April 26, 2013

Sell in May or Stay?

Guest post by Bulls, Bears and Pigs

Two Mondays ago gold took a 10% hit and all because China reported 7.7% GDP instead of the expected 8% the night before. That's not really a big miss and so such a catalyst doesn't seem justify that kind of damage but I guess since this "bad news" came at a time when gold was already trading very weak breaking major support, it doesn't take much to trigger an avalanche of selling with margin calls fueling the fire. I'm not surprised to see the rebound that gold has had and I suspect a full retracement of that panic sell off will take place. I'm kicking myself a bit for not buying calls on GLD a few days ago. My finger was on the trigger but I just couldn't pull it.

Gold the "commodity" is another thing I wanted to talk about in my previous post.. In the 2000's commodities became "financialized" as institutional investors embraced it as a major asset class. As a result we have seen large "investment demand" of commodities via commodity futures and commodity backed ETFs for the past 10 years. There have been debates as to how much impact this had in driving commodity prices. I suspect it had a lot of impact both on the upside and downside. Gold was right in the thick of things went it came to the financialization of commodities. The arrival of GLD in 2004 was the primary conduit for "investment demand" to flow into. GLD has been responsible for massive accumulation of physical gold (since its required to be backed by gold) which no doubt drove the price up. Gold bulls have enjoyed the tailwind of the investment demand for about a decade and make no mistake about it, the investment demand for gold is responsible for the vast majority of the rise in the price of gold - I'd say 80% or more (jewerly demand has been flat and  the drop in the dollar mathematically only justified about a doubling in the gold price from its low at $260 ).  But if you live by the sword you die by the sword. If the investment demand has peaked and is now heading south, then gold bulls are in for a world of hurt longer term.

Gold is such a debated topic. You can find strong arguments pro and con. At first I was going to go through some of the major points of these arguments but I'm going to cut to chase and talk about what counts - where is the price headed.  I think in the short to intermediate term, gold will continue to rebound as it got very ST/IT oversold at its recent low and sentiment as measured by trader type indicators, got extremely negative. Longer term, I believe there's a good chance we have seen the end of the bull run that began in 2001 and here's why...

At the very beginning of a secular bull market for any asset, conditions had been bleak for it for quite some time to the point where nobody wants to own it and the price had been taking a beating to the point where it's significantly undervalued, which of course is the best time to be buying. That's where gold was in 2000. Equities had been in a 10 year bull run, unemployment was at record lows, central banks were selling and the US dollar was king. At a major top/beggining of a bear  it's the opposite. Things look the most promising, the price had been going parabolic and by then everyone who ever wanted to buy has bought, which of course it the best time to sell/short. I believe this situation is where we stand with gold.

Gold had a 10 year run from 2001-2011 without a down year gaining about 550%  from the bottom. Constrast the conditions I mentioned above for gold which prevailed in 2000 just prior to its epic bull run to now. It's the total opposite. During the span of these last 10 years you had a significant decline in the value of the US dollar, 2 huge bear markets in equities, a once in a century meltdown of the global financial system, central banks buying, the most accommodating Fed in history, stubbornly high employment, ongoing concerns of a European collapse and I'm sure I'm missing some other major negatives that support the "gold is a safe haven" notion. Aside from a collapse in the fiat monetary system, things pretty much can't be better for gold and so I think most of the people who ever wanted to own gold owns it by now. So, if we're at that point there's only way for the price to go longer term that that's down....all it takes is the unwinding of one of the major supporting catalysts to trigger the transition.

I've been reading stories about how there have been line ups of people buying physical gold on the dip in Asia. You might think this is a bullish thing but it's not. Shorter term, yes, but not longer term because it shows the type of behavior you see in the first major decline of a bear market - denial. When you see people embrace a big decline like that it's a bad sign longer term. These dip buyers probably represent the last bastion of buyers who have always wanted to buy gold but have been waiting for a "pullback". Once these dip buyers are exhausted the downtrend will resume but in the interim, there could very well be a strong rebound. When the tech bubble burst the initial decline was about 40% but that decline was followed by a 40% rally before the real damage took place!

Switching gears now to the equity markets. We are now approaching the "Sell in May and go away" period. For the past 3 years this strategy worked out pretty well. I've been saying since early this year that we would probably not see a significant correction begin until sometime around May. I gotta tell you though, as of right now, conditions do not support anything more than just a minor dip. AAII has shown 3 consecutive weeks of bears outnumbering bulls by a significant margin, bonds have been very strong for a month and retail inflows into equities has been flat for a month as well. In fact, despite the strong market this week, there was a sizable outflow! I've never seen a major correction begin with such conditions..it instead suggests that the market will go higher still or go sideways with only modest dips.  Perhaps people have been catching on to the "Sell in May and go away" notion and if that's the case, it makes it less likely to work this year!

On the fundamental side of things, everyone's talking about the slowdown in emerging markets and it's no secret that Europe is in recession. Lot's of people are also saying that the weakness in commodities, especially copper, is ominious for the global economy/market. I say that's bullshit. I say the action in commodities is a coincident/lagging indicator.  Look at every significant top in the past few years and you will see "Dr. Copper"  gave no such warnings.  The most flagrant example was how copper and other commodities were making new highs in the first half of 2008 while equity markets were rolling over. What signal did that give? I believe commodity weakness in the face a strong equity market is bullish not bearish for lower prices are economically stimulative. We have seen strong rallies get short circuited anytime commodities run up too much like in the spring of 2010 and 2011 as it provided an economic drag.

The following charts shows the recent state of the global economy.

This doesn't look too great, but the market doesn't care about what just happened, it cares about what's going to happen. This chart shows that the global picture will be a lot brighter in the near future.

Perhaps this brighter outlook as per the leading indicator above, is why the global markets (especially in Europe) have held their own despite the economic data having been piss poor in recent months. The brighter outlook for the global economy also bodes well for commodities in general which would be a tailwind for gold.  I think commodities bottomed this week.

Bottom line: Unlike last the 3 years, conditions are not suggestive at this point that a major correction is going to begin in May. The market seems poised to either go sideways or higher at this point. If conditions change I will change with them.