Gold Bull Stage Two 3

Adam Hamilton
Archives
May 5, 2006

2006 has been a banner year for gold, with the Ancient Metal of Kings powering from $515 to over $650 in just the first four months of this year. This particular mighty gold upleg, since its humble beginnings in early June, is up an unbelievable 60%! It utterly dwarfs all uplegs that came before it in this bull.

As a long-time gold and gold-stock investor and speculator, I have been diligently studying this gold bull since it arose from its own ashes in the $250s back in late 2000 and early 2001. Five years ago this week, gold was trading at $265ish and deflationary predictions of sub-$200 gold abounded. Back then only a radical fringe believed a global commodities super bull was being born.

With gold now up 160% since its April 2001 multi-decade low, this bull is off to a great start. There have been many ups and downs over the past five years, spectacular uplegs and brutal corrections, but on balance gold kept marching resolutely higher despite the naysayers. And as in any bull market, the true students of this gold bull have been blessed with the greatest financial rewards by far from trading it.

As I continue to try and wrap my mind around this awesome bull in order to better understand the probabilities governing its likely future behavior, lately I've been pondering one particular facet of gold bull research. This thread has to do with the major stages through which great secular bulls often evolve.

Great gold bulls generally have three stages. While I wrote an essay on this a couple years ago, here is the short version. In Stage One, gold's modest gains are driven primarily by the devaluation of the dominant global currency of the time. In our current bull, most of the gains in gold up until last summer were attributable to the parallel secular bear unfolding in the US dollar.

But about a third of the way into a great gold bull, anywhere from several to five years in, a critical transition into Stage Two occurs. In Stage Two gold starts rising simultaneously in all currencies. Global investment demand for gold becomes large enough to push it up regardless of action in national fiat currencies. Stage Two is a self-feeding process, the higher investors drive gold the more alluring it becomes to investors.

Eventually, probably in the last couple years of a secular gold bull, prices will have been driven so high by investors in the preceding years that a popular mania erupts. When the financial media becomes all-gold-all-the-time and normal mainstream investors across the world cannot stop discussing how rich gold is making them, a mania has arrived. This final buying by everyone drives a vertical parabola into a breathtaking secular top. But once all mainstreamers are heavily long gold there are no buyers left so its great bull ends.

In this idealized chronology, we are now in the transition between Stage One and Stage Two. Euro gold bursting above its long-vexing ¤350 resistance last June was the catalyst that announced this transition was beginning. Since then there have been many more signs, ranging from gold rising in all major global currencies simultaneously to its once ironclad strong inverse correlation with the US dollar being annulled.

Since we are almost a year into this transition now, the amount of data students of the markets can study is growing. As I discussed in my previous essays on Stage Two of this gold bull, these great transitions are not binary events that happen instantly like a switch being thrown. Rather they are gradual and analog, arriving slowly over many months where behavior from both stages is mixed up and episodic, all jumbled together.

I suspect the reason these transitions do take a long time is due to intellectual inertia among traders. For the past five years in Stage One gold strength was virtually totally dependent on dollar weakness. The most successful trading theories were based on this strong inverse link between these two currencies. With gold now transitioning into Stage Two, world investment demand has dethroned the dollar bear as gold's primary driver, yet many traders still believe the dollar bear is the key to gold.

And since it is ultimately trades that move any market, traders' beliefs are very important in driving price trends. If traders believe that gold needs to rise when the dollar falls or vice versa and they back these beliefs with real-world trades, to some extent their beliefs will become reality. A price is ultimately the product of countless individual trading decisions and is shaped over the short term by whatever motivates these trades.

This Gold Bull Stage Two thread of research is intriguing me again because gold, especially in the last couple months, has reverted into a kind of hybrid Stage One trading behavior. It is once again strongly inversely correlated with the US dollar but it is moving at a far greater amplitude than the dollar. Strategically this is no big deal as the transitions are supposed to have mixed behavior, but tactically there are definitely some implications worth considering.

