by Bob Prechter
An article in a major financial magazine dated April 20 tried to make sense of the metals’ recent plunge in terms of economic causality but was unable to do so:
April 20, 2013
It is hard to find an economic explanation for gold’s sharp fall
GOLD suffered its biggest two-day fall in 30 years on April 12th and 15th. When an asset falls so sharply in price, it is tempting to believe that significant economic changes must be afoot. But an examination of the background to bullion’s decline simply produces puzzlement. In short, it is hard to find a rationale in the current economic outlook that would simultaneously send gold and bond yields down, and stock markets up.
Even when no external cause can be identified, socionomic causality is mystifying to most people. It seems unnatural that major market rise or decline need have no economic explanation. But financial pricing is subjectively determined by unconscious herding impulses and internally regulated by Elliott waves, so mass psychology pushes markets up and down without needing to make economic sense. There have been times when gold and interest rates have fallen while stocks rose, for instance in 1975-1976 and 1990-1993. Nevertheless, we agree that the current situation is anomalous. To relieve the markets’ dissonance, the stock market, the object of even more optimism than gold enjoyed in 2011, should soon join gold on the downside. Also, we believe that significant economic changes in fact are afoot, namely a turn to deflation at Grand Supercycle degree and a resumption of the trend toward economic depression. When those trends develop further, gold’s recent action will start making sense to observers.
The article concluded with an excellent insight:
Like the government-backed paper money that gold bugs despise, gold is precious only so long as enough people agree that it is.
Exactly; when too many people agree that gold is precious, it’s a top. When too few agree, it’s a bottom.
Successful market analysis is rooted in irony and paradox. Our gold and silver analysis at the peak two years ago relied heavily on five arguments directly opposed to those offered everywhere else we look.
1) Central-Bank Buying
An article published on April 19 quoted a report issued by one of the world’s most famous money managers. It reads, “We believe that ongoing central bank purchases and strong gold demand from China and India will help support the gold price in the near term.” At Elliott Wave International, we have used the very same fact of central bank interest in gold to come to precisely the opposite conclusion. In September 2011, the month of the all-time high in gold, EWT made this observation:
Last November, the president of the World Bank opined that governments should reconsider the role of gold in their monetary systems. Governments thrive on counterfeiting money and hiding that fact. The notion of paying respect to gold, in this context, is a radical idea, indicating how deeply the bullish consensus on gold has influenced people’s thinking. Gold’s downturn is either already in place or really close.
As recently as two months ago, reports of aggressive central-bank purchases of gold throughout 2012 sparked assurances that such activity would force gold prices higher. As gold hovered enticingly around $1600/oz., the February 20 issue of EWT pushed our converse point of view even harder:
After a major top and during the first decline of a bear market, novices buy heavily in what they think is just a pullback in an ongoing bull market. It has just been reported that central banks bought more gold in 2012 than in any year for nearly half a century. No doubt they believed that the setback in gold after its high of 2011 was a pullback to buy. They sold all the way up and finally bought. Central bankers are not good traders. They have been making policy mistakes of historic proportion for five years. This is just another one of them.
It is premature to say our logic proved out, but so far it seems that central banks have once again shown that they are not good market timers, and it seems that investors have once again shown that they overvalue both central-bank power and the external-impact theory of financial price movement.
2) Fed Inflating
Since mid-2008, the Fed has been inflating the supply of dollars (the “base money supply”) at the unprecedented rate of 33% per year. In 2012, it accelerated its policy by inaugurating a program to monetize government-guaranteed mortgages and Treasury bonds at the rate of a trillion dollars’ worth per year, with no time limit. Precious metals bulls seized upon these facts as guarantees that gold and silver would soar to stratospheric heights. This style of argument would be useful if financial markets obeyed the rules of mechanics, but they don’t. As The Economist put it, “Many of the most enthusiastic buyers of gold believed that QE would ultimately lead to rapid consumer inflation. So far that has not come to pass.”
Here at Elliott Wave International, we made the opposite argument. Figure 1 was published in the December 30 issue of EWT. Our headline read, “Biggest Inflationary Fed Commitment in History Provides another Selling Opportunity in the Metals.” Who else in the world would write such a headline?
Here is the commentary from that issue:
Speaking of paradox, gold and silver peaked on Fed day, December 12, at a lower high. I haven’t seen any commentary about that amazing event. This wasn’t any old Fed day, either. It was the day the Fed promised to inflate the money supply indefinitely at the rate of over $1 trillion per year, the most aggressively inflationary policy—by many multiples—in its 99-year history.
People think that events move the market, but they don’t. Recall that the S&P made its high for the year on September 14, just one day after the Fed promised to buy $40 billion worth of mortgages per month. Gold and silver couldn’t even manage to make new highs for the year going into the Fed’s promise on December 12 that it would also buy $50 billion worth of government bonds per month.
Figure 12 [reproduced here as Figure 1] shows gold and silver prices for the past year along with the dates of the Fed’s unprecedented announcements. Both times, metals bulls got everything they hoped for and feared. Yet both markets peaked shortly after the first announcement, and they fell hard from a lower peak starting the very hour that Ben Bernanke confirmed the start of his program to more than double his inflating from an already unprecedented rate.
During that hour on December 12, from 1:30 to 2:30, as Bernanke was making his announcement and holding his press conference, I was on the phone doing an interview with GoldSeek radio. (Thanks, Chris Waltzek!)
