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Explaining the gold bull market

One of the simplest and best ways to ascertain gold's long-term trend is to look at its performance relative to commodities in general. This is because a genuine gold bull market will result in gold making higher highs and higher lows relative to most other commodities. Alternatively, if gold is trending higher in nominal currency terms but not against most other commodities, then what we have is a general inflation-fueled commodity bull market (all long-term commodity bull markets are fueled by monetary inflation) with gold going along for the ride. In this latter case, the rise in the gold price is nothing more than an offset to the loss in purchasing power of the currency. So, let's review gold's performance against the Continuous Commodity Index (CCI).

The following chart of the gold/CCI ratio makes it clear that a long-term gold bull market commenced at the beginning of 2001. The chart also makes it clear that gold's long-term bull market has contained substantial intermediate-term swings as well as multi-year periods of 'choppy' sideways movement. In other words, despite the impression created by long-term charts of the US$ gold price, gold's progress since its early-2001 major bottom has been anything but steady.



While short-term fluctuations are often random, the major turning points and swings in the gold/CCI ratio are intimately related to important happenings on the monetary, economic and financial-market fronts. Of particular note:

1) Gold's long-term (secular) bull market began several months after the secular bull market in US equities ended. This was not a fluke. Secular gold bull markets invariably coincide with secular equity bear markets, where a secular equity bear market is defined as a 1-2 decade period during which equity valuations (not necessarily equity prices) trend downward. A consequence is that gold's secular bull market will almost certainly continue until shortly before or shortly after equity valuations reach their nadir. It's reasonable to expect that this point lies at least a few years into the future, because valuations are now high and at no time over the past 10 years has the average equity valuation come remotely close to the level at which previous secular bear markets ended.

2) There was a strong 18-month rise in gold/CCI from the beginning of 2001 through to mid-2002. Not coincidentally, this period was the main part of the economic and financial-market bust that inevitably followed the inflation-fueled boom of the 1990s.

3) Another financial-market and economic boom got underway in 2003 and persisted, in fits and starts, until the first half of 2008. During this 5-year period the gold price trended higher in US$ terms, but relative to most other commodities gold did no more than hold its own. Hold its own is the best that gold can reasonably be expected to do during the boom phase of the boom-bust cycle.

4) The 2003-2007 boom was fueled by aggressive 'monetary accommodation' designed to mitigate the fallout from the 1990s boom. Inevitably, it led to another bust. In fact, it led to an economic and financial-market bust that dwarfed the 2000-2002 episode. Just as inevitably, it led to a much stronger advance in the gold/CCI ratio and an even more aggressive series of monetary measures designed to mitigate the fallout from the artificial boom fomented by earlier monetary measures.

5) The global financial crisis came to an end during February-March of 2009, naturally resulting in an important peak for the gold/CCI ratio at that time.

6) Gold/CCI then corrected for about two years while the financial world breathed a collective sigh of relief and while rising stock markets created the false impression that the 'monetary accommodation' put in place to mitigate the latest bust would set the stage for a genuine self-sustaining recovery.

7) In 2011, doubt about the economic recovery began to emerge and the gold/CCI ratio resumed its bull market. In this case, the main source of the doubt was the euro-zone. The markets began to discount the possibility of government debt default and large-scale banking failure within the euro-zone.

8) Fears of euro-zone government debt default and banking collapse peaked in mid-2012, and so, understandably, did the gold/CCI ratio.

9) The financial world is now well into another period during which rising stock markets create the false impression that 'monetary accommodation' is setting the stage for a self-sustaining recovery. We can be sure that the impression is false because the monetary accommodation is the cause of the price distortions that in turn cause the boom/bust cycle (the bust is nothing more than an attempt to correct the distortions that arise during the boom). The more aggressive the monetary accommodation put in pace to mitigate the economic pain stemming from one bust, the bigger the next bust and the next rise in the gold/CCI ratio are bound to be.

The current careening from bust to boom to greater bust will only end after there is widespread understanding that it makes no sense to suppress interest rates and create a lot of money out of nothing in an effort to fix problems caused by suppressing interest rates and creating a lot of money out of nothing. We seem to be a long way from that point, which all but guarantees that we are a long way from the end of gold's bull market.

The Stock Market

During the first half of 2007 there was a near-vertical rise in the Dow Utility Average (UTIL). The index rose on 10 of the 11 weeks and 16 of the 18 weeks leading up to the peak of around 540 in early-May of that fateful year. The early-May peak was followed by a substantial 3-month correction, a multi-month advance to a marginal new all-time high, and then a cyclical bear market.

During the first half of 2013 there was a near-vertical rise in the Dow Utility Average (UTIL). The index rose on 10 weeks in a row and 13 of the 15 weeks leading up to the peak of around 540 in late-April of what could turn out to be a fateful year. The late-April peak has, to date, been followed by an 11% correction back to the 40-week moving average (the blue line on the weekly chart displayed below).



