Trader’s Narrative

Market strategists have drawn a line and taken sides: is gold in a bubble? Jim Rogers and Nouriel Roubini had a verbal smack down via respective media interviews with the former manager of the Quantum Fund being the believer he’s always been in the power of commodities while the prophet of doom and gloom used the “b” word to describe the precious metal.

Now another pair of strategists have taken sides - although not as personal as Rogers and Roubini. Dennis Gartman, believes not only that gold is in a bubble, but that it should be obvious to everyone. But that doesn’t mean he’s necessarily climbing off the trend:

Meanwhile, David Rosenberg featured this chart to argue not only is gold not in a bubble, it is actually “cheap”:

Leaving aside the obvious arithmetic (instead of logarithmic) scale, comparing the S&P 500 index to the price of gold is a non sequitur. This is due to the incessant rise of the equity index, with that itself due to the survival bias built into the constituents that make up the S&P 500 index. And don’t forget a dash of inflation which pumps up stock prices and therefore, stock indexes. So a ratio of gold to equity prices will for the most part look like a ski hill - and be as meaningful.

I’m also puzzled why Rosenberg is so bullish on gold since he has been one of the prescient strategists who has beaten the deflation drum the loudest.

Market Measure of Forward Inflation
Other than the CPI figures from the US government sources, there is a market determined inflation measure. It is the implicit inflation as per the Treasury Inflation Protected Securities (TIPS). The TIPS data that I showed back in 2008 is no longer published by the Fed. Thankfully, Bloomberg disseminates a metric based on the nominal forward 5 years minus US inflation-linked bonds forward 5 years. So basically, this is the average inflation that the bond market expects from 2010 to 2015:

Source: Bloomberg

In the final days of last year, inflation expectations were the lowest in a very long time, fallin to just 0.41%. Earlier this month they reached 2.89% but today’s forward inflation expectation was still a muted 2.68%. Clearly, the bond vigilantes are not signaling a runaway inflation debacle in the near term future for the US.

So can it be that gold is in an honest to goodness bubble?

Gold Sentiment
Here are two measures of sentiment for the precious metal. The recent survey of Bloomberg terminal users on their conviction for gold found a remarkable 94% to be bullish.

That is a new record high since the survey started in 2004. Unfortunately, Bloomberg’s survey hasn’t been very good as a contrarian indicator. But it has rarely been above 90%. The closest it has gotten to this level was at the start of the year in January 2009 when it reached 91% bullish. Back then, gold was $900/oz. While there is a short history, the sheer lopsidedness of the recent consensus makes it noteworthy.

Courtesy of Elliott Wave, we get another measure of gold sentiment:

The Daily Sentiment Index (trade-futures.com) has been at, or above 90 percent gold bulls since November 3, a string of 10 straight days. The only other comparable streak of optimism over the past 22 years of data is leading up to the December 2, 2004 gold high when the DSI was at, or above 90 percent for 20 consecutive days. At that time, prices made a high at $458.70, declined over 10 percent, and did not exceed the December 2004 high again for the next 10 months. But during this entire 20 day stretch, optimism never reached the single day extreme that today did, with fully 97 percent of traders optimistic on gold’s future prospects. This time, we expect a larger decline, one that lasts longer too.

While we’re on the subject of seasonality and how September is the albatross around the stock market’s neck these days, I’d be remiss to not point out that what has been historically negative for equities has been a boon for gold and gold stocks.

Last year, I also pointed out the positive seasonality of gold in September (and the remaining months left in the year). But, as measured by the Philadelphia Gold Bugs Index (HUI) gold stocks didn’t follow their historical path and finished the month pretty much unchanged. However, in mid-September there was a rally that took the Gold Bugs index 35% higher within the month.

In any case, here is a chart of the monthly performance of gold for the past 5 and 15 years:

If you compare this chart with a longer duration seasonality chart you’ll notice that during this current super-bull market for gold (which started in 2000) seasonality has shifted slightly. For these most current years (red line) there are really two big waves of positive seasonality for gold and gold stocks. The first is about to start while the second comes after a correction in October and lasts from mid-October to February of the following year.

Here’s a chart of the Gold Bugs index with the past two September’s and this year’s marked by a green arrow:

I didn’t bother marking the obvious triangle pattern that has formed in the gold stocks index. Prices are getting coiled into a spring and will potentially break out. However, over-head resistance is just 100 points higher at 475-500 - where the Gold Bugs index hit a wall early last year.

Remember, seasonality, while having a powerful and undeniable influence, is a secondary driver of prices. It is more helpful to think of it as context for the actual analysis of trend.

As a corollary to yesterday’s deflation discussion, I thought I’d cover the consequence for gold and gold stocks. The relationship between gold and deflation is a contentious one so I don’t think it will ever be put to rest. In any case, I wanted to point out an interesting relationship which you’ll be hard pressed to find elsewhere.

