2014 is only about a week old, and to the surprise of many, one of the new year’s top performers has been gold. The precious metal rose nearly 2 percent last week, from a low near $1,180 per ounce to around $1,240. So what should we make of this gain? Does last week’s low represent a bottom for gold? And could this be the start of a new bull market?
The Gold Rally: A Prosaic Explanation
Before we get too excited about any development in the markets, we should understand the reasons behind those movements. Unfortunately for gold bulls, the jump in prices last week wasn’t due to an improvement in the fundamentals or to increased buying by central banks. It was simply due to a re-weighting of major commodity indices.
|Before we get too excited about gold’s rally, we should first understand the reasons behind it.|
Let me explain. Every year, the Goldman Sachs Commodity Index, the Dow Jones/AIG Commodity Index and others rebalance the various commodities that comprise the indices. They increase the weight of some categories of commodities, and decrease others.
So every year, index funds must react to these new weightings. These long only funds, as they’re known in industry slang, benchmark against commodity indices, so they’re forced to buy or sell to bring their portfolios in line with them.
As you might have guessed, both the GSCI and the DJ-AIGCI raised their weightings of gold and silver for 2014, which required index funds to buy precious metals. That’s the reason for last week’s rally.
What’s Ahead for Gold?
Typically, market movements caused by re-weighting last about a week or so at the start of every year. But what will happen once the impact on gold wears off?
As you can see, gold has been range-bound in a downward channel for well over a year now. But gold bulls have reason to believe that the recent low near $1,180 may have marked a double bottom, and that gold will reassert its decades-long positive trend in 2014.
But gold bears may have an even stronger argument. An important technical indicator, the ADX Trend Indicator, is still very negative. And the trading volume during the recent rally was weak, which tells me that few investors other than the index funds are willing to buy in. Overall, inflationary pressures across the commodity sector appear to be nonexistent.
Going forward, gold is likely to remain range-bound, bouncing between the floor near $1,180 and resistance near $1,242-$1,245. If it can crack through that overhead ceiling, gold could make a run toward $1,260-$1,265 based on short covering alone. On the other hand, if it fails to extend past the resistance level, gold will retest $1,220, then possibly fall back toward psychological support at $1,200 an ounce. That may be just what some potential buyers are waiting for.
But if prices do not retreat, investors who have been holding back may eventually throw in the towel and commit some funds to replenish inventories that have been drawn down by strong demand from Asia.
It’s still too early to get dogmatic one way or the other. So for now, we’ll watch the action unfold, and see which way gold goes once the dust settles.