The following piece from Yahoo! Finance (Michael Santoli) is making the rounds: A final purge to $700? What gold bulls' surrender might look like. It has a sexy title that draws forth the reader's curiosity and the piece does a decent job of summarizing the overall state of the gold market in a cogent and to the point manner. However, it was the following quote from BAML (Bank of America Merrill Lynch) investment strategist Michael Hartnett that got me thinking:
“A sudden gap lower in the gold price to below $1,000/oz. should coincide with the final thrust higher in stocks, both indicating capitulation of the ‘stubborn bears,’ the end of the ‘melt- up’ and the next opportunity to get tactically bearish. We increasingly fear next year’s highs in stocks come early.”
Such a scenario makes a lot of sense because the ultimate blow-off top in equities is likely to roughly coincide with an intermediate-to-longer term bottom in gold. The timing and exact sequencing of such a scenario is unknowable and will certainly unfold in the least predictable way possible. This brought to mind one of the oldest ratio charts of them all, the Dow Industrials/Gold chart - pulling out a monthly chart dating back to 1990 there is a lot of information to be gleaned:
Click to enlarge
The above chart offers a pretty standard pattern which we see regularly in individual equities; a large bull phase which concludes with an emotional, greed driven parabolic blow-off, followed by a brutal bear market decline which eventually erases the entire bull move. A bottom is formed over time and then one can typically expect a roughly 1/3 retracement of the decline (often times the 38.2% Fibonacci retracement comes into play) - in the case of the Dow/Gold chart we should anticipate a move back up to roughly the 20.0 ratio level:
The 20.0-21.0 area represents important support/resistance dating back to the 2002-2007 period and also happens to be the 38.2% retracement of the entire 1999-2011 decline. So how exactly will the Dow/Gold ratio get back up to 20? Your guess is as good as mine although a parabolic blow-off in US stocks pushing the Dow to 20,000 while simultaneously experiencing the final washout in gold down to roughly $1,000 would do the trick:
Dow Industrials (Monthly)
Dow 20,000 is only 13% above current levels. Such an advance could occur in the space of a month during a euphoric market blow-off phase....
Gold (Weekly)
Meanwhile gold continues to fumble around beneath the important $1180 level, and the longer this continues the more likely we are to get the next leg lower which, should it transpire, will likely target the $1044-$1053 area.
The problem with trying to 'game' this final phase of the equity bull cycle and gold bear cycle is that if history is any guide, the final 3-4 weeks will be extremely violent with highly elevated levels of volatility. Rick Rule, Chairman of Sprott U.S. Holdings had this to say about market capitulation events:
“Capitulation is a very dramatic event. It’s when most participants in the market give up completely and simultaneously. They are two or three week periods [of] extraordinary [share price] violence. They’re emotionally driven rather than arithmetically driven events."
In other words the US equity market top will occur when virtually every investor is convinced that stocks have further to run to the upside, and the gold market bottom will occur when every marginal holder of gold becomes convinced that the gold price has farther to fall. Both of these events might occur sooner than many expect.....
People don’t consider the possibility that a greed-driven minor downdraft is possible, and are gripped with fear of a major price calamity..
A close above 1188 after hours on options trading halt before their expiry on Tuesday says that competing interests in gold derivatives are jockeying for position for the end of the year.
Derivatives contracts opened in Dec. 2011 are set to expire next month.