Gold Bull Stage Two
The Ancient Metal of Kings has majestically carved a series of new bull-to-date highs in the past week, breaking out to the upside after consolidating for the better part of a year. Contrarians are rejoicing over these awesome 17-year highs in the gold market.
As I've watched gold's latest surge in September, its most striking aspect has been its independence from the US dollar. Since gold bottomed in April 2001 until this past summer, the metal's fortunes have largely been dependent on dollar weakness. Gold was trading like the timeless currency it is and competing directly against the dollar bear.
But back in June a long-awaited event happened with relatively little fanfare that threatened the dollar's stranglehold on gold. Gold priced in euros broke decisively above its vexing €350 resistance for the first time ever. Sustained levels above €350 are absolutely necessary to convince investors around the world that the current gold bull is more than just a dollar bear.
I'd been waiting for this pivotal event for years as it was one of the most likely catalysts to ignite the next stage of our current gold bull. When euro gold broke out in June I wrote, "€350 may indeed prove to be the long-awaited catalyst to ignite Stage Two, where the gold bull powers higher in an accelerating upslope independent of all currencies."
In light of all the bullish technical gold behavior since mid-June, this thesis is increasingly looking right. Our current gold bull, long slaved to the dollar bear, finally appears to be kicking against its goads and starting to move independently of the dollar. The evidence is growing that we are finally sojourning through the transition from Stage One to Stage Two, where investors' profits balloon dramatically.
Before we get into the charts suggesting that gold is starting to decouple from the dollar, it is important to understand gold-bull stages. Great gold bulls tend to have three stages over their lifespans, which unfold consecutively as gold carves a long-term parabola over a decade or more.
Stage One is primarily currency-devaluation driven. This is what we have witnessed in recent years as gold typically only gained significant ground when the US dollar, the world's reserve currency, was losing value. Stage Two is driven by global investment demand which makes gold decouple from the dominant currency and rise on its own fundamental merits in all currencies simultaneously. Finally, Stage Three can ignite near the end of a secular bull when a popular speculative mania drives gold vertical into a blowoff top.
The Stage One behavior of our current gold bull prior to recent months has been extensively studied and well-documented. But now I am seeing increasing evidence that gold is in the process of decoupling from the dollar. If this indeed proves to be the case over the coming months then this Stage One to Stage Two transition is the most bullish event we have seen yet in this gold bull. It is monumentally important.
Our first chart, which proved extremely useful for timing the major gold uplegs and corrections in Stage One, compares the Relative Dollar to Relative Gold. To compute these series, each currency is divided by its own 200-day moving average and then the resulting multiples of these 200dmas are plotted over time. These relative readings have accurately shown us when gold uplegs were overbought and dollar downlegs were oversold.
But the character of this venerable indicator has suddenly changed since June's €350 breakout. As you drink in this chart, think of both gold and dollar charts flattened along a common horizontal 200dma line running at 1.00. The well-established gold and dollar synchronized pirouette seems to be spiraling apart in recent months.
Prior to mid-spring 2005, gold tended to be strong when the dollar was weak and vice versa. Major gold uplegs, illustrated here by gold soaring above its 200dma to higher rGold multiples, only occurred when the dollar was suffering major downlegs, falling below its 200dma to lower rDollar multiples. If you consider the blue and red lines above in a general strategic sense, they could almost be inverted mirror images.
Both gold and the dollar generally stretched away from their respective 200dmas simultaneously to advance their opposing secular moves. And once these secular moves reached sentiment extremes both currencies would contract back to their 200dmas simultaneously in countertrend moves. This tendency was so well defined in Stage One that gold traders could time trades based solely on the dollar's rhythms.
But check out the last couple calendar quarters on this chart. Starting in spring, right around the time euro gold broke €350, the dollar was roaring forward in its greatest bear-market rally in its entire bear to date. If the Stage One relationship between the dollar and gold had held, gold should have been crushed as the dollar surged far beyond its 200dma that usually caps its major bear rallies.
While gold was initially compliant and retreated back to its 200dma in early 2005 as the dollar approached its own, once the rDollar went above 1.00 gold refused to fall any farther. Indeed gold even started rallying as the dollar continued blasting higher, quite uncharacteristic behavior for a Stage One gold bull. While it is still a bit too early to make emphatic prognostications, it sure looks like gold is decoupling from the dollar and transitioning to Stage Two!
