Gold stocks and the stock market – an update

1. Gold Stocks

Since my last look at the gold stocks the sector has rallied sharply - along with the broader equity market, but with a number of notable differences, mainly in terms of leads and lags and relative performance.

As noted in the original post on gold stocks, a strange dichotomy had developed at the time, insofar as the gold/SPX ratio was rising, whereas, oddly, the HUI/SPX ratio was falling concurrently. Shortly after i pointed this out, this trend began to change again in favor of the gold stocks.

The HUI produced a divergent, higher low in November, just as the SPX broke to a new multi-year low in the wake of the previously documented collapse in commercial mortgage backed debt. Furthermore, the HUI has already managed to exceed its secondary late October high, a feat as of yet proving elusive for the SPX.
Since the low was put in, the HUI index has sharply outperformed the SPX, bringing the ratio between the two back to a less 'abnormal' level, although not yet to a level that would be justified by the concurrent multi-year highs in the Gold/SPX ratio.

The rational expectation would therefore be for the recent streak of gold sector outperformance to continue. This idea is additionally supported by the fact that the gold/oil and the gold/commodities ratio have kept rising vigorously as well.
As noted before, this is very important for the profit margins of the gold mining industry, due to energy representing its second biggest input cost factor after labor; other commodity input prices (for instance steel, timber and rubber) are also relevant to gold mining margins.
A large divergence between the current valuation of gold stocks, and gold's real price (which remains at multi-year highs) thus persists. Even if the nominal gold price were to remain static or were to soften somewhat, gold stocks would remain historically very undervalued at current levels.

Obviously the gold sector has crashed along with the rest of the stock market in October for reasons that have nothing or little to do with its fundamental outlook (an argument could be made that fear of deflation played a role in the HUI's relative weakness during October, but this doesn't satisfactorily explain the contrast between gold's relative strength and the relative weakness of gold stocks).
Forced liquidation swept everything along, regardless of relative values. Ironically, the fact that the gold sector is comparatively illiquid meant that it was undeservedly punished with extraordinary severity.
Note however that declines of similar severity happened during previous bull markets in gold stocks as well – the extent of the decline is per se not proof that the long term bull market is over – prima facie it just represents a large cyclical bear market that was unusually compressed in time.

No doubt the sector will continue to be buffeted by recurring deflation fears and the countervailing uncertainties introduced by the ongoing monetary pumping exercises of the central banks.
The markets clearly fear that a deflationary spiral could overwhelm the system, as credit creation by the commercial banking system has ground to a halt, at the same time though, the central banks and fiscal authorities are engaged in the biggest reflation effort ever attempted in the history of the recurrent crises of the modern system of irredeemable currency.
The attempt to recreate the inflationary phantom wealth of the boom is likely doomed to failure (aside from the fact that it makes little sense), but a properly determined central bank operating in a fiat money system can always devalue the money it issues – just ask Dr. Gideon Gono if you don't believe it.
However, regardless of whether these inflationary measures do or do not 'succeed', gold will likely prove to be a good hedge hedge against both outcomes – since both will be marked by 'monetary disorder'.

It remains to be seen if the gold sector is merely going to continue to mimic the larger stock market's moves with a higher beta , or if it eventually manages to decouple and go its own way again, as it did in the 2000-2002 bust. This likely depends on the intensity of prospective recurring liquidation periods.
In the heretofore grand-daddy of deflationary super cycle bear markets of the 1930's, gold stocks crashed with the market in the initial crash wave, but later decoupled and were the only market sector to produce large gains.
It has been argued that the at the time fixed gold price made this possible, but a similar argument could be made now, since the core of the argument is not about whether the price of gold is fixed, but whether gold actually gains in terms of purchasing power.

A note on the gold/CRB ratio: gold has literally exploded against the CRB. It is fairly typical to see gold's price in terms of commodities rise sharply during economic busts, but the extent and speed of this recent rise are indicating that the current bust is a secular one of a very high degree.

