Gold and silver futures finished on Friday at their lowest levels in six weeks.

At the same time, popular ETFs investing in mining stocks closed higher on the week. That’s prompting some analysts to predict that the longer-term pattern of miners outperforming metals might be returning.

“There seems to be a divergence taking place in which stocks have been overly punished and are poised to grind through summer with relative outperformance compared to metals,” said independent analyst Jordan Roy-Byrne in an interview.

Gold for August delivery finished down 1.3% at $1,482.60 an ounce on the Comex, the lowest ending price for a most-active contract since May 17. The contract fell 1.2% on the week.

The SPDR Gold ETF (GLD) finished off by 0.7% on Friday.

Silver for September delivery also fell to its lowest level since mid-May on Friday, dropping 3.2% to $33.705 an ounce. The iShares Silver ETF (SLV) fell 2.5%. The fund’s shares wound up with a 1.1% loss for the week.

The Market Vectors Gold Miners ETF (GDX) slumped 1.6% to $53.74 a share while the  Global X Silver Miners ETF (SIL) also fell 1.6% on the day.

GDX finished up 2.2% for the week and SIL closed ahead by 2.7%.

Optimism over Greece and a surprise rise in manufacturing took much of the attraction away from gold and silver as safe-haven trades, say analysts.

“Gold and silver were on the slide today as safe-haven investments were withdrawn,” traders at Sucden Financial wrote in a note.

Barclays Capital wrote that the yellow metal may slide as low as $1,460 to $1,470 before finding a base.

While agreeing that ETFs that buy metals and track spot prices might face tougher sledding in the short-term, Roy-Byrne says mining stocks are showing increasing relative strength.

Going forward, Roy-Byrne believes miners have confirmed  a bottom and are consolidating. For GDX, he see support at $52 a share with upper resistance at $55 a share.

“It’s a tight range, but we’re in the summer and there has been a lot of liquidation of precious metals holdings in the past six months,” said Roy-Byrne.  ”There’s not a lot of downside left over the next several months.”

Market professionals and experienced investors consider it to be common knowledge that silver has more real-world uses than its precious metal sister gold. Silver is used in coins, photography, batteries, bearings, electronics, and mirrors. Silver also aids in numerous medical applications and even contributes to helping capture and use solar energy. The Silver Institute describes “silver uses” as follows:

Demand for silver is built on three main pillars: industrial and decorative uses, photography, and jewelry & silverware. Together, these three categories represent more than 95 percent of annual silver consumption. In 2007, 455.5 million ounces of silver were used for industrial applications, while over 128 million ounces of silver were committed to the photographic sector, 163.4 million ounces were consumed in the jewelry market, and 58.8 million ounces were used in the silverware market.

Why is this indispensable metal in such demand? The reasons are simple. Silver has a number of unique properties including its strength, malleability and ductility, its electrical and thermal conductivity, its sensitivity to and high reflectance of light and the ability to endure extreme temperature ranges. Silver’s unique properties restrict its substitution in most applications.

While gold is used in numerous consumer products, such as in computers and electronics, according to geology.com about 78% of the gold consumed each year is used in the manufacture of jewelry. Investors also respect the use of gold as an alternative to paper currencies and as a safe haven asset.

The point is silver tends to be in greater demand relative to gold during economic expansions and bull markets. Gold tends to be in greater demand when concerns rise about economic downturns or geopolitical events. These basic investment tenants describe how stock investors can benefit from monitoring the gold/silver ratio, which is simply a study of the demand for gold relative to the demand for silver. Before looking at how the gold/silver ratio can help us better understand the threat of an ongoing correction in stocks, we will review recent historical cases that illustrate swings in relative demand for these precious metals.

According to a February 28 story in The Daily Reckoning:

The US Mint sold over 6.4 million silver Eagles in January, more than any other month since the coin’s introduction in 1986. China’s net imports of silver quadrupled in 2010, to 122.6 million ounces, roughly 13.7% of global production. Meanwhile, mine production can’t meet worldwide demand; the only way demand gets fulfilled is from scrap supply.

