Tuesday July 09, 2013 13:59
"Ahhh, this chair is just right," she sighed. But just as she settled down into the chair to rest, it broke into pieces!
The Story of the Three Bears, a fairy tale
July 9, 2013
I remain bearish on gold price. My May 28 Kitco commentary predicted that Comex gold would fall below April’s low by June 7:
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.
My timing was off by nine-market days but August gold did oblige on June 20 by falling precipitously past its April low to close at $1,286.0 per ounce. This was followed by a second plunge to an intraday low of $1,179.4 on June 28.
Dennis Gartman of the Gartman Letter described gold as being “egregiously, shockingly, violently oversold” following the second drop and he proved right – Comex gold rebounded and has traded range in a tight range above the $1,200-level since.
Like the little girl in the headline fairy tale, gold has sought rest from all this market excitement by sitting down. The familiar safe-haven and monetary alternative chairs have proven much too big for our fallen metal but the commodity chair is “just right.” Presently, gold has near-zero 1-month correlation with the S&P volatility index, or VIX– hardly the attribute of a safe-haven asset. With the U.S. dollar index at multi-month highs, it is difficult to make a case that there is much luster left as an alternate to fiat money. Following the first downdraft in price, R.J O’Brien Managing Director Janet Mirasola accurately described gold’s plight:
The Shiny One has reverted back to commodity status as those looking for safe haven from the coming storm run to the VIX and the US dollar realizing that gold will reap no dividends and as a commodity has to stay firmly in the “risk” basket. (RJO Pre-Market Brief, June 21, 2013)
The question is now whether gold has seen its worst days for 2013 or is there more downside to come? Will Goldilock’s commodity chair soon break into pieces?
Commodity Value Matrix
If gold is behaving as a commodity, it makes sense to track its performance relative to key commodities. One technique that has served me well is a value matrix as described in Figure 1:
Figure 1 – Value Matrix example (Friday’s close, 1-month comparison)
Constructed like a foreign exchange cross rate chart, a commodity value matrix provides relative valuations between commodities and currencies. In this example, the commodities are Comex gold and copper, Nymex WTI crude oil and the U.S. dollar. Read the table of Figure 1 as “1 unit of row A buys X units of column B.” Each cell has the value for the date shown and the percentage change from a prior record (in this case market close Friday, July 5, 2013 and percent change from prior month). Colors enhance the comparisons - shades of green denote positive changes in value; shades of red, negative.
Gold value destruction
Figure 2 illustrates the dramatic value destruction of gold since last November, not only in U.S. dollar terms but value relative to oil and copper (Note 1):
Figure 2 – Value matrix (Friday’s close compared to Nov. 9, 2012)
Applying the common 20% value decline rule-of-thumb to characterize a bear market, three bears jump from the forest of Figure 2. Papa bear is a greater than 40% decline in value relative to oil – in November an ounce of gold fetched 20 barrels of crude; in July, less than 12. Mama bear marks a 30% decline in value in U.S. dollar terms and Baby bear sticks just a nose beyond a 20% drop in red metal terms – 500 pounds per ounce in November versus slightly less than 400 pounds in July.
By startling contrast, oil is the big winner in the value race scoring a nearly 20% rise from November prices and gaining on copper in a relative value just short of 35%.
In the fairy tale, the Goldilocks flees safely to the forest never to return again to the home of the three bears. Markets are cyclical and nothing escapes flights from bears or enjoys runs with bulls forever. For gold is does appear that life with a family of commodity and currency bears will be the status quo for some time to come.
During the second round of Federal Reserve quantitative easing (QE2) gold enjoyed the ascendancy of a long-term bull market. Although it lost value relative to inflated copper prices, the yellow metal crept upward nonetheless. Although the third round (QE3) has done much less to boost copper prices against a backdrop of slowing global demand and brimming inventories, gold is now clearly in a bear market.
If copper prices move sideways to down for the remainder of the year the outlook for the yellow metal is grim. My June 11, 2013 commentary derived a fair value line for gold relative to copper of 400 pounds per ounce. Since the Aug. 5, 2011 U.S. debt downgrade, gold has traded at a premium to copper (i.e. greater than 400 pounds per ounce). Since July 1, gold has traded at a discount mirroring its behavior during QE2 (which witnessed a devaluation low of 290 pounds per ounce in early February 2011).
R.J. O’Brien’s most recent metals outlook (July 8, 2013) is for relatively stable copper prices in the $6,600 to $6,800 per tonne ($2.99 to $3.08 per pound) range for the short-term. The fair value line would therefore put a cap on gold price of $1,196 to $1,232 per ounce. A drop to lower levels of support could easily condemn gold to $1,100 per pound territory – the RJO third support level of $6,259 per tonne ($2.84 per pound) lowers the upper limit to $1,136 per ounce. RJO recognizes the $1,050-level as a key test of the resolve of traders given that “as we move lower, increasing quantities of gold previously purchased start to become under water.” Goldman Sach’s year-end forecast for 2014 was recently lowered from $1,270 to $1,050 per ounce.
Relative to oil, gold’s predicament is even more severe. Using 16 barrels per ounce as a historical line of fair value, gold has traded at a discount since April 15 dropping below 12 barrels per ounce last Friday (Figure 2). There is some consensus that the recent Egypt turmoil has put an additional $7 per barrel on WTI prices – less this premium gold still struggles to exchange an ounce for 13 barrels suggesting at least $92 per barrel is required to keep gold above $1,200 per ounce given a stabilizing Middle East.
For now, Goldilock’s commodity chair may feel “just right” but the legs are wobbly at best with large bears at the door.
Note 1: For this analysis, Nov. 9 was selected for value comparison when gold achieved a peak premium relative to copper of 502.4 pounds per ounce. A similar premium peak occurred for WTI crude two market-days later on Nov. 13.
By Richard Baker, CP Value Analytics