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Special Presentation: Gold

We did the first Inter-Market Relationships Analysis (IMRA) solely dedicated to the gold market almost two months ago and were surprised to find how well received it was. We have this sense that there are quite a number of people out there who are more than a little frustrated by the lack of movement in the 'yellow metal', which is understandable given the backdrop of monetary profligacy. In other words, if central banks have created a veritable tidal wave of liquidity, why isn't it finding its way into the precious metals markets?

As usual, we will stay away from issues like manipulation and conspiracy and concentrate on what we do best- ferreting out and explaining the various inter-market relationships that define the gold cycle. Our goal here is not to make gold prices rise or fall, but rather to deal with four basic issues. First, is the price of gold high or low. Second, is gold in an up or down trend. Third, what events would likely have to take place first before gold prices moved substantially in one direction or another, and fourth, what sort of targets and time frames are we working with.

Many seem to yearn for the 'good old days' of the Gold Standard, but we think it unlikely that a return to this sort of discipline will happen in our life times. Why? There are two good reasons. First, there simply isn't enough gold available. Some time ago we read that, given the current money stock and the global supply of gold, each ounce of gold would be worth something like $70,000 if we returned to the gold standard. Second, human nature being what it is, no simple solution can ever be embraced if a more complex one created through the aid of technology and political expediency is available. A skim through an income tax guide will prove to anyone that this makes sense. After all, why have a flat tax or a straight forward legal system that would get rid of thousands, if not millions, of accountants and lawyers when something even more complex can be created and managed through computers. Why have an elegant system of monitoring and controlling economic growth when we can rely on a central banker who admits on the one hand that the markets are behaving irrationally while suggesting on the other than he really isn't sure whether the money supply is relevant any more- that is, if he could figure out how to define it.

Is the price of gold high or low? This may seem like a strange question, but we think it makes for a good starting point. In 1996, for example, when gold pushed over $400 per ounce, we were dead convinced that the price of gold was 'high'. For those that remember that gold topped $800 per ounce some two decades ago, that may grate, but we define 'high' in different terms than most. Instead of measuring in terms of absolute prices, we measure in terms of speculative interest.

We have included a comparative chart of the gold futures and the ratio between the gold futures and the Philadelphia Gold and Silver Index (XAU) to help explain our point.

When gold is 'high', its price is about 3 times the level of the XAU. On the other hand, when gold is 'low', it is about 5 times the XAU. In late-1987, when the price of gold flirted with $500 per ounce, the ratio hit 3:1. Between 1994 and 1996, on the other hand, the ratio hovered around 3.5:1 or lower yet gold barely broke $400. At $500 in 1987 and $400 in 1996, gold was 'high'.

When gold is 'low', speculative funds are circulating through other markets, largely ignoring the shares of gold mining stocks. As one would guess, in most cases the price of gold is neither 'high' or 'low' but somewhere in between. The movement from one extreme to another helps create or define the cycle.

Where are we now? The chart clearly shows that, regardless of what is going on in other markets, the price of gold is 'low'. The ratio has been grinding higher from early 1996 to the present day, closing the week just under 5.2:1. With the exception of a brief flurry in August 1998, this is the first time since the bottom in late-1992 that gold has truly been washed out.

So, to answer the first question, gold at present is 'low' both on an absolute and relative basis. Except for a small cadre of die-hard supporters, there is no speculative interest or hope remaining that must first be washed out before a true, major bottom can be created. For the first time in over seven years, the gold market has reached a point where the next rally may not be beaten back by eager sellers.

Is gold in an up or down trend? Again, this may seem like an odd question, but since gold prices are well above the levels seen in the summer and early autumn of last year, it is an interesting one to ask all the same. After all, if gold prices are in a down trend, then we would have to expect that the true bottom would require sub-$250 gold prices.

We feature the gold markets quite often in the IMRA, which is done on a daily basis, since it is the one sector that truly bridges the gap between 'monetary' and 'real'. Gold continues as a store of value, for instance, for the vast majority of the world's population who do not have access to complex financial derivatives yet also is driven by the same forces of supply and demand that dictate prices in any other commodity sector.

Returning to our point, the last 'up' cycle for gold, from the end of 1992 through into 1996, was less a gold cycle than it was a metals cycle. If we review some of the relationships that tend to precede or coincide with a true metals cycle, we will have a better grasp of what to look for when it comes to gold itself.

We have included a comparative chart of copper futures and the product of the U.S. T-bond futures and the Dow Jones AIG Futures Index, with the former representing the value of longer-term government bonds and the latter representing commodity prices in general.

The chart shows that between late 1988 and the end of 1992, any increase or fall in bond prices was nicely offset by corresponding but inverse movements in the commodity prices. In other words, if commodity prices were falling, bond prices were rising (interest rates were falling) and vice versa. What changed at the end of 1992? Enough liquidity was created to allow both bonds AND commodities to rise together. Notice that copper prices continued lower for a full year through this cycle, but keep in mind that gold prices began to spike higher intermittently through 1993.

Putting the first two charts together, then, we can see true bottoms for gold at the end of 1992 and also in the current period. If we know that gold is 'low' and we also have some sense that when both bond and commodity prices are able to rise concurrently that a new cycle is beginning to form, we can see the first blurry images beginning to come into focus.

We are constantly amazed these days at the level of confusion that has arisen surrounding the price of crude oil and its effect on the economy. We have always been led to believe, for instance, that rising prices, if validated by money supply growth, define inflation. Instead, we find most economists and pundits claiming that rising energy prices are disinflationary. While we can follow their logic, it still makes us wonder if they also believe that the earth is not only flat, but is also the center of the universe. Perhaps only Wall Street is.

