April 17, 2013

Bulls, Bears and Pigs: Inflection Points

Guest post by Bulls, Bears and Pigs

Quite an eventful week! Lots to talk about. The SPX powered its way to a fresh all time high and is closing in on 1600 yet all I see is more whining and complaining. The latest complaint is that it's the "defensive" names that are leading the market and so the rally is false. Then of course you have the perennial "the bull market is phony because it's all due to the fed" complaint.  Back in 2009 and 2010 there was a lot of complaining about how the advance was occurring on low volume and yet another complaint was that the rally was occurring at the expense of the US dollar and so the bull market was false. Complaining, whining and staying angry at the Fed -that's all people seem to be able to do. By the way the market is up 140% from the bottom and the dollar is only down about 6% from that point and so the "rally is phony" argument is total bs.

A really bizarre thing happened this week with AAII sentiment. Despite the market making fresh all time highs, the bull/bear ratio plummeted to .35  which is the lowest level since March 2009! When I first saw this number I was shocked and I figured it had to be an error but it's not! Normally you see such extremes in bearish sentiment when the market has been getting hammered. I have never seen such a extreme bearish reading like this when the market has been so strong not to mention making all time highs. On a stand alone basis this has enormous bullish contrarian implications but you should never hang your hat on just one indicator. Other measures of sentiment aren't nearly as bullish, but there are some corroborating indicators which suggest that in the ST the market still has the fuel to power higher still. Bonds once again are indicative of this which are in the same condition as  I pointed out last week which led to a ST bottom as I expected. Fund flows into equities have been quiet the past 3 weeks which again supports the notion that shorter term, the road is cleared for the market to make a further advance. One thing's for sure....there's no way I'm going to play the short side with the above mentioned conditions for it suggests that any downside from here will be limited...for now.

Lots of buzz about gold this week and its 20% slide into "bear market territory" as the media is calling it. Readers of this blog know that I've not been a fan of gold for some time but anytime it had a setback I was quick to admit that it looked like a correction rather than the start of a bear. This time however, we could actually be looking at the start of a bear market and if it is...better hang on your hats! First of all, I don't automatically assume a 20% drop constitutes a bear market. It all depends on how that 20% drop takes place. A sudden decline of 20% of a market that had been climbing relentlessly most likely represents a steep correction in an ongoing bull market rather than the start of a new bear market. Examples of such are the 1987 crash, the 1998 correction and the correction in 2011. The 20% decline in gold did not occur this way. It  dropped to its most recent low in a multi-month downward trending fashion characterized by lower lows and lower highs - that's bear market action. It also registered a 21 month low and that's something you tend to see in the early stages of a bear market - not a bull market correction.

Let's look at the explanations for the drop in the gold price. From what I've gathered the main explanation is that  the drop is due to the restoration of confidence in the US and in the dollar which is the result of the relative strength of the US economy and its equity markets.   Last week's drop in gold was probably exacerbated by Goldman's downgrade of gold and the news that Cyprus might sell reserves, but since gold had been declining prior to this, I don't think these factors are soley responsible - they simply added fuel to the fire that was already burning. Basically, I believe that the decline in gold price could be summed as the unwinding of pessimism towards the US and the dollar.

Now having said all this, there are a number of signs that suggest the negativity towards Gold is at a ST extreme. I turned on BNN Friday and all they talked about was the decline in gold and it's not just them; there's tons of coverage out there in the financial media pointing out how gold has dropped by 20% . I read an article in the Globe and Mail  Friday titled "All shine and no substance: the reality of gold." Talk about kicking someone where they're down.  I also noticed every single "technician" out there is expecting a lot more downside this week now that  gold closed below a key support level. Volume in the GLD etf spiked to an extreme which is often indicative of capitulation. GTU is trading at a 6% discount to NAV. The last time this happened was late April-early May 2011 when gold had a sharp but short lived pullback. So, I think there's a good chance that this breakdown in the gold price last week could end up being a massive bear trap and a vicious snapback to 1550-1600 could take place. I may intend to play this I get the right set up. We could be in a situation with gold similar to that of March 2008 in the equity market when the market dropped 20% before making an IT bottom which lead to a strong rebound for 2 months. It's also possible of course that all we are seeing here with gold is a lengthy consolidation/shakeout phase which began in August 2011.If you pull up a LT chart you could make the case that, with the exception of Friday's close, the gold price has been going sideways for several months.

