Tuesday May 28, 2013 14:05
I recently made a friendly wager that Comex gold would break April's low ($1,321.5 per ounce) on or before June 7. It is a fool’s errand to predict short-term fortunes of the yellow metal but this time there may be better than house odds my bet is a good one. The price level relates to gold’s changing valuation relative to key commodities; the timing finds its cue from rolling correlations.
Since early-November gold has lost not only U.S. dollar price but considerable value to equities, oil and copper. As money rotates from gold to central bank-fueled stock markets, a greater than 25 % correction in price is matched by a more than 30% decline in value relative to the S&P 500.
In terms of commodities, an ounce of gold bought 500 pounds of copper and 20 barrels of West Texas Intermediate (WTI) crude oil on Nov. 9, 2012. By Friday’s close, an ounce fetched only 420 pounds of red metal and less than 15 barrels of WTI; a loss in value of 16% and more than 25%, respectively - a bearish time for the Lustrous One on all fronts.
My Aug. 22, 2011 commentary presented a method for value adjusting gold dollar price by historical norms for global commodities oil and copper and companion metal silver. The resulting “value adjusted gold price”, or VAGP©, provides a metric for determining whether the yellow metal is trading at a premium or discount to its value as a commodity. Figure 1 is a plot of Comex gold price and VAGP© from Sep. 2010 to the present:
Figure 2 – Value Adjusted Gold Price (Sep. 2010 to present)
By the early dawn of the Federal Reserve’s second round of quantitative easing (QE2), the dollar price of gold (blue trace) was roughly equivalent to Friday’s close and fairly valued relative to oil, copper and silver. Specifically, on Nov. 30, 2010 gold closed at $1,384.9 per ounce, less than $2 from Friday’s number at $1,383.6. The corresponding November VAGP© (red trace) was also similarly close at $1,383.9 per ounce (note yellow dashed line) indicating a point of price equilibrium between gold and the selected basket of commodities (first yellow circle). Last Friday, the adjusted value of gold price was below the dashed yellow line at $1,291.2 per ounce suggesting that, though the yellow metal has been tarnished for 7-1/2 months, it still maintains a small but declining premium (i.e. < $100 per ounce) to its value as a commodity.
This was not the case as the effects of QE2 inflated metal prices in 2011. By early February, an ounce of gold bought only 290 pounds of copper as the red metal breeched the $4.5 per pound-level ($9,920 per tonne). By late April, as silver headed for $50 per ounce, an ounce of gold fetched only 31 ounces of the white metal – far below the historical 50-51ounce norm (Note 1). Over this period, gold traded at a discount to commodities as shown by the red trace departing the November 2010 equilibrium and remaining above the blue trace until the summer of 2011.
QE2 ended in June of that year and was followed by the U.S. debt ceiling debate which turned the tables for gold. Shortly before the U.S. debt downgrade on Aug. 5, 2011, gold price reached another point of equilibrium (second yellow circle) and has traded at a premium ever since. The premium peaked to nearly $400 per ounce on Oct. 4, 2011 after record gold prices in early September followed by a crash in copper prices. The value adjusted gold price made a low that day of $1,255.6 per ounce. There have been other VAGP© lows since: $1,269.9 on June 25, 2012 and most recently at $1,244.5 on April 23, 2013 following mid-April’s dramatic decline in gold dollar price. Importantly, although these lows occurred for a variety of market conditions, there appears to be a floor to the commodity value of gold that lies in the $1,240-$1,270 range (red dashed line).
