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Recently gold
challenged its all-time high, being propelled largely by renewed concerns
over the Greek debt crisis and the possible ramifications a default could
have on global financial markets. Whilst fears of a possible default in
Greece are supportive of gold prices in the short term, it is important to
understand that such pressures are largely temporary in nature and they do
not significantly change the underlying market dynamics in the longer term.
We feel the best way to describe this is by way of visualizing that there is
a premium built into the gold price that varies with regard to how prevalent
fears over the Eurozone crisis are. Just to clarify, we are considering the
effect that fluctuations in fears over the Greek situation have on the gold
price, not the effect that an actual default would have on the price. When
fears escalate, the gold price increases and when fears subside, then so does
the gold price. It does not necessarily significantly alter the overall
direction of gold prices over the longer term.
We think it is important to understand how changes in
this "Eurozone debt crisis premium" impact the gold price.
Distinguishing between price swings caused by fears over Greece and price
swings that occur when a true fundamental or structural change has taken
place in the market is imperative for valid and reliable market analysis.
For instance the quantitative easing programs
implemented by the Federal Reserve are examples of events that truly changed
the market fundamentals for gold and triggered a significant and sustainable
rise in prices. Fears over the Greek crisis may cause the gold price to move,
often significantly, but once fears subside the price will come right back.
This is because the degree to which people are afraid of turmoil in Greece
has not changed significantly, the underlying structure of the gold market.
To demonstrate this point we will take a look back to
around this time last year, when the Greek issue was dominating the headlines
and there was plenty of fear in the market around a possible default. Then
the bailout package came though, fears subsided and gold prices fell back.
The chart below illustrates the accumulation and erosion of the
"Eurozone debt crisis premium" in gold prices at the time.
Gold had undergone a correction from December 2009 to
February 2010 and was in a consolidation phase during a seasonally weak time
of year when concerns over Greece began to make headlines. This caused an
increase in the "Eurozone debt crisis premium" and therefore an
increase in gold prices. However, it did not trigger a major rally as it did
not alter anything fundamental in the gold market.
The market dynamics at work here are as follows.
Traders and investors were concerned over the Greek situation and therefore
gold was bought as a safe haven or hedge against the financial turmoil that
could follow a Greek default. As the bailout package came through, the
probability of a default decreased and therefore those who were long gold as
a hedge against a crisis began to unwind their positions. This is what we are
defining as the "Eurozone debt crisis premium" and the erosion of
this premium contributed to the 8% fall in gold following the bailout.
Without the fears over Greece, we think that gold prices would have likely
followed a path similar to the blue dashed line on the chart above.
Just as an increase in the premium did not signal a new
major rally in gold, a decrease in this premium did signal a downtrend.
Changes in this premium do not significantly affect the overall trend or
market fundamentals.
Another way to picture this is to presume that fears
over Eurozone debt can be measured on a scale of 0-100%, with 100% meaning
that the market is as fearful of a default as it can be and 0% being
equivalent to the market not having any fears of a default. When this measure
is at 100%, the "Eurozone debt crisis premium" is fully priced into
gold and when it is 0% it is not priced in at all.
Without the "Eurozone debt crisis premium"
gold prices would still follow on the path set by the fundamental factors
that move gold significantly and sustainably over the longer term, such as
quantitative easing.
This is obviously a large simplification, but we are
merely trying to make the point that changes in
fears over the PIIGS and the subsequent "Eurozone debt crisis
premium" is more like changing the intercept of the gold bull market
trend than the gradient.
So why is this important? After all changes in the
price of gold, whether due to changes in the "Eurozone debt crisis
premium" or any other factor, are still changes in price and so impact
our gold positions. Well we think this is important for two main reasons.
Firstly a rise in gold due to an increase in the
"Eurozone debt crisis premium" is not necessarily sustainable and
therefore can impact the validity of technical analysis. An example of this
was seen last year, when a rise in the gold due to Eurozone concerns sent
prices to a new all time high. However shortly
after this breakout prices retreated and therefore we consider this a
"false breakout". Trading this breakout from a purely technical
perspective could have led to losses since gold did not go on a run after
this break out. This emphasises the importance of
understanding the fundamental dynamics of the gold market and combining them
with technical analysis to reach a more reliable conclusion.
We noted the similarities in recent market action and
the situation last year in an update to SK OptionTrader
subscribers on June 21st, just a day before gold prices topped out and fell
over $50, saying:
"The Greek crisis and fears of contagion have
prompted a fair amount of safe haven buying and have kept gold prices
reasonably well supported. However should the situation in Greece improve
with say another bailout (or be perceived to improve) then these safe haven
hedges could begin to unwind, creating a downward pressure on the gold price.
"We saw a similar scenario unfold in 2010 when
gold prices gradually ticked upwards, even setting a new all
time high at $1265 before falling back to around $1150 shortly
afterwards. Given that the 2010 spring rally was also driven by Greek debt
concerns, we are getting a feeling of déjà vu when we observe
the markets. Therefore although a new all time high
in gold would cause us to seriously consider taking a long position again,
any technical breakout to a new high would have to be supported by some
fundamental reasoning as to why gold was about to embark on a major rally.
This is important as there is a big difference between a breakout that
signals the start of a major move and a breakout that is caused mainly by a
lot of safe haven hedge positions in gold that could be easily unwound should
the Greek crisis subside."
The second important reason for indentifying
and understanding why gold prices are rising is that it should affect what
type of vehicle one uses to trade or invest in gold's movements. This mainly
affects whether gold stocks should play a part in your position or not.
Whilst we tend to avoid gold stocks (for reasons that will require a separate
discussion), many investors use them to benefit from gains and falls in the
price of gold.
Using gold stocks to benefit from a rise in gold prices
may be a decent idea if the anticipated price movement is due to a
fundamental change in the gold market that will cause a sustainable increase
in prices, such as the implementation of quantitative easing programs.
However it is not a good idea if the movement is due to something like the
Greek debt crisis.
The logical reasoning why gold stocks have performed
poorly in the recent run up in gold prices is as follows. Suppose there were
two outcomes from the situation in Greece. One is that some form of bailout
package is given and fears over the sovereign debt situation subside. The
other is that Greece defaults on its debt and financial markets go into
turmoil.
Whilst it may be debatable how gold prices will behave
under each scenario, neither outcome is positive for gold stocks. The first
would probably see gold prices rally temporarily and then subside as fears
abated. How much more valuable are gold stocks if the gold price is higher
for a month or so? Chances are it doesn't have a great impact on how much
money the companies are going to make and therefore the stocks aren't worth
that much more under this scenario. With the second outcome, it is likely
there would a massive flight from risk assets across all markets and a
scramble for liquidity. That means gold stocks would be sold, as after all
they are still equities and therefore would be dumped in a dash for cash.
Therefore if one wishes to trade gold on the back of
fluctuations in fears over a Greek default, gold stocks should play no part
in that strategy. In fact one could even make the argument that the best
trade for that type of situation is a long gold/short gold stocks position,
but we digress.
In conclusion our main point is that we think it is
important that one understands how the "Eurozone debt crisis
premium" impacts the gold market and the ramifications that price
movements caused by the changes in this premium have on how one analyses and
trades gold.
Sam Kirtley
SKkoptionstrading
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