Adam Hamilton February 22, 2013 2879 Words
Gold got crushed this week in what can only be described as a capitulation. Cascading selling took on a life of its own as the yellow metal knifed through multiple key support lines. Newsflow exacerbated gold’s free fall, as extreme fear tainted everything with a heavy pall of bearishness. Gold bears were euphoric, coming out in droves to pronounce doom on the metal. But capitulations are actually very bullish events.
Capitulation is one of the ugliest words in the markets, it means surrender. Most of us are taught from a very young age to never give up, never stop striving. So traders are loath to admit they succumbed to a capitulation. Rather than acknowledging they gave into their own fears to sell low at the worst possible time, they try and rationalize their failing. They have to believe the capitulation marks the start of selling.
But that’s not the way capitulations work. These sharp selloffs sparked by extreme unsustainable fear always emerge at the very ends of long demoralizing selloffs. They actually signal the climax of fear, the moment of peak psychological pain. These cascading plunges shake out all the weak hands, the traders who haven’t mastered their own emotions. Only hardcore fundamentally-oriented contrarian traders resist the fear.
Resisting capitulations is an acquired ability. Newer traders, or at least traders new to a capitulating sector, are the most likely to yield to the emotional pressure to panic. The longer you trade, the easier it becomes to identify capitulations in real-time and know from experience that they will soon pass. The very hours where things look and feel the worst, utterly miserable, signal the end of the capitulation.
Provocatively, this week’s gold capitulation was actually pretty mild in capitulation terms. By Wednesday, this metal had been pummeled 4.3% lower over 3 trading days. During gold’s entire secular bull that was born a dozen years ago in April 2001, there have actually been 12 single trading days where gold lost more than 4%! 6 of these occurred during late 2008’s epic stock panic, leaving 6 in “normal” conditions.
So on average over this secular gold bull, we’ve had to weather a capitulation at least once every couple years. And some have made this week’s look trivial. Back in late September 2011 for example, gold plummeted 9.0% over 3 trading days when the Fed failed to launch QE3 as traders were hoping. Yet like all capitulations, that extreme fear was actually very bullish. Just 6 weeks later gold was 10.7% higher.
Capitulations are purely emotional events, fundamentals never have anything to do with them. A series of news items galvanize a bright fear flare-up late in a long vexing selloff. The resulting fear surges out of control and feeds on itself, spawning a short-lived panic-like rush for the exits. As battle-hardened gold traders know, some Fed news is usually the catalyst that sparks the final capitulation selling climax.
That was the case this week too of course. The markets were nervously awaiting the Federal Reserve’s Federal Open Market Committee minutes from its latest meeting at the end of January. Gold traders in particular were concerned about whether the Fed would signal that its QE3 debt-monetization campaign might conclude sooner rather than later. Those minutes indeed proved to be the capitulation spark.
But a spark alone is not enough to ignite a capitulation. It needs to land in a tinderbox-dry sentiment wasteland where anxiety already runs high. Similar FOMC minutes were released back in early January from its previous meeting. They were also interpreted as indicating the QE3 inflation wouldn’t last as long as gold traders expected. Yet gold’s single-day and 3-day selloffs then were only half what we saw this week.
The fuel for gold’s latest capitulation came from its poor performance in recent weeks and months. While each individual weak day for gold was driven by its own unique factors, there was one overlying dominant thread. The surging US stock markets. As the flagship S&P 500 stock index (SPX) powered higher, traders had little interest in alternative investments like gold. The thriving conventional ones stole all the limelight.
While gold is the ultimate alternative investment, the general stock markets are the ultimate conventional one. This chart looks at gold versus the SPX over the past year or so. Before November 2012, gold and the SPX were actually enjoying a moderate positive correlation. Both gold and stocks benefitted from capital inflows at the same times, often rising in unison. And they tended to sell off simultaneously as well.
This was the old “risk-on risk-off” dynamic that has dominated the global markets in the years since 2008’s once-in-a-lifetime stock panic. When traders were feeling better about things, they bought everything. When they were feeling worse, they sold everything. Thus gold and the SPX each surged dramatically in September when both the ECB and Fed announced major new monetization campaigns.
But in November this correlation started to reverse, initially driven by the US elections. When Obama won, the stock markets sold off sharply while gold surged. His victory heralded four more years of extreme record overspending, deficits, and debt growth, which the Fed would have to monetize so interest rates don’t mean-revert to much-higher normal levels. But this truth was soon overshadowed.
After falling to oversold levels by mid-November, the SPX bounced as expected. But after its initial momentum soon bled off, it kept on climbing with usually-small daily gains. While the up days were minor, there were few down days. So complacency quickly overpowered early November’s fear. Despite the coming record tax hikes the fiscal cliff threatened, the stock markets kept on inexorably melting up.
