Incompetent Central Banks Gold Invest by Selling Low and Buying High

By: Ned_W_Schmidt

Wow, the light bulb finally went on last week. Perhaps we have never truly understood investing. Bank of England in the 1990s was selling Gold as it plunged to below $300. Now, with Gold soaring above US$1,000, the Reserve Bank of India is buying. The trick is to apparently sell low and buy high. We always thought it went the other way. But we do note a distinct difference in this pattern from buying high and then selling low. If only central bankers had revealed this secret of high level investing earlier, how much happier we all would have been.

We then learned on Friday that the central bank of Sri Lanka had been buying Gold.

"We have been observing that prices of gold have been going up so we have been strategically buying gold over the past several months as part of a reserve management process of diversifying our portfolio,' he(Central Bank assistant governor Nandalal Weerasing) said.(thepensinsulaqatar.com, 8 November 2009)"

That buying because the price was going up sounds a lot like momentum investing. Buying something because it is going up is good way to end up owning something when it goes down. Will the central bank of Sri Lanka be selling when the momentum is negative? Or, will Gold then be a long-term holding being held for diversification purposes and price recovery? Never have been nervous about a positive view on $Gold till last week.

In our first chart this week is plotted the six-month rate of change on $Gold using the green line, and the left axis. The red line is the inflationary component of U.S. money supply growth. It uses the right axis. We assume that the price of $Gold is somehow influenced by the inflationary growth of the money supply.

As can be observed in that chart, those lines seem to move somewhat together. When U.S. money supply growth is highly inflationary, the return on $Gold seems to rise. When the inflationary component of U.S. money supply growth is declining or negative, the return on $Gold weakens or declines. Those buy signals on $Gold's return are created when the money supply measure turns positive from a negative reading. We note that those buy signals seem to offer good guidance.

Let us consider the more recent experience in that graph. First, we observe the large upward spike in the inflationary component of U.S. money supply growth. That occurred as a result of the massive injection of funds into the U.S. financial system by the Federal Reserve. That aggressive easing did raise the return on holding $Gold.

However, the most recent period is producing some troublesome divergence. The measure of the inflationary component of U.S. money supply growth continues in negative territory. At the same time the return on $Gold has been rising due to the entry of so much momentum driven money into the Gold market. Hedge funds that would not touch Gold at "$400," now love it.

Based on the data presented in that chart, an expectation that the return on $Gold will decline is reasonable. Does that negate the long-term bullish case for Gold? No. What it means is that the long-term is composed of multiple short-terms, some of which we may not enjoy. Note, though, that the money supply measure does seem to be bottoming. It should turn up in the months ahead as the Federal Reserve continues its reckless policies. On balance, the return on $Gold should moderate, and then again turn positive sometime in the coming year.

Our second chart, above, plots the GDM, the Gold Miners Index. That is the index of Gold stocks used as the investment model for the GDX, the Market Vector Gold Miners ETF. The picture presented is worrisome. The GDM has failed to confirm the recent action in $Gold. As stocks discount the future, the GDM may be telling us that today's high price for $Gold may not persist into the immediate future.

We also wonder if a head and shoulders pattern might not be developing. We have drawn into the chart a possible neck line. Any move down through that possible neck line would be worrisome, and suggest further weakness in the stocks and likely in Gold. We note, also, that a similar worrisome picture exists in Silver. Why has Silver not followed Gold higher?

While remaining a committed long-term Bull on $Gold, that no asset price moves in a straight line must be acknowledged. A short-term period of weakness in $Gold seems increasingly likely. Should that happen, U.S. dollar-based investors should use those lower prices to add to positions.

Investors in other currencies will likely have different experiences. For example, EU€Gold has finally escaped the long lateral pattern in which it had been trapped. That action suggests that €700 is the new floor for Euro-based investors. While over bought short-term, EU investors should add to positions on any price weakness, and prepare themselves for higher Gold price. The Canadian $Gold situation is more like that of $Gold. A sharp break may be necessary to shed the accumulated over bought condition. Should that break occur, Canadian investors should add to their Gold holdings.

By Ned W Schmidt CFA, CEBS

Copyright © 2009 Ned W. Schmidt - All Rights Reserved

GOLD THOUGHTS come from Ned W. Schmidt,CFA,CEBS, publisher of The Value View Gold Report , monthly, and Trading Thoughts , weekly. To receive copies of recent reports, go to http://home.att.net/~nwschmidt/Order_Gold_GETVVGR.html

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