Gold up $17/oz to $931/oz

The recent sell-off of gold highlights the volatility of the commodities sector. Investors should keep this in mind when they trade leverage investment types. They should also not avoid such risks, rather they should manage them. Out of such calamity comes great opportunities. Such falls tend to leave trepidation in the minds of investors, but actually these are often the best entry points, particularly for your leveraged investments. Of course we need to look for support indicators.

There is no question in my mind that this was a profit-taking sell-off. I have seen arguments made that the gold sell-off was caused by the liquidation of the gold position of Bear Stearns. I think that is a pack of nonsense. An attempt by some analyst to have a 'profound thought' to get published. Why? Because the smoke has yet settle on the Bear Stearns case. You could argue that the sell off was precipitated by a market awareness that Bear Stearns had long exposure to gold. Regardless I dont think JP MorganChase would be in a hurry to liquidate this holding. Its one of the best asset classes to hold.

The gold price has fallen through the $950/oz support that I saw as support, so it now looks like holding a lower support. Regardless that just makes this a better buying opportunity. I retain my belief that gold is going over $US2,000/oz. In the coming week I will update my model for the gold price outlook.
You might ask what could actually cause the gold price to fall back to the next support at $US850/oz. I suggest talk of central banks selling off their gold reserves. I dont think that is likely since the international monetary system is likely to come under scrutiny in future years and central banks will not want to be holding an empty draw. Another factor might be a decision by the Fed to aggressively raise interest rates based on an inflationary outlook. Again I think recent action and statements by the Fed dont support that possibility. It is my belief in fact that if a bank like Bear Stearns is going to fail, gold is more likely to go up because monetary assets are going up, and the bank fails because they are short on gold, not long. One would have to conclude that Bear Stearns failed inspite of their gold holdings, not because of them.

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Andrew Sheldon www.sheldonthinks.com

Gold finds support at $1000/oz

As expected gold is finding support at $1000 level, having fallen to that level during early Monday US training, then recovered to $1009/oz. Oil prices were off $4/barrel, bringing them back to $106/barrel. Any relief there can be expected to support a rally in equities.

For the rest of the week I think we will see some consolidation above $1000/oz. But I imagine there will be a lot of fund buying in gold thereafter. But I look forward to even greater interest in equities from this point forward.

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Andrew Sheldon www.sheldonthinks.com

Gold convincingly breaks $1000/oz

Gold has convincingly broken $US1000/oz, in fact it ran up to $1030/oz before being sold back to $1010/oz at the time of this post. Based on the current market circumstances, having broken $1000 there seems no 'fundamental' reason why it should not hold the $1000/oz support. It was a firm breach of the psychologically important $1000/oz level, so I am expecting it to hold.
I was actually expecting some short term weakness in gold because its rallied recently, and I expected the USD to hold the important JPY100-101 support for at least a week or two. The failure of the 4th largest US investment bank Bear Stearns on Friday changed that. That saw the Fed aggressively lift support, which greatly changed the risk perceptions in favour of gold, and made the prospect of lower interest rates more likely....all to no avail mind you.

I note the greater interest shown in spec gold stocks today (Monday), and I expect that will continue for the remainder of the week. I do believe we have seen the bottom. As indicated previously, I see base metals trading south, though they will hold their long term uptrend. I expect uptrends will be tied to weaknesses in the USD and I believe these industrial-based commodities will be sold off during times of USD strength. I can't see copper breaking $4.00/lb in the current environment, though I guess since I think the USD is going to 85Yen, that is not out of the question. It is my firm belief that whilst USD weakness works for base metals too, these metals will come under pressure due to subdued economic demand.
There are stock-specific factors to consider here though, such as the 60% increase in production by Matrix Metals and similar expansion for CBH Resources. See my stock blogs for those stories. But my focus herein would be on gold-related stocks - if not producers then stocks which are as close as you can be. Since its difficult financing conditions it should be a good project, and hopefullu already have the equity component of the issue since its a poor market for making equity contributions to project finance.
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Andrew Sheldon www.sheldonthinks.com

Commodity Prices dont respond to the news

Commodity prices did not rally in the face of the 416 point rally in the Dow Jones, which was caused by a $200 billion Fed injection into the US economy. The reason is purely technical. Commodities in previous weeks had already rallied to a new high, so with little upside to that major resistance, we can expect commodities to come off. The Fed injection is good for gold, though even it should weaken for technical reasons. I see gold coming back to $950/oz support. Copper, which peaked last week near $4.00/lb rose $0.10/lb, but was sold off, so now sitting around $4.75/lb. Commodities might not have shown their meddle, but expect commodity-based equities sold off during the last week to perform well, particularly those small spec miners - gold, copper, nickel, coal, etc. You should have been buying them yesterday.

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Andrew Sheldon www.sheldonthinks.com

Why metal prices stronger on weaker outlook

You might be wondering why copper prices are rallying to new highs at a time when the US economy has never looked sicker. The reason is simply two things:

1. The lag between the US economic outlook and producers ability to forecast it. Producers in China and elsewhere are not the most market-savy people. They are waiting for queues from the market before they reduce output. Even when that point in time comes, they are probably more inclined to reduce prices to stay competitive than to accept a slower rate of output. They want to remain relevant, so they willingly accept falling profit margins.

2. The rising USD-denominated price of commodities. Traders need to hold $US to buyt their commodities because all commodities are transacted in USD. At times like now, when the USD is falling, commodity consumers prefer to hold metal rather than USD on account, because they will actually make money from the transaction, and they will happily trade that position. I suggest that commodity inventories are not falling for some metals like copper because of resilient consumption. Really its just consumers building their inventories to profit from the falling USD. If that is the case, we can expect that consumers will dump copper and other metals at some point.

The question is which point? Well here are some clues:

1. Technical support in the USD - but relative to which currency? Well I guess that could be in the currency of a number of large consumer countries, eg. China, Japan, South Korea. Some of these countries have managed exchange rates, so I'm inclined to think it will be a technical resistance in the metal prices.

2. Technical resistance in the metal price: Copper prices have rallied to new highs. The copper price is currently $US3.93/lb, having reached $US3.97/lb in earlier trading. I would suggest that the $4.00/lb level is going to be a difficult resistance level to break, and thus I am expecting copper prices to be dumped from this level.

3. Stockpile levels of the metals: We might wait for the stockpile levels of the metals to start rising as a queue as to when metal prices have peaked, but I would suggest this is a lagging indicator. Understanding the fundamentals, followed by the price action is the best guide. Of course easier said than done.

I think we can expect copper prices to peak around $US4.00/lb - since its an important psychological level. Interestingly the copper price is almost there (currently $3.93), and the bigger news is that the USD has just reached an important support - 102.36 Yen - last reached on 18th January 2005. You can follow the USD-JPY forex and copper price action yourself at Kitco.
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Andrew Sheldon www.sheldonthinks.com

Nickel stockpiles flat, and prices off their low

Nickel stockpiles are currently consolidating at a 1-year high, and I do believe that prices have found a floor, though I dont see it as time to enter this market just yet until stockpiles start falling. Prices seem likely to respond soon enough since they are close to their lows.

