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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.
Alasdair McLeod
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