Bullish Facts Abound, 2nd Half Rally
Ed Bugos
"This
is how liberty is lost... in a blaze of applause" -
paraphrasing Padmé Naberrie, Queen Amidala, from Star Wars'
new Episode III Revenge of the Sith
-----------------------------------------------
The current bounce
off the 165 low in the HUI should be a no-brainer; the more difficult
question is to determine whether it is just a bounce, like the brief one
in February/March, or the beginning of something more bullish, like the
August-November 2004 rally, or perhaps something even bigger?
The HUI (AMEX Gold Bugs) chart is the most
bearish of the gold stock index charts because the 2nd quarter decline
ended almost right at last May’s low, which brings
into focus the possibility of a horizontal neckline, and a nearly 2-year
descending triangle.
If it is a descending triangle the current
bounce has legs to the 200-day moving average at around 210 plus or minus,
after which it could fall back to the May low, bounce around there for
a bit, then head off to 110 – unless it is a bear trap in which
case it would penetrate the neckline at about 160 briefly before turning
up again.
The other indexes either put in a higher
low (relative to the May 2004 low) or a lower one – both of which
can be interpreted bullishly. A higher low (as in the case of the TSE
Venture index, CBOE, and even the XAU) is less bearish for obvious reasons
while a lower low (as in the case of the TSE senior gold index and the
SA share index) rules out a topping formation in favor of a normal intermediate
correction.
If, for instance, the HUI made a lower
low on this latest decline instead of stopping at the May low it could
not really qualify as a top. In any event, there is a positive inference
that can be drawn even in the case of the HUI chart: the recent low was
five points above the May 2004 low, making it a higher
low… technically speaking.
Most skeptics and cynics will
say: five points is nothing in the scheme of things.
That’s true – normally such
a small variation wouldn’t stop me from drawing a straight line
across the entire length of the consolidation connecting the May 2004
bottom to the May 2005 bottom as in the graph above.
However, it is worth noting that the November
high came in only 10 points short of the late 2003 high,
which is also a relatively small variation.
Thus if we are to ignore the small variation
at the low end of the consolidation we should also ignore this one at
the high end – in which case we’d have to draw a straight
line up there too, which in turn would rule out the descending triangle
hypothesis in favor of a straightforward but more neutral rectangular
trading range. On the other hand, if we do not ignore either
variation we would have to perceive a neutral triangle formation that
is more symmetrical than the one I originally assumed back in March/April.
…albeit, the triangle has very gentle
slopes. This is quite possibly the case nevertheless – and it doesn’t
involve a bear trap; a bear trap would necessitate a lower low that looks
like a break down. So far we’ve seen no break down in the averages
or in gold prices.
Notwithstanding that fact,
the geniuses are increasingly convinced that the gold run is over. For
the record, usually these are the people that missed the run, or at best
came in late. I do not deny the possibility of a sharper correction in
gold prices or gold shares – meaning a 30% decline in the gold price
and a 50 percent plus decline in the gold stock “averages”
from the highs – half of which has already occurred.
However, I do rule out the nearby
possibility of deflation (separate article coming after this one) as well
as the possibility that a primary liquidation may get underway now,
prior to a convincing run to the upside. Gold has risen in a steady trend
since 2001. It has outperformed the main US share averages as well as
bonds. But, as you know, it has underperformed most of the key commodity
markets as well as real estate.
These are not sustainable facts in the
context of a gold bull market – in which gold is the best performer,
by definition.
Bullish Case must be Factored,
First!
The markets are focused on foreign exchange fluctuations, the growth in
Chinese final demand, as well as the apparently competing aggregate demand
from an alleged global economic recovery. In fact, analysts even tend
to point to the bullish effects of the new commodity based investment
products (i.e. trust and paper securities) before acknowledging
the effects of monetary expansions (around the world), the resultant loss
in the purchasing power (and confidence) of paper currencies, and the
US dollar’s fall as a reserve currency. It is this observation
mainly that keeps me bullish on gold prices, and by extension, on gold
shares in the short term… and why I am holding out for that buying
climax which is a typical end for commodity advances.
I do not believe that the market has even
partially factored the bullish case for gold, which is basically the premise
that the forces of inflation have overwhelmed the forces of productivity;
and that at the margin, any further expansions in money and credit are
more likely to result in a confidence erosion in the Fed’s notes
than in a PE ratio expansion, lower interest rates, or a strong currency
(some analysts believe that an aggressive inflation policy is bullish
for the foreign exchange value of the currency – they call it “quantitative
easing”). The bullish case for gold has little to do with foreign
exchange rates in the long run even though that is what everyone seems
to be focused on in the short term – partly reflecting their confidence
in the Fed (and other central banks), that “inflation is under
control.” Few people even know what that really means.
So if the trend in commodity prices fundamentally
reflects monetary factors, as we suggest it does, and which in fact was
the primary reason we called for the bull market in commodities to begin
with (earlier than most anal-ists I might like to add), then gold is about
to rack up another US$100 (plus) rally with or without further declines
in the foreign exchange value of the US dollar – reflecting a real
devaluation – and as discussed in the last issue it is characteristic
of gold bull legs to end in a glorious explosion relative to all the currencies
simultaneously… in other words, again, whether the US dollar
index rises or falls gold prices are set to rise sharply.
