GOLD LOOKS UNDERVALUED RELATIVE TO OIL -- DOW COMPOSITE INDEX STILL IN TRADING RANGE -- NASDAQ NEARS MOMENT OF TRUTH

GOLD IS DOING BETTER THAN OIL ... I've recently turned more cautious on the oil sector while turning more optimistic on precious metals. That may seem like a contradiction since both are commodity markets and do have some historical correlation. Part of my reasoning is based on fundamental considerations. A slowing economy reduces the demand for energy. Not necessarily for gold however. In fact, a slowing economy may work in gold's favor. Gold is very influenced by the direction of the U.S. dollar. The U.S. dollar is influenced by the direction of U.S. interest rates (relative to foreign rates). U.S. interest rates have been dropping recently on expectations for a weaker economy (and the view that the Fed is done tightening). That's happening while foreign central bankers are talking about raising rates. That scenario should weaken the dollar. If that happens, gold could trend higher on a falling dollar while energy prices weaken on a softer economy. A more compelling argument comes from their relative values. Chart 1 shows crude oil (black line) and gold (orange line) rising together over the last six years. But they haven't risen by the same amount. The scale to the left shows crude oil rising by a factor of 7.5 times ($10 to $75). The scale to the right shows gold rising by a factor of 2.5 times ($250 to $650). That means that oil has risen three times as far as gold over that time span. Chart 2 shows their relative performance more clearly.

Chart 1

Chart 2

Chart 3

GOLD IS CHEAP RELATIVE TO OIL ... Chart 2 is a ratio of gold divided by crude oil over the last ten years. The ratio peaked in 1999 and fell until the second half of 2005. In other words, crude oil was much stronger than gold during those six and half years. The gold/oil ratio has been rising since the second half of last year however (orange circle). The point of the chart is to show that gold is undervalued relative to oil, and that the pendulum may be swinging back in favor of gold. Chart 2 shows the gold/oil ratio challenging a seven-year down trendline. A upside penetration of that resistance line would make the case for gold over oil even more compelling. Chart 3 shows a similar situation in stocks tied to both commodities. Chart 3 is a ratio of the PHLX Gold & Silver (XAU) Index divided by the AMEX Oil (XOI) Index. There are four distinct trends shown over the last ten years. The falling ratio from 1997 to 2000 favored oil shares over gold. An upturn at the start of 2001 (orange arrow) shifted the pendulum in favor of gold stocks which lasted for three years. At the end of 2003 (black arrow) the pendulum shifted back to oil shares and fell until the middle of 2005. During the second half of last year, the ratio broke the two-year down trendline and turned upward (orange arrow). That signalled a shift in favor of gold stocks. In my view, that makes gold shares undervalued relative to energy shares, and explains why it's possible to favor precious metals while turning cautious on energy.

ANOTHER LOOK AT THE DOW AVERAGES ... Chart 4 shows the Dow Industials moving even closer to their May highs. The chart, however, also shows the stronger action in the Dow Utilities (top line) and weaker action in the Dow Transports (bottom line). One of our readers asked about a current read on the Dow Theory. Although that theory compares only the industrials and transports (which are giving mixed signals right now), there's another way to view all three Dow averages. Chart 5 plots daily bars for the Dow Jones Composite Index which includes all 65 stocks in the three Dow averages (30 industrials, 20 transports, and 15 utilities). It enables us to put all three indexes together in one chart. And, as you might expect, it's showing a mixed picture. The good news is that the DJA survived a threat to its 200-day moving average (red circle) and its June low in mid-August and is now trading back over its 50-day average. The weight of the transports, however, has kept it in a sideways trading range and below the resistance line drawn over the May/July peaks. That's just another way of saying that the DJA is probably going to need more help from the transports to break out of that trading range. The Dow Theory states that an upside move in the Dow Industrials has to be confirmed by a similar upmove in the Dow Transports. At the moment, the Industrials are trading at a new three-month high while the Transports remain below their 200-day moving average.

Chart 4

Chart 5

NASDAQ NEARS MOMENT OF TRUTH ... It's very hard for the stock market to stage a major advance without help from the Nasdaq market. Fortunately, it's been getting some Nasdaq help since mid-July. Chart 6 shows the Nasdaq Composite gaining nearly 200 points (10%) since mid-July. The actual signal of the upturn came with an upside break of its 50-day moving average (blue circle) in early August. Its rising relative strength ratio (bottom line) turned up at the same time and has been rising. That means that the Nasdaq has been leading the rest of the market higher over the last month. [The Nasdaq gained 6% during August versus 2.5% for the S&P 500 and 2.3% for the Dow]. The question is whether its recent rise can be continued. Chart 6 shows the Nasdaq moving into an overhead resistance zone ranging from its early July peak at 2190 to its 200-day moving average at 2225. Interestingly, the Nasdaq could be testing its 200-day line at the same time that the Dow and S&P 500 are testing their May highs. That will be a very important test for the market, especially as it enters the seasonally dangerous September/October time period.

Chart 6