As promised, today’s article picks up where last week’s article left off with the focus predominantly on gold, not gold stocks. This year marked an historic event, as something occurred for the third time in nearly 80 years, which is the value of gold exceeding the value of the S&P 500. The first occurrence was during the onset of the Great Depression with the S&P 500 falling below the fixed price of gold on October 29th, 1929. The gold to S&P 500 ratio fluctuated around parity until the stock market plummeted in earnest in 1931 and 1932, with the peak in the ratio ultimately rising to 4.76 in late February of 1933 as the S&P 500 finally bottomed.
The second occurrence of gold breaking above parity with the S&P 500 came during the severe recession of 1973, with gold rising above the value of the S&P 500 on June 29th of the same year. Gold hovered around parity with the S&P 500 for six months before it made a huge jump with the ratio climbing to 2.79 in early December 1974 as the stock market cratered. The top in gold was associated with the stock market bottoming as the correction in gold and the rebound in the S&P 500 drove the ratio of gold to the S&P 500 back down to parity by the summer of 1976. Just as the stock market was putting another top in 1976, gold had put in a bottom and the gold to S&P 500 ratio was making its second and climatic run.
While the stock market bottomed in 1978, gold failed to correct sizably as it did during the 1974 stock market advance, with the run in gold far surpassing the improvement in the stock market, driving the gold to S&P 500 ratio up to a peak of 7.58 on January 21st, 1980. The blow off top in gold was followed by the beginning of a secular bull market in stocks and a secular bear market in commodities that lasted roughly two decades. The ratio plummeted to a depth of 0.179 by July of 1999, roughly coinciding with the top in the stock market.
Since 1999 the ratio of gold to the S&P 500 has advanced in a stair step fashion where it rises for a period and then moves sideways. The ratio moved up significantly after the October 2007 stock market peak, with gold breaking above parity with the S&P 500 on January 20th of this year, marking the third such occurrence in nearly 80 years.
What is interesting to note is that the first occurrence of gold breaking parity with the S&P 500 came during the deflationary Great Depression, while the second occurrence came during the inflationary 1970s. This proves that gold can perform well under either a deflationary or inflationary scenario. Both prior occurrences of the strength in gold were associated with presidential decisions. Gold spiked 27% in one day when FDR devalued the currency after he took office in 1933 and confiscated privately held gold under Executive Order 6102, with gold remaining illegal for Americans to own until 1974. In 1971, President Richard Nixon removed the gold standard and ushered in an inflationary decade and a fiat monetary system that has been with us ever since.
Since gold has been de-linked from the USD it has displayed an inverse relationship with the USD. The top in gold in 1974 marked the bottom in the stock market and the top in gold in 1980 marked the turn of a secular bear market in gold and a secular bull market in stocks. The tables turned at the dawn of the millennium with gold beginning in a secular bull market and the S&P 500 beginning in a secular bear market. Using the two prior occurrences of gold breaking parity with the S&P 500 shows that once parity is broken the ratio typically stays near parity for several months and then explodes upwards and ends in climatic fashion. So, once parity is broken the action is typically not a whip saw event, where gold falls back below the value of the S&P 500, but the start of a significant outperformance of gold relative to the stock market.
While gold has moved above its former all-time high of 0/oz reached in January 1980, the gold to S&P 500 ratio is 83.42% below the level seen at gold’s prior peak. To reach the prior gold to the S&P 500 ratio high of 7.583 would take ,984/oz gold using the yesterday’s close on the S&P 500, and if the S&P 500 fell to 600 as some maintain is still possible (Jeremy Granthom & John Hussman), we would need gold to reach ,550/oz to reach the prior high. What this analysis shows is that there is plenty of room to the upside for gold to reach its prior mania high relative to the stock market, indicating gold’s secular bull market may not be young in terms of duration, though it certainly is in terms of magnitude relative to prior secular bull markets.
Source: Bloomberg
Intermediate Picture
The Bullish Case
The long term picture for gold, as highlighted above, is that gold remains in a secular bull market until proven otherwise, while the intermediate picture is far less certain. A bullish case for gold is that so far the stock market remains in a bear market while gold is on the verge of assaulting its all-time high north of ,000/oz. The inverse nature of gold and the stock market will prove favorable for gold as long as the S&P 500 remains on the defensive.
