Thomas
DeChastelain
Memorial Archives

Gold Sector Update
posted Aug 28, 2004 at 03:00PM

It was last year before X-mas. The reflation trade was still in full bore and making money on the long side of equities had become almost methodical...to me a warning sign in itself. Then I read two articles from well respected analysts, one Steve Saville and the other (I forget his name) from Morgan Stanley.

One argued that we would experience a deflationary scare followed by "real" inflation. The other argued that we would experience an inflationary scare followed by "real" deflation.

Inevitably these lead to the usual chicken and egg arguments of which comes first, where are we now and how do we tell the difference between "real" and a "scare". For the most part I put the argument on the back burner and kept going while the going was good.

Then came a first little warning - a brief news report talking about how Chinese "officials" were worried that growth rates were getting out of hand and how they would take steps to cool things off. Market Reaction? Nothing...it was ignored. It was a sign to me however that caution was beginning to be due. After all, look at any bullish argument, wether it be gold commodities, cars or technology and very close to the surface you have "China" and the potential of its huge market.

Then some plain luck for myself - I had just exited a nice series of trades in the junior bios when a visiting Chinese official again started talking about cooling things off. At around the same time the Fed were intensifying rate hike language. In short the reflation trade, the carry trade was about to start getting hit from both ends. This time the markets did notice and started convulsing.

My motto since then has been pretty simple, "PAPER = DEATH". And bounces aside it has been a good one to hold. Anyone just sitting on cash the last six months has basically seen the amount of stock they can buy rise substantially.

Indeed you would be hard-pressed to find any equity indexes or sub-index anywhere (outside of energy) where they are not trading with their 50 day moving averages below their 200 dma -a bear market condition.

Of course the "speccier" the stock, the more severe the damage. Explorers of all kinds, gold, base metal even some energies have been gutted. Every junior bio that I exited has lost well over 60% of their value. Unless the company announced that they were sitting on a new Eldorado motherlode, or discovered the cure for cancer...down they went. All along, in the background, was the white noise of exhortations to buy buy buy.

That was then though, and this is now. Inevitably in every market there comes a time when "sitting tight and being right" inexorably turns into "snooze and you lose". So the question I am asking myself now is it time to put cash back to work?

Looking at long term charts of equity indexes one can see why quite a few Elliot wavers think stocks have completed or are it the process of completing wave 4 style corrections. Unhedged gold stocks have been resilient in difficult environment. Growth figures in China have not abated one whit. Dropping oil prices will free up the liquidity to jump-start stocks of all stripes. Even the speccy stocks noted above are showing sign of stabilization and bottoming.

The Equity bears will argue (as I myself have for the most part) that any recent strength in equities is standard counter trend action to unwind oversold indicators and to suck more more capital, i.e. more fuel for the next downleg. They will argue that while the market has been mesmerized by raging oil prices, and they are completely blind to the deflationary forces which are building up to destroy their net worth.

If this entire introduction sounds a little dramatic it is because I think very soon the market is going to start giving us hard answers to some of these questions. When you look at the gold/ currency world it is amazing to how many indices show convergence of 50day and 200 day moving averages. Conventional wisdom dictate that such convergences usually precede strong IT moves in one direction or the other.

I am going to forgo the weekly charts for now. They are available elsewhere on the site and are little changed from last week's.

There of course two objectives. One to try to identify key parameters to allow one to position oneself on the right side of the market.

And as always to start thinking of a trading plan that allows one to get out with only minimal losses in case of error, and preserve capital to "fight another day".

On to some charts.

Gold Bullion



410 is near-term resistance. The moving averages are important support. It would take a move to 385 before bears could really start talking about the start of a new downleg.

US Dollar



Some strong candles as expected, but until 90 is broken with authourity, nothing is settled. Breaking 90 would be a very bullish technical event in that it breaks long-term resistance trend-lines - and opens up the possiblility of trend change taking place.

Breaking 87 would be incredibly bearish...if this is the start of C wave impulse it should stay above 88. The moving averages again offer a tighter line in the sand.

Euro



120 is the key support line here. Break that with authourity and we have a bear flag breaking down, pointing to significantly lower prices.

Bonds vs Gold



Is this a correction or a potential leading diagonal? If a correction it is obviously more complex than the last few, as it has actually been putting in some higher lows.

A break of the triangle to the upside would imply that inflation is falling off the market's radar screens. A break to the downside implies we are still in an inflationary, pro-gold environment.

CRB Index



Techncially in better shape than most equity "paper" markets in terms of moving average support. But the pattern of declining tops is similar, all the more significant given the surging oil price and unchanged growth figures from China. Obviously some components have been tanking hard.

The pattern, like most equity indexes, is an overlapping one, giving it a "corrective" feel. The bulls state that the CRB will soon start a wave 5, usually a great blow-off wave, for commodities and gold. Trend-line resistance can be used a signal.

The moving averages are the key support lines to watch.

Housing Index



The following statistics are from Robert McHughs latest analysis,

"Mortgage Applications fell 6.3 percent for the week ended August 20th according to the Mortgage Bankers Association. Existing Home Sales fell 2.9 percent in July according to the National Association of Realtors. New Home Sales fell a whopping 6.4 percent in July according to the Commerce Department. Inventories of unsold homes rose to 4.2 months, the highest level in a year and a half."

