Gold's Wild Ride - Up and Away?

Nevada Gold Country, White Pine County, Nevada

April 14, 2014

My Jan. 21, 2014 commentary, Gold’s Wild Ride Down May Soon Be Up, explained my switch from gold bear to gold bull one week earlier. I am still bullish although the Comex market remains a wild ride given St. Patrick’s fleeting high of $1,392.2 per ounce followed by April Fools’ low of $1,277.2 (June contract).

On balance, gold is up for the year and joins Treasurys in 2014’s renaissance of unloved assets. Both have done well compared to much favored U.S. equities which stumbled in April on a tech-led selloff, rising tensions in the Ukraine, less than stellar economic data from China and nervousness about future earnings. By Friday’s close, Comex gold was up for the year 11% at $1,319.0 per ounce and the S&P 500 down 1.8% at 1,815.69.

My change in sentiment arose from gold’s reversal in fortune relative to global commodities oil and copper. The January commentary pointed out that a similar condition occurred in late-April 2011. At that time 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 and by that September the yellow metal set an all-time record of $1,923.7 per ounce.

The following is an update of data supporting my decision to join the bulls and a comparison to the 2011 Gartman call. Although a return to the lofty heights of those days is doubtful, revisiting St. Paddy’s high is likely and with a little 4-leaf clover luck, a rally to August 2013 $1,430+ territory.

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 nearly 8-year history of the GVI is shown in Figure 1 from July 20, 2006 through Friday’s close:

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 a 93-month 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).

The closing GVI last Friday was 89.61, 7.2% above the norm of 83.56 established November 2010. This indicates that gold has passed from discount to premium relative to the selected basket of key commodities (Note 4).

In the past 8 years there have been three significant negative deviations from the dashed trend line – these are indicated by dark blue arrows and denoted points #1, #2 and #3 as summarized in Table 1:

Table 1 – Key Gold Value Reversals

A key value reversal occurs when two conditions are satisfied: a change from falling to rising value and a GVI switch from discount to premium (green arrows).  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 (sigma) from trend. This was followed by a much milder negative deviation of -1.5-sigma on April 8, 2011 (Point #2).

The second reversal in April 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 -1.50-sigma on April 8, 2011 followed by -1.46-sigma on April 21. Dennis Gartman’s bullish call occurred near the time the second dip failed to create a greater deviation from trend.

Just prior to Comex gold making its low for 2013, gold value plumbed a maximum deviation of -1.38-sigma on Dec. 27 (Point #3). From then to Friday’s close gold value has increased nearly 12%; gold price, 8.7%. The GVI has also passed from discount to premium confirming the key reversal.

It is likely that the GVI will continue to move upwards toward the long-term trend line. Interestingly, all three cases produced maximum deviations no greater than -1.5-sigma (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 U.S. dollar-based metric for determining whether the yellow metal is trading at a premium or discount to its 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, 2010, the VAGP (reddish brown line) and Comex gold price (blue line) were equal at $1,362.4 per ounce (first yellow circle). After that point, gold traded 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). The VAGP then remained very close to actual gold price until mid-January (third yellow circle) when gold price rose again above its adjusted value.

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.

On Jan. 17, Comex gold closed at the Nov. 26, 2010 norm of $1,251.9 per ounce with zero premium (Point #6). This is in marked contrast to the elevated prices and nearly $400+ premium of Oct. 3, 2011 following the U.S debt downgrade.

Presently, the VAGP is in the middle of the wedge with resistance at the $1,300-level (upper wedge boundary). Breaking decisively above that constraint would be very bullish indication breaking the curse of the contracting wedge.

More reasons to be bullish (and a few to remain cautious)

From a gold value perspective, there are three technical reasons to be bullish for 2014:

1. There remains no statistical evidence to indicate the nearly 8-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 $1,300 per ounce, would likely indicate such a trend reversal as QE3 winds down.

The sword of Damocles hanging over the Lustrous One is better-than-expected domestic and/or global growth with an attendant rise in interest rates – typically a bearish environment for gold prices. This was the scenario to doom Treasurys and precious metals for 2014 but has yet to happen. Given a dovish tilt to Federal Reserve monetary policy, the sword may be safely suspended for some time to come.

A bearish indication for gold would be a return to discount relative to commodities. For this case, the upper-wedge boundary for value adjusted gold price becomes a ceiling for gold price. As Fig. 2 suggests, this would cap gold prices below $1,300 per ounce.

Cheers!

Note 1: For 93 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, an ounce of Friday’s $1,320 gold still fetches 12.7 barrels of oil and 435 pound of copper. However, this stands in contrast to 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 23.8% in dollar price, 36.8% in value relative to oil and 13.7% 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: 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 0.4% of the GVI 93-month mean of 83.24 (updated through April 11).

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
http://eurekaminer.blogspot.com/