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    - 29 May, 2002

Do central banks control the gold price?

There is no doubt that central banks attempt to control the gold price. They joined forces during the 1960s to maintain the gold price at the 'official' target level and auctioned gold during the 1970s in a concerted effort to reduce the market price of gold. Over the past 20 years the overt interventions of the 1960s and 1970s have been replaced by covert interventions. For example, over the past decade a huge volume of central bank gold has come onto the market in the form of gold loans and swaps. These loans and swaps do not result in reductions to reported gold reserves and have, therefore, gone largely unnoticed by the mainstream investment world. Since there is a conspicuous lack of transparency when it comes to central bank gold lending/swapping, the actual amount of gold that has reached the market via such means is a contentious issue (reliable sources put the figure at around 15,000 tonnes whereas unreliable sources say the figure is only about 4,000 tonnes). Whatever the size of the loans/swaps, the official reason given for mobilising gold reserves in this way is to earn income on an otherwise dormant asset. However, since gold interest rates are generally around 1% this official reason just doesn't 'cut it'. It makes no sense that central bankers would risk losing their country's gold reserves in order to make a paltry 1%. There must be another reason and that reason is almost certainly to apply downward pressure to the gold price.

We are confident that central banks have been attempting to manipulate the gold market over the past several years. We are also confident that they will continue their manipulation in the future. So, how successful will they be? According to Mitsui gold analyst Andy Smith, they will be very successful. As we understand it, Mr Smith doesn't think that central banks will dump their gold onto the market in a deliberate attempt to hold down the gold price, but he does expect them to dump a lot of gold onto the market over the next few years for other reasons. Furthermore, he expects central bank selling (or lending) to drive the gold price down to multi-decade lows (below $100).

Where Mr Smith goes wrong is where a lot of people are presently going wrong - he is drawing conclusions on the basis that the trends of the 2000s will simply be an extension of the trends of the 1990s.

Below is a long-term chart showing the yield on US 10-year T-Notes. The dominant trend in the financial markets over the past 20 years has been the relentless move towards lower long-term interest rates. One consequence of this secular downtrend in interest rates was a dramatic expansion of price-earnings ratios in the stock market and, therefore, a secular bull market in stocks. Another consequence was a bull market in central banking. 

An environment in which the visible signs of inflation are diminishing and in which the primary trend for interest rates is down dampens the effects of central banking errors. For example, the Greenspan-led Fed has made one mistake after another over the past 15 years but has, up until now, retained its credibility. Despite some enormous blunders, Greenspan in particular continues to be held in high regard because the most visible barometers of central banking performance - long-term interest rates and the gold price - have kept signaling that everything was under control.

It is important to emphasise that central banks did not create the secular downtrend in interest rates, they were beneficiaries of it. By 1979-1981 mass psychology and market prices had swung so far in one direction that a prolonged move in the opposite direction had become inevitable. Soaring market interest rates and gold prices - the result of an almost total collapse in confidence in the US$ - forced Paul Volcker (the Fed chief at the time) to hike official interest rates to extraordinary heights. This was sufficient to set the new trend in motion.

Our contention is that by 1999-2001 mass psychology and the markets had once again reached an extreme and that another major (secular) shift had become inevitable. This time around it might have been Greenspan's extraordinary rate-cutting that provided the final push that set the new trend in motion. The trends of the 1990s cannot therefore be extrapolated into the 2000s. Bonds have peaked, gold has bottomed, and confidence in central banks (primarily the Fed) is now on the decline. Rather than covering-up central banking mistakes, the new trend will exacerbate them. The central banks can attempt to sell-off their remaining gold reserves, but beyond the very short-term the market won't reward them for doing so. As was the case during the late-1970s, the selling of gold will be seen as a sign of weakness and those currencies with the greatest gold backing will start to command an investment premium.

