Weekly Market Wrap: 19 April 2013 – The case for owning gold is as strong as it ever was

This regular column reviews the condition of several different markets including: stocks, commodities, currencies and precious metals. This week focuses on gold, the Dow Jones Industrial Average, crude oil, copper, and the British pound.

Precious metals

Gold

After breaking down through $1,525 last Friday, gold finally found support on Tuesday this week at $1,321. The yellow metal stopped just short of $1,315, a level that acted as support back in October 2010 and January 2011.

A 3 year (daily) chart of Gold (Click on the chart for a larger version)

A 40 day (60 min) chart of the Dow Jones Industrial Average (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

From a short-term technical perspective the next hurdle for gold is a weekly close above $1,400, which it is currently on course to achieve.

The case for owning gold is as strong as it ever was

What long-term investors need to remember is that none of the fundamental drivers for gold have changed. In fact, the case for owning gold is as strong as it ever was.

Policymakers remain hell-bent on achieving economic growth through the debasement of their currencies (aka currency wars), real interest rates are still deeply negative, and more and more governments are demanding the repatriation of their gold. In addition, inflation remains a real risk.

Since 2008 central banks around the world have created around $14 trillion and injected it into the banking system. Thus far however, this newly created money has not been loaned out into the economy, rather it has remained dormant in the banking system. As a result, money velocity is at a 50+ year low, and hence we have seen subdued rates of consumer price inflation, though it’s worth noting that the inflation has shown up in asset prices such as stocks and sovereign bonds.

There are now signs, particularly in the US, that bank credit is starting to increase, and as bank lending picks up it may well ignite money velocity, finally triggering a ramp up in the CPI inflation rate.

As far as indebted governments are concerned a pick up in the inflation rate is highly desirable, since inflation is the main tool at their disposal for dealing with their colossal debt burdens.

As the former Chairman of the Federal Reserve, Alan Greenspan noted in September 2010, “Gold is the canary in the coal mine. It signals problems with respect to currency markets”, and since today’s fiat currencies rely on confidence, monetary authorities must prevent the price of gold from rising too quickly.

Suppressing the price of gold

The way central banks keep a lid on the price of gold, is primarily through a policy known as gold leasing. Under the policy central banks lend out their gold to a bullion bank such as JP Morgan or Goldman Sachs, in exchange for a fee. The bullion banks then sell the gold into the open market in the hope of profiting from the difference between the lease rate and the yield on other instruments such as sovereign debt.

The banks get a good deal because they are able to pocket the difference between the gold lease rate (currently around 0.41%) and the rate on 10-year US Treasuries (currently 1.70%). The central banks benefit from the rental fee, the demand for their bonds, and from the fact that the gold has been sold into the market and has therefore helped to suppress the price.

What’s incredible about this process, is the fact that central banks continue to show the loaned gold on their balance sheets, even though the actual metal has been sold into the market.

It is estimated that G20 central banks have leased out between 30-50% of their gold. The problems begin when one of these central banks want their gold back, as they are starting to now.

The fact that the gold has been sold, and is therefore no longer held in a secure facility, may go some way to explaining why it will take Germany seven years to repatriate 300 tonnes of its gold from the US Federal Reserve.

One possible explanation for the recent decline in the price of gold, is that the bullion banks are having to return the gold they have leased from the central banks. One way for them to do this, without having to buy gold at the full market price and driving the price up, is to sell gold short forcing the price down. If this were done on a large enough scale the bullion banks might be able to take the price down through major technical support, thus triggering automated stop losses. This may be what we saw last Friday.

The bullion banks are then able to cover their short positions at a hefty profit and buy back the gold they have leased from the central banks. Once the dust settles the scene is then set for the next leg of the bull market.

Stocks

Dow Jones Industrial Average

Having made another all-time high of 14,887.51 on 11 April (4.6% above the October 2007 high), the Dow Jones Industrial Average then began to retrace its steps.

As the chart below shows, the 30 largest US companies are now testing support at the lower green trend channel (circled). If the index breaks decisively below this level, shorter-term traders and investors might want to consider taking profits and waiting for a fresh uptrend before re-entering the market.

A 40 day (60 min) chart of the Dow Jones Industrial Average (Click on the chart for a larger version)

A 3 year (daily) chart of Gold (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

Those with a longer-term outlook will note that although the Dow is up almost 11% year-to-date, the market is by no means expensive. In fact, of the 30 companies in the index, 14 of them are selling at a lower price today than they were 13 years ago, and over same period these companies have increased their revenues and profits considerably.

One example of this is home improvement retailer Home Depot. In the year 2000 the company had annual sales of $38 billion, had profits of around $2.3 billion and was selling for around 74 times earnings. Today, Home Depot has sales of £77 billion, profits of $5 billion and is selling for 24 times earnings. The company has also increased its dividend payout from $0.11 to $1.16 (currently a 2.15% yield).

Commodities

WTI

The triangle consolidation pattern identified a few weeks ago in the US oil market has finally led to a dramatic breakout. The move began last Friday and continued on Monday this week, with WTI (West Texas Intermediate) crude falling 6.5%.

A 14 month daily chart of WTI (Click on the chart for a larger version)

A 14 month daily chart of WTI (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

As stated last week, “If oil breaks the pattern to the downside it could quickly fall to $77.28, a level last tested in June 2012”, and with a whiff of deflation in the air, this move is certainly possible.

Copper

The copper market, which was in a very similar pattern to the one seen in oil, also fell hard during last Friday’s selloff. The pattern in copper (first identified in late February), looks to have reached a short-term bottom with trading in yesterday’s pit session rejecting the 2011 low (not shown) and rebounding to put in a positive close.

A 14 month daily chart of Copper (Click on the chart for a larger version)

A 14 month daily chart of Copper (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

Of all the commodities, copper and crude oil are seen as the two that are most closely aligned with the strength of the global economy. In recent weeks, while global stock markets marched to new highs, both of these commodities fell sharply. Combined with a stronger US dollar, falling sovereign bond yields, and possible stress in the banking system, the weakness of these two vital commodities points to a potential period of deflation.

Currencies

British Pound

The chart below shows the value of the British pound against a basket of currencies. Between late 2007 and early 2009 the value of the pound fell by a staggering -34.8%. Although it has recovered a little since then, earlier this year it broke down through a major support level, and, as is often the case in technical analysis, this level has now become resistance.

A 6 year (daily) chart of the British Pound (Click on the chart for a larger version)

A 6 year (daily) chart of the British Pound (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

If the pound fails to break back above this key resistance level (and there is every reason to think that it will), the pound could experience further sustained falls.

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