Bob Prechter argues it is in fact what he calls a 'grand super cycle degree bear market' – read: a bust that corrects the entire economic advance since 1720. This idea is based on the fractal nature of the stock market described by the Elliott wave system (all types of waves repeat at various cycle degrees – and indeed, one can look at a one minute chart of the stock market and detect up and down waves that have an astonishing similarity to the hourly, daily, weekly, monthly, etc. waves; the stock market clearly exhibits a fractal structure).

I for one think it is difficult to come to a firm conclusion about such extremely large degree waves, because one can easily be off by decades timing-wise, and will only ever know for sure in hindsight , provided one lives long enough.
Bob Prechter bases his view on his long term Elliott wave count of the stock market, but even at very large degrees, such a count can end up in need of revision at a later stage (it has already happened to some extent to his count – the 5th wave of the bull market kept extending).
Regardless though if his dire outlook is correct, we do know one thing for sure: it is a secular downturn, and as such at least of super cycle degree – for the stock market, it means a journey from extreme overvaluation (year 2000) to extreme undervaluation (by 2010 -2014 perhaps?).

This makes the gold sector very interesting, for the simple reason that while it often correlates positively with the rest of the market over the short to medium term, it has a proven negative long term correlation with the broader stock market.

Note though that in the near term, gold itself still needs to overcome a number of technical hurdles – namely resistance in the $830-845 area, and then the major resistance around $925-930. Gold's market structure (in terms of commitments of traders in the COMEX futures) looks quite bullish of late, as small speculators hold an exceedingly small net long position. From this standpoint, it should be easier to overcome resistance than it has been on occasion of the last attempt, but there is no guarantee it will happen.

Charts:


1. The HUI index and its divergent secondary low; several potential technical resistance points are denoted that may have bearing on short term trading tactics. Click on chart for larger image.


2.The HUI/SPX ratio has turned again in favor of the HUI, and is now in 'mid point' territory. Click on chart for larger image.


3.The gold/SPX ratio continues to cling to multi-year highs. Click on chart for larger image.


4.The gold/oil ratio has risen back to its long term average, at the same time a near 8-year high. Click on chart for larger image.


5.The gold/CRB ratio is yet another way of showing that gold's purchasing power has massively increased, in spite of the fact that its nominal price is a good deal below the all time high of March. Click on chart for larger image.


6.The nominal gold price must overcome two major resistance levels to confirm a new uptrend. Click on chart for larger image.



2.The Stock Market

I previously pointed out that the market was likely close to a low in terms of time, as during the last update, wave 5 of 3 was clearly underway. It appears now that wave 5 likely ended at the November 20 low, concurrent with the blow-off moves in mortgage and junk debt yields. In my opinion, it is quite worrisome from a longer term perspective that the market at one point sliced through the lows of 2002 as if they weren't there, but short term this slight undercutting of an old low followed by a reversal back above it is likely a positive sign – at least it should be given a positive weight when looking at the entire probabilistic gestalt.

After i posted the worrisome charts of Citigroup and the BKX, both continued to collapse , C for two more days and the BKX for one more day, whereby their moves down , while short lived, where absolutely astounding in terms of their severity. By the time the market closed on Thursday last week, it appeared as though we were once again on the brink of a true systemic meltdown. Everybody knew that someone had to be hurting big time from the plunge in mortgage backed and corporate debt, and it was equally clear that 'too big to fail' Citigroup was at the center of storm this time.

Friday then brought a late day relief rally that the financial press ascribed to president-elect Obama appointing Tim Geithner to the post of treasury secretary (certain sharp-tongued cynics who want to remain anonymous remarked that 'the nomination of anyone but Paulson would likely have produced a rally; even a block of wood would have done – at least one could be sure that it would remain silent').
This 'explanation' makes no sense however, since Geithner is closely associated with the bunch of nincompoops who 'never saw it coming'. 'It' being the current financial and economic disaster.
Besides, anyone who still believes that politicians matter in the face of this tsunami of a bearish social mood turn and collapsing credit bubble should best keep away from the stock market for his own good.

A more sensible explanation is actually that it was an options expiration, which saw market makers buy back their shorts in the last half hour (when option market makers sell puts, they hedge by shorting the underlying shares – once those puts expire, the hedges are lifted).
The Elliott wave explanation would be: wave 5 was likely finished, regardless of the technicalities surrounding the event.

