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June 08, 2007

China Gold Technicals
by Adam Hamilton

Two years ago I suspect American investors would have unanimously scoffed at the notion that the world would soon look to China's stock markets for guidance rather than the USA's. Yet here we are today. Over these past two years the Shanghai Stock Exchange Composite Index has soared a breathtaking 328%, capturing the world's attention.

At best at the end of May, the SSEC was up 62% this year alone! Such gains are clearly unsustainably parabolic which place the Chinese stock markets deep into classic bubble territory. And the amazing stories coming out of China these days reflect mania extremes. From an accelerating day-trading craze, to record numbers of new stock-trading accounts being opened, to even lowly Chinese laborers giving stock tips, China is caught up in the throes of a textbook stock mania.

While stock manias are certainly fun as American tech investors can attest to, they always eventually end badly. Large rates of gain simply cannot be sustained mathematically because soon all the capital in the world would be sucked into the mania market's exponential growth. So sooner or later all stock manias fail, typically starting with a sharp crash.

From May 29th to June 4th, just four trading days, the SSEC plunged a brutal 15% on a closing basis. In some ways this looks like the start of a collapse technically, but bubble tops are notoriously tricky to navigate as Shanghai's fleeting late February swoon showed. Only time will tell whether this is the beginning of the end of this mania or just another hiccup on the way higher. Either way, the end is inevitable at some point here.

While the stock mania in China is fascinating to study, stocks are not the only market for capital in China. Just like the rest of the world, Chinese investors have investment alternatives. One in particular, gold, is exceptionally interesting at this moment in time. In Western stock-market history when stock manias collapse, gold tends to soar as stock investors flee the imploding bubble. Will the East mimic this behavior?

Believe it or not, buying gold is not a problem in China. The Chinese have a millennia-old cultural affinity for gold and have long bought physical gold from local shops, whether it happened to be legal at the time or not. And the Chinese central bank recently gave preliminary approval for the Shanghai Gold Exchange to launch gold futures trading. So Chinese investors' conduits for investing in gold are growing.

Stock-market issues aside, gold trading in China is thriving. In January the Shanghai Gold Exchange reported its gold trading volume soared 73% year-over-year. On February 18th, Chinese New Year, the Year of the Golden Pig dawned. While a normal Year of the Pig hits every 12 years on the Chinese calendar, a Golden Pig is far rarer. This is the first one in either 60 years or 600 years, depending on which Chinese calendar expert is consulted. A Golden Pig year is believed to offer extreme good fortune and during one the Chinese buy gold to celebrate.

Thus gold investment demand in China is very healthy and growing totally independently of the stock-market situation. But when Chinese stocks start relentlessly grinding lower, will some Chinese stock traders move capital into gold for protection like we do in the West? I really think they will, given the ages-old Chinese love for gold.

As I've been pondering this in recent weeks, I've been wondering what the gold bull looks like to a Chinese investor. Are the gold technicals looking bullish in China? Is now a good time for Chinese investors to plow capital into gold whether or not the stock slide accelerates? If I was in China would I buy gold today?

In order to explore these questions, I had to see today's secular gold bull charted in Chinese currency. It is formally known as the renminbi ("people's currency") but more commonly in the West as the yuan, its principal unit. Yuan is a one-syllable Chinese word that literally means "round", a reference to the round coins from China's history that went by the same name. So renminbi and yuan are interchangeable in the vernacular today.

Now unfortunately getting historical gold-price data from China is not easy. For the early years of our secular gold bull, there was no official gold exchange or national price quotation available. Gold prices could vary considerably regionally based on local supply and demand, and I haven't seen any historical data series capturing any of them. And not being able to read Chinese like a typical provincial American, I couldn't dig deep enough on the Web to piece together real historical Chinese gold-price data.

Thankfully there is a curious peculiarity of the gold market that renders this point moot. Since the US dollar has been the world's reserve currency for decades now, the dollar gold price still dominates world gold trading for the time being. Everywhere on the planet, the local gold price is still a function of the dollar gold price and the exchange rate between the local currency and the dollar. With the Fed working overtime to inflate the dollar into oblivion this situation won't last forever, but it still works today.

Thus we can use the yuan/dollar exchange rate along with the benchmark US dollar gold price to infer the Chinese gold price. This forex-implied local gold price is not perfect, but in my experience it is pretty darned close. Every time I have checked it over the past six years by periodically digging up a true local-currency quote from a local exchange, I have found that the implied gold price is well within 1% of the actual local price.

Using this methodology, the following charts show gold through the eyes of Chinese investors, yuan gold. The right axes of these charts show yuan per troy ounce along with the usual technicals. As in Japan gold prices are usually quoted in grams in China, but ounces are easier for us Americans to understand so I used them here.

The left axes show the dollar price per yuan, the currency exchange rate for China. While this is backwards compared to the customary way the official yuan exchange rate is quoted, yuan per dollar, I find it more logical. Priced this way, a yuan gaining in value relative to the dollar is shown as rising on a chart rather than falling. This nonconventional presentation eliminates a lot of forex confusion.

