Precious Metals. The Second Wave of the Bubble Unwind is Upon Us

I need to say something about precious metals. I’ve been a vocal bear on them since 2011. Those who’ve subjected themselves to my blog—or worse, my Twitter account—know that. The reasons were gently laid out in a 2012 post. Less gently in subsequent ones.

The bottom line is that a pre-crisis boom in commodities lifted gold and silver—even with Fed funds at 5%. Post-crisis monetary policy then turbo-charged it, as people feared rapid inflation, renewed systemic crisis, a dollar crash, and bond vigilantes. Macro tourists lined up to pile in. Big name guys wearing money halos. ETFs and electronic futures trading for the masses poured the gasoline.

In short, they built a bubble. A bubble replete with charlatans hawking it on every medium. Just look at the chart of silver over the past 10 years.

The irony of the precious metals bubble is that it was the guys yelling ‘bubble’, bubbles of every stripe–bond, stock, credit—who sought refuge in the only asset class that was truly in a bubble. In other words, the fear of bubbles created its own bubble, trapping the bubblers. Karma really is running over dogma.

Why did the bubble pop? People progressively suspected there was a recovery, inflation wasn’t materializing, and a dollar wasn’t really going anywhere. Then, when prices started to fall, the real sellers came out. QE3 couldn’t even stop it. This was the first leg of the bubble unwind, roughly late 2012-June 2013.

Since then we’ve been consolidating, with successive bounces of lower amplitude, each time finding footing between 1200-1250. This is what technicians call a descending triangle. Odds massively favor descending triangles resolving themselves to the downside.

Last week my senses started tingling that the second leg of the bubble unwind that I’ve long awaited was on. These calls are always difficult. But I’ve been emboldened by two things. One, the price action after those tingles tended to confirm my suspicions. Second, I read the post today about RIA flows by Josh Brown over at the Reformed Broker. He said the reports showed the largest inflows last week were into gold.

Into gold? How is that bearish? First, as Josh tweeted “Flows follow price action, they don’t lead it”. Second, when the price action is bad in the face of significant inflows, it is historically a very, very bad sign.

In April 2013 I had been short gold and was vocal about it. A mutual fund executive who is a friend of mine, and with whom I regularly discuss markets and economics, said to me, “Just be careful, Mark, with your gold short. The industry is seeing meaningful inflows there.” Of course, we know what happened the following week. I don’t want to draw too tight a parallel on anything that anecdotal, but the similarity to the info in Josh’s post did jump out at me.

Now, I’m not competent enough to tell you how far down this descending triangle “measures to”. I will leave that to the expert TAs. But I do know we closed on Friday below the previous 1200 floor and on big volume.

One has to be humble when dealing with markets, but you do have to take positions. And when you do you want to take them when you think odds are overwhelmingly in your favor–Like, right here, right now.

This is supported by the fundamental side. There, we’re seeing that almost all the elements of the framework laid out in early 2012 are working against gold. If I were very bearish bonds (I’m only moderately bearish), the framework would be firing on all cylinders. In short, it looks like this: CB QE has lost its psychological punch, emerging markets have tepid income growth, the dollar is trending stronger, and USD rates can only be a headwind.

When I’m asked how far do I think gold can ultimately fall, my answer is I don’t know. I can only guess. The guess I’ve been working with is—as a minimum–a return to pre-crisis levels, based on the notion that the post-crisis investment theses have pretty much all turned out to have been wrong. (And, for the record, the statute of limitations on ‘not wrong, just early’ ran out a long time ago. By the time this is over only Peter Schiff, Zerohedge and Jim Grant will be waving their arms.)

On this basis a pre-crisis level would come out at somewhere around 700-750. Of course, bubble unwinds do overshoot, often by a lot. But the 700 area seems to me a reasonable, even conservative expectation, if the broader thesis is right.

Here’s a chart of the asset formerly known as gold. For fun, try flipping it upside-down and imagining it were a stock. Then ask yourself if you would buy it.

 

Yeah, me too.

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