The Bear Case for Gold and the GLD, Even With More Stimulus

Given investors' high expectations for U.S. quantitative easing and additional stimulus in Europe, gold's lack of a truly impressive rally may not be a good sign. Prior to Tuesday, gold was up in four straight sessions on speculation that both the U.S. Fed and the European Central Bank will separately – or perhaps even jointly – institute additional economic stimulus. Tuesday, spot gold traded near 1625.10 on the Chicago Mercantile Exchange. The metal moved back above its 100-day average in recent days – the first time that has happened since March. Also, for the first time since February, gold has seen a weekly buy signal based on the convergence of its moving averages. Yet gold's sliding price pattern since September 2011 threatens to eventually move the metal down to 2010 levels on a technical breakdown. Gold also remains held back by May and June highs, despite very strong market expectations for added stimulus - the main catalyst that traders are counting on to reverse gold's decline. Any ECB stimulus that might be announced this week could set up a false breakout for the yellow metal out of a months-long trading range before the metal falls back significantly. An eventual decline past critical support just below the 2011 close near $148 threatens to send gold futures down to the next major volume support level, as much as 25 percent lower. Odds heavily favor a breakdown by year's end, based on a study of similar price patterns over more than a decade. Using

EidoSearch software

, Benzinga backtested more than six dozen sector and index ETFs that demonstrated at least a 0.82 correlation coefficient or higher with the eight-month GLD price pattern over a similar timespan going back to 2001. Of 82 ETFs tested, 76 of them moved lower after completing a highly correlated 8-month price pattern with the GLD. The mean decline of the 76 falling ETFs was 32 percent. Bulls may argue that there are many fundamental reasons for gold to move higher. Among them is the fact that the yellow metal remains a hedge in times of trouble – for large government buyers as well as institutions and individuals. Central banks around the world continue to add to their gold stashes to hedge against economic trouble. This hedging enables countries outside the U.S. to intervene in their currency markets, and helps some governments maintain their credit ratings.

One reason global gold prices could be out of whack is historically high mining margins. It costs about $500 an ounce to mine gold, and the metal is selling for more than three times that cost. The historic mining-to-market cots has been closer to 1.5 times, said professor Mark T. Williams at Boston College in an interview in the July edition of Financial Advisor magazine. This ratio could be one sign that the gold price has remained unusually high for several years and is consequently due for a fall. Another concern is that a third round of quantitative easing might not be as effective in boosting asset prices, including gold, as the first two rounds. Long-term borrowing costs, as exemplified by 10-year U.S. Treasury Notes, are already near historic lows. To get any kind of bang for the Fed's hundreds of billions of bucks, the central bank may have to focus debt purchasing in other markets such as mortgage-backed securities. More importantly, sentiment could play a large role in gold's future direction. Markets already believe that ECB stimulus is coming. If an announcement comes, there are reasons to think there may be only a weak buying wave. In a Monday

, 19 of 24 money market traders expected the ECB to start buying Spanish and Italian debt. Moreover, 10 out of 19 polled had the expectation that the announcement will come this Thursday, when the ECB hosts a policy meeting and press conference. ECB President Mario Draghi helped to increase that speculation last week,

that he is determined to preserve the euro, “whatever it takes.” In the U.S., markets are not counting on the FOMC to instill more quantitative easing right away, although a recent wave of negative data is increasing expectations of it happening by year's end. The FOMC will have a two-day meeting beginning Tuesday, and ending Wednesday. About 65 percent of QE3 was already priced into the markets as of July 26, according to Bank of America global economics and U.S. rate strategy heads in a note to clients. Assuming the gold market began to price in QE3 at the market's nadir in May near $148, a full discounting of QE3 under BofA's assumptions using back-of-the-envelope math would take the GLD to a price near $163. That's only around another 4 percent higher from Tuesday. With lingering concerns that gold could eventually see a breakdown, a 4 percent price increase may actually be one of the more positive scenarios for the yellow metal.