first majestic silver

Financial Relationships

April 26, 2004

In the late 1960s my friend Eddie Van Andel convinced me that the stock market was a good place to learn about "high finance", and he recruited me to a business called Electronic Stock Evaluators (ESE), for which he worked at the time. ESE was South Africa's first firm of Portfolio Managers that relied heavily on technical analysis, (in addition to fundamental analysis) making use of statistical algorithms on an IBM 360 mainframe computer. We also produced the "Daily Mail" Stock Market Indices on a daily basis, and we later developed what came to be known as the JSE indices. Actually, it was Mike Vosloo who did that, and the last time I heard of Mike he had gone on to become the CEO of the Standard Bank of South Africa. They were heady, pioneering days and, when I hear people talk about the value of indices I recall how Mike went about constructing the JSE indices, and how they differed from the Daily Mail Indices. The nuances were important to us.

In those days there were very few chartists. I know, because I was involved in producing the very first set of commercially available charts in South Africa. When Eddie decided that "charting" was the way to go, I agreed and joined him when he formed Performance Charting.

Performance Charts were plotted manually on translucent semi log paper on a daily, weekly and monthly basis with high/low/closing prices and volumes. We also plotted Point & Figure charts. The translucent paper was critically important, because it enabled us to do overlay analysis for Relative Strength purposes; and I came to understand the vital importance of Relative Strength (Relationships). Of course, the fact that the graphs were drawn on a semi log scale was also important because it enabled us to measure percentage changes - which made the RS comparisons relevant.

Our target market was the Professional Investor market, and at that time there were very few stock brokers who were prepared to countenance this "mumbo jumbo". Again, I know this first hand because I used to accompany Eddie on his sales visits.

The foundation of my education in charting was a regular diet of The Bank Credit Analyst, Dow Theory Letters and regular references to Edwards and Magee. Harry Schultz's books - in particular "Bear Markets" - enabled me to make a profit selling short into the stock market crash of 1969, and I used the profits to pay for a post graduate business degree at Wits University. I was in the first intake of students when the Business School opened its doors.

It was the Bank Credit Analyst that first alerted me to the Relationship between the Gold Price and the USA's "Net Liquid Liabilities", but they stopped publishing the charted movements of this relationship when the theoretical price of gold got to over $1,000/ounce in the 1980s. That was my first warning bell that "Fundamental" analysis was becoming less relevant, as the Central Banks of the world were tightening their "management" grip on the world's economy.

In 1970 Eddie and I parted company on good terms. He continued to pursue his stock market dreams and I decided that I would rather apply my (inadequate) knowledge of finance in the field of Industry - which in those days was the engine of the world's economy.

Nevertheless, I kept up my interest in the subject of the stock market, and when Daan Joubert wrote South Africa's first micro computer based stock market charting program (long before the IBM PC had graphics that were able to cope with the level of sophistication needed) I linked up with Daan on an informal basis and used his program to analyse - amongst other things - Bond Price movements. This was in the late 1970s and early 1980s, and Black Scholes was emerging at that time as the "bible" of bond valuation methodologies. Again, the use of charting to forecast bond price movements was looked on as screwball behaviour; but the application was sound and I was approached by a leading firm of stockbrokers (Frankel Kruger) to write a bi-monthly newsletter making use of Daan's program.

A lot of water has gone under the bridge since then, but a turning point for me occurred one day when my contact inside Frankel Kruger phoned to invite me to a lunch with him and an Institutional client who wanted to pick my brains.

I was heavily involved in the "real world" of manufacturing at the time, and a free lunch sounded OK, so I agreed; and what transpired scared the hell out of me. The Institutional client turned out to be one of the largest financial organizations in the country, and what they wanted to do was develop a PC based software program for "trading". (Such things did not exist at that time)

When I tried to explain to them about the concept of a Primary Trend and how trading techniques would only be reliable if they were conducted within the context of the Primary Trend, they argued that their orientation was so short term that it wouldn't matter. What they were aspiring to do was to "make money", and they believed they could do this by scalping the arbitrage opportunities that occurred on a minute-to-minute basis in any given day. The "theories" of wealth generation, fundamentals, and common sense investing were irrelevant to these hard nosed professionals. These guys were not romantics who thought in terms of "value add". They were highly focussed financial warriors imbued with a killer instinct and a lust for battle.

It was at that point (in 1986) that I came to understand that the world of finance was about to enter a new era. "Charting" had arrived, and would become exponentially more dangerous as more and more converts were brought into the fold.

I remembered then something that Richard Russell had written about in the 1960s regarding his PTI: He would not divulge its components because that would facilitate too wide a usage of the technique and, in turn, the PTI would lose its power.

The years have passed and I have come to the conclusion that the world of finance today has become almost entirely superficial and artificial. Charting still has a critically important role to play, but the previously "obvious" signals are typically not as meaningful as they once were. Fundamentals have become like religion - an anchor for believers in a sea of materialistic storms - but the anchor is not as powerful as it once was, and there are fewer believers in the concept of "value" investing.

Vast quantities of money slosh around the markets like waves in a kid's bathtub, and about the only thing that we can say for certain is that a lot of water is going to land up on the bathroom floor.

But charting still has a relevance to those of us who understand what true "Relationships" mean - because there are so few people who do understand these relationships. Like Richard's PTI, it is precisely because these relationships are "hidden" from general view, that they still have predictive power.

