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GOLDEN
OPPORTUNITY OR GOLDEN TRAP?
by George
Kleinman
Editor, Commodities
Trends
December 14, 2005
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Imagine that you were put in a time machine and were launched from now to 100,000 years in the future, and there’s no way back. You don't know if there are humans or any kind of civilization. You are only allowed to take with you either one million dollars or one troy ounce of gold. Which is it that you choose to take with you? Andrew Stanton, a floor trader in the gold options pit, submitted this question. Judging by my e-mail correspondence and our order flow, gold (and, to a lesser extent, silver) are without a doubt today’s hot commodities. I’m going to spend a bit more ink than usual on this market, and perhaps provide more stats than you wish to see. But if you’re in gold, or if you’re thinking about gold, this is vital information. I see the gold market at or close to a major price point that will lead to either a major washout-type collapse or to an acceleration of the current uptrend. Which will it be? Read on... The recent gold run has been nothing short of spectacular, and the metal has greatly outperformed most gold stocks. In the last 30 days, gold prices have surged 16 percent with virtually no meaningful corrections. If this rate of return were to continue, an annualized return, without leverage, of nearly 200 percent would result. Alongside the historic 1979-80 “Mother Of Bull Runs,” this is the only other time in history gold has had a rally of this magnitude without a major correction. Is this move like that move? If it is, gold is going a lot higher. On the other hand, if the current market action is a blow-off top, then this is the time to exit all precious metals positions and aggressive traders can start to consider bear market strategies. We’ll get back to the historic 1979-80 market shortly, but first I’d like to discuss the bull argument and then the technical tone of the current market condition. The bull argument is that gold is no longer a “barbaric relic,” but a new asset class and a necessary alternative to holding depreciating currencies. The following is an argument (updated and paraphrased) from Jerry Stewart, a retired banker, a successful investor and a friend of mine: “Even at mroe than $500 per ounce, gold is modestly priced today--and about the same price as it was during the Great Depression. “Consider this: Since the Depression, the CPI (consumer price index) has risen about 15 times. At that time gold was $35 per ounce. Multiply $35 times 15. The answer is $525, which is what gold is selling for now. “Now try this ‘15 times’ rule for equities. The Dow was about 100 during the early 1930s (as low as 40 in July of 1932); 15 times 100 equals a Dow of 1,500 for today. Instead, the present Dow is about seven times that amount. "Try real estate: A fine house could be bought for $5,000 in the ‘30s. If house prices moved the same as the CPI times 15, you get $75,000. That same house, depending upon the area, is presently selling for $300,000 to $500,000. And the price of housing is not even figured into the CPI. So the big inflation has been in investment assets. “Another way of looking at this situation (to illustrate the over-pricing of investment assets) is to try to live off the investment income of $1 million dollars. In the ‘30s, you would have lived like a super-king! Today, the (no-risk) investment income from $1 million dollars would bring in about $30,000 per year--hard to live on! “So think about gold as a way to preserve your cash assets.” It’s hard not to like gold in the long term; note on the monthly chart how the market has recently broken above a three-year channel. But this market appears, from a technical perspective, to be due for a correction. Open Interest, at 340,000 contracts, is lower than the 370,000 all-time record level of October, when gold traded well below $500. The rule of thumb: Declining open interest in a rising market is not bullish action. And the bullish sentiment is a bit high right now for my tastes. The commercial players are heavily net short (and they are usually right in the long run), but I guess what really prevents me from getting aggressively long today is the overbought condition of the RSI (relative strength indicator). You can see this on the monthly chart. The monthly RSI for gold is currently at 79, an historically high level. I’ve labeled the points in time where this oscillator (we use the 9-period) has traded above 75 with an "X." On the monthly chart, this has happened only five times since 1988 . All five were marked by a major correction in the uptrend. Monthly Gold 1989-Present The previous four occurrences were: December 2003 (RSI peaked at 77); May 2002 (RSI peaked at 78); June 2002 (RSI peaked at 77); and July 1993 (RSI peaked at 79). All four resulted in corrections that ranged from 9 percent to 17 percent. These corrections did no real damage to the longer-term uptrend--they merely cleansed the market of weaker owners. A similar correction from the recent $531 spot high would point to a move below $500, at minimum. (I would first anticipate support to surface just above $505.) While we never recommend fighting the trend, there are signs this market is overbought. My sense is now isn't the time to load up on gold. The odds favor a washout-type correction (I would like to see that 9-period monthly RSI back into the sixties) to get aggressively long again. In fact this has worked every time the monthly RSI has reached the upper 70s (it’s now 79), except the big bull run of 1979-80. The Historic Bull Gold Move of 1979-80 In August 1979, gold was trading at $288 per ounce. It surged 59 percent to $445 by October of that year with only small corrections. It then broke 18 percent to $365 in one month. But then the really big move started. The market moved from $386 to $513, a move of 25 percent. A 6.5 percent correction to $479 followed. From $479, the market moved to $653--a 36 percent move before another 6 percent correction to $612. The move from $612 to the all-time high price of $895 was parabolic and took place in only seven trading sessions. The all-time high was hit on Jan. 21, 1980: $875 on the spot market, $895 on the futures market (see the chart above). The market was back down to $625 only seven days later, and back down to $450 by late March, just two months later. How did the monthly RSI fare during that run? It hit 80 at just under $400 in September 1979. There was a small 7 percent correction to $370, but the real move had only just begun. The monthly RSI ran to 95 at the $875 high. Monthly
Gold 1979-85 Present conditions differ from those of 1980 (e.g., no double-digit inflation), but if this move is like that move, this leg takes gold up 59 percent from $460 to about $750. It eventually goes up from there another 37 percent to more than $1,000. It seems impossible, but this type of move did happen in 1979-80. If this move is like that move, then throw the RSI and all indicators that measure the overbought condition of a market out the window. Gold won’t have the normal type of corrections. Rather, it will start to accelerate (if this market is a corollary to the “Mother Of All Bull Runs”). This is certainly not impossible because of all the excess liquidity in the world today, especially from hedge funds, India, China and the Middle East. So which is it: a major washout correction or an accelerated type of up-trend? The answer lies in the market action in the coming weeks, and perhaps we’ll see the answer as soon as this week. I don’t see gold remaining stagnant from this level--I’m looking for one of these two scenarios. The market will tell us which of the two is correct, and nobody is smarter than the market. If the market speaks out clearly and loudly, I’ll put out a new gold trading recommendation in Futures Market Forecaster, but you can watch the market action for yourself. Hopefully, we’ve helped you identify what to watch for.
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