However: whereas broader indexes like the SPX and the NYA have clearly made it back above their October lows, the BKX is actually still lagging - in spite of rising over 50% (!) from its intra-day low on Friday last week, it has yet to make it back above the broken neckline of the head and shoulders formation i pointed out.
If there is anything that makes me doubt the 'wave 5 is finished' idea, then it is this fact. It is the single most worrisome fact to my mind, in terms of the overall technical picture.

Yes, the interventionists succeeded in lifting a great weight off the market's mind in the short term, by first agreeing to backstop Citigroup with guarantees amounting to over $300 billion – a move designed to avert the growing danger of a run on the bank (of the total of $820 billion on deposit at Citi, a huge $554 billion was/is held abroad – and thus not subject to FDIC insurance. No doubt these foreign depositors were going to form queues at Citi branches worldwide come Monday, had the government not decided to bail the bank out for all practical purposes), and secondly by announcing an enormous additional monetary pumping exercise that appears to amount to an outright monetization of $800 billion in 'highly rated' mortgage backed and asset backed securities.

Consequently, CDS markets calmed down considerably, and credit spreads declined left and right. Most notably, CDS spreads on Citi's debt were basically cut in half (while this was no doubt a great relief to almost everyone, there are losers in this type of trade as well – and it is actually a bit infuriating that those who made the correct bet – namely that the creditworthiness of Citigroup was increasingly in doubt – were once again cheated of their winnings by a government intervention. I note that there is no great urge anywhere to make their losses good).

The fact remains though – the BKX index is still below its broken neckline. My advice would be to watch very closely what happens once it touches the neckline, which should be within a trading day or two. If it turns back down from there, we can go back to 'red alert' status in my opinion.

The second item that needs to be considered is the fact that yields on longer dated government debt continue to decline sharply. In part this is due to a technicality – the government's recently announced hoovering up of $800 bn. in MBS and ABS has created prepayment risk for mortgages – and that means that a number of MBS portfolios are likely to get a duration mismatch problem, or rather, the previously extant duration mismatch problem has been reversed in the opposite direction (rising mortgage rates lengthened the expected maturities and durations of MBS portfolios, falling mortgage rates will shorten them). Hedging against the eventuality of shortening or lengthening durations is done in the treasury bond and note markets, and currently this is driving yields lower.

However, t-bonds and notes have normally also a strong tendency to confirm stock market rallies by means of declining (i.e., yields rise) – in that sense, their recent action constitutes a non-confirmation.
Note also, with t-bill rates close to zero and other short term rates having declined precipitously as well, this recent move at the long end of the curve actually flattens the yield curve – this is can not be considered a good sign for the 'reflation' effort.

Lastly, on the potentially positive side of the ledger, we have the recent weakening of the dollar index (DXY), which has happened against a backdrop of technical divergences at the recent high. It may finally be due to correct, a fact that is supported by gold strength leading the subsequent weakness in DXY. A large correction in DXY would likely accompany a wave 4 rally in stocks, given their recent strongly negative correlation (a rising DXY and Yen are symptoms of deleveraging).

Summary:

While the recent rebound in stocks suggests the large wave 4 retracement may finally be underway now, there are still important non-confirmations extant. It is always possible that the confirmations will happen with a slight lag, however, one should keep a close eye on what actually develops. The previous warnings regarding the overall sentiment picture remain in force – however, there always comes a point when previously shaken fund managers go from praying for a rally to fearing they might miss one, and such a flip of the herd will eventually produce the retracement rally in self-fulfilling prophecy fashion.
The short term risks seem a lot lower than they were exactly one week ago, but they have by no means disappeared.

Charts:


1.The SPX is back in the 'zone' for now. Click on chart for larger image.


2.The BKX has yet to get back above its broken neckline, in spite of an enormous rally off the recent low. Click on chart for larger image.


3.The long bond is not yet confirming the rally in stocks. Click on chart for larger image.


4. DXY has recently weakened after a high with typical 'end of move' divergences in evidence. It may be a bit early to tell, but a larger correction seems definitely possible. This would be an important development for all risk assets. Click on chart for larger image

charts via stockcharts.com