Mayday

Okay, that really was not fun. The biggest short term drop in gold prices in 30 years has left everyone shell shocked and fearful. The only good thing I can say – and it’s really too early to say it – is that this may finally represent a cathartic capitulation event. That will take time to get over but at least traders could start believing, eventually, that a bottom to a two year bear market in resource stocks might be in the rear view mirror.

Even if that turns out to be true it’s going to be a long hard grind going forward. Most explorers cannot afford to explore and it will be some time before the overall financing environment improves.

No prizes for me for seeing last month’s gold market disaster coming. While I wasn’t expecting a lot of gains for gold this year I certainly didn’t expect to see an avalanche of selling and short selling followed by every mainstream publication declaring the gold bull market is dead.

Is it dead? It’s not out of the question but I doubt it. The heavy buying in the physical market is supportive and, should it continue, it will help support the paper market too. While those who want to go in short in the futures market could just sell away I don’t think they will be as brave as now.

Those who find physical buying meaningless forget the people selling the gold have to restock. I don’t know yet what the total bought in India, China and other areas is but it has been several times the average volume so 3-400 tonnes are likely. Volume bought in China in the first quarter – before the price drop – was over 300 tonnes. That roughly matches selling by EFTs since the start of the year. And that doesn’t count the very strong buying that has come in since the price drop. The market is more balanced than it is portrayed to be by some though we still need a trigger to move prices back to most traders comfort zone in the $1500’s.

The main instigator of the short, Goldman Sachs, it out of the market or in a long position now. I’ve seen goldbug hate pieces about Goldman but it’s pointless to take it that personally. I don’t believe there is anything but profit motive behind the bear raid on gold. It was just a trade to them and they have already moved onto something else. I take that as good news, not bad. Unless they see a real reason to expect large near term downside, one of the largest sellers is out of the market.

There is still a very large speculative short position. I do not know what price level the shorts were put at, but again, it’s just a trade for most of them. The shorts may have enough conviction to ride the trade all the way but why would they bother? At some level – I suspect in the $1500-1550 range-they will start closing short positions.

Interestingly, the largest players who actually deal with real bullion are still reducing their short position and getting longer each week. Most of the trading this group does is defensive, protecting the pricing of actual inventory that is being bought and sold. The group that is most likely to know what is going on in the gold market isn’t concerned about a new price drop. They could be wrong but usually aren’t.

I don’t want to give the impression that higher gold prices are inevitable, at least in the near term. I’ve noted many times that trading across all commodity markets is dominated by chartists. Chartists are in full freak out mode right now.

There is no denying it’s hard to put a positive spin on a gold chart. Many technical analysts are predicting much lower gold prices. The question is whether they have enough collective market power to make it so. They might, though my experience with charts and chartists is that too often fundamentals get ignored when they disagree with a chart.

I can’t tell you how many chartists and commodity bears lectured me in 2009 about copper inevitably going back to the 60 cent range to hit some squiggle on the long term chart. I gave up trying to explain that the average cash cost for a newly ascendant and largely debt-free copper production sector was well north of $1.00 No way would mining companies supply the red metal for half their cash cost just to make a chart look symmetrical.

That wasn’t going to happen and didn’t. The same goes for gold, above ground stocks notwithstanding. It cost $1300+ per ounce all in to make the stuff. Yes, you may see more selling of some above ground stocks like those held by EFTs but that too is finite and seems to be slowing already. It’s safe to say gold production growth will now be slower than sector analysts were assuming. This too we have seen many times.

Early evidence is that the central banks have been large buyers in the past few years and are still buying. That demand coupled with physical gold buying in the emerging economies is a powerful combination that I’m not betting against at this stage.

On the gold as currency front, developments have also been constructive of higher prices. Tokyo has gotten the green light to keep expanding the money supply and to drive the Yen lower. Among other things, that has brought some renewed retail gold purchasing by Japanese customers. They are not huge buyers historically, but that could change now that an official policy to weaken the yen is in place. Gold would be a useful hedge against a weaker yen.

In Europe, the ECB instituted a widely expected rate cut. Comments by ECB head Mario Draghi after the meeting indicate he isn’t afraid to go further if he has to. Spreads between peripheral county bond and German Bunds continue to narrow and are at historic lows in some cases. That’s great, but the banking sector is still dysfunctional and if something gets done short term about that it will be the ECB doing it.

The bond market at least doesn’t seem concerned about imminent disaster in Europe. Given that and the terrible growth projections for the Euro zone any concerns about consumer price inflation look ridiculous. The EU needs to push its money supply up and everyone knows the Germans will agree to nothing before the September election. Draghi may need to act alone again.

The Germans have agreed, reluctantly, to stretch out the time required for peripheral countries to reduce deficit levels. Those that could “afford” to add some stimulus to the mix, like France, probably will.

The refutation of the data behind the book This Time is Different, by Rogoff and Reinhart, heated up the austerity debate. Everyone agrees lower government debt levels are better but Rogoff and Reinhart’s thesis has taken a pounding under peer review lately. That has emboldened the stimulus crowd. Personally, I think dealing with structural issues holding back EC countries is even more important. Unfortunately, many will use the debt debate as an excuse not to make those changes.

With growth numbers falling across the developed world lately there is little chance of the punch bowl getting taken away. The wording of the latest Fed announcement left the door open to increasing as well as decreasing bond buying levels. The inflation hawks on the FED Open Market Committee haven’t gone away. Expect gold price dives every time they squawk about stopping QE. A higher level of QE is unlikely but the odds of it being continued well into 2014 have increased.

With currency printing, negative real interest rated virtually everywhere and consumers in the main gold buying countries snapping up bullion on sale there are a lot of market underpinnings. The real test could be the $1500 level that gold is trying to work its way back to. It could take a few tries for bullish traders to push it back above that level.

I think the final piece of the puzzle is sentiment indicators in the gold market. There are several of them and all of them are in record bearish territory. Not a little bearish or heavily bearish but at all-time records case after case. Sentiment indicators are contrarian when they are at their most extreme. When virtually everyone is bearish the sellers have done their work and largely left the field. Daily bobbing and weaving aside, it’s likely gold’s trend will be up for the next while.

By Eric Coffin

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