Wednesday, August 24, 2011

24/08/2011: Few thoughts on today's Gold price correction

Following a dramatic rise over the recent weeks, gold registered a correction today. At this moment in time, gold for December 2011 delivery is down 5.76% on the day and is priced at USD 1,754.00 / oz. Here's a snapshot:
Of course, one day movement can be many things:
  • A sustained correction (with market settling at lower levels and running along a flat trend)
  • A short-term correction (with a return to, perhaps more sustainable, upward trend)
  • A bear trap (with relatively prolonged period of downward corrections followed by a return to positive trend) and so on
While it is extremely hazardous to profess any explanations for specific daily (and generally high frequency) changes, here are some of the reasons that are being advanced by various analysts as to the possible drivers of today's correction:
  1. The margins theory (see zerohedge comment here): CME raised margins on gold for the second time in the month, having hiked them first 22% and now raising them 27% again (new account margins are now at USD9,450 and maintenance accounts at USD5,500). This second rise follows 26% hike on margins by the Shanghai Gold Exchange (+26%) on Monday to 12%. In theory, margins increases should symmetrically rise costs for short and long positions on gold futures. Which can lead to closing of some positions. In practice, however, two things occur. Firstly, short positions face lower margin exposures than long positions - the difference being small, alas. Secondly, margins increases themselves might be dramatic, but on absolute terms they are still small, unless you are opening highly levered new accounts. The margins theory, in my view, helps explain the physical move in prices, but not the behavioral drivers for investors' reaction. More likely, in my view, is the possibility that two consecutive, short-spread margin hikes signal to the investors that CME is actively trying to prevent gold going parabolic, to contain speculative momentum. If so, current correction is welcome, as it triggers retrenchment of speculative leveraged investors.
  2. The talk about Euro area demands for the collateral on Greek (and Portuguese and Irish... and may be Italian and Sapnish...) loans from EFSF/ESM/alphabet soup. FtAlphaville speculates on this (here). There can be indeed a push for such a move, though I doubt it will result in actual sales of gold reserves. Even if the sales were to take place, European peripheral gold will most likely be placed 'discretely' to other central banks and treasuries, plus the IMF in fear of destabilizing official reserves elsewhere. The last thing Europe will want to do is to dent its own (German, French & UK) wealth and anger a bunch of governments in Asia, plus the US & IMF - all of which are deeply into gold holdings.
Incidentally, couple of days ago I commented on twitter that CME margins increases are long-term positive for gold, if they are successful in cooling off speculative leveraged investors.

My guess - and I stress that this is a guess - is that the current correction can turn out to be relatively deep, but it will not alter long term (9-12 months) upward trend for gold. The reason is simple: US, UK, Japan and Europe are poised to print money. In part, this is already factored into previous highs for gold. In part, the uncertainty about the quantities of QE to be deployed, are offering both the upside and the downside scenarios for the gold price relative to peak.

If, however, the global QE does not materialize, stock markets and corporate debt markets will likely to slip into serious bear sentiment. Which will push gold back onto near-parabolic trend up.

As far as today's short-term correction goes, my view is that it was 'helped' by the shifts of liquidity into equities with markets posting another day of strong upsides.

For a longer-term lesson to be learned: today's correction shows clearly the perils (for ordinary investors) of rushing into an asset with a single large-scale purchase. Instead, gold should be treated as a long-term allocation aimed at real wealth preservation and hedging. Such allocation should be built over time, with sustained - volatility-reducing - strategic long positions. Not with attempts to 'time' the market or based on impulsive buy-ins based on expected capital gains.

And, of course, the volatility shown by today's gold price movement, as well as an even more dramatic volatility in equities and fixed income shown over recent months, highlight the need for conservative, long-term investment strategy based on proper risk management and diversification.
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