Steven Hochberg, Elliott Wave International, Challenges Some Common Assumptions About Gold
Source: The Gold Report (10/19/07)
Steven Hochberg, Chief Market Analyst for Elliott Wave International, tackles the tough questions about gold's role as a safe haven and its up-and-down relationship with the dollar.
Here Hochberg tackles the tough questions about gold's role as a safe haven and its up-and-down relationship with the dollar.
TGR: In our interview earlier this year (posted 5/29/07), you indicated that gold was about to drop toward $450. (Gold had tested $699 in April and had since come off by $50.) You also said that in April's retest of the February high, investor optimism had reached 90% (according to the Daily Sentiment Index), and that such extremes typically mean that a gold rally is in its late stages.
How does gold's current rise make sense in the context of Elliott Wave Theory, when your forecast six months ago presented a completely different scenario?
SH: R.N. Elliott chronicled 11 separate corrective patterns and/or combination of patterns. Most unfold as A-B-C waves to correct an overall up trend. The first leg down is wave A, an intervening rally then develops as wave B, followed by a final leg down which is C. The C leg often draws prices beneath the A leg. In gold’s case, the A leg bottomed in either June or October 2006, and since then the B leg has been underway. Depending upon the pattern, the B leg can either top beneath the origin of the A leg, or modestly past it prior to the start of the C leg down. Gold’s B leg has pushed past the start of the A leg (May 2006), which is a pattern that Elliott called an “irregular top.” In turn, the C leg down should fall below the end of the A leg, and complete all three legs of the A-B-C correction.
Frost and Prechter in their classic book, Elliott Wave Principle, described B waves as “phonies,” “sucker plays,” “bull traps” and “speculators’ paradise.” They are often “unconfirmed” by other averages and “are virtually always doomed to complete retracement by wave C.”
With this in mind, we see three pieces of evidence that support the B leg interpretation of gold’s upward push since June-October 2006. First, the advance is “unconfirmed” by silver so far. Silver, the higher-beta precious metal, is still lagging noticeably beneath its May 2006 peak. Second, market analysts, commodity trading advisors and short-term traders are back at an extreme in optimism, which historically has suggested a trend reversal is near. The Daily Sentiment Index recently pushed back to 90% gold bulls, as did Market Vane’s Bullish Consensus. Both measures mirror the excessive optimism that accompanied the May 2006 high, which led to a 26% decline in spot gold in a little over a month. Even the intervening April high led to an 8% decline before the current rally within the B leg started. And third, the Elliott wave structure of the advance supports the B leg interpretation. Without getting into Elliott wave minutiae, the overlapping waves over the past year are most typical of an upward correction.
The evidence best supports the view that the next significant move in gold will be a C leg that falls beneath the A leg low. If this evidence changes, we will tell our subscribers immediately.
TGR: On a recent Elliott Wave web site, you posted a "Pop Quiz regarding the relationship between the Dow Jones Industrials and Precious Metals." The "correct" answer is that there isn't an inverse relationship between the two markets. On the contrary, your theory contends "all seemingly disparate markets are rising and falling together as liquidity levels expand and reverse. This is not the earmark of INFLATION, but rather, identifies an altogether different economic condition."
How would you describe this "altogether different economic condition"?
SH: Many gold bulls are perpetual inflationists. Our view is different in that we don’t think inflation is a one-way street. They believe the Federal Reserve is printing massive amounts of greenbacks, which stokes inflation. But the growth in Federal Reserve Notes has not been the principal cause of inflation over the past quarter century—it is the growth in credit. The United States has not so much had a currency inflation as it has a credit inflation. And credit expansion (inflation) and contraction (deflation) is a function of psychology, not paper and ink coming from printing presses. We cannot stress this point strongly enough. When mass social mood turns from aggregate optimism to pessimism, the unfolding credit expansion of the past quarter century or more will turn to credit contraction, which is deflationary. Cranking out more Federal Reserve Notes in all likelihood cannot stop the deflation, since credit can contract faster than Notes can be printed. Also keep in mind that the Fed is a quasi-private bank. They don’t want to trash their own balance sheet anymore than any other bank. In fact, in the Great Depression of the 1930s, the Fed refused to crank out notes. But let’s assume that they do decide to “print money,” it will only likely be in reaction to a deflation that is already occurring. In that case the outcome would be hyper-inflation (after the deflation), where the only asset you would want to own would be gold, which historically is true money. But this is all speculation. What isn’t speculation is the vast credit inflation that now weighs on the U.S. economy.
Our view is that credit inflation is a major part of the story—it explains why formerly disparate markets like stocks, commodities, gold, silver and housing are all moving more or less together. As credit expands, everything trends higher. As credit inflation turns to credit deflation, these markets should rollover and more or less decline in sync. We’ve seen the early signs of the turn from credit expansion to credit contraction, via the turn down in housing and many commodities. Stocks have been one of the last asset classes to hold up, but we think they are in the process of turning too.
