Ready for the Contrarian Gold Trade?

Posted by Cam Hui -
I have been a gold bull for quite some time. I highlighted its bullish potential in early 2024 when it staged an upside breakout to an all-time high at 2100. Last November, I reiterated my bullish view with the publication, 2025 High Conviction Idea: Gold. Since then, gold prices have gone parabolic and soared to new highs in all major currencies, including the Swiss Franc, which is considered to be a “hard currency”.
 

 

It may be time for a pause. If you are ready to be a contrarian on gold, the tactical contrarian trade here would be to sell gold and buy bonds.

 

 

The Frothy Debasement Trade

The fundamentals behind the rally in gold has been called the “debasement trade”. The market is discounting mounting debt levels in most developed markets and the inevitable debt monetization that’s ahead. In addition, the seizure of Russian assets in the wake of the onset of the Russo-Ukraine War highlighted the geopolitical risk of holding USD reserves. As a consequence, global central banks have been diversifying their asset base, which manufactured a continuous demand by reserve managers for gold.
 

 

In the short run, the “central bank demand” investment narrative looks overdone and frothy. Michael Cembalest at JPMorgan Asset Management observed that much of the increase in reserve gold holdings is attributable to the rise in the market price of gold (left chart). While central banks are accumulating gold, the increase in gold’s share of global forex reserves is tamer after adjusting for price changes.
 

 

 

Nearing Measured Objectives

How frothy are gold prices? Point and figure charting can be a useful technique for determining long-term price objectives and applying it to gold shows that the metal is highly extended in its advance. A weekly point and figure chart of gold with a 2.5% box and 3-box reversal shows that gold is near its measured price objective of 4564. However, a longer-term perspective using a 5% box and 3-box reversal shows a measured objective of 9800.
 

 

The gold miners are flashing similar warnings of an extended move. A similar 2.5% box and 3-box reversal point and figure chart shows that the gold miners (GDX) have well outrun its measured objective of 57. A 5% box and 3-box reversal shows that the current price is above the long-term objective of 70.74.
 

 

 

Correction Ahead

A review of the technical condition of GDX shows that a correction may be just starting. The ETF staged an upside breakout in early August out of a well-defined rising price channel. The advance reversed itself when its 5-day RSI recycled from overbought to neutral. The percentage bullish on point and figure indicator also reversed from an extreme overbought condition to neutral, which is often a signal of a correction.
 

 

High trading volume can be signs of either bullish or bearish price frenzy. The accompanying chart shows the 20-year price and volume history of the gold ETF GLD. Past instances of volume spikes have usually seen price reversals in gold and abrupt reversals in the relative performance of 7–10-year Treasuries (IEF) compared to GLD.
 

 

Price reversals from extreme overbought conditions can be warnings of price corrections or intermediate tops. The accompanying chart shows a long-term monthly chart of gold going back to 1985. The second panel is the %B indicator, which measures the distance of the gold price is from its 260-week (5-year) Bollinger Band. A reading of 0 means that the price is at its 260-week moving average. A reading of 1.0 means that it is at its 2 standard deviation Bollinger Band.

 

During bear markets a %B reading of 1 or more (grey vertical lines) have indicated market tops. During bull markets, persistent %B readings of over 1 are “good overbought” conditions indicating strong bulls. However, readings of over 1.3, which is what we have today, have marked short-term price tops and tactical price reversals of the 10-year T-Note price relative to gold.
 

 

Please be reminded of Bob Farrell’s Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways”.
 

Here is a plausible scenario of how a correction might unfold. The market is discounting the virtual certainty of quarter-point rate cuts at the next two FOMC meetings, followed by a likely cut at the January meeting. If the Fed signals a dovish cut at the October meeting by emphasizing the softness in employment, rate cut expectations will soar further and bond prices will rally. Real rates decline, which puts downward pressure on gold prices.
 

 

 

A Pause in a Hard Asset Bull

Despite my tactical caution, I remain a long-term bull on gold. The accompanying long-term chart shows that gold staged an upside breakout at 2100 out of a cup and handle pattern and the move has gone parabolic, which is extended and ripe for a correction. A review of the relative performance of gold to the S&P 500 and gold to the 60/40 portfolio shows similar relative breakouts. I interpret this to mean that the market is undergoing a shift to a hard asset price leadership cycle. My base case calls for a multi-month correction and consolidation in the manner of the 2004–2006 experience, followed by a second rally to an ultimate top at much higher gold prices. It is within this context that the long-term point and figure objective of 9800 is achievable in the next 3–5 years.