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The Relative Dollar and Gold 2

Adam Hamilton
April 23, 2004

It has been one heck of a rough week for precious-metals investors and speculators. General fear and despair is multiplying with each new down day in gold as the markets do what they do best, relentlessly test every conceivable weakness in our psychological armor.

For the first time in over a year this week, I actually received more than a dozen e-mails from folks wondering if the bull market in gold was dead, over, finito. I can totally empathize with this growing worry, as the markets are adept at toying with our emotional human hearts like a cat playing with a mouse before it is devoured.

Fear is rampant among the gold community. There is fear of central banks selling gold and capping its price, fear of rising interest rates decimating gold, fear of a renewed Great Bear in gold looming, and the list goes on and on.

This very same emotion of fear that is paralyzing many gold players this week need not be debilitating, however, it can be harnessed for our own benefit. The greatest contrarian of our time, Warren Buffett, is fond of saying that we need to "be brave when others are afraid and afraid when others are brave." Contrarians strive to buy on fear!

As I discussed last week in "Golden Bull Buy Signals 3," I continue to believe that we are now being presented with the greatest buying opportunity in gold and gold stocks in at least a year! From an enormous global supply and demand deficit in gold, to massively negative real interest rates, to endless fiat-currency inflation, all of the long-term secular fundamentals driving gold remain very much in place.

If this is true, if the long-term case for gold is so dazzlingly bullish, then why is fear mushrooming this week? Probably because we live in a frenetic culture where only today's immediate financial news is considered, and today's news is always driven by today's short-term price movements. Falling gold leads to negative coverage which fans fears, a logical progression.

The best way to break free from this cycle of fear is to transcend the immediate to rise above the tyranny of the short-term. The tighter a speculator focuses on short-term movements, the higher the risk that the true big picture will be lost in the random market noise. Just like a military general soaring above a battlefield in a helicopter has a far greater understanding of what is really going on than a general sitting in a humvee on the ground, maintaining a strategic perspective on the markets is crucial.

For me, the best way to understand the short-term is to constantly study market history. If current movements in prices, no matter how disconcerting, can be viewed within the proper context of past market precedent, the odds of getting swept away by our dangerous emotions of greed and fear fade considerably. In light of these studies, I believe the current gold weakness is easily explained and perfectly normal and healthy.

Because gold is the ultimate form of money, in the first third of a major bull market it trades more like a currency than a commodity. The dollar gold price is the exchange rate between paper dollars and gold, and it is affected not only by gold supply and demand but by the US dollar's supply and demand as well. If the dollar is strengthening, then gold generally weakens, at least in the early years of a secular bull market.

The current weakness in gold that is igniting so much consternation is nothing more than an anticipated pullback in gold due to a bear-market rally in the US dollar. Periodically the dollar bear market is broken by a countertrend rally and the gold bull market simultaneously suffers through a countertrend pullback. No big deal.

While the carnage through which we suffered this week may seem unique and distressing, it has already happened four times in the past couple years. As King Solomon wisely said millennia ago, there is nothing new under the sun. Our graphs this week provide the crucial strategic context that can help short-circuit the deadly emotion of fear.

When the gold and dollar behavior in the recent months is viewed from a strategic perspective, it looks about as intimidating as Alan Greenspan wielding an aluminum baseball bat not very!

OK, please forget about this week for a moment and drink in the big picture presented here. Gold is in a bull market and the US dollar in a bear market. The respective 200-day moving averages for these competing currencies, as always, run parallel with their primary trends and confirm the obvious. Gold is generally rising and the dollar is generally falling. Easy to understand, right?

Indeed, the inverted relationship between gold and the dollar is visually striking. The yellow lines help highlight the short-term trends within the long-term gold bull and dollar bear. When the dollar is weak gold is strong, which makes sense since the dollar gold price is just the exchange rate between gold currency and the dollar currency. When the dollar is strong, gold is weak. This chart could easily be labeled "Currency Wars".