The stunning gold trading action in the past few weeks certainly appears to confirm a fundamental change in gold's relationship with the dollar. Back on August 30th gold traded under its 200dma, just below $431. Since then it has surged up to 1.087x its 200dma in very short order, carving the big spike that sticks out on this chart like a central banker at a rap concert. What did the dollar do during this time? Pretty much nothing.
On August 30th the US Dollar Index was trading at 1.038x its 200dma, the exact same relative multiple it traded at earlier this week. Gold's entire September surge was independent of the dollar's behavior! Investors were bidding up gold for other reasons than just dollar weakness. This is very important as it is exactly what we should expect in Stage Two. Gold rises independently in all currencies regardless of the dollar's machinations.
To get an idea of just how unique such a dollar-independent gold surge is, examine the past major rGold rallies in this chart. Every single prior one occurred only when the rDollar was falling in its own trading band, when the dollar was sinking rapidly under its own 200dma. In Stage One it is dominant-currency devaluation that is the primary driver of gold, not investment demand.
While I am hesitant to use only a few months of data to declare Stage Two, I do think these events are harbingers of it. Moving between major stages in a bull market is a gradual process. The decoupling starts slowly with frequent relapses back to Stage One behavior. But as this transition matures more and more time is devoted to Stage Two independence. Stage One gradually fades into Stage Two over a transitional time.
Our next chart also highlights this evolving transition between the stages. It records the absolute 20-trading-day returns achieved in both gold and the US Dollar Index so far in 2005. We chose 20d returns because most calendar months run 20 to 21 trading days, so this is like looking at how much gold and the dollar have returned on a rolling-month basis continuously. This alternative perspective also reveals the transition underway.
The yellow line overlaid on the gold and dollar 20d returns is the gold/US Dollar Index ratio. It shows which currency has the balance of power at any given time. When this ratio is falling the dollar is outperforming gold, and when it is rising gold is outperforming the dollar. It provides a reference point off of which to frame the 20d returns we have witnessed in the dollar and gold so far this year.
Prior to mid-June when euro gold broke €350, the dollar and gold returns were offset as we have come to expect in Stage One. When the dollar was doing poorly gold was thriving and vice versa. A stylized version of this relationship is rendered in the lower-left corner of this chart. It looks like a series of offset sine waves where gold is almost totally dependent on the short-term fortunes or lack thereof in the dollar.
The primary reason we built this chart is to have some kind of empirical measure of just how unique this transitional behavior really is. In January the dollar was up 4% while gold was down about 5%. In March gold was up 7% on a 20d basis while the dollar fell almost 4%. By April the dollar was again up 4% while gold bled the same 4%. In May both the dollar and gold approached 5% in their respective oscillations.
Other than the brief gold spike in March, there really is a lot of parity in these 20d returns. When the dollar is up 4%, for example, odds are gold will be down about 4%. Incidentally I looked at this data going back to the beginning of this gold bull in 2001 and the results were similar. There was a strong, though not airtight, tendency for the gains/losses in gold to be very similar in magnitude to the losses/gains in the dollar.
This parity behavior establishes a hard empirical baseline from which we can judge the uniqueness of this apparent Stage Two transition. The breakdown of Stage One protocol looks to have started in mid-June just when euro gold broke above €350 for the first time ever. This pivotal event does indeed appear to be catalytic in broadening the group of international investors buying gold.
While early June looked normal, the 20d returns of both gold and the dollar started falling into July. The serpentine offset relationship that looks like a sideways version of the serpents entwining the medical symbol caduceus started to fail. In August Stage One behavior kind of returned but gold was up far more than the dollar was down, +6% compared to -3%. And so far in September both currencies are up but gold's 7% surge utterly dwarfs the dollar's flat month-over-month returns.
Granted several months is not much data to discern a major secular development, but you have to admit that gold's behavior in recent months really looks like it is decoupling from the dollar's dominating influence. Rather than gold just mechanically offsetting the dollar at a similar magnitude, lately gold has been doing whatever it wants regardless of the dollar's own behavior. It looks like it is gradually achieving Stage Two independence!
Just as great secular gold bulls unfold over more than a decade, the transitions between their three stages are not instant but a gradual fade. I was trying to think of an analogy for this and for some reason driving in sleet came to mind. Having grown up in the north I unfortunately have a lot of white-knuckle experience with ice driving.
