The recent plunge in gold prices below $1500 an ounce has suddenly awoken, well, just about everyone.  The “gold bugs” are yelling that it is a conspiracy theory by the Fed while the stock market bulls say it is a sign that the Fed has achieved its goal of creating economic growth.  Unfortunately, both arguments, while great for headlines, are wrong.

In August of 2011, during the original debt ceiling debate, gold spiked sharply to just a tad over $1800 an ounce.   In my weekly missive that month I answered the question of “Should I Buy Gold Now?” stating: 

 

 

“In a one word answer…Are you kidding me – Gold has never been this overbought before and if you ever want to be the poster child of buying at the top – this is it.  Okay, not really a one word answer but here is my point. Gold is currently in what is known as a ‘Parabolic Spike’. These do not end well typically as it represents a ‘panic’ buying spree.  Therefore, if you currently OWN gold I would recommend beginning to take some profits in it.”

At that time i showed four potential levels of retracement.

The advice at that time fell on deaf ears as investors feared that the government was going to default on its debt and the economy was going to plunged back into a deep recession.  Of course, anyone paying attention to the 10-year treasury rate, as it plunged to then record lows, would have understood that a default was not going to be the case. 

Of course, the debt ceiling was eventually raised and disaster postponed due to last minute negotiations.  The release of that fear, and subsequent interventions by Central Banks globally, led to a rotation out of the fear trade which began the process of a gold price reversion. 

Parabolic spikes in asset prices always lead to price reversions.  Whether it is gold, oil, or the price of Apple stock – excesses to one extreme lead to excesses in the other.  It is often in the final leg of this reversion process that investors “give up” on the previous long held beliefs and throw in the towel.  This action is known as “capitulation” and tends to be a buying opportunity for astute investors at some point. 

The chart below shows the long term price of gold relative to the percentage deviation in price from gold’s 34-week moving average.

As shown – the current deviation is the largest since the early 1980′s as Reagan and Volker set out to break the back of inflation and spur economic growth.   Deviations of this magnitude are generally met with fairly sharp positive price corrections from such extreme oversold conditions.

I have noted on the chart above the three previous times that negative deviations were roughly 20% or larger.  The difference this time, as opposed to the 80-90′s, is that the economy is not about to launch into a sustained rate of organic growth driven by falling interest rates and inflation.  In fact, all of the recent economic data, as shown by the composite economic index below, shows quite the opposite.

As stated previously – readings below 30 on this composite index have generally been associated with recessions in the past.  This is why the idea that the drop in gold prices is due to a burgeoning economic outlook is short sighted.  There is no evidence of such being the case.  Take a look at the annual rate of change in personal consumption expenditures which makes up 70% of the gross domestic product report.  

The economy, along with housing, has been supported by massive interventions by the Federal Reserve, artificially low interest rates and fiscal policies to stabilize the economy.  Without these supports there would be no economic growth at all.   However, even with all of those supports, economic strength is struggling currently.

Therefore, gold is not selling off due to any belief that an organic economic recovery is underway.  That concept is just as far-fetched as the Federal Reserve conspiracy theories that have abounded in the blogosphere as of late.  The simple truth is that gold is completing a journey that it began nearly two years ago which can be summed up in four words:

“Reversion To The Mean.”

As we have discussed previously using the example of a rubber band – physics state that if we stretch a band as far as possible in one direction, when released, it will travel beyond the mean.  The same is true from over extensions in the financial markets.

The chart below shows the price of gold and the times that it has reach 3-standard deviations above the 34-week moving average.  Such extensions have always led to reversions in price.  The bigger the extension has been on the upside the bigger the reversion has been. 

The current correction is well within the normalcy of extreme price movements.  It also suggests that the current correction is likely closer to its end than its beginning.

There are plenty of signs that tell us that the global economy is not getting stronger but quite the opposite.  Commodities are weak, interest rates are falling and economic activity is slowing.  While gold is currently selling off sharply it isn’t because the global economic intervention experiment has worked – it is more of a function of tax related selling, margin calls and short term market dynamics.   These will pass in fairly short order.

In the meantime – the real concern for investors should not be the fall of gold – but the overall stock market.  With investors fully allocated to the markets – the lurking correction therein is potentially far more dangerous to portfolios than the current fall in gold simply due to weighting differences.  The decline in interest rates is telling a much different story than what economists and analysts are currently predicting as shown in the chart above.

With earnings season in full swing my suspicion is that even with earnings hurdles moved substantially lower in recent weeks it may not be enough to offset the softening global economy.  Of course, then again, maybe this is what gold, commodities and interest rates are really telling us.