September 26, 2005
Gold Digs In
By Brady Willett

When gold rallies strongly I normally begin to rage that the price of gold is about to suffer a massive decline because the commercials control the market.  Not today.  Rather, today something more tangible than the hope of skyrocketing gold is in the play: the reality that the commercials were incapable of defending last year’s highs. 

Exactly why the commercials failed to hold gold below last year’s highs is open for debate.  Some have argued that global demand fundamentals are boosting the price of gold, others have suggested that renewed inflationary concerns are sending investor’s into gold, and still others are baselessly speculating that “Gold has garnered the attention of some big money players” (Norcini).  Whatever the case may be, there is no doubt that the latest surge in gold has not been the result of a weakening US Dollar:

As of last Friday October gold was up by 5.8% since the end of August (or $25.40 an ounce).  During this same time the US Dollar (index) was up by 2.085%.

Rather than flatly state that gold has permanently decoupled from its inverse relationship to the US dollar, the argument could be made that gold is rising on heightened anticipation of a resumption of the US dollar bear.  GFMS suggested as much in their recently released gold survey:

“Investors still seem quite jumpy over prospects for the dollar. We’ve long been expecting a day of reckoning for the greenback given the colossal scale of the US budget and fiscal deficits and nothing has really happened to bring us any reassurance on these fronts. If anything, in the wake of Hurricane Katrina, things have got worse…If that falters and US economic growth falls away, alternative investments could be hot property.”

Needless to say, with gold having, at least temporarily, delinked from the dollar, there is reason for optimism; there is reason to believe any price shakeouts orchestrated by the commercials will be smaller than expected before September 2005 going forward. This is good news for gold bulls.

Forget About Oil?

Some have speculated that gold is starting to decouple form the dollar because it is reacquiring its historical relationship with oil.  I disagree. If a quantifiable gold/oil relationship existed this would mean that a rising price of oil has a constant and predictable inflationary impact.  It doesn’t. Rather, arguing that gold/oil ratio trends since Nixon closed the window are important is kind of like saying the 1990s stock market mania ended badly because equity investors suddenly awoke one morning and starting paying attention to the historical relationship between stock prices and P/E ratios.  They didn’t.

For that matter, the latest rally in gold has not been as tied to oil as many think. After all, when oil was gushing above $70 a barrel in late August gold was languishing around $434 an ounce. Suddenly, as the price of oil declines, gold takes off on one its most powerful rallies since the gold bull began?


That said, while the relationship between oil and gold is not a strict one – meaning don’t expect any historical ratio to predict what will happen to either commodity tomorrow - it is worth remembering that oil has a negative, albeit dwindling, impact on price inflation in the US, and gold is well regarded as a hedge against inflation.  In other words, there is a connection between rising oil and rising gold – a positive connection that has been on display in each of the last three years.


Obviously at some point rising oil will negatively impact US consumer demand and/or help spark recession, and this could lead to a serious decline in the price of oil. It is at this point when the gold bulls will turn in their gold/oil ratio dreams, and once again place their attention on the US dollar.

Conclusions

New highs in silver would help confirm that precious metals fever is getting contagious. Similarly, new breakout highs in the XAU and/or HUI index would be confirmation that the latest rally in gold has legs.  As it stands now gold rallied to 18-year highs and nothing – not silver, gold stocks, or the US dollar – have confirmed the move. This does not bode well for the price of gold in the near-term. 

What also does not bode well is the fact the commercials are still adding to their net short position. The current (as of Sept 20) commercial net short position stands at 203,454 contracts, or the highest tally since December 17, 2004 (there is no need to rehash the massive $43 spot sell off that took place after December 17, 2004). All that is required to say is that bull market optimism does not spread when prices are standing still, and baring a dollar crisis the commercials appear ready to go to record lengths to stop gold from rising any further.

Before getting too negative (in the beginning I said something about not raging that the commercials were about to instigate a massive price collapse), remember that in each of the last three years gold has reached yearly highs in the month of December. Remember also that another history lesson that has been covered on numerous occasions in this space before has come to pass:
 
“…the best time to buy gold is in late August (or before open interest is expected to rise dramatically in Sept/Oct).”

In short, backed by positive supply/demand fundamentals, a weak US dollar outlook, cornered commercials, and positive seasonal forces, the outlook for gold in the near term is positive.  Yes, there will be price declines (probably in the immediate term) and moments of doubt, but for the remainder of 2005 a serious price collapse appears unlikely. One key level of psychological support is $450.

The commercials may not rake in great profit at say $450 an ounce, but reducing their net short position during price pauses may be the only strategy they have left.


“Old gold scrap fell a hefty 11% in the first half despite higher prices…Growing accustomisation to prevailing levels was, perhaps, the main driver of this fall.”  GFMS

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