During a sleet storm rain freezes and creates nasty black ice on road surfaces. It is no fun at all to drive on. It doesn't matter what kind of car you drive, unless you have sharp metal spikes studded in your tires you have virtually no traction regardless of rear-wheel, front-wheel, or four-wheel drive. With treacherous black ice coating the roads like cold death, drivers have little choice but to creep along with barely any traction and try to stay between the ditches.
As you move from the center to the periphery of the sleet storm, driving conditions improve. There are patches of black ice with no traction but there are also wet spots with improved traction. As you finally emerge from the storm, dry spots start appearing on the road with normal traction. Eventually you get completely out of the storm and the roads are dry so you can return to driving as aggressively as you wish.
Just as the transition from black ice to dry road, from barely any traction to normal traction, is gradual, so is the transition from Stage One to Stage Two. Initially in the transition gold has a tendency to behave like Stage One and be oppressed by the dollar with little traction of its own. As time marches on though, the low-traction Stage One conditions fade and more Stage Two behavior with traction becomes evident. Eventually gold migrates into Stage Two where its traction is great and it starts rallying independently of the dollar.
While I don't think we are in the normal-traction dry spots of full-blown Stage Two yet, I suspect we are moving beyond the slippery Stage One black ice to a combination of icy, wet, and dry spots intermixed. Going forward gold should perform increasingly well on balance relative to the dollar, gaining more traction in the months ahead. And €350 really could have been the catalyst that sparked this new global investor interest in gold.
Prior to the €350 breakout in June, many if not most international contrarian investors considered the gold bull that we perceive in the States as little more than a dollar bear in disguise. Gold was "up" in dollars only to offset direct losses in the dollar's international purchasing power. Over the past four years many times after I wrote an essay on the gold bull I would receive e-mails from overseas disputing that it really existed.
This euro gold chart, which can also be considered dollar-neutral gold, is representative of most non-dollar currencies. There was already a subtle uptrend in euro gold, a stealth bull market, but not many folks realized it. While euro gold's 200dma defined its primary trend as up, earlier above-trend anomalies that were stopped cold at €350 in 2002 and 2003 made many investors feel that euro gold was just grinding sideways endlessly.
Until €350 fell and the 2002 highs were eclipsed, this gold bull wouldn't be considered real. This just happened in June, a glorious event. After that earlier breakout euro gold consolidated around €350 and this old perceived resistance zone became new support from which this latest major breakout launched. This was important because new bull-to-date euro-gold highs ought to attract in skeptical investors worldwide.
If this gold bull is the real deal for its own fundamental reasons and not merely a dollar bear, then vast fortunes will be won before it fully runs its course. Prior to this summer, American contrarian investors were the largest group of folks who believed in it. With new bull-to-date highs in all major currencies though, now foreign contrarian investors are taking notice. Gradually they are moving capital into gold and driving it higher.
The single most-important determinant of the gold price is global investment demand. When investors get interested in gold and even deploy tiny fractions of their portfolios into it, supply just won't keep up with the new marginal demand. And gold, like most investments, even sports an inverted demand curve. The higher its price goes the more investors want it so a feedback loop manifests driving it higher and higher. There is no rush like a gold rush!
Today with euro gold running near €385, levels that were virtually unthinkable even six months ago, more and more investors will start paying attention to gold around the world. This gold bull is not just a dollar bear, but part of a much larger general commodities bull.. Global gold supplies, both mined and central-bank sales, are totally inadequate to meet the multiplying investment demand. Gold's price has to rise forcing it to decouple from the dollar.
With a Stage Two transition probably now underway thanks to international investment demand, the opportunities for investors are staggering. The greatest percentage gains of great bull markets are made in Stage Two. Prices marching relentlessly higher with periodic corrections are probable for the next half-decade or more once Stage Two is upon us. This is analogous to the tech bull in the second half of the 1990s before the mania arrived.
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The bottom line is a Stage Two gold bull transition appears to be upon us. In recent months gold has been acting with increasing independence from the dollar, pushing the precious metal up in all currencies simultaneously. This is attracting in new investors around the world who will help drive gold even higher and stoke a virtuous circle of new investment demand.
When Stage Two finally arrives in force, it will herald the middle third of this gold bull where profits earned will utterly dwarf the Stage One gains we have seen so far. If you haven't invested in the precious metals yet, you sure don't want to miss the approaching dawn of Stage Two!
Adam Hamilton, CPA
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