On March 10 we showed how defensive assets, such as the VIX and utilities, were gaining strength relative to the stock market. Just as the changes in relative strength can help us better understand a possible shift in market sentiment, the gold/silver ratio could be termed the “defensive/expansion ratio”. When investors are playing defense, the ratio rises since gold is in favor relative to silver. When investors are less concerned with Armageddon-like events and more focused on better economic times, the ratio falls since silver is in favor relative to gold.

In terms of where the economy sits right now, the Fed opened its March 15 statement with an upbeat tone:

Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually. Household spending and business investment in equipment and software continue to expand.

On March 15 we looked at the performance of numerous asset classes and market sectors under two scenarios – during the April-August 2010 ‘flash crash’ correction and during the subsequent QE2-induced rally off the August 2010 lows. Today we dig a little deeper into the data to help us better understand the risk of another prolonged correction occurring in the coming months. The table below shows how investments related to precious metals performed during a defensive/corrective period (left) and during a period where economic expansion/inflation-friendly assets were in favor (right). Investments related to precious metals are highlighted in green. Gold is represented by the gold ETF (GLD). Silver is represented by the silver ETF (SLV).

Just as we would have guessed, gold outperformed silver during the ‘flash crash’ correction by a margin of almost 2-to-1. Similarly, when market participants became less fearful and began to focus on economic growth and QE2, silver significantly outperformed gold in late 2010 and year-to-date.
The question of the day is:

What are silver and gold telling us now and how does it potentially impact the stock market?

The chart below shows a bullish turn in the gold/silver ratio that was “confirmed” by a higher high on April 27, 2010. Think of April 27 as a bullish turn in the defensive/expansion ratio, meaning defensive-minded investors overtook bullish investors in terms of their conviction.

As shown below, the stock market did not perform well after the bullish turn in the gold/silver ratio. Compare April 27 in the chart above to April 27 in the chart below.

The good news is the present day gold/silver ratio is not telling us to swap our silver and stocks for gold; at least not yet. The gold/silver ratio remains in a downtrend (pink line), which means the conviction of gold buyers has not yet surpassed the conviction of silver buyers. Said another way, the conviction of defensive-minded investors has not yet surpassed the conviction of economic bulls.

Three things need to happen from a technical perspective for gold to gain the upper hand on silver. The first one, breaking above the pink trendline, has not even occurred yet. It may indeed happen in short order, but for now the gold/silver ratio is terming the current state of the stock market as a “pullback”. It may indeed upgrade the classification to a “correction”, but relative to the events of 2010 we have not even met that standard yet.

In terms of our investment strategy, this analysis does not alleviate our concerns about Japan and the fast-approaching completion date for QE2. As we stated yesterday, this remains a ‘prove it to me’ market, meaning we have been and are open to raising more cash using the incremental approach. On Wednesday, we cut back further on gold stocks (GDX), Australia (EWA), Germany (EWG), and inverse-Treasury bonds (TBT). The current state of the gold/silver ratio does leave us open to better than expected outcomes over the next few weeks. Our short-term bull/bear checklist, based on the S&P 500, remains in the “be patient” range.

The CCM 80-20 Correction Index is telling us to remain defensive, but to also keep an open mind relative to where stocks may be in three-to-six months. In the tables below, high numbers indicate more favorable conditions in terms of historical risk vs. reward.

The figures in the tables are as of Wednesday’s market close. Notice the current risk reward numbers (top of table below in yellow and green) and are attractive relative to the market’s average and median profiles under various conditions.

The market’s current profile, from a positive perspective, means little unless we see evidence starting to accumulate which points to a probable change in the short-term trend. Said another way, until we see evidence to the contrary, we need to maintain a defensive bias. Once the evidence begins to shift, we have to look at the market objectively to make the best allocation decisions possible.

Source:Time to Trade Stocks and Silver for Gold?

