Inter-Market Relationships Analysis
Intermarket Gold Analysis
When people ask me what I do for a living I am never quite sure how to answer. I write and distribute a daily financial markets newsletter that analyses financial markets trends from an intermarket perspective - which makes me an editor, publisher, and analyst, I suppose - but long before I have finished the sentence most people's eyes begin to glaze over. Of course, if you asked my 10-year old daughter she would probably say something like, "I don't know but he sure sits in the front of the computer a lot."
If you were involved in the financial markets in 1987 you might have noticed the U.S. dollar weakening. You probably noticed that the strongest sectors through much of that year were the commodity cyclicals- including the golds. Some might even recall that the Fed was raising interest rates and bond prices were falling almost daily. Yet, when stock prices collapsed in October most analysts and participants were taken completely by surprise.
George Soros took his first run at shorting Thailand's currency toward the end of 1996, if we recall correctly. Through much of 1997 news stories popped up occasionally warning of weakness in currencies throughout South East Asia. As one central bank after another raised interest rates in an attempt to stop or reverse the outflow of capital, the U.S. equity markets continued to push higher. All of a sudden...the financial markets were in a state of crisis. Were there any warning signs? Of course there were. There is always a relationship between the foreign exchange, fixed income, equity, and commodity markets. In fact, we would argue that it is imperative for any investor to know which way currencies are trending and where the key stress points are.
We wanted to show a few of the charts that we include in the IMRA (Inter-Market Relationships Analysis) from time to time. We do quite a bit of work on gold and the gold mining sector since it is one of those areas that many people remain deeply interested in. The first chart is a simple comparison between the price of gold futures and the Swiss currency.
The chart argues quite nicely that when the Swiss franc is falling relative to the U.S. dollar the overall trend for gold is 'down'. We tend to use price channels to define and delineate 'the trend' so it is easy to see that while gold is capable of spiking quickly to the channel top, it isn't going to move any higher until the dollar stop rising vis-a-vis the European currencies.
The second chart that we have included is going to take a bit of work to explain. We show gold futures against the ratio between gold futures prices and an index of gold mining stocks- in this case the Philadelphia Gold and Silver Index (XAU). While some may argue that the XAU is not the purest measure of the health of the gold mining sector, we have found that it works well enough for our purposes.
Now...why look at the gold/XAU ratio? Because it gives us a reasonable idea how much speculation is in the gold mining stocks at any given time. It does that by moving from one extreme to another. When the ratio is 3:1 or less we can conclude that gold is 'high'. When the ratio is 5:1 or more, then gold is 'low'.
The idea here is actually quite simple. When the value of gold mining stocks rises disproportionately to the price of gold it indicates that speculative capital is being directed toward this sector. In other words, the interest in the stocks of gold mining companies is great enough to allow these companies to attract new capital. What we have seen over the past couple of decades are intermittent windows where capital becomes available to finance new mines and, ultimately, increase the future supply of gold. At the peak the gold/XAU ratio moves down to about 3:1. Conversely, when there is little or no interest in this sector capital becomes almost impossible to obtain. By the time the ratio drops back to 5:1 you will find almost no interest in gold or the gold mining sector by the general investment community.
There are two ways to look at this. Longer-term investors would do well to pick up gold mining shares when no one is interested (i.e. the ratio moves down to, or below, 5:1) and then hold them until the next period of speculation appears. Those with a shorter-term investment horizon would be better off waiting for some improvement in the ratio and then holding on until it began to deteriorate once again.
At present our view on gold and the gold mining sector is quite positive. The gold/XAU ratio turned upward last November and has been gradually improving.
The third chart today provides a perspective on gold that uses the relative strength of two different bond markets. I have included a comparative chart of gold futures prices and the price difference between U.S. and Canadian long-term bond futures.
How does this work? Canada is a major commodity producer. When commodity prices are trending lower the Canadian bond market tends to do better than the U.S. bond market for the simple reason that lower commodity prices tend to be a positive for the U.S. and a negative for Canada. In other words, we can 'see' the general trend for commodity prices in general and gold in particular through the relative action of these two bond markets.
When the U.S. bond market is outperforming the Canadian bond market the trend tends to be positive for gold. In other words, when gold is rising long-term U.S. bonds will increase more in price than long-term Canadian bonds. From the autumn of 1999 through to the present day the bond market has argued that the environment for gold is generally positive.
The last chart today shows an interesting way to look at gold prices. We need to remember that every price is a ratio, though in most cases we value things in terms of 'cash'. If you only had the choice of cash or 'something else' then this might be fair, but in reality most of us have a few more options available than that. When, for example, you sell a stock you exchange it for cash but when you sell one stock to purchase another you are actually more concerned with their 'relative' value. The same would be true if you liquidated an investment portfolio to purchase real estate. On the other hand, we continually stress that 'cash' is also a relative term since the movement of exchange rates will make 'cash' in one currency rise or fall relative to the value of 'cash' in another.
In any event, we have included a chart of the ratio between gold and sugar prices. The chart shows that last year gold had moved back down to a level that could be called 'cheap' relative to the price of sugar. Commodity traders who understood this would realize that the relative prices were beginning to get out of line and would start to make adjustments. That might mean buying gold, selling sugar, or both.
Conclusion
The short to medium term trend for gold is actually quite positive. We can see through the bond (relative strength of U.S. bonds) and equity market (gradual build up of speculative premium in the gold mining shares) that there has been a bit of a tail wind behind the gold sector. On the other hand, the $280-81 level represents significant resistance for gold and won't be broken, we suspect, until after the U.S. dollar stops its ascent.
As it happens, we went positive on the XAU last November and recently went negative on the U.S. dollar - for a variety of reasons. If we are correct with this latter view, then there is every chance that gold will successfully push through $280-81. That opens up the possibility of a strong, and potentially very quick, move up to the $350 level.
Kevin Klombies
IMRA
krk@krk-imra.com
September 15, 2001
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