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Buy or Sell Gold Now? Check the VAGP First

By Richard Baker      Printer Friendly Version Bookmark and Share
Aug 22 2011 11:30AM

eurekaminer.blogspot.com

The Value Adjusted Gold Price© (VAGP©) offers a simple technique to influence buy/sell decisions for gold traders and investors. The approach can be used for any currency denomination and is validated by comparing it with a recent chronology of buy/sell recommendations from a renowned commodity trader.

Gold is presently a very tall tree but it will not grow to the heavens - precious metals are known for periods of consolidation and sometimes violent correction. Even most ardent believers in the 30-year secular bull market for the yellow metal have a disciplined approach to creating positions. The following is one such technique.

The Value Adjusted Gold Price© (VAGP©)

My Aug. 8th Kitco commentary presented the Eureka Miner’s Gold Value Index© (GVI), which computes the relative value of gold against a basket of key commodities independent of currencies. The GVI is assigned a value of 100 for a high gold value achieved June 7, 2010, the day the DOW closed below the intraday low of the so-called “Flash Crash? which occurred one month earlier.

Last August, after the Federal Reserve signaled their second round of quantitative easing, known as QE2, gold lost significant relative value as commodities inflated over the duration of the new monetary policy (November 2010 through June 2011). April 11 the GVI dropped to a low of 67.7 but has dramatically regained value since. On Aug. 8, the GVI closed above par at 102.7, a new high for 2011.

Because the GVI is independent of currency, it can be used directly to value-adjust gold price in any currency – either it is U.S. dollars, euros or Indian rupees. Here is the formula for the Value Adjusted Gold Price© (VAGP):

 VAGP = (83.556/ GVI) * (currency denominated gold price)

When the GVI equals 83.556 the VAGP is equal to the current gold price and is considered at fair value with respect to historical commodity norms. By this logic if the daily gold price is below the VAGP, then gold is undervalued; if above, overvalued.

Here is a plot of a U.S. dollar-denominated VAGP from June 7, 2010 through Friday’s close:

During the morning of June 7, the VAGP (magenta line) was $1,036.8/oz compared to a higher COMEX gold price (dark blue line) of $1,240.8/oz; gold was thereby overvalued relative to the reference commodities in the GVI. By that November, the VAGP and gold price converged during a brief period of calm when gold-referenced commodity ratios were stable and near historical norms (ref: July 28th Kitco commentary).

As commodity inflation gathered steam earlier this year, gold became increasingly undervalued until the VAGP hit a peak of $1,835.3/oz on April 21, while COMEX gold traded at the low $1,500/oz level. With the end of QE2 in June, the debt ceiling debate and credit downgrade in the U.S. and the worsening sovereign debt debacle in Europe, the VAGP and COMEX price quickly flip-flopped in early August on falling commodity prices. At Friday’s close, COMEX gold closed at $1,852.2/oz and the VAGP traded places at the $1,500/oz level scoring $1,506.8/oz. The arrows indicate the present divergent trend between the two prices.

A Buy/Sell Strategy based on the VAGP

A plot of the spread between the COMEX gold price and the VAGP suggests a fairly simple buy/sell strategy. Here is a chart of that difference or “delta? (magenta line) with a two-standard deviation (2-s) upper and lower bound (black solid lines) over the same time period:

Presumably, it is a good time to buy gold at the bottom of a value cycle when it appears price and value are ready to rise together. On April 21 (point A on the above graph) a Kitco News Market Nugget  reported that Dennis Gartman, editor/publisher of the Gartman Letter, made bullish comments about gold to his subscribers. Bill O'Neil of Logic Advisors LLC made similar remarks on CNBC Business News the day before. This is significant because he and Gartman are much respected commodity traders and are often openly skeptical of gold seeking greater rewards elsewhere in the commodity space.

On June 10 (point B), a second Kitco Nugget  relayed that Gartman was adding more gold to his April position, primarily in euro and sterling terms. Gold price and value had indeed moved higher and were now very near fair value in U.S. dollars (dotted line).

In early August, the VAGP delta crossed fair value and moved rapidly into overvalued territory. On Aug. 5 (point C), Gartman said on CNBC Business News that he had reduced his gold position by one-half. Finally, a Kitco Nugget  reported Friday (point D) that Gartman warned high gold prices may dampen buying enthusiasm, “Gartman says that despite gold’s rise to dizzying heights, he is cautious and less enthusiastic than he was a few days ago.?

Nearing the top of a value cycle – time to sell?

Conclusion

The VAGP delta chart fits fairly well with the buy/sell recommendations from at least one renowned commodity trader. The 2-standard deviation lines provide notional boundaries for add/reduce decisions in the neighborhood of fair value. The decision to sell an entire position versus profit-taking with partial positions is dependent on a trader/investor’s time horizon and outlook.

When headlines trump fundamentals, the news of a European bank failure could propel gold prices much higher. A falling VAGP for that scenario would probably signal global contraction (i.e. gold-referenced commodity ratios rising). Alternately, for those who believe in a slow-but-steady growth outlook, gold prices are showing signs of being very over-extended with a re-convergence of gold price and VAGP overdue. For either viewpoint, the daily VAGP  may provide a useful input to your buy-or-sell gold decision.

By Richard Baker, CP Analytics
http://eurekaminer.blogspot.com/

 

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Disclaimer: The prices of precious metals and physical commodities are unpredictable and volatile. There is a substantial degree of a risk of loss in all trading.