Keep in mind that Gold is the type of asset class that performs best when its strongly outperforming the other asset classes. This seems like an obvious statement but it is an important one. If stocks or bonds are performing very well then money (usually mainstream) flows into those asset classes and not Gold. If conventional asset classes perform well, there is little reason for the masses to go into Gold.

In the chart below we show Gold against various asset classes. Gold has made a new high in nominal terms but hasn’t held it. One reason why could be the weak performance of Gold against stocks, currencies and commodities. In recent months, money has flowed into those markets and not Gold. Gold made marginal highs against both bonds, but with risk aversion increasing and a possible US Dollar rally, how long will that last?

Gold’s real performance is mixed which suggests a sustained breakout in nominal terms is unlikely at present. Gold has started to outperform stocks and commodities and we expect that to continue. However, there is a clear divergence with Gold priced in other currencies, which suggests that recent US Dollar weakness has buoyed Gold. While struggling, the US Dollar has yet to break support. Sentimentrader.com’s public opinion is only 31% bulls for the US Dollar.

When many markets are in flux as is the current situation, intermarket analysis becomes all the more important. Comparing markets against each other helps us decipher the leaders, the winners and the laggards. The current picture for Gold is mixed but could become more clear if/when the greenback confirms its bottom. We would welcome that as it would clear out the last of the weak hands and position Gold ready to move higher.

These are difficult times. When trends are shifting or changing we need to analyze various markets and asset classes to get a better handle on what is going on. This analysis allowed us to foresee the lack of a true breakout in Gold and gold shares while the gold permabulls cheer-leaded onward. If you are looking for more professional guidance to help you ride this bull market, then consider a free 14-day trial to our premium service.

Good Luck!

Jordan Roy-Byrne, CMT
Jordan@TheDailyGold.com
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US stocks are only following the same pattern they’ve followed in the last three bear markets. The midpoint crash (1907, 1937, 1974, 2008) gave way to a furious rebound in each case. Following 1937, the market retraced 62% of its losses. Following 1907 and 1974, the market peaked three and a half years later after retracing roughly 95% of the losses. Three and a half years and a 95% retracement equates to the S&P 500 peaking at 1500 in April of this year.

Before you assume I’m a permabear gold-bug, take a look back to an article from February 2009. With the S&P 500 at 764, I called for a 15% decline before the market bottoms and rallies for months and significantly in percentage terms. In our 2011 Market Outlook we called for the market to peak in April or May possibly as high as 1500.

That forecast is on track as the market gains momentum yet as bearish forces quietly accumulate. We’ll start with sentiment.

The following chart is from data from a Bank of America Merrill Lynch survey of asset managers and hedge funds who cumulatively manage nearly $1 Trillion. The data shows what percentage are overweight or underweight US equities. The percentage of managers overweight US equities has soared in recent months and is basically at a 10-year high.

Here are two more charts courtesy of the Short Side of Long. The data is from the AAII and Investors Intelligence.

The 12 week-MA of the bullish sentiment is well north of peaks in the past five years.

The 12-week MA of Investors Intelligence bulls is at its highest level since January 2007. There is good chance it will surpass the 2007 level in the coming weeks.

This growing bullish sentiment will coincide with the S&P 500 hitting major multi-year resistance. Excessive bullish sentiment coupled with multi-year resistance is not exactly a recipe for a major breakout. It’s a recipe for the end to this cyclical bull market.

Moreover, as we’ve noted time and time again, the factors that will cause stocks to reverse are the same factors that will propel Precious Metals into the early stages of a bubble. Increased monetization will be required as interest rates begin to rise and as the economy fails to grow fast enough to mitigate the debt burden. New debts and the rollover of old debts will be financed at higher rates, thereby increasing the debt burden which in turn, impacts the governments ability to juice the economy.