A warning from rolling correlations
My May 6, 2013 commentary noted that since mid-2006, gold has been positively correlated with global commodities oil and copper more often than not - the yellow metal is usually quite comfortable running with the commodity herd. However, gold can occasionally leave the herd to play a safe-haven in crisis, monetary alternative or some combination of the two. A scatter plot of 3-month and 1-month rolling correlations of gold with oil and copper was used to identify role changes (Note 2). Figure 2 is an update of that chart from mid-April through Friday’s close:
Figure 2 – Updated correlation map (mid-April 2013 to present)
After the mid-April washout in gold price, copper-gold and oil-gold correlations were quite high on both a 1-month and 3-month basis (i.e. > +0.8). This is shown by the dark green square in the upper-right corner called the “rhino zone.” Since May 3, copper and oil prices have held fairly steady but their correlation trajectories have fled the rhino zone with significant velocity with falling gold prices (note the increasing distance between data points). I made my wager on further price decline May 21 as both copper and oil entered the left-half plane of negative 1-month correlation indicating that gold has been culled from the commodity herd.
Based on past history, the oil and copper trajectories will likely take a counter-clockwise turn into the "danger zone" of 1- and 3-month negative correlations at the expense of gold price in the next several weeks. A similar pattern occurred after the 2011 U.S. debt downgrade which was bullish for gold and bearish for oil and copper. With the yellow metal now in a multi-month downtrend, the outcome should be reversed – bearish gold and supportive, if not bullish, for oil and copper prices. Further evidence is stability divergence of both copper and WTI gold ratios (Note 3).
Last week challenged this thesis as gold not only recovered dollar price but re-gained value relative to equities, oil and copper. This is evident in the slowing of the oil and copper trajectories (decreasing distance between data points) after the May 21 wager. However, the trajectories are still in bearish negative territory with falling 3-month correlations.
$1,200 per ounce gold
On the date of my wager, R.J. O’Brien Managing Director Janet Mirasola warned, “The identity crisis that our Shiny friend is suffering from may result in a return to a base commodity fundamental that would price the metal at around $1,200. True momentum and a falling out of fashion could take the price even lower…”
Fig. 1 supports her assertion suggesting a commodity value floor in $1,200 territory (red dashed line) and shows a declining premium between gold’s dollar price and commodity value (by my calculation, VAGP©). It appears a third equilibrium point is not far away which will find gold returning to fair value relative to the oil, copper and silver commodity basket. Gold is already trading at discount with respect to WTI crude but still maintains a premium relative to silver and copper.
Timing is a trickier proposition. The 7% pullback of the Nikkei last Thursday, gave gold some “safe-haven” relief and slowed the bearish trajectories in the correlation map of Fig. 2. Further declines in equities could extend support for gold price and make my June 7 deadline for gold’s new low premature. However, lacking any global financial or geo-political shocks, money should continue to flow inexorably into equities and fade the current safe-haven allure of the yellow metal.
Comex gold price falling below April’s low will be the first step to reaching price equilibrium in the $1,200 range. After that point, gold may very well enter a period where it trades again at a discount to key commodities. This would repeat the reaction of the yellow metal during QE2 for the current round of Federal Reserve monetary easing, QE3.
Headline photo by the author: 2013 High School Rodeo in the heart of North American gold country – Eureka, Nevada
Note 1: The gold value norms used for this analysis are 16.3 barrels per ounce for WTI crude, 363 pounds per ounce for copper and 51.0 ounces per ounce for silver.
Note 2: In Figure 2, the 3-month (Y-axis) and 1-month (X-axis) correlations of copper with gold are updated each market day and the correlation pair is plotted as a red diamond. Connecting the day-to-day points (red lines) creates a correlation “trajectory” of not only correlation values but also implied direction (red arrow). The resulting plot or correlation map is divided into four quadrants. The upper-right quadrant (green) represents positive 3-month and 1-month correlations of the red and yellow metal; the lower-left (red), negative correlations. In the upper-left and lower-right quadrants, the correlations have mixed signs and are called “Transition Zones” (yellow).
Note 3: By Friday’s close, the gold-WTI 1-month stability was 3.5%; gold-copper, 4.3% - ratio stability > 3% is considered to be potentially divergent and worrisome. Ratio stability is defined as the standard deviation of the gold ratio normalized by its mean over 1-month.
By Richard Baker, CP Value Analytics