We have included a comparative chart of, from bottom to top, the ratio between the Amex Oil Index (XOI) and the Philadelphia Gold and Silver Index (XAU), gold futures, and crude oil futures from mid-1991 to the present day.

Why? It used to be that rising energy and precious metals prices were considered to be inflationary, or at the least assumed to be the product of an inflationary environment, since both rose in value through much of the 1970's. In today's world, it seems, everything is under control unless gold prices rise, so central bankers are motivated to pour gasoline on the monetary fires on the one hand while selling physical gold into the market on the other. This might make sense if gold prices defined inflation, which, of course, they do not.

In any event, the comparative chart highlights a number of issues that we routinely point out in the IMRA. First, the XOI/XAU ratio traded within a narrow channel for fifteen years prior to 1996, with the upper and lower extremes marking important turning points in a variety of markets. That channel was gradually rising, however, so that today the limits would normally be found if the XOI was at 4.5 and 2.5 times the XAU. Since last week's closing levels were associated with a ratio of over 9 times, we have some sense of just how far this divergence has extended.

One of our key contentions in the IMRA is that 'the trend' that we are dealing with today finds its origin back in 1992. The technology cycle, for example, really began to dominate about that time. If we look at crude oil prices, we can see that they were moved down out of the channel in 1997 and that the inexorable rise in prices through 1999 simply brought this sector back on trend. Fair value, then, for crude oil would be found between about $27 and $33. If so, the same would also be true for the metals sector. Gold prices would have to rise back to somewhere between $400 and $430, if not much higher, to get back to trend as well.

Our point, then, is that while gold prices are 'low', they are also likely well past their absolute lows. The longer-term trend points to higher prices as one group after another fights off the damage created through 1997 and 1998.

Is there 'one thing' that we should pay attention to when we are examining the gold price trend? We would argue that the direction of the European currencies, especially the Swiss franc and euro, against the dollar is especially important. We have included a comparative chart of the Swiss franc and gold futures to help illustrate out point.

If gold prices collapsed in 1996 and have not yet returned to trend, is there any other market that might help explain why this is? 1995 and 1996 also marked the peak for both the Japanese yen and the European currencies against the dollar. While the yen turned higher with crude oil prices, the European currencies are still trending lower.

Using a shorter-term chart, we can see how the lows for gold's price in the summer of 1999 coincided with a bottom of sort in the Swiss franc. As the franc came back up to trend line resistance, gold prices began to recover- ultimately moving close to $70 higher over a very short period of time.

We note as well that the recent recovery in the gold price has coincided with strengthening in the Swiss franc. The last period of strength, by the way, lasted for three months (early July to early October) with almost all of the increase in gold's price taking place over a few days near the end. The current recovery has lasted over two months so far, so it is reasonable to assume that even in a down trend that gold may exhibit some upside volatility some time in July, perhaps taking it up to $305.

This would be an appropriate time to elaborate on this point. What we mean is that even in the context of a major down trend, gold prices could exhibit some short-term strength up to that level. However, IF the U.S. dollar were to turn lower, we would expect something much more than a compressed rise followed once again by months and months of weakness.

To spin off on another tangent, as we attack the question of whether gold is in an up or down trend, we have included a comparative chart of the ratio between gold and silver and the ratio between the S&P 500 Index and the stock price of Merrill Lynch.

The purpose of this chart is to show that the current cycle is much bigger than most imagine. While central bank sales and bullion bank chicanery may have kept gold's price depressed, they don't define the trend. One might well argue that those actions, as malodorous as they appear some days, are exactly the sort of things that tend to occur at the end of a long cycle and may well be necessary to set the stage for the beginning of a new one.

For much of the 1980's, Merrill Lynch's stock price fell in relations to the broad equity markets. The S&P 500 was 12 times Merrill in 1983 and about 70 times in late-1990. This was a period dominated by speculation in real estate, baseball cards, rare coins, and other hard assets. Gold's price increased steadily against the price of silver during this time.

From the early 1990's forward, the tide shifted. Financial assets came back into vogue and the S&P 500 Index has now returned to less than 12 times the share price of Merrill Lynch once again. While Warren Buffett's foray into the silver market in 1997 helped accelerate silver's strength relative to gold (creating a temporary divergence), the longer-term trend still remains intact. We might argue that Mr. Buffett's timing was about 4 years too late and that he would have done well to have sold gold short at the same time, but we will leave that for another day.

The point here is that the medium to longer-term trend for gold is inextricably linked not only to the trends in the currency markets, but also to what is going on in the financial markets. In order for gold to rise in a sustained and meaningful fashion, the U.S. dollar must fall AND the equity market's bubble must be popped. Since neither has happened, we would have to assume that gold is still fighting a substantial head wind.

If commodity prices in general, and crude oil in particular, have rebounded, where does this leave gold? We have included a comparative chart of gold divided by the Dow Jones AIG Futures Index (DJFI) and gold divided by crude oil futures prices. We can see that relative to both markets, gold prices are now currently very depressed.

Is the price of gold high or low? It is definitely low. Is it in an uptrend? No, not yet. What would it take for the trend to turn higher? A break not only in the dollar but also the equity markets. Is this likely? We believe so.

The Dow Jones Composite Index, shown here with the U.S. Dollar Index, shows just how closely these two trends have worked together. The dollar may well be on the verge (actually within a few days) of a substantial decline. In the short term gold prices could run over $300. How high could prices go? To come back on trend, as crude oil prices have done, gold would need to push well over $400. When? If not this month, then most likely by autumn and definitely by the end of the year. We will follow all of these trends and relationships in the days to come in the IMRA, of course, and continue to explain how the dynamics are unfolding as we go forward.

Inter-Market Relationships Analysis
Kevin Klombies Editor/Publisher
www.krk-imra.com

July 10, 2000