Higher rates won’t be good for stocks and higher rates won’t mitigate inflation or inflation expectations. The reason being, when you have a super high debt load (as most Western nations do) higher rates only exacerbate the debt burden. It will force local, state and the federal government to cut back, which has an impact on GDP. Higher inflation will also cut into corporate margins. We are expecting a mild bear market and not the 40%+ decline we’ve seen recently.

Moving along to Gold, we see a lack of interest in the market yet it is currently only 3% from its all time high.

Sentimentrader.com, a great website that tracks sentiment for various markets said this about Gold:

The pullback in gold has generated a ton of media attention, and that has impacted sentiment among Rydex traders, futures traders and the public in general, all of which are showing at least modestly extreme pessimism toward the metal.  Overall, sentiment has become its least optimistic in gold in over two years.

Furthermore, a survey of wealth managers in Canada showed only 33% of advisers as bullish on Gold. That figure was 64% as recently as Q4 2010.

This doesn’t mean Gold will immediately soar. More so, it tells us that Gold’s downside is limited as sentiment has shifted significantly.

With stocks nearing major resistance carrying excessive bullish sentiment and Gold’s downside limited, let’s take a look at the Gold/S&P 500 chart. The 2009-2010 price action has some similarities to the 2006-2007 price action. The chart shows that this is likely a good time to increase positions in Gold and reduce positions in stocks.

After all the bubble bursts of the past decade, everyone wants to be a contrarian. If you are a regular Joe investor, now is your opportunity to be a contrarian and look smart in a few years. Mainstream managers now feel vindicated and feel a chance to promote stocks again. Don’t make the mistake many have already made twice. I’m writing this for the mainstream investor and the retirement investor because I don’t want to see them get sucked back into the market at the wrong time courtesy of asset managers who will find any reason to promote stocks.

Meanwhile, Gold is providing an excellent opportunity. Its holding up well while the focus is currently elsewhere. The hot money is out of Gold, yet its only 3% off its highs. In the long run, that is scary bullish. In the coming months look for stocks to peak and for Gold to regain its leadership. If you’d like to learn more about how you can profit from the Gold bull market then consider a free 14-day trial to our premium service.

Jordan Roy-Byrne, CMT
Jordan@TheDailyGold.com
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Currently, stocks are performing well as are commodities led by energy. As a result, some investors feel they won’t need to invest in Gold if the “conventional” options are performing well. I expect this to continue in the early part of Q1 in 2011. This is partly why the precious metals complex is consolidating or correcting.

Interestingly, stocks and commodities have continued higher and higher making new recovery highs. Precious metals on the other hand, diverged and experienced a routine but significant correction. Gold has underperformed for months. We believe this is a healthy divergence which could be the very beginning of something important.

Bears and deflationists like to champion the “all one market” theory. While this can be true from time to time, it is incorrect in the larger picture. First of all, since 2000 stocks are in the red while Precious Metals (2nd row in chart) and Commodities (bottom row) are significantly higher. Moreover, check the performance during each bear market in stocks. Precious Metals gained during both bear markets!

Thus far, stocks are actually following our forecast. We are looking for sizeable gains but a peak in April/May. Higher interest rates and inflationary pressures will cause a mild bear market similar to what we experienced in the late 1970s and from 1910-1914.

We’ve written often about the implications of higher interest rates. A highly indebted nation that is already monetizing debt can ill afford higher rates. That produces higher costs of servicing old debts and higher costs of financing new debt (deficits).

The chart below shows the 30-year Treasury Bond. The market is breaking down and is likely to test support at 115. The good news is that the bullish consensus was recently 20%, which means there are too many bears and bonds should bounce. However, the market is now below the long-term moving averages and dangerously close to breaking to multi-year lows sometime in 2011.

A breakdown in Treasuries means higher interest rates across the entire spectrum. This means higher borrowing costs for homebuyers, homeowners, corporations and Uncle Sam. Increased monetization from the Federal Reserve will put upward pressure on input costs for most corporations. As a result will we see a mild bear market in stocks with continued inflationary pressures. The factors that will cause the new bear market in stocks and bonds, are the same factors which will drive an acceleration in Precious Metals.

