Wednesday, 17 May 2017

Cyclical Reversal in Gold and Commodity Markets

Fundamentals of gold is one of the most difficult thing to work out. Probably because gold could be viewed simultaneously as a commodity, store of value, inflation hedge, geopolitical fear hedge, etc. The forces that drive its price are multiple. So it's simpler and better to do technical analysis on it.

Gold is many things, but industrial metal ain't one of them. Or is it? Its industrial usage is certainly play a small role. But then, if you look at the price action from the cyclical commodity peak of 2011 up until today (17 May 2017), gold's correlation with commodity is quite strong.

Let's look at 3 charts in particular.

Spot gold chart from 2011 to 2017
Spot gold chart from 2011 to 2017

Metals and Mining ETF chart from 2011 to 2017
Metals and Mining ETF chart from 2011 to 2017

Spot Copper price chart from 2011 to 2017
Spot Copper price chart from 2011 to 2017

The XME (Metals and Mining) ETF capture prices of industrial metal. I've also included Dr. copper because it's the supposedly most important barometer of industrial strength.

The 3 charts all shown important similarities. They all peaked at 2011 and bottomed in the beginning of 2016. Actually gold is slightly ahead, therefore leading, the other 2 charts by a month or so. All 3 prices are kept under the long term resistance lines that extend from 2011 up until today. And the green arrows in all 3 charts all showing that their prices are within the striking distances from the long term downtrend resistance line.

While i haven't included them, many other charts of diversified mining majors - BHP, RIO, FCX - all showing similar price actions. This shouldn't come as a surprise.

After a strong run-up from the 2016 bottom, the commodity complex peaked in Feb 2017, and corrected for some 3 months. Maybe i speak too soon, i think the correction is over and ready for the next leg up. The price actions so far are telling me this, at least for a short term rally.

If i need to cite fundamental reasons, i'll say the falling DXY plays a part. And the OBOR (One Belt One Road, aka Belt and Road) Initiative initiates this commodity rally. If OBOR is going to play out as it's planned, its effect on commodity prices should dwarf Trump's proposed infrastructure spending (if it happens at all). And also, PRC is just better at doing these things than USA as they have done so in the last 3 decades. There's talks that China may underwrite some of the U.S. infrastructure deal, which is win-win for both countries.

The size of the project is mind boggling that this project involves some 65 countries (and intends to expand to 100 countries). When all said and done, it should inject some 4 - 8 trillion dollars into the world economy, much of it flows into commodities.

If the current commodity rally is going last for a few months, all the charts with the long term downtrend resistance lines would likely be broken, taking gold along with it for the ride. I couldn't see how gold would be down or even stalled out while the commodity complex is charging ahead.

Perhaps, the correlation between gold and the commodity complex has more to do with the reflation theme. When commodity prices are rising, this leads to inflation, and an inflation hedge is the most notable and enduring investment theme for gold. Geopolitical risks like Brexit or French Election or Trump's D.C. dramas only provide transient boosts to gold prices as a fear hedge. As soon as those fears subsided, the gold rallies quickly fade away. A flash in the pan. Only inflation fear can sustain gold rally over a long period because inflation can last for years while geopolitical fears last only as long as the events, which typically for days or weeks. So for a sustained bull market in gold or commodity to occur, you need an economic boom that ignites inflation (something central banks have been trying to do for years with some successes).

OBOR and U.S. Republican infrastructure build will take time to play out. Depending how much of these 2 gigantic projects are being implemented, but as far as commodity prices go, we are much closer to the bottom than the top.

Even ignoring the falling DXY and OBOR, the synchronized global growth we are witnessing right now alone should be positive for commodity prices and inflation. So sooner or later, the long term resistance line will be broken. I bet on sooner.

If you're thinking about buying gold because of the scenario i painted above, you're better off buying base metals like copper or even zinc. They're likely to outperform gold.

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