Are We Really Heading To Lower Lows Or Yet Another Whipsaw?

-Are inflation, deflation, or “safe haven” status true constant drivers of precious metals?

-Anecdotal market sentiment from this year’s PDAC convention

-Recent Commitment of Trader’s Reports

-Upcoming week’s market expectations

With the precious metals market causing serious hurt to metals traders and investors since my last article in November of 2015, it has become quite clear that no one really has a handle on this market.  It has confounded almost everyone since 2011, and most have been left dumbfounded at the moves they have witnessed, which have also left them on the wrong side of the market week after week.

Many folks believe the metals act as a “safe haven” during times of market instability.  Many others believe that deflation causes gold to rise and others believe it is inflation that causes gold to rise. And, many others simply believe that metals are manipulated, since they are unable to understand their movements at all.

Well, this past week, we witnessed an equity market decline, along with a rise in interest rates. And, I am sure you have read, just as I have, that an interest rate rise signals inflation, which surely causes metals to rise.  So, would not those who believe in inflation being a driver of metals and those who believe in metals as a “safe haven” have been looking higher in metals this past week?  Well, that is not exactly what we witnessed, was it?

You see, what has been thought of as a driver of the metals direction has been turned on its head for the last 3 years.  Nothing seems to make sense to most participants.  Metals seem to be in a bizzaro world, if you will.

The problem is many of these expectations have not truly been researched from an intellectually honest perspective.  Many have seen metals rise “sometimes” when the equity markets decline, and assume metals are a “safe haven” asset.  However, if one truly studied the movements in the metals vis-à-vis movements in the equities, one would notice times in which the markets and metals have moved in lockstep, and other times where they have moved opposite each other.  There is clearly not enough empirical evidence to suggest that they act as a “safe haven” relative to the equity markets.  Rather, it does make for a nice sound bite, so people use it when metals move up when the markets move down, and are silent about this when they move in lockstep.

Then there are the inflation/deflation arguments.  If one performed an analysis of this issue from an intellectually honest perspective as well, one would come to the conclusion that neither proposition is wholly correct.  In fact, one simply has to go back to look at how gold performed in 2007-2009 to see how metals whipsawed both party’s expectations.  So, based upon market history, it is quite clear that inflation, deflation, or “safe haven” status have not been a constant driver of metals.  So, we must continue in our search for what is a constant driver for precious metals, and not just a coincidental driver of metals some of the time.

The other issue upon which people rely, which is related to the inflation argument, is that an interest rate rise signals inflation, which will cause metals to rise.  Unfortunately, this is an oversimplified statement, and can lead one down a primrose path.  One must realize that rates rise for many reasons, and inflation is only one such reason.  The true driver of interest rates is “fear.”  And, there are many reasons which cause people to fear.  There is fear of inflation, fear of deflation, fear of war, fear of political upheaval, etc.  But, the one fear which can cause interest rates and gold to rise, yet cause deflationary pressures on equity markets, is the fear of debt default.

Yes, fear of debt default can cause a high yield deflation.  We learned that well in 2011 when the European countries saw their borrowing rates rise parabolically, while the equity markets took it on the chin.  And, gold was soaring during this period of time. I believe that gold will once again develop its next bull market run under this type of scenario over the next few years.  Yes, my expectation is that the fear of sovereign debt default will be the proximate cause yet again.

Historically, the one constant under all circumstances mentioned above is that metals have been driven by fear, or lack thereof.  And, those that have read me for years have come to know that I analyze metals based upon these “fear-factors.”  I attempt to gauge the sentiment of the metals market in order to determine both the short term and long term direction.  And, over the last 3+ years since I have called the top in metals here on Seeking Alpha in August of 2011, we have done so quite accurately.

I would like to digress for a moment and provide an anecdotal sentiment perspective I gleaned from this year’s Prospectors and Developers Association of Canada (PDAC) annual convention.  I was honored in being a featured speaker there this year, and discussed how I viewed us as being on the cusp of the next great bull market in the investment world. But, the most common comment I received from all those with whom I spoke was that the attendance had been quite underwhelming.  You see, to one who tracks sentiment in the market, this speaks volumes.  To me, it signals that many are losing interest in the metals and mining markets.  It means that market sentiment is finally approaching a point at which we can finally see a long term low being struck. And, if I am right, next year will likely mark the lowest attendance they will ever see, followed by much stronger attendance in 2017.

Now, some look to reading “tea-leaves” when they attempt to discern the direction of the metals.  They will review information such as “gofo-rates” and Commitment of Trader’s reports.  Clearly, those can represent somewhat useable information, if one understands their limitations.  While both those reports can evidence a building sentiment shift in the market, neither of them will provide you with an accurate depiction as to when a turn will actually occur in the market.  Keynes put it best when he said that “markets can remain irrational longer than you and I can stay solvent.”  So, if one uses this as one of the tools in their tool-box, do not expect an immediate reaction in market direction as one of these becomes more and more extreme.

As for the Commitment of Traders’ report, for those that do not know, these reports come out on Friday afternoons, but only represent the positioning of the “players” as documented the prior Tuesday.  And, as we all know – especially after last week – a lot can happen between Tuesday and Friday in the metals market.

