Gold Looks Ready To Break Out

From both a technical and fundamental perspective, gold looks like it is ready for another breakout. After the burst in prices in August, pullback was expected but now it is leveling out, showing that it is ready for another price breakout.

September 14, 2011
Cliff Wachtel
Seeking Alpha

From both a fundamental and technical perspective, gold looks ready to break out. Of course, the recent modest pullback has once again brought out the warnings that gold is a bubble. However, these are typically based on sentiment or momentum indicators, which don’t mean a lot when the long term fundamentals behind a move remain strong and in place, as we’ll discuss below.

Technical Picture For Gold

On the daily charts, gold has formed a classic pennant pattern comprised of lower highs and higher lows, indicating the balance of power between buyers and sellers is becoming even.

After gold’s recent burst higher in early-mid August, some pullback would be expected, however, as the pennant pattern shows, while gold’s been falling modestly on normal profit taking, buyers have been stepping back in at higher levels. We also note that the 20 day EMA (yellow) has generally been a support zone since at least February 2011 with a few brief exceptions. In general, a pennant is a continuation pattern, meaning gold could be getting ready for its next move higher.

Certainly the fundamentals exist to create more of the kind of ongoing anxiety about both the USD and EUR that has been driving gold higher for years. Remember, gold is neither a safe haven nor risk asset in the classic sense. Rather, it’s a currency hedge, particularly against declines in the two most widely held currencies, the USD and EUR. See here for more on the myths and facts about what drives gold.

Here’s a quick review of what’s likely to continue demand for such hedges in the coming weeks.

Fundamental Picture For Gold

Longer term, the fundamentals that have powered gold higher remain.

There are rising risks of more potentially currency devaluing stimulus in both the US and EU (elsewhere too, but flight from the USD and EUR is what’s been driving gold).

In the EU

Either a new round of cash for Greece or Greek default should add fuel to the flight out of the EUR over the coming months, though in the short term we could see brief EUR rallies as markets jump around on rumors.

In the US

The Ongoing Debt-Ceiling Saga: There are justifiable worries that a super committee tasked with reducing the deficit will struggle to find a compromise and yet again damage faith in America’s ability to deal decisively with its debt issues. After all, the representatives of each party are just there to represent their parties’ positions, which conflict. One troubling sign already is that Senate Minority Whip Jon Kyl threatened to quit after increased pressure to cut defense spending. Adversity continues in Washington.

US Budget Showdown: The federal government’s new fiscal year begins October 1, yet Congress is (surprise!) far from a budget deal. While the debt ceiling battle in August set the limit on government spending, it’s the budget that decides how that money is allocated. So far the House of Representatives has passed only half of the 12 bills needed to fund Federal operations, and the Senate has only moved on one of the 12. Per one report:

  • An unnamed congressional aide put the odds of reaching a timely agreement at 50%.
  • Meanwhile, Congress must also reach agreement on some additional funding bills in the coming weeks, regarding Aviation, Transportation, and Disaster funding.

While we strongly suspect that Congress would like to avoid another embarrassing display of incompetence and naked politicking after the debt ceiling mess, the 2012 presidential campaign has essentially begun. So at minimum there will be a huge temptation for the same kind of market scaring last minute brinksmanship we saw in late July and early August, which Standard & Poor's deemed as too irresponsible to merit a continued AAA credit rating.

Conclusion & Ramifications

Barring some really unexpected good news from either the EU or US, the odds suggest gold is just making a normal consolidation before making another test of the $1900/ oz range. We don’t expect that, given the recent track record of EU and US leaders, and right now, markets are essentially in their hands. I know, I know, not encouraging. If things get worse (good chance) before they improve, expect a test of $2000, and beyond if the merde really hits the fan on either continent. The bigger risk is Europe. The US has control over its destiny in the near term and can avoid trouble if Washington simply chooses to behave itself. Meanwhile, the EU’s ability to control events is fading by the week, if not the day.

So How To Profit From This?

Obviously, consider buying gold on dips below your chosen strong support levels. Typically, the support zone has been between the 20-35 day EMA.

Slightly less obvious approaches include exploiting the above fundamentals in other asset classes. For example:

Other commodities: Taking long silver positions on dips, as silver tends to move with gold. Growth oriented commodities like copper should remain under pressure, especially given the slowing growth worldwide. Oil is harder to call, given its more essential nature and less elastic demand.

Other risk assets like stocks: The above fundamentals keep our bias to short positions when near term rallies begin reversing. However, this is certainly a time to be compiling a buy list if we get another string of hard selloffs, so that you can start taking partial positions as things stabilize. While all this should imply a bias towards safe haven assets, prices for these are not attractive, though I’d consider the NOK or SEK, or bonds denominated in these or other currencies backed by relatively healthy economies that have some yield.

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