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Gold’s Wild Ride Down May Soon Be Up

Tuesday February 18, 2014 14:01

From the Heart of North American Gold Country…

Jan. 21, 2014

In late-April 2011 Dennis Gartman, commodity trader and author of the respected Gartman Letter, made a bold bullish prediction on gold price. Comex gold was then about $1,500 per ounce; by that September the yellow metal set an all-time record of $1,923.7 – those were the days of golden bulls.

I’ve been bearish on U.S. dollar gold price since May of last year as explained in my commentary, Oil, Copper & $1,200 Gold – A Wild Ride Ahead. Gold had retreated to just under $1,400 per ounce at the time of that column and the ride further down proved wild indeed - gold experienced horrific value destruction not only in U.S. dollar terms but value relative to global commodities oil and copper.

On Jan. 14, I wrote Debbie Carlson, Global News Editor for Kitco News, announcing a change of heart:

I've thrown my bear suit away and will say that the worst may be over for gold.

Bird's-eye view:

  1. The discounting process relative to oil and copper seems to have bottomed and gold is now regaining value on both.
  2. The key trend to break is the yellow metal's descending relation with equities. While not there yet, an overdue equity correction could initiate a sustainable reversal of fortune.

Gold price outlook? Not great but the lows are probably in.

I neglected to add that similar technical conditions behind the 2011 Gartman call have reappeared – could the outlook be more bullish?

Comex gold closed Friday at $1,251.9 per ounce. Going forward the yellow metal should at least stay above December’s low of $1,181.4 (February contract) and find stiff resistance at the $1,350-level. Breaking decisively above that would be very bullish with the next challenge occurring at last August’s high of $1,434 per ounce.

What do the data say?

A Key Value Reversal

The Eureka Miner’s Gold Value Index© (GVI©) is a powerful tool for understanding gold’s value relative to global commodities 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 7-1/2 year history of the GVI is shown in Figure 1 (updated through Jan. 17):

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

As explained in my July 22, 2013 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 7-1/2 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 (Note3).

Importantly, the closing GVI last Friday was 83.56, equal to the norm established in November of 2010. This indicates that gold is currently at a point of equilibrium, transitioning from discount to premium relative to the selected basket of key commodities (Note 4).

In the last 7-1/2 years there have been three significant negative deviations from the dashed trend line – these are indicated by blue arrows and denoted points #1, #2 and #3 as summarized in Table 1:


Table 1 – Key Gold Value Reversals

A key value reversal occurred after the first two as the GVI regained value (green arrows), passing from discount to premium. The first occurred July 3, 2008 during the Great Recession (Point #1). Following the Lehman Brothers collapse that September, oil and copper prices seriously deflated. During this period gold prices dipped below the benchmark record of $1,082.9 per ounce set March 17, 2008 but fell much less than oil and copper causing a spike in gold value of 136.4 on Feb.17, 2009 – a startling +4.7-standard deviations (s) from trend. This was followed by a much milder negative deviation of -1.48 s on July 3, 2008.

The second reversal in April 2011 (Point #2) was near the end of the U.S. Federal Reserve’s second phase of quantitative easing, or QE2. QE2 had inflated key commodity prices much more than gold causing a notable downdraft in gold value. There were actually two dips in April; the first and most severe was -1.53 s on April 8, 2011 followed by -1.50 s on April 21. Dennis Gartman made his bullish call when the second dip failed to create a greater deviation from trend.

Just prior to Comex gold making its low for 2013, gold value deviated -1.47 s on Dec. 27 (Point #3). From then to Friday’s close gold value has increased nearly 5%; gold price, 3% - could a third key reversal be underway?

There may be a retest of the recent gold value low as in April 2011 but I’m inclined to believe that the movement is up from here for both value and price. Interestingly, all three cases produced maximum deviations of approximately -1.5 s (light blue line) before reversing to the upside.

