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Oil, Copper & $1,100 Gold - The Seven Year Itch

Monday July 22, 2013 12:02

A stairway to nowhere! I think that's just elegant...

Marilyn Monroe in the movie, The Seven Year Itch (1955)

July 22, 2013

To suggest that the 12-year rise in U.S. dollar gold price has been a “stairway to nowhere” would be a very bearish assessment indeed. However, given the downdrafts of 2013, it does appear this fading star may have to wait some time to land another blockbuster role as a safe-haven, monetary alternative or combination of the two. The casting calls with a strengthening U.S. dollar in a rising interest rate environment have been brutal. For the near term, I remain bearish on dollar price for the blonde metal but bullish long term as some of her former elegance returns with rising inflation expectations …whenever that happens.

One of the biggest hurdles for gold has been the massive quantitative easing, or QE, programs of developed nations. In theory, “printing money” should boost gold’s allure as witnessed by recent short-term rallies in gold price with every dovish comment from the U.S. Federal Reserve. These have proved short lived and each QE cycle since the Great Recession has caused steep erosion in value relative to key commodities before a serious recovery in gold price is possible – typically, after or near the end of each QE program.

Gold has lost bearish levels of U.S. dollar price and value relative to global commodities oil and copper in the present QE3 cycle. Monitoring this commodity value trend is important to anticipate the next sustainable recovery in gold price.

The Seven Year Itch

For seven years, gold has enjoyed an upward trend in value relative to both oil and copper. In mid-2006 when gold was in the mid-$700 range, an ounce bought 10 barrels of Western Texas Intermediate (WTI) crude and 200 pounds of the red metal. Even with all the price and value carnage of the last several months, $1,290 gold still fetches 12 barrels of oil and over 400 pound of copper. However, this stands in contrast to mid-November of last year when $1,700+ gold bought 20+ barrels and 500 pounds. Comparing last Friday’s closing prices to Nov.13, 2012, gold has declined 25% in dollar price, 40+% in value relative to oil and 18% relative to copper.

The Eureka Miner’s Gold Value Index© (GVI©) is a powerful tool for understanding gold’s value relative to these key commodities, assessing its curious relation with past and present QE cycles and anticipating the yellow metal’s near- and long-term market direction.

The GVI computes a currency independent value for gold against a basket of commodities in much the same manner as the US Dollar Index® (DXY) determines the value of the dollar relative to foreign currencies. The GVI basket includes Nymex (WTI) crude oil, Comex copper and Comex silver (Note 1).

A seven-year history of the GVI is shown in Figure 1:

Figure 1 – The Eureka Miner’s Gold Value Index© (mid-2006 to present)

Along with a plot of the GVI (reddish brown line) are key dates and gold price benchmark records. The dashed orange line that goes from the lower-left to the upper-right of the graph is the seven-year value trend with boundaries of +/- two-standard deviations (dotted lines). The solid orange line represents a “market norm” attained on Nov. 26, 2010. This date lies roughly in the middle of a six-week interval when key commodity ratios returned to near historical norms and enjoyed a halcyon period of rock sold stability following the Great Recession. Reassuringly, the GVI norm at 83.56 is less than 1% from the GVI seven-year mean of 82.98 (Note 2).

For the first two QE cycles, gold is less valuable at the end of a cycle compared to the beginning. A similar trend appears to be in place for QE3.

Table 1 compares these results:

* The QE3 cycle is ongoing; the value given is for July 19, 2013

Table 1 – Gold value erosion during QE cycles

QE1 was implemented in late November 2008 during the dark days of the Great Recession and was quickly followed by crashes in commodity prices that December and early-2009. On Feb. 17, 2009 the GVI hit a maximum value of 136.4, a nearly 5-standard deviation from trend. This December-February period witnessed copper drop to the $1.5 per pound-level and oil to less than $35 per barrel. Gold briefly breeched the $1,000 per ounce, a level not seen since the collapse of Bear Stearns on March 17, 2008 (i.e. first Comex benchmark record of Fig. 1, $1,082.9 per ounce).

