Gold Is Against The Ropes
Oct. 5, 2014 3:00 AM ET
Summary
- Gold is now sitting at support.
- Common trend extrapolation has everyone looking lower.
- Upcoming week's expectations.
In a title fight, when one boxer has been terribly bludgeoned and is being pushed back on the ropes, the ref often steps in to call the fight. We are now witnessing such a situation in the metals world, but there does not seem to be a red to step in. Gold is on its own.
Since the highs of 2011 - the so called hey-day for gold - it was the heavy-weight champion of the world. Everyone who attempted to short gold was dealt fast knock-out punches, just like Mike Tyson's opponents in the late 80's. No short traders could stand in the ring with it.
But, in 2011, gold clearly lost its edge. It was dealt its own knock out blow. In 2012, it attempted a come-back, however, in April of 2013, it was dealt yet another knock-out blow. So, in 2013, with the gold-bug world in its corner, it attempted yet another come-back. Everyone was so convinced that this comeback was for real, and it would regain its heavy-weight glory. But, of late, it has been bludgeoned again, and is up against the ropes. Will October of 2014 deal it a final knock-out blow?
Just three months ago, I remember standing alone against a tide of extreme bullishness in gold. I was staunchly retaining the position that lower lows will be seen in the metals. Yet, everyone else seemed so confident that we were on our way to higher highs. Many even went so far as to ridicule my expectation, and warn me that my short trade would be stopped out for a nice loss.
Now, amazingly, everyone seems to be convinced that gold will be dealt a final death blow. I am being sent daily emails about other analysts now calling for sub-$700 levels on gold. But, one cannot blame them for such expectations. 95% of analysts and just about 100% of investors engage in what we normally refer to as trend extrapolation. And, this is why the herding principle works so well.
Many look at the trend as it currently exists, and simply expect it will continue indefinitely into the future. Very few are able to identify points at which a trend can change. And, those that attempt to do so often lack the tools and ability to do so on a consistent basis.
So, I have to ask you, how difficult is trend extrapolation? Simply draw a trend channel and follow it. It is the crudest form of analysis and works very well during a strongly trending market. But, it will never be able to identify the point at which a trend changes until after the fact. And, why would you need to read an analyst to provide you with a lot of technical-speak to simply provide you with trend extrapolation?
Well, I would say that such analysis is far better than what I consider driving a car, while looking out the back window. Yes, I am referring to fundamental analysis which has only hurt most investors over the last 3+ years in the metals market.
In my humble opinion, I believe that, as more and more study is conducted into investor psychology and the social aspect of economics, we will ultimately abandon the use of "fundamental analysis" as the main research tool in identifying market direction. In fact, many noteworthy scholars and economists have begun to recognize that using fundamental analysis to determine market turning points is akin to driving a car blindfolded, while facing the rear window.
As an example, in a paper written by Professor Hernan Cortes Douglas, former Luksic Scholar at Harvard University, former Deputy Research Administrator at the World Bank, and former Senior Economist at the IMF, he noted the following regarding those engaged in "fundamental" analysis for predictive purposes:
The historical data say that they cannot succeed; financial markets never collapse when things look bad. In fact, quite the contrary is true. Before contractions begin, macroeconomic flows always look fine. That is why the vast majority of economists always proclaim the economy to be in excellent health just before it swoons. Despite these failures, indeed despite repeating almost precisely those failures, economists have continued to pore over the same macroeconomic fundamentals for clues to the future. If the conventional macroeconomic approach is useless even in retrospect, if it cannot explain or understand an outcome when we know what it is, has it a prayer of doing so when the goal is assessing the future?
I think all those that are intellectually honest understand the severe limitations in using fundamental analysis for prognostication purposes in a non-linear market, such as the metals. And, this applies to stocks, as well as the overall economy, with the best example I have seen to date being the case of AAPL stock.
For years, AAPL's stock kept driving higher and higher. Its fundamental picture was as rosy as could be. However, as we approached the 700 region, and as almost all analysts joined the consensus of AAPL heading to levels exceeding 800, those of us who understood sentiment were looking for a market top. Unfortunately, the great majority did not see it coming, and many lost a lot of money when AAPL topped right when a small number of us expected.
So, why is tracking sentiment more effective than fundamental analysis?
Fundamental analysis is generally defined as a method of evaluation that attempts to measure "value" by examining related "current" economic, financial and other qualitative and quantitative factors. Fundamental analysts will utilize "current" macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management).
Therefore, market fundamentals are the existing conditions of a market based upon historical data. In order to utilize this information for predictive purposes, economists will employ a form of trend extrapolation. This effectively presumes that the current market conditions will continue indefinitely into the future, until they do not. This is possibly the crudest form of linear extrapolation. But, can it really foresee turning points in a non-linear environment? If we wait for the underlying "fundamentals" to change, are we not already within a different trend within the market that is now changing underlying fundamentals?
The common perception in the market is that the news causes changes in market psychology and fundamentals, which then causes changes in prices. But I believe that the correct, more consistently applicable premise is that market psychology and sentiment are the causes of news events and changes in prices, whereas fundamentals are purely lagging indicators, and the result of psychology and sentiment changes.