Additionally, growing balance sheets by world central banks and growing deficits in developed countries are putting strains on global currencies and credit default swap (CDS) spreads are rising on sovereign debt issues in the G7 countries. The rise in gold has been associated with rising fear levels by investors with soaring fiscal budgets across the globe. This can be seen when looking at the CDS spreads on 5-Yr Euro-denominated UST debt and gold below, with spikes in the CDS associated with spikes in gold, with both trends continuing to move higher. This same trend can be seen across G7 countries with the average G7 CDS on 5-Yr sovereign debt issues rising in tandem with gold as gold becomes the ultimate global safe haven currency.
Source: Bloomberg
Source: Bloomberg
Global currencies are falling apart relative to gold as gold hits new highs relative to global currencies (2nd panel below), and is on the verge of further currency breakouts relative to the Canadian Dollar (CAD), the Swiss Franc (CHF), and the US Dollar (USD) (1st panel). As long as fears remain high with respect to fiat currencies and ballooning government fiscal deficits, gold should remain strong.
Gold Denominated in Foreign Currencies: Rebased to 100 as of 03/14/2008
Source: Bloomberg
One other positive for gold right now is that gold stocks relative to gold have held up, which is significant as gold stocks typically lead the price action of gold. The AMEX Gold Bugs Index’s (HUI) relative strength ratio to the gold ETF (GLD) remains above its 50d MA and its RSI is still holding above 50. A break through the 50d MA of the relative strength ratio and a decline below 50 on the RSI would probably signal a top for gold, though gold stocks may underperform gold for a short period as they test the rising trend line of its relative strength ratio (top panel) before gold stocks may outperform once more.
Source: Stockcharts.com
The Bearish Case
While the inverse correlation of gold to the stock markets was cited above as a bullish support for gold, it can also work against gold. If the stock market bottoms this year there is a good chance that it will be associated with a top in gold, not necessarily “THE” top in gold for this cycle but “A” top. This relationship can be seen by comparing gold with the S&P 500 in the 1973 and 1981 recessions during the prior secular bull market in gold. The figure below normalizes gold to 100 at the onset of the recession and the x-axis is the duration in months before and after the recessions began. What is interesting to note is that gold is following a similar path to what was seen in the recessions highlighted below. If gold follows the 1973 path then it should be peaking in the next month or so at a new high before undergoing a sizable correction, which is certainly possible given gold’s close proximity to its former high. If gold follows the 1981 recessionary path, then we could see strength in gold for another six months before a correction is seen. At either rate, both recessions witnessed a peak in gold anywhere from 13-19 months after the recession began, pointing to a top of intermediate nature in gold’s future in the next six months.
Source: Kitco.com
While gold breaking parity with the S&P 500 is bullish in the long run, as once that feat is achieved gold experiences sizable outperformance relative to the stock market for several years, the ratio of gold to the S&P 500 also carries a negative current outlook. In terms of gauging peaks in gold relative to the stock market I looked at the 200 day moving average (200d MA) of the ratio of gold to the S&P 500. From there I took the deviation of the ratio from that average to measure relative overbought and oversold conditions. Not surprisingly, what I found was that large positive deviations of the gold to S&P 500 ratio from the 200d MA were often associated with significant peaks in gold, or at least marked the beginning of lengthy sideways consolidation in gold as it worked off its overbought condition. Additionally, what I also observed was that there is a shift in the overbought zone for the ratio depending on whether gold was in a secular bull or bear market.
During the secular bull market in gold of the 1970s, overbought regions for gold were seen when the gold to S&P 500 ratio was north of 40% from its 200d MA, while significant bottoms were witnessed when the ratio fell to 20% below its 200d MA.
Source: Bloomberg
After gold made a parabolic blow off top in early 1980 it began roughly a 20-year secular bear market. The first decade of its secular bear market witnessed a shift in the overbought zone in the gold to S&P 500 ratio from roughly 40%-60% north of its 200d MA to 20%-40%, while -20% below the 200d MA still remained a good entry point into gold. The latter half of gold’s secular bear market witnessed the overbought zone shift even lower, down to 10% above its 200d MA of the gold to S&P 500 ratio. Once again, -20% below the 200d MA of the gold to S&P 500 ratio often marked bottoms in gold.