If most people were running around worrying
about inflation, then 1) the stock market averages would not be trading
at a 20 times PE ratio, 2) bond yields would be markedly higher, and 3)
I would be looking for a top rather than betting on a buying climax.
At the moment, inflation expectations,
while steadfastly on the rise, are confined to a relatively small proportion
of the market. This cannot be disputed at current stock/bond valuations.
If we got our move to the upside, a 30 percent correction in gold prices
would be more plausible than it is from the current level. Anything is
possible.
My
main premises (monetary) could be wrong and gold prices might be on their
way to the low US$300 area… robbing us of the vindication that should
be ours if our premises are correct.
In any event, besides drawing a positive
inference from the technicals as well as sentiment (not just the lack
of bullish sentiment but also the fact that participants are focused on
the wrong drivers), I also have yet another bullish
observation to communicate regarding the relationship between gold stocks
and the Dow. Gold stocks are usually counter-cyclical assets.
This means that they tend to rise when
the Dow falls, and vice versa. This is historically very apparent, and
even in the current cycle it was evident up until 2003 when the correlation
turned positive (I argued then that this was due to the market’s
general lack of confidence in the substance of the Dow’s comeback
– and indeed one could argue that the current weakness in the gold
shares partly reflects increasing confidence in the substance of the Dow’s
comeback).
At any rate, in a report during 2003 I
went back to the 1962-80 gold share bull market in order to gauge this
correlation during bull market periods, and found that as the bull market
progressed the inverse correlation (between gold shares and the Dow or
S&P 500, etc.) became stronger… i.e. that it was weak during
the sixties but by the late seventies it became strong. My hypothesis
was that it became psychologically ingrained.
Clearly, the current generation is not
likely to have this relationship fully ingrained, especially not if most
of the public is still bullish on the main stock market averages. Many
investors are now looking at the gold sector in terms of a REFLATION trade,
meaning that the cost of stimulating the economy by monetary policy is
higher gold prices but not necessarily a gold bull market in the counter-cyclical
sense.
This could be the result of the positive
correlation rather than the cause of it.
In any event, the bullish inference
in all of this is the fact that the gold shares have decoupled from the
Dow over the past 12 months or so, and the sector has been one
of the weakest in the market… especially since November. I realize
that, as already mentioned, the (correct) inverse correlation is probably
still weak because the bull market is quite young. However, the decoupling
is another bullish factor for the gold sector to the extent that it marks
the return of the counter-cyclical correlation.
…That is, provided you are as bearish
on the main averages as we are.
For as I said last issue the one way our
outlook is fundamentally wrong is if the economic recovery has more substance
than we estimate. In this case, the counter-cyclical relation may have
returned but it would mean the Dow goes up and gold stocks down.
My gut says
that what we’re seeing in the gold shares right now is something
akin to the way that a tide gets sucked out just before the tsunami hits
the shore.
The Dow might wobble higher yet and I’m
not sure if the gold share tide has more to ebb; but nonetheless, I do
believe we are approaching an important inflection point that will convince
the world (and the Fed) that the gold bull market has finally arrived.
Either way, the likelihood is strong that
the gold shares will rally enough to make trading profits in the short
term; and if the averages (especially the HUI and XAU) break out over
their November highs, look for another 50% or so move – in other
words, on the break out to new highs in the HUI, my target for
that average would be somewhere between 300 (worst case) and 400 (best
case). The best case implies a double from here. The frustrating
part of the ride may indeed be about to come to a close.
Conclusion:
The bullish facts for the gold sector are as follows:
- Gold is undervalued
in terms of the other commodities – gold ratios still at multi-year
lows
- Weak hands out, strong
hands accumulating
- Gold and gold share technicals
still largely bullish
- Sentiment: has turned
bearish, remaining bulls have wrong focus, bullish case not factored
- Marginal gold producing currencies
(like the South African Rand) are weakening again
- Gold shares have decoupled
from the broader stock market averages (Dow & SPX)
- Gold share move last week was the best
advance in over a year
- Gold share valuations
back at attractive levels
- Global gold production contracting,
pace of de-hedging continues, metal generally scarce
- Stock markets wobbly,
potentially topping
- Oil prices could be
set for new highs (on possible political events in Saudi Arabia)
- Fed is behind the curve
and still accommodative; as well, money supply is growing fast again
- Forex movements are
less relevant at this point
- French referendum on
EU constitution is bullish either way
- Changes at Fed, including Greenspan’s
departure
- Seasonal trends turning
in gold bulls’ favor
The bearish facts include the possibility
that the gold share technicals are more bearish than I am suggesting (i.e.
they reflect scenario #1); that there is a possibility that foreign exchange
rates are indeed still relevant and the USd is about to rally harder than
I expect it to; and lastly, the possibility exists that I have underestimated
the strength of the economic recovery (doubt it), and the major stock
market averages make new highs. Regarding interest rates, I do not believe
that they will rise very fast until gold prices rocket through
US$500, and even then it would be more bearish for stocks and
bonds than gold. And as for the CPI and PPI, I don’t care.
When they start coming in strong, I’ll
probably be selling some of my gold… because that’s the news
the weak hands like to buy! If clients are underweight and have
been waiting for an opportunity to get back on board, now’s the
time.
Ed Bugos
Editor - The GoldenBar Report
www.goldenbar.com
June 17, 2005
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