Bernard Baruch, an exceptionally successful American financier and stock market speculator who lived from 1870- 1965, identified the following long ago:
All economic movements, by their very nature, are motivated by crowd psychology. Without due recognition of crowd-thinking ... our theories of economics leave much to be desired. ... It has always seemed to me that the periodic madness which afflicts mankind must reflect some deeply rooted trait in human nature - a trait akin to the force that motivates the migration of birds or the rush of lemmings to the sea ... It is a force wholly impalpable ... yet, knowledge of it is necessary to right judgments on passing events.
During his tenure as chairman of the Federal Reserve, Alan Greenspan testified many times before various committees of Congress. In front of the Joint Economic Committee, Green- span noted that markets are driven by "human psychology" and "waves of optimism and pessimism." Ultimately, as Greenspan correctly recognized, it is social mood and sentiment that moves markets. I believe this makes much more sense when deriving the causality chain.
During a negative sentiment trend, the market declines, and the news seems to get worse and worse. Once the negative sentiment has run its course, however, and it's time for sentiment to change direction, the general public then becomes subconsciously more positive.
When people become positive about their future, they are willing to take risks. What is the most immediate way that the public can act on this return to positive sentiment? The easiest is to buy stocks. For this reason, we see the stock market lead in the opposite direction before the economy and fundamentals have turned. This is why R.N. Elliott, whose work led to Elliott wave theory, believed that the stock market is the best barometer of public sentiment.
Let's look at the same change in positive sentiment and what it takes to have an effect on the fundamentals. When the general public's sentiment turns positive, this is the point at which they are willing to take more risks based on their positive feelings about the future. Whereas investors immediately place money to work in the stock market, having an immediate affect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, which take time to secure. They then place the newly acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they are then able to provide more goods and services to the public, and, ultimately, profits and earnings begin to grow - after more time has passed.
When the news of such improved earnings finally hits the market, most market participants seem shocked that the stock starts to move up strongly (even though the stock likely bottomed well before the public takes notice when the investors effectuated their positive sentiment by buying stock), and they simply attribute the stock's rise to the announcement of positive earnings.
There is a significant lag between a positive turn in public sentiment and the resulting change in the fundamentals of a stock or the economy, especially relative to the more immediate stock-buying activity that comes from the sentiment change. This is why fundamentalists can be left holding the bag at the top of a market, when the news and fundamentals look the most attractive, right before the market begins to dive, as sentiment turns in the opposite direction well before the fundamentals.
This lag is a much more plausible reason as to why the stock market is a leading indicator, as opposed to some form of investor omniscience. This also provides a plausible reason as to why earnings lag stock prices, as earnings are the last segment in the chain of positive mood effects on a business growth cycle. It is also why those analysts who attempt to predict stock prices based on earnings fail so miserably. By the time earnings are affected by a change in social mood, the social mood trend has already been negative for some time. And this is why economists fail as well - the social mood has shifted well before they see evidence of it in their "indicators."
In 1996, Robert Olson published a study in the Financial Analysts Journal in which he studied the effects of herding upon "expert" fundamental analysts' predictions of corporate earnings. After studying 4000 corporate earnings estimates, he arrived at the following conclusion:
Experts' earnings predictions exhibit positive bias and disappointing accuracy. These shortcomings are usually attributed to some combination of incomplete knowledge, incompetence, and/or misrepresentation.
Mr. Olson's article suggests that "the human desire for consensus leads to herding behavior among earnings forecasters," with the herd always looking for the current trend to continue unabated and indefinitely. But, those that have experience in the non-linear work of the stock market understand that the most bullish calls by these "expert fundamentalists" almost always come at the top of a market or stock.
So, allow me to apologize for my digression and ranting, but I have seen so many articles coming out of late that are extremely bearish on gold that it has even shocked me. If you remember, as we came into 2014, I wrote that this would likely be the year we see bullishness for metals die. And, it sure seems like we are witnessing exactly that now. And, yes, I think it will get even worse at the lower levels I expect. In fact, when we start seeing multiple articles claiming that gold is not to be touched as the bull market is clearly over, that will likely be when we have hit bottom.
Now, moving on to the current state of the gold market. While I correctly expected that gold would not break down yet below its 2013 lows this past week, we clearly did not get the bigger bounce I had wanted to see. Gold was clearly much weaker than I had expected. But, we have now made it into October, and, as I said last week, it is during this month that I think we have the potential to see gold break down below its 2013 lows.
I also owe everyone an apology. In the GLD, there is one thing I did not take into account. Although I have written before about how toxic the GLD is for long term investors, I did not take into account one of the reasons I noted it was so toxic - the loss of value inherent in the fund itself, irrespective of what the price of gold does. So, while gold has not yet touched its 2013 lows, the GLD has, due to this inherent loss of internal value. Therefore, it will actually take a strong break down below 113.50 to signal that we are on our way to our lower degree targets sooner rather than later.
Ultimately, I still would like to see a corrective bounce back to at least the 118 region before we set up to drive down to much lower lows in GLD. I can even see an "evil" set up which marginally breaks below the 2013 lows to run stops on traders, and then shoot back up in this corrective bounce I would like to see. It would stop many people out of their long positions and then cause them to chase the run up in price, at the same time that shorts begin covering. Both of these scenarios would leave a vacuum underneath the market which would support a strong drop later this month.
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