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Fitting the pieces of the inter-market puzzle together

The pieces of the inter-market puzzle often don't fit neatly together, one reason being that 'well established' inter-market relationships periodically change. We've recently seen a great example of this with respect to the well-known relationship between the gold and currency markets. More often than not gold performs well when the euro is strong and the US$ is weak, and yet since early February the gold market has strengthened on the back of euro weakness (and resultant US$ strength).

We pay close attention to the relationships between different markets, but due to the fact that these relationships regularly vary and sometimes break down altogether we always place more emphasis on individual market analysis. In a perfect world the conclusions based on inter-market analysis will mesh with, and support, the conclusions that stem from individual market analysis, but in the real world there is regularly a conflict. When a conflict occurs we give priority to the individual market analysis. Gold, for instance, is much more of a play on a general decline in monetary confidence than a play on US$ weakness, so it really wasn't surprising that major concerns about euro-zone stability led to the gold price rising in US$ terms while the US$ moved sharply higher against the euro.

Currently, the pieces of the inter-market puzzle do fit together quite neatly. At least, it seems to us that they do. For example, a counter-trend rebound in the stock market would be expected to go hand-in-hand with counter-trend rebounds in industrial commodities, the euro, and the commodity currencies, along with some consolidation in the gold market, which is exactly what is happening. The rebounds could continue for a few more weeks, following which the overarching trend -- a trend that involves a shift away from growth-oriented investments towards 'safe havens' -- should resume.

Chasing Performance

The Stock Market

Noteworthy comments from the latest Barrons Roundtable

Barrons Magazine has just published the mid-year edition of its "Roundtable" discussion. For the uninitiated, the Roundtable comprises 10 well-known analysts/investors who opine on the markets and give suggestions on how to profit from the financial environment that they anticipate. Here are some of the most interesting and sensible comments from the latest installment:

Felix Zulauf (Owner and president, Zulauf Asset Management, Zug, Switzerland) said:

"European and U.S. policymakers believe China eventually will bail us out, but China is tightening. Its real-estate sector will get hit badly. All the leading indicators are topping around the world. Commodity prices are heading lower. The stock market probably will make its low for the year in late summer or fall. The upside is probably 5%, the downside 20%. If there is a big break in the fall and the Federal Reserve starts printing money again, stocks could rally."

And:

"In commodities, I would short aluminum and the DJ Stoxx 600 Optimised Basic Resources ETF, as well as the iShares MSCI Brazil Index and the iShares MSCI Australia Index. I expect base-metals prices to decline due to softening demand and record inventories. The U.S. dollar rise that started against the euro will spread to almost all other currencies. Resource currencies like the Australian dollar and Brazilian real are in the early stages of a cyclical decline. By shorting these ETFs, investors can catch declining equity prices as well as falling currencies."

And:

"It would be best if the weaker members left the EU. If they don't leave, the devaluation of the euro will continue. Eventually it will have to decline to a level at which even the weakest member can compete in the world economy. At the end of the day, the EU will break up, because its other members are using Germany as the payer of last resort for their sins. German citizens will revolt and vote in a new government with a different attitude."

We totally agree with the above, although we aren't in agreement with all of Zulauf's views. For one example of disagreement, he thinks that US Treasury bonds will be a good investment for the next 6-9 months, but the T-bond currently doesn't appeal to us as either a 'long' or a 'short'. For another example, in a recent interview with Eric King he said that he expected central banks to allow deflationary forces to build over the next few years and to then suddenly engineer a massive inflation of the money supply to effectively wipe out all bank debt, destroying the currency in the process. This forecast makes no sense to us. Central bankers such as Ben Bernanke believe in 'fighting' deflation -- or what they perceive to be deflation -- every step of the way, but at the same time they are mindful of the need to maintain the illusion that the official currency is sound. Consequently, there is likely to be a gradual build-up of an inflation problem until a 'tipping point' is finally reached where "the masses wake up".

Fred Hickey (Editor, The High-Tech Strategist, Nashua, N.H.) said:

"The "exit strategy" talk of earlier this year now has gone by the wayside. All exit strategies have been put away. That is why I continue to be heavily invested in gold. The stock market is dangerous as valuations aren't where they were at the lows last year. I expect stock prices to keep falling unless and until the Fed starts printing again. If that happens, stocks can go up. It is hard to say where the market will be at the end of the year. That also makes it a dangerous market to short.

The alternative to printing money would be to let the market clear the excesses in the system. But that becomes more difficult the longer it is postponed. Ultimately that is what will happen. As Ludwig von Mises said, the final outcome of a credit expansion is general impoverishment."

