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Crash Patterns

On the rare occasions when the US stock market crashes, the crash never begins immediately after the price peak. Instead, the ultimate price peak is followed by a process that involves an initial decline (usually 5%-10%), a rebound that retraces 50%-90% of the initial decline, and then a second decline to support defined by the low of the initial decline. This process, or "crash pattern", takes two months or more to complete. If a crash is going to happen it does so after the price breaks below support defined by the initial low.

It should be understood that the vast majority of "crash patterns" don't actually lead to crashes. A lot of times, support defined by the initial low will not be breached and the "crash pattern" will turn out to be a routine consolidation. Other times, a break below support defined by the initial low will happen without prompting a crash. In the same way that most dogs aren't poodles but for an animal to be a poodle it must first be a dog, most crash patterns don't lead to crashes but for the stock market to crash it must first follow the crash pattern.

The price action of the S&P500 Index during 1987 provides examples of two crash patterns, one of which -- as everyone knows -- ended in a crash, and the other of which turned out to be a routine consolidation. Here's a chart with the crash patterns circled. Also noted on the chart is the test of the low that happened a few weeks after the October crash.



An implication of the above is that even if the US stock market has just hit its ultimate peak, the second half of July would be the earliest that it could crash.

We hasten to point out that a crash is NOT a likely outcome for the US stock market during 2013. As previously advised, our best guess is that the market will make a rounded top over the next 6 months and then roll over into a 1-2 year cyclical bear market. That being said, the combination of the relentless nature of the advance of the past 7 months, the disconnect between earnings growth and share-price growth (the "earnings game" results in the earnings of most companies coming in ahead of expectations every quarter, but the fact is that S&P500 earnings and revenue have barely grown at all over the past 12 months) and the complacent sentiment (the popular view that nothing can go wrong as long as the Fed keeps monetising $85B of bonds per month) makes a crash more likely than it would ordinarily be. First, however, we need a "crash pattern" to form, beginning with a 5-10% pullback.

The crash pattern described above applies to the US stock market and possibly to the stock markets of other developed economies, but it doesn't apply to gold and silver. Gold and silver are quite capable of rocketing up to a major price peak and then immediately crashing, as was seen with both of these metals in January of 1980 and as was seen with silver in April-May of 2011. Also, as per recent experience it is clearly possible for gold and silver to crash after breaking below the bottoms of multi-quarter trading ranges. However, the aftermath of the gold-silver price crash of April-2013 has, to date, been similar to the aftermath of the US stock market's 1987 crash. Of particular note, following gold's April-2013 price crash there was a 2-3 week rebound and then a decline to test the crash low.

The Stock Market

Most US stock indices made multi-year highs on Wednesday 22nd May and then reversed to end the day below the low of the preceding day, making Wednesday an outside day to the downside for these indices. The following daily chart shows the NASDAQ100 Index (NDX).



It's obviously way too soon to be drawing any conclusions about the significance of Wednesday's price action. The price action was blamed on Ben Bernanke's utterings and the minutes of the latest FOMC meeting, but what we have is a market that has gone up in straight-line fashion since mid-April and is looking for a reason to 'correct'. A normal short-term correction could take the NDX back to former resistance (now support) at around 2875.

Gold and the Dollar

Gold

Gold backwardation/contango and interest rates

Gold is said to be in "contango" when the spot price is lower than the nearest futures price and the prices of nearer futures contracts are lower than the prices of longer-dated contracts. In other words, a contango in the gold market is effectively the same as a positively-sloped yield-curve in the credit market. "Backwardation" is the opposite. Specifically, gold is said to be in backwardation when the spot price is higher than the nearest futures price and the prices of nearer futures contracts are higher than the prices of longer-dated contracts. Backwardation is therefore similar to an inverted yield-curve. Due to the fact that gold's existing aboveground stock is massive in relation to the amount of gold that gets mined in a year and that most gold is held as a store of value or speculation (meaning: it doesn't get consumed in commercial processes), there should never be a shortage of gold. This results in "contango" being the norm in the gold market.

The main point we want to address today is the relationship between the gold market's contango and the zero-risk short-term US interest rate. For the purposes of this discussion, we will consider the yield on the 3-month T-Bill to represent this interest rate. Also, before proceeding we'll note that a single "spot price" doesn't exist in the gold market. We therefore determine gold's "contango" or "backwardation" by comparing the prices of liquid futures contracts, beginning with the difference in price between the nearest liquid COMEX futures contract and the price of next liquid contract.

