Let's take a break from the broad market woes to talk about gold. Since
the day I mentioned that GLD filled its gap, gold has fallen 5%. Conversely, if you had purchased DZZ (UltraShort Gold ETN) on the 14th or 15th based on
my hint to do so, you'd be up as much as 20%. Meanwhile reports of supply shortages in the bullion market (i.e., gold coins) aren't jibing with the precipitous fall in the price of gold. I want to take a little detour first and discuss the significance of gold before delving into the technical aspects of its chart.
Not too long ago, gold was the tangible asset underlying dollars. Every dollar was a claim against some amount of gold, and thus the dollar was known as the "gold standard," eventually becoming the world's reserve currency. Why not—it was redeemable for gold, which for millennia was what humans had deemed fit as a medium of exchange and store of value. Over the course of the 20th century, the dollar-gold relationship lost much of its luster as modern economic theory took root, and the importance and centrality of gold as the basis of the dollar became increasingly compromised. During Nixon's presidency, the relationship between gold and the dollar was finally severed. From the mid-70s onward, every dollar has been a claim against words spoken by the US government, so air, really. We've had the "mold standard" as the global reserve currency for 30+ years; I think we'll soon see how well this experiment has turned out.
Alan Greenspan in 1966 wrote a marvelous piece titled
"Gold and Economic Freedom", which I first read in Ayn Rand's great but dated essay collection
Capitalism: The Unknown Ideal
. The essay highlights some very interesting phenomena. Prior to the creation of the Federal Reserve, banks' reserves were gold—not CDs, not government securities, agency debt, Icelandic krona or whatever passes for bank reserves these days. Gold acted as a check against foolish behavior. If banks were too loose with credit (think financial bubbles), they'd run out of lending ability because they'd hit the limit on their gold reserves. To avoid a bank run they'd have to curtail lending. Interest rates would then rise, reflecting scarcity of supply, borrowing would slow down and recession would hit. Then the cycle would start anew. This was the boom-and-bust cycle that characterized the economy prior to WWI.
Well, some economic brainiacs (precursors to the financial wizards that invented collateralized debt obligations, the stuff that brought down Wall Street this past year) thought this was dumb and decided gold was the problem. What if banks had more reserves? Then they could lend out at will, the economy would grow indefinitely and we could permanently avoid severe recessions. Just increase your reserves! Since you can't spin gold out of thin air, the Federal Reserve was created. The Fed (via Treasury) has the power to issue debt ("paper reserves") and use that to give "value" to the dollar. So now the thing underlying the dollar is no longer a tangible asset (gold), it is an I.O.U., a promise made by the government against future tax revenues, a liability! Nowadays banks can hold gold as well as paper reserves. What do you figure the ratio is between your bank's gold reserves and its paper reserves? 1:100,000 is probably too generous.
The interesting thing about nature, specifically the law of identity, is that you can't cheat it. In terms of the current financial crisis, loose lending based on a seemingly limitless supply of paper reserves got us into our current pickle; and now the government's solution—bailout, money market guarantees, nationalization of banks and related entities,
de facto creation of a sovereign dearth fund—is to issue more credit???!!! You can't create something out of nothing for nothing; it comes at a price, and the price here is looking like currency collapse. For argument's sake, imagine that the national debt stood at a quadrillion dollars. If you owned government debt, how comfortable would you feel that the money you loaned would get paid back at all, let alone with interest? US government debt is debt that Treasury expects to repay from future tax revenues—i.e.,
what we pay to the I.R.S. every year. Somewhere between the current national debt figure of $10.5 trillion and $1 quadrillion is a tipping point where the dollar will cease to be good. Because at that point, so much would be owed that only default or debasement (the printing of dollars) will appear as viable options. At that point, our national currency will become the New Dollar, and an old dollar will be worth about as much as an Icelandic kroner. Gold, which cannot be debased as it is a scarce resource (unlike paper), would hold up its value; hence its attractiveness. Even as the price of gold has been dropping, gold coins have been selling out at coin dealers everywhere. Usually, when supply tightens, the price of the good goes up (think short squeeze), so this is a rare circumstance indeed.
Now to the technical aspects of gold. Gold's chart history is short because it moved with the dollar until the 1970s. The other interesting thing about gold (and oil, for that matter) is that its Elliott Wave cycle is not related to the general market cycle. While the recent plunge in equities was a warning shot portending
a multi-generational bear market to come, the recent plunge in gold was merely a pullback within a secular bull market. In 1980 gold hit its Cycle 1 peak, and then Cycle 2 lasted for about 20 years. We are currently tracing Primary 2 within Cycle 3. The chart below depicts price action in CEF, a Canadian fund whose holdings are solely gold and silver bullion, from 1993-present. This security is a proxy for gold itself.
Notice that from late 2000 until early this year, gold put in 5 stark waves up, and then from January until now has traced an a-b-c correction. As usual, the C wave is the fiercest of them all, falling farther and faster than anyone thought possible. Gold could correct even farther, but it cannot fall below the beginning of Wave 1 in 2000, and probably won't get much lower than the bottom of Wave 4 in mid-2007. The best news of all is that once gold stops correcting, it will begin Primary 3 of Cycle 3. Typically Wave 3 of 3 is one of the most bullish. So I will be watching the gold sector for signs of life and a good setup in the coming weeks.