When we look to the COT report in particular, we normally look towards the Commercial players, as they supposedly represent the largest segment of the market – hence, arguably, the largest representation of market sentiment.  This past week, as of Tuesday, we noticed that they were still heavily short, but did cover a small amount of those positions.  I am willing to bet that the upcoming week’s report will begin to show a much more significant drop in their short positioning, especially due to the sizeable drop we witnessed this past Friday.  But, we clearly will not know that until next Friday. 

The reason I am able to make such a bold statement is due to the sentiment pattern I am reading. You see, I came into this past week with a bearish bias.  In fact, at the end of last week, I noted a bearish set up to my subscribers in my trading room at Elliottwavetrader.net as silver moved into the 16.70-16.90 zone.  And, the same set up was presented in GLD and GDX over this past weekend. 

In fact, last weekend, I noted the potential for an extremely “evil” set up in the metals, which would likely hurt the most traders, and cause the most confusion over the next several months:

Yes, there is a pattern that would provide us with a large corrective flat pattern which will take the metals back down to their 2014 lows, and then back up to their 2015 highs.

As you can see in the attached daily GDX and silver 144 minute charts, there is a pattern in place which can take us back down towards the lows of 2014.  Silver has the cleanest of patterns for this set up, and as long as silver remains below the 16.90 level, we can see a . . . drop . . . which can take us back towards the 14 region in silver.  A breakdown below Friday’s low, with follow through below 15.50, has me targeting the 14 region again.  But, I don’t believe that will take us much below that region. Rather, I think that would set up a . . .  rally back up towards the 2015 highs.

Now, I have to admit that this pattern would be “evil” in nature, as it would likely hurt the most traders/investors from a psychological standpoint.  First, those who believe we have bottomed will have their hearts in their throats as the market heads down to the 2014 lows.  Those that believe we have lower lows to be seen will be shorting aggressively, and expect the bottom to fall out, should this drop materialize into the middle of March. 

However, if this larger flat plays out, the (b) wave would bottom right at the 2014 lows, or even slightly break those lows, potentially stopping out the longs.  My expectation is that it would then reverse and develop into a tremendous short squeeze, which would then have the stopped out longs chasing it all the way back up to the 2015 highs, along with causing the shorts to frantically cover their positions.  And, such a move would make everyone believe, once again, that the double bottom has held, and the bull market is back.  Bulls would become quite confident again, and bullishness would likely rise to a level which can support a very strong drop to much lower lows later this year.  This also sounds strangely similar to what happened in 2013.   

Yes, this is an evil pattern, and should it play out it would likely hurt the most people on both sides of this trade.   But, please do remember that this is simply conjecture at this point in time.  We will need to see the market break Friday’s low, and then follow through below the 15.50 level in silver.  If the market chooses to follow this pattern, the drop to the 2014 lows would likely occur within the next week or two.  So, it really will not take us long at all to know if we will see this pattern following through or invalidating. And, should this pattern fail to follow through to the downside, we will know quite quickly, with a rally through the 16.90 level early next week.

So, coming into this past week, I clearly had short-term short positions in place. As of Friday, I had taken profit on much of those short trades from the prior week, but still hold some of them since the decline has not yet proven to me that it has concluded.  But, the main reason I took profits is that silver ended the week right at its support zone noted on my charts. 

This brings me to another point about trading metals.  If you think you will garner every single point in the trading of these metals in both directions, you are fooling yourself.  One must know how to take risk off the table during corrective action in the market.  But, then again, one must be able to recognize it as corrective action to begin with.  And, most of this market has been whipsawed so badly, they don’t know whether they are coming or going.  So, this is not a market one should be trading based upon “gut,” or “business sense,” rather, one must be able to know how to track market sentiment and know when to take profits. 

But, at this point in time, since silver has provided me with the best directional indications, I have to use it to lower my risk, as it is has now come into support.  I have also modified my support level on silver slightly down, to the 15.40 level.  And, should the market gap lower on Monday below such support, then my remaining short positions will be that much more profitable.  Should silver gap up, then I will discern the nature of the move higher, and may even attempt to re-short at resistance, or will clearly stop out of the remaining short-term short positions should we move through resistance impulsively.  But, the point is that if a chart provides you with a high probability directional move during a correction, one must be wise enough to take profits at the appropriate times, even if you miss more of the move you had initially expected. 

For now, my expectation is that precious metals will continue lower in my “evil” scenario noted above.  In fact, I can easily see GLD even take out last year’s lows to stop out a significant number of long traders before it begins a rally back towards the 2015 highs again. 

And, as many have asked me, we certainly could now be on our way to the final lows in the metals.  But, I have to say that I do not think that is the higher probability perspective based upon the nature of the decline we have witnessed from the 2015 highs.  I think we need to bring more bulls back into the market before we take many more out of the market when we finally head to much lower lows.

But, should I be wrong, and we head directly to much lower lows, I sincerely hope your focus will be on the long-term long side of this market, rather than attempting to short for every last drop of blood which will be spilling in the streets.  Remember what Baron Rothschild said . . . that is the time to buy, not sell.

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Courtesy of ElliottWaveTrader.net