With stocks and bonds in a bear market, your friendly neighborhood investment professional and his ilk will have nowhere to turn but to Precious Metals and hard assets. You see, until what will be a few months in the future, there were other options (aside from Precious Metals). Treasuries performed well from 2000-2003 and from 2007-2008. Stocks performed well from 2003-2007 and from 2009-2010. This is why even 11 years into a bull market, the global allocation to Gold is only 1%.

Fear not fellow gold bug! Our time is coming. Three to six months from now, bonds and stocks will be in a simultaneous bear market for the first time since the late 1970s. Yet, this time around the fundamentals for Precious Metals are even more powerful and sustainable. Even those who trumpet the “stocks are an inflation hedge” argument will be forced to chase performance in the coming bubble and mania in precious metals.

In the meantime, speculators and investors are best advised to do their due diligence in order to uncover the value and growth plays in the junior mining sector which may explode in the coming years. We certainly are for our subscribers.

Good Luck!

Jordan Roy-Byrne, CMT
Jordan@TheDailyGold.com
Subscription Service

Controlled markets in which price does not equilibrate supply and demand are often characterized by shortages. When this happens in gold market, it’s called “tightness” rather than shortages. It sounds better.

The tightness in gold is revealed by the growing spread between physical and paper gold. This is revealed in the chart below. The tightness becomes statistically significant when spread exceeds two deviations. The spread currently stands at 1.73. Physical relentless push since October 2010 and the spread’s stickiness during the paper operation have to be raising some eyebrows.

Gold London PM Fixed and Gold ETF (GLD) Ratio:

Headline: PRECIOUS METALS: Gold Rises In Asia; Physical Market Tight

Gold and silver were both up in Asia Tuesday as sentiment started to firm after repeated tests of technical support in recent sessions.

Indications from the physical market in Asia point to continued strong demand, while gold is likely to benefit from any intensification of the euro-zone sovereign debt crisis.
Mitsui Global Precious Metals said the “physical market will be tight for a while,” sentiment echoed by the Perth Mint, which told Dow Jones Newswires that physical gold demand from Asia exceeded its current ability to supply.

“There are signs that buyers are entering the frame once again,” Triland said in a note.

Source: online.wsj.com

Source: The Gold Market Is ‘Tight’

Gold 4 Hour Chart
As you can see from the chart below gold has formed a possible double top. The fact that it made a higher high is actually a bearish sign for the intermediate term 1-3 weeks. When we see a higher high getting sold into with big volume it typically means the big money is unloading large positions into the surge of breakout traders and short covering that occurs when a new high is reached. Following the big money is very important to keep an eye on as it can warn us of possible trend changes before it occurs.

The current selling volume is not exactly a healthy sign if you are looking for higher prices in the near term. If this pattern breaks down I would expect $1340 to be reached very quickly.

Keep in mind gold it in a strong up trend still. Shorting is not the best play in my opinion. I prefer to see pullback which washes the market of weak positions then jump on the long side for another bounce/rally.

SP500 Market Internal Strength – 10min, 3 days chart
I watch these charts to get a feel for the overall market strength on a short term basis. The top chart shows the SPY etf breaking above a resistance trend line on Friday afternoon. This occurred on light volume meaning it is mostly likely a false breakout and Monday we could see a gap lower at the open or a pop & drop. The two other indicators are reaching an extreme level which normally tells us a pullback is due in the next 24-48 hours of trading. The question is, will us just be a bull market pause or will we get a decent pullback.

The red indicator in the top chart and the red indicator levels on the charts below that help us time the market as to when profits should be taken or to tighten our stops if we have any long positions.

The broad market is still in a very strong uptrend so moving stops up and buying on oversold dips is the way to play it.

Weekend Market Analysis Conclusion:
In short, both gold and the stock market are in a bull market (uptrend). Trying to pick a top to short the market is not a good idea. Instead I am looking for an extreme oversold condition to help reduce downside risk before taking a long position.