Source: Bloomberg
Source: Bloomberg
As gold has shifted from a secular bear market to a secular bull market at the turn of the century, its overbought zone also shifted from 10% above the 200d MA of its ratio to the S&P 500 in the prior decade to 30%-40% in this decade. The first spike above 30% from the ratio came in September of 2001 and was followed by a ~7% correction in gold, while the next spike in the deviation was in 2002 that saw an initial 6.3% decline in gold followed by a five month consolidation before gold moved higher. The ratio reached nearly 30% above its 200d MA in early 2003, which witnessed roughly a 15% correction in gold over two months.
The next significant overbought condition in the ratio relative to its 200d MA came in May of 2006 when it rose to 34.6%. Gold fell over 21% in one month and then underwent a nearly year and a half consolidation before reaching a new high. The subsequent overbought condition wasn’t seen until March of 2008 when gold broke ,000/oz, with the gold to S&P 500 ratio reaching nearly 50% above its 200d MA. Gold then witnessed nearly a 30% correction over eight months. During this eight month consolidation the ratio nearly reached 50% above its 200d MA for the second time last year in October, which witnessed a 21.52% correction in one month.
Source: Bloomberg
The recent surge in gold as it approaches its 2008 highs has pushed the ratio of gold to the S&P 500 nearly 60% above its 200d MA, the most overbought condition since the peak in gold in 1980, more than 28 years ago. Clearly at this juncture gold’s outperformance relative to the S&P 500 is reaching extreme territory. To put a more quantifiable context to gold’s recent outperformance I measured the standard deviation of the ratio to its historical average relative to the 200d MA. As seen below, the outperformance of gold to the S&P 500 relative to its 200d MA is nearly four standard deviations above the mean, an event that should occur only one one- hundredth of a percent of the time, or roughly once every 27 years, which is actually roughly the last time this event was witnessed as seen in the chart below.
Source: Bloomberg
What the figure above illustrates is that gold’s outperformance relative to the S&P 500 is clearly extended and likely to mean revert back to the 200d MA, which using yesterday’s close on the S&P 500 would imply 6.88/oz gold holding the S&P 500 constant, a decline of roughly 37%. This shows the magnitude of the outperformance of gold relative to the stock market and the size of the correction needed to bring it back to its 200d MA. While a sharp and violent correction in gold that brings its ratio to the S&P 500 back to its 200d MA is possible, further sideways consolidation is more likely while the S&P 500 finds its footing, which was seen in 2002 and 2003 when the ratio was significantly above its 200d MA.
What is also bearish for gold is the strength in the USD that is predominantly due to weakness in the Euro, which composes 57.6% of the USD Index. The Euro Index ($XEU) is on the verge of breaking down to new lows, which would likely take the index back down to the 2005 lows if it breaks current support at 123.94. A break in the Euro to new lows would lead to a breakout in the USD Index ($USD) which could put some strain on gold advancing much further.
Source: StockCharts.com
While strength in the USD is bearish for gold, since September the correlation between gold (GLD) and the USD has become less negative, with a significant reduction in the correlation since the start of the year as strength in the USD is not translating into weakness in gold. While gold and the USD are both displaying strength this trend can not continue. A failure to breakout by the USD Index would clearly be bullish for gold, and may be the point where their correlation returns to a more negative relationship.
Source: Bloomberg
In Summary, gold is clearly still within the confines of a secular bull market until proven otherwise. Current conditions suggest gold is quite extended relative to the S&P 500 and may undergo a period of underperformance, though any corrections from current overbought levels will likely prove to be pit stops in gold’s assault to new highs and a move north of 4.0 in the gold to S&P 500 ratio before this secular bull breaths its last. The end to the current secular bull market in gold will likely be associated with a break through the lower channel of the gold to long bond ratio, the ultimate inflation/deflation monitor. While there is no doubt that we are currently in a cyclical episode of deflation, the trend in the ratio of gold to bond prices suggests that the secular inflation that began in late 2000 is still underway. Until gold breaks through the lower trend channel below, it appears that the future for gold remains bright.
Source: StockCharts.com