Andy Smith talks about the gold price being driven below $100/ounce by the massive selling of gold by central banks, but central bank selling can never be a reason to be long-term bearish on gold. Central bank selling appeared to be a millstone around the gold market's neck during the 1990s because the bankers' desire to limit the upside in the gold price was in tune with the primary trend in the market. Attempts to limit the gold price will continue in the future but they cannot be successful if we are correct that the primary trend for interest rates has turned upward. A consequence of the new trend is that each gold sale will weaken the currency of the country doing the selling. Therefore, the more gold a country sells the higher the gold price will eventually move in terms of that country's currency. It must be this way because rational speculators and investors throughout the world will try to position themselves in synch with the major trend and, thanks to decades of inflation, they have vastly more dollars, euros, yen, etc. than the central banks have gold.

Overview

From the latest Weekly Update: "...we expect the biggest moves in several markets - stocks (down), gold (up) and the Dollar (down) - to occur during the September-December timeframe. However, the way the story is unfolding at the moment the biggest risk to our forecasts is that these moves will happen earlier than previously expected. As such, although counter-trend moves are likely in the short-term we will probably not attempt to trade these counter-trends (at least, not as far as our TSI commentaries are concerned). Rather, we will keep our eyes firmly fixed on the big picture."

As each day goes by the odds improve that we are going to see a major stock market low, gold price high and dollar low earlier than originally expected. Based on a number of technical indicators we should have seen counter-trend moves this week (higher for the S&P500, higher for the Dollar and lower for gold), but these have clearly not materialised. Gold has now closed higher in New York on 9 of the past 10 trading days (an incredible run) so a pullback should still be expected, but the current short-term trends appear to be very strong. As such, the above-mentioned counter-trend moves will probably only last 2-3 days.

There were three main reasons why we expected the biggest moves in the gold, stock and currency markets to occur during the September-December period. Firstly, in order for the NASDAQ's decline following its 10th March 2000 peak to roughly match the total length of the Dow's decline following its 1929 peak and the Nikkei's decline following its 1989 peak, it would have to bottom between October of 2002 and January of 2003. Secondly, over the past 6 years major bottoms in the S&P500/XAU ratio have regularly occurred during the September-October period. Thirdly, the gold, stock and currency markets are clearly inter-related so we considered it highly probable that an extreme in one market would coincide with extremes in the other markets. When we put our analyses of the individual markets together the October-December period stood out as being the most likely time for an extreme in all three markets.

We can, however, use historical precedent to make the case that the markets could reach extremes between late-June and mid-August. The reason is that the first major low following a secular peak has often occurred during this time window. Examples are:
a) The Dow bottomed in late-June/early-July 1932
b) Gold bottomed in late-June/early-July 1982
c) The Dow bottomed in early-August 1982
d) The Nikkei bottomed in mid-August 1992

The bottom line is that things are getting very interesting and we could well see blow-off moves in stocks, gold and the US$ during the next 10 weeks.

The US Stock Market

Bull or Bear?

In previous commentaries we've shown charts of the S&P600 Index (an index of small-cap stocks) and have highlighted the broadening top formation that has developed over the past 2 years. Below is another look at this index.

Small cap stocks have clearly been in a bull market over the past 2 years with the S&P600 Index reaching an all-time high as recently as last month. Mid-cap stocks, in general, haven't been as strong as the small caps, but the S&P400 Mid Cap Index also hit an all-time high last month. In other words, mid-cap stocks have also been in a bull market.

Since we know that the senior stock indices (the S&P500, the Dow Industrials and the NASDAQ100) have done poorly over the past 2 years while small and mid cap stocks have been in bull markets it is reasonable to assume that large-cap stocks must have experienced a 2-year bear market. It might be reasonable to make such an assumption, but the following chart shows that it wouldn't be entirely correct to do so. The chart, provided courtesy of http://www.decisionpoint.com/, compares the standard S&P500 Index (the S&P500 is a capitalisation-weighted index) with the unweighted S&P500 Index (the same stocks but with every stock given equal weight in the index). Notice that while the S&P500 peaked in March of 2000 the unweighted S&P500 peaked in May of 2001 and came close to matching that peak in March of this year. It would be difficult to argue that the unweighted S&P500 has been in a bear market.