While this first euro gold chart isn't as important for what I want to discuss today as it was in my previous two essays to announce the beginning of the transition, I went ahead and updated it anyway for continuity's sake. It does illustrate just how potent this early Stage Two has been in boosting gold in major non-dollar currencies and driving new investor interest worldwide.

Early last year, euro gold was in a tight modest uptrend and really not doing anything too exciting. Meanwhile dollar gold was fairly volatile, correcting sharply into 2005 and then consolidating in the first half of the year. The interesting thing is that despite the sometimes wild gyrations of dollar gold, euro gold was pretty flat. Why? The dollar's own gyrations were offsetting gold's nearly one-for-one in the opposite direction at the time.

Thus in Stage One gold looked relatively flat and boring to virtually everyone but Americans. Sure, gold was up substantially in dollars but dollars were down substantially in pretty much all other non-pegged currencies so it was a wash. But as Stage Two started transitioning in, once euro gold decisively broke ¤350, all of a sudden gold became interesting to investors outside of the dollar world.

Since then euro gold has soared beyond my wildest expectations for such a short period of time encompassing less than a year. Year over year as of this week, euro gold is up a dazzling 59%! This has been particularly fun for me as an analyst since I no longer have to spend time, as I did in the past years, convincing Europeans and other global investors that this gold bull is the real deal and not just a dollar bear.

On a pure technical sidenote, it is interesting that euro gold is once again near its major resistance. Since late last year it has failed in several upside breakout attempts. Will this time be different or will euro gold once again retreat to its support near its 50dma? Only time will tell, but technical probabilities definitely favor a euro gold retreat in the coming weeks rather than a euro gold break out. All bulls flow and ebb.

This next chart does a better job of illustrating how extraordinary gold's Stage Two transition has been so far relative to the dollar. Gold's 20-trading-day return is plotted over the dollar's. Why 20 days? This is about one trading month, a period of time long enough to help capture major surges yet short enough to offer crucial technical detail. The yellow line is the gold/dollar ratio, when it is rising gold is outperforming the dollar and vice versa.

Six months ago when I wrote my last essay in this series, big monthly gold moves might see a 6% to 8% month-over-month gain before collapsing into a correction. This latest gold upleg has been so unbelievably powerful though that it is totally resetting the standards. Gold was up about 13% month over month in both December and January and 15% in April! Stepping back a little and contemplating, these numbers are staggering.

Unfortunately it is impossible for anything, let alone a global market as big as gold, to sustain 12%+ monthly growth rates. Why? In order to drive prices sharply higher, ever more capital has to bid on an asset. But the bigger the market grows, the exponentially larger the amount of new capital that is necessary to keep it rocketing higher at a similar rapid rate. Assuming 145,000 tonnes of gold in circulation worldwide, this market is worth a breathtaking $2.5t at $650!

While a $25m junior miner may be able to grow at 12% monthly for a fairly long period of time, there is absolutely no way a $2,500,000m global commodity/currency market can pull it off on a sustained basis!

The pure mathematics of a 12%+ monthly growth rate offer another perspective on the absurdity of sustaining these phenomenal levels of growth without sharp corrections. Remember the Rule of 72? In rough terms, if you want to learn how long it will take your investments to double at a certain return you divide 72 by that return. 72 divided by 12% monthly equals 6 months. So if 12% monthly returns are sustained gold will double in six months, quadruple in a year, and be sixteen times higher by May 2008! It's not going to happen though, as this would yield $10,400 per ounce!

Now I am heavily invested in gold and gold stocks and consider myself a raging bull. For years I have been writing about the high potential for $5000+ gold at the ultimate climax of this gold bull when its Stage Three popular mania matures. In fact in real terms, gold's 1980 Stage Three climax was the equivalent of about $2200 in today's devalued dollars. But to hit a Stage Three parabolic blowoff takes at least a decade, it is not something we will see this early in a gold bull.

Yet if gold's stellar 12%+ monthly performance over recent months is sustained, it will already be trading at $2600 by next summer, well over the January 1980 spike high in real terms. This is just not logical so early in a secular bull. These bulls last for over a decade because that is how long it takes for global supplies to gradually be grown to meet global demand. Building new mines is a long, slow process that cannot be rushed.

