Why I'm Still Bullish on Gold and Silver

James Brumley's picture

Tuesday, October 4, 2011 - 12:30pm

by James Brumley

A little hysteria can go a long way, especially when it concerns financial markets. And with gold prices plunging 15% last month, it almost goes without saying all those SPDR Gold Trust (NYSE: GLD) owners are now biting their nails, wondering whether the three-year rally has finally run its course. After all, the tumble from $1,900 per ounce to $1,650 is the biggest one-month dip we've seen from gold in years. Surely this is a sign the tide has turned, right?

Maybe. More realistically, it's just another blip in a much bigger uptrend.

Nobody was complaining on the way up
The pullback was nasty to be sure. What seems to have been overlooked, however, was the equally oversized run-up gold made before topping out back on Sept. 5. From July 1 to Sept. 5, gold prices soared from $1,487 per ounce to $1,905. That's a 28% rally in just two months, which is the biggest unfettered rally since 2009 (though 2009's 31% rally took four months to complete). In fact, the last time we saw anything as dramatic as this year's third-quarter rally in gold prices was the 51% rally between August of 2007 and March of 2008.

Point being, the size of the gain right in front the pullback left traders little choice but to think defensively and lock in profits at the first sign of trouble. There was just plenty of room to fall.

Gold Prices

The story isn't so different for silver, or for stakeholders in the iShares Silver Trust (NYSE: SLV).

Silver prices fell 31% between Sept. 2 and the end of last week (Sept 30). The selloff was even larger than the 28% dip in April, which came after (and this isn't a typo) an 82% run-up between late January and April 25, when we hit a multidecade high slightly above $50 per ounce. Though silver prices partially rebounded in July and August, let's face it -- silver prices were still burning off the excess from that 82% move earlier in the year. In fact, last month's was the biggest plunge in silver prices since the three-month, 49% implosion in 2008, yet silver is still priced at three times what it was at that low.

Silver Prices

In the grand scheme of things, the exact numbers and dates are irrelevant. The message is far more important, particularly for those who are still hanging on to the SPDR Gold Trust or the iShares Silver Trust exchange-traded funds (ETFs). And the message is this: this is nothing we haven't seen and survived before. Indeed, we've survived worse.

Oh, the meltdown both precious metals made in 2008 certainly felt insurmountable at the time, but both came roaring back within a matter of weeks to dole out three more years of higher highs. Has anything really changed between now and then?

What about the strength of the U.S. dollar?
Gold bears are quick to point out that the U.S. dollar started to rebound in late September, coinciding with and even prompting the pullback from silver, gold and most other commodities. Bluntly though, the punishment doesn't come anywhere near fitting the crime.

The U.S. Dollar Index has gained just under 7% since Aug. 26 -- a very minor move relative to all its gyrations since 2008. More dramatic moves the dollar has made of late include the 19% rally in late 2008, during which gold only fell 23% (though silver got cut in half during that period). The greenback rallied 17% in early 2010, and silver prices didn't budge during that rally -- meanwhile, gold prices actually moved higher. But now, all of a sudden, the sawbuck makes a very modest bullish move and gold and silver are nothing but liabilities? Sorry, the relationship is too inconsistent to use as the reason for gold's demise now.

U.S. Dollar Index Compared with Gold, Silver Prices

No, the most plausible explanation for the sudden setback is the most obvious one -- gold and silver were overbought in the short run, and it was time to pay the piper. The longer-term uptrend for each has most definitely not been broken, though. Moreover, silver and gold could (and likely will) give up more ground in the near-term future without snapping their overall uptrend. Moreover, the dollar's trend still isn't exactly decidedly bullish. The charts above make that quite clear.

It's certainly not a very esoteric explanation. But that doesn't mean it's not the right one.

Risks to Consider: Unfortunately, a mob mentality within the precious metals market has replaced rhyme and reason for the better part of 2011, and that herd-like effect was still in effect as of last week. Never underestimate the potential madness of a crowd to lead it to strange conclusions.

Simultaneously, neither gold nor silver are at the bottom of their bullish channels yet, so there is room to give up more ground before hitting a solid floor.

Action to take --> While the recent intense volatility may prolong a recovery in gold and silver prices, the same underlying fundamentals that pushed metal prices this far are still in place. These forces include a generally-weak U.S. dollar, brewing inflation, a Federal Reserve that doesn't even want a stronger dollar, and -- more recently -- fear of a global currency collapse. These are all bullish for gold, yet none are poised to evaporate anytime soon. This recent dip and any subsequent dip from gold -- especially if that lower support line around $1,400 is met -- is an attractive entry opportunity as the metal continues its erratic march toward multiple price targets in the $2,200/$2,300 per ounce range. That's at least 33% higher than where it's priced now.

As for silver, it doesn't benefit from inflation worries and currency wars the way gold does, and is the more speculative of the two at this point. It's still in a broad uptrend, though, so it's suitable if you have a higher risk tolerance.

James Brumley does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.