The extent to which the gold market is in contango is usually linked to the zero-risk short-term interest rate, with a lower interest rate leading to a smaller contango (a smaller difference between the price of gold for immediate delivery and the price of gold for delivery a few months or more into the future). To understand why this is so, consider the case of a gold trader that wants to take delivery of gold in three months. The trader could either buy a futures contract that expires in three months or buy physical gold immediately and store it for three months. The latter option would entail a storage/insurance cost and an opportunity/financing cost related to the interest that could have been earned, or that would have to be paid in the case of a loan, over the three-month period on the money that has been invested in the gold. The trader will therefore choose the latter option if adding the storage/insurance cost and the opportunity/financing cost to the price of gold for immediate delivery results in a lower number than the price of a futures contract expiring in three months. Otherwise, he'll choose the former option.

Continuing with the explanation, arbitrage trading will generally ensure that the relationship between interest rates and the gold "contango" remains tight. For example, assume that the price of gold for delivery in three months moved to a 5% premium over the price of gold for immediate delivery and that the sum of the 3-month interest rate and the gold storage/insurance cost was 1%. In this case a trader could lock-in a 4% profit by purchasing physical bullion and simultaneously selling the futures contract. Many large traders (such as bullion banks) would do exactly that, thus bringing the futures price into line with the "spot price" and the short-term interest rate.

With gold storage/insurance costs being fairly constant at only a small fraction of a percent per year, the extent to which the gold market is in contango will mostly be determined by the short-term US$ interest rate. In other words, when the T-Bill yield is close to zero, as it is right now, gold's contango should be very small. In fact, it should be so small that minor random price fluctuations could momentarily lead to backwardation, which is what has occasionally happened over the past five years.

As we write, the price of gold for delivery in June-2013 (the nearest liquid futures contract) is marginally lower than the price of gold for delivery in August-2013 (the next-to-nearest liquid futures contract), which, in turn, is marginally lower than price of gold for delivery in December-2013. This miniscule contango is consistent with the current T-Bill yield of 0.04% and therefore says a lot more about the Fed's manipulation of interest rates than about the gold market.

Escape Velocity

The idea is beginning to take hold that at some point over the next several months the US economy will reach "escape velocity". At that point, so the thinking goes, the economy will have enough forward momentum that it will no longer require the 'support' of aggressive Fed money creation. Furthermore, so the thinking also goes, the upcoming reduction in the Fed's monetary accommodation is bound to cause gold's bear market to continue.

There is so much wrong with the above line of thinking that thoroughly debunking it would require a book. However, the super-abridged version of the counter-argument goes like this:

The Fed's aggressive 'monetary accommodation' during the late-1990s caused the investment boom that inevitably led to the bust of 2000-2002. The even more aggressive 'monetary accommodation' put in place to alleviate the pain of the 2000-2002 bust caused the ensuing economic recovery to be weaker than average and also caused another investment boom that inevitably led to a much bigger bust during 2007-2009. The even more aggressive 'monetary accommodation' put in place to alleviate the pain of the 2007-2009 bust caused the ensuing economic recovery to be even weaker than the 2003-2007 episode as well as yet another investment boom that is guaranteed to lead to the next in the series of escalating busts/crises.

The "escape velocity" analogy is absurd, because the distortion of prices caused by the 'monetary accommodation' creates and supports bubble activities that can't exist without the continuing flood of new money. These activities WILL collapse after the monetary flood is stopped or significantly slowed, revealing a reality that will undoubtedly provide justification for the next round of 'monetary accommodation'. Moreover, gold will only do poorly until it starts to become clear that the preceding monetary accommodation hasn't helped. This point could be reached as a result of either a "tapering off" or a panicked acceleration of the current monetary accommodation.

Current Market Situation

At this stage it looks like gold successfully tested its mid-April low on Monday 20th May, although it hasn't yet moved far enough above the low to confirm that this is, indeed, the case.

If a successful test of the mid-April low has just happened then the gold price should move up to the low-$1500s within the next month or so.



Gold Stocks

It could turn out that Monday's upward reversal in the gold sector marked an important low -- the latest in a series of important May turning points. However, significant additional strength will be required over the days immediately ahead to determine if this is, in fact, the case.

If you purchased a short-term trading position in a gold-stock ETF during the first three days of this week it would make sense to place a sell stop just below Monday's intra-day low.



Currency Market Update

Over the past month the US$ has been very strong relative to all major currencies except the euro. The euro has weakened a little, but is still holding above critical support at 127-128.



The A$ and the C$, the main commodity currencies, appear to be completing major topping patterns. Both have recently broken below long-term trend-lines and are rapidly approaching long-term lateral support at around 95. A chart of the C$ is displayed below.



There is probably a lot more upside in store for the Dollar Index over the next 6-12 months, but with many currencies now very 'oversold' relative to the US$ there's a good chance that the Dollar Index is close to a short-term peak.

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

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html