Inflection Point?

May 13, 2004

If one monitors the relationship between investments that have a high "beta" (volatility relative to the overall market) and those that have a low beta one would anticipate the high beta investments to point the way to the market's Primary Trend.

By way of explanation: Those investments that are deemed to be "sexy" will probably outperform the market as a whole on the way up, and will probably also lead the market on the way down. Thus, at turning or "infection" points, one would expect the relative strength charts to be giving signals.

In this context, let's have a look at the relationship between the "sexy" $HUI and the "plain" $XAU

The following WEEKLY chart (courtesy Stockcharts.com) confirms that the $HUI has been outperforming the $XAU during the gold bull market.

Note how the 50 week Moving Average appears to have provided support to the relationship, and note, particularly, how the downside penetration of the MA line in July 2003 proved to be a market bottom.

It is of great interest that we currently have another downside penetration, and this raises a question: Is this another market bottom for gold, or is it the beginning of a new down trend?

My personal view is that there is a higher probability that it is signalling a market bottom than that the Primary Trend of gold is changing to become bearish.

Unfortunately, I don't have the time nowadays to sit and labour over these articles, so I will have to give a thumbnail sketch of why I have this view (NB. This is not an investment recommendation. I sold half my gold/silver shares several weeks back and I repurchased a couple of weeks ago and I am naturally concerned regarding whether I may have made a mistake or whether I made the correct decision. The purpose of this article is to clarify my own thinking and to "share" with anyone who may wish to read my ramblings).

The daily Relative Strength chart is showing what might turn out to be a double bottom, and the MACD of the relationship has just given a technical buy signal. (See below)

Unfortunately, this buy signal will only be meaningful if the Primary Trend is "Up". However, if the Primary Trend IS pointing up what it ALSO signals is that "speculation" is still likely to be present in the gold market, and that we therefore need to proceed from the base understanding that volatility on the upside is likely to continue, and possibly accelerate. Concomitantly, if this next up move does turn out to be the beginning of a second "Primary Leg", then it is likely to be a highly speculative one, filled with emotion.

I would also like to warn readers that I do not believe that the gold market behaves like other markets and that it will therefore NOT have a "third" Primary Up-leg. What we "may" be about to experience is the second and "Final" Primary Up-leg.

The reason for this is that the gold market is very thin, and is also subject to artificial outside influences. From my past experience in the 1980s I came to the conclusion at that time that the Second Primary Up-leg of the Gold Bull market is more likely to take on the characteristics of the "gambling" oriented Third Up-leg that is typical of other more freely traded markets.

In a more freely traded market the THREE Primary Up-Legs are driven by:

  1. Visionaries (in the First Leg)
  2. Professionals (in the Second Leg)
  3. The Public (In the Third Leg)

The Gold market is too thin to allow the broadly based "Professional" market to participate - for the main reason that Professional Investors require an "exit", and the gold market is too thin to allow for an orderly exit - either at the top or on the way down. For this reason, - PROVIDED we are about to enter the next Primary Up Leg of a Bull Market - it seems likely to me that this next move will likely be driven by the Public; who will be behaving more with emotion than with rationality.

So, we have a conundrum:

If the Primary Trend of the Gold market turns down from here, it is likely to signal a return of "normal" market conditions in the financial markets in general. However, if it turns up from here then the Financial markets in general may be approaching a period of dislocation.

The EXTENT of the dislocation will influence the extent of the emotionality that will begin to manifest in the gold market - because I believe that gold is the ultimate barometer of Social Pressure - and THAT is the Primary Reason why I have been monitoring its so closely for the past thirty years or so.

So the $64,000 question is: Given that we appear to have reached an inflection point, will the Primary Trend of the Gold Market resume its upward march, or will it turn down from here?

To me this is not a question for technical analysis. The charts do not have "predictive" power of this nature. They merely reflect what the market is currently thinking, and analysts then make a best guess as to whether this thinking is likely to continue or change.

In my mind - AT THIS POINT IN HISTORY - there is a greater probability that the financial markets will increase in their level of nervousness than that they will calm down.

