Waiting for a Reconfirmation of the Fear Index

October 3, 2005 – All of the pieces of the puzzle are falling into place neatly and pretty much on schedule. When the puzzle is finished, it will show a clear picture of gold’s bull market.

The first piece of the puzzle was gold’s climb against the weakest currency, namely the US dollar. Then one-by-one gold started climbing against other weak currencies. One of the first to go was the Japanese yen. Then over this past summer gold started breaking out against the euro and the Swiss franc, completing more pieces of the puzzle.

Recently we saw gold break a 24-year downtrend line against the British pound. Last week one more key piece fell into place. The XAU Index of gold mining companies made a new 8-1/2 year high. It was also good news last week that silver started showing some strength, which bodes well for the precious metals.

There is one more important piece of the puzzle that’s missing. We need a reconfirmation of gold’s bull market from the Fear Index. To get this reconfirmation, the Fear Index must close above its previous peak reached in November 2004.

My calculation for the Fear Index based on preliminary data as of September 30^th is 1.24%. That’s slightly below the 1.25% level reached on November 30^th, 2004.

I only calculate the Fear Index at month-end, so it is a lagging indicator rather than a leading one. That fact limits its usefulness, but I don’t like to ignore the Fear Index either. I would rather have it on my side than against me, because if it’s not confirming, it might be doing so for a reason. In that case, it would be giving us an important message, namely, that the bull market is not as strong as we might like. This observation brings up an important point.

In every letter I present the Fear Index and its 21-month moving average (see the data at the top of page 4). I have received a lot of questions from subscribers asking why I didn’t mention anything about the sell signal given by the Fear Index when it was below its 21-month moving average in May, July and August. The answer is simple. I was intentionally ignoring it.

To explain, I use a number of models to help me identify the trend of the market, which is the important point. Commodity traders sum it up as: “The trend is your friend.” That adage sounds trite, but following that advice is how you make money in commodities (in any market really). Given the reality that no one knows the future, you make money by riding the trend. The important secret to the commodity traders’ adage is that trends last longer than you expect.

In any case, I ignored the Fear Index sell signals (when the Fear Index declined below its 21-month moving average) because I did not think on balance that gold’s trend was reversing to the downside. The Fear Index is just one of the many tools and other factors I bring into the equation when I follow markets and report on them in these letters. Also, no mathematical model, no matter how good it is, can in the end substitute for human judgement.

Consequently, I ignored the sell signals generated by the Fear Index, and so far I have been right to do so. But, and I stress this point, we now need the Fear Index to reconfirm gold’s bull market. We need the Fear Index to close above the November 2004 peak, but when it does, I expect a powerhouse move in the Fear Index – which means gold will be soaring. Take a look at the above chart of the Fear Index.

Note the two horizontal dotted lines. The lower one marks the November 2004 peak. The important point is that once the November 2004 peak is cleared, there is no resistance on this chart until the other horizontal line at 2.6%. That means once the Fear Index clears 1.25%, I expect it to climb to 2.6%, and I expect it to make this climb within a relatively short period, probably 18-months or less.

The practical significance of this expectation is that the move from 1.25% to 2.6% represents more than a double, and as a consequence, we can expect the gold price to more than double during this period. It would have to more than double for the Fear Index to equal 2.6%, given how the Fear Index is calculated (please refer to its formula above).

The gold reserve remains relatively unchanged, and while M3 does change, it grows – it rarely declines. If it just stays the same, the only possible result for the Fear Index then is for the gold price to increase. Therefore, if the Fear Index more than doubles, the price of gold must more than double too.

If you are not mathematically oriented, or never cared much for algebra, don’t worry about it. I’m planning before the end of this year to provide in one of these letters a more detailed analysis of projecting the gold price using the Fear Index. But begin thinking about a double in the gold price because I do not think it will be long before the Fear Index gives us what we need – the important reconfirmation. In fact, I expect the November 2004 peak will be exceeded at the end of this month.