Since early 2002, there have been four major uplegs in the price of gold, noted with the blue numbers above. It is striking that every time that gold was marching higher, however, the US Dollar Index was falling lower. The corresponding four major downlegs in the dollar are noted with the red numbers. In this early-stage gold bull, gold simply would not climb higher unless the dollar was meandering lower.

But it wasn't only the gold uplegs that ran concurrent with but inverted to the fortunes of the dollar, it was also the periodic gold corrections. Whenever the US dollar temporarily stabilized for a few months, gold tended to trade sideways and consolidate. Whenever the dollar rose in a bear-market rally, gold corrected downward. These key intercurrency relationships are so easy to see in a multi-year chart that even a child could easily understand them.

Interestingly, this is not just a visual thing but is strongly backed up by hard math. The daily correlation between gold and the dollar in the chart above is an amazing -0.938! Statisticians multiply this correlation coefficient by itself to get a number they call the R-Square value, which is running 88% in the chart above.

This means that a whopping 88% of the daily movements in the price of gold in the past couple years are directly explainable by and probably attributable to the behavior of the US dollar! Believe me, such incredibly high correlations over multiple years of daily data are rare in the financial markets, so this is really noteworthy. Outside of foreign-currency exchange rates, of which gold is one, such high multi-year daily correlations are virtually unknown.

Thus from a strategic perspective, it is readily apparent that gold and the dollar have been hopelessly intertwined so far in this gold bull market. The most direct driver of the price of gold in these early years of this bull is the exchange rate between gold money and the dollar currency. If you can accept and digest this simple truth, then you are halfway to understanding why the gold carnage in April was not only nothing to fear, but it probably heralds a rare and exciting major buy opportunity in gold and gold stocks.

If you have read any of my recent essays, then you know that I have a current fascination, some would say an obsession, with the idea of normalizing market prices relative to their 200-day moving averages. The 200dmas are probably the most important lines in all of technical analysis. Not only do they run parallel to the primary long-term trend in any market, but they form the magnetic major support and resistance that short-term countertrend reversals usually seek.

The 200dmas rendered above are perfect examples. In this gold bull, every major gold pullback ended right near its 200dma. If you went long gold or gold stocks any time that gold traded near its 200dma in this gold bull to date, you were blessed with excellent to legendary returns. The 200dma of a major bull market is its most important long-term foundational support.

The dollar bear market of recent years also illustrates just how beautifully this concept works when reversed. In every major dollar bear-market rally, which are temporary countertrend reversals, the dollar stopped rallying and turned lower near its 200dma. The 200dma of the US Dollar Index formed its most important fundamental long-term resistance line.

Back in early January I was very wary on the near-term fortunes of gold, primarily due to this dollar and gold chart. I wrote about it on January 9th in my original "The Relative Dollar and Gold" essay. If you look carefully at the vertical 2004 line in this chart, you can see why. Not only was gold extended far above its 200dma as 2004 dawned, but the dollar was stretched far below its own.

Not surprisingly, popular psychology certainly reflected these opposing extremes in early January, with gold zealots calling for $500 gold by March and the dollar short trade more crowded than Mexico City during rush hour. The problem with these major 200dma divergences is that markets tend to advance and retreat, flow and ebb, and they had already moved relentlessly in one direction for many months so a short-term countertrend reversal was due. 200dma convergences, a dollar bear rally and gold correction, seemed inevitable.

In order to more precisely examine these extreme dollar and gold 200dma divergences, I applied my concept of Relativity to both data series. Relativity just means dividing both the dollar and gold by their respective 200dmas and plotting the results. The resulting Relative Dollar (rDollar) and Relative Gold (rGold) eliminate the visual skew inherent in the usual graph above and normalize the percentage distance that the dollar and gold happen to be away from their 200dmas at any given time.

This exercise led me to conclude my original dollar and gold essay on January 9th with, "For now though, the oversold dollar levels and overbought gold levels in Relativity terms are troubling. The US Dollar Index really looks like a major countertrend rally is imminent and due. And if a bear-market rally in the dollar launches, for any reason, odds are that gold is going to get hit over the short-term. Get ready!"

