In part I, I looked at the technical picture for gold and gold mining shares. With regards to the recent price action I made the following observations:

1) the 50% retracement level of the move from October, 2000 to December, 2003 served as support for the recent sell off

2) gold and gold mining shares still remain in a down trend

3) gold and gold mining shares need a period of consolidation before heading higher.

In part I, I presented a graph similar to figure #1, which is a weekly chart of the $XAU, the gold mining index. As before, the hidden price data is the 15 largest capitalized gold mining stocks. The middle panel is a McClellan Oscillator measuring the number of advancing and declining issues. As you can see, this indicator has not broken to new highs nor has it even broken a down sloping trend line. Similarly, the relative strength indicator still remains below 1 and has not broken its down trend line as well. All this suggests that gold and gold mining shares remain in a down trend.

Ok, the reason to go over this again was I received a fair amount of emails and the tone of these responses was if I had committed a blasphemous act against gold. I cannot interpret it any other way.

Figure#1/ $XAU (weekly)

Gold is in a down trend. This doesn't mean it cannot or will not go higher or the down trend will stay a down trend forever. The point I was trying to make was this: I would not be buyer of gold here without a period of further consolidation. [This is the most neutral comment I can make!]

Now on to new business.... This report will be a look at some of the fundamental reasons why gold might go higher or lower. I tried to set this discussion up in part I by presenting the chart in figure #2. Here I was trying to show that the $XAU and the S&P 500 generally trade opposite to each other. That is until the "reflation trade" of 2003, which was characterized by easy monetary policy from the world's central banks. The unwinding of this trade at the beginning of this year led to lower prices in both gold and in the major indices. That was then and here we are now. So for today I am going to look at what might be some of the fundamental drivers that will lead to higher or lower prices in gold.]

Figure#2/ SPY vs. $XAU (weekly)

Gold is known as an inflation hedge so it would make sense that as inflation increases so should the price of gold. But as we all know what makes sense in the stock market usually doesn't put the dollars and cents in our wallets. And not surprisingly that is the case with inflation and gold. Taking a simple trading system where you go long gold when inflation today is greater than 6 months ago and close out the position when inflation is less than 6 months ago yields very poor results. See Table #1 (pink column). This system traded profitably; however, greater than 90% of profits where due to 1 trade during the hyper-inflationary period of the late 1970's.

Higher inflation usually leads to higher interest rates and higher interest rates usually makes holding dollars more attractive. Therefore, higher rates are usually good for the dollar which is not good for gold. So then what is the effect of lower interest rates on gold? Let's put together another simple trading system. This time buy gold when interest rates are lower today than 6 months ago and sell the position when interest rates rise to levels greater than 6 months previously. This system actually made money rather consistently, and on its own could yield handsome profits. The results are presented in Table #1 (green column). Of note and because I thought it was important for you to know, doing the opposite of this trade was a big loser.

TABLE #1

* Select Profit Factor is gross profit/gross loss with outlier trades thrown out; for example, in the rising inflation scenario, normal profit factor is much higher; this is due to 1 trade skewing the results; take this one trade out and you get select profit factor; in other words, don't depend upon the home run to make money.

So the next question to ask is how can we improve on these results? Well when rates fall, the economy is usually contracting or to put it another way, a contracting economy will lead to falling rates and the expectation is that inflation is in our future. This appears to be the best time to buy gold. It appears the time to buy gold is when the economy is contracting as measured by the National Association Purchasing Managers Index being below 50. Let's test it out! We will go long gold when NAPM crosses below the 50 level (contracting economy) and close out the position when NAPM rises above 50. This simple system produced stunning results, which are shown in Table #1 (brown column).

Lastly, what do we get when combine lower interest rates with a contracting economy? You get a great trade in gold. Aside from the fact that the dollar should do poorer in this environment- less reason to hold dollars if rates are low and less confidence in our economy, I can only assume it is the anticipation or expectation of inflation that leads to higher gold prices. In this system to initiate a long trade interest rates must be lower today than 6 months ago plus NAPM must be less than 50; the position is closed when rates rise above the value from 6 months ago. The results of this system are no short of spectacular and improved on either system alone. The results are presented in Table #1 (gold column).

So where are we today, this week, this month? Well for the last 3 years gold has risen over 50%. And guess what? We all know rates have been dropping to historic low levels for 3 years as well. Furthermore, gold started higher just as the recession was taking hold (NAPM was in low 40's). Currently, NAPM is 62.4 and rates have been headed higher. As a matter of fact, gold's swoon coincided with rising treasury rates; this past week, softness in the economy and the specter of rates rising slower than once thought may have been behind the gains in gold.

But as we see so often in the markets, the time to buy is not when everyone knows but when the expectation of such and such occurring is way down the road. The time to buy gold is not when there is inflation but many months prior to its existence. Furthermore, if interest rates are such a big influence on gold, then this is not the time to buy gold. What is the likelihood of interest rates going lower? It's possible but it is an unlikely scenario. The Federal Reserve may do nothing at its next meeting but I don't think lowering rates is on its agenda. Even if they did lower them, how much lower could they go? It is more likely that the Federal Reserve will raise rates and raise them slowly. This will not "scare" the markets; plus raising them now may give the Fed ammunition later to lower them if the economy does soften.

An expanding economy and the talk of rising interests does not appear to be the time to be buying gold or to look for that big move. This plus the fact that the price action says down trend makes me neutral at best on the yellow metal.

The other thing to ponder is whether there will be an uncoupling between gold and the stock markets. That is, as the "reflation" trade unwinds further the stock markets and gold may resume their more " normal" relationship. And in this case, I can more easily envision a scenario where gold heads lower or consolidates while the stock market heads higher.

One last caveat. Gold could go higher if geopolitical events assume a greater focus. (This is difficult to quantify but I want to comment on it anyway). In these uncertain times, gold could be that insurance policy for that dreaded event or time. This in and of itself, may lend support to owning gold. And it may make good sense.

That is The Technical Take!

The Technical Take

$ gold in down trend

$ optimal time to buy gold is with economy contracting and interest rates falling

Note: there will be no part III to this look at gold; I was able to cover everything I wanted to in these two parts.

Thanks for reading and I hope you have found my analysis informative, insightful and profitable....

If you would like more information regarding my methodologies, please contact me at blueguyzee@yahoo.com.