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Gold (Still) Trapped in a Value Wedge

Monday December 09, 2013 11:01

Gold (Still) Trapped in a Value Wedge

Global monetary expansion to mitigate the 2008-2009 financial crises and stimulate recovery has had a significant impact on metal prices – a flood of easy money that has often trumped the laws of supply demand. My September 16 commentary explored the relation of gold price with the U.S. Federal Reserve’s three quantitative easing programs, the first of which began shortly after the Lehman Brother’s bankruptcy filing in September 2008.

The first cycle of quantitative easing (or QE, the printing of money to buy bonds) reflated crashing copper prices from sub-$2 per pound levels and boosted gold prices from $800 to $1,100 per ounce territory. The second cycle inflated metal prices on overzealous global recovery expectations pushing copper to $4.5+ per pound records in early-2011. This was followed by a second crash in copper prices after the U.S. debt downgrade Aug. 5, 2011 and an all-time Comex record gold price of $1,923.7 per ounce Sept. 6, 2011. The third QE cycle, started in September 2012, continues at full strength with tapering expectations for 2014. So far, QE3 has not seen the extreme gyrations of the previous cycles and may very well be remembered as a time of metal price stabilization.

Comex gold price has, however, suffered a significant decline under the third program falling from $1,700-levels in mid-November 2013 to a close of $1,229 per ounce Friday. Gold has also lost value relative to U.S. equity markets and key commodities. Although gold’s inverse relation to the soaring S&P 500 is notable (presently -0.7 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 Sept. 3 commentary, A Bear Case for Lower Gold Price (With a Happy Ending), explained why this is so. It is instructive to update the data and charts of both September commentaries to see what lies ahead for 2014. Currently, my low side projection is $1,150 per ounce or lower with rallies capped at $1,375. Breaking decisively above the upper limit would be a very bullish indication for gold price going forward.

Still going down…

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 Dec. 6):

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.

A properly selected norm should not depart significantly from a long term average of the data, it is therefore reassuring that the GVI norm of 83.56 is within 0.5% of the GVI seven-year mean of 83.11 (updated through Dec. 6, 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 Dec. 6, 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 initially gained value at the beginning of the third phase, the trend has been downward since mid-November, 2012 (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 closed slightly below the solid orange line (83.43 versus 83.56, 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 (red line above blue) until a few days before the U.S. debt downgrade (second yellow circle). From the downgrade to this September, gold traded at a premium (blue line above red). Since September the VAGP has remained very close to actual gold price.

By Friday, Comex gold closed $133 below the Nov. 26, 2010 price with a negative premium (i.e. discount) of $1.84 per ounce. This is in stark contrast to the elevated prices and nearly $400+ premium of Oct. 3, 2011 following the U.S debt downgrade.

Since the spring of 2011the VAGP has made a succession of lower highs (upper dashed line) and lower lows (lower dashed line). 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 as gold prices peaked in August (Point 1, Fig. 2). The VAGP reached a low on June 26, 2013 of $1,173.4 per ounce (Point 2). Ominously, as the premium transitions to discount (Point 3), gold price could fall to the $1,150 per ounce level or lower before the end of the Q3 program.

Update to Happy Ending

The conclusions of my Sept. 3 commentary remain essentially unchanged except for updated levels feeling the squeeze from the value wedge of Fig. 2:

  1. 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 nearly 20% from its Nov. 13, 2012 peak but still only 1.2-standard deviations below trend. Deviations greater than 2-standard deviations would challenge this assertion.
  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). A value adjusted gold price gapping above the red dashed line of Fig. 2, or approximately $1,375 per ounce (previously, $1,400), would likely indicate such a trend reversal.
  3. The Federal Reserve’s taper of their current bond buying program is expected to begin sometime in the first quarter of 2014 and QE3 will likely 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 either from a mean reversion perspective based on the 7-year mean or the above GVI norm argument – these two metrics are less than 1% from each other presently and the GVI is now just below the norm.
  4. The GVI will return to material premiums someday (i.e., > $50 per ounce, presumably after QE cycles have run their course) and gold prices will rise naturally again with inflation expectations.

Cheers for the holidays!

Note 1: For 89 months, 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 2013, $1,230 gold still fetches 12.6 barrels of oil and 380 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.9, 2012, gold has declined 29.0% in dollar price, 37.4% in value relative to oil and 24.7% relative to copper.

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 Note 1; 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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