Beware Non-Confirmations

November 4, 2002

The following two Point and Figure Charts demonstrate just how difficult it is to make a definitive call in today's market.

(Charts courtesy StockCharts.com)

Freddie Mac and Fannie Mae are in the same home mortgage space, both are giving warning sell signals at a point when the S&P 500 chart giving a buy signal. All three charts are up to date to November 1st, 2002.

So where does this leave us?

It provides evidence that trying to "trade the market" is a mug's game - as opposed to "investing with the Primary Trend", which is sensible.

To be brutally objective, it is clear that the Industrial Equity markets are hugely oversold relative to their trailing long term moving averages. Mathematically, this is caused by prices that have fallen far faster than they have fallen - on average - in the past "x days". Arbitrageurs typically argue that "therefore, there needs to be a correction to the mean", and it is the arbitrageurs who typically provide the buying stimulus at that point. They buy because they perceive prices to be "relatively cheap" from a historical perspective.

The problem with this view is that it is predicated on nothing other than a personal perception of crowd psychology. And if you are going to be arrogant enough (dumb enough?) to want to capitalise on your personal view of which way the crowd is going to jump next, you will be well advised to focus on a technical concept called a "non-confirmation".

By way of example:

If it is accepted that the industrial equity markets move contra cyclically to gold, then why is it that BOTH gold and the equity markets have been rising in the past couple of weeks? This is what is known as a "non confirmation". If the foundational assumption is true (which can readily be seen by reference to the long term charts), then one of them must have been travelling in the wrong direction in the recent past.

By way of another example:

If it is accepted that the US Dollar also moves contra cyclically to gold, then the movement of both in the recent past has provided CONFIRMATION that the underlying behaviour of these two markets has been "normal".

As a matter of logic, therefore, if the synchronous movement in Gold and Equities does indeed represent a non confirmation, then it seems more likely that equities have been travelling in the "wrong direction" in the past few days. Further confirmation of this view is provided by a downward pointing 200 day moving average of the S&P - which implies that the Primary Trend is DOWN.

So, which view are you going to believe?

  • Shares are oversold and they MUST rise to bring them back to the mean. Or,
  • There is technical evidence of a "non-confirmation" of underlying expectations within the market - ie There is a possibility that what we have been seeing has been mere price turbulence in the equity markets.

(As an aside, it could be argued that the impending elections in the US is the ultimate driver of this turbulence, and equity price movements may have been caused by nothing more than "betting on the outcome" by the arbitrageurs.)

Personally, I don't have the stomach to pit my wits against the market as a whole. In humility, I will acknowledge that the market is The Master. It seems far more sensible to me (and less confrontational) to make the Trend My Friend. I have a negotiating style which seeks to have both parties aligned on the same side of the table - focussing together on arriving at a mutually beneficial result - and this style has stood me in good stead over the years.

I am therefore happy to align myself with the Great Tide of the markets, and patiently wait for events to unfold as they may.

So, in simple terms:

  • The 200-day Moving Average of the Dow and S&P500 is pointing down, and I am accordingly disinvested.
  • The 200-day Moving Average of gold and the XAU is pointing up, and I am accordingly invested.

Admittedly, I assumed my (dis)position in the former instruments long before it became apparent that the Great Tide was going out, and I assumed my position in the latter instruments when gold bounced up from a double bottom at around $250/oz a couple of years ago - before it became apparent that the Great Tide was coming in.

But then these decisions were predicated on a totally different set of investment parameters. It didn't make sense to me at the time that I should have to wait around 200 - 300 years to get my money back from some NASDAQ investments, and it didn't make sense to me that gold and silver would continue to trade at levels which were lower than the cost at which most mines could dig them out of the ground.

With an approach such as this, the non confirmations in the charts can be viewed with objective interest - rather than with the adrenalin pumping; and decisions can be taken calmly - as opposed to "on the fly".

Given the non confirmations that are manifesting, I remain unconvinced that we will see any excitement in the so called "technical" upward reaction in the equity markets. And if, as in the past "n" years, the equity markets rise between November and April, I will not lose any sleep because of the profits I "could have made". Rather, I will be focussing on having avoided the losses that I could equally likely have incurred given that P/E ratios are still at levels of between 30 and 48 times earnings, depending on which earnings number you choose to accept.

In the end analysis, the purpose of investment is to finance wealth generating activity.

That is why I tend to focus more on the activity itself than on anything else. I will invest when I can see that the underlying profitability of any company in which I am invested will return me my capital within a maximum of 8-10 years.

In the current investment environment, that criterion seems to me to be capable of being met by some (not all) gold and silver mining companies. Historically, the markets have always over-reacted and so if I can see 8-10 years, I am certain that someone else will eventually bid the price up to the point that he/she can justify 24 - 30 years; and he/she will be welcome to have my shares at the price prevailing at that time. It seems highly unlikely to me that I will still be invested in Gold or Silver shares when the underlying P/E ratio of the companies are running at 200 - 300 times.

Selling at these prices will not be a function of intelligence, but rather of luck (and perhaps greed).

Conversely, buying at such prices virtually guarantees losses, regardless of your "luck" - which is why I can't get excited by the concept of paying a premium to invest in a marginal gold mine that has a low life expectancy. Its reserves will run out long before my capital has been recouped.

All of which goes to explain why "non confirmations" in the charts are nothing more than interesting diversions to someone who is focussed on the Big Picture. They provide warning signs that some Investment Geniuses may soon be experiencing the pain that typically flows from the arrogant assumption that The Market can be outsmarted.

The Federal Reserve Bank of New York holds the world's largest accumulation of monetary gold.

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