There are several reasons for this:

1. The Industrial Revolution has essentially been built on "energy", and the Primary Source of that energy in the past three generations has been oil. The oil price is now signalling that the industrial infrastructure of the world may be coming under threat from a cost point of view - which, in turn, is likely to have a structural impact on consumer prices. (In my mind, when the politicians finally start to understand what is happening they will discover that the failure to ratify the Kyoto Protocols was one of the most heinously irresponsible omissions in the history of Mankind. Ratification of these protocols would have given rise to a raft of technologies which would have fast tracked the reduction of our dependence on oil as the primary source of energy. This is quite apart from the global warming issue which is equally serious.)

But there is still hope. The following chart shows that the markets are expecting the oil price to top out (or at least pull back somewhat)

2. So, if the oil price is reaching for a (temporary?) peak, as Alfred E. Newman used to say: "Wot. Me Worry?" Well, the short answer to Alfred is "Yup, you had better worry", because Industrial Activity in the World has been artificially stimulated (much like a junky injects himself with drugs) by Fiat Money Supply - to the point that the world economy has become "Hooked" on this Fiat Money supply. Like the Junky, if we don't wean the economy off this money (drug) supply, then it is likely at some point to drop down dead. So, it seems unlikely that the Money Supply will continue to rise for much longer because that will virtually guarantee the junky's death by overdose.

The bottom line is that the reason oil may be topping out is that demand for oil may reduce due to a coming slowing down of the industrial economy of the world.

3. The above leaves us with a likely moribund economy going into the future, and a mountain of Debt that the junky will have to work out of its system. 

But how can the debt be worked out if the money supply growth rate is going to slow, leading to a slowing down (at worst) and a maintenance (at best) of economic activity?

Clearly, if people have been borrowing money on the base assumption (which has proved correct over three generations) that in an environment of inflation you borrow valuable money today so that you can pay it back over time in depreciating value currency. And the reason it depreciates in value is that more of it is being printed and being made available. But what if the money supply stops growing? Well then, inflation will top out and the current currency will retain its value. In fact, it will probably grow in value as insolvencies start to grow and the availability of this money comes into a period of SHRINKING availability.

The interest rate charts are reflecting that the markets are anticipating currency to become more valuable because the price of that currency (as reflected by interest rate) is now rising:

So, the Federal Reserve (as well as its self interested backers) is/are finally facing the result of its historical follies:

If it continues to infuse the money drug into the Economic System, the system is likely to overdose - and die - but if it tries to wean the junky off the drug, the junky is likely to experience TERRIBLE withdrawal symptoms.

Which brings us to gold.

Up to now, gold has not shown any symptoms of being regarded as the currency of last resort, but here are a couple of straws in the wind:

Just yesterday, I received some junk mail about a competition to win an $80,000 grand prize consisting of a $60,000 motor car and $20,000 of Gold Bullion. Yes. Gold is still alive and well in the minds of the public - despite the attempts of the Central Bankers of the world to discredit it.

My logic tells me that, this being the case, the ONLY way that the authorities can once again bring the world economy under control is to "embrace" that which is still generally regarded by the world at large as having value, and INCORPORATE it into the solution. What I am therefore expecting to see - in time - is that the authorities will eventually start to make noises about going back to some form of gold standard. However, that will come with a concomitant set of "compromises", one of which is likely to be that gold will once again come under the "official" control of the world's financial authorities.

In my mind, it will be a choice of this outcome or anarchic chaos, and the public will eventually submit.

The problem, as ever, is timing. However, I have discovered over the years that I am usually 10-15 years ahead of my time and therefore, for the foreseeable future, I am personally taking the view that gold is more likely to enter the second up leg of its Primary Bull market than it is to enter a Primary Bear Market.

This may turn out to be a mistake (I now understand that I am not a crystal ball gazer) - which is why I am also pursuing other cash generating activities.

I have always seen the wisdom of Cecil John Rhodes' argument: Democracy is flawed because it gives rise to "lowest common denominator" decisions. To avoid such decisions, one needs to have a political infrastructure that can influence the outcome of these decisions. Ultimately, there has to be a boss (with checks and balances). As the old saying goes: A camel is a race horse that has been designed by a committee.

Yes, Cecil, the world cannot be run by "committees". But it cannot be run by megalomaniacal individuals either. It is therefore time for the likes of George Bush to be ejected from the system. The system needs to flex its muscles every now and then to keep the megalomaniacs honest.

But, in the final analysis, Cecil, if we don't put the interests of society above those of the individual, then society will disintegrate. How will that help all the individual geniuses?

China has only 2% of its Total Foreign Reserves in gold.