As we can see in this 5yr chart, nickel prices are consolidating at current levels (right chart)
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Andrew Sheldon www.sheldonthinks.com

Copper prices up, stockpiles falling

There is some good news in the market for copper stocks, as copper prices are up to $US3.50/lb, and seem destined to reach $US3.75/lb before they are sold off. The reason for the rise is clearly stronger demand, but also traders in futures covering short term requirements. Mostly its just technical trading. I see copper trading this range for a year to come.
Stockpiles are falling as a result - in fact stocks are plummeting on the LME. See Kitco.
The copper price like alot of commodities is trading in an ascending wedge, and will eventually break out as a result of inflation or debasement of the USD.
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Andrew Sheldon www.sheldonthinks.com

Copper prices reach new high

Copper prices have broken out to fresh highs, in fact copper prices are up almost 3% at this point to $US3.40/lb, though I expect prices will pull back to support at $US3.30/lb in coming days. See the charts at http://www.kitcometals.com/charts/copper_historical.html. The UK Bank of England has followed the Fed by cutting rates. The prices have limited upside. I dont see prices breaking $3.90/lb, but we can expect institutions to trade the metal between $2.90-3.80/lb. So I see the metal going sideways for some time to come, but with good rallies.
Basically we are looking at copper forming an ascending wedge structure with the apex to be reached in a year or so. I can see it breaking out at that point due to inflation and a weak USD, but I can also see higher interest rates undermining the copper price at some point. The other emerging trend will be the amount of money doing into new mine development around the world. I see this step as a currency management policy to some extent correct the over-investment in US treasury notes (ie. A falling USD). That investment will eventually result in higher mine output whilst higher western inflation will eventually undermine western consumption.
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Andrew Sheldon www.sheldonthinks.com

China world's largest gold producer

According to www.gfms.co.uk/Press%20Releas...7_overview.pdf, China has overtaken South Africa as the world's #1 gold producer.
I have not read the report but there are numerous reasons for this:
1. Falling Sth African production due to: (i) Blow out in mine costs, (ii) Strong Rand because they mostly produce precious metals, PGEs, gold, plus other high priced metals, (iii) deep underground mines that are inefficient, (iv) High pay rises for highly unionised workforce, and from memory, alot of workers (immigrants) dying of aids onsite. Black empowerment also cutting investment. Just look at the outside investment/diversification of gold producers, eg. Anglo in Philippines, Harmony in Aust & PNG. Other African states more attractive. Some of this is just globalisation, but also risk diversification. In recent years the fall in production has been quite startling, like a 15% drop in gold production last year.
2. Chinese investment - alot of USA, UK, Australian & Canadian development dollars in China has no doubt helped build the gold mining output, plus the huge gold resources in western state of China.
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Andrew Sheldon http://www.sheldonthinks.com/ - yep but sometimes he doesnt get time to read.

How high is the gold price going? Part B

Another useful ratio for anticipating future gold price movements is the chart of the oil price vs the gold-oil price ratio. Because of the importance of oil and gold, there is an even better price series to construct this ratio. Unfortunately for a great many years the gold price was fixed, so going back beyond the 1900s is futile since the gold data series is distorted.
It is apparent that the gold-oil price ratio has traded within a band (approx. 7 to 34) for the last 146 years.
This band was only breached for a short time during the 1930s Great Depression. What is interesting is that there appears to be a change in trend, or the commencement of a new cycle starting with the Depression in 1933.

I have no conclusive evidence to account for the cause in this cycle, but I can suggest some insights into its cause, or the relationship between gold and oil prices. Gold and oil are both tangible commodities priced in USD. Both commodities are driven by supply & demand for periods of time, but gold has a 2nd function as money. By 'money' I mean 'real' money with a tangible asset to support it. Unlike the paper trash that is backed by governments legal sanction to expropriate your wealth. When fiat (paper) currency is no longer trusted because of declining credit standards, then a speculative demand for gold emerges, and hence the price of gold rises in these periods. It matters little whether the credit crisis is created by business, households or government, you can be sure government will be called upon to clean it up.
For this reason, in 1933, a high gold price corresponded to a very low oil price, as demand for petroleum sank with the global economic woes. I think the black bands marked above account for the normal price variance of oil & gold during periods of normal economic conditions. I suspect the 1920s broke this trend because during a boom, gold prices were low because the metal offered no yield. This also corresponded to the ascension of the modern car-based society, so I suspect there was a shortage of oil for transportation at this time.

Ok looking to the modern times. The following chart offers a better (daily) data set - from 1986 to 2008. It shows the oil-gold price ratio trading in the same band, though on this occasion the band has a shorter time span and more data points. It is apparent that the curve slopes slightly upwards. I suspect the slow is the result of growing energy intensity for the global economy. We all know the USA reliance on oil has fallen as it has shifted to a services economy. But we need to appreciate that this shift is offset by growing reliance of China, India and other developing countries for oil - hence a rising energy (oil) intensity for them. Anyway thats my theory. More imoportant is what it implies about gold prices. It suggests in relation to oil prices they are relatively low. Of course the fortunes of gold (in terms of oil) will be greatly improved as oil prices fall. We can expect at some point inflation to prompt central banks to raise interest rates to subdue spiraling wages. This will spark a slowing in the global economy and a contraction in oil demand and prices.

It is difficult however to use this ratio as a price determinant for gold. There are several reasons:
1. Oil prices are very volatile
2. OPEC has considerable impact on oil prices
3. Oil prices - unlike the DJIA or gold - are priced at the margin for industrial demand

We can however use the ratio to give us some guidance though of when to sell as time passes.

How high is the gold price going? Part A

Increasingly I am seeing the question being asked - How high is the gold price going? Its a great question. A great people are inclined to take a punt and say some huge number in the future, though few people are able to defend these numbers. I think fewer still understand the fundamentals underpinning gold. I have written so much on this subject - I wont repeat - other to say that - yes, supply and demand are driving the market price, but ultimately it has nothing to do with the metal balance calculations published by the World Gold Council. The reason those numbers mean nothing to traders is because those numbers are NET figures calculated for a market at two (annual) points only, and certainly not the points which you bought and sold your investment.
The reason why the gold price does not depend on falling gold supplies from South Africa/Australia, growth in demand from India, etc, is that the higher the price goes, the less gold Indians can buy. Indians just dont control much of the global capital. Nor do they have the leverage that fund managers have. More important than that is the fact that the investment that drives gold prices is the more transient 'speculative demand' for gold by investment funds, hedge funds and the like.
So back to the question.....There is actually a lovely correlation between the gold price and the Dow Jones Industrial Average (DJIA) Index that has stood the test of time. The index has proven itsel in the 3 speculative precious metals booms in the 1920s, the 1950-60s and now the 1990-2000s. It will be apparent from the following chart that gold is not just going anywhere - but that it has a target in mind. Mind you that index includes the DJIA as a variable, so its conjecture where that number is going. You will have to see my market commentary blog(http://market-action.blogspot.com/) on the Dow outlook to see my projections for that index.
Based on my price target for the DJIA of 11,650pts, I can see gold rising to around $US2,200/oz. Some people will laugh off this projection, but I make the following points:
1. Credit markets are highly inflated. There is so much money in the market,
2. Inflation over 35 years: Its been thirty five years since gold last peaked, so thats alot of inflation to factor into the present day price of gold, and dont be so sure that the published CPI is a legitimate measure of inflation. Governments have been fiddling with the books since before you were sucking your thumb.
3. Small size of gold market: The total gold market is worth just twice the value of Microsoft. There is few other places to place your money. Other precious metals have significant industrial demand bases, and are less liquid. The reason why gold is attractive is that there are all types of funds available.