The overall strength of the market (SP500 and Gold) I think are starting to weaken but in no way am I going to short them. We continue to buy dips until proven wrong because indicators can stay in the extreme overbought levels for a long period of time. Generally the biggest moves happen in the last 10-20% of the trend.

If you would like to get these weekly reports and my trading tips book free be sure to visit my website: www.thegoldandoilguy.com/trade-money-emotions.php

Before you all rush to berate me for saying gold may go through a mild correction, read this paragraph before you take my work and my name through the proverbial mud . . . AGAIN. Before discussing why gold may go through a short-term correction, I would point out that in the long term I believe gold is in a secular uptrend that could last much longer than many market pundits or traders might prognosticate.

I do not hold myself out to be an economist, but it appears to me that there are several catalysts looking towards the future that likely will give gold a boost. Unfortunately, the reasons gold could continue rallying are not economically pleasant and certainly not exciting to discuss as by now they have been beaten into our psyches. Instead of pounding the table about all of the various reasons investors should own gold, I am going to focus on a potential opportunity to buy gold at lower prices.

Based on a variety of technical indicators and analysis paired with some fundamental opinions, a trader could make the case that gold is in need of a downward price correction. Gold has been purchased with strong volume for more than a year as a result of several reasons. When looking at a weekly chart of the gold ETF GLD it becomes apparent that the shiny metal is overbought and in need of a pullback, or at a minimum some healthy consolidation.

As can be seen above, gold remains in a strong uptrend and price is well above the 50 period moving average. In fact, the 50 period moving average on the weekly GLD chart has not been tested since April of 2009. The long term trend remains bullish, but as stated above stated above not needed here a pullback is possible.

If we take a look at the GLD daily chart we notice the same long term uptrend that that is needless here we witnessed when looking at the weekly chart. In contrast the daily chart does show potentially bearish formations beginning to work. While the bearish formations patterns, too close previous use of formations may fail or may turn out to be totally false why totally, just use false, it is strong enough on its own based on future price action, at this point a double top formation is possible as is a head and shoulders pattern. This is not to say that GLD cannot grind higher because the weekly chart looks quite strong, but the daily chart is at least posting a warning that lower prices or at least a period of consolidation may be coming to fruition in the not-so-distant future.

While I am expecting a meaningful pullback or correction at some point, I do not believe that gold is going to crash lower. In fact, I am viewing the possible correction in gold as an excellent potential long entry. Clearly traders could look to purchase GLD around the 50 period moving average on the daily chart ($133.06) and then add to the position if the neckline is tested. I do not believe that price will get to the neckline, but if it does I expect that level to hold and a new rally to take shape. Until gold gets below the 50 period moving average on the weekly chart, it remains in a technically constructive uptrend.

There are a variety of ways to purchase GLD if an equity trader wanted to leg into the trade at a variety of price targets. One strategy would be to simply accumulate partial positions at predetermined price targets. When considering entering a longer term position, investors and traders should formulate a plan and then trade that plan. Through the use of a trading plan, the trader can remove emotion from the subsequent purchase(s) while managing risk.

For those who would like to use options to acquire GLD common stock, the easiest strategy would be to sell cash secured naked puts. Secured naked puts do not require significant option trading experience and most option brokers will allow relatively inexperienced option traders to use this strategy. Each option contract represents 100 shares of GLD, so the trader sets aside a portion of his trading capital to purchase 100 shares of the underlying.

As a basic example, if a trader sold a cash secured January 133 put the trader would be required to have the appropriate cash in the account to purchase 100 shares of GLD at $133/share. So in order to have the put totally secured, the trader in this example would need $13,300 to fulfill the required capital obligation. For a more speculative trader that was looking to collect option premium based solely on time decay (Theta) and had no intention of owning common stock, margin encumbrance would be required. Most option brokers will demand that option traders be able to post 15-20% of the total obligation (Reg T) and will allow more experienced option traders to use margin in order to cover the remaining portion. Traders using portfolio margin can use this strategy to add income to their portfolio without tying up a significant portion of their trading capital.

