Six Things for Gold Traders to Watch

Here are six things I'm personally keeping an eye on to gauge the direction of the price of gold:

1. COT report. AceFX shared with us gold COT data. This report shows that commercial traders -- generally believed to be "smart money" traders involved in day-to-day operations of the commodity in question -- are short gold. The commercial traders are increasingly short while others are increasingly long; in such a scenario, when the non-commercials run out of fuel in their trend, they will start liquidating, and the commercials can see this as an opportunity to add to their short positions and push the market further down.

Below is the chart Ace shared with us in the thread he started on this subject.

Click to See Enlarged Chart

2. Consolidation on daily chart. Below is a daily chart. We see consolidation via a pennant formation -- a formation that often precedes a sharp breakout. Accordingly, I think there could be a sharp breakout if the market can break above resistance at $980 or support near $925.

3. US banking system still under stress. US banks are still failing, and more may be on the way. Bank failures increase the need for safe havens, which gold, with its long history of serving as a stable monetary commodity, can provide.

4. The Federal Reserve is still aggressively monetizing. The Federal Reserve has stated they will continue to print money and buy assets through the end of October. Additional money creation without the creation of additional productivity stands to devalue the currency, and is the kind of event that can precipitate a run on a currency. Currency devaluation, particularly when it stems from monetary policy put forth by governmental/quasi-governmental agencies, is bullish for gold, as gold is regarded as a hedge against currency devaluation resulting from central banking policies.

5. Financial fraud rising. Courtesy of Jesse comes the chart below, which shows that financial fraud is rising in the US. Fraud weakens the US dollar and the political economy it stems from, and thus could be seen as bullish for gold.

Click to View Enlarged Chart

6. Financial Fraud in Comex. Comex recently permitted gold futures contracts to be settled not only with physical delivery, but with delivery of shares of gold exchange-traded funds like GLD. GATA explains how this inflates the amount of paper gold, much of which may not be backed by real physical gold. This may result in a split in the gold market -- prices for physical delivery and prices for paper gold.

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Tracking the Collapse of the US Dollar

The case for a severe weakening, and perhaps even total collapse, of the US dollar is something I've been making for some time on my blog. As the dollar has begun experiencing some deeper bouts of weakness and has given back all of its gains since October 2008, I wanted to step back and take a big picture look at where we are on the path to dollar collapse -- and re-evaluate whether or not we will stay on this path.

The first big picture event we should look at is the price of gold. A new bull market in gold began in 2001. This is a long-term trend, I believe the next leg of this trend will start shortly.

The second big picture event worth noting is the collapse of the US stock market in 2008, particularly the second half of the year. Remember there are two sides to a currency crisis: (1) an overproduction of supply of the currency and (2) a loss of confidence and demand for the currency. The Federal Reserve's monetary policy is, in my opinion, the primary contributor to the oversupply of currency, and the corresponding price inflation/currency weakness we've seen over the past decade. The stock market collapse reflects a weaker demand for US financial assets, and thus a weaker demand for the US dollar -- particularly when one considers that the finance industry is a major component of the US economy.

At this point, we should ask ourselves if these trends have reversed: has monetary policy sought to tighten money supply? And has the US economy repaired its banking sector? In my opinion, the answer to those questions is no. Bernanke is firmly committed to inflation as a monetary policy, and the Obama-led stimulus packages has already resulted in an increase in broad measures money supply like MZM. So fundamentally, I think we're still on the track to dollar devaluation.

Recent Milestones in Treasury Bonds and the Dollar

There are two milestones which recently occurred which suggest the US dollar devaluation trend may be set to accelerate. Those trends are:

1. Treasury yields have spiked sharply. This suggests bond buyers are now demanding a greater rate of return on the money they lend. The reason for this, in my opinion, is concerns regarding a weaker dollar in the near future.

2. UUP, the ETF which tracks the US dollar index, is on the verge of breaking a major support level. See the chart below.

Trading This Environment

My trading outlook remains the same, in that dollar devaluation is the primary trend, and that it is here. I favor buying precious metals, commodities, and commodity currencies. I favor shorting the US dollar and US Treasury bonds. At this point, I view it as a relatively safe bet that long gold/short long-term Treasury bonds will likely end up as the trade of the year.

Disclosure: Long gold, silver, and Canadian dollars. Short US dollar.

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Demystifing What Gold is Telling Us

Well, gold bugs around the world have been having a good chuckle of late, as the market is re-affirming the often eccentric and religious-esque views of gold bugs: gold is up over 11% for the year in US dollars, and up over 4% over just the past five trading days. Which begs the question: why? There are a few possible answers to this question:

1. Deflation. This crisis is global, and everyone is flying to safe stores of wealth. Over the big picture of human history, gold has served as the best store of wealth -- and thus gold is rising. In many ways this is the classic "gold is money" argument, one typically championed by Austrian economists. Robert Blumen has offered an excellent explanation of this argument.
2. Inflation. Gold is typically a hedge against inflation concerns, and as the US federal government continues to aggressively "stimulate" the economy, the rally in gold may be a reflection of increased concerns regarding inflation.

