Gold and the Stock Market

Sometimes we worry that we are throwing too many alternative scenarios at our readers and, in doing so, creating an unnecessary amount of confusion. It would be nice to be able to lay out in clear, concise terms, what we think is going to happen and why it is going to happen that way. It is usually possible for us to do exactly that as far as our longer-term (12 months or longer) views are concerned, but when it comes to the shorter-term stuff our level of uncertainty is typically greater. This is because the shorter the time frame the more random the market movements tend to be (on any given day it is often difficult to distinguish the 'signal' from the 'noise'), and also because the financial markets are extremely deceptive. In particular, on a day to day, week to week or even month to month basis, the markets will usually behave in a way that stops most market participants from understanding the big picture. As such, during long-term bear markets there are enough rallies of sufficient magnitude to keep hope alive most of the way down, and during long-term bull markets there are enough gut-wrenching pullbacks along the way to keep most participants, even the correctly bullish ones, from fully committing to the uptrend.

For the reasons laid out in detail in many commentaries over the past 3 years, we are confident that the gold price is headed MUCH higher and that the major US stock indices are headed MUCH lower. And, as each month goes by the evidence that these views are correct continues to pile up. However, the gold and stock markets are doing a very good job at the moment of concealing how they are going to get from where they are now to where we expect them to be in 12 months time. 

The fact that the paths to be taken by both the gold and stock markets over the next few months are less than clear is not surprising because all the major markets (stocks, bonds, currencies, gold and commodities) are inter-related. In other words, the firmer our grip on what is going to happen with the gold market over the next 3 months the better our chances of figuring out how the stock market drama is going to play out over the same period. Fortunately, although we can't know exactly how the gold market's correction is going to unfold and, therefore, when the next leg in gold's bull market is going to begin, we have been able to establish some guidelines. These are:

1. From a seasonal perspective, the most likely times for a low in the gold price are July-August and October-November.

2. The rally in the US$ shows signs of being shallow and short-lived, suggesting that a major downturn in the gold price is not on the cards.

3. At the recent peak in the gold market the small traders did not have a large net-long position in gold futures, meaning that there were not a lot of weak hands in the market.

Taken together, the above suggest that the gold price will reach its correction low over the coming month or so and that this next low will be above the previous low (reached in early April when spot gold traded down to around $320). Also, given gold's cyclical tendencies a reasonable assumption is that there will be a low in August and another (higher) low in October-November.

We are now going to do our best to avoid creating more confusion while throwing some more potential scenarios your way.

There is a tendency for the S&P500/gold ratio (the S&P500 Index measured in terms of gold ounces) to reach important peaks at around the same time as, or before, the gold price is making an important low. Therefore, if our gold market view is close to being correct then regardless of what happens to the nominal S&P500 Index, the S&P500 Index in terms of gold is likely to have peaked by the time the gold price reaches its next correction low. That is, even if the S&P500 Index continues to rally for several more months (something we don't expect, by the way) the S&P500/gold ratio is likely to peak some time between now and the end of August.

The below chart compares the S&P500/gold ratio with the gold price over the past 5 years and shows projections based roughly on what we've discussed above. As far as the stock market is concerned, these projections show what we consider to be the most bullish outcome. An equally likely alternative to the outcomes illustrated on the below chart is that the next low in the gold price will be followed by a rally to a new high for the year (as opposed to the on-going consolidation shown on the chart). In this scenario, a July-August peak for the S&P500/gold ratio would be followed by a major decline rather than the extended topping process represented on the chart.

As an aside, the above chart shows an Elliott Wave (EW) interpretation of the action in both the S&P/gold ratio and the gold price over the past 4 years. Our experience has been that EW analysis has little value as a forecasting tool, but it can be very useful in explaining what has happened in the past. Furthermore, it can also be used to explain what is likely to happen in the future in those situations where one has already developed a high-confidence view via non-EW methods. We certainly do have high-confidence views regarding the longer-term outcomes for the gold and stock markets and have, on the above chart, shown how an EW analysis would mesh with these views.

