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Gold Bubble, But Keeping My Eye on the Dollar

Everyone has been droning on about the gold bubble.  No one should pretend they know when that bubble will pop so until then I would stay away from jumping in front of that freight train.  Below I will go over some gold correlations- against the dollar, CPI, and the S&P.

Gold and the US dollar is typically nicely inversely correlated, no surprise there.  When the dollar is weak, investors will tend to flock to gold (the old flight to quality move), pushing the price of gold higher- a currency hedge.  Hence, we see a -0.64 correlation between gold and the dollar since 1990.  That correlation lied at -0.71 from 1990-2000 and -0.76 from 2000-2010.  In my later time frames of the latter half of this decade, this correlation has been breaking down, becoming less negative.  The correlation during 2005-2010 was -0.54 and during 2009-2010 was -0.21.  Since January 2010 the correlation has been only marginally negative at -0.09.

This correlation break down tends to occur in global economic crises during which the rest of the world may view the dollar as the flight to safety play for currencies.  Thus, the dollar goes up while the flight to quality play for gold remains in tact as investors turn to a hard asset, one that has historically been seen as a stable place to store wealth in and theoretically could act as a currency (if all else fails with paper money).  In fact, during the 2008-2009 financial crisis, there were moments of positive correlation such as when the market bottomed around February-March of 2009. 

As you can see in the chart, correlation can be restored fairly quickly.  Again, for 2010 YTD the correlation was just -0.09, but since about September we have seen a nearly 1:1 negative correlation, -0.95 by my method of calculation.  In the past 60 trading days, the gold/dollar correlation has been -0.97.

Next, gold as an inflation hedge.  The below table shows the correlations between gold and inflation as measured by the Consumer Price Inflation (NYSEARCA:CPI).  Unfortunately, I was only able to gather CPI data from 2000 on.

The correlation between gold and CPI is not as strong since 2000.  However, one study I found shows that the correlation between the two has been 0.71 since 1970.  From 2009 to present, the correlation has strengthened again to 0.89.

And finally, how has the S&P been trading relative to the yellow metal?  Below are the correlations:

Traditionally, when stocks have performed poorly, investors would turn to gold, implying a negative correlation.  We do see this negative correlation play out, particularly from 1990-2000 when the correlation was -0.81.  However, we have seen the correlation direction reverse and as gold continues to climb alongside equities the correlation has landed in positive territory.  As with the gold/dollar relationship, correlation can change course fairly quickly.  While 2010 YTD correlation between gold and the S&P lies at 0.18, that correlation has been 0.94 over the last 60 trading days.

To me, the main question is not when gold will stop climbing or when the stock market’s rally will end, or pause.  I want to direct most of my focus on the dollar, which I believe will be the catalyst in triggering real moves in gold and equities, given these recent extremely high correlations between these three.  I am inclined to believe that the dollar will finally catch a bounce in the coming weeks (not just yet, but perhaps in the next month or so), which will trigger the market to pull in and gold to slow its climb higher (note that I said “slow” and not “reverse” as I believe gold can keep being a bubble as long as it pleases, which in my opinion can be a really long time).  The dollar index on a technical front also looks like it might be nearing some nice trendline support as illustrated in the weekly chart of the DXY0 below:

Disclosure: None.