Has a Bull Market Begun?

Gold stocks have risen so much and so fast recently that a pullback, resp. consolidation either has begun already or is likely to begin soon. We have therefore decided to post a brief update on the situation in order to discuss what might happen next. Back in late November, we made a few remarks in order to clarify why we have focused so much on the gold sector again since last summer.

Processing plant of the Driefontein mine in South Africa

Photo via goldfields.co.za

Here are a few excerpts:

“When a market is down 83% like the HUI gold mining index is, we are generally more interested in trying to find out when it might turn around, since it is a good bet that it is “oversold”. Of course, it if makes it to 90% down, it will still be a harrowing experience in the short term.

We like these catastrophes because they usually mean “the stuff is cheap and there is probably something people don’t see”. That is definitely the case here, since one of the things that has been routinely ignored is the improvement in costs and cash flows that is slowly but surely progressing at many gold producers.”

Something evidently did get overlooked.

The HUI has rallied by about 57% in a mere three weeks – right after setting a trap for bears by briefly breaking below multi-month support. It has now reached an area of lateral resistance and is quite overbought, so some sort of consolidation is highly likely over coming weeks – click to enlarge.

Here is another important point we made at the time:

“While we are waiting for the turning point, we are always interested in the potential for tradable rallies until it happens, because they tend to be so big in this sector. Just look at the last move from 104 to 140 in the HUI – that’s as if the DJIA went from its current level of 17,792 points to 24,000 points in just two and a half weeks. Will it do that? We doubt it. The HUI can – and not only that: it can rally that much and still be a few light years below its 200 day moving average. In short, these “small bounces” are really gigantic, because prices are so compressed and the sector is so small and illiquid.”

In recent weeks we have indeed seen one of those “small bounces that are really gigantic”. As we have pointed out, rallies in the gold sector are eminently playable regardless of whether they are just a short term flash in the pan or the beginning of a bigger move. As far as we know, we have just witnessed one of the biggest, if notthe biggest three week rally in a stock market sector in history (especially shortly after breaking to a new low for the move).

There are essentially two possibilities now: one is that similar to recent years, the sector has given us a scorching performance in January, that will once again be surrendered over the remainder of the year. While we cannot rule this possibility out (more on this further below), we don’t believe it is likely.

The other possibility is that the sector has just made a major low and is poised to continue its advance after a period of consolidation. Readers may want to take the time to review the “comparative analysis” section in “How to Recognize an Emerging Bull Market” – which shows possible road maps for the coming months in case a bigger move is in store (here are links to charts of the successful turning points of 1986, 1992/3, 2000/2001,2008 as well as the failed turnaround attempts of 1998 and early 2015).

Assuming the rally does not fail, what would some of these historical patterns look like if we were to apply them to the current chart of the HUI? Below we show three of them, scaled to current index levels: 1986, 1992 and 2000:

Past patterns following major turning points, applied to the HUI Index of today (the scale is adapted to current index levels). As can probably be guessed, the corrective activity in all cases successfully tested the 200-day moving average from above. In 1992 and 2000 the market continued its advance after just one month, resp. 5 weeks of corrective action, while the correction took four months in 1986 – click to enlarge.

A few days ago, our reader Richard DellOrfano has mailed us a link to a comprehensive technical analysis of the chart of Newmont Mining (NEM). While NEM has subsequently moved a bit higher, the message that some sort of consolidation will soon be required certainly remains valid.

Naturally, there are always differences, so the current pattern is not going to be an exact replica of any of the previous ones, but as a rough guide, they are probably nevertheless useful. The important thing is this: if a genuine medium to longer term turn has occurred, then the biggest part of the advance is yet to come.

Readers may recall an article we posted in August about a noteworthy surge in insider buying in gold stocks at the time (see: “A New Multi-Year High in Buying by Gold Sector Insiders” for details). Our friend Ted Dixon of INK Research in Canada has mailed us an updated and annotated chart of gold insider activity, which we reproduce below:

In hindsight it seems that the enormous surge in insider buying in gold stocks last summer was probably a quite meaningful event.

As Ted commented to this chart:

“Here is a chart I included with our monthly gold stock subscriber report. Essentially, insiders have sent a confirming signal that a meaningful bottom was put in place this summer.

Of course there are risks, including a rapid break of the US dollar above 100 on the DXY (US Dollar Index). Fortunately, gold investors have not been scared off by a rising greenback recently. The Fed, on the other, seems quite concerned about a dollar breakout..suggesting that it is not going to happen. And even if it does, we could potentially see enough gold demand from negative interest rate countries to help bullion buck the historical trend (pardon the pun).”

“Monkey Magic”?

The Chinese lunar holiday is beginning and Chinese gold buyers will be out of the picture for a little while. In an article entitled “Gold’s Monkey Magic Seen Fading After Biggest Advance Since 1980”, Bloomberg has taken the opportunity to inform us that skepticism about the recent rally remains quite pronounced.

There is one point made in the article that may have merit and suggests that some caution remains warranted: namely that gold has been rallying in January for several years now, and that all these rallies have reversed again in March at the latest. So we have a pattern that has been repeated several times, and it may well happen again.

Other than that, the article merely demonstrates that most so-called “gold analysts” apparently know very little about the gold market. For instance, we read the following bullet points right at the beginning:

“Top consumer China buys less during lunar new year holidays”

“Lack of jewelry demand will send price to $950, SocGen says”

This primarily means that SocGen urgently needs a different gold analyst. As we have pointed out many times, gold is not an industrial commodity. Data points such as jewelry demand or whether “China is buying less during the lunar new year holidays” are completely irrelevant to the gold price.