We agree. The "exit strategy" talk of the past 9 months was pure propaganda. Central bankers can't withdraw their monetary support because they never permitted the necessary liquidation of the mal-investments fostered by the preceding inflation-fueled boom. Instead, with plenty of help from politicians they fueled additional mal-investments. This means that any genuine attempt to 'tighten the monetary reins' WILL lead to another financial crisis. So, rather than shifting away from the inflationary stance of the past 20 months, additional weakness in the stock market and the re-emergence of deflation fear over the months ahead will very likely prompt another round of monetary largesse. In today's world there are few things as predictable as the reaction of the central banking community to rising fear of deflation.

Marc Faber (Managing director, Marc Faber Ltd., Hong Kong) said:

"The S&P might drop to around 950. I am bearish about the world. In the second half of the year, data on economic growth and corporate profits will disappoint. At the same time the Federal Reserve is run by a money printer, and a prospective vice chairman, Janet Yellen, who said she would implement negative interest rates if she could. Interest rates, in real terms, will stay at zero forever."

And:

"The European economy is rolling over, the U.S. economy could roll over, and there is evidence of a slowdown in China. As soon as economies around the world weaken again, central banks will have another excuse to ease and keep interest rates artificially low. The global economy could deteriorate but the markets might not go down, because there is more money-printing and more stimulus packages. But the market could get more selective. From March 2009 through April 2010, equities and commodities went up, in particular industrial commodities. In the future, industrial commodities might not perform well, because of a global economic slowdown, but some equities could do well."

And:

"I...recommend shorting the Australian dollar as a way of playing the slowdown in China, which will lead to reduced demand for industrial commodities. Australia, a major commodities producer, is like a warrant on China. I would rather short the Australian dollar because the Chinese market already has fallen 30% from its August 2009 high."

Our views are most closely aligned with those of Marc Faber.

Current Market Situation

The following daily chart shows that the S&P500 Index broke above short-term resistance in the low-1100s earlier this week. The breakout creates a measured objective of 1160, a rise to which would put in place the "right shoulder" of the "head and shoulders" topping pattern that many pundits think is unfolding.

The main problem with the "head and shoulders" idea is that it's a little too popular amongst the bearish contingent. Here are two other possible short-term outcomes that are just as likely:

1. The S&P500 moves back up to around 1200 over the next four weeks in what will prove to be a successful test of its April high. This scenario has the advantage of being consistent with our short-term currency market outlook.

2. The S&P500 tops near its current level and soon begins its next downward leg.

Regardless of whether it ends at 1120 or 1160 or 1200, we believe that the current rally will turn out to be the counter-trend variety and will be followed by a decline to new lows for the year. Also, we have previously said that we would downgrade our short-term stock market outlook to "bearish" if the S&P500 moved up to within 2% of its 50-day moving average. It traded within 2.1% of this moving average on Wednesday, which is close enough.

Our short-term bearish outlook is based on the opinion that the S&P500 has maximum upside potential to around 1200 and downside risk to the mid-900s over the next few months.

Looking at the US stock market from a different perspective, the following chart shows how the S&P500 has performed in gold terms over the past 8 years. Notice that the S&P500/gold ratio recently broke below lateral support and that similar breaks of support have been followed by substantial declines.

The break below support would be confirmed by a move below the early-June low of 0.84.

Gold and the Dollar

Gold

The gold market has recently been 'marking time', which is common for this time of the year. The following daily chart shows that resistance lies at $1250 and support lies just below $1200.

A daily close below the aforementioned support would suggest that a pullback to the low-$1100s was underway.

Gold Stocks

There are certain cases where the level of trading volume is a meaningful indicator. For example, when a small-cap stock begins to rise in price on unusually high volume with no news it probably means that a positive development is in the works. In most cases, though, volume isn't important. For example, if we were 'long' a stock that fell by 50%, the fact that it happened to fall on declining volume would be of no consolation. Taking a specific example, the entire rebound in the US stock market from the March-2009 bottom occurred on low volume, but it was still the best post-crash rebound ever and caused short-sellers to lose just as much money as they would have lost if the trading volume had been 'healthy'.

That being said, the gold sector's volume pattern is moderately interesting. What's interesting is that since the beginning of this year the trading volume has generally trended in the opposite direction to the price, meaning that volume has risen during the price declines and fallen during the price advances. The only exception to this pattern occurred during the first half of May, when there was a spurt in the demand for gold-related investments amidst a market-wide mini-panic. This volume pattern is clearly evident on the daily GDX (Gold Miners ETF) chart displayed below.

