A Look At Gold

By: Captain Hook | Tue, May 30, 2006
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The study below originally appeared at Treasure Chests for the benefit of subscribers on Monday, May 15th, 2006.

Where do I start today? That is the question rolling around my head right now because there is so much to cover. Someone sent in a question this weekend. Do you guys ever take a break? Answer: rarely. Again, because one must stay on top of these things, especially when change comes so fast now. And as you know from our musings last week, change could be coming very fast if the dollar ($) heads toward 80 for real in the near future, because Mr. Bernanke will have a rather difficult decision to make. He will have to decide whether or not he will raise rates sufficiently to attract capital back to the States (think half a percentage-point), which many think could crash the stock market, or allow capital to leave letting the $ crash, which in the end could have the same effect on both stocks and bonds as foreigners pull their money out of all things American anyway.

While some degree of the latter scenario outlined above is definitely possible, the problem we have with the extreme case right now, that being a $ crash because of inaction on the part of Bernanke (his test as it were), is that it's impractical to think those with sufficient capital to move the foreign currency markets on a lasting basis (think governments and multinationals) would do so today knowing the damage this would unleash in the other economies. That is to say, how would such a move benefit China for example, where a crashed global trading block is the last thing ruling gangsters wish to see at this point with the 2008 Olympics so close at hand? Answer: it wouldn't, so don't expect to see this. This is what the gold against $ situation looks like right now (at least before today), extending impulsively to the upside, and we will show you later on why it's most likely destined to see new highs as well. Of course this may not be before a very sharp commodity like correction, possibly beginning in earnest overnight. (See Figure 1)

With this in mind, and understanding the fiat currency equation is a zero sum game in more than respect, along with being pointed out by Marc Faber this week, China has scant gold reserves in relation to its total foreign currency reserves, so expect more buying to take place behind the scenes for this reason no matter what the price is doing. That means the Gold / $ Ratio should reach new highs based more on strength in gold, and not on $ weakness. Thusly, and based on this understanding, gold will likely continue to grind higher until it at least gets back to its previous inflation adjusted highs at approximately $2,200 Handy and Harman pricing at some point minimally if history is a good guide. (See Figure 1)

In the meantime however, if the overnight action is not taken back in the day session today, we could be in for a larger degree and long overdue correction in the metals moving into the summer. Sell in May and go away is what you will hear if this holds true. The good part of such a correction is that in terms of the metals it should be 'normal', although we cannot guarantee that about the stocks. Let me show you what I mean, where to start things off in this regard, you may remember my comment from last week that the Dow / XAU Ratio was falling precipitously, and that we are closer to a zero premium situation in precious metals stocks than most people think.

Anyway, if you did not get that message clearly, what this means is the fortunes of precious metals stocks are invariably being tied to those of the broad measures of stocks increasingly as a function of general liquidity conditions. The understanding here then is that because the Dow / XAU Ratio is not at unity yet, and that we can expect more relative strength in precious metals stocks before this concern becomes a real issue, at the same time it should noted they are becoming more closely tied to the general direction of the markets, and subject to liquidity related risks not present just a few years ago. Of course if my partner Dave Petch is correct, this whole process should be considered healthy from a bull market perspective because along with increasing instances of energy issues, precious metals stocks should begin populating broad market index measures more frequently anyway, meaning prices will likely be substantially higher than they are today. This would of course also likely mark the point at which on a risk adjusted it would make little sense to own precious metals stocks in favor of bullion, and meaning a top in the metals should be only a few scant years afterward.

Again however, and in terms of further refining the above understanding in the here and now, because the markets have become more a function of speculation than investing largely due to misplaced objectives of officialdom, hedge fund managers, and the public alike, unexpected volatility is likely to become something stock, commodity, and precious metals investors will have to live with increasingly along the way. Therein, in the case of commodities in general, and more specifically gold and silver, as mentioned previously, all are presently as overbought as they have ever been. Here is another measure showing that in terms of commodities, we are seeing 20-year returns right now, meaning the best comparative rates of return witnessed on an annualized basis since the better years of the last commodity cycle. (See Figure 2)

Many are taking the financial imbalances we have been talking about on these pages more seriously now. The fact these concerns have been ignored for so long is a large part of the reason commodities have outperformed precious metals thus far in the larger degree sequence, even to this day, and is why we have higher absolute prices ahead of us if history is a good guide. This understanding is made quite clear if you compare gold's 20-year returns (see Figure 6) against those of commodities in general, as seen above.

What does this suggest we should expect in the future? In a nutshell, as we do not know how long the Boyz down on Wall Street will be able to keep things glued together, in the end this means that gold will be the last commodity / equity to top because it's also eternal money, and people will flock to it in times of uncertainty. In the meantime however, and again if history is any guide, using the 70's as a comparison model, it's possible some quite violent swings could now be ahead for precious metals investors if equities come unglued. As you can see below, once gold failed off the $200 interval in 1974, it almost fell back below $100 before it regained traction. (See Figure 3)

Thusly, and using this comparison as a model, it's possible we are at such a juncture once again, where we could be in for a much sharper correction than most market participants are hoping for. Furthermore, such an outcome would not be surprising in the least considering instances like these are usually tied to meddling middle men playing with liquidity measures, which we know to be the case (think pre-election tightening) based on recent comments coming out of officialdom.

Now, it should be noted that put / call ratios for precious metals stocks as measured by the Philadelphia Gold And Silver Index (XAU) (just type in XAU and hit the submit button) are currently setting a floor price at 140, as mentioned previously, so if things do not change in this regard, one would not be wise to expect greater volatility out of the metals, as characteristically in the end they will typically prove to be more stable than their related equities. This means that one should not expect more than a 15-percent correction in gold from top to bottom worst case scenario based on this observation in isolation, imputing a target of $616 for the move. This target would certainly fit in nicely with previous discussions we have had concerning gold and the Progressive Interval System (PI). (i.e. the last big bounce in gold was off the 3-percent test above $600 at $618, bouncing exactly at $616.) Note, such an outcome would also conform to the gold is a beach ball analogy provided for you the other day, as well.

Should we say more at this point? Probably not, as we have touched on numerous bases over the past few days. Now it's time to watch and see which way the wind blows.

Since publication of this commentary on our site back on May 15th, much has obviously occurred in the world of gold. At the time, most were not talking about a correction, let alone a move back down to the $600 area. If you are interested in learning more about what we currently see as 'the scoop' concerning gold's future price action, we invite you to visit our site. What's more, while there, you may discover more about how an enlightened approach to market analysis and investing could potentially aid you in protecting your finances into the future. And of course if you have any questions or criticisms regarding the above, please feel free to drop us a line.

We very much enjoy hearing from you on these matters.

Good investing all.

Special Acknowledgement: All charts above provided by the Chart Store.



Captain Hook

Author: Captain Hook

Captain Hook

Treasure Chests is a market timing service specializing in value-based position trading in the precious metals and equity markets with an orientation geared to identifying intermediate-term swing trading opportunities. Specific opportunities are identified utilizing a combination of fundamental, technical, and inter-market analysis. This style of investing has proven very successful for wealthy and sophisticated investors, as it reduces risk and enhances returns when the methodology is applied effectively. Those interested in discovering more about how the strategies described above can enhance your wealth should visit our web site at Treasure Chests.

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