You might think my projection for the Dow Jones falling to 11,650pts is too pessimistic, but actually that is my conservative scenario. If I used the current DJIA Index value of 12589.07 points (8 Jan-08), we would need to look at a gold price closer to $US2,600/oz.

Of course the argument is not whether we should be pessimistic or conservative, but realistic. So to be realistic, I would expect the Fed to drop interest rates slightly prior to the next US election, or at least keep them on hold. We have already seen tacit announcements by the US government to provide some level of support to the credit market. Though its hard to see a bale out on the scale necessary. With a rising threat of inflation I think there will some a point in the next months (after the US election) when the Fed will be forced to raise interest rates. I would expect it to trail the inflation in this respect so as to not cause serious economic malaise.

Periods of inflation are historically periods of flat corporate earnings, though at first businesses actually benefit from asset inflation, but earnings falter with basic cost of living inflation (food, oil, rent). That is the stage where we are now. So I see flat earnings being offset by rising inflation, causing equiities to have swings to provide yield incentives to investors, but otherwise I see broad market equities going sideways for years to come. The excitement will be in the gold market.

Based on this chart, you would have started buying gold or gold stocks back in 2000, and you would have made excellent returns, though base metals soon over-shot gold. Clearly this ratio will be a good indicator of when to sell as well.

The gold-DJIA ratio is not the only measure of when to buy and sell gold. Next we will consider the gold-oil ratio.

Base Metals surprisingly strong

Base metal mining stocks have been weak over the last 3 months - the blue chips having fallen 20- 30%, whilst the smaller emerging producers have fallen as much as 70%. The reason of course is the belief that commodity prices will fall with any softening in the global economy. I think this is sure to happen. At some point the Fed and other central banks will be forced to respond to inflation. Higher interest rates will be necessary. But until then we can expect governments to respond to subdued demand (amidst weak but growing inflation) with cuts or stable interest rates. I think we should not expect the Fed to have some balls. They might correctly sense that a 'dose of reality' will be good for the market, but they will not want to surprise it too much.
So is the sell off in base metal miners and emerging producers justified? I think it depends on the market. There are some strong factors in base metals favour:
1. Demand for metals in China remains strong. I believe Chinese demand will not remain strong. Historically I have found the Chinese traders and producers to be poor market analysts. They are sooo anti-conceptual. Demand has been strong for so long, so they believe it will be strong tomorrow. They would rather be wrong with everyone else than right alone. Chinese traders will be the last to recognise that the market is turning. That augers well for markets in the short term.
2. Weaker markets has a benign impact on domestic commodity markets. If you are a Canadian or Australian investor, you might be miffed by the fall in commodity based mining stocks. Miffed because metal prices remain strong, so why are mining equities being sold off with reckless abandon. The reason is that international investors are preparing for a slump in commodities (apart from gold). Whilst a falling $AUS or $CAN will boost or offset the fallin USD prices of commodities for domestic investors, the international investors will loose on the exchange rate. Expect those foreigners to re-enter the market at lower prices. Of course it makes sense for local (Australian & Canadian) investors to abandon mining stocks if the foreigners are going to, but they should also be ready to buy back in. The trick is to find the turning point in the $A. See my forex blog. So whilst base metals have fallen off slightly (15%), so has the Australian dollar, so producers are actually doing rather well, unless they have entered into some rather unfortunate hedging positions.
3. Tight supply. There is of course a concern in the markets that a slide in global economic activity will undermine demand for metals, and that should not be ignored. But there is also considerable tightness in equipment, plant and consumables supplies that has actually prevented an expansion of metal supply capacity. The implication is that prices might not adjust as much as expected. Having said that, prices are high in part because of that tightness, so any relief will be bad for prices. But that need not be true for all markets. A number of projects have not proceeded because they were out-bid for plant by bigger projects controlled by bigger companies. The iron ore, bauxite miners have got their ball mills before a small gold miner. So supply has been curtailed in some commodities more than others.

Gold looking for support

Gold is doing very well as expected despite weakness over the last few days. You can expect gold to fall back to $US840/oz, its highest support level. If you are worried about gold - dont be? Its true that a strong global (US) economy has been a positive for gold, but actually its under-performed other metals. During the following 'inflationary period' expect gold to out-perform. There are several reasons for this:
1. Gold is driven by speculative demand - not supply & demand. The reason is that most gold consumed is typically recycled because of its high value, and thus because there are so much gold inventory that any year's supply or demand becomes irrelevant.
2. Gold is a hedge against inflation because you dont hold gold to make a yield. It is precisely the poor yield on gold that has made it a poorer performer (against base metals) over the last decade.

The speculative demand for gold arises from several angles:
1. Gold is not priced so high compared to other tangible assets. So if there is a liquidity crunch, gold will perform better because assign from cash - everything is going down except gold. In that context, gold only goes down because ignorant speculators are selling a stronger gold security to cover positions elsewhere.
2. Gold is a tangible asset so its price will generally rise (due to inflation) along with other commodities, real estate. But there will need to be a demand-related shake out of those markets first, and that is already happening.
3. Gold is more attractive if yields are falling. With other asset classes priced so high, the yield on all asset classes is looking a little thin. If there is little yield from all asset classes, then the small yield (gold lease rates) on gold looks good. For this reason, as the Fed responds to the weakest US job figures in a long time by reducing interest rates, expect gold to perform well.

For all these reasons one can expect the gold price to fall on short term profit-taking, but there is still alot of latent speculative demand for gold that will support it on weakness.

Base metal prices resilient

Despite all the bad news we are hearing about the economy, its interesting to reflect on commodity prices. Given the weak overtones, you might have been expected to see weakness in commodity prices. Well they have been surprisingly resilient. Copper has fallen to $US2.90/lb, but its back up over $3.00/lb. Zinc and lead are fairing even better.
I would like to think that its a sign of incredible resilience in the global economy, but I dont think so, or at least its not the whole story. I think its a shortage of metal, or more specifically delays and difficulties commissioning new mine capacity, combined with the odd strike, as mine workers attempt to benefit from some of the high metal prices. There is a huge shortage of semi-autogenous grinding (mills), tyres and a range of other consumables. Its evident that these shortages are delaying projects, and even hindering established projects. So whilst the global economy might we softening, there is little relief for commodity buyers. The reason I suspect this is the case is because metal stockpiles seem to be falling. Take a look at stockpiles at the LME and COMEX exchanges. Nickel is rising to medium term highs, but zinc stockpiles have been falling since Oct'07, lead stockpiles started falling this week, copper on the COMEX has falling stockpiles since Oct'07, and flat on the London Metals Exchange lately. Aluminium stockpiles have stabilised.
At the same time most of the commodity producing currencies have experienced something of a sell-off. eg. The AUD has fallen from 93c to 87c against the USD. So it all looks good for commodity producers. So I like Matrix Metals, given that its planning to expand output significantly.

