Gold plummets 4.6% overnight

Last night we were reminded of the small size of the gold market is, as it was dumped by financial institutions. The gold price fell $US37/oz or 4.6% to $US792/oz, having just risen short of $US850/oz. I guess no one is more surprised than Frank McGhee, head precious metals trader at Integrated Brokerage Services in Chicago. He told Reuters "I would be very surprised to see it penetrate much below the $800 level". I am too Frank....I am too.

The reason why I am surprised is that tensions in the Middle East are still high, but then there are a number of negatives:

1. Carry trade being unwound by rising USD

2. The gold price was retracing from a major resistance of $US850

3. Gold is a very small market traded by institutions

4. Falling oil price - it fall $2.70/barrel overnight to $93.62. Not so significant.

5. The rise in gold price was quiet rapid so any retracement was going to be as well

But like Frank I was surprised that gold fell below $US800/oz, and I'd be surprised if it falls back further given the Iran situation. Mind you I dont see the Iran issue flaring beyond a few bunker-busting missile hits on nuclear installations in Iran. However the risk upside should lift gold. In the short term, maybe there wasn't enough concern there to lift gold, and it was just technical trading.

Looking at the charts its not so surprising that gold fell off from a major support, and perhaps its more the fact that equity markets were coming under pressure at the same time and were sold into to cover losses elsewhere. Market liquidation hurts all markets. For this reason, without any solid support for gold (Middle East tensions and an interest rate cut), I think gold will continue to fall as long as the larger equity markets are being sold. More importantly, the sell off may in fact be a symptom of forthcoming hedge fund losses. This is the biggest sell-off of precious metals since June 2006 when futures fell 7.6%.
At some point equity markets are going to price in some inflation into their earnings multiples (PERs). When this occurs we can expect a significant fall in equities and, and I think it will flow through to gold until that inflationary expctation becomes a market reality. At that point we will see a stellar performance from gold.

Technical Analysis

The chart of the Dow Jones below shows that gold is close to the major 12800 point support that it fell to in Aug-07 sub-prime related sell-down. On Thursday we are due for another interest rate setting by the Federal Reserve. It seems more than likely that there will be another Fed cut at that meeting. This will prove negative for the USD, but you would think positive for gold and equity markets. It should keep the Dow above the 12800-point support a little longer. But after a big fall in gold, I dont see a rapid recovery in gold. More likely a more gradual decline to the major $740 support, then I think we are in for a more significant rally than the last.

In the chart below we can see that gold was sold off within a fraction of the $850/oz resistance reached in Jan 1980. That last red candle is an engulfing candle, suggesting that gold has parred back all the gains of the previous week, and is a sign of further weakness. I dont see any significant support until the $740/oz level, suggesting there are significant falls in gold coming. I think that support will prove to be a very solid one, and I dont see a fall to $US700/oz.

So we might be looking at a post-Xmas rally in gold stocks, but until then I suggest growth-related stocks look more promising as equity markets go for another rally. But at some point inflation and risk premiums will be priced into markets.