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Understanding the Key Support Levels for Gold


This selloff was expected, and when it's done it will offer an attractive entry point for long-term gold investors.

Gold bulls and inquiring minds are perplexed by last week's mayhem in the precious metals markets. In addition to gold and silver, copper prices also went into free fall last week which is an ominous sign for the broader economy in general. We live in interesting times as geopolitical uncertainty, social acrimony, and financial collapse shape the world around us.

The situation in Europe continues to worsen and central banks and wealthy individuals are trying to find safe havens to protect their wealth. Most gold bugs believed that gold and silver would be the answer, but in this environment that hypothesis did not play out. In addition, the Federal Reserve came out with Operation Twist, which market participants despised. Since the third round of Quantitative Easing was not announced, risk assets such as the S&P 500, gold, and silver sold off sharply.

Many gold investors believed that gold is a "safety" trade. I would agree with them if the objective is to remain "safe" from ever-rising inflation. In a "run for the exits" sell-off caused by deflationary pressure and debt destruction, gold will generally show relative strength versus equities. However, I would remind readers that during the deflationary period back in 2008, gold held up far better than the S&P 500, but prices were volatile. The gold futures chart from 2008 is shown below:

As can be seen from the chart above, gold futures were volatile throughout 2008 with the March high point representing a 19.83% gain for the year. The low point for gold futures in 2008 was in October and represented a loss of 21.07%. The total return for gold futures in 2008 was 1.94%. Clearly gold futures showed volatility throughout 2008, but gold clearly outperformed the S&P 500 during the same period of time.

The S&P 500 was lower by 37% in 2008, thus gold was clearly the safer asset during 2008 in terms of return. However, one asset class was safer still and had considerably less volatility -- the US dollar. In 2008, the US dollar index futures closed the year with gains around 8.44% with far less volatility than gold or the S&P 500. I am pointing this out to readers because a similar situation is unfolding presently.

Moving forward to the present, the US dollar index futures have put on an impressive rally that started back on August 30, 2011. Since August 30, the dollar index futures are trading higher by around 7%. As it turns out, on August 31 I entered a long call ratio spread using the PowerShares US Dollar Index Bullish (UUP) ETF with members of my service and we were able to lock in a gain of around 30% recently. The daily chart of the US dollar index futures is shown below:

All of the calls for hyperinflation in 2011 and a massive crisis in the US dollar are not coming to fruition. In fact, the opposite is occurring as deflationary pressures are helping force the US dollar higher. I would point out that the majority of economists and analysts were all predicting hyperinflation for several years and so far they have been wrong. Gold nor any other asset can rally forever, but long term investors must understand that even during a raging bull market corrections and pullbacks are commonplace and healthy.
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