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The Question Investors Should Be Asking About Gold


The question is not, is it time to buy gold, but rather, has this falling knife landed?

The secret to a good mind is attention, and attention to a subject depends upon our interest in it. We rarely forget that which has made a deep impression on our minds.
– Tryon Edwards


With the end of earnings season just around the corner, the tape has been showing some interesting action. Last week I discussed a potential small consolidation before being able to determine the next most probable move for the equity market. This is precisely what is occurring -- no apparent direction combined with intra-day indecision. Since the post-holiday week, three of the "Four Sister" indices (the Dow Jones Industrial Average (INDEXDJX:.DJI) the S&P 500 Index (INDEXSP:.INX), and the Nasdaq-100 Index (INDEXNASDAQ:NDX)), have all been fighting with the May 22 "Fed day" reversal high. The fourth, on the other hand -- the Russell 2000 Small-Cap Index (INDEXRUSSELL:RUT) -- is not seemingly bothered with any additional consolidation as it continues on its merry way.

Once the season is over, the market will once again turn toward economic numbers and the Fed to placate its next move. This, in my humble opinion, is where the technical rubber meets the road and investors will be able to get a better comprehension of short and intermediate-term direction.

Click to enlarge

With that said, my firm felt it prudent to discuss another topic which has reentered investors' minds over the past week, due to some very boisterous upside moves of late: gold. Is it time to buy it? Has all the risk waned? Is there more downside, and if so, how much? These questions, as simple as they may seem, are all about risk and what it might be like to catch a falling knife. Maybe the better question investors should ask is: Has the knife landed?

I've been in this business going on 25 years and have seen only one instance where a person / investor has caught the actual bottom of a move and continued the position for a long-term profit. Considering the amount of times I've seen thist attempt made, we're probably talking in the range of one-tenth of 1%. This, in my firm's opinion, is a fool's errand. Now the question becomes, what makes it not a fool's errand? Is it the dead thud a knife makes as is sticks into a wooden floor?

Below is a chart showing gold since 1971 (42 years). Evident in the graph, this last move since 2003 is not the first time gold has been on a terror. Of course the prior, the 71-79 era, was the onset of massively expanding interest rates which helped bolster the price. Today there are many technicians, market pundits, timers, etc, clamoring about purchasing gold due to the fact that much of the risk has waned. Some are even going so far as to say it's an identical play as 1982. For all intents and purposes, there are some similarities, but there is more to consider. Looking back to the 8-year move and subsequent retracement of the '70s, it's easy to view the 50% retracement over a 2-year span after topping in '79. When extrapolating this forward to today, the math tells a different story about risk.

Click to enlarge

The second gold chart illustrates -- with a current valuation of ~$1,300 and potential 50% retracement being the dead thud -- that $1,030 is the risk, assuming the prior '79-'82 is the template. As such, there continues to be 20% risk to the downside. Supposing a 3:1 ratio of profit/loss that an investor might be looking for, gold would have to have the potential of $2,080. However, if the past is any indication of the future, the neckline of $1,550 (where gold broke recent trend support) is the next stopping point from a technical view (similar to '79's $480 neckline). Interestingly enough, the bounce from the '82 retracement low of $325 to the neckline break of $480 was a 50% move. If gold does retrace back to $1,030 and bounce to the $1,550 neckline, it would be a… wait for it, wait for it… a 50% move.

Click to enlarge

None of this analysis is meant to say gold will go to $1,030 and then bounce to $1,550 in the following months. Yet, analysis has to begin somewhere, and there has to be a semblance of reasoning behind it. Many times investors listen to noise about missing the bottom or what the quick trade is, and end up getting hurt. I can't tell you how many times I've heard "Buy Apple Inc (NASDAQ:AAPL)! " since the September $700 high in 2012. Recently at $400, this should give time for pause when attempting to catch any knife yet to make a dead thud.

I hope this helps and finds you well.

Editor's Note: Read more at Tesseract Asset Management.

Twitter: @TAM_News
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No positions in stocks mentioned.

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