Remember our old friend Warren Buffett's brilliant quote? He said to be brave when others are afraid and afraid when others are brave. In early January others were afraid of the falling dollar and brave on the new bull-to-date gold high. The only contrarian play to make at the time was to fight our emotions and do the opposite, battening down the hatches for a dollar bear-market rally and gold correction.

The Relativity chart normalizing both the dollar and gold relative to their key 200dma lines really drives this point home, bringing the precise inverse relationship between these two competing currencies into sharp focus.

Relativity essentially takes the first normal dollar and gold graph above, forces the 200dmas into a straight line along the level of 1.00, and indexes the actual dollar and gold prices to this constant base. Any ambiguity or optical illusions of the original graph are purged and the true interaction of the dollar and gold prices with their 200dmas becomes crystal clear.

The yellow visual guidelines in this relative chart are nearly mirror-image sawteeth, far more precise than we witnessed above in the original graph. Like two ice dancers spinning together, both the dollar and gold generally diverge from and converge to their respective 200dmas in unison. Since early 2002 there have been four dollar bear-market rallies and four corresponding gold corrections.

As I discussed rGold extensively in the past two weeks, I am focusing on the rDollar in this essay. I truly believe that a basic understanding of the strategic dynamics of the dollar's recent behavior offers enough light to burn the fog of fear away from any gold speculator's heart. The fourth major dollar bear-market rally we just witnessed is the key to putting gold's correction in its proper non-threatening strategic context.

As the red line above illustrates, the dollar ebbs and flows within its secular bear market. While its primary trend is to head lower away from its 200dma, periodically it retreats back up to its 200dma to regroup, working off temporarily oversold conditions. These countertrend reversals are normal, healthy, and exactly what we would expect in a major bear market. The four major dollar countertrend reversals, or bear-market rallies, are labeled with the red numbers above.

While market history never repeats exactly, it does tend to rhyme rather well. This rhythm in the dollar bear-market rallies is readily apparent in the chart. These rallies tended to launch once the dollar had retreated down near 90% of its 200dma, and once underway they tended to run for a few months or so until the dollar advanced back up near its 200dma.

Back in early January, the rDollar had ground down to 0.905 when my first rDollar essay was published. I was concerned about this at the time because the dollar had launched powerful bear-market rallies that hammered gold from similar levels in both mid-2002 and mid-2003. The dollar's nemesis rGold was also at its second highest point in the entire bull market to date, well into our greater-than-1.11 neutral zone. The precedent wasn't encouraging.

When the rDollar had hit 0.905 in mid-2002, it immediately launched into a powerful bear-market rally that stopped gold in its tracks. This 2002 dollar rally lasted for 66 trading days before giving up its ghost. About a year later in 2003, a strikingly similar event transpired. The rDollar fell to 0.903 but then soon began rallying and pummeled gold. The rDollar ultimately soared to 1.004 before it ran its course, just above its 200dma. This 2003 dollar rally lasted for 68 trading days.

With two rDollar 0.90ish interim lows and two major dollar bear-market rallies running about a quarter in duration spawning from these lows, a potentially tradable pattern had emerged.

So, with the rDollar once again finding itself near 0.90 in early January of this year, strong rDollar support, it seemed prudent to expect a dollar bear-market rally that could carry the US Dollar Index all the way back up near its 200dma and would probably last a quarter or so in duration. The dollar and gold had simply stretched too far away from their 200dmas and were overdue for countertrend convergences.

At the time I wrote, "For my fellow gold and gold-stock speculators, I would be really cautious here and not add new positions. You also probably ought to ratchet up the trailing stop losses on your existing positions. The next great buying opportunity to ride another glorious gold upleg will probably not occur until gold converges with its 200dma, until Relative Gold once again approaches 1.00 parity. If the past is any indication, this countertrend move could take a few months to fully play out."