Referring back to the chart in our previous discussion on the consequences of deflation you can see that we’ve had several periods of negative real interest rates. Naturally, these are when the inflation rate is higher than the nominal interest rate.

These periods coincide with great opportunities for buying gold and gold stocks. For example, in early to mid 1970’s and again in 2003. This doesn’t always hold true however. For example, the gold mini-bull of the mid 1980’s happened without a negative real interest rate environment.

In the 1970’s inflation was rampant and pushed real interest rates below zero. Until Volcker’s ‘take-no-prisoner’ style of monetary policy choked off inflation and brought real rates above zero. But of course, the situation in 2003 wasn’t that we had excess inflation but that nominal interest rates were being kept much lower than they should have been by the Federal Reserve (and we all know how that played out eventually).

Since deflation usually arrives at times of economic slack, one way to try to measure the relationship between the performance of gold and deflation is to look at how it did during recessions. Click the thumbnail to the left to take a look at a spreadsheet showing this data since 1945. The data is courtesy of EWI - they are also giving away a free 60 page eBook on Understanding Deflation which is chock full of similarly interesting tidbits.

The average performance of gold during recessions since 1945 is a miserly 4.8%. What about this most recent recession? We know the start of it but while many are prognosticating its end, we don’t have an official end date from the NBER. So let’s see how gold has done since December 2007:

That’s much better than the average but much lower than the outlier from the mid-1970’s. Still, it is not even enough to marginally move the average over the past 11 recessions. So according to this, holding an investment in gold during deflation is not usually a smart idea.

Trading gold and gold stocks however is still lucrative. One of my favorite indicators is the K-Ratio which is a ratio of gold stocks to gold itself. Here are two long term charts of the K-Ratio (using the Philadelphia Gold Bugs Index and the CBOE Gold Index to approximate gold stock prices):

Right now, the K-Ratio is trading mid-way and not really giving any signals. If it does fall again to previous lows, then we could have another set up for a ramp higher. Until then, I’m not too excited about gold.

As gold bullion made a third attempt at the round number $1,000 there is a rush to feed a seemingly insatiable demand for gold securitization:

The most recent related IPO was the Claymore Gold Bullion Trust (CGL.un) on the Toronto Stock Exchange. Claymore is a small but innovative Canadian based asset manager and they’ve created a unique product. For starters, the fund will hedge almost all of its currency exposure to the US dollar. So Canadian investors will hold gold in Canadian dollars, not against the US dollar. Second, although structured as a closed end fun initially, if there is a persistent discount to NAV, it will convert to a ETF at the NAV (and therefore, eliminate discounts/premiums that plague all CEFs).

The Claymore Gold IPO was oversubscribed ($460 million Cdn) with over half being taken by large institutions. What really made Claymore’s product attractive to US institutions especially is the different in taxation schemes. By investing in an ‘offshore’ security, US investors can avoid the 28% luxury tax they would normally have to pay for holding gold and instead pay a much smaller 15% tax rate.

In the end, I can’t help but remember what we should have learned long ago: Don’t Buy What Wall St. Sells.

So is Claymore’s Gold IPO a signal for a top in gold?

Consider that the Claymore Gold CEF (probably ETF in due time) joins a quickly crowding field. Sprott Asset Management launched their Sprott Gold Bullion Fund, an open ended mutual fund earlier in the year. These join the existing two gold funds: the Central Fund of Canada (CEF) and Central Gold Trust (GTU) - both of which took advantage of the appetite for gold to raise $200 million each via a secondary offering last month. Even more interesting, the secondary offerings for both of the existing gold CEF’s were done at premiums to NAV.

But all of these funds pale in comparison to the SPDR Gold Shares ETF (GLD), which believe it or not, holds more gold than the Swiss central bank.

Those who bought this IPO placement (Thursday May 28th, 2009) from their brokers at $10 were immediately underwater:

Right now there is a small discount to NAV and the only consolation is that Claymore will convert from a CEF to a ETF if it persists for a few more months. But of course, the value of gold will play a much more important role in whether this was a smart investment or not.

Remember that last year Sprott flagged the top of the commodity bull market by issuing their own IPO. If we’ve learned anything about market timing, it is that when the ducks quack, Wall St. feeds them.

By Robert Prechter, CMT

The following article is adapted from a brand-new eBook on gold and silver published by Robert Prechter, founder and CEO of the technical analysis and research firm Elliott Wave International. For the rest of this revealing 40-page eBook, download it for free here.

I have often read, “Gold always goes up in recessions and depressions.” Is it true? Should you own gold because you think the economy is tanking? Whenever we hear some claim like this, we always do the same thing: We look at the data.

