Yep, It's a Train

From the November 2nd, 2014 HRA Journal: Issue 222 

My apologies if the graphic leading the editorial seems flippant.  That’s not the intent.  It just seemed to sum up the prevailing attitude of resource stock traders.   If bear market bottoms are supported by fear and disgust (and they are) I think its fair to say we should be very close to one now.  

Based on many recent conversations with friends, colleagues and traders I can tell you that the sentiment is 100% negative right now.   That isn’t good short term and doesn’t bode well for tax loss season that is about to be upon us but—medium term—it’s a positive sign.  We’re most definitely in the teeth of the bear and fear and loathing are the signposts to the exits in this sort of situation.

One interesting note about this month was that both the Subscriber Investment Summit and the New Orleans Investment Conference had better turnouts than just about anyone expected, especially the former.   Significantly (I think) the turnouts were better than the previous show.   I am hoping this indicates the bottom fishing has begun.   Bottom fishers are a patient lot so don’t expect to see offers getting snapped up far and wide.   We still have tax loss and year end to get through at a minimum.

I can’t promise this will be over fast but it’s worth remembering that the biggest wins tend to be born at the worst of times.

***

And I thought the end of QE US was going to be the issue when it came to market optics.  It was, but only in part.  The bigger issue is someone else’s QE.   Japan shocked the market on Halloween eve by announcing a massive increase in it’s QE program and, as importantly, a massive increase in intended purchases of domestic and foreign equities.

The decision was a controversial one, even within the Bank of Japan.  BoJ chair Kuroda was the tie breaking vote that forced the decision through.  Increasing equity purchases might have been less controversial around the cabinet table.   Japan is using the same playbook as the US.  QE gooses asset and stock prices in the hope it feeds through to more general economic activity.

That has been only partially successful in the US.  Most of the gains from QE have accrued to a very small percentage of the wealthiest segment of the population.  Japan is more egalitarian than the US when it comes to incomes but only time will tell if that makes QE more effective there.

The Japanese QE announcement came a day after the results of the latest US Fed meeting that were deemed to be hawkish by the markets.   That combination led to a smack down in gold, oil and other commodity prices.

The impact on equities was the opposite, mainly due to the Japanese investment fund announcement.  The Yen collapsed (which was the intent) dropping over two percent in a few hours and the Topix stock index in Tokyo gained almost five percent.

More cheap money, whatever the source, was all Wall St traders needed to hear.   The S&P index climbed to a new nominal high and European bourses all had better days than they deserved.  I’m sure traders are hoping Japan will be buying their indices as well as the Nikkei. As the charts above detail the news was rather different for both gold and oil.    Gold dropped through the $1180 level that has been supportive three times in the past two years.  Technically, the level isn’t “broken” until we get through at least one more trading day.  A reactive yen rally/USD drop could save the day but we have to think in terms of worst case scenarios.

There are a number of support levels below the current price.  Every chart analyst seems to have a different one. They range from $1160 where the price bounced Friday all the way to $1000 depending on how bearish the analyst is.   I don’t have a favorite personally because I watch macro factors at least as much as charts. Several of those converge in coming weeks and I think the bottom, whatever it is, will come fairly soon.

I was surprised by the strength of the reaction to the “end” of QE in the US.  Maybe I’m too cynical. The most hawkish Fed governor suddenly having second thoughts about ending QE was just too conveniently timed .  The true intent of the comments was to put a floor under the stock market.  It worked.

Given that it, was surprising so many traders apparently went long gold before seeing the Fed announcement.  Its one thing to give a speech that buoys traders, quite another to issue an official Fed decision that effectively says “Wall St says jump and we say “how high?”  I never took the idea that QE would be extended seriously but others obviously did based on the way the dollar and gold traded.

The Fed statement didn’t stress the uneven job market this time and that is what set traders off.   Lost in that reaction was the fact that the Fed got more—not less—dovish in its comments about inflation.  Also significant is that there were NO hawkish dissenters on the Fed board.  The only dissenter this time thought QE should have been extended.

Even the policy hawks on the Open Market Committee are getting more worried about the weak inflation rate in the US. The upshot of this is that while the employment comments were more hawkish I don’t think the timetable for rate increases changed. No one wants deflation.

The US posted slightly better than expected Q3 GPD numbers.  The main reason for the beat was lower imports, which in turn is directly related to lower oil prices.   Lower energy costs are obviously a plus, especially in North America. The $20/bbl  drop is a boost to discretionary spending the US needs.

Oil and Gas analysts I have talked to are mixed on the future of oil prices but none are very bullish.  Most think the price drop is an overdue reflection of growth in supply in the US and several OPEC countries coming out of recent civil wars.

It looks like OPEC is determined to test the willingness of US producers to deliver oil at or below $80.  They want their market share back.  Most large US producers say they can handle current prices.  If that is true this could be a long game of chicken and oil prices could be down for an extended period.  That’s good for the world economy but increases the dangers of deflation.

Strong numbers all around and someone else’s QE reignited the Dollar rally as you can see from the chart above.  It’s not overbought anymore but soon will be if it keeps rising like this.

The big question is whether Japan’s actions force a policy response from the ECB.   The Germans and their Nordic neighbors hate the idea of QE.  They are so worried about inflation that they now run a real risk of standing idle while Europe enters a deflationary spiral.

Sweden, which still has its own currency and central back, just cut its lending rate to zero.  That was an admission that the central bank moved too fast to tighten.  I am skeptical the Germans will agree to any form of true QE.   Plenty of people hate it, including gold bugs, but its hard to argue it didn't work in the US.  At the very least its hard to prove it didn’t work.