It is extremely unlikely that 2013 will turn out to be an exact replica of 2007. However, the general 2007 pattern continues to be a realistic scenario for 2013. The general 2007 pattern entails almost all of the gains for the year being in place by June and the market gradually rolling over into a cyclical bear market during the second half of the year.

Gold and the Dollar

Gold

One of the biggest short-term risks

Over the past several years there hasn't been a meaningful correlation between the gold price and the amount of gold bullion held by the SPDR Gold Trust (GLD). Furthermore, there's no good reason why there should be a meaningful correlation, because the amount of gold held by GLD is not determined by the change in the gold price; it is determined by the difference between GLD's market price and its net asset value (NAV). In particular, GLD's bullion stash gets boosted if the price of GLD rises by more or falls by less than the spot gold price, and GLD's bullion stash gets reduced if the price of GLD rises by less or falls by more than the spot gold price. That being said, the following chart comparison shows that the amount of gold bullion held by GLD has fallen sharply along with the gold price over the past three months. In other words, over the past three months there has been a strong positive correlation between the gold price and the amount of gold bullion held by GLD.



There is no way of knowing for sure if the recent decline in GLD's bullion stash is a cause or an effect of the decline in the gold price. We suspect that it is both, in that the owners of GLD shares are, as a group, apt to be relatively quick to exit in reaction to signs of weakness in the gold market. It's likely that they sold enough in reaction to the modest weakness in the gold price during February-March to push the GLD price downward relative to the spot gold price, causing GLD to cough-up some of its bullion, and then panicked after gold broke below support at $1525-$1550, causing GLD to cough-up more of its bullion.

The total amount of physical gold dumped onto the market due to the aggressive selling of GLD shares amounts to about 10.5M ounces since the beginning of the year and 9.5M ounces since 19th February. Although this is not a substantial quantity in the context of the overall gold market, it would certainly have exacerbated the decline in the gold price. That's why we say that the reduction in GLD's holdings was likely both a cause and an effect of the price weakness.

All of which brings us to the short-term risk that we want to highlight. If we are to believe what he has said in the press, hedge-fund manager John Paulson still controls 22M GLD shares (current market value: about US$3B). This is about 6.5% of the total number of GLD shares currently on issue. Paulson is a weak hand, in that if his performance continues to flag he could be forced to sell assets to meet redemptions from his fund.

The risk, then, is that Paulson's hedge fund could become a forced seller of GLD shares at some point over the next few months, leading to more of GLD's physical gold being dumped onto the market and possibly transforming a normal pullback in the gold price into something more serious. A development such as this wouldn't affect gold's long-term trend because it wouldn't change any of the important long-term drivers of gold's real price, but it could lead to a better short-term buying opportunity than would otherwise occur.

Current Market Situation

The US$ gold price has tested short-term resistance at $1400 on each of the past seven trading days. A break above this resistance, a likely occurrence within the next few days, will probably be followed by a rise to test the more important resistance in the $1470s.

The price action continues to evolve as if the May low was a successful test of the April low.



Gold Stocks

The HUI showed a modicum of strength on Wednesday 29th May, but it is still a long way from confirming a trend reversal. Confirmation of a trend reversal will sometimes happen immediately after a top or a bottom, but it's more common for the confirmation to arrive well after the price extreme. In the HUI's case, it would take consecutive daily closes above 300.



For GDXJ, a proxy for the junior end of the gold-mining sector, confirmation of a trend reversal would come via consecutive daily closes above $13.00.



By the way, confirmation of a trend reversal from down to up will often not be a buy signal. It all depends on how extended the price is to the upside when the confirmation arrives. For example, a rapid rise to well above 300 over the next few days would confirm a trend reversal and at the same time set the stage for a pullback. Alternatively, if a break above 300 were preceded by a couple of weeks of choppy price action in the 280-300 range then the upside breakout would probably be 'buyable'.

Currency Market Update

During the six years prior to February of this year, intermediate-term rallies in the US$ were driven by stock market weakness and/or euro-zone debt/banking crisis, while periods of stock market strength and euro-zone stability were accompanied by US$ weakness. However, since February of this year the Dollar Index has been positively correlated with financial-system confidence, in that it has rallied in parallel with stock market strength and dwindling worries about heavily-indebted euro-zone governments and banks. Does this mean that there has been a major change in the relationship between the currency market and other markets?

At this stage we don't think so. Our view continues to be that a meaningful (5-10 point) advance in the Dollar Index beyond last year's high (84) will require a general flight to safety, which will likely be prompted by either a gut-wrenching stock market decline or a panic away from the euro.

That being said, as far as the next few weeks are concerned the correlation of the past 3.5 months will probably persist. One reason is that both the stock market and the US$ are very 'overbought' and acutely vulnerable to downward corrections.

Update on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html