So please realize that gold's early Stage Two behavior, while awesomely exciting, is an anomaly even within a powerful bull. Sustained double-digit monthly appreciation rates rapidly become mathematically absurd. All bulls flow and ebb, and gold's is no exception. Just like today, at every previous major interim high the majority of gold enthusiasts saw no correction coming yet it always came anyway. Gold is overbought once again.

While gold's average monthly returns will mean revert over time to a reasonable average even while its bull continues to climb on balance, believe it or not this isn't what is capturing my attention today. Near the bottom of this chart there are numbers and percentages. These numbers are two-calendar-month correlations between gold and the dollar while the percentages express the r-square values of these correlations.

In Stage One gold and the dollar were strongly negatively correlated. Check out the inverted blue and red mirror images of gold and dollar returns from January to May 2005. In March and April that year, gold and the dollar had a strong -0.90 negative correlation. Thus 80% of the daily moves in gold could be explainable and predictable by daily moves in the dollar and vice versa. This is quintessential Stage One behavior.

Then in late May 2005, this correlation started meandering all over the map as gold decoupled from the dollar's Stage One dominance in its transition into Stage Two. In September and October these competing currencies had a strong positive correlation, and by November and December they were not correlated at all. During this two-month period only 3% of gold's daily price action could be explainable by the dollar's.

This is exactly what I expected to see in the transition and ultimately Stage Two. Global investment demand for gold should push it around totally independently of the fortunes of the US dollar. This will lead to radically shifting correlations. Sometimes gold and dollar demand will sync up driving a temporary positive correlation. At other times one will fall while the other rises, leading to the traditional negative correlation. And at still other times they will move totally independently creating no meaningful correlation whatsoever.

Over the last two calendar months, March and April, gold and the dollar have once again been trading in opposition. They had a strong negative correlation yielding an r-square of 78%. This is really interesting as it is pure Stage One behavior. Once again seeing periodic episodes of Stage-One-like behavior should be expected and is nothing to be concerned about within the scope of an entire bull, but Stage One reversions near potential interim highs definitely do have tactical trading implications.

For example, if gold traders are now in the mood to trade in opposition to the dollar, which is fine, will they continue their bias if the dollar enters one of its periodic sharp bear-market rallies? If the majority of traders think since gold is rising while the dollar is falling then gold ought to fall when the dollar rises, what happens when the dollar turns north? Obviously if this bias continues gold will be sold off on a dollar rally.

Over the last couple years, the dollar has never had a month-over-month return lower than -4% until today. While this may or may not remain a natural bounce point for the dollar, it is certainly interesting to consider. If traders start perceiving the dollar as temporarily oversold and drive a rally here, and the gold traders have been conditioned over the last couple months to expect an inverse relationship, then gold will be sold.

Another interesting point to ponder is even though gold has been trading in opposition to the dollar lately, the raw amplitude of its month-over-month gains is far greater than the dollar's losses. While the dollar is off about 4%, gold is up about 13% in the last 20 trading days. Global gold investors should be able to drive more enthusiasm and capital for their passion than dollar bears, so this magnitude disconnect should probably not be unexpected. In addition bulls have unlimited upside potential while bears can only fall towards zero. But the behavior of the gold investors is a wildcard.

If the dollar rallies, gold may be so strong that it will not correct proportionately to this rally. If investors hold most of the gold and refuse to sell on weakness, this will be the case. But if gold's recent amplitude levels relative to the dollar remain the same and the dollar rallies, then gold could correct by a much greater percentage than the dollar might rise. If pure speculators trading gold futures sell hard, this latter scenario could certainly unfold.

While I sure don't know what is going to happen tactically in the months immediately ahead, I think it is important for gold traders to be aware that we are now going through a Stage-One-like episode in the transition. Depending on how much traders are paying attention to this, their biases could lead to a gold selloff on any meaningful dollar rally. So at least be cautious if you are long gold in pure speculations.

