Gold Price Forecast: Bearish Pattern Calls For Caution

Wednesday, November 16, 2016

gold going down

In the aftermath of the unexpected Trump victory, there is a warning signal showing up in the precious metals markets that investors should be aware of. Despite fundamentals that seem to be supportive for gold, the market may be headed for a retest of the December 2015 low of $1,045, or even lower within the next 3-6 months.

While we remain bullish on precious metals over the long run for fundamental reasons - historic low interest rates, central bank inflation policies, unsustainable debt levels, and unwinnable international wars - we are very keenly aware that these fundamentals do not dictate that prices of precious metals must rise.

For example, these same fundamentals were true from 2011 - 2015, yet gold lost over 45% of its value with silver losing 65% over the same timeframe. Those who clung to their fundamental beliefs, that the above factors would cause the precious metals to rise, suffered serious losses.

The truth is that markets do not move based on fundamentals over the short or medium-term. Yes, over many decades, gold will retain its value, but over periods less than two decades the incredible swings in the price for gold is caused by the psychology of the market, rather than any specific fundamental.

As investors, we must pay attention to what the market is actually doing, and not what we want it to be doing, if we want to succeed.

To do otherwise is a recipe for disaster.

Lesson From The Crash Of 2008

This lesson was learned, for example, during the crash of 2008 when -- despite the thesis that was proposed by many precious metals analysts that when the subprime / housing bubble burst, it would cause the stock market to crash and therefore gold to rise -- gold actually fell during the market collapse. What more, gold mining equities actually fell more than the S&P 500. During the crash of 2008, while the broad US stock market lost 55%, most gold stocks fell 80-90%.

Those who understood the fundamental problems with the world economy failed to stay open to the possibility that the market would react differently to the crash than they originally expected.

The precious metals proponents were completely wrong that gold, silver, or gold/silver equities would protect them.

Instead of paying attention to what the market was actually doing, these forecasters held stubbornly to their preconceived notions.

It was the ultimate irony - intelligent investors who saw the crash coming failed to adjust their game plans when the market gave them new information.

We learned the lesson then, strongly, and vowed to never fall for the same strategy error again. In short: we must never ignore what the market is actually telling us in favor of preconceived ideas. And right now, the precious metals are giving us mixed signals with some big warning signs.

Psychology Is The Most Important Factor

Let us take a hypothetical example:

Assume that all the fundamentals we know to be true regarding gold continue to be true: the Federal Reserve and most world central banks continue to print money, debasing the currency every single year. Major world governments continue to spend more money than they take in, and continue to fund their deficits with debt. Governments continue to bail out banks and other well-connected corporations deemed "too big to fail". Negative interest rates continue to punish savers.

All of these fundamentals are what we expect will drive increasing numbers of people to seek safety in precious metals, which will raise their prices significantly. And of course, the gold and silver mining equities are highly leveraged to the prices of the underlying metals. 

However, continuing this hypothetical example, let us assume that despite those fundamentals being true, the majority of the world's population fail to buy any gold or silver. Let us assume that the reason they fail to do so is as basic as: they simply do not care.

Human beings do not always act logically. Let us assume that despite the negative fundamentals for fiat currency, people decide to keep their savings in US dollars, British pounds, Euros, Canadian dollars, etc.

What would happen to the price of gold?

Despite improving fundamentals, gold would fall.

This illogical market action could continue for years. This happened, for example, during the time periods of 1980 - 2001, and again from 2011 - 2015. 

The markets are not logical -- we must accept this fact.

And what more, we cannot simply ignore an illogical market. To do so would be contrary to our best interests.

Warning Signs Coming From Gold Mining Sector

The red flags are coming from the precious metals mining sector. As the miners are intrinsically related to the price of the underlying bullion, we must monitor them both in tandem in order to form sound conclusions.

The selling in the miners was ferocious and unabated starting last Wednesday morning. While the GDX fell over 16.5% for the week, it actually fell a staggering 18.7% from the Wednesday high through the Friday low.