Bull to date at best, yuan gold has powered 172% higher from April 2001 to May 2006. Although such gains are nothing compared to a parabolic stock market, gold's rise has been slow and methodical. It is based on global supply and demand and not local euphoria. Chinese investors with capital invested in gold have done quite well while bearing just a minuscule fraction of the risk that stock traders have borne.

Interestingly the May 2006 gold highs, Y5764 an ounce, were actually all-time highs for China. Back in the early 1980s when the all-time US gold highs were carved, the Chinese yuan was much more valuable relative to the dollar, lowering that yuan-gold high. Back then one yuan cost about $0.57 in dollar terms compared to just $0.13 today. So in one sense the China gold bull is already breaking new high ground in nominal terms, something that has yet to happen in the States.

Now you sharp-eyed students of the markets have no-doubt noted that the China gold bull looks an awful lot like the US gold bull. Indeed. This is largely due to the yuan currency peg which existed for the decade ending July 2005. As you can see above reflected in the red yuan price, the Chinese currency was dead flat for the first four years of this gold bull. It was hard-pegged at 8.28 yuan to one US dollar, or a little over $0.12.

So up until the People's Bank of China started the process of decoupling the yuan from the dollar in July 2005, the China gold bull paced the dollar gold bull one-for-one. Their charts to that point are indeed perfectly interchangeable. And since we American contrarians earned fortunes in the first four years of this gold bull and were quite satisfied, I have no reason to believe Chinese investors didn't feel the same.

At Zeal we have been tracking gold in major world currencies for years now, so before I started working on this essay I did know that the Chinese gold bull looked just like the US one before July 2005. But what I hadn't realized yet really startled me this week. The greatest upleg of this entire gold bull started in July 2005, the first Stage Two upleg labeled above. It's the one that ended in May 2006 and led to enormous realized gains for prudent contrarians.

Well, in US dollar terms gold bottomed about a week before the strict yuan-dollar peg was loosened. Then it meandered lazily near lows for a couple weeks, in the midst of which the yuan news broke. Then gold really started climbing higher in earnest about a week after the yuan news. It is a strange coincidence that the most powerful gold upleg of this entire bull market launched virtually simultaneously with the Chinese effectively severing their longstanding dollar peg!

I really don't know what to make of this yet. My gut feeling is I suspect it is indeed pure coincidence, nothing more. Gold had consolidated for the better part of a year and was deep under its 200dma in oversold territory in the weeks surrounding the China announcement. I was already very bullish on gold the week before the announcement for reasons that had absolutely nothing to do with China. Correlation does not necessarily imply causation.

This being said, the more years I study the markets the more I respect their underlying complexities. Often relationships exist between disparate markets that are not readily apparent. One key example is today's Tortilla Crisis in Mexico.

Corn tortillas are a crucial staple food for at least 50m poor Mexicans. But due to Americans burning corn to fuel our cars thanks to the ethanol craze, corn prices have soared. This is pricing corn tortillas out of the reach of most poor Mexicans. It is such a big issue the Mexican government fears widespread civil unrest. Who would have thought that American ethanol could lead to a potential Mexican revolution?

My point here is even though it seems improbable that the severing of the yuan/dollar peg had anything to do with global gold supply and demand in July 2005, we can't rule it out emphatically. Perhaps the US dollar sold off on the quasi-floating yuan and gold caught a bid because of it. Perhaps the newly-rising yuan inspired enough confidence in the Chinese populace to increase its gold investment demand. That could have driven gold's initial spike off its lows which then enticed in global investors. All I know for sure is that the coincidental timing here, within one week, is very intriguing.

Since the peg was loosened, the yuan has been climbing. Indeed this year its climb has accelerated considerably as the red line above shows. The rising yuan means that gold is getting relatively less expensive for Chinese investors. In the forex-implied sense, it takes fewer yuan to buy a dollar and hence fewer yuan to buy enough dollars necessary to buy an ounce of gold. Of course the Chinese don't have to actually buy dollars first to buy gold, but due to the dollar's dominance of the world gold market this is how Chinese gold pricing effectively works.

Hence the Chinese gold bull looks more subdued than the dollar's since July 2005. The higher the yuan climbs, the more it moderates gold's gains in dollar terms. This is readily evident above in the blue yuan-gold line. This is a double-edged sword for Chinese gold demand. With a rising currency the Chinese can afford to buy more gold, but with this same yuan rise nullifying some of gold's dollar gains the yuan-gold incentives to buy aren't as compelling as dollar gold's. Nothing begets buying like higher prices, and the strengthening yuan moderates those for yuan gold.

But overall in a strategic sense, the China gold bull looks very much like the American gold bull. Yuan gold is up 172% at best compared to 181% at best for dollar gold. And despite the rising yuan in the last couple years eroding some of the raw gold gains in dollar terms, the yuan gold performance since the dollar peg was dropped has still been excellent in an absolute sense. The secular gold bull is alive and well in China!

