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Wednesday, February 9, 2011

Precious metals and the validity of technical analysis


Last month’s drop in the price of gold was accompanied by almost universal recognition of a head-and-shoulders top, one of the classic reversal patterns recognised by technical analysts. This is a pattern that marks the end of a trend; the end of a bull or bear market, or at the very least a bull or bear phase. But how relevant is technical analysis to precious metals?

There is no doubt that using chart analysis in the right circumstances can be a powerful tool, but this presupposes that investor sentiment, in other words the emotions of greed and fear that drive investors, is properly reflected in the price. For this to be true, investors with these emotions must dominate the market, and prices themselves must be an accurate reflection of supply and demand. This is habitually true of equity markets, where public sentiment predominates, and for which technical analysis was originally developed. It is obviously less true of other markets that are dominated by other factors, such as changing patterns in non-investment demand or the manipulation of interest rates; but wherever the public’s investment activities are part of the pricing, technical analysis will always have some relevance. However, precious metals have their own peculiarities.

Gold and silver are segregated into two basic markets, paper and physical, which have become somewhat detached from each other. The public interest, with respect to investment, is mostly corralled into the paper markets such as futures and options. The public interest, with respect to hoarding, is entirely centred on the physical. While many of us indulge in both activities the distinction has to be clearly understood because investment motivation is entirely different from that of hoarding. In economic terms, investment is the application of savings for the expectation of a return, but hoarding is the removal of savings from circulation entirely. Investors expect to make a return measured in their paper currency, while hoarders seek protection from their currency. Technical analysis is of no interest to hoarders, since they are driven by fear alone and price is therefore immaterial.

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