Based on the weekly chart listed above, the target support areas are around $133/share and $130/share respectively. We will assume the trader wanted to purchase 100 shares at each price point. The trader in this example could sell 1 GLD January 133 Put and 1 GLD January 130 Put. Based on current prices, the trader would receive a credit of $235 for the GLD January 133 Put and a credit of $139 for the GLD January 130 put. Total credit on this trade would be around $374 not including commissions. If GLD does not sell off and continues to rally, the trader has the potential to collect a large portion of option premium from the two cash secured puts that he sold. In this case, the maximum gain would be the total credit received of $374 at expiration if the trader did not get assigned GLD common stock.

It is critically important to understand that there is significant risk in this trade as the theoretical loss would be over $26,000 assuming that GLD were to go to 0 and the trader did not close out the position. Clearly gold is not likely to be worthless, and the odds of losing $26,000 are slim to none however it is theoretically possible. If the trader in the example gets assigned the stock he still gets to keep the option premium for which he sold the puts for which was $374. Since he was purchasing 200 shares of GLD, his total cost would be reduced by $1.87 a share (374 / 200 = 1.87). The average price he would pay for 200 shares of stock would be $131.50/share (133+130 / 2 = 131.50), thus his actual price per share would be $129.63 (131.50 – 1.87 = 129.63).

The profit engine for the naked puts is time decay (Theta). Volatility and price risk exist and would become reality if a massive overnight sell off in gold took place. However, if the trade operated as is custom in traditional market conditions the option trader in this case either will earn a portion or potentially all of the premium he received for selling the puts or he will be assigned 200 shares of GLD with a total basis of $129.63. If the trader wishes to own 200 shares of GLD and has the capital to purchase the common stock, this is an excellent way to develop a trading plan that takes advantage of support levels and remains profitable if GLD continues higher.

If you would like to receive my Free Options Strategy Guide & Trade Ideas join my free newsletter: http://www.OptionsTradingSignals.com/profitable-options-solutions.php

J.W Jones

This essay is based on the Premium Update posted on December 10th, 2010

We picked up the Asian addition of The Wall Street Journal this week and on the back page was an article titled “China reveals Huge Appetite for Gold.” The article states: Gold’s record rally has been attributed to everything from worries about inflation, the dollar and the emergence of exchange-traded funds. One big factor many may have missed: huge buying from China.

We haven’t missed it. We have been writing about the rising Chinese demand for gold in many previous updates.

It used to be that America was the New World and Europe was Old. Now they both look frayed around the edges and the New World label seems to belong to China and other emerging market economies. This new growth has been accompanied by a voracious appetite for the yellow metal.      

Data cited last week by China’s state-run Xinhua news agency showed that China imported 209.7 metric tons of gold in the first 10 months of the year, a fivefold increase compared with the same period last year. This is interesting. China is now the world’s biggest producer of gold and consumes all its own production. China’s booming mining industry produced 277 metric tons of gold so far this year, up 8.8% from the same period last year. This means that in addition to buying up everything from local production, they are also importing a hefty chunk for a total of at least 486 metric tons so far. Without a doubt, a good portion of this gold is finding its way into the vaults of the People’s Bank of China gold reserves. Keep in mind that in April 2009 the People’s Bank of China announced that it had added 400 tons to its reserves for a total of 1,054 metric tons making China the world’s fifth-largest holder of gold, just ahead of Switzerland, and among the six nations plus the International Monetary Fund that have reserves of more than 1,000 metric tons.

Over the past several years, China’s money supply expanded by over 50%, due to a massive lending boom that helped generate record GDP growth. That boils down to a lot renminbis searching for somewhere to go. The Chinese are just as worried about inflation and the erosion of the value of paper money as the rest of us. They have been looking for tangible safe investments in which to park their cash. Their problem is that as individuals they are limited in where they can invest. Capital controls restrict investment opportunities for individuals abroad. In China they can place it in a standard bank account and receive a negative rate of return, given an inflation rate running at about 3%. They can also invest in the stock market, but Chinese equities are much more volatile than those in developed markets, so that carries some risk. That leaves real estate, gold and other tangible assets.

