Monday April 22, 2013 13:44
APRIL is the cruellest month, breeding
Lilacs out of the dead land, mixing
Memory and desire, stirring
Dull roots with spring rain.
“The Waste Land,” T.S. Eliot
Few would question that April has been cruel for gold and copper. Comex gold started the month closing at $1,600.90, near the middle of a tight trading range initiated mid-February – pretty quiet action for the yellow metal after trending down from its $1,800+ high set in October. By April 15, gold closed at $1,361.10; a drop of nearly $240 per ounce. To date, the intraday peak-to-trough is an even more alarming $280, with gold plumbing $1,321.50 on April 16. The intraday spread from October is $482 per ounce – a vertiginous 27% descent into bear country. Friday the yellow metal rallied some to close at $1,395.60 per ounce.
The travails of the red metal are less severe on a percentage basis, but very bearish nonetheless. Friday scored a Comex closing low of $3.1485 per pound for April after nearly breaking $3 per pound the day before. This compares to an April high of $3.4525 per pound and a February high of $4.0160. On an intraday basis, the spread from the 2012 high to Thursday’s low crosses the 20% bear threshold with a 24% decline.
Surprisingly, the gold-to-copper ratio, or GCR, remains relatively stable – the doldrums compared to the high seas of currency price variations.
My March 25 commentary looked at a history of the gold-to-copper ratio from mid-2006 to the present and noted that the period following the August 2011 debt downgrade was increasingly tame compared to the tumultuous jolts of the prior years which included the Great Recession and the initial shock to commodity markets directly after the downgrade. In this light, the events of April failed to derail stabilization of this important metric of relative valuation. An ounce of gold fetched 463 pounds of copper at the time of the March commentary; Friday closed at 443 pounds, a decline of less than 5%. In July 2006 an ounce was worth roughly 200 pounds.
Gold not only increased its value relative to copper in the last 6-1/2 years but the valuation has remained resilient to short-term dollar price volatility (Note 1). I believe as long as gold maintains a growing premium to hard assets like copper, its long-term dollar-denominated prospects are good.
Presently, gold has a high correlation with the red metal and other key commodities (Note 2). Gold ratio stability and the longer term value uptrend serve an important role in understanding the future direction of both metals. If either or both breakdown, there could be more cruel months to come.
Gold-to-copper ratio stability
My March 11 Kitco commentary looked at the stability of the gold-to-copper ratio as a powerful tool to divine market direction. Figure 1 is plot of ratio stability from July 20, 2006 to this Friday’s close:
Figure 1 – Gold-to-Copper Ratio & 6-1/2 year trend
In this context, stability is defined as the standard deviation of the ratio normalized by its mean over a rolling 1-month period (red curve). The green line is an average stability of 3.2% from mid-2006 to the present. A stability factor above the mean is considered potentially divergent; and below average to be “very stable” (green arrow). Divergence typically occurs during periods of high market stress. As a matter of practice, I use a threshold of 3% to trigger a divergence warning. The 6-1/2 year period coincides with a time that gold has gained relative value relative to copper (Ref 2, Note 1).
The data and exponential fit (dashed line) within the dotted ellipse of Figure 1 is a period following the Aug. 5, 2011 U.S. debt downgrade from Sept. 1, 2011 to the present. As suggested by the model, this is a very stable time with most of the curve falling below the mean. Furthermore, stability has steadily improved until very recently - the stability factor Friday was 3.62%, moving away from the model at 1.25%. Although this departure signals a divergence warning, the deviation is only 1.2 standard deviations, or 1.2-sigma, from the exponential model.
This is in stark contrast to the highly divergent spikes during the Great Recession (13.7 % October 2008) and shortly after the credit downgrade (10.0% Aug. 22, 2011).
Gold valuation trend relative to copper
Figure 2 is an update from my Feb. 25 commentary of the gold-to-copper ratio (GCR) and a 6-1/2 year linear regression model plotted from early-August 2011 to Friday’s close:
Figure 2 – 6-1/2 year gold valuation trend relative to copper
The day-to-day GCR data are shown by red diamonds and lines. The solid green trend line that moves from the lower-left to upper-right corner represents ratio expansion (i.e. gold gaining value relative to copper). The dashed green line establishes a plus 2-sigma boundary from trend; the dashed red line, minus 2-sigma. The 3-month GCR moving average is given by the solid red line.
