Alasdair Macleod – 8 Feb 2011
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.