All that glitters is not gold: look for market truths

In 2009, news headlines were touting that gold would continue to hit new highs and it did, over the years that followed it appreciated from around $US1000 an ounce in 2009 to the dizzying heights of around $US1920 an ounce in September 2011, equating to growth of around 85%.

However, it was after the peak and when it began its decline that a lot of investors bought gold – bars and coins were particularly popular. Unfortunately, this poor timing on the part of the uneducated investor is typical of what occurs. To understand the reality of any market you need to know some simple truths. Let me explain.

Firstly, let’s put gold under the microscope as an investment. Ten years ago Dale Gillham, who is now chief analyst at Wealth Within, gave me a simple investment philosophy: “The best kind of investment provides the opportunity to generate income and capital growth and if you are not getting both of these then someone else is. This is one of the reasons why the best investment vehicles are property and shares, and with this information I build my wealth. While I like gold, investing in the precious metal doesn’t fit my investment test.”

Think about it this way, gold was seen as being a defensive asset, and if you try to use gold for this reason – to diversify your portfolio – you have essentially elected to buy and hold gold. This means your capital will be exposed to dramatic fluctuations in the market price and you don’t have the buffer of being able to earn income while you hold it. While this is not an issue if the value of gold is rising, what if your strategy for defence becomes the weakest link in your portfolio as it falls?

A defensive approach can work provided you have the knowledge to act when conditions change, however, the reality is that most investors may be able to buy but don’t know how or when to sell. Gold, like other investments, is cyclical in nature and therefore at times will be high risk to hold. So trying to diversify without understanding this or how a market works means you are likely to be no better off in the long run.

One of the keys to understanding when to buy and when to sell an investment traded on the open market is in knowing what is occurring when prices go from low to high and high to low. Sounds simple, and it is, and yet so many people overlook how powerful knowing this can be.

You will already know that market prices, including gold, run on fear and greed. Having done years of research into investments myself, I have found plenty of evidence to show how history repeats itself and the masses continue to be driven by their emotions, not logic, when making investment decisions. This makes it so much easier for those ‘in the know’ to read the market and ensures the cycle repeats.

Most price cycles operate as shown on the chart below. This is not a chart of gold; it is a powerful tool that represents how any market will move over time. Whether you are investing in gold, the sharemarket, currencies, or something else where prices are transparent, you will see this phenomenon.

I have broken up the chart in terms of its phases with a corresponding explanation below:

1. The first phase of the cycle at the left of the chart is called ‘accumulation’. Prices have stopped falling and are moving sideways. Remember that the prior fall will still be fresh in the minds of uneducated investors who are fearful that prices could go lower and media reports don’t help as they are selling doom and gloom. That said, to the educated, the market begins to show signs it may turn back up as those ‘in the know’ begin slowly accumulating.

2. The second phase sees an initial rise in prices off lows. The big money makers continue to accumulate and the short-term traders enter the market in search of quick profits. News reports are still mixed and so the herd doesn’t yet know which way to run.

3. Phase three – it is typical after an initial rise to see prices fall back quickly to test prior lows as short-term profit-takers exit. During this time the masses are still generally pessimistic and more likely to remain out of the market.

4. Further up the rise the masses begin to take notice of improving reports in the media, there is money to be made and the masses begin investing again, albeit cautiously, while a large portion of investors still remain out of the market. Those ‘in the know’ already have some nice profits to underpin returns.

5. The market takes a breather and trades sideways for a short while as the buyers and sellers attempt to agree on price, there is talk in the media about possible market tops, and traders and nervous investors exit here. Eventually the market shows signs that the buyers not the sellers are in control and prices break through the top of the sideways move to confirm the start of the next phase.

6. In this phase the market will have its last hurrah and can be the most volatile as it makes a top. The market is now on its final stretch when we typically see the masses pour in. Prices are rising strongly, news reports are upbeat and typically this phase is where we see the steepest rises in price – the market looks set to run on forever. The taxi drivers are talking about the money they are making, and anyone who hasn’t invested starts to dip their feet in the water – often this is when the most conservative and uneducated investors come in. The educated investors and the institutions are either already starting to pull back their capital or are preparing to do so.

7. Volatility increases, prices swing wildly and fall from their highs, news reports vary and show cracks emerging but the uneducated are drawn in by opportunities marketed to them to buy at cheaper prices. As this volatility starts short-term traders exit and they begin to look for opportunities to short the market as it pulls back, forcing it lower. Shorting the market is about making money by selling at high prices without physically owning anything and buying back at low prices to close out the trade and balance the books. Some of the institutions also begin to take short positions or buy into defensive areas with good cashflow.

8. The market gets wound back up in a buying frenzy in this phase we call ‘distribution’, as prices have become so much cheaper than at the top. This is when money is changing hands from those with little or no knowledge to those ‘in the know’. Mum and dad investors are buying, those who missed the run to the top are now investing their hard-earned cash, hoping the run will resume, and it does for a while as the market moves up to challenge the top.

9. In the last phase the music stops and a further fall unfolds, usually this is the most dramatic fall in the cycle. This is when the truth begins to emerge about the risks in this market, emotion takes hold and heavy selling occurs. This is where those trading short essentially have their brokers borrow stock from some of the big funds, which you may be invested in, they then sell the stock and after the fall they buy back in so as to profit from the decline. Mainstream media is all about doom and gloom and the masses panic, forcing prices down quickly. Along the decline will be a few false starts where the market moves back up and the short sellers and uneducated who can’t take any more stress finally sell. This creates a final drop or what we call an ‘exhaustion of the sellers’ just before the bottom, and the cycle starts again.

The idea of owning a piece of gold may be attractive to some investors, however, even gold can be high risk without an understanding of what occurs in the marketplace. The next time you consider buying into an investment consider where it might be in the overall cycle. By simply understanding the bigger picture of a market cycle, you will be ahead of 95% of investors when it comes to picking the most opportune points in time to enter and exit an investment.