Gold consolidating

In the coming weeks I suspect gold will consolidate in USD terms, but expect the signs of a weaker global economy to feed into lower currencies for commodity producing currencies like the AUD, CAN, BZL, etc. The implication is that precious metal (gold, silver, platinum) prices will be strong in local currency terms. So I am expecting stronger gold stocks despite some consolidation in gold prices. I also this this week gold stocks will loose ground because of general weakness in the overall market.
In the chart below I am suggesting the gold price is in the formative stages of a 'flag structure', the implication of which is - when the wedge is closed, we are going to see a $80/oz increase in gold prices. For the unhedged gold producer, tha equates to around 10-20% increase in earnings. So I'm looking for $US940-950/oz gold price in the next 6 months, and likely $A1100-1150/oz in Australian dollar terms.

Copper prices break support

Copper prices have fallen to $3.12/lb, breaking an important support at $3.20/lb. The positive news is that we have a Fed meeting on Thursday, and if there is a Fed rate cut, that might be enough to support the market. So we might see a recovery. Spot prices will under or overshoot, so it would be worth waiting for that confirmation of market direction.

Gold plummets 4.6% overnight

Last night we were reminded of the small size of the gold market is, as it was dumped by financial institutions. The gold price fell $US37/oz or 4.6% to $US792/oz, having just risen short of $US850/oz. I guess no one is more surprised than Frank McGhee, head precious metals trader at Integrated Brokerage Services in Chicago. He told Reuters "I would be very surprised to see it penetrate much below the $800 level". I am too Frank....I am too.

The reason why I am surprised is that tensions in the Middle East are still high, but then there are a number of negatives:

1. Carry trade being unwound by rising USD

2. The gold price was retracing from a major resistance of $US850

3. Gold is a very small market traded by institutions

4. Falling oil price - it fall $2.70/barrel overnight to $93.62. Not so significant.

5. The rise in gold price was quiet rapid so any retracement was going to be as well

But like Frank I was surprised that gold fell below $US800/oz, and I'd be surprised if it falls back further given the Iran situation. Mind you I dont see the Iran issue flaring beyond a few bunker-busting missile hits on nuclear installations in Iran. However the risk upside should lift gold. In the short term, maybe there wasn't enough concern there to lift gold, and it was just technical trading.

Looking at the charts its not so surprising that gold fell off from a major support, and perhaps its more the fact that equity markets were coming under pressure at the same time and were sold into to cover losses elsewhere. Market liquidation hurts all markets. For this reason, without any solid support for gold (Middle East tensions and an interest rate cut), I think gold will continue to fall as long as the larger equity markets are being sold. More importantly, the sell off may in fact be a symptom of forthcoming hedge fund losses. This is the biggest sell-off of precious metals since June 2006 when futures fell 7.6%.
At some point equity markets are going to price in some inflation into their earnings multiples (PERs). When this occurs we can expect a significant fall in equities and, and I think it will flow through to gold until that inflationary expctation becomes a market reality. At that point we will see a stellar performance from gold.

Technical Analysis

The chart of the Dow Jones below shows that gold is close to the major 12800 point support that it fell to in Aug-07 sub-prime related sell-down. On Thursday we are due for another interest rate setting by the Federal Reserve. It seems more than likely that there will be another Fed cut at that meeting. This will prove negative for the USD, but you would think positive for gold and equity markets. It should keep the Dow above the 12800-point support a little longer. But after a big fall in gold, I dont see a rapid recovery in gold. More likely a more gradual decline to the major $740 support, then I think we are in for a more significant rally than the last.

In the chart below we can see that gold was sold off within a fraction of the $850/oz resistance reached in Jan 1980. That last red candle is an engulfing candle, suggesting that gold has parred back all the gains of the previous week, and is a sign of further weakness. I dont see any significant support until the $740/oz level, suggesting there are significant falls in gold coming. I think that support will prove to be a very solid one, and I dont see a fall to $US700/oz.

So we might be looking at a post-Xmas rally in gold stocks, but until then I suggest growth-related stocks look more promising as equity markets go for another rally. But at some point inflation and risk premiums will be priced into markets.

Gold vulnerable for short term sell off

Gold has rallied to $845/oz overnight, but was sold back to $833/oz. This of course reflects the fact that gold is a relatively small market, and for that reason institutions were short-term selling before gold reached the $850/oz peak (resistance) reached in Jan 1980.
Well of late I lost a HDD due to a computer virus, so I've not made posts, but just to backtrack a bit. Gold is going to offer a stella performance for several reasons:
1. Strong Rand - South Africa produces most of the world's gold. the problem is, as gold prices go up, so does the Rand, and significantly so because of the huge reliance they have on precious metals (gold & platinoid metals).
2. Subdued growth in gold
3. Growing inflationary expectations - there is a fallacy that you can avoid inflation by suppressing demand. This is nonsense. Inflation is a monetary phenomena, not a demand issue.
4. Tensions in the Middle East - Iran will push the US to military action then back down
5. Outlook of low yields - real interest rates since we have a Fed cutting rates when inflation is stronger

It never ceases to amaze me the lack of appreciation people have for the speculative demand for gold. They look at Indian jewellery demand and think its significant. Basically what drives the gold market is speculation - at least in the times when it warants interest. Of course if there is no monetary concern, then gold is subdued. In those instances it trades as a 'physical commodity'. But when the value of money is being eroded or the asset bubble is in question, people and institutions flock to gold....a market the size of 2 Microsoft's. Its minute compared to the markets from which people are divesting, giving gold alot of upside. So though gold was sold off, dont expect it to stop. I suspect even gold shares might be bouyed by the outlook despite the late sell-off.



Finally a comment about Iran.
The reason that the Iran situation is good for gold is because there are signs that Iran is escalating the conflict over nuclear weapons. Ali Larijani, the chief negotiator for Iran's nuclear project, has resigned after 2 years. Larijani was a close friend of Ali Khamenei, the supreme leader of Iran, though he appears to be at odds with the ayatollah and President Mahmoud Ahmadinejad. I think these 2 idiots are hoping to milk the US conflict for all they can get. Think about it – they are oil exporters and they probably have a stock of gold. President Ahmadinejad is very unpopular on economic policy, so clearly he has learned from the Bush-Blair-Howard team on how to win votes. President Ahmadinejad displaced the reform-minded candidate in the 2005 election. Polls suggest Ahmadinejad has lost half his support base. The president's term ends in 2009.
The replacement as chief of the National Security Council is Saeed Jalili, who supports the president. Interesting 183 of the 290 member parliament praised Larijani, suggesting most of the parliament is against this policy.
The president's term ends in 2009. Perhaps they hope to get greater concessions by pushing the US to war, as well as gaining more support in Iran (‘read anti-US sentiment’), or are they trying to ensure the president is replaced by another hardliner? I think they will continue to push until the US does drop bombs because they want to fuel US resentment. A few Iran lives means nothing to them.

