Why Gold?

The following article concludes that in the current economic environment, regardless of your predisposition as an investor (optimistic, pessimistic or neutral) the message of the charts is that a long term oriented investment in gold and/or gold shares will be prudent.

Because technical analysis is now the subject of such intense interest by so many investors across the World, the short term chart signals are sometimes (and increasingly) confusing. For example, in the past two days the $XAU has risen around 10% from its low. Volatility of this nature is extraordinary in the context of compound Returns On Investment of around 15% p.a.- including dividends - generated by the stock market as a whole over generations,

There is a technique which veteran analysts use (those of us who are "investment" oriented as opposed to "trading" oriented) to cut through all this noise, and that is to ratchet backwards and look at the markets through the other end of the telescope.

This can be achieved in two different ways:

• We can look at longer term charts (weekly, monthly, quarterly)
• We can set our instruments to ignore any apparent signal until the price (or ratio) has moved (say) 2.5% to 3% beyond the absolute arithmetic point at which the signal was given.

The following two charts (courtesy stockcharts.com) provide an important example of this. They reflect the Price of Gold as divided by the Commodities Index. It can be argued that this particular relationship reflects the view of the market as a whole regarding whether (or when) the World's economy will begin to spiral out of control.

For the purposes of clarity, gold may either be looked at as being a conventional commodity that is used in jewellery and specialised electronics applications; or it can be looked upon as "the currency of last resort" in the event of a loss of faith in "Fiat" currencies.

In this context there are three possible scenarios relating to a chart of the ratio of $Gold:$CRB:

• If the gold price is moving sideways relative to commodities then it is objectively (and without doubt) being viewed by the market as a commodity.
• If it is rising relative to commodities - but has not yet reached a new high relative to commodities - then it may be regarded as being potentially the currency of last resort.
• If it rises to a new high relative to currencies and, because of the propensity of the market to react in a knee jerk fashion to technical breakouts, continues to rise at least 2.5% to 3% beyond the breakout - then gold will have entered a new era and will have emerged from its cocoon to once again become viewed as the currency of last resort.

When you cut through all the smoke, mirrors, opinions, debate and static, the above three scenarios are exhaustive. It is beyond the bounds of logic that gold will fall (in a Primary sense) relative to commodities because - in the end analysis - gold has wide ranging practical applications by virtue of its malleability and its imperviousness to oxidation. These two characteristics combined render it unique.

The 2.5% X three box reversal Point and Figure chart below shows that from 2000 to 2004, gold was rising relative to commodities, but that at some time in 2004 (P&F charts are not plotted relative to time, and the dates are merely inserted as a convenience) gold broke DOWN relative to commodities.

Note that the "X"'s represent rising prices, and the "0"'s represent falling prices, and an X or a 0 will only be entered to follow a 0 or an X if the price has reversed 3 X 2.5% or 7.5% from the direction in which it was previously travelling.

On any horizontal line, the number of blocks that have either an X or a 0 represents a level of consolidation, and following a breakout to a new high or low from that consolidation level, analysts have found that the extent of the breakout is very often related to the extent of the consolidation. Thus, as an example, if you count 4 blocks of consolidation across, and there is a break out from that level, the extent of the move will often be found to be at least four blocks, and sometimes a multiple of four blocks. There is no rational (that I am aware of) as to why this should be so. It is a relationship that has been discovered through empirical observation and should be taken as merely one tool in an arsenal of technical tools. For the sake of completeness, there is another technique - called a "vertical count" technique - which draws a relationship between the extent of the previous move and that of the anticipated move; as is also measured in numbers of blocks. Proponents of the vertical count target argue that the number of blocks in the coming move will (following breakout) be at least equal to the number of blocks in the preceding move - whether that move was up or down.

The reader's attention is drawn to the horizontal level of 148.45 on the chart below. If you count the number of uninterrupted blocks across, you will see that there are 18 (eighteen) blocks. 18 X 2.5% = 45% and, should gold ever break to new highs relative to commodities, in terms of this measure it can be forecast that the ratio will rise by at least 45%. Some will argue that the move will be 45% above the 148.5 level, whilst others will argue that the move will be 45% from the point of breakout to a new high, or from 163.86. (or 159.86 given that the break above that level turned out to bde false)

Importantly, this will be a breakout of a RATIO. It says nothing regarding where either underlying number will move in an absolute sense; and it also says nothing about the time horizon. Thus, if we are heading for an era of inflation, if commodities should rise 50%, then gold will probably rise 50% more than 50%. However, if we are heading for a period of deflation and commodities should fall by 33%, then the gold price might just stay at its current level.

Importantly, the first chart below shows that gold has recently been in a period of decline relative to commodities because the most recent series of entries has been 0's. In this context, the ratio will need to rise by at least 7.5% (3 X 2.5%) from its bottom level of 144.83 (see left hand scale) - to 155.7 - for gold to be regarded as having entered a new interim rising phase relative to commodities. In the process, it will add another horizontal block and the horizontal measured move will then be 19 X 2.5% or 47.5% following any possible breakup.

The second chart below is most intriguing, because it shows a subtly different picture.

It is a 3% X 3 box reversal chart and, in context of my opening remarks above regarding volatility, it shows that gold has yet to enter an interim bear phase relative to commodities because the most recent series of entries has been rising X's.

i.e. Notwithstanding the fact that the ratio is currently 147.07, this level is not more than 9% (3 X 3%) below the previous peak, and an entry of the 0's is not yet appropriate.