Gold bulls have their reasons to remain bullish the main one being that there is unprecedented "money printing" going on all over the globe via QE and it's just a matter of time before the inflationary impacts of this gets unleashed. Well, first of all, QE is not money printing per se because it doesn't permanently raise the supply of dollars for the Fed can reverse QE and therefore "destroy" the money they created at will.  Gold bugs have been warning about hyperinflation for over a decade now and it hasn't happened. We never had an inflation problem. If we did, it would be reflected in the bond markets via high interest rates and rates have been historically low even before QE. If you want to see a period of high inflation look to the 70's where interest rates were double digits and there was broad based inflation in all goods and services. Yes, we saw a dramatic rise in energy prices over the past 13 years but that was primarily the result of supply/demand dynamics of commodities namely a surge in emerging market demand - not monetary policy and the commodity price spike didn't spill over much into the general prices of goods and services. I'm sure you can find exceptions but for the most part, you can't honestly say we've had an inflation problem in North America. And if monetary policy was the main driver of commodity prices explain to me how the prices of coffee, natural gas, orange juice, olive oil and other commodities have plummeted in value over the past few years to multi-year lows. Easy money probably has an exacerbating effect on a bullish supply/demand situation for a commodity or any asset class but it's not the primary driver...at least that's my view. Anyhow, I digress

Getting back to gold. When I first turned bullish on gold in late 2000 it was because confidence in the US was just starting to roll over from an all time high and I figured that since I believed a big bear market in stocks was underway, the status of the US being the economic powerhouse of the world would fade considerably along with confidence in the US dollar as a reserve currency. Basically,  I believed that there would be a gold bull market due to a substantial rise in pessimism towards the US in general which would make people flock to gold which at the time was very under owned. Also, the avg cost of producing gold was well above the gold price at the time ($260/oz) which meant that gold strictly as a commodity was undervalued . We all know what happened afterwards (and by the way I got off the gold train waaaaaay too early).

 So, if the gold bull market was to have ended and a new secular bear has begun I ask myself do we have an inverse of the conditions that I noted back in late 2000?  The answer to that is yes!  Let's first look at factors I outlined above

1)confidence in the US/dollar.

There's no doubt in my mind that pessimism towards the US and the dollar hit extremes these past few years. There's is the notion that the US is in a state of decline equivalent to the fall of the Roman Empire. The dollar has been beyond trashed and it's status as the world's reserve currency severely weakened as central banks have looked to diversify out of dollars and into Euros and gold these past few years....the same gold by the way that they were willing to sell en masse in the 1990's for sub $400/oz. Despite all the trashing of the dollar and how the fed has been "debasing" it,  it's about the same level as it was 6 years ago (trade weighted as per ticker $USD) and has been on an uptrend for about 2 years which started right about the same time gold peaked. I doubt this is a coincidence. There have been many reasons cited as to what drives gold but it's  been my opinion that the main factor is the US dollar.  Gold as a "reserve currency" or "safe haven" has only one major competitor and that's the US dollar.

2) ownership level of gold

A secular bull market begins when an asset class is under owned like gold was in 2001. Only the hard core gold bugs held gold and/or gold stocks. I cited here a few times how in 2001 when gold started rising I specifically recalled the "pros" on CNBC dismissing the move saying gold should be traded not invested in.. That notion has been completely reversed. In recent years the pros have stated that gold is in a LT uptrend and should be a component of one's portfolio at all times to protect them from upheaval and central bank "money printing." They also said that gold will do well in inflation or deflation conditions. lol! What a crock of shit that statement is. Investment demand in gold surged over the past 10 years especially since 2008 and so it's definitely not under owned anymore. I don't think it's as over owned like tech stocks were in 2000 but I think there's enough people "in the pool" to fuel a big bear market should they start unloading gold.

3) avg cost of production

This one is a bit tough to ascertain  From what I can gather the avg cash cost of gold production is about $950/oz give or take but the "all in cost" could be average about $1250.  That suggests that the gold price isn't over inflated on a commodity level. This suggests we shouldn't see a complete collapse in the gold price should there be a gold bear market but if things get bad for gold a fall to $800-$1000 is quite doable as bear markets often send a commodity below the cost of production...sometimes well below it. Just look at what happened to nat gas.

WTF? For some reason blogger didn't save what I had written after the above paragraph. Well, it's too late to rewrite it now...I'm off to bed!