If you want to know why this is so and what is actually relevant, we recommend reading our previous missive “Misconceptions About Gold” and Robert Blumen’s “What Determines the Price of Gold”.

A chart provided by our friend Michael Pollaro: the S&P 500 Index (blue line), the gold price (pink line), the US dollar (purplish line) and real interest rates (in the form of the continuous 5 year treasury yield minus CPI, green line) – click to enlarge.

In fact, it seems SocGen’s gold analyst is not the only one that’s confused:

Gold, after posting its biggest rally to start a year since 1980, will drop this month as Chinese consumers slow purchases that surged before the start of the Lunar New Year, according to eight of 12 analysts surveyed by Bloomberg. Prices that touched a seven-month high of $1,200.97 an ounce on Monday may drop to $1,100, based on average estimates from seven analysts providing forecasts.

So two thirds of the gold analysts surveyed by Bloomberg appear clueless about what actually drives gold prices. One bearish analyst supplied an opinion that seems a lot less hung up on how much the Chinese are buying (readers only need to consider that we have heard about “record buying by China” every year since 2011, while the gold price dropped by nearly 45% – it should be glaringly obvious by now that it is irrelevant, even if one doesn’t know what drives gold prices).

The problem with this analyst’s opinion is that it hinges on a forecast which we believe has very little chance of coming true:

“Upwards moves in gold usually run out of steam around the time of the Chinese New Year,” Georgette Boele, a strategist at ABN Amro Bank NV in Amsterdam, said by e-mail on Monday. The metal may drop to $1,130 this month, she said. “A stronger dollar, higher U.S. rates and an improvement in investor sentiment will remain negative drivers for the metals.”

An “improvement in investor sentiment, higher US rates and a stronger dollar”? All these things certainly wouldbe negative for the gold price. Unfortunately, Ms. Boele doesn’t let us in on why investor sentiment should improve – or why anyone should expect higher US rates and a rally in the dollar. None of this seems likely to happen. The Fed Funds futures market has by now priced out the rate hikes the Fed has so boldly pre-announced.

While it is certainly not an infallible market, we believe it is a lot more reliable than anything Fed members are saying. In reality, the monetary bureaucrats don’t know what they are going to do. If the stock market keeps falling and a US recession begins (which seems increasingly likely, as the leading sectors of the economy are already in recession), there will be renewed easing by the Fed.

Treasury bond yields and inflation expectations have plunged, and the junk bond market is in crisis, none of which suggests that additional rate hikes are likely to happen. As an aside, the markets have just rebuked the BoJ’s attempt to impress them by imitating the ECB’s negative interest rate lunacy – and they have done so rather loud and clear:

The BoJ’s credibility is in the process of getting shredded – click to enlarge.

The so-called “credibility” of the ECB and the Fed are probably next on the menu. The asset bubbles they have created seem in the process of deflating, and Ms. Yellen appeared as clueless as ever in her recent hearing on Capitol Hill (she is a Keynesian focused on a lagging economic indicator, namely the labor market. She appears not to have noticed yet that a credit crisis has begun).

We concede that the possibility that risk asset prices will reverse back up and that a recession will be delayed for a little while longer exists – it just seems to us that the probability is quite low. What we do think is likely is that there will soon be a pause in the shellacking of stock prices, simply because stock markets have become quite oversold. On the other hand, as we noted on Monday, crash risk has become elevated as well (as is always the case when an oversold market lingers just above a major support level)

Bloomberg has also deigned to interview two lone gold bulls, Messrs. Adrian Day and Adrian Ash. We believe Mr. Ash is on to something:

“We’ve had four years of losses in gold, but it seems the bottom has come in just at the moment when central bankers have again run into a wall,” said Adrian Ash, head of research at BullionVault, an online trading service in London. “It’s clear that the Fed won’t be able to raise rates this year, and investors are taking another hard look at gold. This rally could get very interesting.”

We leave you with one last chart, an update of our comparison between the mid cycle correction of the 1970s gold bull market and the recent 2011 – 2015 downturn in the gold price. They continue to track very closely, with the only difference being that everything happened at twice the speed in the 1970s (this was mainly due to the fact that the gold price was fixed prior to Nixon’s gold default and had to catch up with the monetary inflation of the prior decades).

The 1970s mid-cycle correction temporally stretched by a factor of approx. 2.1, vs. the bear market since 2011 – the two patterns continue to track very closely – click to enlarge.

Conclusion

It is likely that a correction in the gold sector has either already begun or will soon begin. Given recent inter-market correlations, it will probably coincide with a short term rebound in risk assets. A correction will provide us with valuable information: a reluctant pullback with overlapping waves that holds above the 200-day moving average will confirm that at a minimum a medium term bull market in the sector ois now underway. If that is indeed the case, the biggest gains are yet to come.

We assign a lower probability to the bearish outcome that has been the standard procedure in recent years – namely that we have just seen another flash in the pan rally in January that will be followed by a continuation of the bear market. At its recent lows, the bear market in gold stocks was already on a par or exceeding the worst bear markets in the sector’s history. All of the previous major bear markets were followed by major bull markets. With central banks having implemented the biggest monetary pumping experiment of the post WW2 fiat money era in recent years, it seems to us it is highly unlikely that this time will be different.

Rock drilling in a South African deep level gold mine

Photo cvia dailymaverick.co.za

Charts by: StockCharts, INK Research, Michael Pollaro, St. Louis Federal Reserve Research