Commodities: Gold's Risk Scenario

Introduction

Majority of you know I am a US Dollar bear and Precious Metals bull in the long term. I have actually held the same view from the short term perspective and invested accordingly in my fund. Despite my strong belief in my own views, a good fund managers should always question potential scenarios which occur in the opposite manner to the way one plans it.

In the following short article, I will put forward a potential risk scenario where my bullish PMs outlook ends up being wrong or delayed (depending on what word you would like to use) for a year as this asset class could suffer a major correction. Before I continue, I would like to remind you all of the poll we held earlier this year on the blog, which showed that the overwhelming majority were bullish on the PMs sector.

Gold's Risk Scenario

I am long PMs (Silver) and also short the US Dollar. However, I must admit that one of the major risk scenario to my bullish view is Gold itself. The price of Gold is now up 11 years in the row. That in itself is a worry, because that type of a hot streak is such a rare occurrence in the market environment. Let me explain.

From 1982 secular bull in stocks, until the 2000 tech bubble peak, S&P 500 never posted 9, 10 or even 11 years of gains in the row. It is actually very rare for any asset to do so according to history. I did a bit of research and found that one of the last major assets was Nikkei 225 into 1990 before crashing 66%. Last secular bull in PMs during 1970s also never recorded gains anywhere close to 10 or even 11 straight years in the row.

Educated Retail Investors

Retail investors are becoming smarter and investment business has changed a lot since the internet has started flourishing the last decade. Today, a lot of retail investors on blogs and forums understand secular bull market in PMs is alive and well. They do not trust government fait currencies and have been buying up precious metals for awhile now. I congratulate these folks!

However, markets are not as easy as the paragraph above sounds, so the story plays out with a lot of twists before "The End" occurs, similar to reading a book. You see majority of people learn about secular markets and than buy up as much Gold and Silver as possible waiting to get rich, because they know how it will all end. The problem is that you cannot just skip to the end of the book and read the final chapter. There are chapters in between and they are quite important when participating in a bull market.

Bull Traps Are Common In Bull Markets

Most retail investors today believe that the PMs bull market will end soon with a major spike occurring in coming couple of years. That is possible of course. Having said that, I personally believe that there is a decent chance a major correction will occur first, similar to that of the 1970s. It doesn't have to be the same, but in 1970's Gold had a huge run up into 1974. It than fell over 40% in a space of a year or so and took out a lot of weak hands (and strong ones too) in a major correction, which tends to be titled a bull trap. Just as it looked like it was all over for Gold, it than spiked almost 9 times from $100 or so all the ay to almost $900 in intra day ($850 closing basis) in January of 1980.

Now, look at Gold in the last three or four years. Gold bottomed in October 2008 around $680 and rallied for three years straight topping at around $1,920 into August 2011. Now if you think about it from a basic common sense stance, that is quite a big move. Since than Gold has dropped almost 21% into late December 2011 low around $1,530. Is that enough of a pullback after an impressive 3 year move? Is that enough of a correction after 11 years of gains in the row?

Technicals Point To More Downside

I do not like using technical analysis too much, but consider the following. When we look at the weekly chart, the price has not traded properly below 200 MA for 3 years, RSI has not been below 50 for over 3 years as well, and finally MACD has not been below 0 for over 3 years too. These momentum indicators tend to be more useful on longer time frames like weekly or monthly charts and for Gold, it is looking like all of these indicators need to mean revert and reset themselves by becoming more oversold from a weekly perspective. Finally, despite Gold's correction last year into late December of 21% (bear market), we have actually not even retraced 38% Fibonacci level. A 50% common retracement puts Gold at $1,300 believe it or not.

Summary

From a contrarian point of view, we should consider the possibility of the economy surprising majority by having a great year (during elections especially), while Gold has first annual loss since the secular bull started a decade ago. In other words, even though I am invested on the long side in the Precious Metals market, I admit that there is a strong possibility of a 1975 replay, where Gold could fall hard to shake majority out in a bull trap. Bull markets climb a wall of worry and disbelief; so prices cannot and will not go higher if majority are expecting a secular bubble spike in the next week or month or year to begin. Please remember, this is not my prediction and I would not short a secular bull market. I am just putting forward a potential outcome, which should not surprise the wiser ones amongst us.