Be of Stout Heart

By Howard Katz    Jul 13 2009 10:30AM

Gold bugs went to the wall on Wednesday as the price of gold dropped just shy of 20 points. What to do? Is this the tail end of a decline (and a time to buy)? Or is it the start of a bigger decline (and a time to sell)? A great deal rides on the answer to this question, and this is the question I address in the One-handed Economist of July 10, 2009. For the full answer, you will have to send in your subscription, but here I can at least give you a few hints.

Over the past few months, we have discussed many of the common chart patters. We discussed the saucer (or rounding) bottom, an example of which occurred at the bottom in gold stretching from 1998-2002 and signaling the advance of the past 8 years. We discussed the symmetrical triangle formation, which occurred over the heart of 2006-07 and predicted the advance in gold to $1000. We discussed the ascending triangle formation which is taking shape in gold right now and is predicting an advance beyond the $1000 level. We also discussed the double top pattern which has formed in the U.S. dollar since last November and which (if it can break below 78 ¾) will signal a decline in the dollar to new low ground.

But to solve the problem of this past week’s action, we must introduce another pattern. This is a very powerful and common pattern called the head and shoulders bottom. A head and shoulders bottom is a chart pattern which, if turned upside down, roughly resembles a man’s head and shoulders.

Above is the chart of the HUI over the past year showing a head and shoulders bottom. Crucial to the head and shoulders bottom (or top) is the neckline. This is a line connecting the left shoulder to the right shoulder. The neckline defines the upper boundary of the head and shoulders bottom, and it plays the same role as the horizontal line in an ascending triangle. It is the line which, when penetrated on volume, completes the formation and tells us that it is valid.

A very interesting aspect of all head and shoulders patterns (both tops and bottoms) is the point count. Once the neckline has been penetrated, the formation is considered valid.  (A rise in volume on the penetration is necessary if it is a head and shoulders bottom but not if it is a top.)  There is then usually a pull back to the (now broken) neckline. Then, over a period of time the formation moves to its price objective.

The price objective of a head and shoulders bottom is calculated by measuring the (vertical) distance from the bottom of the head to the neckline. This should be done on a semi-log chart because what we are interested in is the percentage distance, not merely the point distance. For the HUI, the bottom of the head is 151. The neckline at that point is 350. This is a percentage gain of 2.3 times. We then project this 2.3 times multiple from the point where the breakout occurred (340). This gives us a price objective of 782. This would be a very nice move and would imply a gold price above $1500. The HUI chart ran in the 6-26-09 issue of the One-handed Economist as part of our analysis of the forces on gold and the gold stocks.

The Commodity Pendulum

One of the principal reasons that I am aggressively bullish on gold at this point in time is my theory of the commodity pendulum. I originated this theory in 1996 and have not seen it picked up by any other market analyst (although they are welcome to it, proper credit requested). The theory is simplicity itself; yet the implications, both for the price of gold and many other goods, are astounding. Indeed, if you do not understand the commodity pendulum, then you are stumbling around in the dark, and your ability to predict the financial markets is definitely impaired.

In 1963, Milton Friedman and Anna Schwartz published A Monetary History of the United States. This covered a century of American history and studied the money supply and the price level. They found that, whenever the money supply rose, then the average level of prices rose about 1-2 years later and about 3-4% less. For example, if the money supply rose by 10%, then 2 years later the average price level might rise by 7%.  Since U.S. population was increasing by 3-4% per year during this period, what this means is that per capita money supply predicted the price level by 1-2 years.

This worked nicely for a hundred years. But then in the 1970s the price level began to run ahead of the money supply. In the late 1970s, the worst year for money growth was 8% in 1978, but in 1979 prices rose by 13.3%, the worst year in American history. I scratched my head but could not figure out what was going on.

Then in the 1980s and ‘90s, the opposite happened. The money supply exploded rapidly, but the price level did not respond. During this period prices were rising at a rate well below the money supply.

By the mid-‘90s, I had it figured out.The whole thing started with the Kennedy tax cut of 1963. That was the start of budget deficits and money creation on a regular basis in American history. Prior to that time money had only been created during the emergency of a war. After 1963, money was created on a regular basis. Now let us look at commodity prices over the past half century:

When the U.S. started printing money in 1963, commodities, at first, did not respond. This illustrates an important fact. Economic goods differ in how quickly they respond to an increase in the money supply. For example, prices go up faster than wages, showing that the conventional mantra that wages are pushing prices higher is garbage. Every single time there has been an increase in money, prices have gone up first, and wages have only followed at a later time. Cost push inflation is a lie.

