Gold and the Dollar

The 1970s Roadmap

We would never make an investment/trading decision solely on the basis that a market appeared to be following a similar path to one that it had followed during some past time. This is because there are always a lot of differences between the present and the past. However, patterns do tend to repeat themselves and we can certainly learn from what happened in the past. Also, we've found that it helps to have a rough roadmap in mind for the markets we are trading and to then continuously check the current price action against our roadmap (that is, against our expectations) to make sure we are on the right track. 

Recently we've considered two possible scenarios for gold stocks, with one of these scenarios being that gold stocks will continue to follow a similar path to the one they followed during the bull market of the early 1970s. The below chart, which overlays the percentage change in the HUI since its November-2000 bottom onto a chart showing the percentage change in the Barrons Gold Mining Index since its January-1972 bottom, indicates that the correlation between 'then' and 'now' remains high. If this high correlation persists then the HUI will surge to a very important peak over the next 2 months, after which there will be a substantial and lengthy downturn.

Now, let's take a look at charts showing how gold and the US$ performed during the 1972-1977 period (the same period covered by the above chart). Note that in the second of the below two charts the line on the chart rises when the US$ is strengthening against the Swiss Franc.

The above charts show that:

a) Gold stocks peaked in August of 1974 and then trended lower for 2 years before commencing the next phase of their secular bull market.

b) The gold price peaked in December of 1974 and then trended lower for about 20 months before resuming its advance.

c) The US$ bottomed in February of 1975 and then moved sideways for about 2 years before resuming its decline.

That is, gold stocks peaked about 4 months in advance of a peak in the gold price and the gold price peaked about 2 months in advance of a bottom in the US$. It therefore wasn't possible, during 1974, to successfully trade gold and gold stocks by reacting to what was happening to the US$. Anticipation was required because gold stocks and gold began to discount a trend reversal in the US$ months before the reversal actually happened. 

Interestingly, gold and gold stocks have tended to lead the currency market over the past few years just as they did during the first half of the 1970s. We therefore think it is reasonable to assume that gold-stocks and gold will lead the next major trend reversal in the US$. In other words, the current action of the gold price is likely to tell us a lot more about the future value of the US$ than the current action of the US$ tells us about the future price of gold. 

There are two logical places for the US Dollar Index to bottom this year, one being in the 90-92 range (just below the current level) and the other being near the 1995 low (around 80). If the market expects the US$ to bottom in the 90-92 range then gold stocks will probably NOT surge to a major peak over the next 2 months. However, if the market begins to suspect that support in the 90-92 range will not hold and that much lower levels are likely for the US$ over the coming several months then the prices of gold and gold stocks should soon rocket higher. In other words, if the gold sector is to continue along a similar path to the one followed by gold stocks during the early 1970s then the market must soon start to believe that the US$ is going to drop well below 90 over the coming months. Such a decline in the US$ would, in turn, almost certainly lead to a bottom from which a 1-2 year rally, or at least a 1-2 year stabilisation, in the dollar's exchange value would occur. 

If, on the other hand, support at 90-92 is going to hold then we are already close to a US$ bottom. Such a bottom, though, would probably only lead to a 3-6 month dollar rally or dollar stabilisation. This is essentially what we've referred to as scenario 'b' in recent commentaries (under this scenario gold stocks would pullback for a few months before embarking on a major advance).

Hopefully, the above explains how a 1974-type major peak and subsequent 1-2 year decline in gold stocks is possible. If we are going to get a major bottom in the US$ later this year then a huge surge in gold and gold stocks is likely over the next 2 months. However, if it is anticipated that the dollar is going to bottom near current levels then we would not get a surge in gold and gold stocks in the short-term, but neither would we likely get a pullback lasting more than a few months. In summary, it all depends on how much of a dollar decline the market decides to discount.

Newmont and Gold

Newmont Mining (NEM) is now almost completely unhedged. The company has strong management, is the world's largest gold miner in terms of reserves and annual sales, has a geographically-diverse portfolio of gold mining assets, and is not unduly affected by large changes in exchange rates (except to the extent that those changes impact the US$ gold price). Furthermore, the NEM stock is fairly valued at its current level based on a gold price of around $370. These characteristics mean that NEM is probably a better proxy for the overall gold sector than any of the popular gold-stock indices (including the Schultz Gold Index).

The below weekly chart of the NEM stock price shows the base that has been more than 5 years in the making, the importance of resistance at $30-$31, and just how close NEM is to achieving a major breakout. Further to the above discussion, a decisive break above $30 by NEM would have huge implications for the entire gold sector.

We exited an NEM call option position a couple of weeks ago and wouldn't be interested in re-establishing a trading position in NEM options with the stock so close to a potential stumbling block at $30. However, we would probably buy the first pullback after a break above $30 and we would certainly buy (with great enthusiasm) if the stock price drops to around $26 over the next few weeks. In the short-term a pullback is just as likely as an upside breakout.

Below is a chart of the NEM/gold ratio. NEM is a leveraged play on the gold price so it is not surprising that the NEM/gold ratio tends to move in the same direction as the NEM stock price. This chart shows the consolidation that has been underway since May-2002. It also shows that the major 1996 peak in the NEM stock price corresponded with an NEM/gold ratio of about 0.15 and that peaks over the past 5 years have tended to occur when the NEM/gold ratio has moved up to around 0.10. With a gold price of $410 a ratio of 0.10 would imply an NEM stock price of $41.

Why did we choose $410 in the above paragraph? Because once gold broke above resistance at $360 it put in place two likely targets over the next few months, the first being this year's peak of $390 and the second being $410 (see monthly gold chart below).

Actually, once NEM breaks above $30 it will be on its way to $50, but it should make it to $41 before the first sizeable correction occurs (note that $41 would also be the rough target created by an upside breakout from the contracting triangle that has been forming since May 2002).

Current Market Situation

The Amex Gold BUGS Index (HUI) broke above resistance at 140 last week, but the performance of gold stocks relative to the gold price continues to be uninspiring. It seems that it is going to take a move by the gold price to above its February high ($390) to generate some speculative enthusiasm for the gold stocks.

When the gold price rocketed higher in January and February this year the popular explanation was that the gold market was reacting to the war tensions. Our view, at the time, was that the war was actually a 'negative' as far as the gold market was concerned because it was distracting investors from the real reason for gold rally (the real reason was, and is, US$ weakness). If gold can now move above $390 it will prove that the war was not the reason for the previous strength and provide an air of sustainability that should certainly boost many of our gold stocks. We think this will be the case even if the gold price moves only $10-$20 above the February peak.

The risk to gold and gold stocks in the short-term is that the US$ might be close to an intermediate-term bottom. The Dollar Index is within spitting distance of its 1998 low, the euro has just nudged above its 1999 high, the Swiss Franc has reached its 1998 peak and the A$ (see monthly chart below) is very close to reaching the 67c target we first mentioned late last year. As such and even though there aren't yet any signs that the dollar has bottomed, now is certainly not a great time to be getting bearish on the US$ and bullish on other major currencies.

Update on Stock Selections

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Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/