My Oct. 30, 2012 commentary noted a rather dramatic mean reversion to the gold valuation model at that time (shown in Fig.2 as a dotted green line). Last fall witnessed the day-to-day GCR, 3-month average and long-term trend all converge. The average and trend not only converged in magnitude but also in slope making this period (dashed ellipse) particularly notable and justifying “The Grand Reversion” and “Reference Model” monikers for the reversion period and trend model respectively.
Given the current and reference models, it is reasonable to question whether the long-term trend is breaking down. The green and dotted green lines are still nearly coincident which is positive for gold - a significant change in slope between the two would be troubling indeed. On a more bearish note, the GCR finds itself in a descending channel of ratio compression since early November 2012 (light-blue lines, gold losing value to copper). If this continues unabated, the current and reference models will diverge in slope signaling a breakdown in the long-term trend.
I do not consider the gold value uptrend to be challenged until the deviation from trend is greater than 2-sigma (dashed red line). On Monday April 15, the GCR departed from the current trend by -1.18-sigma (dashed orange line) and then recovered with a ratio expansion to near the 3-month moving average by the close Friday. The corresponding maximum deviation from the reference model was -1.25-sigma. By Friday these deviations had declined to -0.75-sigma and -0.83-sigma respectively. None of these deviations are at a level to statistically infer a breakdown in the long term gold value trend. Furthermore if the GCR continues its present expansion and crosses the 3-month average, there may be greener pastures ahead for gold price.
Is April the Cruelest Month?
Kitco’s Debbie Carlson included my most recent view on gold’s challenges in her weekly metals outlook column (Ref. 3):
“The new dichotomy for gold is a strong pickup in physical buying in Asia balanced by continued outflows in gold exchange-traded funds. This will probably limit the upside for the yellow metal against a backdrop of bearish influences including fear of gold liquidation by central banks in the troubled southern countries of the eurozone and the eventual unwind of the Federal Reserve from its present generously accommodative policies…”
She found a majority of participants in the Kitco Weekly Gold Survey (Ref. 4) are bullish for gold prices this week although less certain about the near and longer term direction.
Copper faces the headwinds of brimming Shanghai and London Metal Exchange inventories, falling expectations for global growth and upticks in mining production (e.g., copper giant Freeport-McMoRan reported Thursday that copper production rose 18% in the first quarter).
To answer the question begged by the title of this commentary, it is encouraging that the GCR stability has not spiked to the extreme divergent levels of the recent past and the valuation trend remains, at least statistically, on solid ground. The descending channel of gold’s loss of value to copper is concerning (red arrow, Fig.2) but could reverse with a sustained movement above the 3-month average.
If copper bearishly falls to the $3 per pound level again, a trend-breaking 2-sigma deviation (i.e. a GCR drop to 365 pounds per ounce) would imply $1,100 per ounce gold – a number even below Goldman Sachs recent bearish estimate for $1,270 gold by 2014 (Ref. 2). Conversely, gold returning to Goldman’s 2013 estimate of $1,450 would require copper to rise to nearly $4 per pound to meet the negative 2-sigma criterion, a price level far beyond the most optimistic near-term predictions for the red metal. So perhaps, April will prove to be the cruelest month for copper and gold even though significant challenges lie ahead for both metals in 2013.
It is likely then that the next few weeks will witness the red and yellow metals muddling within trading ranges, “stirring dull roots with spring rain.” Look forward to Lilacs.
Note 1: The 6-1/2 year record for this analysis is Jul. 20, 2006 to Friday’s close, April 19, 2013; a total of 81 months.
Note 2: The 1-month rolling correlation of Comex copper and gold is +0.89; the 3-month is +0.85. With respect to another key commodity, the 1-month rolling correlation of Nymex WTI crude and gold is +0.88; the 3-month is +0.83.
Ref 1: Oil, Copper & Gold – All in the Family (Richard Baker, Kitco commentary, Jan. 22, 2013)
Ref 2: Goldman Sachs Says It's Time to Short Gold (By Katy Barnato, CNBC, Apr 10, 2013)
Ref 3: METALS OUTLOOK: Tug-Of-War Action Possible For Gold Next Week (Debbie Carlson, Kitco News, April 19, 2013)
Ref 4: Gold Survey: Survey Participants See Higher Gold Prices Next Week (Debbie Carlson, Kitco News, April 19, 2013)
By Richard Baker, CP Value Analytics