 Gold Bull Stage Two
2
Adam Hamilton
Archives
Nov 18, 2005
It has been a heck of an awesome
week for gold, certainly one of the most exciting in recent memory.
Not only is the Ancient Metal of Kings closing in on the fabled
$500 level in dollar terms, but the psychologically crucial €400
euro-gold level was finally overcome. Gold investors everywhere,
including me, are rejoicing.
Contrarian investors and even
some mainstreamers are discussing gold's sizable daily gains,
but I think the most intriguing aspect of gold's action this
week surrounded its relationship with the US dollar. On Wednesday
gold carved a new bull-to-date high just under $478 while the
US Dollar Index simultaneously hit a rally-to-date high above
92. Such an event is totally unprecedented in this gold bull,
Twilight Zone stuff.
Born back in April 2001, until
June 2005 this gold bull's behavior was heavily dependent on
the dollar's fortunes. Like an inverted mirror image of the mighty
US dollar, gold rose when the dollar fell and vice versa. Gold
acted merely as an alternative currency to the dollar and traded
as such. Global investment demand was insufficient then to drive
gold high enough to decisively decouple from the dollar's dominance.
But back in June a long-awaited
event finally came to pass, euro gold broke above its long and
oppressive €350
resistance. This event was so important and pivotal because
it helped convince
investors around the world that this gold bull was more than
just a dollar
bear. New euro-gold highs helped signal that gold finally
had the fundamental strength to rise in all the important global currencies,
not just in the rapidly devaluing US dollar.
For years
I'd been waiting for the €350 breakout as it seemed like
the most likely catalyst to ignite Stage Two of this gold bull.
Great gold bulls have three
stages. The first stage is currency-devaluation driven, gold
typically only gains significantly as the world's reserve currency
loses value. The second stage is driven by global gold investment
demand, forcing gold to decouple from the dominant currency and
rise on its own fundamental merits.
The dawn of Stage Two has huge
implications, it is when the gold bull really comes into its
own and starts galloping. Stage Two is a paradise for investors
since its ultimate gains ought to vastly exceed the excellent
gains with which we were blessed in Stage One. Since June's €350
breakout, it looks like this gold bull is increasingly transitioning
from Stage One to Stage Two. I documented gold's dollar
decoupling a couple months ago.
This week to witness gold actually
close at its highest levels in this entire bull the very same
day the rallying dollar achieved its highest level this year
is staggering! Gold is being driven to new highs not by flight
capital fleeing a crumbling dollar, but by prudent investors
around the world bidding up its price because they want to own
gold. This is the clearest evidence yet of gold's dollar decoupling,
of the glorious dawn of Stage Two!
In order to better understand
this phenomenally bullish event, I decided to update our Stage
Two charts this week. They use euro gold as a proxy for documenting
gold's extra-dollar progress, compare rolling-month returns of
gold and the dollar, and analyze both currencies' behaviors relative
to their respective 200dmas. More background information on these
charts appears in my original Gold
Bull Stage Two essay.
The fall of euro gold €400
this week is immensely bullish and very exciting! The euro has
become the second-most-important currency on earth so it is a
great proxy for gold's extra-dollar progress in general. Despite
the European nations' traditional love for invading each other,
the rise of the unified European Superstate and its currency
appears unstoppable. Even Asian nations are now accepting payments
in euros for crude oil, other raw materials, and finished manufactured
goods.
The dollar cost per euro is
graphed in red on the left axis and is the best place to start
digesting this chart. The currency
countertrend moves that erupted in the initial days of 2005
drove the euro lower as its secular bull market entered correction
mode. From January to May, the euro plunged from near $1.35 to
under $1.25, a big move in the usually glacial-slow currency
world. Yet euro gold barely rose during this time as it largely
languished under €330.
This conundrum presented a
problem for contrarian investors across the globe. The price
of gold should rise when fiat currencies fall, as gold is the
ultimate currency in world history. But since gold refused to
rise materially in euro terms in the first five months of this
year, it was obvious to foreign investors that the US dollar
still dominated gold. The dollar was rising and gold was grinding
lower in the States rather than responding to euro weakness.
But heading into June, gold
suddenly started rising in euro terms, apparently growing more
responsive to major currencies other than the dollar. Euro gold
broke out of its modest early 2005 uptrend and blasted towards
the €350 graveyard in the sky that had slaughtered all
previous attempts to shatter it for three years running. By June
gold was rising despite the dollar's parallel strength driving
euro gold well above €350.
Since these €350 levels
had acted as such hardened overhead resistance for so long, a
lot of investors assumed gold wouldn't be able to hold above
€350. Soon it started correcting as expected in late June.
But in July euro gold bounced at €350, an encouraging action
that would happen twice again in August. The old €350 resistance
that had battered gold for years was increasingly becoming support
for an assault on brave new highs.
