“Strange Bedfellows: Dow Jones and the Precious Metals”

By Joshua Enomoto, Contributor

While the traditional thought process amongst gold and silver bugs is that precious metals provides a hedge against the “system,” both in terms of rampant inflation of fiat currencies, as well as a precipitous decline of the stock market. The reality is that these revered assets would only effectively protect against one of these events, and certainly not both at the same time. Runaway inflation would lead to higher prices in EVERY asset class as the dollar is being devalued and would require nominally larger amounts of greenbacks to purchase an identical product before the inflation.

A stock market crash, however, suggests deflation, a situation where everyone wants to sell and no one wants to buy, and while it is certainly possible that the Dow and gold could eventually share a 1:1 ratio, where one gold ounce could buy one share of the entire Dow index, the problem is, nobody knows for sure how the actual numbers will stack up. W ould it be Dow 1,000: Gold 1,000? Or Dow 6,000: Gold 6,000? Of course, in a deflation, every asset’s price is reduced as supply exceeds demand, and therefore, the value of the dollar increases.

The current market paradigm is that precious metals are acting as “risk-off” assets, meaning that investors fearful of volatility are seeking shelter in fiat currencies, namely, the US dollar. One doesn’t have to personally “believe” in this trend, but rather acknowledge that it exists and look for trading opportunities as a result.

Let’s start off by looking at a 3-month snapshot of the Dow Jones Industrial Average:

Generally speaking, the Dow has been trading steadily upwards above its 50 day moving average, with much of the bullishness being attributed to the markets pricing in a potential QE3. That potentiality became a reality on September 13th, and since that fateful day, investors on Wall Street have been trying to push the index past the 13,600 resistance level, but failed repeatedly. Finally, on October 19th, the Dow dropped to 13,350, or a 2% drop from its quantitatively-induced high. The doji star the day prior proved ominous.

As you may know, doji stars occur when the opening and closing price of a trading session are identical or close to identical. In and of themselves, they reveal very little aside from the fact that there was ultimately very little enthusiasm by either the bulls or the bears to push the price one way or the other; however, in this particular context, it revealed hesitation in moving forward with the prevailing trend. Another big drop on the 23rd confirmed that the bears established near-term control of the sector, with their eyes firmly set on the 200 DMA, sitting just under the 13,000 mark.

Interestingly, if we take a look at gold’s 3-month chart, we see a very similar pattern:

The yellow metal started to rally around mid-August, after a half-year of frustrating consolidation from February’s highs. The price continued to surge higher based on speculation of central bank money printing that eventually was realized through major announcements by the European Central Bank, the Federal Reserve, and the Bank of Japan. Since all commodities are priced in US dollars, the announcement of QE3 was the biggest catalyst for gold. Unfortunately, at least for the near-term, it has proven to be the final one.

The major psychological target for the gold bulls was the 1,800 price point, but it proved elusive, with the 1,780 level instead proving strong and consistent resistance. Gold’s decline came a bit sooner than the Dow’s, as on October 5th, the metal failed to secure and hold a recent run-up. From then on, aside from a few isolated sessions, the price of Gold continued to roll downwards.

Whatever fundamental catalyst that failed to get the Dow above 13,600 clearly put a ceiling on gold’s nominal target of $1,800. Let’s get real here: the driver that got both the index and the metal up and running was speculation of QE3. And the reason they both failed earlier in the year and now is risk, specifically the Eurozone debt crisis sending scared money scrambling into the waiting arms of the dollar.

But as with any crisis, there is an opportunity, for those that are patient and have a steely resolve. Both the Dow and gold have suffered through a correction but will resume their upward trajectory. The fundamental players are the same, namely the Federal Reserve’s commitment to QE3 and low interest rates. With the economy dragging its feet, the only option, aside from universally unpopular austerity programs, would be to aggressively increase the scope of quantitative easing.

Let’s take a look at the technicals, starting with the Dow Jones:

Based on the Slow Stochastic oscillator, the current status of the Dow is extremely oversold. In fact, over the last 3 years, if you were to simply “buy” the index based on when the Stochastic was below the 20 level, 75% of the time, you would have realized an immediate profit. As the RSI is also nearing an oversold status, more often than not, the chances are good that the index will rise from here.

It’s the same story with gold:

With the yellow metal, the conditions are even better. Analyzing the same 3 year period, buying on sub-20 Stochastics would have been a good decision 80% of the time. And whether you were bullish on equities or on commodities, the simple fact is, even if you were to have bought when the Stochastics gave a “false” reading, you would eventually be in the black only a few months later.

Perhaps the best opportunity, however, is silver:

Since it tracks the price of gold 70 to 80 percent of the time, it too is poised to rise from its currently oversold status. While it is more volatile than its illustrious cousin, the current spot price of $32.10 is worth taking a look at. The bears met significant resistance trying to push the price under $32, and momentum indicators suggest that the downturn is losing steam and that a reversal could be in play shortly.

In conclusion, whether we like it or not, the Dow is currently trending parallel to the precious metals and the same fundamentals that affect the index have had a similar effect on gold. That being said, it is the Fed’s solemn pledge to prop up the economy by propping up the stock market, which means the Dow will be roomies with gold in the foreseeable future.