So, it appears that there has been a vicious bear market concentrated within a relatively small number of stocks while the vast majority of stocks have either moved higher or traded sideways. This small group of stocks has, however, exerted enough influence on the senior stock indices to cloud the issue as to whether or not the overall stock market is in 'bear mode' or 'bull mode'.

Our view is that outside of the tech and internet sectors, a bear market has not started...yet. What we have most likely been witnessing over the past 2 years are the final throes of the 1990s' bull market.

Current Market Situation

We came into this week expecting the market to put together some sort of counter-trend rebound, but up until now there has been no sign of any strength whatsoever. Put/call ratios have been quite high, but option volumes have been very low. Rather than indicating fear the high put/call ratios are therefore more an indication of a lack of optimism.

We still think a counter-trend rebound is likely over the next few days, but rather than taking the S&P500 into the 1110-1120 range as per our previous expectation we suspect that any rally at this time will fail at, or below, the 50-day moving average (currently at 1105). If a rally does materialise we would use it to good effect by buying some more put options.

Gold and the Dollar

Gold and currency trends

Earlier in today's commentary we talked about the secular trend in interest rates and how this trend had influenced the way that central banks were perceived. Long-term interest rates have not yet broken out to the upside (the primary trend is still down), but when we zoom in on the trends in the gold and currency markets over the past 7 years we can see that important changes are underway. These changes are consistent with our view on interest rates.

Below is a chart comparing the XAU with the Swiss Franc since the beginning of 1995. The Dollar embarked on a bull market in 1995 (indicated on this chart by the Swiss Franc's post-1995 downtrend) that ended during the final quarter of 2000. The SF has gradually moved higher against the Dollar since October of 2000 and recently broke-out from the downward-sloping channel in which it had traveled since 1995. Not surprisingly, gold stocks (as represented by the XAU) trended strongly lower with the SF during the 1995-2000 period and turned higher with the SF during the final quarter of 2000. 

The XAU's upside breakout from its post-1995 downtrend has been far more decisive than the SF's breakout. This is indicative, we think, of a growing distrust in all fiat currencies and central banks (not just the US$ and the Fed).

Current Market Situation

Below is a weekly chart of the euro. Yesterday (Wednesday) the euro futures closed above last September's peak and the Dollar Index futures closed below last September's bottom. Things are starting to move quickly. A Dollar rebound over the next few days is likely, but as noted under "Overview" it now looks as though the Dollar is going to accelerate lower a few months earlier than originally anticipated.

The gold price has hit major resistance at $325. This resistance might be "major" but it is unlikely to contain the gold price for long if the US$ keeps falling. Once through 325 there is no significant resistance until we get to the 370-400 range, although we doubt that the price will immediately move that high because a break above 325 is likely to prompt some form of official intervention. Central bank intervention won't have a prolonged negative effect on the gold price, but the CBs certainly have enough clout to influence the market in the short-term. This is particularly the case with speculators being heavily net-long gold futures and sentiment towards gold being more bullish than it has been in many years.

Update on Stock Selections

In Market Alert E-mail #85 we suggested that anyone who felt under-exposed to gold could look at buying a small Canadian gold stock called American Bonanza (CDNX: BZA). At the time of our alert the stock was trading at C$0.18 (it closed at 0.22 yesterday). 

Including the shares issued in a just-completed private placement BZA has a market cap of around C$20M. Its main asset is the Copperstone project in Arizona which contains a 1.2M ounce gold resource. At BZA's current price investors are therefore paying about US$10/ounce for this gold in the ground. From a technical perspective the stock could pullback to 0.15-0.17, but there is certainly no assurance that it will see those levels again.

Also in the above-mentioned e-mail we suggested buying Apex Silver January-2003 $17.50 call options. We will use Tuesday's average price of US$2.30 for record purposes. 

In Market Alert E-mail #86 we mentioned that Crew Development Corp (CRU.TO) was another company worth buying near its current price (C$0.55), although we said we would only add it to the Portfolio if it traded down to C$0.53. CRU has moved above its 200-DMA for the first time since last June and looks strong from both technical and fundamental perspectives. 

 
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