Gold rebounding from subprime contagion

Financial markets plunged around the world over the last few weeks as the subprime mortgage crisis spread beyond U.S. borders. Who would have thought that when a homeowner defaults on his adjustable rate mortgage in Iowa, a major German bank would declare a crisis, French hedge funds would refuse to accept redemptions, central banks around the world would turn money supplies on like fire hoses, and the U.S. Federal Reserve would abruptly change from vigilance against inflation to a rescue mission for worldwide financial markets?


In the wake of the subprime contagion, precious metals and oil fell in tandem with paper assets. Many of our customers have been asking, shouldn’t precious metals be rising if paper assets are falling? If only things were simple the answer would be an emphatic, yes. The primary losers in the current debacle are speculative investors who purchased asset-backed securities that use subprime mortgages as collateral. These collateralized debt obligations have now become almost impossible to trade. The resulting liquidity crisis, fueled by banks refusing to lend to other banks, caused a selling panic that affected all markets. Precious metals, unfortunately, were caught in the down-draft, as we'll discuss in detail later in this update.


The most important thing to remember is that recent declines in precious metals are likely be short-lived, just like the ones following the Shanghai Surprise of late February, when a sharp drop in the Chinese stock market rippled through worldwide markets. On the heels of that contraction and liquidity crunch, gold fell from $689 to $640 in several trading sessions, and silver fell sharply as well. Within six weeks, however, they'd recouped all losses.


Gold has shown remarkable resilience in the face of the biggest international financial crisis in years. Yes, its recent fall from $685 to as low as $642 in inter-day trading was disappointing. But astute investors, immediately realizing that gold was suddenly on sale, quickly bid the price back up to over $650.



As the two-year chart reveals, gold has traded between $645 and $685 an ounce for most of 2007 and remains within its major 2007 trading range, indicated by the green support line and red resistance line. In addition, we're now able to see a much larger triangle pattern developing, as indicated by the longer blue trend lines. We've seen this type of pattern a few times before, with a flat top and a rising bottom; in each instance a higher gold price has followed. Today’s triangle pattern has a rising bottom and a somewhat declining top. In the present economic environment, it's difficult to believe gold will break lower once this triangle pattern comes to a full point in the coming months.


Since setting its May 2006 high of $730, gold has remained in an extended consolidation phase. The recent financial crisis in paper assets reinforces our belief that this phase is coming to end, perhaps more quickly than we expected. Gold's positive fundamentals have not changed—they remain exceptionally strong—but fundamentals for paper assets have changed dramatically for the worse, putting precious metals in a much stronger position going forward. We believe gold is fairly valued between $665 and $685 an ounce today and any price under $665 looks cheap to us.


Time will tell, naturally, but gold’s ability to hold within its primary 2007 trading range, despite the forced liquidation of hedge fund positions in metals, oil, and stocks, is a testimony to its fundamental strength and resilience in the face of extreme financial turmoil. There is simply too much fear afoot in financial markets to allow safe-haven gold to drop very far. And if these fears grow, the gold price will grow with them.