What the above chart illustrates is that, when money is increased, then commodities lag even more than wages. Here commodities lagged by 8 years. By this time, consumer prices were quite a bit higher. Then in 1971, commodities, being undervalued in real terms, exploded to the up side.  Now commodities were rising more rapidly than consumer prices. The result was that the commodity increases fed through into consumer goods and pushed them up more rapidly than the money supply. A good example was the rise in crude oil pushing up the price of gas-at-the-pump. As “inflation” began to hit the headlines, the Fed tightened. The stock market declined, and interest rates went to 16% (T-bills). This is the upswing of the commodity pendulum: commodities up, interest rates up and stocks down.

But by 1980, commodities had gotten overvalued. As they started to decline, this decline fed through into consumer prices. It was not enough to cause them to decline, but they did rise at a slower rate. In the ‘80s and ‘90s, consumer prices under performed the money supply, and the media invented the word “disinflation.”

By 1999, commodities had fallen so far in real terms that they were even more undervalued than they had been in 1971. I predicted at this time that what was in store was a massive rise in commodity prices which would lead to a large rise in consumer prices and which, in turn, would force the Fed to tighten.

The first downswing of the commodity pendulum (1963-71) lasted almost a decade, as did the first upswing (1971-1980). The second downswing of the commodity pendulum (1980-1999) lasted two decades. Therefore, my working assumption is that the second upswing of the commodity pendulum will last two decades (approximately).

If we look at the chart above, we see that the Commodity Research Bureau Index ran all the way up to 600 last year. When the general commodity sell-off hit, it declined, but note that it held at precisely the 1980 high (of 334). That is a long term support level, and it turned the commodities markets on a dime.

IMPORTANT NOTE: The current heads of the Commodity Research Bureau let themselves be talked into one of these modern pseudo-mathematical indexes (which is dominated by crude oil and is not representative of a wide range of commodities). To PR their new index, they named it the RJ-CRB index and renamed the real CRB index the Continuous Commodity Index. Without that no one would have used their new index because it is too heavily weighted toward crude. The new index has just a few years history, and anyway; if I want to look at the price of crude, I can just go to a chart of crude.  The old CRB index (which I chart above) is available at most commodity web sites under the symbol CI. This is the index with a long history from which we can draw inferences. E-mail your favorite commodity chart web site that the proper name for the CRB index is CRB (not CI or CCI), and do not be taken in by the RJ-CRB.

The commodity pendulum tells us that the next important thing to happen in the financial markets is that commodities will resume their rise. This will feed through into consumer prices, and consumer prices will start advancing rapidly. (This was starting to happen in mid-2008, as the 12-month year-over-year CPI was up by 5.4%, the highest in 17 years. However, the U.S. media did not notice it, and they are now so obsessed with the prediction of a future decline in prices, that they do not have the slightest clue.

The idea of the commodity pendulum is invaluable in helping me to predict gold prices. I know that commodities are going to race back to their mid-2008 highs. I know that there is no chance of a general decline in prices and a certainty of a general advance in prices. I know that the advance in commodities has, order of magnitude, another decade to run. Thus the $1000 peak in gold of March 2008 is analogous to its peak near $70 in 1972 or its peak at $125 in 1973. There is a long way to go. Also, when I saw the (very large) undervaluation of the CRB at the 1999-2001 bottom, I was prepared for a buy signal in gold. It came late in 2002 with the breakout of a giant saucer bottom at $340 (which I discussed in the 4-20-09 article).  At that point, I turned bullish on gold and have been long term bullish ever since.

The One-handed Economist is the only place you can find discussions of the commodity pendulum and applications of this idea to the price of gold (as well as other goods).  I want to announce to those who are interested that I am no longer associated with the web site, www.thegoldbug.net.  My new web site is www.thegoldspeculator.com.&nbs p; And my blog will appear at www.thegoldspeculator.blo gspot.com. 

The blog is a commentary on political and social events (no cost).  The One-handed Economist is a financial newsletter which predicts the various financial markets and comes to conclusions about specific actions you can take (be they stocks, commodities or other financial instruments).  Its price is $300/year.  I will try to hold this price for as long as I can, but with the wave of price increases I see coming I do not expect that that will be too long.  If you want to subscribe, then just go to www.thegoldspeculator.com and click on the PayPal button.

Thank you for your interest.

Howard S. Katz

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Howard S. Katz was one of the early gold bugs of the late ‘60s and ‘70s, turning bullish on gold in 1965. His favorite gold stock, Lake Shore Mines, went from $3/share to $39/share over the course of the seventies (sold at $31). Katz turned increasingly skeptical about gold as it mounted its final rise in 1979, and he called the top after the close on Jan. 21, 1980 (with gold at $825.50/oz.). Katz traded gold in and out during the ‘80s and ‘90s and once again turned long term bullish in Dec. 2002. His thoughts on commodities, stocks, bonds and real estate are available in a letter entitled The One-handed Economist and published every two weeks giving specific advice on trades in stocks and futures. This letter is available (both electronic and paper copy) for $300/year with a 3-month trial for $100. Send to: The One-handed Economist, 614 Nashua St. #122, Milford, N.H. 03055.(Include both electronic and mailing address.)