gold and gold equities.
From a broader perspective, the bull market has been periodically punctuated by corrections since 2001 when we first became bullish, and we believe this will be the case in the future. However this correction could be more protracted, potentially meaning a year or so might be required before we see the gold price test the old high of US$1030 per ounce.
We believe further downside is possible in the mid and large-cap gold companies, although this is likely to be less severe given the already-significant declines. We also anticipate bargain-hunting from astute gold buyers like we saw on Wednesday this week, as investors appreciate a true buying opportunity when they see it.
The recent weakness in the oil price and the Australian dollar is likely to prove a positive tailwind for the stock market in the months ahead, and we anticipate the market in general could rally from extremely oversold levels following the reporting season. While the sharp decline in the broader market has been soul-destroying for many, we believe value is now abundantly present in today’s stock market, and the probability is high that the market has bottomed over the past few weeks.
Commodity prices in general seem to be responding to a latent fear that the global economy is slowing and that this will bring on deflation, or a fall in real asset prices relative to money. We would like to explain this in a bit more detail, so forgive us for sounding a little too technical here. Maybe pour yourself that extra cup of coffee and read on!
Historically, deflation has been to central banks what kryptonite has been to superman. Modern day central banks have evolved to the point where they are no longer afraid of deflation. One only has to recall Fed Governor Ben Bernanke saying that avoiding deflation is easy, because the Fed has a machine called a printing-press and money can be thrown from helicopters. Yes, he really said it.
Whilst the ‘deflation’ word has not yet been uttered by any Fed officials, the markets are signalling that this is now a threat. The fact that the US dollar is rising against gold and commodities in general is deflationary. The purchasing power of paper-money is increasing.
We believe however that this will only bring about a temporary halt to the bull market in gold, because central banks are now beginning to reverse course on interest rates. Despite their tough talk over recent times, it is our view that actions speak louder than words – and we believe that central banks will open up the liquidity spigots and begin pumping money rapidly into the economy to avoid recession.
This time, things will be different and the Fed will be accompanied by most of the central banks around the world. Inflation will be back on the agenda at some point, but will be taking a back seat to economic growth, and at some point real assets will once again begin to appreciate against all currencies (and not just the US dollar).
Bull markets are said to climb a wall of worry. In recent months, deflation has taken hold of the global economy because of the massive de-leveraging (or de-risking) that is occurring in credit markets across the globe. The precious metals markets are only the latest victims of this de-leveraging process. We think that over the months ahead that these deflationary forces will be increasingly recognised by central banks around the world, setting the stage for co-ordinated monetary easing.
As we have long-maintained, the global economy is not in a position to deal with deflation. The US Fed and Treasury will do everything they can to offset deflation’s debilitating effects. But not before rattling the gold bulls by allowing gold to fall. Which is exactly what we are seeing now. And for those who bought gold at US$255 an ounce, this will be all too familiar territory.
Throughout history, gold has been a hedge in inflationary and deflationary times, and we continue to believe that gold will retain this hedge value. During times of deflation, governments try to ‘reflate’ their economies, which effectively lowers the purchasing power of their currencies against real goods. This has happened repeatedly since money began to be used by the Romans a few thousand years ago.
Right now, precious metals and commodities are experiencing a sharp and nasty correction. While this could continue for a few more months, as happened during the second half of 2006, we maintain that we’re in a correction, not a long-term bear market.
The flip side of the commodity sector’s pullback has been strength in the US dollar. As shown in the chart, below the US dollar index has rallied strongly recently. Ironically, this strength has come predominantly against the Euro, as well as commodity based currencies such as the AUD, CAD and NZD.
In recent years the euro has been the beneficiary of a hawkish central bank, the ECB. While the US was cutting rates earlier in the year, the ECB tightened, citing inflationary concerns. That tough stance has now led to fears that the economies of the Eurozone are sharply slowing.
Last week, ECB President Jean-Claude Trichet kept interest rates on hold at 4.25%. However, his downbeat language on economic growth saw traders factor in interest-rate cuts in the months ahead, which saw the euro weaken and the US dollar rally.
There is currently much hype surrounding the US dollar’s recent strength, but from a longer-term perspective the recent rally is not overly impressive. The chart below demonstrates how parlous the performance of the US currency has been over the past six years. While there may be further short-term upside in the US dollar, longer-term, the currency’s negative fundamentals will reassert themselves. And this of course is good news for gold.
The United States still faces massive budget-deficits in the years ahead, and sooner or later we strongly believe the US dollar will resume its downward decline. As the US Federal deficit grows considerably over the next few years, vast amounts of US dollars will be added to the financial system. In time, this can only be negative for the dollar and positive for the gold price.
With significant technical damage being incurred over the past week within the gold sector, it is possible that the gold price could endure a more prolonged consolidation period than we initially expected. However, we have probably already witnessed the steepest declines in the price of gold and precious metal stocks. We therefore remain committed as long-term investors within the precious metal sector, and believe exiting positions now at current depressed prices would likely prove a mistake.
Like all of other sectors within the share market (such as the banks, financial services, discretionary retailers and airlines) that have undergone sharp price reversals, the damage has been done quickly in the precious metal sector, giving investors little time to react to the changing financial landscape.
On this occasion we have proven too slow to react and crystallise short-term trading profits. Whilst this will be disappointing for some of our Members, we still remain firmly committed to gold’s longer-term attractions and believe that the sector represents strong longer-term value. Looking ahead over the next few months, we are optimistic of a rebound in the price of crude oil ahead of the peak Northern Hemisphere winter season, which could well drag gold along with it.
The great value investor, the late Sir John Templeton once said that bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell. In our view the bull market in precious metals has a lot further to go.
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