A real estate collapse is a potentially devestating deflationary event that has not been priced into any market.

One of the mantras that has become accepted truth in gold circles, is that a collpase in real estate will be good for gold. I do not agree with this and indeed think this is an extremely dangerous assumption to make. In 1990 any Japanese gold bulls who thought that way are still trying to get the tire marks off thier faces.

The fact that gold and the housing market have been trending strongly together over the past few years is no coincidence. Rising housing prices is a hall mark of inflation, chief friend of gold. A hot housing market with all the attendant durable goods needed to fill them, are tremednous demand drivers for a host of commodities...again good for gold. Both love the spending of cheap, easy money.

Collapsing real estate prices means you are getting more house for the buck, i.e. the dollars purchasing power is going up. A collapsing housing market means demand and thus prices for everything that goes into them, also drops.

What about all those morgage backed derivatives imploding? First let us admit that there are probably only a handful of rocket scientists out there that can really understand how all of these things are linked together. Can such occurence cause a dollar swan? yes sure why not. But it could also just as easily cause a systemic rush for cash that inevitably will bring in the momentum players and hedge funds drive the USD up way beyond rational expectations.

In the end when a person with a debt load is called upon to make good or else....they do not go out and buy more assets...they liquidate them.

The plain truth is that until it happens nobody can really know for sure how a real estate bust will effect currency. There is however plenty of historical precedent that the effect may not be what a lot of people are expecting.


HUI



The action of unhedged gold stocks was incredibly bullish. Even in an environment of a strong dollar, declining bullion, and shrinking yield spreads, it held on to important support. Unhedged gold stocks are probably the most sensitive barometer to the economic climate and such divergeces are signals that make one stand up and notice.

HUI/Gold Ratio



In the past breaking out of a down trend line also coincided with a break of the 200 dma, giving the signal a much higher degree of confidence. Here the 200 dma remains as resistance, but the break of the downtrend line is still a big plus for the bull camp.

Yield Spread



There really is no way to ignore it anymore. The yield spread has continued to drop and yet gold stocks have held up very well. Bullish divergent behaviour like this has to be acknowledged.

Silver



When I look at this chart all I can think is my silver bullion bars, which I half-jokingly refer to as the "best paper-weights $800 can buy" will be serving me in that capacity for some time to come.

Yes open interest is rising and there is another gap that potentially may be filled. But this chart gives me the willies.....it is screaming "collapse".

You have a clearly impulsive wave down followed by an overlapping corrective sequence mapping out a bearish flag formation. Then there are negative technical divergences and of course on top of that you have the extreme positioning of the large speculators who are 96% bullish.

6.5 strikes me as the key price support to watch but from a contrarian viewpoint this chart is unbuyable.

To put it bluntly I feel silver is the most bearish aspect of the entire PM sector right now amd threatens to be a albatross around gold's neck although each must be traded on thier own charts.

DISCUSSION/TRADING STRATEGIES

First again to start with the disclaimer that everyone's circumstances and trading styles are different. Someone who has been holding gold stocks for years will have a different outlook than someone who has held since the May bottom who again is different from someone who came in during the last rush and is now in the red.

From my viewpoint the real key to watch right now is the USD. Will it convincingly break the 90 level? From a TA perspective there is no reason why it can't. It isn't overbought and there is plenty of technical juice to fuel such a move. If it does then for me the decision to stay out becomes simple.

Now what if it doesn't? What if it just tepidly reaches the 90 level and then comes back under....or more bearishly breaks moving average support?


Well looking at the HUI daily chart the swing line to me remains 200. A dip that goes below and then comes back above 200 would be a price based (vice a momentum based) buy signal.

I would have an anally tight stop...like 199 on the HUI...indeed in this kind of momentum trading I either finish the day in the green or I simply eat my commisions and get out. One could buy a half position on that and buy another half on a breach of the 200dma.

I would think..if this does turn out to be a wave 5 that it would certainly at least be the equivalent of the preceding leg...even breaching the longer term resistance trend-line and make a stab at 240.

If it reached that level I would sell. It would make a clean five waves up and I would want to look at the retracement. If this turned out to a finishing C wave then the subsequent down move should be clear and easy to read and your profits stay protected. If the retracement was corrective then one could reenter in order to take advantage of the the next impulsive leg up.

Again this is momentum trading based on price alone with little regard to technical codnition...not bottom picking which is more depandant on momentum indicators. You are completely dependant on good timing and faith that a herd will come behind you to push the price up. If they don't show up you are screwed ...and thus my fetish for stops.

A more conservative approach is to simply let gold go and complete this impulive leg, and then wait for the retracement. One, there will still be lots of stocks that are still cheap, and two, the technical picture should a be a lot clearer and easier to read.

Whether in and out I would keep an eye on the bond/gold ratio to how the triangle resolves itself.

Anyways I hope all of this has given you some benchmarks to watch and perhaps some ideas for your own trading strategies.

Good trading.

Bullet Bullet Bullet