The first thing to point out is that gold did not make a nickel of U.S. money for anyone in any of the recessions and depressions from 1792, when the gold-based dollar was adopted, through 1969, a period of 177 years. Well, to be precise, there was a change in the valuation in 1900, when Congress changed the dollar’s value from 24.75 grains of gold, the amount established in 1792, to 23.22 grains, a devaluation of just six percent total over 108 years. The government did raise the fixed price from $20.67/oz. to $35/oz. in 1934, but that action occurred during an economic expansion, not during the Depression. In 1968, gold finally began trading away from the government’s fixed price. Even then, it slipped to a lower price of $34.95 on January 16 and 19, 1970. So the idea that gold always goes up in recessions and depressions is already shown to be wrong. It did not go up in terms of dollars in any of the (estimated) 35 recessions or three depressions during that period.

What almost always does happen during economic contractions is that the value of whatever people use as money goes up as prices for goods and services fall. When gold is used as money, its value in terms of goods and services goes up. But gold can’t go up in dollar terms when gold and dollars are equated. So no one “makes money” holding gold under these conditions. It is a fine point: What tends to go up relative to goods and services during economic contractions is money, and when gold is officially money, that’s how it behaves. What we want to know is how gold behaves in recessions and depressions when it is not officially accepted as money.

Many gold bugs say that because gold was a good investment during the Great Depression, it is a “deflation hedge.” We addressed this topic in At the Crest of a Tidal Wave (1995, p.357) and Conquer the Crash (2002, pp. 208-209). At the time, government fixed gold’s price, so it didn’t go up or down relative to dollars. Gold was a haven during that time, the same as the dollar was, since they were equated by law. But gold served as a haven because its price was fixed while everything else was crashing in price during the period of deflation. Gold bugs like to claim that gold would have gone up during that period had it not been fixed, but the crashing dollar prices for all other things suggest that in a free market gold, too, would have fallen. It would have fallen, however, from a higher level given the inflation of 1914-1929 following the creation of the Fed. So gold became worth more in dollar terms than it was in 1913, which is why it began flowing out of the country. In 1934, the government finally recognized the new reality by raising gold’s fixed price. Since 1970, markets have been in a large version of 1914-1930, except that gold has been allowed to float, so we can clearly see its inflation-related, pre-depression gains.

Observe that gold’s price remained the same for a Fibonacci 21 years after the Fed was created in 1913; it was revalued in 1934. [Ed. Note: For a full chapter on Fibonacci time considerations for gold, download the 40-page Gold and Silver eBook.] Then it held that value for 35 (a Fibonacci 34 + 1) years, through 1969. So aside from the revaluation of 1934, the inability to make money holding gold during recessions, depressions, or any time at all save for the day of the revaluation in 1934 held fast for 56 (a Fibonacci 55 + 1) years following the creation of the Fed. So even after Congress created the central bank, no one made money holding gold in a recession or depression for two generations.

In 1970, things changed dramatically. Investors lost interest in stocks and preferred owning gold instead, for a period of ten years. The same change occurred again in 2001, and so far it has lasted seven years. But, as we will see, recession had nothing to do with either of these periods of explosive price gain in the precious metals.

The period of time one chooses to collect data can make a huge difference to the outcome of a statistical study. If we were to show the entire track record from 1792, gold would show almost no movement on average during economic contractions. If we were to take only 1969 to the present, it would show much more fluctuation. To give a fairly balanced picture, combining some history with the entire modern, wild-gold era, I asked my colleague Dave Allman to compile statistics beginning at the end of World War II. This is what most economists do, because they believe “modern finance” began at that time and that things have been “normal” since then. It’s also when many data series begin. So our study fits the norm that most economists use. It also provides results entirely from the Fed era, making it relevant to current structural conditions.

[Ed. note: To study the six tables revealing gold’s performance record vs. stocks and T-notes since WWII, download the 40-page Gold and Silver eBook.]

Table 1 shows the performance of gold during the 11 officially recognized recessions beginning in 1945. Although one could make a case for different start times, we took the 15th of the starting month and the 15th of the ending month as times to record the price of gold. The results speak for themselves. Even though it is accepted throughout most of the gold-bug community that gold rises in bad economic times, Table 1 shows that such is not the case.

The only reason that the average gain for gold shows a positive number at all is that gold rose significantly during one of these recessions, that of 11/73-3/75. The average gain for all ten of the other recessions is 0.16 percent, almost exactly zero. The median for all 11 recessions is also zero. If we omit the five recessions during which the price of gold was fixed, the median gain is 3.09 percent.

For long-term forecasts and more in-depth, historical analysis for precious metals, including the six revealing tables mentioned in this article, download Prechter’s FREE 40-page eBook on Gold and Silver.