As expected, this €350
breakout emboldened investors around the world. For the first
time there was hard data suggesting that this gold bull was not
just the puppet mirror of a dollar bear, but an independent entity
that would rise globally on its own fundamental merits. Gold
surged around the world in September and blasted to new bull-to-date
highs in all the important
currencies including the euro. And the dollar also had a
strong parallel rally that same month.
Gold's sharp surge opened investors'
eyes around the world. Instead of promptly collapsing after such
a fast move, which would have been entirely justifiable technically,
gold buying interest persisted. Gold spent last month consolidating
near €390 rather than surrendering its gains. Investors
from around the world were pouring enough capital into gold to
keep it relatively high and buoyant despite the dollar's strength.
The great thing about investments
is their demand curve is inverted. The higher their prices go
the more desirable they become to investors. In the past couple
weeks global gold investment demand surged again driving gold
above €400 for the first time in history. And all this
happened, amazingly enough, not when the dollar was weak but
when it was blasting up to major new rally-to-date highs. Gold
is decoupling!
While extra-dollar gold charts
like euro gold are certainly evidence enough that we seem to
be transitioning into Stage Two, the empiricist in me always
wants to precisely quantify pivotal market events. One chart
I've been watching for a few months attempts to do this. It graphs
the absolute 20-day returns of the dollar and gold. Since calendar
months generally each contain about 20 trading days, in effect
this is a rolling-month returns chart.
In Stage One the dollar and
gold moved in nearly lockstep opposition, so if the dollar was
up 3% in the last 20 days then gold would be expected to be down
3%. Indeed this is what we observe from January to May when Stage
One dollar-dependent behavior governed gold. But starting in
June at the €350 breakout an amazing thing happened. The
strong negative correlation between the dollar and gold reversed
and shot positive.
Rather than moving in opposition
as expected, in June the gold 20d returns soared far faster than
dollar 20d returns waned. Then in July both returns dropped,
in September both rose, in October both fell, and so far this
month both have risen. The actual calendar-month correlations
and their r-square values are noted above. The white r-square
percentages reveal how statistically likely the behavior in one
currency is able to explain and predict the other's behavior.
These correlations and r-squares
are computed not on the 20d gains charted above, but on the underlying
daily dollar and gold closes themselves. Check out the extremely
high negative correlations above in February, March, and May.
On average in these Stage One months, 91% of the behavior of
gold could be attributed to the dollar. From January to May inclusive
the monthly r-square average ran 73%, showing a dollar-dominated
gold.
But in June this correlation
actually went positive. Rather than moving in their long-established
lockstep opposition, the dollar and gold suddenly tended to move
in the same direction. While the 0.44 positive correlation is
not large in an absolute sense, as it only represents a 19% r-square
value, it is an enormous departure from what he had been seeing
in gold. This is hard statistical evidence that the Stage Two
developments are real.
Since this radical change of
course in June, two more months have run positive correlations.
In September gold and the dollar matched each other so closely
that a very strong 0.90 correlation emerged. That month 81% of
the behavior of gold could be statistically matched with dollar
strength rather than weakness. These three positively-correlated
months averaged an r-square value of 47%, very impressive early
in the transition.
Meanwhile July, August, and
October reverted back to the usual Stage One negative correlations.
Yet these correlations were very weak compared to those witnessed
in the first half of 2005. The average r-square value for these
particular months was just 26%. Obviously this is a far cry from
the 73% average from January to May. Statistically, verified
through correlation analysis, gold is absolutely decoupling from
the dollar.
With gold decoupling, an obvious
question is why are we still seeing any negatively correlated
months at all? Why doesn't the metal just get on with it and
leave the dollar in the dust for good? For a variety of reasons,
this Stage One to Stage Two gold bull transition must be gradual,
not instant.
Both gold and dollar prices
are driven by investors and speculators buying and selling. For
four years
almost without exception gold prices were slaved to the inverse
of the dollar's fortunes. Traders are now used to naturally expecting
gold to rally on dollar weakness and slide on dollar strength.
In trading well-worn habits create a lot of inertia and die hard.
Many traders will still be operating on a Stage One paradigm
for some time to come yet until they finally realize that the
gold market has fundamentally changed for the better.
Gradually investors and speculators
will begin understanding the new Stage Two dynamics. Over time
the number of traders with Stage One mindsets will shrink while
the Stage Two crowd will grow. Stage Two will only be fully here
when the vast majority of market participants accepts that gold
has decoupled from the dollar to rise or fall on its own fundamental
merits and they trade accordingly. No one knows how long this
will take.
And measurement problems make
divining the length of this transition even more challenging.
For instance, gold and the dollar, even though they have tended
to move in opposite ways strategically over months, can do anything
they want from day to day. The shorter the period of time considered
for any market analysis, the greater the obscuring influence
of random noise becomes. The calendar-month correlations used
above are very short and highly susceptible to being buffeted
by random daily market noise.
