Since topping on February 3, 2012, a short-term correction in near-term gold futures has unfolded–essentially as a sideways consolidation, with a modest downward bias. (see Exhibit 1 below for details). Over the last couple of days though, gold climbed dramatically, notching new highs. Notwithstanding recent strength, we see scope for a medium-term decline in the price of the yellow metal. Accordingly we suggest risk-tolerant traders assume negative exposure.

Exhibit 1: The Short-Term Correction in Gold Prices

We have seen several articles that attribute gold’s gains of the last couple of days to the Greek Bailout agreement primarily, and escalating political tensions with Iran secondarily. Intuitively, it makes sense that commodities directly tied to the economic cycle might benefit from the European Union’s progress right-footing its constituent economies, but, in our thinking, it requires a stretch to justify the move in gold using this same rationale, as the precious metal’s industrial utility is quite slight (based on World Gold Council estimates, technological usage of gold accounted for only about 11% of total demand in 2011).

In a sign that others are as unsure of the origin of this move as we are, the aforementioned article opens with the suggestion that gold rallied on the expectation that the bailout would spur higher raw materials demand. Later in the piece though, an analyst from LGT Capital Management is quoted as indicating that gold rallied because investors are skeptical that the latest aid will not solve the “Greek problem”. Seems like a longshot to think that both of these factors are undergirding a move in the same direction, at the same time.

Conversely, increasing tensions with Iran could conceivably increase demand for gold as a store of value in uncertain times. However, is action so imminent that capital markets should be pricing in some manner of conflict? U.S. equities certainly do not appear concerned about a potential showdown.

As another possibility, consider that on Sunday the Chinese Central Bank reduced reserve requirements for the second time in as many months. This action is obviously born of concern about sagging macroeconomic growth. In support of this notion, the HSBC Flash Purchasing Managers’ Index (released today) suggests that Chinese manufacturing activity contracted for the fourth consecutive month in February. While representing only a bit more than half of Indian demand for gold, China is the second largest geographical market for gold jewelry, and boasts the fastest gold demand growth rate (according to World Gold Council estimates). Given the recent easing coupled with the likelihood for additional stimulus (a natural conclusion given the recent weak Chinese growth readings), could gold’s move higher represent optimism over increased growth potential in the second largest market? Maybe.

A technician might argue that the rationale for the move is irrelevant. Only the move itself is of importance. Given the difficulty we have encountered in finding a compelling rationale for gold’s two-day mini-run, this saw sounds like a sage admonition. Accordingly, we will now turn our attention to gold’s forward prospects.

After declining since February 2nd, short-term momentum now appears poised to improve through early-March. However, our static-price momentum forecasting model suggests that this support will be short-lived. As such, we expect the march lower to resume following a temporary bout of strength.

Exhibit 3: Daily Coppock Momentum Guide for Gold

Accordingly, our general counsel to speculators that made bets on declining gold prices earlier this month is to stick it out, as we think there is a strong probability of sub-1700 (or lower) price prints in March. However, the commodity currently appears ready to continue its advance in the days immediately ahead. Thus it is important to manage risk.

Long put options or inverse gold ETFs have limited downside potential. Investors in such instruments should stand their ground to the extent that they can bear a further run-up in gold prices. On the other hand, short commodity, ETF or call option positions feature theoretically unlimited risk. These positions require a more active risk management strategy based on the investors willingness and ability to bear volatility.

More to come as circumstances warrant. In the meanwhile, stay safe (or at least only as unsafe as you can reasonably bear).

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