TGR: Do you mean that gold and silver are not safe havens during periods of economic turbulence?
SH: Well, let’s look at two particular high-profile episodes of “turbulence” and see how gold behaved. Consider the stock market crash of 1987, since we are now “celebrating” its 20th anniversary. Most of us remember that the DJIA lost 22% in one fateful day of trading (October 19, 1987). What people may not remember is that gold was no safe haven from that terrible episode. Spot prices closed at $475.25 in May 1987 and on the worst day of the stock crash, closed at $481, less than $6.00 higher. The fact that it held together was fleeting because by mid-December, with gold prices only modestly higher ($499.75), gold started a decline that wiped away 29% of its value to a temporary low in September 1989. In fact, gold rallied with stocks from February 1985 until the top day in 1987.
Another example is the fourth quarter of 1990, when U.S. Gross Domestic Product (GDP) fell 3.0%, during a recession that lasted from July 1990 to March 1991. It was the single worst quarter of GDP in nearly 20 years! Spot gold prices declined from $410 in August 1990 to $354 by March 1991, down over 13% by the end of the recession. Eventually, prices fell to $328 by January 1993, down 20% from the August 1990 level. Was gold a safe haven during this period of “economic turbulence?” Gold is an asset class unto itself and has to be analyzed as such, in our opinion, not in relation to other asset classes.
TGR: There is little doubt that the sub-prime meltdown will continue to worsen (with more floating point mortgages coming due throughout 2008). The ripple effect will be more foreclosures, bankruptcies, restricted credit, loss of investor confidence, and even greater turbulence in the housing market. How big a shakedown do you forecast for the stock markets in late 2007 and 2008?
SH: Housing is a large part of the U.S. economy, yet is a relatively illiquid asset. Sub-prime loans and falling house values will be working their way through the system for years before prices return to equilibrium. This will occur irrespective of what happens in the stock market. In terms of equities, we see a historic degree of optimism and/or complacency toward the potential for a major market decline. For instance, a bullish plurality is now at an all-time record 256 straight weeks, as measured by Investors Intelligence Advisory Survey (dating back to 1963). And this is with stock market valuation levels off the charts. In terms of dividends—one of the more honest ways to value equities—the DJIA would have to decline by 25% to equal the dividend valuation on the top day in 1929, a level from which the index fell 89%. In our view, the massive complacency in the face of massive overvaluation is not the type of environment where one should place a large percentage of their portfolio in equities. In fact, short-term liquid investments such as 90-day T-bills (rolled over) have outperformed the broadest market index (DJ Wilshire 5000) since the start of this decade. We think this is a good place to be until it becomes popular, which appears to be a ways away.
TGR: In our last interview, you noted that "a big mistake pundits make is to assume there is a fixed correlation between the dollar index and gold." Nearly everyone seems to think this is what is happening now as the dollar continues to drop and gold rises almost in lockstep. How is it possible that so many fairly astute observers could be missing the point?
SH: That's a good question, and often I ask myself this because most of these people are exceptionally smart. But many of them also believe in a fixed correlation between the U.S. trade deficit and the U.S. Dollar. That is, as the trade deficit grows, the dollar must go down. Yet if one simply takes the time to plot a chart of the U.S. Dollar Index over the U.S. Trade Balance, the absence of a fixed correlation is so obvious that it jumps right off the page at you! There are times when the U.S. Dollar and gold trend in the same direction; there are times when they trend in opposite directions. If one wants to argue that there is a consistent negative correlation between the dollar and gold then, by definition, this negative relationship must hold true through all market cycles. If it doesn’t, then the argument for a consistent negative correlation becomes moot.
TGR: If the value of the dollar does not correlate with the price of gold, then what is the biggest driver of the precious metals market?
SH: The single biggest driver of precious metal prices is the same thing that drives every other financial market, namely human psychology. The aggregate swings from abject pessimism to sheer ebullience and back explain why supply rises or falls to meet demand. It is why demand increases and decreases. This is the true fundamental for all freely-traded markets. We study the Wave Principle so intently because it catalogues the patterns that mass psychology trace out, as it moves from one extreme to the other and back.
TGR: Richard Russell of Dow Theory Letters recently commented (9/25/07) that he no longer discusses Elliott Wave Theory in his newsletters (whereas he once did extensively) because he felt it has become too popular. He said that the spread of what he calls "Elliotteers" who misapply the use of Elliott waves has undermined the credibility of this analytical tool. Do you think this is happening?
SH: Russell’s an old pro and in his commentary he was kind enough to mention Bob Prechter and our firm Elliott Wave International. We think we provide the best and most complete Elliott Wave analysis in the world, which cuts through a lot of the haze. I urge people to check us out at www.elliottwave.com, where they can read our analysis and make up their own mind.