first majestic silver

Special Gold Issue

November 27, 2000

From time to time we like to take a break from the routine of covering all the various capital markets and focus specifically on gold. There is something altogether fascinating about this commodity; we suspect that this comes from the manner in which it transcends the boundaries between the various markets.

The Inter-Market Relationships Analysis (IMRA) is our attempt to explain the trends and dynamics of current, past, and future capital markets. Little of our work is derivative since we have made a point of knowing as little as possible about a wide variety of topics; in this one area of endeavor, at least, we seem to have found some success.

We always find it strange that the study of intermarket relationships strikes so many as novel or imaginative. We all know that changes in interest rates affect asset valuations and that commodity price trends help certain sectors while hindering others. We are generally comfortable with the idea that currency trends can make goods and services in one region more or less expensive than others and we have no doubt that many grasp the concept that significant changes in equity market levels can impact economic activity through the so-called 'wealth effect'. In other words, the basic notion that the equity, fixed income, currency, and commodity markets impact each other makes perfect sense, yet almost all fundamental and technical analysis is based on the premise that each market is virtually an island.

In our view it is pure folly to ignore the importance of trends and trend changes in other markets. You only have to watch (with wry amusement) earnest young analysts trip over each other to have the highest price targets for Internet/e-commerce companies on the way up and then scramble to lower them all the way down to know that they really have NO IDEA. No idea why the trend began, no idea why the trend turned, and certainly no idea what the number of the bus was that just ran over them. The IMRA represents our meager effort to explain the 'how, why, and when' behind the trends.

Gold is intriguing in that it is part money and part commodity. On a production basis it is less than one-fourth as important as live cattle yet small price movements have a significant impact on the course of world events. Why? Simply because around 85% of all the gold mined in the history of our world still exists in the form of coins, bullion, and jewelry. A relatively small percentage change in the price of an ounce of gold traded on a futures exchange can impact the valuation of over 100,000 tons of gold.

Is gold important? We believe so. Is it cheap? Let's start with this

We show a comparative chart of the ratio between gold and the Dow Jones AIG Commodity Index and the ratio between gold and crude oil futures prices.

The chart shows that gold has been falling, relative to commodity prices in general, since 1987 (exactly the time, by the way, that Alan Greenspan took office). However, while the trend has been broadly lower, the ratio has traded nicely within a channel, alternately moving from the top to the bottom and back again. At present, gold is hovering near the bottom of the channel so the risk of a relative price decline is quite small.

Gold has traditionally traded from 10 times to about 27 times the price of a barrel of crude oil. At current prices it is well below anything seen during the past two decades. In fact, the only previous situation that were at all similar (1985 and 1990) ended with a very sharp collapse in the price of oil.

In summary, relative to crude oil in particular and commodity prices in general, gold has moved from 'cheap' to 'dirt cheap'. However, since this relationship could be corrected quite easily by a substantial drop in energy prices, we are going to have to look a bit harder to find our answers.

We have included below a comparative chart of the ratio between the S&P 500 Index and gold as well as the S&P 500 Index in terms of the Japanese yen.

Why? It is easy to suggest that the equity markets are 'too high' but few actually grasp what this simple statement means. 'Too high' relative to what? Since every price is a ratio, the basic notion that something is 'too high' implies that it is currently overvalued (whatever that means) in terms of cash. Since cash has a different value in every currency, it is much too simplistic to suggest that any market, in and of itself, is too high or too low without looking at the relative merits of what it is being compared to.

In this case we are looking at the U.S. equity markets, as represented by the S&P 500 Index, relative to the price of gold as well as from the point of view of a Japanese investor. We see that equity prices had been rising at a steady pace relative to the price of gold up until 1995 and had actually been virtually flat to this point when viewed through the yen. In other words, the Japanese yen was rising at the same general pace as the U.S. equity markets, creating virtually no incentive for Japanese money to invest in U.S. stocks.