Opportune time for agricultural commodities

Anyone interested in agricultural commodities should check out my latest post on my forex blog. Its particularly pertinent to NZ and Australia. See http://forextraneous.blogspot.com/2007/09/dont-ride-off-nz-economy.html.

Gold breaking out! Confirmed

Friday's trading in NY gave us clear confirmation that the price of gold is just about to rally. The gold price closed at $US743.70/oz, the highest level in 27 years (since Jan 1980). And if you think thats significant consider that inflation over the last 27 years is likely to have discounted the gold price by 60% by the distorted CPI measure , and probably 120% in real terms. You would need to look to see how the money supply has expanded over that time.

The break is convincing in several respects:
1. Gold broke the previous high of $730.30 set on the 8th May'06.

2. The gold price rally was convincing in itself - up $9.75/oz
3. The gold price closed near its daily high
4. The gold price move is supported by strong fundamentals

But if we look at the following chart we can see that the current rally in the gold price is partially due to gold fundamentals (in as much as the gold price is rising in terms of all currencies) and partly due to a weaker USD (in as much as the USD denominated gold price has risen more). Of course what we would like to see is the gold price break out in Euro & Pound terms, as well as Yen and AUD.

A real increase in the gold price in terms of multiple currencies communicates a growing distrust of monetary units. The reason for this distrust is the relative decline in the valu of those currencies. Currencies decline in value in real terms because the amount of currency in circulation is growing faster than the productive capacity of the global economy. You might think this is a signal to buy other tangible or physical assets as well, but actually this is not the case because their prices are already too high. Most asset markets are high priced because in a period of prolonged monetary expansion, those assets become priced (not on the basis of cost + profit margin) but your ability to pay and your belief in the sustainability of those high prices. The consequence is thus, asset prices are too high, and they will only offer gold buying when interest rates have risen to an extent that property holdings have been deleveraged. You might ask what level of deleveraging has to occur. Well that depends on each country's monetary expansion over the last 20 years less the amount of productive capacity added. Those countries like Australia which have huge exposure to metals are more vulnerable, even though they are helped by gold mining capacity.
You might ask 'why gold' since it is an asset? Well the reason is that gold has under-performed as an asset class over the last 5 years compared to other assets. The reason that it has under-performed is because it offers a low return - assuming you lease the metal, and none if you dont. Its this criticism of gold that makes it the most attractive investment, along with other precious metals. But gold is the best at this stage of the cycle because other precious metals will suffer eventually from a 'demand shock' as higher interest rates curtail industrial demand for commodities.
But gold is a financial asset as well, and as such, its possible for companies to leverage themselves into gold, so prices will in times of uncertainty be volatile. Financial intermediaries will be inclined to sell gold to cover other loss-making positions. But gold will recover like no other financial instrument - at least until the market is deleveraged. In times of instability markets tend to over-react.
Over the last 20 years western governments have been competing in a money expansion fest. Rising inflation will undermine that. Governments can conceal inflation, but they can't conceal the financial burden that places on 'real' people, so there will be a backlash. Higher gold prices will raise attention to this fact. Why is gold over $400/oz if not inflation? Afterall it offers bugger all return. The reason is - its real money when fiat paper is not trusted. The other sign of high inflation is wages...and with falling housing prices, reseting interest rates, tight labour markets, we can expect higher rates.

Source of Base Metal Charts

Until about 12 months ago you could download daily price and stocks data for base metals. Sadly the LME has gone commercial and you now have to pay for it through one of their intermediaries. Fortunately Kitco and others offer daily prices and historical charts which effectively does the job for you. I would however argue that the charts are not as accurate as the trading platform charts.

The historical charts can be accessed at:
1. Copper: See www.kitcometals.com/charts/copper_historical.html
2. Zinc: See www.kitcometals.com/charts/zinc_historical.html
3. Nickel: www.kitcometals.com/charts/nickel_historical.html
4. Lead: www.kitcometals.com/charts/lead_historical.html
5. Aluminium: See www.kitcometals.com/charts/aluminum_historical.html
6. Tin: See ???
In the precious metals we have
7. Gold: See www.kitco.com/charts/techcharts_gold.html
8. Silver: See www.kitco.com/charts/techcharts_silver.html
9. Palladium: See www.kitco.com/charts/techcharts_palladium.html
10. Platinum: See www.kitco.com/charts/techcharts_platinum.html
11. Rhodium: See www.kitco.com/charts/historicalrhodium.html

These are the traded metals where there is a high level of price discovery or disclosure. There are of course alot of other where price information is not so transparent because these metals prices are concealed by confidential commercial agreements between producers and end users. The reason for this is that these markets are illiquid. Another problem is that the metals are often sold as ores or metal concentrates with widely variable concentrations, as well as price bonuses (for precious by-products) and penalties (for deleterious contaminants). For this reason its difficult to reach a standard price for these commodities because every refinery has a different pricing policy to achieve competitive advantage. These metals include:
12. Zircon:
13: Niobium:
14. Tantalum: See www.metalprices.com/FreeSite/Charts/tantalite_charts.html?weight=lb (before 2006) and http://metalsplace.com/prices/?a=14&grt=6 since.
15. Molybdenum: See www.adanacmoly.com/adanac_stock.php
16. Manganese: See www.metalprices.com/FreeSite/Charts/mn_ferro_charts.html?weight=lb (before 2006)
17. Cobalt: See ??
18. Magnesium: See http://metalsplace.com/prices/
19. Chrome: See ??
20. Antimony: See ??
21: Bismuth: See ??
22. Tungsten: See http://metalsplace.com/prices/?a=4&grt=5
23. Mercury: See ??
24. Vanadium: See ??
25. Cadmium: see www.asianmetal.com/Metal_News/index_product63_en.asp or http://metalsplace.com/prices/?a=15&grt=6
26. Iron ore: See http://metalsplace.com/prices/

No other metal not listed here is sold as a discrete commodity because they dont occur in isolation. Even some of the commodities above are seldom mined as a discrete commodity. eg. Cobalt is usually a by-product of nickel mining, bismuth is often a by-product of tin mining, antimony is often associated with gold. These metal combinations might simply be liberated by physical crushing, but often they require more expensive chemical separation processes that directly impact on the value of ores, thus making price determination less transparent.

Finally we have the energy-based commodities:
25. Petroleum:
26. Natural Gas:
27. Uranium (yellowcake): See www.uxc.com/review/uxc_g_price.html or in constant dollar terms www.uxc.com/review/uxc_g_hist-price.html
28. Thorium: See http://minerals.usgs.gov/minerals/pubs/metal_prices/

Otherwise you can perform price queries at this site: www.metalprices.com/freesite/historical/price-query.asp. See the US Geological Survey for more more info on commodities: http://minerals.usgs.gov/minerals/pubs/metal_prices and www.crbtrader.com/fund/articles/default.asp. Here are a few other places for metal price charts - http://www.mineralstox.com/.