Two things happened at about the same time recently. On the one hand the real estate market was beginning to look like a bubble and the government made all out efforts to slow it down, and on the other hand, the gold market opened up for Chinese citizens.

The WSJ notes that up until a few years ago China’s gold market was strictly controlled by the central bank, which bought all the gold mined domestically and then sold it to jewelry makers. Recently, the government loosened restrictions on buying, both by individual and institutional investors. Just this August China began allowing more banks to import and export gold, opening up the gold market to the institutions and their clients. Last week the Chinese approved the country’s first gold fund designed to invest in overseas listed gold ETFs. This year many Chinese investors added gold to their portfolio and at the Shanghai Gold Exchange, trading volume rose 43% to 5,014 tons in the first 10 months of 2010.

The major trends in any market are caused by changes in the fundamentals, and since we have just seen an improvement in the latter, let’s see if the long-term charts reflect that (charts courtesy by http://stockcharts.com.)

They do. The very-long-term chart that you can see above features the ratio of gold to corporate bonds. Here, we clearly see the distinction between long-term consolidation and long-term rallies. Once a consolidation has concluded, the breakout is generally quick and sharp to the upside. Of course, the rallies in the ratio correspond to the major rallies in gold itself, which is why it is important to analyze it today. We have seen the aforementioned rallies on two occasions both in 2005-2006 and again in 2007-2008.

Based on prior trends, if this ratio breaks out above the resistance line, a bigger rally is likely to be seen. It appears that we are in such a situation today. There is a strong likelihood that once the consolidation is over gold may very well rise to the $1,600 level.

Whether or not it’s going to take place right away is a different story. Please take a look below for details.

Zooming in slightly provides us with an estimate of the probable downside target level if the decline is to continue. Based on recent price movement and historical trends, a decline here could possibly be seen to the $128 level. This would correspond to a spot gold price close to the $1,300 level.

Zooming further allows us to see that several support levels have together stopped a recent decline. This could be interesting phenomenon to those, who still doubt the usefulness of the analysis charts from the technical perspective. Volume levels have been higher on the downside and since the recent decline was quite small, it seems appropriate to wait for additional signals before any bullish sentiment surfaces.

There’s more to the analysis of volume than the above statement (available in the full version of this essay), but the main point remains unchanged. Meanwhile, let’s move to the analysis of the ratio that should be included in the arsenal of every Gold and Silver Trader – specifically because of its accuracy in predicting local tops.

The GDX:SPY is a measure of mining stocks performance relative to all other stocks. We have previously discussed the unique single spike in volume signal as one, which has been extremely reliable in finding local tops in the past. In last week’s Premium Update, we wrote about not seeing the single spike in this ratio. It did not appear that the local top was in. Soon after that, however, such a spike in volume was indeed seen, and a local top emerged.

Volume levels have been emphasized in the above chart. The high volume levels, which are noted by arrows, are very closely aligned with local tops. This is a clear indication of the importance of volume levels analysis with respect to prices. The suggestion here is for further weakness in the near-term.

Summing up, the major trend appears to be up, and it may not be long before the massive rally resumes. Still, in the short run, a corrective phase is still not out of the question. Should it materialize, it should be viewed as an opportunity to add to one’s gold and silver investments.

To make sure that you are notified once the new features are implemented, and get immediate access to my free thoughts on the market, including information not available publicly, I urge you to sign up for my free e-mail list. Sign up today and you’ll also get free, 7-day access to the Premium Sections on my website, including valuable tools and charts dedicated to serious PM Investors and Speculators. It’s free and you may unsubscribe at any time.

Thank you for reading. Have a great and profitable week!

P. Radomski
Editor
www.SunshineProfits.com

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