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The US manufacturing sector stays strong

The Institute of Supply Management (ISM) issued its monthly report on the US manufacturing sector on Tuesday 2nd September. This report is the most useful coincident indicator of US economic performance.

The latest report showed that the strengthening trend of the past several months continued in August. Of particular relevance, it showed that the New Orders Index, a chart of which is included below, rose to a 10-year high. This means that the US economy is still in the boom phase of the boom/bust cycle caused by monetary inflation and interest-rate manipulation. The boom could end at any time, but it hasn't ended yet.



This Friday we get the next installment of the monthly US Employment Report. The Employment Report is one of the most useless indicators of economic performance, but it often causes significant knee-jerk reactions in the financial markets due to its apparent influence on the Fed.

The Global Boom/Bust Indicator

The gold market is generally weak relative to the industrial metals markets during the boom phase of the inflation-fueled, central-bank-sponsored boom/bust cycle and strong relative to the industrial metals markets during the bust phase of the cycle. In other words, the gold/GYX ratio (gold relative to the Industrial Metals Index) tends to fall during the booms, which are periods when economic confidence rises while mal-investment sets the stage for an economic contraction, and rise during the busts, which are periods when the mistakes of the past become obvious. This is due to gold's historical role as a store of purchasing power and a hedge against uncertainty.

By shading the bust periods in grey, we've indicated the global booms and busts on the following chart of the gold/GYX ratio. During the 16-year period covered by the chart there have been three busts: the recession of 2001-2002 that followed the bursting of the NASDAQ bubble, the global financial crisis and "great recession" of 2007-2009, and the euro-zone sovereign debt and banking crisis of 2011-2012.

The booms tend to fall apart more quickly than they build up, so the rising trends in the gold/GYX ratio tend to be shorter and steeper than the falling trends.



Gold/GYX's current situation looks most similar to Q2-2007. At that time the ratio tested its late-2006 bottom and then reversed upward, marking the end of the boom that began in 2003. However, gold will soon have to start strengthening relative to industrial metals such as copper in order for the 2007 similarity to be maintained. If this doesn't happen and the gold/GYX ratio breaks decisively below its December-2013 bottom, it will indicate that the boom is going to extend into 2015.

We stress that gold's relationship to the boom/bust cycle is primarily about its performance relative to other commodities, especially the industrial metals. It is not about gold's performance in US$ terms. For example, from mid-2005 through to mid-2006 gold performed poorly relative to the industrial metals, but this was a good time to be long gold and a very good time to be long gold stocks. It's just that the industrial metals handily outperformed gold during this period, which makes sense considering the global economic and financial-market backdrop at the time. For another example, from May through November of 2008 gold performed extremely well relative to the industrial metals. This makes sense considering the global economic and financial-market backdrop of the period, but it was a bad time to be long gold and a very bad time to be long gold stocks.

A few words about frustration

The Stock Market

The S&P500 Index (SPX) continues to trade sideways around the magical 2000 level. Specifically, on each of the past 7 trading days the SPX closed at 2000 +/- 3 points. A sharp move is likely to begin within the coming few days and the direction will most likely be down, but the possibility of an upside blow-off cannot be ruled out.

Meanwhile, back in Europe, more evidence has emerged that the EURO STOXX 50 Index (STOX5E) has completed a downward correction of similar size and duration to the downturn that occurred during May-July of last year. We first mentioned the likelihood that the STOX5E had completed a downward correction in the 25th August Weekly Update.

The evidence we are referring to is illustrated by the following chart. The top section of this chart shows that the STOX5E has clearly moved above its 200-day and 50-day MAs, and the bottom section shows that the STOX5E/SPX ratio has reversed course on at least a short-term basis.



Note that it isn't just the STOX5E that the SPX has begun to underperform. There are signs that the relatively expensive US stock market has begun to underperform on a global basis.

Gold and the Dollar

Gold

Last week's price action ushered-in the possibility that the gold price would drop to the bottom of its short-term channel this week. As illustrated by the daily chart included below, a drop to the channel bottom has just occurred.



Our view is unchanged. We think that the slow two-steps-down-followed-by-one-step-up decline that began in early-July is a correction to the rally that began in early-June, and that everything that has happened over the past 9 months is part of a long-term basing pattern at the beginning of a new cyclical bull market. However, for our interpretation of the short-term price action to remain plausible, the gold price will have to begin rallying soon (by early next week at the latest).

The biggest short-term threat to gold is the potential for upward acceleration in the US stock market, which would most likely occur as part of a final upside blow-off. An upside blow-off in the US stock market over the weeks ahead is not a high-probability outcome, but it has a realistic chance.

Gold Stocks

The HUI went down with gold during the first half of the trading week but remains within the bounds of the rectangle in which it has oscillated since late-June. Refer to the top section of the following daily chart for details. A break below the bottom of this rectangle would suggest a downside target of 215-220, whereas a break above the top of this rectangle would confirm that the oscillations of the past 2 months constituted a mid-trend consolidation and suggest that the HUI was on its way to 300. We have been expecting and continue to expect an upside breakout from the rectangle, but the risk of a downside breakout has risen due to the fact that we are now into September with no sign of the expected rally.

The GDXJ/GDX ratio has been the best indicator of the gold-mining sector's short-term situation. As noted on the bottom section of the following chart, an upward surge in this ratio marked the start of the last two tradable gold-mining rallies. There's a high probability that it will also mark the start of the next rally, so any strength in the HUI will be suspect if it isn't accompanied by material strength in the juniors (as represented by GDXJ) relative to the seniors (as represented by GDX).



The Currency Market

There's a high probability that the euro is close to a short-term bottom. This is due to a) the extent to which it is oversold (as measured by momentum indicators and distance below the 200-day MA), b) the huge speculative net-short position in euro futures, c) the close proximity of the current price to the bottom of the 2-year price channel (see chart below), d) the recent upward reversal in European equities relative to US equities, and e) the recent upward reversal in an index representing European bank stocks. The ECB meeting later today (Thursday 4th September) could be the catalyst for a modicum of additional downside, because there is much anticipation that new 'stimulative' measures will be introduced at this meeting. However, an upward reversal is likely within the next few days almost regardless of what the ECB announces.

Also, the ingredients are in place for an intermediate-term bottom in the euro.

Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://research.stlouisfed.org/