Gold climbed above the $1,000 level earlier this month, marking the 3rd time since March 2008. After reaching the psychological level, gold has ranged between $985 and $1,025. It was able to sustain the $1,000 level for 2 weeks, but is currently below it. Further downside pressure below $980 would indicate a bearish signal in the short term and could form a double top near $1,030.
Gold benefits from inflation, i.e. the expansion of the money supply, and uncertainty. It’s a very telling story of US dollar strength, or in this case weakness. As Forex traders, we understand this pair concept well. Gold and other assets are paired with a currency, often quoted in US dollars. Gold prices rising can simply be the result of a weakening currency.
The same applies to other assets, including equities, like the S&P index. People often gauge the strength of an economy by its stock market. However, what that stock market is priced in can give wildly different results. For example, the following is a monthly chart of the S&P 500 priced in US dollars, gold, and oil:
The entire S&P rally from September 2002 to October 2007, substantial growth of over 100%, was only there in terms of US dollars. Priced in gold and oil, the S&P fell during that period and has been on a steady decline since 2000. A major reason for the difference is the inflation of the US dollar. That rally corresponds to the significant inflation by the Federal Reserve under Greenspan that created a bubble.
After the bursting of that bubble and a sharp decline, the S&P bottomed in March 2009 and has had 60% growth in about 6 months time. Are we in for another large rally in equities? What can we take from the previous experience and forecast this time?
Bernanke has inflated the money supply far greater than Greenspan, and thus we expect further significant weakening of the US dollar. This weakness will continue to cause asset prices to rise, in equities and commodities. If volume picks up and confidence remains, equities could very well return to their all time highs within a couple of years. However, several worrisome factors remain, such as US national debt, toxic assets, and commercial real estate, and these could shake the current confidence.
Growth in equities is often associated with a strengthening economy, but if it is a result of the currency being inflated, leads to higher prices on consumer goods, then sharply decline in a correction, what has that economy really gained? We can also expect another bubble, like Greenspan’s housing bubble. It is likely to show in equities and at least one sector of the economy, though which sector is unknown. There is always potential to gain in the short to medium term from bubbles, but it is not a wise long term investment as they end with a burst and very sharp decline.
Like the previous rally, don’t expect equities to significantly gain over commodities, such as gold and oil. For all the growth between 2002 and 2007, gold and oil strengthened over the S&P. Currently, the S&P is not quite at a bottom in terms of gold or oil, but both remain within a downward channel.
So we are bullish commodities, cautiously bullish equities, and bearish the US dollar in the medium to long term. In Forex, we are bullish the “commodity currencies”, i.e. the Australian dollar and Canadian dollar, which are correlated to gold and oil respectively. Look for opportunities to go long AUD/USD and short USD/CAD.