The first major red flag showing up this week in the HUI gold miners index is an ominous head and shoulders top pattern.

The Head&Shoulders Top pattern takes its name from the shape of a silhouette of a person. The defining features are three components: a left shoulder, a larger central head, and a right shoulder. The support ("neckline") of the pattern should be similar for all three components.

In the chart above, the neckline support was the range between 190-195 on the index, shown in black.

We can see the left shoulder formed on the bounce during April from the support zone at 190, up to 235, and then back down to 190 by the end of May.

The head formed from late May and consisted of the larger bounce from the support zone at 190, up to 285, and back down to 190 in October.

The right shoulder bounced slightly less than the left shoulder, hitting only 225 before falling back to 190 from October through last Friday.

We can see how important the 190 neckline support has been for the HUI index since April.

This support was broken on Friday -- the pattern is thus considered to be triggered and in play until proven otherwise.

In our firm's portfolio, this is why we took defensive action on Friday.

Ramification Of The Head&Shoulders Pattern

When the neckline support of the head and shoulders is broken, the pattern is triggered. The target for a triggered pattern is derived from subtracting the amplitude of the head from the broken support - in this case 95 points. This is shown above by the dashed black lines.

Subtracting the 95 amplitude from the neckline at 190 gives a target of 95, which means the large-cap gold miners would be returning to their bear market lows as an initial target.

In summary, the head and shoulders pattern has been triggered on the HUI index, and it argues that the entire rally seen thus far in the gold and silver mining sector will be erased within the next 3-6 months.

What would be the fundamental backdrop for the precious metals miners to fall fully back to their 2015 lows?

It could only be that they are anticipating gold to fall back to its 2015 low of $1,045, or perhaps even lower. Beyond this can only be the realm of speculation at the current moment. However, we will not mince words, as the head and shoulders pattern is clear, and it was triggered on Friday: it calls for the miners to fall back to the 2015 lows.

Important Caveats To The Head&Shoulders Pattern

No single pattern is correct 100% of the time.

We would argue that in life nothing is 100% certain (except for the apparent certainty of death), and the same goes for the markets. No pattern, nor form of analysis, is perfect. Some forms of analysis work better than others, but no single pattern gives 100% correct results all the time.

In studying these examples in the past, approximately 1 in 3 head and shoulders patterns will fail, even after they are fully triggered. Failed patterns serve to scare out those who place 100% faith in any one system, before the market quickly reverses and advances without them.

For the above head & shoulders pattern to fail, we would need to see the neckline support recovered quickly and decisively within the next two weeks, maintaining closes above 200 on the HUI gold miners index.

We will be watching closely for this possibility.

We need not be fully invested 100% of the time. When there are mixed signals, a mixed strategy can be the best one from a risk management perspective. Defensive hedges such as puts could also be an appropriate strategy.

Summary

The bearish Head&Shoulders Top pattern in the HUI index argues that the miners may retreat to their 2015 lows within the next six months. Such could only occur if the metals themselves are headed back to 2015 lows. Those who have profited from the 2016 rally in precious metals may consider taking some of those profits off the table, or employing defensive hedges. Mixed signals call for re-evaluating the medium-term strategy. A policy of following what the market is actually doing, as opposed to what we wish it was doing, it essential for long-term success.

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Christopher Aaron is a former counter-terrorism officer for the CIA and Department of Defense. He has always had an independent, analytical outlook, volunteering to serve two tours in Iraq and Afghanistan from 2006 – 2009 to gather real-time intelligence for military leaders in Washington, D.C. Drawing upon his investigative skills, he turned his attention to the financial markets in the mid-2000’s and has been sharing his research and analysis for over a decade.

iGold Advisor is dedicated to providing intelligent and independent analysis of the precious metals, currency, and commodity markets. We are neither perma-bulls nor perma-bears on any asset; rather, we endeavor to maintain a focused discipline on the psychological, wave, and cycle patterns that ebb and flow continuously through all markets. You can reach Christopher at: caaron@gold-eagle.com.

www.iGoldAdvisor.com