Gold's Bullish Revival

For two full years, the surface of gold has failed to glisten, as dark clouds cast shadows and doubts on the usefulness of the strangest metal in the world. Part commodity, part currency, part speculation vehicle, part safe-haven store of value, gold can behave so oddly that investors don’t exactly know what they’re dealing with half the time.

But if you look at gold’s larger picture, a remarkable pattern emerges with surprising reliability. We are right now seeing the budding of a new impulse wave that may blast the gold price past its inflation adjusted all-time high of $2,500 an ounce – perhaps as early as the spring of 2015.

Adding even more impetus to the move, strong fundamentals from an insatiable demand for physical gold to geopolitical tensions in the Middle East have aligned themselves with technical patterns for some truly significant momentum potential.

Are you ready for it? How should you position yourself without killing your investment if the expected impulse fails to materialize?

Fundamental Backing

Let’s start with the easier fundamentals before hitting the technicals, which are a harder nut to crack. Gold’s foundation now has at least five major layers, all highly supportive of a stronger price going forward.

• Rescue packages: After falling for more than 20 years from 1980 to 2001, gold’s fate turned with the millennium as two major crises – the 2001-03 tech meltdown and the 2008-09 U.S. housing implosion/global credit crisis – drew government rescue packages that continue to this day. Cash stimuli and ultra low interest rates around the world for some 8 years out of the last 12 are expected for some 4 or 5 years more, until rate normalization by 2017-18.

• Central bank purchases: A second layer of support is provided by central banks, which have been net buyers of gold every year since 2008, with the World Gold Council expecting another year of 500+ tons of purchases for 2013. Partly due to fiat currency weakness expected to continue for a few more years, and partly due to banking treaties (BASIL) imposing higher stores of reserves for banks, both commercial and central banks will continue to suck up the gold being dumped through paper ETF sales.

• Emerging market demand: A third foundation layer is the 12-year physical gold buying spree by the growing middle classes in emerging markets, traditional savers who have long valued gold. The WGC indicated that while paper gold sales from ETFs in 2013 so far have reached some 650 tons, the demand for physical gold in China and India alone is estimated to reach 1,000 and 850 tons, respectively, by the end of the year. Add central bank purchases and we have a ratio of 2.5 tons of physical gold purchases for every 1 ton of paper gold sales so far this year.

• Lower mining output: Not only has the dominance of gold purchases over gold sales been depleting stockpiles, but the replenishment of those stores has also been slowing. Since the gold price fell below the average cost of production – ranging from $1250 to $1500 an ounce – a series of closures of the most inefficient mines has led to a contraction of the gold supply by 6% in Q2 alone, the WGC reports, adding that the closures “may start to have an impact on the supply pipeline by the end of this year.”

• Geopolitical strife: The most recent top layer of gold’s foundation is the potential for war in the Middle East, one of the most highly charged political powder kegs in the world. War upsets currency values, which drives gold upward in all countries. Missile strikes against Syria for its alleged recent use of chemical weapons may have been put on hold, but the intent to prevent Iran from reaching the final stage of producing enriched uranium – the chief ingredient in nuclear weapons – is still very much alive. Any strikes against Syria could set the entire region ablaze, lighting the fuse for gold’s blast through the long awaited “fifth wave”.

The Mighty “Fifth Wave”

One of the best known and most repeating technical patterns on a commodity’s price chart follows a cycle of five legs, comprising three upward rallies (numbered 1, 3 and 5) alternating with two downward corrections (numbered 2 and 4). Each can be subdivided further, with the rallies following a five-wave count of their own, while the corrections follow a three-wave count (lettered A, B and C).

All over the Internet, you will find many attempts at superimposing the above described pattern on the gold price from 2005 to the present. But it doesn’t quite fit. Why? Because gold is a strange one, a hybrid that follows its own rules and its own pattern.

On the following chart of the SPDR Gold Trust ETF’s (NYSE: GLD) weekly closes since 2005, we can see the basic 5-wave pattern – rallies 1, 3, and 5 in green, and corrections 2 and 4 in red. (click to enlarge)

Source: BigCharts.com

Gold is currently sitting at the beginning of the all-powerful fifth wave, which is usually tremendously bullish and climaxes the entire bull-run with a parabolic slope to a dizzying high – as last happened 33 years ago, when gold soared from $216 in 1979 to $850 in 1980 – a rise of 293% in just a single year.

That’s triple. If repeated again this time, gold would soar from July’s $1,200 to $3,600 – possibly over the next 18 months by the spring of 2015. Although, given the size of today’s global market, momentum like that could fuel itself to well over $4,000 an ounce.

Why by the spring of 2015? A series of sub-trends within rallies 1 and 3 provide some insight. Apart from the major corrections of waves 2 and 4 – measuring 30% and 33%, respectively – each of rallies 1 and 3 had smaller corrections of their own, depicted in orange below. (click to enlarge)

Those minor corrections of mid-2006 and late-2009/early 2010 (labelled 1B and 3B) were only 17% and 13% respectively, about half the tumbles of waves 2 and 4.

But it’s the spacing of all these spikes to record highs (1A, 1C, 3A, and 3C) that is utterly remarkable. They are all some 21 months apart, almost precisely, having occurred in May 2006, March 2008, December 2009, and September 2011. Each minor correction (1B and 3B) was almost squarely in the middle of its bull-wave.

Extrapolating from this, we might expect this next fifth wave to run some 21 months or so from June of this year until March of 2015, with a minor correction of some 15% or so at about its middle, say from April to June 2014, a traditionally corrective period for gold. Then, from July of next year to the spring of 2015, we could expect that all-powerful parabolic second half of bull-wave 5 to break through the $4,000 mark.

Incidentally, early 2015 is about the time economists have been anticipating the beginning of interest rate hikes by the Federal Reserve, which could be what finally kills the gold bull this time around.

Gold’s Near Term Choices

Over the immediate term, expect some choppiness. The first announcement of Fed bond purchasing reductions expected the 18^th of this month could deal a heavy blow to equities, commodities, and bonds, as the U.S. dollar runs with a lighter yoke on its shoulders.

But less stimulus is still stimulus. Even with some tapering, the Fed’s balance sheet will still be expanding to greater and greater levels with each passing month. If monthly bond purchases are reduced in steps by some $20 billion per quarter, it would still add another $405 billion by mid-2014, which FOMC Chairman Bernanke indicated to be the target end date. That’s almost another half trillion added to the balance sheet over the next year.

If gold’s previous $1,180 support level holds after this month’s FOMC announcement, you might consider jumping in with both feet. Even sooner if missiles are fired at Syria.

But don’t ignore the gold producers. With operations leaner than before, and with numerous write-downs of good-will purchases from recent years, gold miner stocks could gain by larger percentages than gold itself.

For some diversification, you might consider splitting your gold allocation across the Market Vectors Gold Miners ETF (NYSE: GDX), the GLD trust noted above, and the gold streamer Royal Gold Inc. (NASDAQ: RGLD), which tends to outperform gold on the way up, but also loses more on the way down for its increased volatility.

Even if my timing is wrong – and it thoroughly can be – many of the producers pay some nice dividends while you wait.

Joseph Cafariello

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