We don't want to make a big deal of the gold sector's volume pattern, mainly because we don't think it is a big deal. However, it is consistent with the idea that all of this year's price action has occurred within the context of an intermediate-term correction.

Another point worth mentioning is that GDX and the gold-stock indices broke above the tops of their recent trading ranges on Wednesday. These breakouts don't say much about the future, but they do help with risk management. The reason is that if these breakouts are 'real' then the lows of the past week will not be breached. This means that 'stops' on long trading positions can now be raised to just below the lows of the past week (452 for the HUI, $49.80 for GDX).

The following weekly chart of Silver Wheaton (SLW) shows that a combination of channel and lateral support lies at around US$17. A break below $17 would probably bring the lower support at $13 into play.

In the 2nd June Interim Update we wrote: "Speculators looking for ways to hedge long-term exposure to gold and silver stocks could consider purchasing December-2009 put options on Silver Wheaton (SLW) with the stock in the US$19-$20 range." SLW ended Wednesday's session just above the top of this range and within a few percent of its May high.

If you need to hedge then the optimum time to do so is when prices are high, not after they have broken out to the downside. SLW is a good candidate for a put-option hedge, not because there is anything wrong with the underlying company but because: a) it is extended to the upside on an intermediate-term basis, b) it often performs like a high-beta play on the gold-stock indices, c) it could be completing the counter-trend rebound that invariably follows the initial decline from an intermediate-term peak, and d) it has a lot of downside potential.

Currency Market Update

The following weekly chart shows that the Dollar Index has reversed lower after testing major support at around 89. The correction will probably last a few more weeks and could encompass a test of the recent peak. Our best guess at this time is that it will end somewhere between the moving average lines shown on the chart.

A daily chart of June euro futures is displayed below. A likely target for the current rebound is the 50-day moving average, which is at 1.273 and falling.

The biggest threat to the forecast for a continuing euro rebound is the potential for an immediate resumption of Europe's debt crisis. Fear about the solvency of European governments and banks has abated over the past couple of weeks, but it lies just beneath the surface and could re-emerge as the dominant financial-market influence at any time.

The highest-profile concern right now is the freezing-up of Spain's inter-bank money market. The capital markets are essentially closed to most Spanish banks, so the government of Spain -- via the Bank of Spain -- has decided to carry out and publish the results of bank "stress tests". The hope is that such a gesture will remove uncertainty and stimulate the flow of credit.

Stimulating the flow of credit within the banking industry could buy some time, but it wouldn't even touch on the main issue. The main issue is that there is too much debt. The banks have too much debt and most governments have too much debt.

Update 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)

Clifton Star Resources (TSXV: CFO). Shares: 28M issued, 38M fully diluted. Recent price: C$4.18

CFO is an exploration-stage junior gold mining stock that generally moves to the beat of its own drummer rather than to the beat of the gold market. For example, even though CFO has a lot of unhedged in-ground gold in a secure location (Quebec), and therefore stands to benefit greatly from gains in the gold price, it regularly rises on days when most gold stocks are down and falls on days when most gold stocks are up.

When CFO rocketed up to C$7-$8 in late February we thought it was a good candidate for partial profit taking. Shortly after it began a downward trend, and in the 19th April Weekly Update we speculated that the maximum realistic downside potential was defined by support at C$3.80-C$4.00. At that time we said: "If CFO dropped to near this support and there were no company-specific negative developments in the mean time then it would be appropriate for speculators to 'back up the truck'."

CFO has just dropped to the C$3.80-$4.00 support area (see chart below for details), so is it now time to 'back up the truck'?

We believe that this is an excellent buying opportunity and that the stock is close to its ultimate correction low, but we do have one concern. The concern is the lack of drilling results over the past few months. A massive drilling campaign got underway early this year and we expected that this campaign would yield a steady stream of drilling results throughout the year, but apart from one uninspiring press release in April there has been no drilling news from CFO since February.

The lack of news is not a management failure on CFO's part and does not, as far as we know, indicate a problem with the project. It is important to understand that CFO's Duparquet gold project in Quebec is a 50/50 JV between CFO and Osisko (OSK), with OSK being the operator and therefore having the primary responsibility for generating and publishing the drilling results. The issue, we suspect, revolves around the fact that while the Duparquet project is everything for little CFO, it is only the third most important project for the much larger OSK.

The unexpected lack of drilling news opens up the possibility that CFO will drop to the mid-C$3 area before bottoming out, but the C$13/share target mentioned in our 22nd February commentary remains valid. This target is based on the JV proving up a 10M-ounce gold resource at Duparquet.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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