QE in its many forms generates a big problem that has to be dealt with at some point: debt.  Assuming Japan keeps buying up debt to the tune of $100 billion/month its frightening debt overhang will become terrifying.   The US actually has the best chance of getting out from under its QE obligations but it will take a very long time and require more than a bit of luck.

Japan, so far, has been able to fund almost all it’s debt domestically thanks to its historic high savings rate.   That is one reason why we haven’t already seen the Yen tank and interest rates spike there, though Tokyo would be happy to see the Yen keep falling.  That can’t go on forever though.  Japanese PM Abe is aware of that which is the main reason he still plans to hike sales taxes again even through it will crimp consumer spending.  It’s a thin high wire Abe is walking.  Let’s hope he doesn’t slip.

In some ways Europe is in a tougher spot since it’s really a federation at best, not a single country where reforms can be pushed through under a single budget.   That’s one of the reasons the Germans resist the idea of large scale QE.  They suspect (probably correctly) that they will be left with the cheque when everyone else leaves the table.

China is yet another wild card.  It undertook what one can think of as a QE program though its actions were more fiscal than monetary.  Beijing hugely expanded spending and lending in 2009 and deserves as much if not more credit than Washington for reversing negative market sentiment.

That came at a real and large cost.  Debt levels rose dramatically and the current government is loath to drive them even higher.

Growth has been slowing in China for several quarters though it’s still high by the standards of most of the world.   Beijing needs to rebalance its economy while avoiding a collapse of high debt sectors. It really doesn’t want to turn on the printing presses but is so worried about potential bankruptcy at the state owned enterprise and local government it might anyway.

This may all seem like side topic but it feeds rather directly into gold and metals prices.  One of the main intents of a QE program is competitive devaluation.  Actual or suspected QE in addition to weaker growth numbers has helped both Japan and Europe achieve weaker currencies.  Both are just fine with that as a partial outcome.

A cheaper currency improves the trade balance and, in this case, both areas need higher inflation so that side effect is desired, not feared.  The opposite is true in the US of course.   I’m sure many are pleased to see the greenback get some respect but its not doing exporters any good and will make inflation tougher to generate.

A stronger $USD has been the bane of commodities for months now.  The Fed/Japanese QE announcements accelerated an existing trend.   Now we’ll have to see how far the trend runs.

In the near term we should assume the BoJ is selling Yen and buying dollars directly and perhaps indirectly if the pension fund is buying US equities.   I don’t expect the ECB will be that direct but may be forced to if the Euro gets lifted as part of a short Yen trade.

This all means the USD is likely to go higher and gold and other precious metals lower.  I’m not convinced Japan will succeed in getting as big a drop in the Yen as it probably wants, ditto for the EU with the Euro.   Our fondest hope for both areas is that something actually works for once.  I’m not convinced of that either but the powers that be panicking a bit is a good thing on balance.  It might wake things up enough that the currencies move less that I fear.

The connected question is how closely and tightly gold trades inversely to the Dollar (in Dollar terms, obviously). The chart below plots the dollar gold price and the trade weighted dollar index against each other.  The dollar index is inverted so the two traces would match more or less perfectly if the inverse correlation was perfect.

As you can see from the chart the inverse correlation has indeed been close to perfect at times but the rule doesn’t always hold.  Look back farther than mid-2012 and the correlation band is much wider, and there are plenty of period’s pre-2009 where gold and the dollar traded together.

The other period, interestingly, where the inverse correlation seems to be weakening is now.  Look at the right side of the chart and you can see the lines diverge.  Gold can still fall even with weak negative correlation if the dollar moves strongly enough but breaking the shackles to the greenback is the first step.

Why should this happen?  Two reasons, which only strengthen if gold keeps trending lower.  The first is physical demand out of China and India. As chart below shows, buying in China is rising rapidly.  The same seems to be true in India though the growing informal (read: smuggled) gold supply makes it hard to judge.

The second reason is, or should be, recognition that we are getting to price points that will have a measurable impact on mined gold supply.  So far high grading has kept gold production going up but that can only last so long.  If gold stays in the current range or drops lower we will start to see some big changes to development and production plans.  It won’t happen overnight but production will start to drop and many, many projects will get shelved.  Ultimately this will put a floor under the price which is one reason I find predictions of sub $1000 gold prices for years to come hard to take seriously.

As you’ve no doubt noted the potential positives for gold and other precious metals are medium term and the negatives are short term.  Prices can keep dropping for a while even if I’m right.  I don’t think we’re talking months to find a bottom but it could be weeks.

In the meantime we have a terrible markets for juniors to deal with—again.   Here too I think the bottom is measured in weeks, though that is mainly due to the tax loss selling calendar.  Tax loss selling bottoms usually occur the first week of December.  A couple of well-known funds are selling and they will have company in coming weeks as redemptions pile up.

I’m still not seeing capitulation style volumes except for a few selected stocks.  I’ve noted before that bothers me and it still does.  After more than three years of pain however I can see capitulation being markets by lack or absence of bids alone.  I still want to see tax loss selling over with though.

Things tend to move fast in the metals markets.  I’m all for getting to the bottom, whatever it is, ASAP so we can move on from there.  Things seem 100% negative right now and that—no kidding—is the good news. Markets rarely stay 100% anything for very long.

Watch Eric Coffin’s latest video presentation from the Vancouver Subscriber Investment Summit on October 9th, 2014. Click here now to watch “Finding Gains in a Zombie Market”.

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