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Each week we reply to questions from our subscribers and include them in our Premium Updates. Today’s essay is dedicated entirely to commenting on one of the letter that we received this week. It touches several interesting points and shows us that there are still some controversies and doubts regarding two most popular approaches to analyzing financial markets, i.e. technical and fundamental analysis, that need clarification. For clarity’s sake we decided to put our comments alongside it, in addition to answering the reader’s final question.

Q: I appreciate greatly your regular analysis, but cannot help but have doubts on one aspect of your technical analysis. It is significantly influenced by the USD index movement, in which when the euro falls, the Index rises and risk assets fall off, including gold (in an environment where inflation is for tomorrow and global growth is slowing).

A: Yes, our analysis is currently heavily influenced by the movement in the USD and euro, but the key word here is "currently". There will be a time (as you write below) when gold will move higher whether the dollar moves higher or not. In fact, this has already happened before. At times we have even analyzed currencies and used tops in USD as a signal for tops in gold. Just because USD is currently the key factor for precious metals investors and traders, doesn't mean that it will remain so going forward. That's why we constantly monitor correlations between various markets and see how they change, so that we know when to pay extra attention to the currency markets and when it's only optional.

Q: But hiding behind the USD and US Treasuries as an alternative safe haven is a short term game, as real returns on 10 year treasury paper is negative, and US debt is still too high with slowing growth. At some point market players will start to diversify from concentrating so much in the USD and start to simultaneously diversify into gold because of the headwinds visible in the US economy (fiscal cliff, etc.). No market player in this environment will put too many eggs in just the USD because it is also clearly perceived as only the least dirty shirt in town. When this diversification happens, gold and the USD Index could initially both rise. And this will be the first leg of a bigger move in gold when the USD shirt looks even dirtier.

A: Agreed.

Q: Traditional technical analysis cannot tell us when this will happen in this current environment where traditional technical correlations are more susceptible to macroeconomic/political developments.

A: Agreed. Technical analysis cannot currently tell when these fundamental factors will come into play. Again, the emphasis is on "currently". We could also add "directly" to that. Technical analysis will probably tell us that in the form of a bullish formation and the overall strength in the gold market, for instance relative to underlying factors like stocks, currencies and commodities. Support lines, cycles and Fibonacci retracements don't explain why a given move is likely to be seen. They just tell you that it is the case. So you will never know if a given formation is the result of one fundamental factor or another one.

The most important comment that we would like to make here is that it is not the point of using technical analysis to detect the timing of the market's recognition of certain factors months ahead. When you buy a sports car you don't complain about it not being a good vehicle for a transportation company - you enjoy the ride. Technical analysis is just one of the tools at our disposal. We put great emphasis on it in our weekly analysis because this is where the biggest changes can be observed. The fundamental picture is bullish for precious metals. And even though we discuss the latest news, our long-term views on gold and silver really don't change (we will make relevant comments on medium-term moves, though). So, we use the technical analysis to predict what can be predicted and we use fundamental analysis (including macroeconomic and political developments) to establish the main trend and position ourselves accordingly. Additionally, we hold some in physical form as insurance against serious financial turmoil. This way, the fact that not everything can be predicted using technical analysis becomes less important. Also, without it, one's forecasting abilities would be much more limited.

Q: What most are saying is that to stop the US shirt from getting dirtier, the Fed will intervene again with QE3 and so push the USD Index down and gold/risk assets up. However we all know that this debt problem is structural and requires fiscal reform. More and more monetary easing will push the problem further back, make it worse, and in the meantime incorrectly convey the view that past correlations still hold as in better times.

A: If the correlation numbers are significant then the correlation will be in place and analyzing one market will help to analyze another. When the abovementioned factors kick in, the correlation numbers will start to reflect that and we will know not to pay attention to these other markets anymore.

Q: With (a) more QE by the Fed, the USD Index goes down and gold instantly up because of the USD/gold correlation.

A: Probably yes.

and with (b) no QE the USD Index stays strong for the foreseeable future as concern increases about the US economy and traders/investors simultaneously hedge their USD exposures with more gold.

A: The USD may not stay so strong for the foreseeable future. It could move higher and then decline again or move sideways. It would depend on what happens with other currencies. After all, currency exchange rates are just comparisons of speeds at which each currency sinks. If other currencies improve somewhat, it could be seen as weakness in the dollar. Also, traders and investors don't have to automatically hedge their USD exposures with more gold. This is likely to be seen at some point in the future, but we can't tell how soon.

Q: For me these macro considerations, (a) and (b), will drive the gold wheel going forward more than technical analysis.

A: Technical analysis is not the main factor behind the precious metals secular bull market. Macroeconomic problems in the world, massive money supply, artificially low interest rates, BRIC countries' growth and other fundamental factors are. Technical analysis is just a tool that helps to time the best entry and exit points within this major move up. As such it will not drive gold, just as it has not driven it in the past. However, will the short- and medium-term moves continue to be detectable by technical analysis? Most probably yes.

Q: Technical analysis is useful in indicating the support levels to watch out for while the USD Index rises. But it may be only that – an indication, because market participants know either way gold will win out. And precisely because of this gold may not fall below USD 1500 (…). I think these considerations need to be more openly discussed even if one argues that gold will eventually win out but may have a technical drop of another, say, 20% before we get there.

A: We will be happy to discuss technical factors pointing to higher or lower prices in gold in the short term. However, the above-mentioned factors neither support nor contradict gold's decline in the short run. It is simply something that will likely be seen "in some time," probably months or even years from now.

Q: There are ways of staying in a gold position and hedging the downside risk, and even making money on the volatility in the short hedged position through playing (in/out) the intraweek volatility in the price ranges, even as they shift going forward. But I understand this may not be everyone's cup of tea! That’s what I do currently building up a bigger positive spread between my long/short positions so that I have additional spread to play with when deciding when gold has reached a bottom and I start closing out my shorts. I hope to do this in 2013, if not sooner, and would be surprised if gold loses another 15%. (…). I know it is a tough call as you have customers, and need to position yourselves accordingly, but if you had to call it (based on your view about QE timing, and other economic/political interventions) , do you think that the next big move up in gold will be this year or next and what upside range would you foresee?

A: I think that the next big move might start close to the end of this year or in 2013. At this point we see this as a 60/30/9 probability: 60% for this year, 30% for next year and 9% for the following years. The remaining 1% is for the case that we are wrong about the secular bull market in precious metals and that the next big move up in gold doesn't arrive for at least 10 years.

To sum up and somehow answer the title question, we would like to stress that we don’t choose just one of these methods and shun the other, as we believe that the key to successful market analysis is using them both. However, one still needs to remember that each serves different purposes – fundamental approach is essential in positioning oneself properly and to know what to expect in the long run, while technical analysis is indispensable in tracking day to day changes and short- and medium-term trends as they unfold.

Current situation in the precious metals market is probably the best confirmation of the above sentences: an investor using only the fundamental approach would have probably lost serious amounts of money during recent declines, telling themselves “hey, I know the fundamentals are good so I got to go long on gold” while the followers of only technical analysis might have already lost their faith in the precious metals sector, as the technical situation is not as promising now as it used to be. But combining both approaches lets one come up with a coherent strategy that is likely to pay off handsomely in the future. If you’re interested in reading our replies to other questions or examining our latest Premium Update (with over 20 precious-metals-related charts), we invite you to join our subscribers.

Thank you for reading. Have a great weekend and profitable week!

P. Radomski