What changed in 1995? After many years of ascent, the Japanese yen finally turned lower against the dollar, creating the first rational reason for Japanese money to migrate into U.S. financial assets. Instead of losing as much through dollar depreciation, on average, as they might gain in equity market appreciation, Japanese investors were rewarded on both sides of the trade.

Of course it wasn't just the Japanese yen that turned lower in 1995- the European currencies also began to weaken. However, the deflationary spiral that Japan found itself mired in during the latter half of the last decade, and the Bank of Japan's move to push the cost of overnight money in its banking system down to 'zero', certainly have had a much larger impact on the various financial markets than many suspect.

Since gold still has a certain monetary value, it may be best to look at one of the trends affecting the price of money i.e. interest rates. We show the U.S. T-Bond futures (scaled upside down) and the Dow Jones AIG Commodity Index in terms of the Japanese yen.

Since we previously noted that gold has been falling, relative to commodity prices in general, since about 1987, it may be interesting to see what other trends extend that far back as well. The chart shows that the combination of a strong yen and weak commodity prices created a rather massive decline in yen valued commodity prices through into 1987 but from that point forward a significant reverse 'head and shoulders' bottom formation has been built. Notice that the left shoulder lasted about 4 years (1986-90), the head 7 years (1990-97) and early next year the right shoulder would be 4 years old as well (1997-2001). The chart also shows that each time the neckline was tested (1990 and 1997) that bond prices also were testing their major trend line.

Since we scaled the bond chart upside down to show it moving 'with' the commodity chart, this might be a bit confusing. In essence we are trying to show two things. First, strength in commodity prices coupled with a flat or declining yen has the potential to change the very fabric of our financial system. We would argue that the trend line drawn on the chart would represent the crossover from deflation to inflation for Japan. Second, since sub-2% long-term interest rates are inconsistent with a positive inflation rate, the entire global interest rate structure is at risk of a serious upheaval. The chart shows that U.S. long-term bond prices will likely test the lows of last January around the time that commodity prices in yen terms test resistance. We can only imagine what will likely to happen to bond prices if the neckline is broken...

There may be risk in the bond market some time next year, especially if the yen continues to weaken, but at present we are faced with a rather significant break to the upside by the U.S. T-Bond futures. We show the T-bond futures once again along with the ratio between the Baltic Freight Index (BFI) and gold futures prices.

The BFI (or Baltic Dry Index) is simply an index of ocean freight rates for bulk or container cargo over 11 different widely used routes. Since the vast majority of world trade relies on ocean-going shipping, the BFI represents both the cost of moving goods and the health of world trade.

The comparative chart shows that a strong BFI/gold ratio (shipping rates rising relative to the price of gold) is generally associated with a weak bond market. In other words, as economic activity accelerates the price of shipping and money (interest rates) tends to increase.

Our point, however, is that while bond prices can move up and down within the context of a declining trend, we tend to see a bond price breakout when the BFI/gold ratio finally peaks and rolls over. In other words, if the bond market strength seen last week is to continue then freight rates must decline or gold prices must begin to rise. This gives us some sense that a fundamental trend change in other markets could create a more positive environment for gold.

Continuing with the bond market, we show a comparative chart of the Philadelphia Gold and Silver Index (XAU), gold futures prices, and the price spread between long-term U.S. and Canadian bond futures prices. We are looking to see if price trends in gold and the share prices of gold mining stocks are related to the flow of capital between the bond market of a major commodity producer (Canada) and that of the world's largest industrial nation (U.S.).

The bond price spread declines when Canadian bonds are outperforming and rises when U.S. bonds turn relatively stronger. The chart shows that for at least the past decade the Canadian bond market has been stronger on average.

Does this make intuitive sense? We think so. During periods of declining commodity prices we would expect economies based on commodity production to operate below potential. The overall downward trend in commodity prices has resulted in a general trend toward a stronger Canadian bond market.