The higher they climbed, the more enamored investors became with them and the more alternative investments fell out of favor. This dynamic was compounded by fund selling. As high-income investors feared the massive tax hikes targeting them, they started to realize gains to lock in 2012’s tax rates. They put in redemption requests to funds, and the funds had to sell something in order to raise this cash.
Some chose gold, their most liquid asset. So this metal took a sizable hit in late November and mid-December. That selloff, which I explained in far greater detail in our newsletters, started molding gold’s sentiment environment into this week’s capitulation-ready one. After that gold quickly stabilized, actually advancing on balance between late December and early February. Its young upleg remained intact.
But late last week, gold started to break down again as the SPX continued to claw to a seemingly endless series of new cyclical-bull highs. Trading volume was light as most Asians were on week-long market holidays for Lunar New Year celebrations. So American shorts took the opportunity to launch a bear raid, to sell gold aggressively at a time when the world wasn’t paying attention. So gold started sinking lower.
Once again there was a bearish rationalization for every individual down day, which I will detail in our newsletters. But the net result was gold started breaking key technical levels. First its young upleg’s support failed, along with its critical 200-day moving average. With each additional technical breakdown, fear and anxiety grew. So by this Wednesday’s FOMC minutes’ release, sentiment was ripe for a spark.
As gold plunged below $1600 that morning on traders’ anxiety about what the minutes would reveal, that was the last straw for many remaining bulls. They had reached the limits of what they could bear, so they sold aggressively. And naturally selling begets selling. The more sellers pile in, the lower prices go which scares in a whole new round of sellers. And this self-feeding cycle cascades into a capitulation.
The climaxing day of any capitulation marks peak bearishness, when everyone is utterly convinced the falling price will keep selling off indefinitely. And indeed on Wednesday, we saw a rash of hyper-bearish predictions for gold. Many analysts claimed its secular bull was ending. I had to chuckle at that, as its latest interim high was 18 months earlier in August 2011. Highs are when to be bearish, not new lows!
This week’s capitulation was the end result of a multi-month decay process that began with alternative investments falling out of favor in November. Remember that gold and the SPX had a 0.55 positive correlation between January and October 2012. From November to this week, that reversed totally to a much stronger 0.74 negative correlation! The levitating stock markets’ melt-up rally really weighed on gold sentiment.
That alone is a very bullish omen. The general stock markets are topping, due to roll over into a new cyclical bear. The SPX’s cyclical bull that began in March 2009 is long in the tooth. As of this week it had powered 126.3% higher over 47 months, far bigger and longer than the mid-secular-bear cyclical-bull average of a doubling over 35 months. And complacency is off the charts, the primary topping indicator.
So the probabilities overwhelmingly favor a major selloff in the stock markets, likely a new cyclical bear that will cut the SPX in half over a couple years. Just as alternative investments fall out of favor when stock bulls top, they regain favor in a big way as stock bears deepen. This dynamic is certainly very bullish for gold today, which has been a proven performer in this secular stock bear’s past cyclical bears.
But even without the prospects for a new stock bear, gold’s technicals still look very bullish despite this week’s capitulation. In the chart above note that gold has been consolidating high, trading in a range between roughly $1550 and $1775. Despite all the technical carnage this week, gold still remains above its longstanding consolidation support! From these same levels last summer, a major rally was born.
I’ve been studying and trading the markets for decades, and I would love to be able to predict capitulations. Seeing them coming would make trading a lot easier. Normally you want to buy low late in a correction, and the majority of corrections don’t end in capitulations. But for the exceptions that do, the absolute best time to buy is that very capitulation day. As fear peaks, prices are at their cheapest.
But unfortunately capitulations are inherently unpredictable. Much of the time a long demoralizing selloff necessary to fuel a capitulation doesn’t experience a proper spark before the next upleg begins. So if you waited for a capitulation that never came before buying, you’d miss the low prices. Each capitulation requires a complex intertwined mix of events, technicals, and sentiment that are unique to that time.
So the only rational strategy for bulls is to buy cheap late in corrections without waiting for capitulations that usually don’t come. But when they do, simply steel yourself and weather the brief plunge. They are a great test of your contrarian mettle, separating those who can really walk the walk from those who merely talk the talk. If gold looks like a bargain before a capitulation, it is far more attractive after one.
Last week before all this unfolded, I wrote an essay on gold’s young upleg. In it I made the bullish case with the technicals at the time that gold was due to surge. I still believe this is true, as the capitulation since was an extreme emotional anomaly that has already passed. While it did damage technicals, it doesn’t change the bullish thesis on gold one bit. Here’s an update of last week’s chart, post-selloff.