Having said this, another interesting observation is that the number of uninterrupted horizontal blocks is fewer than in the 2.5% chart at its maximum breadth point of 148.63. There are only 9 blocks - representing a potential 27% move following a breakout.

Importantly, the breakout level would be at 162.41 - which represents a triple top.

Clearly, if the 3% X 3 box reversal chart is the dominant chart, then the price of gold relative to commodities is likely to be far less volatile than it would be if the 2.5% chart were dominant.

Before launching into a "so what?" analysis, let's see if the commodities charts can throw any light on this question of inflation vs deflation.

The 2.5% chart of the $CRB below shows a breakout; with the horizontal count target being not significantly higher than current level. Importantly, though, there has been a breakout and, if you accept the vertical count target method (which I am reluctant to do at this point), the move should finally culminate at a target that is around 20% higher.

Interestingly, the 3% chart has yet to give a further buy signal - ie the jury is still out regarding inflation, and the Primary trend at this point is still down, notwithstanding the X's. On the other hand, should a breakout materialise, the vertical count target can be seen to be significantly higher than the current price - ie roughly 45% higher.

Analysis

The market is yet to pass judgement on whether inflation will prevail over deflation, but the inclination appears to be leaning subtly towards inflation.

In this event, as a matter of pure subjectivity, I would lean towards the 3% chart of the RATIO as being the dominant chart. There is no objective justification for this view. It is merely the product of my own judgement.Under circumstances such as this, the gold price will probably rise about 27% higher than the commodities index, and a holding in gold will represent a "win" situation because holders of gold and related investments will be ahead of the inflation curve; and as commodities in general rise by up to 45%.

It will follow under these circumstances that the gold price itself will have a minimum final destination of $420 X 1.45 X 1.27 = $773 - or slightly higher if the measurements are taken from the point of breakout as opposed to the level of consolidation.

In the event of deflation - and again as a matter of pure subjective judgement - I am more comfortable that the 2.5% chart of the $Gold:$CRB ratio will probably prevail. Thus, provided I have a high proportion of my assets in gold and gold related investments, any decline in pricing of my assets in general will be afforded a reasonable modicum of protection by a less violent (if any) decline in the value of my gold holdings. There are some who will argue that the gold price might even rise in an environment of deflation, but I am unable to get my head around that argument. Yes, it is possible that cash "might" be thrown at gold during deflationary times, but cash is likely to be at a premium under such circumstances.

It is only if Fiat currencies are no longer accepted as media of exchange that gold might rise in price in deflationary circumstances, but woe betide us if this happens because there will certainly not be enough gold to go around.

Conclusion

The proportion of your investment holdings represented by gold and related investments will depend on your personal pre-disposition.

If you are at this point in time an aggressive investor (anticipating inflation) you will probably (paradoxically) put a small proportion of your investments into gold. However, if you are a defensive investor (anticipating deflation) - as I am - you will probably (paradoxically) put a large proportion of your investment holdings into gold.

Why the paradox?

The state of mind of an aggressive investor is such that he/she is predisposed to see upside in most opportunities and, under such circumstances, "prudence" - in the form of portfolio balancing - is called for. In an environment of inflation, one would spread one's investments across a portfolio of commodities - including (say) oil, and anticipate that some would outperform others.

Conversely, the state of mind of a defensive investor, at this point in the long wave economic cycle, is that there is a reasonable probability that the propensity of Central Banks to print yet more money will be negated by an increasing propensity for the public to save. i.e. As was the case in Japan, the velocity of money will likely slow down, and this will cause the multiplier effect to implode. It will follow under such circumstances that most asset classes will experience absolute price declines. In turn, this will cause a rise in the number and value of debt defaults - which will cause deflation to feed on itself.

Under the latter circumstances, the "safest" place to park one's hard earned capital will be in gold and related investments, and that is why you will (as I have done) put a significant proportion of your assets there.

Overall Conclusion

Arguably the most important chart in the world of finance today is that of the ratio of $Gold:$CRB because it shows that at present, the world economy is still perceived by the markets to be under the control of the world's Central Bankers.

Those with an optimistic bent will "hope" that gold does not break out relative to commodities, because this will allow for "normal" investment and wealth creation activities as we all go about our "normal" business.

An investment in gold and related investments - at this point in the Long Wave cycle - appears to be a no lose situation. Cutting through the day-to-day static caused by excessive speculation and the resulting volatility in share (and bond) prices; we arrive at the final conclusions as follows:

• If the chart of the $Gold:$CRB ratio continues to consolidate in a sideways pattern, life will carry on as normal, and we can go about our normal day-to-day business with peace of mind. Under these circumstances, however, it is unlikely that our gold investments will generate significant profits.
• If the chart ratio breaks to new highs in an environment of inflation, we can anticipate that an investment in gold will represent a "win" relative to commodities in general (but not necessarily relative to all commodities individually)
• If the chart ratio breaks to new highs in an environment of deflation, we will want to be debt free, and to be heavily invested in gold and gold related investments in order to protect our overall net worth as best we can.

I think it's fair to say that the investment environment today is more difficult than I have ever experienced in the past 35 years of watching the markets, and that in this context, "trading" the markets may be thought of by prudent investors as an exercise in Russian Roulette.