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Wednesday, 20 August 2008

Why Gold Got Crushed This Week -- and Why It Will Roar Back

Ay, caramba! Not to put too fine a point on it, gold bugs got hit in the face with a frying pan this week. The yellow metal dropped like a hot rock on Monday, hitting its lowest levels of the year.

So what in the world happened? And is all hope lost for gold?

The short answers to those questions are as follows.

1. South Ossetia happened.
2. No, all hope is not lost. In fact, gold will be a screaming buy again at some point down the road.

Let me explain...

Russia, Georgia and the Dog That Didn’t Bark

To start, you’ve probably read about the shooting war that flared up between Russia and Georgia (the country, not the state) over the past week or so.

One minute, Russian and Georgian leaders were focused on the 2008 Olympic Games in Beijing. The next minute, Putin was flying home as fighter jets scrambled and tanks rolled in to South Ossetia.

It’s a fascinating little conflict. U.S. politicians are putting all the blame on Russia, but things are a bit more complicated than that.

I’d love to dive in to the geopolitical implications of what just happened -- and they could be big in the long run -- but that would be a distraction from our gold discussion. So we’ll leave the political analysis alone for now.

To understand why gold fell through the floor, you first have to understand some basic trading psychology. One of the most powerful trading adages around -- and one we’ve mentioned in these pages repeatedly -- is that “it’s not the news, it’s the reaction to the news.”

As a trader, you look at how a market reacts to news, good or bad, to determine how strong or weak the trend really is. If a strong market reacts poorly to good news, that’s a sign that maybe it wasn’t so strong after all... or that maybe the strong trend is now weakening.

Conversely, if a bearish and beaten-down market shrugs off a round of further bad news, that’s a sign that perhaps the bearishness has run its course.

Getting back to the Russia-Georgia shooting conflict. The key “tell” for traders here is that gold didn’t jump up when conflict broke out. Under more normal conditions, you would expect gold to see a huge pop on news of military conflict in an unstable region.

So when that didn’t happen, it was sort of like Sherlock Holmes’ “dog that didn’t bark.” The fact that gold reacted poorly, when it should have acted strongly, caused traders to rush for the exits. And that stampede in turn caused the price of gold to fall through the floor.

Commodity Correction and Euroland Recession Fears

As you are likely aware, gold’s weakness comes against the backdrop of a massive commodity correction.

The Reuters / Jefferies CRB Index ($CRB) is down over 20% from its 2008 highs (although it is still substantially up on the year). The U.S. dollar has also exploded higher this month, putting in one of its strongest trading performances in years.

This is happening, in part, because of a big sentiment shift between the U.S. and Europe.

For a while it looked America’s economy was sick while Europe’s economy was strong. Now the buzz is that perhaps things are the other way around... maybe America will slip past the credit crunch mess relatively unscathed, while Europe takes the harder hit.

As a result of these whispers, along with fears of global slowdown, you have the dollar going up while commodities go down. (The euro has also gone into freefall, which WaveStrength Options Weekly readers should be particularly happy about... Adam recently sent me a note to gloat over the absolute killing he is making on Euro FX puts.)

The Worm Will Turn Yet Again

So that’s the long and short of it. Against a big dollar rebound and a general commodity correction, traders were already feeling anxious about their hefty gold and oil positions.

In other words, these guys were already as nervous as a long-tailed cat in a room full of rocking chairs when the Russia-Georgia shooting war broke out... and so when gold failed to respond the way it should to the prospect of military conflict, they ran like hell for the door.

But here’s the thing: This commodity correction is just that -- a correction. We’re in maybe the third or fourth inning of a nine-inning game. The idea that global slowdown will put an end to the commodities run is just silly.

A quick anecdote... I hardly ever read USA Today, except when I’m traveling. When they put it in front of my hotel door in the morning, I’ll occasionally flip through it over breakfast, just to see what mass-market America is reading.

In San Francisco this past week for the Global Opportunities Summit, I saw a USA Today headline that caught my eye. I forget the wording, but the gist was “Commodity Bull Market May Be Over.”

Now let’s be serious here, I ask you: If The Economist, the Wall Street Journal and the Financial Times can’t get the major market calls right -- upstanding publications that they are -- what are the odds that the all-time top for one of the biggest bull runs this century has seen is going to be called by freakin’ USA Today?

Pardon my French, but there’s evidence out the ying-yang as to why the commodities bull is far from over. We’ll get into that more in future Taipan Dailies... but I’m closing in on 1,000 words here so it’s probably time to put away the soapbox on this subject. (I think after I hit the ‘Send’ button, maybe I’ll go do some tai chi just to calm myself down.)

Oh, and as to why gold will come roaring back?

In a nutshell, inflation isn’t dead. Not by a long shot. That’s another thing Wall Street doesn’t really understand... why the prospect for a massive inflationary tidal wave actually requires slowdown fears to kick in first.

I’ll explain what I’m talking about there when I write to you again on Friday. That will help you see why a time is coming when you’ll want to buy gold with both hands. (I know I will be.)

Warm Regards,

Justice Litle
Editorial Director, Taipan Publishing Group

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