Editor's Note: Subscribe risk-free now to listen to the full 24-minute interview and hear what Bob had to say during those heady minutes when the world was sure that gold and silver could only go straight up. Learn more and get a special offer at the bottom of this page.
If the historic “Fed day” of December 12 was truly a trap for the bulls, gold and silver prices should not exceed their peak levels on that date (see the rightmost arrows in Figure 12).
At the time of the first announcement (QE3), gold was trading at $1770 and silver at $35. The metals edged higher for another three weeks and then began to retreat. At the time of the next announcement (QE4), gold was at $1720 and silver at $33.60. Last week gold sold for $1320, down 30% from its high, and silver for $22, down by more than half. Figure 2 shows an update of this daily chart.
Observe in Figure 2 the series of first and second waves of increasingly smaller degree in the chart for silver. (Gold has the same profile, but the internal waves are imperfect.) These labels denote the earliest bounces along the Slope of Hope. The “third of a third” wave or “Prechter point” is that brief time of extreme acceleration at the center of an impulse. We used to call it the “point of recognition,” but this phrase is inaccurate. Market participants never recognize anything; they simply change their minds. The center of the wave is when, in a falling market, investors on balance shift their focus from looking upward to looking downward, from calculating the profits they expect to make to estimating the losses they fear might incur. It seems this event took place at Intermediate degree this month. This labeling will hold as long as gold stays below $1600.
3) The “Crisis Hedge” Argument
The Elliott Wave Theorist has established that during times when gold is not used as money it tends to rise in price when the economy is expanding and fall when it is contracting. This fact challenges the ubiquitous claim that gold is a “crisis hedge.” As gold was peaking in September 2011, EWT made this observation:
In a credit-based monetary system, gold goes up more easily when the economy expands, because money is plentiful, supporting speculation. (See the study published in the March 2008 issue of EWT.) Gold and silver tend to fall during recessions, even amidst credit crises, as happened from March to October, 2008. This year, silver topped along with the stock market in the last week of April. The downturns in those two markets provided an early warning of economic contraction. (EWT, 9/16/11)
In the third quarter of 2012, gold was still managing to hold at a fairly high level after 3.5 years of economic recovery. But by failing to continue upward, the metals were still functioning as an early warning of recession. The December 30 issue posted a chart (shown here as Figure 3) and updated the outlook:
The March 2008 issue of EWT went into great detail showing that in almost every case, gold rises in price when the economy is expanding, not when it is contracting. Once again this relationship proved to be the case, as the metals rose through most of the economic recovery that began in 2009. They petered out early, in 2011, even though some measures of economic activity showed continued slow growth. (When the figures are inflation-adjusted, there is virtually no growth, and the early fade in the metals market probably reflects this fact.) Silver topped just one day before the NYSE Composite did (see chart, October issue). After falling, the metals have rebounded into the fourth quarter of 2012 along with the rise in stock indexes. Both sectors are giving end-of-days performances, with some measures (silver and the NYSE Composite) leading on the downside and some (gold and the Dow) barely off their highs.
If the economy is getting ready to contract again, as I believe it is, metals are likely to go in the same direction: down. Notice how gold and silver performed in the last crisis, during 2008. As the chart indicates, gold fell 34% and silver fell 61%. If you expect another crisis, you should expect another fall in gold and silver. Since the next crisis will be much bigger than that of 2008, the fall in gold and silver will be greater, too. (EWT 12/30/12)
Figure 4 updates this weekly chart.
Observe that the last two sentences quoted above offered a counter-intuitive argument. That’s why it had a prayer of working. Common sense, intuition and everyday notions eventually kill investors in financial markets, whereas thinking contrary to them often works.
As it happens, there truly was a crisis—a terrorist attack—on April 15, the very day that gold had its biggest plunge. Shown here is USA Today’s front page for April 16. What external-cause believer would have anticipated the juxtaposition of the two headlines we have circled here? Lest we forget, on that same day, a story broke that ricin-laced letters had been mailed to as many as five government officials, including a U.S. Senator and the President of the United States. Given such headlines in advance, most economists and “fundamental” analysts would have predicted a huge jump in the price of gold. But the gold market didn’t care about either event. Why should it? External events don’t move markets; internally regulated psychology does.
It is likely that metals ended their series of “wave two” rallies (per Figure 2) right when the economy ended its expansion, as noted beside the asterisk in Figure 4. We will know once we get the economic reports a few months hence.
4) The “Gold Is Cheap” Argument
Gold bulls have been saying that gold must be priced far higher if it is to serve as the world’s money. But the September 2011 issue of EWT made a case that gold at $1921.50 was expensive:
Those who argue that gold is still cheap might want to consider [Figure 5], which shows that since 1913, when the Fed was created, gold has achieved four times the gain of the Consumer Price Index. To match the gain in the CPI, gold would have to fall below $500/oz. Granted, the CPI is a manipulated index, so it might understate the true gain in consumer prices. But there is still a notable disparity.
When the CPI starts falling, gold will have to drop even further to narrow this discrepancy.
5) The Conviction that Post-Peak Lows were “Support”
For the past two years, everyone from ETF traders (see chart on page 7 in the March issue of The Elliott Wave Financial Forecast) to central bankers (see discussion above) were loading up on the metals, figuring the post-peak setback was a buying opportunity.
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Wolf Richter