Four Clues for the Price Direction of Gold

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In the world of commodities, gold always seems to attract lots of interest. There are so many commodities that trade on the futures exchanges around the world. There are contracts for everything from lean hogs to frozen concentrated orange juice, from tin metal to oats and from live cattle to cotton. However, if you ask most people which commodities they watch the answer tends to be crude oil and gold.

Gold has captured the imagination of the human condition for thousands of years. The yellow metal holds a special place in history, and it is mentioned over and over again in the Bible. Gold is unique, it is precious, and it represents wealth, value, and security. Human beings can never own gold; they can only hold it for their lifetimes. While people live for a short-term when compared to the history of the world, gold lives forever. Each ounce of gold that has come out of the crust of the earth over the history of our planet still exists today. Central banks hold around 18 percent of all of the gold ever produced over the course of history or around 32,000 tons.

Gold is not only a valuable metal when it comes to the human condition; it is a meaningful symbol. A person with a heart of gold has the kindest soul. The winner in a race or contest gets a gold medal. People tend to perceive gold as “better” or more desirable than other colors.

Gold is a metal, a symbol, a commodity, a currency, and one of the oldest means of exchange or barter known to humankind. Gold is fungible and an enigma at the same time.

So many investors and traders follow the price of gold each day. In fact, even the most conservative money managers and investment advisors often suggest that their clients maintain 5-10 percent of their total investment portfolio in the yellow metal.

Gold is historically a hedge against inflation. It is portable, a 100-ounce bar worth $125,000 at a price of $1250 per ounce only weighs 6.857 pounds, and at that price, one million dollars’ worth of the metal weighs less than 55 lbs.

Many people buy and sell the yellow metal in an attempt to make money from trading or investing. There are four clues that I watch when it comes to predicting the path of least resistance for gold.

Technical Patterns

A price chart is a picture of the past and as history tends to repeat itself technical analysts or chartists look for the development of patterns that are likely to happen in the future. A price chart is a sort of a crystal ball when it comes to predicting the futures path of least resistance for gold or any other asset. Technicians look at many factors in an attempt to determine a price direction. They measure the momentum and strength of a trend using statistical tools like stochastics or relative strength indices. Technicals try to identify areas of price support and resistance based on past performance. Short-term traders tend to look at short-term charts or price patterns that occur within a day or over a few trading sessions. Medium and longer term traders tend to study weekly, monthly or other longer term pictorials to understand price behavior.

While past performance is never a perfect measure when it comes to predicting the future, an experienced technical analyst knows that many other technicians looking at the same chart will come up with the same conclusions. Therefore, there are many times when technical analysis will create herd behavior in a market and a self-fulfilling prophecy when it comes to the path of least resistance for price. In gold and other markets, prices go higher when there are more buyers than sellers and go lower when there is more selling than buying. Therefore, understanding the direction of the herd of buyers and sellers in a market is an important clue for price guidance and technical patterns often insight at many times.

The Price of Silver and Other Commodities

Commodities like gold tend to move together with other raw materials that can serve as a substitute.

For example, people have a choice of what to eat for a meal. Therefore there is a relationship between the prices of cattle and hog futures. If cattle become expensive compared to pork, demand for pork may increase, and the price tends to follow. If the price of oil moves significantly higher, people may switch to another fuel like natural gas to heat their homes, and that could influence prices. Inter-commodity spreads are the price differentials between two commodities. When one can be a substitute for the other, these differentials can offer valuable clues about value. The long-term mean level for a price relationship can serve as a fair-value benchmark. A move away from that long-term average often makes one commodity that is a substitute for another cheap or expensive on a value basis.

When it comes to gold, inter-commodity spreads between the yellow metal and silver, or platinum offer valuable clues as to whether gold is cheap or expensive on a historical basis. The 40-year average of the silver-gold ratio or the number of ounces of silver value in each ounce of gold value is around 55:1. When the ratio is below 55:1, or it takes less than 55 ounces of silver to purchase an ounce of gold, gold is historically inexpensive compared to silver. When it takes more than 55 ounces of silver to buy an ounce of gold, the yellow metal is traditionally expensive and silver cheap. 

Platinum also has a long-term value relationship with gold. Platinum is a rarer precious metal, has a higher production cost than gold and has more industrial applications on a per ounce produced basis. That is why platinum’s nickname has often been “rich man’s gold.” When platinum trades at a huge premium to gold of over $200 per ounce, gold is historically cheap when compared to platinum. When platinum trades at a discount to the yellow metal, gold is traditionally expensive using the comparison.

Using inter-commodity spreads is a tool to understand the value of gold at its current price and can offer significant clues as the future price action because long-term price relationships tend to revert to mean levels after periods of divergence.

Supply and Demand

Fundamental analysis is the study of supply and demand for a commodity. When it comes to the gold market, the metal is rarely if ever consumed it is only in a person’s possession for a lifetime. When I look at the fundamentals for gold, I examine current annual production which tends to be around 2,800 tons. I also look at the buying and selling behavior of governments who hold the precious metal as part of their foreign currency reserves. The International Monetary Fund publishes quarterly reports on changes in official sector gold holdings. Other organizations, like the World Gold Council, also offer analysis on government buying and selling in gold. A significant buying or selling program by a government can influence the price of gold. Therefore, it is important to watch for these developments in the market.

Each year it is overall investment demand or hoarding and dishoarding of gold that is the primary factor in driving the price of the metal. Watching metrics like open interest in futures contracts and the CFTC’s weekly Commitment of Traders report, flows into and out of gold-based ETF and ETN products, and compiling other information about the flows of buying and selling of gold provide critical clues that contribute to price direction.

Inflation

Finally, gold tends to reflect inflationary pressures in an economy. When analyzing the price of gold in U.S. dollars, U.S. inflation trends tend to influence price direction. However, gold trades in many different currencies so gold in euro is sensitive to European inflation rates, gold in yen, Japanese inflation rates, and in other countries around the world, the price direction of gold in a local currency is often a function of inflationary trends.

Gold is often the ultimate weapon to protect against inflation, and as such, it tends to be an excellent barometer for this economic condition.

Understanding the path of least resistance for the price of gold is no easy task. However, these four clues will help you when it comes to being a better-informed investor in the gold market.