Inter-Market Relationships Analysis
Gold, Equities, and Bonds - Timely Comment
One of the tricks to doing analysis on a daily basis is always to have an inventory of ideas to draw from. Quite often there are topics that we want to cover but know can wait for a day or two. This is simply not one of those times.
When (if) equity markets trading begins in the morning there is a strong possibility that a number of different sectors are going to move quite quickly. We are looking for a peak in the bond market, a bottom in the equity market, and some sort of upward spike in the gold sector. It may take a number of trading sessions before the extremes in all three markets are reached but just in case it doesn't...we wanted to show a couple of relationships that might help shed some light on what otherwise could be a very emotional and confusing situation.
Over the past couple of years gold has tended to spike up INTO equity market bottoms. One of the reasons we have remained positive on gold through the past few months is the lack of this sort of behavior. In other words, we could 'see' the pressure building but hadn't witnessed- yet- the sort of action that would signify that the corrective cycle had moved to completion.
To explain we have included a comparative chart of the S&P 500 Index (scaled upside down) and gold futures. In 1999 the S&P 500 Index went through a period of consolidation (keep in mind that lower prices on this weekly chart are signified by a rising line!). For months gold prices remained depressed until...boom...they snapped upward in September. If we go back through the gold price chart we can see that an initial trend line was set earlier in 1999 and, as always, the violent price move higher was simply a return back to 'trend'. Fair enough.
The S&P 500 Index has been consolidating/declining since the latter half of last year. If history repeats then the apparent gold price hibernation in the interim has really masked a 'coiling' of unexpended power. In other words...in a very short period of time gold prices could move a long ways.
Our sense that there was another shoe yet to drop was rewarded when the S&P 500 Index recently broke to new weekly closing lows. If gold was going to rise up into the equity market's bottom then last March/April could not have been 'the lows' for equities (and clearly wasn't). It is difficult to project exactly where gold could rise to (although it is always quite simple in hindsight, we find) but using a parallel trend line to the 1999 experience we come up with a number around $340. That is in the ball park, so to speak, with the $350 number that we provided last week.
Another way to look at this is to combine the base metals sector (copper), with the gold mining shares (Philadelphia Gold and Silver Index- XAU) and look at it through the bond market. Sound complicated? Let's try to explain.
We have included a chart of the U.S. 10-year T-Note futures (Sept.) and the ratio between the XAU and copper. The chart covers the period from the second half of 1989 through to the end of trading last Monday for the XAU/gold ratio.
If you had simply used the XAU/copper ratio and ignored everything else, you could have exited the bond market virtually at 'the peak' in 1989, 1996, and 1998 and caught everything but the last price run up in 1993. Since it has worked so nicely, we wanted to show where things stand at present.
The 'key' level for the ratio is 1.19:1. We have marked with vertical lines where the bond market was when the ratio pushed up through this point and also note that through much of 1997 and 1998 the ratio approached this level but...failed just below it. The bond price peak occurred at the exact point where the ratio finally managed to move marginally through 1.19:1.
What does this mean?
It suggests that bond are a reasonable long-term hold UNTIL the XAU moves almost 20% higher than the price of copper. With copper currently trading around 65 to 66 cents, this argues that bond prices would peak if the XAU were to drive up through 77 (compared to 55.50 at last Monday's close).
Conclusion
We have felt for some time that the equity market's correction wouldn't be complete until gold had some sort of price spike. In the context of a continuing bear market for gold (a potentially moot point) a price spike up to the $340 to $350 region appears to be about right.
Given the current inverse relationship between bond and stock prices (falling equity prices are pushing bond prices upward) it makes sense to pay attention to anything that could signal a bond market peak even if one is only interested in the equity markets. A remarkably reliable indicator- the XAU/copper ratio- suggests that bonds will continue to rise until either copper prices fall further or gold mining shares rise higher (or both). At current copper prices the XAU would need to jump about 40% although that will change as the week goes on- depending on what happens to base metals prices.
In sum, there is nothing here that can't be reached in a matter of days. A build toward $350 per ounce for gold would certainly be enough to kick the gold mining group (XAU) up towards 75-80. That would indicate a potential bond market price peak and correspond generally to an equity market bottom.
Our last point is that it doesn't really matter what the Fed or the U.S. Treasury does here- to a point. We would argue that they might delay the inevitable but are unlikely to change the final outcome. In fact, the longer they keep the financial markets from finishing this corrective process, the worse it will get. Interesting and exciting times indeed.
Kevin Klombies
IMRA
krk@krk-imra.com
September 18, 2001
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