Back to my original impetus for this thread of research, do Chinese investors fleeing Chinese stock-market weakness have good technical reasons to buy gold today? The answer is definitely yes. The China gold technicals really look quite bullish now and I would not hesitate to throw long gold if I was in China. This next chart zooms in on the last couple years, since the peg was loosened.

During secular bull markets, secular support occasionally shifts to a steeper upslope. Interestingly yuan gold is now near its second major support line of this bull market. While yuan gold has slid a little below it recently, this line has held five times over the past two years and odds are it will hold again. If you want to buy anything in a secular bull, one of the best times to do it is when a price is near its secular support.

Yuan gold is also near its 200-day moving average today. All bull markets flow and ebb relative to their 200dmas. They rise above and outpace their 200dmas in uplegs and then fall back down to their 200dmas in necessary corrections to rebalance sentiment. Within a fundamentally-driven secular bull, the highest-probability-for-success time to add long positions is when a price is near its 200dma.

With yuan gold near both secular support and its 200dma, it looks like a great time for Chinese investors to buy gold. With these two technical developments alone, I would be very comfortable buying within a secular bull. But in addition to these two major technical buy signals, a myriad of minor ones are confirming them. The yuan gold technicals are pretty much universally slanted towards the bullish slide today.

Note that yuan gold has carved a series of higher lows and higher highs since early October, a textbook young upleg. At best in May it was up 21% since its October lows, definitely not a number to scoff at. Other than the recent weakness spawned by central-bank gold-selling fears out of the West, yuan gold has remained within a nice uptrend channel for eight months now. Thus gold is already showing consistent strength and laying the foundation for its next sharp run higher.

Another bullish factor evident in yuan gold is its long consolidation. For about a year now, yuan gold has largely oscillated around Y5000 per ounce. In bull markets there is tremendous fundamental supply-and-demand pressure for a price to rise, so when a price consolidates sideways for an entire year big forces build behind it. These consolidations reflect poor sentiment. But eventually some catalyst emerges that dispels this sentiment and a price soars heavenwards as fundamentals aggressively reassert themselves. The longer the consolidation, the higher the odds of a big surge up once this happens.

So totally independent of stock-market considerations, yuan gold looks very bullish today for a variety of reasons. Chinese investors should have no problem buying gold if they believe the metal's global fundamentals remain bullish. And to have gold near technical lows is a huge boon for China's stock-market investors. As they start to get scared some will certainly flock to the stability of gold. And doing this when gold is technically cheap is far better than doing it when gold is technically dear.

Provocatively, yuan gold is only about 11% below its all-time highs today. A surge in Chinese gold demand, regardless of whether it is driven by gold's own fundamental merits or fears of falling stocks, could drive yuan gold above last May's Y5764 level in relatively short order. And since there is nothing like new highs to generate interest, even more Chinese will follow the early investors in after new highs are hit.

In the stock-market history of the Western world, speculators tend to flock to gold when panics and collapses set in. Sometimes gold falls initially when people are scared enough to sell everything indiscriminately, but very soon rationality starts returning to some and they start buying gold. This leads to a rising gold price which attracts the interest of even more buyers. And soon gold is powering higher despite a major stock-market downleg.

And with the great Chinese love for gold going back thousands of years, I suspect the Chinese investors will have an even stronger urge to buy gold when stocks crumble around them than we do in the West. Gold is the ultimate store of wealth and safe haven in any financial-market storm, and the Chinese probably instinctively realize this to a far greater degree than we ever will in the West. Odds are a major Chinese stock selloff would lead to a surge in gold demand out of China.

This is interesting, as in the States a fear prevails today that a China stock-market crash or panic is going to drag down the whole world with it, including general US stocks and commodities stocks. In order to address these concerns, I analyzed the probable implications of a major Chinese stock selloff for both the general US stock markets and commodities stocks in particular in the latest issue of our acclaimed monthly newsletter. The conclusions will probably surprise you! Subscribe today.

In addition to our cutting-edge research on markets and promising individual stocks, as well as trade recommendations when technical conditions warrant, our subscribers also get exclusive access to our charts. We track all kinds of key prices and indicators and plot the results on large high-resolution charts on our website. This charts section includes charts of the gold price in ten major world currencies, including the Chinese yuan. So you can watch as yuan gold challenges new all-time highs.

The bottom line is China's gold technicals look quite impressive today. Gold is weak technically and weak sentimentally in China, just like in the US. Yet its global fundamentals remain super bullish. A technically beat-up market coupled with strong fundamentals cannot persist for long. The Chinese investors are really blessed to see technically-opportune gold prices at the same time their stock bubble might finally be cracking.

And if Western investors tend to flock to gold during stock panics, how much more will Eastern investors? In the West we were taught to hate gold since we were kids, that it is a "barbarous relic" that offers no returns. But in the East gold is still venerated as the ultimate financial asset. A stock panic coupled with a strong cultural affinity for gold ought to be pretty exciting to watch unfold.

Adam Hamilton, CPA
Zeal LLC.com

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If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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