Gold testing resistance at $US730/oz

The gold price has rallied up to the $US730/oz resistance as expected. This is the last hurdle before we see alot of upside. Given the speed of the rally it would not surprise me to see gold fall back to $694-700/oz level. This was previous resistance and would make a strong support. But by no means is the gold bull over. In fact it would not surprise me if gold rallied on from here. As always - its prudent to look to the charts for guidance at this critical junctures - at least for market entry and exit.

So as we can see from the chart, gold is currently at $733/oz. Thats its previous high set back in May-07. Lets see what the market action shows over Monday and Tuesday. I'm could go higher because it closed the week off a high point. But there is the possibility of a stronger USD if the European Central Bank shows an indication that it wil also lower interest rates. Since central banks are mandated to set policy rates that will sustain economic growth, you can bet that they will making early statements to prevent the Euro from trading too high. So that might be a short term factor driving gold down in the short term. But thats merely a USD-denomination issue - weaker nominal rates and higher 'real' inflation (not the CPI nonsense figures) highlight the fundamental upside for gold.

Gold breaking out!

In recent weeks I have displayed some caution with respect to gold in the short to medium term fearing a sell-off in gold along with other markets, notwithstanding the long term positive outlook for gold. I misread the 'fundamentals' and thus I now find myself fully committing to the market. Whereas yesterday I was only 30% invested, today I am fully invested in gold-copper stocks - with a focus on unhedged producers. The commitment comes with alot of confidence, because not only has the gold price broken out on the upside of a wedge, it has moved up some $12/oz to test a previous high set in Mar'07. The gold price has however not yet broken that resistance, so we will be looking for the market to confirm the break-out with a higher gold price in New York and London later today. If this resistance at $694/oz is convincingly broken, then we are looking at a new target of $720-730/oz in the short term, and far higher in the long term.

The rationale for not yet investing in gold (stocks) was that I perceived a possibility of short term weakness in gold as a result of investment fund selling, as they raced to cover positions, so wanted to wait mostly on the sides until the confirmation came today. Clearly the market believes the US government and Fed are going to support the credit market, or that it will otherwise save itself. Regardless I will support the trend as long as it persists. See A Speculators Dream to see which ASX stocks I'm holding.

Gold - Trend confirmation imminent

We are very close to having our trend confirmed in the gold market. Gold was on the cusp of a trend change on Friday until the Bernacke-Bush duo conspired to sing the same happy song, but look at what they are offering:
1. Bush is offering creditors support if they have a good credit history - to his credit its better targeted support than the central bank flooding the banking system with liquidity
2. Bernacke providing the market with at least the 'hope' of a rate cut. Its my personal opinion that if he was going to offer a rate cut - it would have come 2 weeks ago.

So the choir singing was a surprise - but it comes no surprise that the performance was out of tune. Am I starting to sound like a nervous central banker. Well, just to offer some technical support to this premise:
1. The gold market rallied $8/oz on the news of the Bush-Bernacke support
2. Bush at least seems to be conveying the message that the US government and Fed are on the same ball team by speaking on the same day (Friday)
The bad news for markets:
1. The Dow has not broken resistance - see Market Commentary
2. The gold price has not broken its previous high. Instead it was sold off from $675/oz to $672.

So I think its premature to take a position in the precious metals market or stocks. At this point I see all markets being sold off - but the precious metals market will eventually shine.

Gold Outlook - gloomy?

The gold market has been disappointing a few people of late. In the midst of a meltdown of equities - a 10% fall - the gold price was pretty subdued, in fact it fell on several occasions, but recovered. Clearly those seeing gold as a 'safe haven' were matched by those needing to sell 'safe gold' to cover margin calls on their equity and other commodity exposures.

Well thats all well and fine, but what is the outlook for gold now?

Gold Fundamental Analysis
What we know about gold is that its:

1. Relatively cheap: Attractive when other asset classes are over-priced and central banks feel compelled to support those asset prices with easy money

2. Negative real yields: Gold is attractive when nominal yields on treasuries are low because inflation they are likely to be negative. So if gold lease rates are low and gold prices are considered low, then the metal is likely to be supported.

3. Uncertainty: Gold is attractive if there is a threat of war, whether on the battlefield or trade tensions. The rationale is that asset prices are supported by consumption and during wars capacity is directed from productive to destruction capacity, so paper money or higher taxation is required. Gold is taxed only at the point of production or sale (if profit), and even then there is the potential for unrecorded production or sale.

There are numerous misconceptions about gold that are supported by 'gold cynics', 'gold bugs' and gold producers alike. Really these arguments are often rationalisations by 'purists' that carry weight with the uninformed by virtue because their arguments are supported by alot of information. Some of these arguments are:

1. Gold is no longer relevant: Since gold's role as a unit of money was partially replaced by fiat paper money in 1933 (under Roosevelt), and then totally in 1971 (under Nixon) it never really lost its relevance. This point should be highlighted by the current price of the gold - around $655/oz.
2. Paper is not backed by gold: Well this is true, but it would be wrong to suggest that paper has no tangible assets backing , since under the modern banking system paper is created through the origination of credit, and that credit is backed by very tangible property. Home loans at the point of origination are backed by tangible collateral valued at 80-90% of the loan amount. Ever wondered why banks are reluctant lenders to business without tangible assets or regular income. The gold standard 'purists' would have us believe that they believe in a 'free market' but they were advocates of fixed price of gold, as when gold was fixed at $35/oz (pre-1971). But clearly that system didnt work since it required governments to subsidise its value. It actually makes more sense for the gold price to be free floating so gold is valued on the basis of supply and demand. Rest assured that there will not be too much volatility because the value of new gold output (2500tonnes) per annum is just 1.7% of the total above-ground supplies (150,000 tonnes). The implication is that gold would fall in value as mine costs fall but this would increase the purchasing power of all the existing gold in existence. This would be the productivity dividend. No other metal offers this benefit because other metals have a much larger proportion of their utility tied to industrial use.

3. Speculation is attributed to an excess of fiat paper: Whilst its true that fiat money does spark speculation, so does rampant wealth creation. When the global economy is growing at a pace that causes a rapid increase in incomes and falling interest rates, its understandable that people will be bidding up property prices. There is an expectation that they will miss out since people realise that the bull market will be sustained over a long period of time. The speculation arises merely because there is an expectation of a protracted increase in property prices, or equities. For this reason, weakness in equity prices are perceived as an opportunity to buy more rather than sell so long as the market supports credit creation. In western markets there is however another factor. The regulation of property markets through zoning regulations artificially raises the value of property.

Given these factors I would contend that gold is rising not because of fears of a financial crisis but because wealthy is growing whilst gold production is lagging in a number of countries. That means there are more buyers chasing less gold.

Gold Technical Analysis

In the chart below we can see that gold prices have been range-bound since Feb'07 between $640-690/oz. Currently gold is in a downtrend, and I expect it to fall back to $640/oz support. This view is supported by recent candles that show gold's failure to break the downtrend. Each rally is sold into. The good news is that gold was supported in the recent sell-down (10% equity market correction), but it remains in question whether the uptrend is supported. If this uptrend is broken, gold could move into a consolidation pattern or fall back to a lower support. Gold investors should sell gold if it fails to hold that uptrend line. Commonly when a trend is broken, it might recover to the trend, but then fall off thereafter..so the next week will be very important for gold.