However...the bond market relationship changes rather dramatically when gold prices begin to rise. We can see that from 1992 through to the end of 1995 that gold prices, as well as the valuations of gold mining equities, rose while the bond price spread moved from the channel bottom to the channel top. Yet, we also can see that the bond price spread has moved higher twice (1997-98 and 1999 to the present day) without any real impact on the gold markets. How can we explain this?

Up until the late summer of 1998 there was little change in the bond price spread. The so-called 'flight to quality' bond market move that year certainly had a significant but temporary impact on the bond prices spreads. In other words, we suggest that 1998 was a temporary, but rather vicious, divergence. The current period is a bit more of a challenge since it coincides with a major commodity price recovery AND also began just as gold prices hit THE LOWS. In other words, we have maintained that the trend for gold is, and has been, 'up' since September 1999. Since we have not seen new lows in the price of gold since that time it is a point that is hard to refute.

If the trend is 'up' yet prices aren't improving, there must be some other force at work. Since spot gold prices are still hovering only marginally (if at all) above the average cost of production, the issue begins to get a bit murky.

We show a comparative chart of the Dow Jones AIG Commodity Index and the ratio between the Philadelphia Gold and Silver Index (XAU) and gold futures. This is truly interesting.

As commodity prices rise, the value of gold mining equities relative to the price of gold tend to rise as well. The chart shows that broad commodity price trends tend to coincide with an increase in the speculative premium of commodity-related equities. If we were to mask the XAU/gold chart from the beginning of 1999 forward and ask someone to make a guess, based on the action to date in the broader commodity index, what the ratio would now be, we would imagine that the answer would be between .30 and .35. Given $270 gold, that would suggest that the XAU might be fairly valued around 80 to 95 instead of the current level of around 45. Of course, if gold were to move up to, say, $350 the numbers get even more extreme.

We have included a comparative chart of crude oil futures prices and the price spread between platinum and gold futures prices to help put things back into perspective.

We argued earlier that extreme valuations in the equity markets could well be a result of the major trend change in the European and Japanese currencies against the dollar and this trend change began back in 1995. If we accept that 'the trend' runs back at least this far then we can put some of the other markets into perspective as well. The chart shows that the rise in crude oil prices as simply a move back 'on trend'- that the increase from $11 to over $30 for a barrel of oil was much more understandable than the price collapse through 1997 and 1998. In other words, the broad trend toward rising oil prices was hit by a temporary divergence but prices are now back to exactly where they should be.

The same is finally true for the price spread between platinum and gold. The chart shows that the divergence has finally been closed.

What does this mean? Well...quite a bit, actually. In the absence of some sort of significant global economic slowdown, commodity prices will continue trending higher. Since crude oil and platinum had to work quite hard to get 'on trend', it would appear as if there wasn't enough speculative capital available to move other commodities higher as well. With the leaders up to the highs, we stand some chance of seeing price strength widen into other markets.


Gold prices are low relative to cash, equity markets, and commodity markets in general. Much of the weakness can be traced back to the major turn higher in the U.S. dollar against the yen and European currencies in 1995. However, by early next year- especially if the yen continues lower- Japan could swing quite abruptly into an inflationary situation. If so, then Japanese interest rates will be forced sharply higher, destabilizing the world's major bond markets.

Gold prices should benefit from underlying commodity price strength, especially now that the strongest commodity groups have hit some sort of resistance. Gold mining shares are as undervalued, relative to the price of gold, as most other sectors are overvalued. A simple 'return to the mean' could still see the XAU double even if gold prices remain flat. In the meantime, how high is 'high' for gold? If crude oils price drop and rebound was a simple correction of a divergence, then gold would appear to be fairly valued around $400.

Inter-Market Relationships Analysis
Kevin Klombies Editor/Publisher

In the Aztec language the name for gold is teocuitlatl which means "excrement of the gods."
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