A few trading days ago a friend (who prefers to remain anonymous) sent us an Elliott wave interpretation of the XAU which we wanted to share with our readers. Although the recent downtrend has become even more extended since this chart was made, this possible wave count interpretation isn't altered because of this. What we like about the interpretation (apart from the fact that it basically sees the recent weakness as a large degree correction of the uptrend from the 2008 low) is that it fits well with the mess of overlapping waves near the highs. There was no clear impulse move into a classic blow-off top, which is what usually happens with gold stocks at the end of a bull market.
Anyway, here is the chart:
An Elliott wave interpretation of the correction in the XAU – click for better resolution.
A second chart shows a close-up of this view roughly outlining the 5 waves of the corresponding wave C in the HUI (we would note here that ever since hedging has been largely abandoned, the XAU is actually the more representative index, as it has far more component stocks):
The HUI and GLD; the numbering concerns the C wave in the HUI that is the equivalent of wave C in the longer term view of the XAU above – click for better resolution.
Valuations and Correlations
As we have recently pointed out, the ratio of gold stocks to gold has hit its lowest level since 1942 – a low that was reached in the course of the market's mini-crash after the attack on Pearl Harbor in December 1941. It has since then fallen even further and is now well below its 2008 crash low, which in turn was hitherto the greatest extreme since 1942 before being outdone in the course of the recent decline.
Another way of illustrating how extreme the situation has become is by considering where valuations are today compared to the past. As recently as in early 2008, Newmont Mining (NEM) still traded at three times book value, by no means an unusual valuation for a gold stock (gold stocks have traditionally tended to trade at a hefty premium in terms of p/e ratios and price-to-book compared to other mining stocks). Today NEM trades barely above one times book value.
The XAU – gold ratio hits yet another new 71 year low – click for better resolution.
Newmont Mining, price-to-book: from 3 to 1 in five years – click for better resolution.
What is also quite noteworthy – something we have also pointed out in the past well before the effect became as obvious as it is now – is that gold stocks have decoupled from the broader equity market since approximately the summer of 2011. This is as it should be. The gold sector is the only market sector that is long term negatively correlated with the stock market at large, as the profit margins of gold miners tend to improve during economic contractions and tend to shrink when economic confidence increases.
This is due to the fact that the real price of gold tends to rise during contractions – in short, the input costs of gold mining are falling relative to the gold price in times of recession. Why is this so? The most likely answer is: during contractions, uncertainty about the future rises and the demand for money therefore tends to increase. Although gold is nowadays not 'money' in the sense of representing the commonly used medium of exchange, the market treats it as if it still were money.
Not only that, the market tends to reflect the fact that while during recessions central banks usually get busy increasing the supply of their fiat confetti, no-one can increase the supply of gold willy-nilly. The supply of gold increases by a mere 1.4% per year at present, tendency falling (the stock of gold becomes ever larger relative to the more or less static flows from mining activity). Not a single central bank in the world has this kind of discipline. Even in 'deflationary' Japan the money supply has risen faster than this since the bubble burst in late 1989.
One more remark regarding the correlation of gold stocks to the SPX: in the short term, considerations concerning liquidity can lead to both markets trending more or less in the same direction. This happened e.g. in the wake of the 2008 crash, when the gold sector became the leading market sector from the lows as the Fed's liquidity gusher was first turned on at full blast. There are always leads and lags to consider, so even when the two markets are broadly negatively correlated as is the case at present, they will occasionally get into sync again for brief periods.
The HUI versus the SPX: the vertical red line indicates when the previous positive correlation began to break down and was replaced by the more 'normal' negative correlation again – click for better resolution.
Sentiment and Positioning
Instead of the aggregated commitments of traders data we wanted to show a chart we have recently come across that breaks out the gross positions of the 'managed money' component of the disaggregated CoT report on COMEX gold futures. While the net position remains long, both the recent increase in the gross short position and the associated decline in the net long position have been remarkable.
The gross short position (blue line at the bottom) and the gross long (blue line at the top) and net long (yellow line) positions of the 'managed money' component of the disaggregated CoT report. The light blue background shows the gold price – click for better resolution.
A few remarks on this chart. What is good about it is obviously that potentially some fuel may be provided in the form of short covering should the market turn around and that the positioning data have created a divergence with gold's price (this is to say, there have been two decisive moments in time when price was lower, but the positions were not as stretched, namely in 2008 and in mid 2012). Something that is also a positive (not shown here), is that the small speculator long/short ratio has declined well below 2, to approximately 1.33.
However, we hasten to add that one should definitely not assume that just because these short positions have risen, a market rally is necessarily imminent. In fact, it would be a very bad sign if money managers became so bearish as to flip over to a net short position.
It is short term bullish when gross and net long positions are reduced in a correction in an uptrend, but it is far less bullish when the decline in the net long position owes mostly to an increase in shorts.