Take the relationship of Interest Rates to other markets, as an example: (The following analysis makes reference to charts from StockCharts.Com and from Commodity Futures charts)

It is clear from the following chart that Bond Yields (interest rates) in the USA are no longer falling - and may even start to rise structurally - but what are the possible implications of this?

Well, one relationship that might be affected is that of interest rates and the level of the US Dollar. Note how the US Dollar monthly chart appears to be reaching for what might turn out to be a double bottom at around 80 - 85.

TFC Commodity Charts
U.S. Dollar Index (CEC)
Monthly Price Chart

The US$ has been in a Bear Trend relative to Interest Rates since mid 2003, but it is important to recognise that this trend can continue EITHER if the dollar continues to fall OR if the yields continue to rise.

If the US Dollar starts to stabilise at around the 80-85 level, then a continuation of this Bear Trend in the relative relationship will occur if yields continue to rise strongly.

So the question arises: Will the US Dollar fall to new lows, or will yields break out to new highs?

A clue to this answer might lie in the relationship between Bond Yields and Real Estate related investments.

It can be seen from the two following charts that, whilst Fanny Mae is still in a rising trend relative to Bond Yields, Freddie Mac has broken down.

What this tells me is that there is a higher probability that yields will continue to rise than that the US Dollar will continue to fall.

If we look at the relationship between Gold and Bond Yields, we see that the relationship is at a very critical juncture. If yields rise any further, or if gold falls any further, the rising trendline - that has been in place since early 2001 - will be penetrated on the downside.

Is there a relationship between Commodities and US Bond Yields?

Well, according to the chart that follows, if there is it does not appear to have reached a particularly vulnerable stage, and commodities can fall (or alternatively yields can continue to rise) for some time before the relative Bull trend is threatened.

The chart below shows that Commodities have been in an exceptionally strong Bull trend of late:

However, when one looks at the copper chart, it appears that everything is not as rosy at it might appear on the surface:

TFC Commodity Charts
Copper High Grade (HG, Comex)
Weekly Price Chart

Note how the monthly chart of copper appears to be breaking down from a diamond pattern which, in turn, appears to have formed following an exhaustion gap.

Logically, if copper continues southwards, it is unlikely that the Commodities Chart as a whole will continue northwards.

So, the balance of probabilities favours a pullback in the Commodities Index.

But there is also a relationship between the $CRB and Gold, as can be seen from the following chart:

Even more importantly, that relationship is currently in a Bear Trend - ie Gold has been falling relative to the Commodities Index.

Of course, this relationship might reverse itself if the Commodities Index itself falls, so let's at another important relationship - namely that of Oil to Commodities Index:

That relationship appears to be heading for a "inflection" point, but note the gap on the chart (and note that gaps are usually covered). Also note that the Oil:Commodities ratio is still below its 200 day MA.

What about the oil price on its own?

The chart above shows a "possible" double top in the Oil Index, and the question arises as to whether this will be a point of withdrawal or a point of break through. Which is it likely to be?

The Point and Figure chart below seems to imply that it might be a break UP (but still relative to Commodities as a whole)

And the following daily chart seems to confirm this - but it ALSO appears to be reaching an overbought position from a trading perspective (Nore how the MACD histograms are starting to fall):

From another perspective, the oil price divided by the US Dollar looks incredibly strong, and this begs the question: If the dollar holds at the 80-85 level then for a break out above the RS peak level in the chart below, the oil price will need to continue to explode upwards.

Perhaps, a more likely outcome is that the relationship will pull back from here - with oil weakening relative to the Dollar (note that 669.84 below is lower than the peak level, and that a continuing pullback is not out of the question)

Finally, we come to the gold price chart itself:

It is clearly at a critical juncture and, if the $392 level is broken on the downside, an immediate target will be $376/ounce - which is still above the rising trendline.


Are there any conclusions that we can draw from the above:

Tentatively, we can argue the following:

  • The US Dollar has strong support at the 80-85 level. If it holds, then one scenario will manifest, and if it breaks, another scenario will develop
  • If the US Dollar holds, it seems likely that Yields (interest rates) will continue northwards; and all of commodities, oil and gold will head southwards
  • Conversely, it is the very strength of yields that may cause the US Dollar to hold these levels.
  • That interest rates may indeed continue northwards is hinted at by the relationship of Freddie Mac's price to yields - which has already broken down.
  • It seems possible (but unlikely) that the US Dollar will break to new lows. In this event, oil and gold will probably rise to new highs.

And this is where the chartists might find themselves burned at the stake:

From the following weekly chart of the dollar, it appears that the Dollar is going to break DOWN.

The RSI is approaching overbought levels, as is the MACD histogram, and the MACD line itself is in negative territory and the price is below its 50 week MA.

So, the $64,000 question is:

Will the "trading" techniques prevail or will the Relative Strength analysis prevail?

If trading techniques prevail, gold will rise like a phoenix from here.

If RS analysis prevails then gold will fall from here - which will cause certain critical trendlines to be penetrated on the downside..

Frankly, I don't know the answer; and I also note that the position has become significantly more complex in the past week when roughly a third of all outstanding gold short COT positions were closed out - which is a bullish sign.

However, I have come to believe that the "obvious" is not to be trusted - precisely because there are so many chartists who can see immediately that which is obvious.

My common sense tells me that the minority will survive and prosper in the market place, and by acting on the above weekly chart I will not be amongst the minority. I will be amongst the majority of chartists.

Which is why I have chosen to sit this one out and pay more attention to the Relationships.

I will be watching the yields and the US$ with great interest in the weeks ahead.

The purity of gold is measured in carat weight.
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