The US Stock Market

Microsoft just sounded the death knell for the great stock-option scam

The reported financial results for many US companies, particularly the large-cap technology companies, have been given a substantial boost over the past 10 years by the fact that a lot of employee compensation has been in the form of stock options. Earnings have benefited because most companies have not expensed the value of these options in their financial reports to shareholders and the media. At the same time, cash-flows have been boosted because the companies were permitted to deduct the value of options from their incomes for tax purposes. This was all totally legal, but it was/is a scam because either stock options are an expense or they are not. If they are an expense then the associated cost of the options should be deducted from the earnings reported to shareholders and the media as well as from the earnings reported to the IRS. If they are not an expense then they should not qualify as a tax deduction. As an illustration of how significant the option scam was/is, Cisco Systems has been a very profitable company and was briefly the world's largest company in terms of market capitalisation. However, had stock options been correctly expensed then Cisco would not have made a single cent of profit over the past 5 years. 

Microsoft was one of the pioneers of the large-scale use of stock options so it is fitting that MSFT has probably just signaled an end to the practice. In an announcement on Wednesday MSFT stated that it would no longer be issuing employee stock options. Instead, it will be issuing restricted stock (stock that will vest over time if the employee remains with the company). Furthermore, MSFT confirmed that all equity-based compensation (the existing stock options and the restricted stock issued in the future) would be expensed from now on.

The management of companies such as Cisco (the ones that don't have profits in the absence of the stock-option scam) are no doubt going to resist the move towards option expensing for as long as possible, but the tide has turned.

Current Market Situation

From the e-mail alert sent to subscribers following Monday's stock market surge: "...stock markets throughout the world were very strong on Monday. Monday rallies are often suspect, but even though almost all of the upside in the major US stock indices occurred during the first 2 hours of trading there were definitely some bullish developments during yesterday's session. In particular, the NASDAQ100/Dow ratio moved to a new recovery high. This suggests that the S&P500 Index is still at least a few weeks away from a major peak. Also, the Semiconductor Index (SOX) made a new closing high for the move.

One possibility we haven't discussed, because it didn't seem at all likely prior to yesterday's trading, is that the stock market will surge to a 'blow-off top' over the next 1-2 months. Such an outcome would set the scene for a spectacular collapse over the ensuing months. We'll discuss this prospect in more detail in Thursday's Interim Update if the market is able to hold, or build on, Monday's gains."

Below is a 2-year chart of the NASDAQ100/Dow ratio. The NDX/Dow ratio is the indicator we've watched more closely than any other over the past 6 months because it has consistently moved lower during the final stages of rallies in the market and during the early stages of major declines. Another way of saying this is that the NASDAQ100 Index tends to gain downward momentum first during the major declines and lose upward momentum first during the final stages of counter-trend rallies. So, as long as the NDX/Dow ratio is making new highs it is reasonable to assume that the overall market has not yet reached its ultimate peak. Therefore, this week's surge to a new high by the ratio suggests that both the S&P500 Index and the Dow Industrials Index are probably at least a few weeks away from their ultimate highs.

Note that the below chart also includes a 70-day moving average. Why 70 day? Because this is the number that has given the best results in terms of confirming trend changes over the past 2 years. Whenever the NDX/Dow ratio has crossed its 70-day MA over the past two years it has proven to be a timely warning that either a substantial rally was underway (when the ratio has crossed from below to above this MA) or that a major decline was about to commence (when the ratio crossed from above to below this MA).

As mentioned in this week's e-mail alert, the new highs in the NDX/Dow ratio mean that a 'blow-off top' is possible in the market over the next several weeks (a blow-off top occurs when a market that has been trending higher for an extended period goes 'vertical' for a few weeks). Blow-off tops always end in major trend reversals, so beyond the short-term such an outcome wouldn't be bullish. Like crashes they are, however, quite rare, so even though the door is now open for such a move we don't consider it to be the most probable outcome. 

There are enough bearish divergences on the go at the present time for us to think that a pullback remains the most likely short-term outcome. For example, the General Electric stock price has been noticeably weak of late (GE is the world's largest company in terms of stock market capitalisation) and the Walmart stock price remains comfortably below its April peak (Walmart is the world's largest company in terms of annual sales). If the overall market were going to rocket higher over the next six weeks then Walmart should be making new highs right about now. As things currently stand WMT is in 'no man's land' between resistance and support. A move outside the 51.50-57.50 range shown on the below chart is needed to tell us anything meaningful about the overall market situation. 