For a full explanation of this chart and its implications pre-capitulation, read last week’s essay. Today I want to focus on the new technical picture gold’s latest capitulation created. It hammered the metal down to a new upleg support line labeled Support 3 above. Yes, gold’s young upleg is still intact albeit uglier. It began in mid-May at $1538. As Wednesday’s capitulation climaxed, gold was still 1.7% higher at $1565.
Whenever a major support line breaks like happened to Support 2 this past week, some traders freak out. It is never fun to be long something expecting it to head higher and then see the bottom fall out technically. But realize technical analysis is a dynamic process, the best-fit lines are constantly evolving as new price data flows in. Actually Support 1 was this upleg’s initial support, not last week’s Support 2.
As long as gold remains above its mid-May low that birthed this upleg, it remains alive and well regardless of where support lines are drawn. Typically fast capitulation-like selloffs quickly reverse, as the extreme fear triggers short covering which generates a sharp V-bounce higher. So if we only stay under $1600 for a few days, Support 3 will be redrawn at a steeper ascent. Temporary breakdowns are considered extra-trend anomalies.
But what if gold keeps heading lower? What if it breaches its May lows? In that case, what looked like a mid-upleg pullback within an ongoing upleg between October and February will simply be recast as a correction between uplegs. Gold will still be in its high consolidation that began in mid-2011, poised for a major new upleg on wildly oversold technicals and bullish fundamentals. Just like it was last summer.
Support and resistance lines are subjective, drawn manually by each analyst as best-fit lines between price limits. They continually evolve and change on a monthly, if not weekly, basis as prices meander up and down. Technical analysis only works because so many traders choose to buy and sell based on it. But since it is subjective and always changing, there’s no sense getting worked up over broken support.
Also realize that bearishness peaks with fear during capitulations. So it is perfectly normal to see nothing but bearish predictions during and after a capitulation selloff. We humans have the natural tendency to extrapolate the present into the indefinite future. So when prices are falling, we assume they are going to keep falling. So we rationalize our outlook, selectively look for arguments to support our emotional bias.
Just after a capitulation, almost all commentary is bearish. It varies from the end-of-the-bull arguments to merely further downside. Even the less-bearish end of this spectrum is dominated by views looking for the falling price to keep trending a little lower before it bounces. Analysts and traders never like to call bottoms because it makes them stick out from the herd, leaving them with the risk of being proven wrong.
But contrarians don’t care, because we are always fighting the crowd. We strive to buy low, when a sector is already hated late in a major selloff. If prices fall lower still after we buy due to a relatively-rare unpredictable capitulation, so be it. If you liked gold for fundamental, technical, and sentimental reasons when it was trading near $1675 earlier this month, its outlook is far more bullish now near $1565!
Regardless of what the Fed says, it can’t stop monetizing debt anytime soon. Interest rates would soar which would devour the US government thanks to Obama’s debt bomb. And quantitative easing is just a sideshow to the Fed’s real monetary inflation, which continues perpetually. The Fed fears inflation expectations far more than inflation itself, so it is constantly trying to jawbone them back down.
And despite inflation garnering all the headlines as far as the bullish case for gold is concerned, it is but one facet of this metal’s bullish fundamentals. There are other major drivers of gold investment demand globally, inflation is just a tailwind. So no matter what the Fed does with QE3, or tries to convince the world it is going to do, the great majority of gold’s bullish case remains intact. The Fed’s role is minor.
At Zeal we are hardcore experienced contrarians who have successfully weathered every capitulation of this entire secular gold bull. We’ve suffered the misery, pain, and despair, and have been forged into far tougher traders because of it. We refuse to sell low in capitulations, we’d much rather sell high later. This has contributed to our stellar track record. Since 2001, all 637 stock trades recommended in our newsletters have averaged annualized realized gains of +33.9%!
If you want a detailed account of what triggered this latest capitulation and its implications, subscribe to our acclaimed weekly and monthly newsletters. They follow the gold market in great detail, with the goal of launching profitable precious-metals-stock trades. We have many fundamentally-excellent open positions pummeled to incredible bargain prices thanks to this capitulation. Subscribe today and seize the opportunity to buy low!
The bottom line is gold’s capitulation this week is very bullish. These sharp selloffs indeed happen within healthy secular bulls from time to time, if just the right mix of technicals and news converge. They trigger panic-like selling driven by extreme fear that quickly burns itself out. While challenging to weather psychologically, these shakeouts are nearly always followed by major rallies as sentiment rebalances.
Gold’s low-volume holiday technical breakdown that cascaded into this week’s capitulation was purely emotional. Gold’s bullish fundamentals haven’t changed much at all since the summer of 2011 when its last bull high was achieved. After a long high consolidation since, this metal is overdue to surge to new bull highs over the coming year. If the capitulation scared you out, you are going to miss the coming gains.
Adam Hamilton, CPA February 22, 2013 Subscribe at www.zealllc.com/subscribe.htm