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Gold Trapped In A Value Wedge
Tuesday October 08, 2013 14:29
It is no fun being bearish about gold price when you write a market report for miners in the heart of North American gold country. At present U.S. dollar levels, exploration activities slow, smaller mines close and the big mines cut costs and retreat to higher grade ores. Such is the mining industry; nothing new but it was a lot cheerier when gold was north of $1,600 per ounce.
The August gold rally was brilliant but collapsed as traders removed risk premium related to Syria and on the tapering expectations of the U.S. Federal Reserve. The Friday Comex closing price was a dismal $1,308.6 per ounce nearly 9% below the August peak and a bearish 25% down from November’s high, after which things began to unravel for the yellow metal.
Hopefully, the upcoming FOMC meeting this week will shed light on the plans for unwinding QE3. I have been bearish about gold’s near term prospects since May and continue to believe that quantitative easing has been more the culprit than the cure for gold’s present plight. Global Editor Debbie Carlson included my thoughts on the bear side of her Friday Kitco Weekly Gold Survey:
“Gold is also threatening to test its July low relative to S&P 500. Importantly, the yellow metal physical demand from Asia has also disappointed during a season that is typically very strong…. Even though the taper may be mild or delayed, QE3 is likely to continue for some months to come and will further erode gold’s value to key commodities.”
Although gold’s present inverse relation to the U.S. equity mark is notable (still a healthy -0.8 correlation on a 1-month basis), the value relation with key commodities is the more important indication for judging when this down-cycle will reverse and a sustainable recovery in gold price begins. My last commentary, A Bear Case for Lower Gold Price (With a Happy Ending), explained why this is so. It is instructive to update those data and charts to see what lies ahead in the near-term and the happier long-term.
Down it goes…
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 U.S. 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 Sep. 13):
Figure 1 – The Eureka Miner’s Gold Value Index© (mid-2006 to present)
As explained in my July 22 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.
In the spirit that a properly selected norm should not depart significantly from a long term average of the data, it is reassuring that the GVI norm of 83.56 is within 0.6% of the GVI seven-year mean of 83.05 (updated through Sep. 13, 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 compares these results:
* The QE3 cycle is ongoing; the value given is for Sept. 13, 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 regained ground in August the value downtrend has now resumed 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 the market norm at current prices (third red arrow). Friday was the first time that the GVI closed at a discount to the commodity basket since August, 2011 (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 September 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 (reddish line) until a few days before the U.S. debt downgrade (second yellow circle). From the downgrade to Thursday’s close, gold traded at a premium (blue above reddish VAGP line).
By Friday, Comex gold closed $53.8 below the Nov. 26, 2010 price with a negative premium (i.e. discount) of 20 cents per ounce. This is in stark contrast to the nearly $400+ premium of Oct. 3, 2011 following the U.S debt downgrade.
Importantly, the VAGP made a succession of lower highs (upper dashed line) since the spring of 2011 while the lows 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” of the two dashed lines 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, 2013 low of $1,173.4 per ounce (Point 2). Ominously, as the premium transitions to discount (Point 3), gold price could fall below either of these levels.
Update to Happy Ending
Headlines have kept gold price volatility high in September. The weekend spike on the Larry Summers withdrawal as a candidate to replace Ben Bernanke is a good example. An unexpected outcome of the FOMC meeting or the upcoming Congressional debate on the debt ceiling may restore gold’s premium to key commodities and gold could head back to $1,400 territory. However, I believe these transitions higher will be fleeting and the general trend remains in place for lower gold value and price as QE3 winds down.
The conclusions of my last commentary remain essentially unchanged except for updated levels which are feeling the squeeze of the value wedge of Fig. 2:
- There remains 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 by more than two weeks ago but still only 1.3-standard deviations below trend. Deviations greater than 2-standard deviations would challenge this assertion.
- 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 August gold rally just consolidated 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 $1,400 per ounce (previously, $1,410).
- More realistically, the taper announced this week 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 continue to trade at a discount to key commodities. 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 now just below the norm.
- Even if (3) is correct, the GVI will swing to premium someday (presumably after QE cycles have run their course) and gold prices will rise naturally again with inflation expectations.
Cheers!
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, $1,300 gold still fetches 12 barrels of oil and 410 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 24.4% in dollar price, 40.0% in value relative to oil and 19% relative to copper - updated Sept. 13.
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
http://eurekaminer.blogspot.com/
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