Looking at the long term trend in gold in the chart below we can see that the current trend has been in place since July 2005. We can also see the historical importance of the $640 level. If that fails to hold, I think we are looking at a gold price of $US540/oz - upon which I expect support at gold's base line trend.

Conclusion

My rationale for thinking gold might fall to this level is:
1. Strong global growth: The global economy is no lower US-centric since China and India are growing 3times the pace of the US. Whilst US GDP per capita might be 20x more than these countries, these 2 countries combined have 10x the population and increasingly they are contributing to global output.
2. Growth displaces yield: If global growth stays strong you can expect equities to be the focus and for weakness in bonds. There is the prospect that the Fed might provide the stimulus of lower interest rates to keep equities in play. I think the stimulus is likely to be a token 0.25% cut, and I think they will take it back when the market can hold it. I dont believe the Fed wants asset prices going any higher. I think they will be trying to keep then flat. The Fed will still be worried about inflation.

Anyway we will know very soon...

Base Metals - due for a shake out?

The base metals like Copper, Aluminium, Zinc and Lead seem to be holding up very well considering the uncertainties in the market. In contrast nickel is faring far worse, but it has likely bottomed. Paradoxically nickel miners are recording strong prices. There are I guess a number of reasons for this:

1. Strong demand from China

2. A market view that the Fed will support the market with a rate cut

3. Tight supplies for some metals

Having said that, the fundamentals dont look so good for some metals, and some charts might give reason for concern. The chart above shows that copper prices have retreated from a strong resistance level. My belief is that copper is headed down to $US2.50/lb, but it will then find support. Long term I think the outlook is positive, and we are likely to see an ascending triangle develop in coming years....a protracted period of high prices. I think things will be ok in the short term because it takes time for bad loans to be liquidated, and in the meantime there are strikes and the prospect of a Fed stimulus. But I really dont see higher copper prices in the medium term.

1.Copper prices have been held up by strikes in Chile and Mexico

2. We have yet to see any flow through of softer demand from China

3. There is a shortage of lead and aluminium because of a lack of discoveries. Stocks are thus short and prices bouyant.

But there has been alot of nickel capacity added so nickel prices have collapsed. But we might expect a turnaround there, so for the next 2-3weeks I expect stronger metal prices, but then massive selling.

Precious Metal Outlook

The market has been abuzz with conflicting advice on the direction of precious metals. Some argue that the precious metals have already gone up, inflated by the same credit bubble that pushed up other commodities, whilst others argue gold and silver have been a laggard until now because of strong global strong, and that gold and silver will rally because the Fed will lower short term interest rates to stabilise asset (property & equity) values.
There are a number of issues here that make me reflect:
1. The Fed has for a long time cared little about asset prices - that was on the upside, not the downside. And its long held mantra was that it would do what it takes to preserve growth. It seems unlikely that the Fed will engage in any monetary stimulus, but rather it is more likely to engage in short term stimulus to stabilise the markets. I think the Fed is aiming for an orderly unwinding of bad credit. The problem is, I think markets, looking for performance will not be impressed by the 'low growth' scenario, so I think they will sell off equities, and I think property will follow it.

2. Gold prices: Based on the chart below, gold does not look too bad. It seems to be following its upward course, but what's got my attention is the selling off, evidenced by a string of 'engulfing candles'. Short term profit taking? Perhaps. What has me worried is that if there is a correction in stock & commodity prices, funds will be selling precious metals to cover their positions. This would lead to alot more 'panic selling', the result of which I think would see gold fall to $US550/oz. Talk about life being a 'tight rope'.

3. Silver prices: I would have thought silver prices would exhibit a close correlation to the gold price, though perhaps silver has lost some of its monetary charm, and is weak because of the weaker outlook for silver industrial consumption, given that a much higher proportion of silver than gold is used by industry. The silver chart looks seriously bad, so I suspect its about to fall back to $8/oz and consolidate around $9/oz.

In conclusion I dont think the Fed would mind a fall off in asset prices just as it has not been too concerned about a rise in asset markets. I just think it wants to ensure a smooth fall so that people can sell out or go broke 'silently', so that consumer demand is not hindered. I think the Fed will fail on this point. I dont think the Fed will lower short term rates in Sept'07, or if they do, they lower it by 0.25% instead of 0.5%. I think they of course want the market to believe they will support the market with an interest rate cut, but I think instead their intent will just be to allow the uncertainty to wash out of the market. I think the other reason for weaker precious metal prices will be a shake out in base metal markets. I can see volatility on the LME and Comex exchange, where funds will be liquidating gold to pay margin calls on other metals, and otherwise just liquidating.
The good news is that gold and silver will recover, but it will present a good buying opportunity. Months ago there was alot of talk about a shake out in the commodity markets, but that fear seems to have been overshadowed by the 'sub-prime scandal'. I think commodity price collapse might be about to occur. So you'd thus have to expct some volatility in the $AUD, $CAN, RSA particularly, but it will be short term price action for gold and silver.

Gold & silver performance

Alot of people seem to hold gold and silver in total disdain. I was just reading an article on Yahoo (http://finance.yahoo.com/expert/article/richricher/42433) by Robert Kiyosaki. There are several aspects to these complaints...but I was actually surprised to see that alot of people hate Kiyosaki...you would think they were blaming him for the property collapse, or not warning them. Just shows how much people are living in a totally rationalised dream world. I can't imagine more press on any issue but overheated US property markets for the last 2 years.
Well Kiyosaki's latest posting is his recommendation to buy silver. Critics argued that gold & silver had under-performed against other metals, that precious metals were no longer relevant, that silver was no longer used in film...so his a total idiot. Well first of all, gold has doubled and silver done even better over the last few year despite the popularity of digital cameras.

But more important I think for performance junkies is that you dont buy physical metal - you buy stocks. But consider some of the other benefits of metals over other industries...and tell me that it shouldn't be in your portfolio.

1. How many companies allow you to effectively choose which 'factories' (mines) you invest in?
2. How many industries can you get supply cost curves for each producer?
3. How many industries have terminal markets so they can sell everything they produce?

4. How many industries offer producers the opportunity to lock in (hedge) future prices?

5. How many other commodities give you 100%+ price rises?

6. How many other producers give you a total breakdown of mine costs and revenues?

None, except other metals. Not all miners mind you, but those for whom its a selling point, and just as a matter of routine for any company that has to produce a mine feasibility study. It might not be in stock exchange disclosures, so look in the presentations to analysts on their websites.

Its true that precious metals have not performed as well as other metals, but consider why:
1. Mining costs have doubled in the last few years - not because of gold & silver mining but because the big iron ore, coal, base metal projects around the world hogged all the geological services and mine consumables, pushing prices up considerably. Well those metals will have softer prices in future because they are demand-based.

2. Strong currencies have undermined the performance of precious metals more than other metals because their prices have not risen so high. Commodity currencies like Australia, South Africa, Brazil, etc have mostly doubled, so thats had a huge impact.

