Is Gold Immune To A 38.2% Retracement?

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This is either a hypothetical or a rhetorical question depending on who you ask, but I think it is extremely important nonetheless:

Is Gold Immune To A 38.2% Retracement?

The gold bull has managed to finish positive 12 years in a row, and that kind of track record develops a certain level of expectations and cockiness among its fans. If you’re a baseball fan then you know what it’s like when your team visits Yankee Stadium and competes against the traditionally highest payroll in the sport year after year. Yankees fans expect to always win, and there is no convincing them that they won’t be making the playoffs again this year.

The same feeling of invincibility has permeated the gold bulls over the years, and yet as investors it is important to remain objective about a paper investment no matter what it is.

In fractal theory, a 38.2% Fibonacci retracement is the healthy “pause that refreshes” in an uptrend. It is completely natural for an asset that has made a large trending move (two steps forward) to recharge (one step back) before resuming the trend. Yet for some reason this concept generates huge emotional reactions when referring to gold.

I am not debating the fundamental reasons for owning physical gold as that is well known, but instead I am asking from a risk-management perspective why paper gold is exempt from reaching the 38.2% retracement level (roughly $1285) or lower of the entire bull market. It does not mean that the bull market is over, but it might explain the psychology that is actually preventing the bull from going higher in the near-term.

May 26th Gold Retracement

The 2008 drop easily cleared the 38.2% retracement level of the bull market, and all it did was launch an even bigger uptrend into the 2011 top. If healthy retracements create large short positions, negative sentiment, and fresh buying from new investors, then why would a long-term investor in gold not want periodic retracements to occur?

Unless you’re living in a cave or your mom’s basement, you are aware that everyone in the world knows how bad gold sentiment is, how extreme the positioning is in the futures market, how strong the retail market is, etc…and you should be thankful because that is the fuel that creates another move higher in a secular bull market. However, those facts don’t prevent price from making a healthy retracement because money ultimately flows to where it is treated the best. Right now, there are a few central banks that are giving away money for free and if you’ve ever seen a video of Wal-Mart on Black Friday you know that people love free stuff. Yes, it might be junk if it wasn’t free, but that doesn’t mean people still won’t go crazy for it while the intellectual community drives by shaking their collective heads.

Professional money managers who have been bullish on gold (and continue to be) are dumping paper gold en masse because their portfolios have been massively underperforming equities for the last two years. Their jobs are on the line each and every quarter, and when your performance is measured against your peers then being a contrarian can get you fired or generate redemptions no matter how strong your convictions are.

In other words, the case for the price of gold going higher is well known, and many investors can recite it by heart. Until the market finally gets the hardcore longs to question that theorem or eliminates them by wiping out their paper portfolios then the bull will remain dormant. It is amazing what a 38.2% or 50% retracement can do to an over-leveraged long, and that is why risk management is so vital for staying in the game for the duration of a secular bull market.

If you truly believe in gold then own the physical version because it is on sale right now…but if you are trading paper then it shouldn’t matter what ticker symbol is in your buy order because it is just numbers on a screen. Paper gold is not exempt from a retracement, and long-term bulls should be thankful that the extreme conditions are being created that will ultimately fuel the next leg higher.

Be careful trading any instrument if you believe that it can never go down. Risk management is the most important concept in trading, and holding through massive drawdowns is a very poor strategy because nobody knows the exact timing or direction of the next move. You can only control your risk when price is close to your entry price, and the further it gets away to the downside the more damage it can do. It is better to check your ego at the door and take small paper cuts than to absorb one massive loss that can affect retirement plans or even a standard of living. Every asset can go up or down in price farther than we can imagine, and as investors all we can control is our risk on each trade no matter what our outlook is.

Good trading all.

Steve Chapman, TRI


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