Fast forward to today. The fourth major bear-market rally in the US dollar that indeed unfolded in recent months has catapulted it from an rDollar level of 0.905 to 0.998, now kissing its 200dma. This dollar rally ran for 70 trading days, exactly in line with the powerful dollar bear rallies of mid-2002 and mid-2003. Not at all surprisingly, the strong countertrend dollar move pummeled gold and gold stocks. So what's there to worry about?

Now way back in early January when the dollar rally and gold correction really started, was there any fear at all in gold? Did the mighty Rothschild clan allegedly claim they were abandoning gold for the first time since my Lord Jesus Christ walked this Earth? Did Italian central bankers make global headlines by threatening to convert their centuries-old hoard of gold into gaudy jewelry to sell to tourists? The answer is no! No one had heard of these "threats" when the gold correction really began in January.

The only time rumors really get traction is when market prices support rumors. Back in early January most folks were bullish on gold so bullish gold stories got all the play. Today most players are bearish on gold so bearish stories are abundant. Daily price movements drive market news, and news reflects short-term sentiment. But focusing so intensely on the short-term that the greater strategic context is lost is a great and costly folly that should be avoided.

Rumors are fun and interesting, adding a great deal of romance and excitement to the financial markets. But, if you want to earn profits in this brutal arena, it is best to consider rumors as merely sideshow entertainment while focusing on cold, hard, unemotional analysis. Amusement aside, here is how I interpret this correction in gold.

Gold and the dollar are inversely related. Both gold and the dollar were extended too far from their 200dmas in early January and countertrend moves were due and anticipated. Both gold and the dollar remedied these unsustainable extremes by converging to their 200dmas. It's really that simple. Why fear the normal and obvious?

Rather than fearing, gold investors and speculators ought to be rejoicing today, dancing on the rooftops! Why? Examine the strategic context of the chart. Every time in recent history that both the dollar bear and gold bull have neared their respective 200dmas, it has marked the end of these countertrend moves. The primary secular trends always reasserted themselves soon after 200dma convergences such as we are witnessing at this very moment.

And what are these primary trends? The dollar is in a secular bear market, and major currency trends usually run for five to seven years before reversing. This dollar bear isn't even halfway through the lifespan of a typical dollar bear yet.

And gold, of course, is in a secular bull market that should last for a similar amount of time. As the dollar bear and gold bull quit correcting and reestablish their primary paths, the gold price ought to start heading higher soon. And if you scroll back up to the first chart, you will notice that there is no better time to go long gold than when it is near its 200dma. That's today friends!

Fear? To heck with fear! As contrarians we have to steel ourselves to feel neither greed nor fear, since both emotions are immensely destructive. I am unashamedly bullish in gold and gold stocks right now, more bullish than I have been in at least a year. It is not because I am greedy or scared though, but just because the charts are all converging to herald a magnificent buying opportunity right now.

If you are interested in guidance on what to buy, we have been awaiting this glorious opportunity at Zeal since gold stocks topped late last year. We have spent the better part of six months patiently and prudently preparing for this very breathtaking day when the dollar and gold converge with their 200dmas.

In the upcoming May issue of our acclaimed monthly Zeal Intelligence newsletter to be published exclusively for our subscribers in early May, I am going to discuss today's fantastic precious-metals opportunities in depth. I will talk about exactly what we are buying and why, in addition to adding a bunch of specific buy recommendations on stocks and options for the coming major gold upleg.

Please subscribe today so you don't miss it! As the graph above shows, major concurrent 200dma convergences don't last long and odds are that today's magnificent opportunities won't either.

Warren Buffett wisely advised that we should be brave when others are afraid and afraid when others are brave. Today folks are brave on the dollar and afraid on gold. We need to force ourselves to take the opposite approach, and the charts strongly support the bullish view on gold and the bearish outlook on the dollar.

Cowering in fear over a garden-variety dollar-bear-rally-induced gold correction makes no sense, but even so acting today in the face of gold weakness requires courage. Another major gold upleg appears to be on the very verge of launching, but only the decisive and brave will seize today's awesome opportunity to saddle up and ride it. Get long now!

April 23, 2004
Adam Hamilton, CPA
email: zelotes@zealllc.com

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