But thats all history. Any softening in the global economy will undermine demand based commodity prices and the currencies along with them, but precious metals will out-perform. I expect gold and silver will fall too if financial institutions are forced to sell hard assets to cover loosing financial positions, but precious metals have yet to have the final play. They will at least double over coming years, and I think even better. And you will also benefit from weaker commodity currencies, and investing in the growth earnings of miners...just another reason to invest in stocks...not physical metal.

Whilst I like Kiyosaki's recommendation I think the timing is a little wrong. Why? Because I think that precious metals will be sold off along with everything else if their is a rapid collapse in asset markets, so its best to sit on cash until precious metals take some direction - that is they break a previous high or low.

The chart above shows silver holding the $11/oz support, but I think if thre is a sell off of assets then silver will be sold off, so better to wait for support in more certain markets because they fell faster than they climb. I can see silver falling as low as $8/oz. But it will eventually go as high as $50/oz.

Yeh I know ...people have been saying it for 50 years....well its happened already in the 1970s and its been on an uptrend since I researched (with WHI Securities) and recommended all metals in 2001. Since then it has been strong...but it will go for another rally.

Relationship between gold, oil & Dow Jones Index

Its interesting to ponder the historical relationships between certain commodities. By looking at such relationships we can often see patterns that we might not otherwise have seen. A great many scientific discoveries were made on the basis of pattern recognition, and all knowledge is based on patterns. In a sense logic comes down to similarities and differences between objects (foundation of perception) and ideas (foundation of conception, clarified by context).

The trick of course is to ensure the relationships we observe describe something in reality and are not some arbitrary construct. The best way to determine that is:

1. Identifying similar relationships in related variables

2. Identifying patterns over a longer period of time

3. Establishing a hypothesis that describes the events you describe

4. Testing your hypothesis in a different context.

The focus of this topic is the price of gold in terms of $US, oil and the Dow Jones Industrial Average. The benefit of these materials is that they have been traded for a long period of time, so offer a good historical data base. Gold and oil prices are internationally-traded commodities with a high value so we dont need to be concerned by local disparities because of cultural bias or disparities in transportation costs.

Looking at the oil price, we can see that in the last 20 years prices have varied between $10 to $78 per barrel. Thats a fair spread. This is in nominal dollars. If we adjusted for inflation we can expect this spread to be around half. Looking at the chart below, we can see that the oil price reached a peak of $78/barrel in Mar'06, and has just retraced from a 2nd peak in the last 2 weeks. The implication of this is that we are facing 2 outcomes:

1. The oil boom has ended - the chart pattern suggesting a 'double top'. We should be looking to reduce exposure to oil until we get confirmation at the $55/barrel level.

2. The oil boom is continuing - the chart pattern suggests an 'ascending wedge', in which case the oil price could fall back to $55/barrel and find support before recovering.

Clearly we dont need to know anymore until we get to that level since oil prices are going their under either scenario. This is supported by the current tightening in interest rates and possible recession outlook. So when $55/bbl is reached, we should be looking for a new direction. Of course its possible that oil prices could still go higher, in which case we should see oil prices holding the $70/bbl support.

The gold price is at an historically high level in nominal terms but consider that copper prices have rallied from $0.80/lb to $3.50/lb (450%), but gold has only risen from $290 to $720/oz (350%). Considering this and the fact that gold prices are much lower in real terms, perhaps there is more upside to gold. For a number of reasons I think we are looking at a 'super-cycle', where the expansions have been lengthened by market liberalisation and technological innovation. When you consider that Vietnam (75mil), Bangladesh (150mil), Indonesia (230mil) have yet to really open up their economies, there is still alot of cheap labour offering ever-lower unit labour costs. Thus I maintain that there is still alot of market potential, both for opening up new consumer, savings and debt markets. At the end of the day, that's of significance to gold because it results in greater consumption, which erodes the stockpiles retained by central banks. Can we expect gold to break $700/oz again, or are we looking at a fall back to the $500/oz support?

The following chart is an interesting way to look at gold and oil prices. By looking at the price of oil in terms of gold we are stripping out inflation and productivity issues which impact on both. Oil and gold prices have historically had a close relationship. Yet oil is an industrial material, whilst gold has a quasi-monetary value besides. I would suggest that gold follows the industrial supply-demand paradigm in the good times, but functions as a monetary unit when paper (fiat) money is in question, where the threat is inflation. Of course credit expansion can be unwound by cost of living inflation or asset deflation (debt liquidation).

Reading from the chart we can see (in blue) that the gold-oil ratio trades within a certain band. Lookng at the next chart we can see that the gold-oil ratio has changed over time, so there is a cyclical element to the trade, and as it stands we are at the start of a new downtrend in the ratio, which augers for much higher prices in future. It would be interesting to tie these departures from trend to specific times or events.

Yet another ratio we can look at is the Dow-Gold Ratio. This ratio is simply the Dow Jones Industrial Average (DJIA) divided by the gold price in nominal terms. The DJIA represents just 26 stocks on the NYSE, however they embody some of the largest companies in the world, so it is still seen as a good proxy for the US market. The rationale for using it is that it has been measured since 1897.

The chart suggests that the value of equities is growing at a much faster rate than the price of gold, and that there is a linear relationship between these variables. I think the rationale for this relationship is the growing use of credit or more importantly the greater leverage offered by financial institutions. The implication is that a certain amount of that money floods into equities, pushing up prices (equity indices) to an unsustainable level, and then they fall off. As we can see, when the Dow reaches a peak (as it did in Sept'00), gold prices are bottoming.

Investing in precious metals

Interested in gold bullion - see the London Bullion Market Association listings of gold & silver bullion dealers whom buy and sell gold. Website: www.lbma.org.uk/good_delivery_gold.html. Better still, consider buying stocks in gold or silver producers. See my various equity market blogs.

Commodities - what and how to invest?

Based on my analysis presented in my Market Commentary blog we are looking at 5 or more years of subdued growth and stable asset prices, or a precipitous shakeout of asset market and credit liquidation culminating in a rapid transition to economic growth, though a calamitous shift in wealth from those with asset or liability exposure to those with cash. The question is:
1. Does the Fed have the skills to maintain a flat market for 5 years?
2. Will global markets be exposed to exogenous factors that might impose instability, eg. bird flu?

Does it not strike people that the safe option is to avoid assets. But under this scenario, where do you put your cash?
1. Cash - the problem with cash is that it makes you no money
2. Gold bullion and other precious metals
3. Gold 'derivatives' that offer exposure to the gold market. The problem with financial instruments like these is that you might not be safe from a failure by the counterparty or market maker. Best to avoid these products.
4. Gold stocks offer the best exposure since you dont just have a fixed exposure to the physical metal, but exposure to a growing inventory of metal, as long as the stock is producing or close to production. The benefit of this is that you have the opportunity for the market to price in long term high gold prices and such an extrapolation can blow out your capital gain. There are several things you should look for - unhedged production and the ability to scale up production.
5. Gold exchange traded funds (Gold ETFs) offer 2 types of exposure. Some buy physical metal, others buy stocks. Equity funds can target emerging producers or blue-chip exposure.