Let us not forget: the big speculators are the group that tends to be right about gold's major underlying trend. Their growing skepticism is not an unalloyed positive sign as many other writers currently maintain. Quite to the contrary, it is a reason for concern. Bulls would want to see this gross short position reduced as quickly as possible.
On the sentiment front, things are as one might expect still quite gloomy. The Hulbert Gold Newsletter writer index is in negative territory (advisors recommend a net short position), and the public opinion measures for gold and silver (several prominent sentiment surveys that have been merged by sentimentrader into a single index) are wallowing at extremely low levels – relative to recent years that is. It should be pointed out here that these levels are only extreme in the context of an ongoing bull market. If a bear market should be beginning, then we would have to adjust our ideas of what represents sentiment extremes accordingly, as much lower levels in these measures would then eventually be seen.
The HGNSI is back in negative territory – click for better resolution.
Public opinion on gold remains at very depressed levels relative to what has occurred in the course of the bull market to date – click for better resolution.
Public opinion on silver has likewise declined sharply – click for better resolution.
Two more charts that have to do with gold stocks rather than gold follow below. They indicate that at the very least, 'a' low should be very close now. Whether 'a' low will become 'the' low will always depend on the shape of the subsequent rally, and the developments in fundamentals, positioning and sentiment. It is always possible that whatever low forms in the near future will turn out to be quite meaningful for the long term, but there can be no guarantee of that. The technical damage has been very extensive, so it is simply not possible to a priori rule out the possibility that a more serious bear market has begun, regardless of the fact that a vigorous short term rally is probably quite near.
We are of course well aware of the fundamental situation and the probability that it will continue to be essentially bullish for gold for the foreseeable future (i.e., the next several years), but one would do well to keep in mind that the 1970s bull market was interrupted by a 50% decline before prices soared to new highs. It is moreover always possible that future fundamentals will turn out different from what is expected. Quite often the market is simply wrong (if that were not the case, no-one could ever make money in the markets), but it happens at times that a seemingly inexplicable market move becomes easily explicable at a later stage. That is why one should respect technical developments, even if they are at odds with one's perhaps well-founded convictions. Note here that we remain bullish on gold for a variety of reasons. The above is meant as a reminder that we could well turn out to be wrong (or rather, wrong again).
The first chart is the bullish percent chart of the broad gold stock index GDM. This shows the percentage of gold stocks that are currently on a point & figure buy signal. It has fallen close to the lowest level possible (which is zero). At just above 3%, it is at its lowest since the 2008 crash. When almost no stocks sporting P&F buy signals are left in a sector, it is certainly a sign of extreme oversold conditions.
The GDM bullish percent index wallows at a lowly 3.33% – click for better resolution.
At this point we would also like to point out that it seems likely that a major reason why gold stocks have fallen so much further relative to goldrecentlyis that many people have been pulling money out of gold stock funds. These funds were then forced to sell in order to meet redemptions and since the sector is fairly illiquid even at the best of times, this has produced outsized price declines.
How long such redemption-related activity may continue is not known at this point, but the next chart gives at least small grounds for hope on that front.
It shows the Rydex precious metals fund, the assets it has under management as well as the cumulative net cash flows into the fund. What is positive about this chart is that the cumulative cash flow ratio has just produced a divergenthigher low. This frequently occurs near turning points.
Rydex precious metals fund with AUM and net cash flow ratio (cumulative); while price and AUM have made a lower low, the cash flow ratio has come to rest at a higher low. This may be a sign that net redemptions from gold stock funds are close to stabilizing – click for better resolution.
Lastly we should also mention that the premium to net asset value of the closed-end funds GTU (physical gold) and CEF (physical gold and silver) has disappeared entirely. GTU trades at a 0.4% discount to NAV and CEF at a 0.2% premium. Historically both have tended to trade at far higher premiums most of the time, although there have also been times when e.g. CEF has traded at a hefty discount. Still, the lack of a premium at present certainly indicates a very low level of enthusiasm on the part of buyers.
There are more and more signs that the gold sector is going to make a low of sorts soon. There is of course also a risk that the extremes discussed above could get even more extreme, but usually these conditions have been associated with at least temporary low points. Once a low has been recorded, we will have to watch closely how the subsequent rebound unfolds. This should provide additional clues as to whether the larger degree bull market remains intact or not.
Note that even a big decline such as the recent one is not per se proof that there is no longer a primary bull market in force. Recall that e.g. the stock market fell by 40% at one point in 1987, which later turned out to be a mere hicc-up in a far larger uptrend. At the same time one should be aware that a number of worrisome signs have recently emerged. One is the fact that gold stocks keep falling relative to bullion (as they have so far tended to lead it lower) and the other is the fact that money managers playing the futures market are turning increasingly bearish. Both conditions must change appreciably if the larger degree bull market is to be resurrected.