Precious metals and the
validity of technical analysis
Last month’s drop in the price of
gold was accompanied by almost universal recognition of
a head-and-shoulders top, one of the classic reversal
patterns recognised by technical analysts. This is a
pattern that marks the end of a trend; the end of a bull
or bear market, or at the very least a bull or bear
phase. But how relevant is technical analysis to
precious metals?
There is no doubt that using chart
analysis in the right circumstances can be a powerful
tool, but this presupposes that investor sentiment, in
other words the emotions of greed and fear that drive
investors, is properly reflected in the price. For this
to be true, investors with these emotions must dominate
the market, and prices themselves must be an accurate
reflection of supply and demand. This is habitually
true of equity markets, where public sentiment
predominates, and for which technical analysis was
originally developed. It is obviously less true of other
markets that are dominated by other factors, such as
changing patterns in non-investment demand or the
manipulation of interest rates; but wherever the
public’s investment activities are part of the pricing,
technical analysis will always have some relevance.
However, precious metals have their own peculiarities.
Gold and silver are segregated into
two basic markets, paper and physical, which have become
somewhat detached from each other. The public interest,
with respect to investment, is mostly corralled
into the paper markets such as futures and options. The
public interest, with respect to hoarding, is
entirely centred on the physical. While many of us
indulge in both activities the distinction has to be
clearly understood because investment motivation is
entirely different from that of hoarding. In economic
terms, investment is the application of savings for the
expectation of a return, but hoarding is the removal of
savings from circulation entirely. Investors expect to
make a return measured in their paper currency, while
hoarders seek protection from their currency. Technical
analysis is of no interest to hoarders, since they are
driven by fear alone and price is therefore immaterial.
The general segregation of precious
metal investment and hoarding interests into two
different camps has become self-reinforcing. Hoarding
psychology is so different from normal investing,
because to a hoarder, rising prices may be taken as a
confirmation of his worst fears, and only encourages him
to hoard more. He is also frightened into action by
growing economic and systemic risks, and at times of
price consolidation it is these that probably dominate
his actions.
Unfortunately, all commentary on
precious metal prices is directed at investors and
investment, so this important distinction is not often
made and rarely understood. For this reason technical
analysis has an unjustified credibility in current
economic and market conditions for precious metals. Its
application only makes sense in the paper market in
isolation and when there are no other factors; but it is
of no interest to the hoarders in physical markets. This
is a conflict to resolve and we need to know which
market is dominant in order to assess the likely
influence of any investment tools designed for
investors.
Currently, portfolio exposure to
precious metals is calculated to be less than one per
cent, yet gold and silver is very widely hoarded.
Investors measured by both numbers and financial
commitment are the smaller party by far. Furthermore,
hoarding is increasing rapidly, and includes a potential
two billion gold-loving savers in Asia. The central
banks by definition are themselves hoarders rather than
investors, though their motivations are certainly not so
pure. The collective presence and power of the hoarders
is far larger than that of investors, and given the
continuing determination of central banks to inflate
their currencies, the relative importance of hoarding is
set to grow. We must therefore conclude that investment
tools such as technical analysis have little and
diminishing relevance as a means of forecasting precious
metal prices.
This has not completely erased some
short-term relevance, as January’s sell-off has shown.
When investment and speculative interest grow as they
did in the last quarter of 2010, prices do become
vulnerable to technical considerations. However, this
knowledge is routinely used by market manipulators to
panic investors into poor investment decisions. Any
investor naive enough to think precious metals are
simply an investment game that can be played on charts
becomes easy prey for the large commercials prowling the
paper markets.
The use of technical analysis for
predicting precious metal prices is merely one of the
ways in which investors seek to extrapolate past
relationships into future prices. In the process they
ignore the wider world and the fact that economic
circumstances are very different today compared with
say, thirty years ago. Far more relevant is to try to
understand the motivations and actions of hoarders, most
of which have no knowledge or interest in portfolio
theories: will they increase or reduce their desire and
tendency to hoard? And what are the positions of the
central banks, which try to influence hoarding
behaviour: might they lose control of the market?
As well as these important
considerations we can now add that of global financial
politics, with China in particular encouraging its
citizens to hoard, in a move seemingly designed to make
life extremely difficult for Western central banks. Does
this amount to economic war, and if so what are the
implications?
Investors are not often
intellectually or emotionally equipped to understand and
deal with these vital issues. Wannabe hoarders
continually insist they should use technical
considerations to time their entry, still confusing
investment with hoarding. They are seeking to maximise
profits, not protect themselves from whatever it is that
hoarders worry about.
Hoarders will be either right or
wrong. It will go wrong for them if governments somehow
manage to turn paper money into sound money without
involving gold. Under any other circumstances the
hoarders will eventually be right; and if they are right
price becomes immaterial. As economic events progress
and the weaknesses of paper money become more widely
understood, signs of panic will develop. We will see
serious attempts to use the paper market to force
physical delivery – not to ramp the price, but just to
gain possession. We will see ETF holders switching from
derivative-based ETFs into properly structured ETFs,
fully backed with actual metal. We will even see
redemption of metal-backed ETFs for the metal itself. We
will see the bullion banks struggling to switch
unallocated accounts into allocated, and we will see a
desire to remove custody from the banking system
entirely.
Perhaps some of this is starting to
happen. We don’t know for sure, because hoarders, unlike
investors, do not advertise their intentions. But there
is evidence that there has been a steady disappearance
of physical metal from the markets since the 1980s. The
pace has more recently quickened at the same time as
investment and speculative interest has grown in paper
markets. It is a classic demonstration of Gresham’s Law,
with paper investors being manipulated by the commercial
shorts to suppress the price of the physical, leading to
the disappearance of metal from circulation.
So relying on technical analysis is
a mistake leading to a certainty: the majority of
investors will miss the boat completely, because they
will continue to think as investors.
8 Feb 2011