We will continue to hold the December put options that are currently in the TSI Stocks List. In the event that the market does experience an upside blow-off over the next few weeks these options will lose most of their remaining value, but they would fully recover during the subsequent collapse. In the event that the market pulls back over the next few weeks but does not provide us with evidence that a major decline is underway (e.g., via the NDX/Dow ratio moving below its 70-day MA), we will exit the puts. Lastly, if we do see evidence that a major decline is underway we will probably add more put options to the Stocks List.

As an aside, we generally consider speculations in out-of-the-money options to be 'all or nothing bets'. Consequently, the amount of money put at risk in any such speculation should always be small enough that a 100% loss can be taken without causing any emotional or financial discomfort. In the coming Weekly Market Update we'll deal with risk management practice as it specifically relates to options trading.

Gold and the Dollar

Gold in terms of 'other' currencies

The below chart shows the US$ gold price multiplied by the US$ Index, so it effectively shows how the gold price has performed in terms of major currencies other than the US$. This chart indicates that the relative value of gold has, over the past 4 years, risen in terms of fiat currency in general rather than just in terms of the US$ (if every one percent fall in the Dollar Index over the past 4 years had resulted in a one percent rise in the gold price, the chart would show a horizontal line).

With reference to the above chart, notice the big difference between the price action of the past 4 years and what happened throughout the 1990s. In a bear market a steady trend towards lower prices tends to be punctuated by sharp rallies, whereas in a bull market a steady trend towards higher prices tends to be punctuated by sharp declines. 

Current Market Situation

Below is a daily chart of August gold futures. As has been the case for about 8 months now, the 18-day moving average continues to act as support during the medium-term uptrends and as resistance during the medium-term downtrends. We expect the gold price correction to continue over the next few weeks, but if August gold achieves two consecutive daily closes above its 18-day MA (currently at $351.20) then we will assume that a bottom is in place. In the mean time, gold has short-term downside risk to around $335. 

Below is a chart of the AMEX Gold BUGS Index (HUI) covering the now 14-month long consolidation period. When the HUI moved to a marginal new high on 17th June we didn't think it was signaling the start of a major advance (refer to the "Gold Stocks" discussion in the 18th June Interim Update). Apart from the fact that a continued surge in the gold stocks at that time wouldn't have been consistent with what we expected to happen in the currency market, the straight-line nature of the move up to resistance meant that immediate follow-through was unlikely. The current consolidation is, however, setting the stage for a powerful advance. The HUI will probably move below its recent low of 144 before it breaks above the major resistance at 154-156, but regardless of how/when it happens we expect that the next break above resistance will confirm that a major rally is underway.

Below is a weekly chart of Swiss Franc futures. Our downside target for the current correction has been the 0.70-0.72 support range, and that remains the case. However, the SF probably won't get there in a straight line.

The silver price has once again moved up to resistance in the 4.80-4.90 range. Our view has been that the next test of this range would be unsuccessful, that is, that silver's next visit to this resistance would result in an upside breakout. However, we are skeptical of silver's short-term upside potential here due to the straight-line nature of the recent advance. This just means that a short period (1-3 weeks) of consolidation in the 4.70-4.90 range will probably occur prior to a breakout. A daily close above $4.90 (basis the nearest futures contract) would strongly suggest to us that a major rally in the silver price was underway. 

Update on Stock Selections

Richmont Mines (AMEX: RIC) has announced a buyback of up to 5% of its outstanding shares. Stock buybacks are usually bullish, so this is a positive development. RIC is excellent value by most measures, but has low reserves and resources. If it can significantly increase its gold reserves, either via exploration success or acquisition, its stock price would probably move much higher. In the mean time, given the cheapness of the shares the stock buyback is a good use of some of the company's substantial hoard of cash. With the stock price only about 10% above major support, RIC is a relatively low-risk buy near its current level.

Shares of Northgate Exploration (TSX: NGX) will begin trading on the AMEX on 11th July under the symbol NXG. From a technical perspective, the stock is currently sitting at resistance. A daily close of C$1.60 or higher would suggest that NGX was going to make it to around $1.90 before the next significant pullback occurred. The stock has short-term downside risk to around $1.30, but the path of least resistance appears to be up.

NovaGold (TSX: NRI) continues to power ahead, but it will eventually pullback. After a stock breaks above a downtrend it will often drop back to its former downtrend-line before resuming its upward move. Such a pullback for NRI over the next few weeks would see the stock price drop back to around C$3.20. There are, of course, no guarantees that it will pullback this far.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/