So which one is it?

In my opinion, both. With that said, I view inflation as the larger concern, as I have said many times before. If the environment were truly deflationary, Treasury bonds would be the true recipients of flight to quality, as well as dollar holdings in FDIC insured banks. Instead, 20+ year Treasury bonds have fallen by more than 13% thus far (as measured by TLT). Negative correlation between TLT and precious metals suggests inflation, not deflation. The chart below illustrates.

Deflationists will point to the fact that the US dollar may be strengthening relative to other fiat currencies -- although this is not necessarily a reflection of deflation, as it could simply be interpreted as weakness of all global currencies, all of which are falling against gold. More relevant may be the rise in PPI and energy prices in January of 2009. While one month alone does not provide sufficient evidence for a substantive reversal in macroeconomic trends, it is not consistent with deflation, and may suggest that the Fed's inflationary actions in the second half of 2008 may be kicking in.

Conclusions for Trading

The recent activity in the market has led me to make the following revisions:

1. The forex market is increasingly a trader's environment, perhaps even a daytrader's environment.
2. Gold and silver may retrace, perhaps even by several hundred dollars, though I would view it as an opportunity to buy on dips. The global economy is getting worse and conditions are being aggravated by the actions of central bankers. As a result, the fundamental case for gold and silver will get stronger.
3. Counterparty risk is rising -- this strengthens the argument for increasing the physical delivery portion of one's precious metals portfolio.
4. Because of inflation concerns, my bias is against short positions in all asset classes. If I were a trader of stocks or commodities, I might look into shorting positions relative to a broader index (i.e. short a particular stock while going long the sector ETF, under the rationale that the stock will do worse than the entire sector).
5. Oil's behavior has been quite peculiar; I've yet to find a convincing explanation for why it's moving the way it is. As it escapes my fundamental analysis, and as I find it less appealing than currencies from a technical analysis perspective, I'll stay away from oil.
6. As gold becomes too expensive for many, silver will grow in appeal. And as silver fell more than gold during the second half of 2008, it may be set for a larger rally.

Disclosure: Long gold and silver.

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Money Coming Out of Treasuries And Into Gold

To understand how the macroeconomic picture is changing, we can take a look at how various asset classes are changing relative to one another. With that in mind, see the chart below, which shows the ETFs for four asset classes -- Treasuries, gold, commodities, and the S&P 500 -- to see where money is moving.

The chart illustrates the following:

• 20+ year Treasury bonds were rising, but now appear to be consolidating and possibly turning bearish
• S&P is rangebound between 850 and 950
• Gold is rallying
• Commodities are still in a bear trend

Interpretation

The rise in gold coupled with weakening Treasury bonds, commodities, and S&P suggests the market is still rooting out false forms of wealth -- and that the market is shifting to gold as its preferred method of safety. Inflationists will posit that the rise in gold results from greater inflation concerns, and this may play a part into it as well; money supply indicators and money velocity indicators are both pointing to inflation.

Trade Setups

Two potential trade opportunities come to mind:

1. Betting on a continued exodus from Treasuries into gold, in that the market will continue to favor gold over Treasuries as a safe haven
2. Long commodities relative to S&P; commodities seem grossly underpriced relative to the S&P, doubly so for those expecting a deflation spiral.

Disclosure: Long gold.

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How the Mumbai Militants Will Affect Financial Markets

As has been widely reported by the international media, there were recently attacks by militants in Mumbai. Here are some thoughts on how this will affect financial markets:

1. Gold. The proliferation of militant networks around the world has coincided with the emergence of a bull market in gold. The more unexpected attacks by organizations that are not nation-states we see, the more we can see a rise in gold -- and likely silver as well.

2. Defense ETFs. US President-elect Barack Obama has already declared Pakistan a threat and has suggested he may order troops into Pakistan. Moreover, in light of these recent attacks, India has already requested Pakistan take action. In the event of US entry into Pakistan, this would be a bullish sign for US defense ETFs, like ITA and PPA. It is crucial to note, however, that we are in a bear market in US equities; personally, I don't see this bear market ending soon, and thus would be reluctant to go buy ETFs and stocks that are dependent on the US macroeconomy.

3. India ETFs. ETFs that track the Indian economy on US exchanges -- namely EPI and PIN -- may see additional downward movements. These markets were already in a bear trend prior to the attacks, similar to how US markets were already in a bear trend prior to 9/11. This would be an additional bearish argument for India ETFs.

Disclosure: Long gold and silver. No positions in Defense or India ETFs.