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A Bear Case For Lower Gold Price (With A Happy Ending)

Tuesday September 03, 2013 16:29

Even the most cynical market watcher would find it hard to deny the robustness of August’s gold rally. On an intraday basis, the Comex December contract moved more than $160 per ounce from Aug. 7 to Aug. 28, a nearly 13% bounce. More impressively, the $1,434 August apogee marked a greater than $250 ascent form the frightening depths of June’s flirtation with $1,100 territory, a 21% rally.

Other good things happened for the yellow metal too. By mid-August it, broke to the upside from a descending channel of value destruction relative to the S&P 500 that began mid-November and bottomed in early July. This reversed a seemingly inexorable drain of investment money from the tarnished store of wealth to the brighter shine of ascendant U.S. equities. Gold has also regained value with respect to global commodities oil and copper after enduring bearish value destruction to both, roughly coincident with its stock market-associated descent.

Gold’s renaissance is reportedly thriving on the uncertainty of the moment: safe-haven sirens from Egypt and Syria with an impending, albeit delayed, U.S. punitive strike on the latter, “taper talk” surrounding U.S. Federal Reserve bond-buying program, crashing currencies in emerging markets, the upcoming G20 meeting, Friday’s monthly job report, German elections and the return of the U.S. Congress which now has the opportunity to not only shutdown the government but put its ham fist into the spiraling Middle East crisis. Oh…and September is typically a lousy month for stocks which should reinforce gold’s negative 1-month rolling correlation (presently a flexing strong -0.88).

Before goldbugs uncork another bottle of champagne, I sense something a little flat in the bubbly. With this backdrop of headlines, why has gold retreated from its August high? Given the history of the last several years, one might imagine $1,500 or $1,600 gold on the near horizon but Friday’s Comex close was a wilting $1,396.1 per ounce. By the time this column posts, the yellow metal may very well be darting back into $1,400 territory on a new headline but for how long? With all the fanfare about bull runs, gold price is about where it was in late-November, 2010. Pop…fizz.

My July 22, 2013 Kitco commentary stated:

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.

Although this assertion may appear counter-intuitive to gold enthusiasts that pray the QE3 “taper” be light or delayed, the data are the data – time to review and update two key charts.

By the way, there is a happy ending to all of this: QE-infinity is off the table, inflation expectations will rise as surely as the sun someday and the long-term prospects for gold price are still bullishly intact.

Down but not out

The Eureka Miner’s Gold Value Index© (GVI©) is a powerful tool for understanding gold’s value relative to global 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 (Notes 1 & 2).

A seven-year history of the GVI is shown in Figure 1 (updated through Aug. 30):

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

As explained in the July commentary: 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 period of rock sold stability following the Great Recession.

Reassuringly, the GVI norm at 83.56 is only 0.6% above a GVI seven-year mean of 83.04 (updated through Aug. 30, Note 3).

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

Table 1 (updated through Aug. 30) compares these results:

* The QE3 cycle is ongoing; the value given is for Aug. 30, 2013

Table 1 – Gold value erosion during QE cycles

The three large red arrows of Fig. 1 indicate gold devaluation periods for each of the associated QE cycles. Even though gold has regained ground in August it is less clear that the value downtrend is over for QE3 (a detailed analysis of the two prior QE cycles is given in the July commentary).

The GVI reaction to QE3 continues to resemble a scaled down version of the QE1 cycle. The GVI peaks in November, 2012 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 tapering will begin but it is likely that gold will soon again trade at a discount to the commodity basket (i.e. below the solid orange line, Note 3).

Bear Case - The Gold Value “Wedge”

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 reddish VAGP line).

However, the premium has dramatically declined this year and on Aug. 15, the gold price came within a few cents of equaling its commodity-adjusted value. By Friday’s close, Comex gold is only $33.7 up from the Nov. 26, 2010 price with a premium of $46.8 per ounce. This is in stark contrast to the $300+ premiums of October 2012.

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 June 26 when the VAGP dropped to a new low of $1,173 per ounce (red circle), less than $60 below gold price (it’s important to note that on an intraday basis gold fell below $1,200 on June 28, this analysis is based on closing prices which have remained above $1,200 for 2013).

The “gold value wedge” exhibits a very bearish pattern. The VAGP came close but failed to break the upper boundary (point-1, upper dashed line) as gold prices peaked in August (Point 1, Fig. 2). VAGP has a level of support at the $1,250-level (lower dashed red line) and then the June 26, 2913 low of $1,173.4 per ounce (Point 2). Ominously, if premium transitions to discount, gold price could fall below either of these levels.

The Happy Ending

There is a happy ending to this story:

  1. There is no statistical evidence to indicate the seven-year gold value uptrend of Fig.1 is on the verge of collapse. Friday’s close shows gold value down but only by a rather sheepish 1.1-standard deviation below trend. Future deviations greater than 2-standard deviations would challenge this assertion – so far so good.
  2. QE1 and QE2 cycles suggest that sustainable gold rallies and even benchmark records are possible near the end or after the programs cease (Fig. 1). One could argue that the beginning of QE3 tapering marks the beginning of the end, that the recent gold rally is just resting and sustainable new highs are ahead. The true test of this view point would be a value adjusted gold price gapping above the red dashed line of Fig. 2 or approximately $1,410 per ounce (accompanied by a $1,460 gold price at the present premium).
  3. More realistically, the taper will be modest and QE3 will remain with the markets for some months to come. As such, it would be perfectly normal for gold to trade at a discount to key commodities again. This makes sense from a mean reversion perspective based on the 7-year mean or the GVI norm argument – after all they are less than 1% from each other presently and the GVI is only slightly above either.
  4. Even if (3) is correct, the GVI will swing to premium again someday (presumably after QE cycles have become only the subject of post-mortem studies) and gold prices will rise naturally again with inflation expectations.


That’s not all bad is it?

Note 1: 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, $1,400 gold still fetches 13 barrels of oil and over 430 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 19.3% in dollar price, 35.5% in value relative to oil and 14% relative to copper - updated Aug. 30.

Note 2: The GVI is assigned a value of 100 based on the 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 3: 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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