Sunday, August 10, 2008

The Bubble is Bursting

For this past week, commodities corrected quite dramatically, which, I am sure, has left many commodity bulls feeling somewhat nervous. If this is the case, I hope that this post will help assuage any doubts.

The first chart is that of the XAU. It is a monthly chart that goes back until 1981:

In my view, the XAU is still in a very powerful bull market. This is evidenced by the fact that over the last 6 years, we can observe a series of higher highs and lower lows. Furthermore, all moving averages are also positively aligned at the moment.

It is often said on financial news stations that gold or commodities are in a bubble. I could not disagree more strongly with this type of statement. One reason for my view is that if you glance at the above chart, you will notice that gold stocks are still at approximately the same level that they were at 25 years ago. I cannot come up with many other asset classes that are in this position.

For a bubble to occur, the general public must become over zealously bullish on a sector. This has not even come close to happening with gold and silver. As an example, the bank I am employed at offers a precious metals mutual fund. This fund fully makes up 0.03% of assets under management. Contrast this number to the prevalence of high-tech holdings seen during the late 1990's.

The next chart also should support gold's case. It shows the Dow Jones divided by the value of the Gold since 1981:

In the early 1980's, the the Dow and an ounce of gold had roughly the same value. During the 1980's the Dow and the price of gold began to deviate, as the Dow rose, and gold fell. This trend continued well into the 1990's, where the pace began to accelerate, ballooning to the point where the Dow could buy over 40 ounces of gold.

This trend lasted for 20 years, and extended 4,000% against the price of gold. However, since the year 2000, this trend has changed directions, and has been deflating remorselessly since then. This is the real bubble that wall street does not mention.

Since I feel that this concept is so important to understand, I have included the opposite perspective of the chart below. It shows gold divided by the Dow:

A few weeks back, I was listening to an interview with investment guru, Peter Schiff. When pressed for an eventual upside target for the price of gold, Schiff said that he thought that the Dow and gold will eventually have the same value. If this is the case, and I believe that it is, then the chart above has a lot more climbing to do.

Anyway, here is a monthly chart of silver:

Silver is in a similar situation to the XAU mentioned above. Obviously, it is in a very strong bull market as well, and this correction is not unlike the corrections we've seen before.

Keep in mind that these charts present a bullish case for gold for the long-term. I am not suggesting that gold will necessarily rise next week. In fact, I have no idea what will happen next week. For the short term, gold has been in a a very clear downtrend, and following the rules outlined in my previous post, I had no choice but to short gold stocks over the last 2 weeks, and I will continue to hold my shorts for as long as the short-term trend persists.

No comments: