WHY LONG-TERM TREND FAVORS GOLD -- STOCKS IN LOW-VOLUME OVERSOLD BOUNCE
WHY NEXT TARGET FOR GOLD IS $500 ... After reaching $700 in 1980, the price of gold fell for the next twenty years before hitting bottom at $250 in late 1998. Bullion started to rise in early 2002 and is close to doubling in price. One of the ways to arrive at an upside price target is to double the price from the bottom. That puts the next price target around $500. Another way is look further back in time to find previous resistance levels which are usually price peaks. The monthly bars show price peaks in late 1987 at 1982 just above $500. Since gold has a tendency to stop at round numbers, I'm using $500 as the next major upside target. I don't view that as the final upside target however -- but an interim target. Gold is within $25 of that top which would suggest that it's nearing a point where some profit-taking might be expected. Over time, however, I believe the $500 barrier will most likely be exceeded. After a twenty year secular bear market, I find it hard to believe that gold's new secular bull market will have ended in less than five years. I also continue to believe that gold stocks are historically undervalued.
Chart 1
GOLD STOCKS HAVE A LONG WAYS TO GO ... Chart 2 plots the Gold & Silver Index for the last twenty years. Although it bottomed in 2001, it's still 40 points (36% from the highs reached in 1996 and 1987). That suggests to me that gold stocks have a lot further to go before their bull move has ended. The solid line overlaid on the XAU is the S&P 500. Notice the generally inverse correlation between the S&P and the XAU over the last twenty years. Gold stocks were one of the worst group performers over the twenty year secular bull market in stocks. The upturn in gold stocks occurred in 2000 as the stock market was peaking. Gold stocks languished since the start of 2004 as the stock market rallied. Now that the market is starting to look toppy, gold stocks have become the market's strongest sector. That confirms the historical tendency for gold to trend inversely to the stock market. Gold does best when investors lose confidence in stocks. That's doubly true if they also lose confidence in bonds.
Chart 2
MAJOR SWING TO GOLD ... Chart 3 is a ratio of gold divided by the S&P 500 since 1980. The scale is logarithmic, (which is based on percentage instead of absolute changes) because it's better for longer-range analysis. During the inflationary 1970's, gold prices soared while bond and stocks were down to flat. The commodity boom ended in 1980 as did the bull market in gold. One year after gold peaked, bond prices launched a major bull market in 1981. Stocks turned up one year after bonds in 1982. For the next two decades, paper assets like bonds and stocks experienced secular bull markets while gold did just the opposite. The gold/S&P ratio declined from 1980 to 2000 as the secular bull market in stocks ruled. The 2000 stock peak, however, worked to the benefit of the gold market which has done much better than stocks in the five years since then. Of particular importance is the fact that the gold/S&P ratio broke a twenty-two year down trendline during 2002 signaling a major shift in fortune between the two asset classes. Chart 3 suggests to me that the outperformance of gold over stocks isn't a short-term phenomenon; nor is the new trend in favor of gold ending. If anything, it's getting stronger.
Chart 3
Chart 4
GOLD/S&P RATIO IS BREAKING OUT ... Chart 4 gives a closer look at the gold/S&P 500 ratio since its bottom in 2000. After rallying from the start of 2001 to the start of 2003 (as stocks were falling), the ratio peaked in early 2003 and has been trending sideways since as the stock market embarked on its cyclical bull market. In the second half of 2005, however, the ratio has broken out to the highest level in two and half years. That upturn is a combination of rising gold prices and weaker stock market. The upside ratio breakout suggests to me that the cyclical bull market in stocks is ending and that money is moving to the gold market as a hedge against a falling market. It's also moving to gold as a hedge against inflation and rising interest rates. I also happen to believe that gold is cheap relative to oil. That was one of the reasons that I recently suggested rotating some funds out of energy and into gold stocks. I still like energy stocks on a longer-term basis (especially natural gas); but I think there's more value in gold. Chart 5 is a ratio of gold stocks (XAU) divided by the Energy SPDR (XLE). The ratio bottomed in 2001 as gold stocks did better than oil until the end of 2003. At that point, energy stocks took over leadership as the ratio fell. After falling close enough to its 2000 low, the gold/oil ratio shows signs of turning up. The 26-week Rate of Change (ROC) line also appears to have bottomed. That suggests that commodity leadership may have shifted from oil to gold.
Chart 5
NYSE BOUNCES FROM OVERSOLD TERRITORY ... The market has put together two straight up days since Friday. Part of that is due to a short-term oversold condition in the major market averages as shown by the 9-day RSI line in Chart 6 bouncing from oversold territory under 30. The NYSE is also finding support at its 200-day moving average. That's not surprising either. The problem is lack of upside volume. Trading activity has dropped off noticeably over the last two trading days. That doesn't inspire a lot of confidence. Neither does the fact that weekly indicators are still in negative territory. We'll have to watch the charts closely to see if this is just an oversold bounce or the start of a more substantial fourth quarter rally. So far, the evidence of a significant upturn isn't that impressive.
Chart 6
