Golden Inter-Market Relationships
Inter-Market Relationships Analysis (IMRA) produces a daily chart-based review of global capital markets trends. In simpler terms that means that we look at a wide variety of relationships that are either on the go or in the process of changing and discuss their impact on the equity, fixed income, foreign exchange, and commodities markets. Since gold is both widely followed and intrinsic to much of our work, we tend to look at it quite closely.
Why is gold so important? Two reasons. First, while the actual amount of gold produced each year is small compared to, for instance, crude oil, it still retains a substantial impact. As the introductory information to the Dow Jones AIG Commodity Index stated, "Production data alone also may underestimate the investment value that financial market participants place on certain commodities". They go on to note that, "Of the approximately 121,000 tons of gold mined since the dawn of recorded history, approximately 103,000 tons are still held by central banks and by non-governmental entities as coins, bullion, and jewelry." Second, gold tends to act as a bridge between various markets. It is on one hand a monetary asset- representing a portable store of value- while on the other hand it acts as an industrial commodity. Its value or price will tend to be impacted by currency markets trends, changes in real and absolute interest rates, broad commodity price trends, and the ebb and flow of equity markets speculation.
We went positive on the gold sector in November of 1999 and have held that view through to the present day. One of the intermarket arguments that we relied on had to do with the relative action between U.S. and Canadian long-term bond futures. At top right we show a comparative chart of gold futures and the price spread between U.S. and Canadian long-term bond futures. As can readily be seen, this price spread moves 'with' the trend for gold.
Why? In broad terms one could say that Canada is more of a commodity 'producer' while the U.S. is mainly a commodity 'consumer' so during periods of rising commodity prices (in this case gold) there would be a net stimulative impact on Canada that would have a corresponding effect on their interest rate structure. Up until September of last year the bond price spread remained relentlessly positive and helped us to maintain our positive view on gold.
At bottom right we show a comparative chart of gold futures against the ratio of gold to the Philadelphia Gold and Silver Index (XAU). This is an especially interesting chart because it helps not only with the gold's underlying trend but also helps identify levels that represent extremes.
To explain, consider that mining companies are continually finding new ways to cut their cost of production. This implies that they can be profitable at lower and lower prices for gold which explains why each peak in the gold price has been lower than the one that preceded it. We try to look past the absolute value of gold and focus instead of the degree of speculation evident in the equity markets.
What does this mean? At bear market lows for gold there is very little speculative interest in the gold mining shares. The ratio between gold and the XAU tends to move up to about 5:1. At bull market highs, however, this ratio tends to move down to around 3:1.
Within the range of these two levels- 5:1 and 3:1- one can see why the gold mining equity sector can be both punishing and extremely rewarding. At $300 per ounce for gold the XAU can easily range from a low of around 60 to a high of 100, depending on the market's view of whether that price for gold is 'low' or 'high'. At present the ratio is recovering from the extreme lows reached at the end of 2000 and is nicely confirming the current strength in gold itself.
We show here the ratio between gold and the Dow Jones AIG Commodity Index (formerly called the Dow Jones Futures Index) as well as the ratio between gold and crude oil.
One has to wonder whether it was merely a coincidence or some sort of well ordered plan, but gold's value relative to the commodity markets in general has been in a down trend from the summer of 1987 (Alan Greenspan was appointed Chairman of the Federal Reserve in June of that year) through to the present day. There have been two tests of the trading channel top- in 1993 and the end of 1998- but so far the channel has held. We are now going through the third good test of this ratio.
Gold tend to wander back and forth relative to crude oil with the relative highs and lows generally matching the gold/commodities trend. At relative extremes gold can be valued in excess of 25 times a barrel of crude oil and as low as 8-10 times crude oil. On average, however, the relationship tends to move back and forth around 18 to 20 times.
In terms of the current trend...we pointed out several weeks ago that the Australian SE Gold Index had cleanly broken up out of a bear market trend that extended back to 1987. We show a chart of this index along with a Relative Strength Index to help show that the move has some validity.
If the major reason for caution on the golds at this time is their relative level vis-à-vis the broad commodity markets (DJ AIG Commodity Index) then the action in the Australian equity markets is somewhat comforting in that it argues that this 14-year trend can indeed be broken.
At left we show the ratio between the XAU and Australian SE Gold Index to help put the North American situation into proper perspective.
From 1986 through to the present day the ratio between these two indices has moved back and forth within a fairly well defined range. At present the XAU is plumbing the lows of this range. In other words, if one were betting on relative strength then the Australian market is the place to be but if one were looking for longer-term relative value then the North American gold mining sector is definitely more attractive.
A logical question to ask might be "Why now?" . One answer would be that it is simply their turn to enjoy some of the benefits of the relentless push of liquidity into the financial markets by various central banks.
We also show a long-term chart of the stock price of Barrick (ABX) from Canada's Toronto Stock Exchange. Relative to the long-term trend it is easy to see that Barrick 'bubbled' from the start of the last decade into 1996 and then spent some 5 years working back to the trend line. After a number of bounces off of this line Barrick is now testing the top end of its corrective channel as it hammers away at Cdn$30.
One of our more compelling arguments recently has been that gold tends to benefit when a major currency moves into a state of uncertainty. Perhaps that is the wrong way to put it in the case of the Japanese yen as there is some certainty that the Bank of Japan and the Japanese government is in favor of trying to depress the external value of the yen in order to help stimulate Japan out of its deflationary funk.
If we conclude (and we do) that all investment trends- no matter how irrational they may appear at the time or even in retrospect- are based on rational decisions by investors, then some of the recent strength in gold begins to make sense. Japanese investors facing the current and future prospect of a depreciating currency appear to be moving steadily into gold as a hedge. Given the precarious balance in the gold market- with current demand met through sales of forward mining production and leased central bank gold- it may not take much of a marginal increase in investment/speculative demand to blow a few hedges apart and move gold's price incrementally or, perhaps, substantially higher.
The chart at middle right shows gold in terms of the Japanese yen and contrasts it with the movement of the XAU. The parabolic nature of gold's price in terms of the yen indicates that this is a trend that is picking up steam and has a ways to run before it finds next resistance.
From a longer-term perspective we have also noted that two trends coming out of the 1990 recession are now in the process of either failing or potentially turning. From 1990 through to last year the price of gold was weak relative to silver- with the ratio spiking down on the news in 1997 that Warren Buffett was accumulating a substantial position in silver. The chart below right argues that this trend has now turned. The recent 'squeeze' in the silver market pulled the ratio back to the top of the trading channel...but no further. This was both a nice test of the new trend and sufficient confirmation that something new was indeed in the wind.
The other major trend involved relative strength by the financial sector vis-a-vis the broad equity markets. In a disinflationary environment one would expect to find that each peak in interest rates would be followed eventually by lower lows. This is exactly the sort of environment that financial-oriented companies tend to thrive in as they borrow short and lend long. The news background at present is rife with reports of problems- ranging from Argentina to Enron to Global Crossing- and the news is likely going to get worse before it gets better.
Gold has the potential to move up to $320 and perhaps to $350 in a 'normal' market place. If things start to get a bit wild (and the yen value of gold relative to the 1997 peak will offer an interesting test of how stressed the system is) then all bets are off. As long as the gold mining shares continues to outperform gold itself (the gold/XAU ratio continues to work lower) we will maintain our positive view and try our best to enjoy the ride.
Inter-Market Relationships Analysis
Kevin Klombies Editor/Publisher
www.krk-imra.com
February 8, 2002
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