Our final chart examines this phenomenon from a different perspective. When gold and the dollar are divided by their respective 200-day moving averages and plotted, their relative performance becomes readily apparent. Conceptually think of this chart as both 200dmas flattened along the 1.00 line and then gold and the dollar expressed as constant multiples of their own 200dmas over time. The stages and transition are really easy to see in this unique presentation.

Early last year rGold and the rDollar were carving mirror-image patterns on the opposite sides of their respective 200dmas as they had been doing for years during Stage One. But starting in last June or so, gold stopped simply mirroring the dollar's relative pattern. The euro gold ¤350 breakout drove new global investment demand which was powerful enough to cause gold to start decoupling from the dollar. By late last year gold was climbing strongly in an independent fashion in the early months of Stage Two.

If gold had remained in Stage One, the dotted blue line shows its probable path relative to its 200dma. The distance between the solid blue actual rGold line and this dotted blue hypothetical Stage One line reveals the degree of gold's gains that have happened outside of the dollar. They have really been quite impressive. Stage Two is here and it is very real and gold investors are already earning awesome profits betting on the acceleration of global investment demand.

This being said, a couple of factors combine in this chart to create short-term concerns for gold speculators. First, gold's amazing surge since mid-March coincided exactly with a steepening slide in the US dollar index. Thus gold's entire run from $540 to today's levels was undergirded by this dollar slide, which is definitely making an impression on gold traders. If the dollar rallies and gold is sold off in sympathy, gold's correction could be pretty steep given the enormous gains it has racked up in just the last six weeks or so.

This Stage-One-like behavior is even more ominous considering gold's incredibly optimistic technicals. This week gold stretched an unbelievable 1.305x above its 200dma! Prior to this upleg the highest rGold levels we had seen in this bull to date were merely 1.184x back in early 2003 leading into Washington's invasion of Iraq. Such overbought extremes are even rare in modern history, only occurring a half-dozen times ever, including the famous blow-off top in 1980. The last time gold extended this far over its 200dma was actually back in 1982!

So now we see gold transitioning into Stage Two, but at the moment trapped in a Stage-One-like trading pattern moving in strong opposition to the dollar. On top of this gold's monthly returns of late have been so enormous that they are not mathematically sustainable. They have driven gold to stretch to its highest levels above its key 200dma in nearly a quarter century! With gold looking very overbought technically and trading in opposition to the dollar, what will happen when the dollar inevitably bounces into a bear-market rally?

As a mere mortal I cannot see the future, but I suspect gold will be sold. The big question in my mind is whether gold's huge amplitude of swings relative to the dollar will continue. If it does gold could fall sharply, which is probable if short-term speculators have the upper hand. If this amplitude doesn't hold to the downside though, if long-term investors are dominating, then gold's correction on a dollar rally may be mild.

Either way, corrections in secular bulls are totally normal and healthy, and they are good for both investors and speculators. They bleed off excessively bullish sentiment and lay the foundations for the next powerful upleg. They also provide the best buying opportunities that we ever see in secular bulls. Investors can add to their long-term positions at relatively cheap levels and speculators can load up on high-leverage trades for the next upleg.

At Zeal we are locked and loaded and good to go for such a correction. We have been researching elite gold stocks extensively for years now and have many trades lined up once probabilities are highly in our favor for throwing long again in a big way. Today we list around twenty high-potential-for-success gold stocks in our Watch List in our monthly newsletter. Please subscribe today so you are armed with the cutting-edge research and elite stocks to look into buying once gold again becomes temporarily oversold.

The bottom line is gold's transition into Stage Two is proceeding nicely. Gold's uplegs and gains are getting bigger and better than anything we saw in Stage One. Its behavior is also becoming more and more independent of the dollar on balance, with episodes of strong positive correlations, strong negative correlations, and no correlations all intermixed over time.

But today we are now sojourning in one of those Stage-One-like negative-correlation episodes. This, coupled with very overextended gold technicals, may lead to a major correction in gold if the dollar enters one of its periodic bear rallies. So please be careful here and keep plenty of powder dry to buy the resulting bargains.

Adam Hamilton, CPA

May 5, 2006

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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