Breaking 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, 2010, 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 last 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 at the Nov. 26, 2010 norm of $1,251.9 per ounce with zero premium. This is in marked contrast to the elevated prices and nearly $400+ premium of Oct. 3, 2011 following the U.S debt downgrade.

Since the spring of 2011, the VAGP has made a succession of lower lows (lower dashed line) and lower highs (upper dashed line). The VAGP reached a low on June 26, 2013 of $1,173.4 per ounce (Point #4). The VAGP came close but failed to break the upper boundary as gold prices peaked in August (Point #5). The “gold value wedge” formed by the two dashed lines exhibits a very bearish pattern.

Presently, value and price are in the middle of the wedge with resistance at the $1,350-level (upper wedge boundary). Breaking decisively above that constraint would be very bullish indication breaking the curse of the contracting wedge. Passing that test, the next challenge occurs at last August’s high of $1,434 per ounce (Point #5).

Gold and the S&P 500
The value relation between gold and the S&P 500 is illustrated by a plot of the gold-to-S&P 500 ratio, or AUSP, defined as the U.S. dollar price of gold divided by the S&P 500 stock index:

Figure 3 –Comex Gold-to-S&P 500 Ratio (Aug. 15, 2012 to present)

On Aug. 31, 2012, Federal Reserve Chairman Ben Bernanke reinforced expectations of a third phase of quantitative easing, or QE3, at the Jackson Hole gathering of economists and central bankers. The AUSP was comfortably elevated then and rose even higher to a peak of 1.2710 on November 15, 2012 with QE3 beginning that September.

The ratio then bearishly slid into a descending channel as money rotated away from gold assets into equities. This trend transitioned to a sideways channel July 5, 2013 (dashed blue lines, AUSP=0.7431). More recently the AUSP has broken decisively below that lower boundary and is on a second leg of descent (dashed red lines) with this Friday’s market closing at a value loss of 46.0% relative to the November peak (AUSP at 0.6809 versus 1.2710). Breaking above the upper boundary of the second declining channel would be another bullish indication for the yellow metal.

Reasons to be bullish (and a few to remain cautious)

Gold is currently in a narrow trading range awaiting a catalyst to move higher which may come from the upcoming FOMC Jan. 28-29 meeting in combination with the approaching Chinese New Year commencing Jan. 31. A dovish tilt on the Federal Reserve QE3 tapering program and/or increased physical buying in Asia would be bullish for the yellow metal. Gold faces many headwinds in 2014 which include low U.S. inflation together with deflationary pressures in Europe, rising Treasury rates and a slowly improving global economy (e.g., recent World Bank GDP estimate 3.2% versus 2.4% for 2013).

However, it appears the discounting of gold relative to key commodities bottomed in late-December which suggests the low is in for gold. Until gold decisively breaks its declining relation with the U.S. stock market (Fig. 3), it is doubtful there will be much upside movement beyond $1,300 prices. The Friday closing AUSP at the upper boundary of the second declining channel is an encouraging sign.

Technical reasons to be bullish for 2014:

  1. There remains no statistical evidence to indicate the 7-1/2-year gold value uptrend of Fig.1 is breaking down. Negative deviations greater than 2-standard deviations would challenge this assertion; in this entire period there have been no declines materially greater than 1.5-standard deviations.
  2. Relative to gold’s commodity value, conditions have re-appeared that are similar to those at the time of Dennis Gartman’s prescient bullish call on gold price in late-April 2011.
  3. QE1 and QE2 cycles suggest that sustainable gold rallies and even benchmark records are possible near the end or after the programs cease (Dec. 12, 2013 commentary). A value adjusted gold price gapping above the red dashed line of Fig. 2, or approximately $1,350 per ounce, would likely indicate such a trend reversal as QE3 winds down.


Note 1: For 90 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, $1,250 gold still fetches 13.2 barrels of oil and 375 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 27.7% in dollar price, 34.2% in value relative to oil and 25.4% 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: 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 0.6% of the GVI 7-1/2 year mean of 83.10 (updated through Jan. 17).

Note 4: 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; 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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