3 Critical Forces in Assessing Gold

03/03/2017 7:00 am EST

Focus: COMMODITIES

Landon Whaley

Editor, Focus Market Trader

Context is everything in life, and the same is true in markets. The more our world moves towards boiling everything down to 140 characters or a 10-second Snapchat, the more easily an event's context is lost or ignored, cautions Landon Whaley, CEO of Whaley Capital Group and editor of The Whaley Report.

When it comes to markets, understanding the current context of price action is crucial. It's the difference between successful investing and undergoing investing death by a thousand cuts because you're constantly on the wrong side of market moves.

What is the context of the recent gold price rally? To understand the context of any market's behavior, I rely on my Gravitational Framework to understand the three most critical forces, or gravities, that impact asset prices: fundamental, quantitative and behavioral.

Despite its price ascent this year, gold's gravities are decidedly bearish.

Fundamental Gravity: Bearish

U.S. economic growth accelerated for the last six months of 2016, and that streak continues. January's retail sales data were the latest in a growing number of economic data points showing that U.S. growth has improved for the seventh straight month.

The most important aspect of the monthly retail sales report is the trend in annual growth of the "control group," which accelerated from 3.4% in December to 4.0% in January. The control group's sales number is critical because it's used in the official calculation of GDP.

January's sales were a strong start to the year; they imply that consumer demand is markedly improving, and support surveys showing massive improvement in consumer confidence since the election.

People are putting their money where their confidence is, and it's bullish for the U.S. economy, and therefore bearish for gold.

Quantitative Gravity: Bearish

I track a number of quantitative factors to help me time my trades. One of the most critical aspects of a market's Quantitative Gravity is its correlation, or relationship, with other markets.

Historically, gold has had a negative relationship 89% of the time with the greenback and 75% of the time with U.S. yields. This means gold mostly moves in the opposite direction of these two markets.

This spells trouble for gold, because right now U.S. growth and Fed policy are putting a solid tailwind behind both markets.

Behavioral Gravity: Bearish

Our Behavioral Gravity Index (BGI) is made up of multiple components designed to help me quantify investors' perspective on a market. Gold's BGI is indicating that investors agree with me and are leaning bearish, but that they aren't bearish enough.

One component of gold's BGI is the speculative positioning in gold futures markets. As of last week, investors were SHORT $12B worth of gold futures contracts. But they could add an additional $5B in SHORT exposure before gold's BGI would register an extreme reading and thereby indicate a need for caution.

The Bottom Line

As long as U.S. growth continues to accelerate, the U.S. dollar remains above $97, and 10-year Treasury yields remain above 2.238%, then gold will touch $1,124 (a 10.8% decline from the present) before it closes decisively above $1,310 (3.9% higher than now).

The reward-to-risk ratio is almost 3-to-1 in favor of the downside. Gold's 9.4% rally to start the year has only improved the conditions for a SHORT trade. That my friends, is context.

The Trade Idea

My preferred way to trade gold is through Market Vectors Gold Miners ETF (GDX) because it is a leveraged play on gold.

I would SHORT GDX up to the $25.80 level.  If you initiate the trade, I would use a risk price that is $1.25 above your entry price.

There are three possible profit targets for this trade : $23.00, $21.50 and $19.20. There is a ton of support around $23.00; if GDX breaks below that price for three consecutive days then I would make that figure your new risk price for the remainder of the trade.

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