Gold: A Breakout — or a Fakeout?

by James Brumley | August 23, 2012 12:06 pm

Doubts about gold’s rebound a month ago were understandable. The world’s favorite precious metal suffered a sharp, 7% selloff in May, and as of late July it still hadn’t shaken it off, despite a decent-size advance late in the month.

Now, though, with gold at a four-month high, it’s tough to think the small rise (so far) isn’t part of a bigger bullish trend. Factor in the supporting move the Fed appears ready to make[1], and what you’ve got is a recipe for a nice trade on the SPDR Gold Trust ETF (NYSE:GLD[2]), or for those so inclined, gold futures.

Before you blindly jump on the gold bandwagon though…

The Fundamentals

It’s been a weird, crazy market this summer[3] to say the least. That same weirdness applies to gold, which uncharacteristically did nothing except drift sideways between May and mid-August. The most reasonable explanation? With Europe’s debt/austerity woes stagnating and America’s economy weakening not yet needing a stimulus, traders did what they thought was best for the situation … nothing.

Things are clearly different now, with gold rallying, up 2.9% in the past three days. What’s driving the rally — and driving traders out of hibernation?

1. The possibility of QE3. Not that it’s the only contributing factor, but it was the final one, the one that pushed the gold bulls into action. On Tuesday, the Federal Reserve posted the minutes from its most recent meeting. It turns out that quantitative easing — the third one during this economic cycle — was being discussed as a possible answer to what the Fed is starting to view as a struggling economy. The discussion of QE3 in no way guarantees such a stimulus, but the mere mention of it was enough to goad speculators because it was the first time additional stimulus it had even been brought up since QE2 from the middle of last year.

2. Consumption. With the average gold price being 7% higher in the second quarter of 2012 than it was in the second quarter of 2011, it’s not difficult to believe that global demand and consumption was down by the same 7%. Globally, we only used 990 tonnes of gold last quarter, versus 1,065 tonnes in the second quarter of 2011. Tapering demand from China and India was the key culprit. Between the two countries, usage of gold fell from 451 tonnes to 326 tonnes.

But wouldn’t that indicate a downtrend? It depends. In this case, the experts are now thinking the dried-up demand for gold stemmed from fear of a slowdown in China — and India to a lesser degree — that never quite got as bad as expected. With the pendulum swinging too far in the wrong direction, some say now it’s poised to swing back with equal force.

3. Falling U.S. dollar. One of the reasons gold turned weak in early 2012 was the fact that the U.S. dollar (the denomination gold is priced in) had become so strong in the shadow of Europe’s problems, which threatened the relative value of all its currencies. Now, the inflation and interest rate scenario in the U.S. is weakening the U.S. dollar relative to other currencies, pushing gold higher. It’s not a trend that’s apt to come to a quick halt.

Given those three factors, the path of least resistance for gold remains to the upside. So, this budding strength is no surprise. There’s still another consideration though…

The Technicals

Click to Enlarge
The good news for the gold bugs is that this chart wiggled its way out of a converging wedge (orange) with a bullish effort. The bad news is, the big move over the past three days has already carried gold into an overbought condition. That’s OK: It doesn’t threaten the bigger uptrend now any more than stalling at the 200-day moving average line did on Wednesday.

It does mean we’re apt to see a small pullback in the foreseeable future, though, just to burn off some of this froth. The key will be finding a floor at or above $1,603 or so with that pullback, which is a confluence of technical support, and the midpoint of the wedge(s).

Of course, what traders really want to know is where the ultimate top is likely to materialize. While nobody has a crystal ball, you may want to keep an eye on the $1,785 area. That’s where the 61.8% Fibonacci retracement line awaits, and it’s also close to where gold topped out twice several months ago.

For the SPDR Gold Trust, it’s roughly the $172 level. Gold’s $1,690 level is also an important Fibonacci line, but the $1,785 area gives the three fundamental factors discussed above enough time and space to fully play out.

Besides, most of the major analytics firms are calling for gold to reach the $1,700 — or higher — by year-end. Those calls, in addition to the technicals and fundamentals, are all going to fuel one another.

As of this writing, James Brumley didn’t hold any securities mentioned here.

  1. Fed appears ready to make:
  2. GLD:
  3. a weird, crazy market this summer:

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