As QE1 progressively added liquidity to failing markets, oil and copper prices reflated and gold pulled back from its highs. This caused dramatic erosion in gold’s value (first red arrow) until the yellow metal regained momentum by the end of 2009 setting the second Comex benchmark of $1,244.3 on Dec. 3.

QE2 began just prior to the Nov. 26, 2010 market norm and eventually upset this equilibrium with inflating copper prices. By early February 2011, the red metal soared above $4.5 per pound while gold was only a few dollars from its price at the initiation of the program. As a consequence, gold value fell to a low of 69.1 by Mar. 25, 2011 (second red arrow). The second phase QE program ended that June followed by the U.S. debt debate and debt downgrade on Aug. 5, 2011. This propelled gold price to its all-time record Comex benchmark of $1,923.7 on Sep. 6, 2011 and set in motion a second crash in copper prices.

The GVI reaction to QE3 looks like a scaled down version of the QE1 cycle: The GVI peaks in November, 2011 to 103.7 after the September program start. The value then quickly erodes returning the GVI to near the market norm at current prices (third red arrow). No one knows when QE3 will begin tapering but it is likely that gold will soon again trade at a discount to the commodity basket.

$1,100 gold

The Eureka Miner’s Gold Value Index© can be used to modify current gold prices as discussed in my Aug. 22, 2011 commentary. 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 U.S. dollar value as a commodity.

Figure 2 is an updated plot of Comex gold price and VAGP from Sep. 2010 to the present:

Figure 2 – Value Adjusted gold Price (Sept. 2010 to present)

On Nov. 26, 2012, the VAGP (reddish brown line) and Comex gold price (blue line) are equal at $1,362.4 per ounce (first yellow circle). After that point, gold trades at a discount to its commodity value until a few days before the U.S. debt downgrade (second yellow circle). from the downgrade to Friday’s close, gold has traded at a premium (blue above VAGP line).

Importantly, the VAGP has made a succession of lower highs (upper dashed line) since the spring of 2011 while the lows have bounced off a floor in the mid-$1,200 per ounce area (lower dashed line). This was violated with conviction June 26 when the VAGP dropped to a new low of $1,173 per ounce (red circle), less than $60 below gold price.  If the VAGP chart were stock price, traders would be fleeing for the exits – a very bearish pattern.

Gold traders should be no less wary in the near term. As the VAGP premium vanishes, it is likely that both gold and VAGP price will re-enter $1,100 territory.

What about the longer term?

Figure 1 suggests a relation between quantitative easing cycles in the U.S. and the value of gold in commodity terms. Although the end of QE3 is uncertain, gold appears to be following the playbook of the two previous programs: a period of significant devaluation that returns gold at or below fair value relative to key commodities.

For QE1 and QE2, gold price increases to new price records occurred after or near the end of easing cycles. A market “tell” will be a reversal in the present gold value downtrend. Savvy commodity traders Dennis Gartman and Bill O’Neil returned to buying gold within days of each other when the gold value trend reversed in late April 2011 under QE2.

Will the seven-year gold value uptrend continue? It is probably too early to say for certain. However, the 2013 GVI moves below trend are all comfortably within the 2-standard deviation boundaries of Figure 1 suggesting that the GVI will return to trend after the cessation of QE3 and U.S. dollar gold prices will move higher. This may herald the long awaited rise in inflation expectations and a market rush to embrace their fallen star – for a gold enthusiast that would be “just elegant.”
Note 1: The GVI is assigned a value of 100 based on morning prices of June 7, 2010, when the DOW fell below the intraday low of the so-called “Flash Crash” which occurred one month earlier. Since the commodity-based value of gold spiked that day, 100 represents a “high value” for gold.

Note 2: If the GVI is above this line of equilibrium (i.e > 83.56), gold is considered to trade at a premium to the basket of commodities of the previous note; a discount if below (<83.56).

By Richard Baker, CP Value Analytics
Eureka, Nevada

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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