And as this transitional decoupling
into Stage Two becomes more pronounced, gold will eventually
be trading totally independently of the dollar anyway. Thus the
correlation analysis that was so powerful while gold moved in
lockstep opposition to the dollar in Stage One will rapidly become
meaningless as the respective individual fundamentals driving
both currencies push them in their own independent directions.
Stage Two is ultimately not a shift from negative to positive
dollar and gold correlations, but from negative to no correlations.
Our final chart shows where
gold and the dollar have been trading relative to their respective
200dmas. This Relativity
principle is extremely useful for trading markets in secular
trends and has served us well in recent years. If this Stage
Two transition continues, soon the rDollar trends will probably
be useless for gold trading as the dollar and gold head their
separate ways. Here it really highlights the early transition
though.
The stylized drawing on the
lower left of this chart illustrates the undulating opposing
patterns between gold and the dollar as multiples of their own
200dmas that characterized and defined Stage One. Once the decoupling
started in June though, suddenly this mirror-image pattern vanished.
The dollar climbed farther above its 200dma in a bear rally while
gold simultaneously soared above its own 200dma in a new upleg.
If rGold had continued on its
Stage One path since June, it would have generally followed the
dotted arrow rendered above. Today gold would probably only be
around 95% of its 200dma, which itself would be lower. If gold
had continued Stage One behavior since June, my best guess is
we would be seeing $400ish gold levels today. Instead gold decoupled
and is now pushing $500 despite the dollar's considerable strength.
In light of all this evidence,
the thesis that gold is now transitioning into the second stage
of its gold bull is becoming more compelling with each passing
week. The behavior of gold relative to the dollar has unarguably
changed since June. We can see it in the charts of gold graphed
in other major currencies and we can quantify it precisely by
analyzing the statistical relationship between gold and the dollar.
With Stage Two dawning, the
implications for investors are profound. If you visualize a secular
gold bull as a decade-plus-long parabola,
the Stage One behavior we witnessed until this past summer is
basically a gradually rising line. All of the greatest rallies
and most exciting uplegs of the past four-and-a-half years are
contained within this modest gradually rising line. The first
third of a major bull market is always the least impressive.
Stage Two is when this long-term
parabola starts curving up. It is when gains really start to
multiply and mainstream investors around the world start lusting
after gold and driving it relentlessly higher. In dollar terms
the rallies and uplegs of Stage Two will tower over the Stage
One events we've grown used to. This bull will get bigger, badder,
and meaner and the opportunities to profit will grow proportionally.
Fortunes will be won.
While ample opportunities to
profit in this gold bull should abound in the coming years, the
particular opportunity that really strikes me today is the growing
anomaly between gold and gold stocks. Despite incredibly bullish technicals,
gold stocks continue to lag the awesome surge in gold. Gold ultimately
drives gold stocks, but at the moment gold-stock investors don't
seem to believe that Stage Two is really coming.
The HUI gold-stock index is
struggling under 250 today while gold is within spitting distance
of $500, a mega-psychological level that will work wonders for
gold-bull awareness among mainstream investors in the States.
A veritable Biblical deluge of mainstream capital could start
pouring into gold stocks once gold trades decisively above $500.
Yet the HUI was actually higher two years ago when gold was just
first breaking $400!
This anomaly cannot be sustainable.
Gold is in a powerful fundamental bull for global supply and
demand reasons, investors worldwide are bidding it up forcing
it to decouple from the dollar, and it's the price of gold that
drives gold-stock profits and hence ultimately gold-stock prices.
The elite gold stocks have lagged so far behind this glorious
early Stage Two gold surge that they ought to rocket like a bat
out of hell once investors comprehend their vast potential.
At Zeal we have been layering
in positions in elite unhedged gold stocks preparing for this
event for many months. Our conservative HUI target for this upleg
based on bull-to-date behavior, not even factoring in the Stage
Two impact, is another 33% or so higher from today's gold-stock
prices. It will probably easily exceed our expectations. It is
not too late to layer in great gold-stock positions for this
upleg now, but it may soon be.
All of our current gold-stock
and silver-stock trades, which will thrive if the HUI surges
to catch up with gold, are detailed in our acclaimed monthly
Zeal Intelligence
newsletter. Please subscribe
today before this unsustainable divergence between elite
gold stocks and gold closes and ends this rare opportunity.
The bottom line is gold's behavior
is resembling early Stage Two patterns more and more with each
passing week. To see this metal reach new bull-to-date highs
the same day the dollar reaches yearly highs is really extraordinary
and quite exciting. Gold is decoupling from the dollar with increasing
zeal and one of these months it is never going to look back.
It is trading on its own fundamental merits, dollar be damned.
Despite all this gold bullishness,
gold-stock investors generally remain wary and worried, a perfect
contrarian sign. Sooner or later gold stocks will have to acknowledge
gold's unprecedented new strength and streak higher to catch
up.
Adam Hamilton, CPA
November 18, 2005
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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