Gold and the S&P 500, Part 2

February 21st, 2013

by Dominic Cimino

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Gold has at least temporarily fallen from grace. As other risk assets (e.g. stocks, commodities and the Euro currency) continue to move higher, spot gold prices have continued downward in their divergent trend, and have moved beneath the important support level offered from the 100-week moving average (see Gold and the S&P 500). The chart below shows gold's next support area, the 1525-1500 area. Beneath that is the 200-week moving average at the 1400.00/oz. level. Why has gold lost its luster? Is it only temporary, or will the 1900.00/oz. level remain gold's all-time high for years to come?

Before I begin to consider these questions, I'd like to mention two facts about gold that should be remembered:

  1. Lately, there has been more selling pressure of gold than buying pressure. First 1900, then 1800, and subsequently the 1700.00/oz. price levels were ultimately controlled by sellers. As I write this article, the same appears to be true about the 1600.00 area.

  2. Gold is definitely a form of currency. I don't say that because it has been considered so for 2000 years, which is often cited. That's not enough. Gold is a currency because at any given moment, it can officially become a currency again. Don't kid yourself. Central governments could at some point reinstitute a partial return to the gold standard. France and Britain are two examples of countries that previously returned to a gold standard. With currency wars now raging, it's possible that at some point, nations view a gold standard as the only means of restoring confidence in their currencies.

    That's why I say it's a currency right now. Consider a credit card as an analogy. A credit card is not money, per se. Yet when you pull it out and exercise your credit, it becomes money. Likewise, although gold presently has little intrinsic value, it could at any time again become official currency. Central banks wouldn't be buying it if they didn't agree about its currency potential.

Now let's get back to gold's present weakness and its implications. I can only think of three possible explanations for gold's recent weakness and inferred lack of buying interest relative to selling. Either:

  1. Gold is no longer considered a necessity in one's portfolio since marked economic uncertainty has given way to clarity. Therefore, there's no longer a need for gold. Why not instead invest in stocks which are certain to continue rising?

    I give this reasoning little plausibility since it would seem that the type of investors who originally bought gold because of global economic uncertainty would not presently be selling out because the global macroeconomic picture has improved substantially. I could be wrong, but that's my feeling. If I'm right about this assumption, then for me the next two possibilities are the only feasible ones. I believe they both have reasonable enough probabilities. You may think me crazy to believe number (3) is possible, but please first read number (2), which seems to be more mainstream thinking.

  2. Gold is taking a breather and washing out weak longs before it stages another leg up. After all, gold's chart was parabolic. We've all been inundated with advertisements to buy gold, and stores that will purchase your gold have popped up all over. It's been a virtual gold craze. Perhaps the market just needs a breather, and needs to vanquish the unfortunates that bought near the market's peak.

    Let me emphasize – this is a very plausible reason for gold's current weakness. If further central bank liquidity injections once again capture headlines, buying interest could once again rule and lift gold to new heights. In this scenario, stocks could continue to benefit from inflationary central bank policies, provided everything else remains status quo.

    However, it is rather curious that in early October of last year, gold recorded its 2012 high, even though less than a month earlier the U.S and Europe both announced their commitment to additional, unlimited money creation. Furthermore, new Japanese leader Shinzo Abe announced his reflation campaign in December, with a 2% inflation target and unlimited money creation if necessary. Yet, as much of the world seems to have at least partially embraced Ben Bernanke's theories about dealing with deflation, which were put forth in his 1999 paper, Japanese Monetary Policy: A Case of Self-Induced Paralysis; and as these further money creation and inflation targeting tools have been announced and implemented, gold has moved lower. This brings us to a final possible explanation for gold's current weakness, one that you may find unfathomable.

  3. Gold has seen its peak since the current market pause for gold, thought by many to be merely temporary, will surrender to a war on gold as investors realize that central bank money creation is closer to its end than its beginning. I feel compelled to give this possibility a near equal probability to (2), perhaps because few seriously consider it. If this is true, then gold's topping in September of 2011 might be a divergent warning signal for all risk assets. Gold might be sending a divergent message that deflation and money contraction may be on the horizon because of the potentials for another credit contraction, a fall in asset prices, and a potential central bank reevaluation of monetary policies. A divergent signal two years in the making would certainly be plausible if a major secular change was unfolding, one that reversed decades of inflationary, fiat currency manipulation. Granted, this possibility means endgame for the global financial crisis. It could possibly mean a broad-based significant fall in asset prices, and perhaps a return to the old adage, "Cash is king." Who knows what else could possibly unfold if this was the case? As a trader, I guess a way to describe this phenomenon would be to call it a blow-off-top in money creation. The recent announcements of unlimited money creation by central banks would certainly fit into this scenario.

In conclusion, it's very important to watch price levels if you're to attempt to gauge this sell-off in gold. If gold cannot hold its support levels and rebound, this may suggest that previously effective central bank liquidity injections are nearing their end for whatever reason, and that gold and stock values may be in trouble. On the other hand, if 1500.00/oz. or 1400.00/oz. holds for gold, then maybe it's only been a wash-out of weak gold longs; with the implication that central banks continue to have their way in lifting asset prices.

Finally, one thing stands out for me. I don't think gold and the S&P 500 Index can continue to diverge for much longer. Therefore, watching S&P 500 Index price levels will also be critical. If the spread between gold and the S&P 500 Index goes negative, and the S&P holds above support levels, then perhaps the stock market has a modest correction before moving higher again. Gold would probably come back in that scenario. But if gold and the S&P both begin moving in tandem through support levels, it might be wise to look out below.

Dominic Cimino

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Preferred planning concepts, LLC & Cambridge are not affiliated.


© 2012, Dominic Cimino of Preferred Planning Concepts, LLC (You can explore the services offered by Preferred Planning Concepts by viewing us on our website at www.ppcplanning.com) Any redistribution, reprinting, or reference to this chart or content is allowed so long as reference to the author and source is acknowledged.

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