Saturday, October 26, 2013

The Change in Sentiment toward Gold

Equities had another banner week with most of the major averages finishing at all time new highs or had posted new highs during the week.  The Dow Jones Industrial Index is lagging the other major averages but the Dow Transports are on fire breaking above the 7000 level on Thursday to finish the week at 7009.05.

While quarterly earnings are coming in at expectations (after analysts lowered the bar) revenues are still, on average, light.  Nevertheless, a good earnings report at the beginning of the day is enough to "goose" the market and send it on its way.  However, the real driver is ongoing Fed liquidity which continues to inflate the stock market.

As I stated in last week's commentary, we're getting into a low volatility environment where the indexes slowly and methodically make their way higher.  And we're seeing the same pattern during the trading day that we've seen so often in these gradually levitating markets over the past few years as the "smart money" comes in at the end of the day and program trading starts buying up stocks:

(click on chart for larger image)

Here's a five minute chart of the S&P 500 with the last half hour circled.  This is a classic pattern we've seen many times before and is indicative of "the big money" positioning themselves at the end of the day.  It is especially noteworthy as it is occurring on a Friday.  These guys are not afraid to hold over the weekend which is another very bullish sign.  And why should they be afraid?  The Bernanke/Yellen duo has the market's back!  

Here's a daily chart of the S&P 500:

(click on chart for larger image)

I circled Tuesday through Friday's price action.  In last week's commentary I identified probable targets for the S&P going into year end.  On Tuesday, we blew through the 1.282 Fibonacci extension (on chart) only to stabilize there on Wednesday and Thursday.  On Friday we decisively closed above the extension and made another all time new high.

Assuming we continue higher and there is nothing to suggest that we won't, I'm targeting the following two Fibonacci price extensions:

1781.40 (1.618 extension)
1864.79 (2.618 extension)

I'm reiterating my call that we will see the S&P 500 at 1860 by the end of the year.  

That doesn't mean that stocks aren't getting tired.  They are.  I watch the markets very closely and compile data every trading day to determine fluctuations in momentum and breadth and I sense that if they didn't have the "Fed floor" under them we'd be seeing some corrective price action.  The Russell 2000 Small Cap Index which has been leading this market higher all year "stutter stepped" on Friday:

(click on chart for larger image)

This is a sixty minute chart of the Russell and I highlighted a support area when the index gapped higher on October 18th.  As you can see, the gap is providing support (as gaps normally do) and unless we see the Russell break down under this support any weakness is transitory.  

Investor sentiment has reached the point that, in the past, would be signaling an imminent market correction.  The AAII Investor Sentiment Survey that measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months came in this week at 49.2% bullish versus only 17.6% bearish.  But with Fed liquidity continuing to pour into the market through it's primary dealer intermediaries, stocks for all intents and purposes can't stage a meaningful correction.  Only the catalyst of an exogenous shock could trigger the program selling that would push stocks down in any meaningful way.  

Another bullish indication in a contrarian way is that we're now getting commentary from market pundits warning of a possible crash and that the market is overvalued.  When people come out and start talking like this you know that we're nowhere near any meaningful correction.  An opposite historical example of this is Professor Irving Fisher who, within days of the 1929 market crash stated that stocks had reached "a permanently high plateau."   So far as valuation goes, in many ways it is in the "eye of the beholder".  I would agree that the market is floating on a liquidity induced high and based on that parameter, it is overvalued!  But as I said to a colleague this week, who cares?  Anyone managing money in this environment would be crazy to sit on the sidelines while this market registers consecutive all time new highs.  Most importantly, the Fed "put" continues to keep a floor under the market and their low interest rate policy actually forces anyone who needs to grow their money into the market.  Even a catastrophic event that could precipitate a sell off in equities would be blunted due to Fed largesse.  This is indeed a bull market that everyone loves to hate!  And that sentiment is bullish.  The market continues to climb the "wall of worry".

I wouldn't want anyone to think that I'm complacent about the situation we find ourselves in with the financial markets and the economy.  In the rest of this commentary I will be reiterating many of the concerns I have about the present state of the global economy from the viewpoint of what I believe the gold market is telling us. I personally can't see the quandary the Fed faces ending well.  However, that doesn't mean there has to be a crash or that other factors can or will come into play that will either mitigate or deflate the perceived asset bubble that many believe is forming.  And there is absolutely nothing that I can see on the horizon that would upset this market going into year end.  Even seasonality is on the market's side as the market historically outperforms going into year end.  

My regular readers know that I watch gold very closely as I am searching for indications that the "reflation trade" is gaining momentum.  Additionally, with Armageddon tail risks muted, gold has returned primarily as a predictor of future inflationary pressures.  

We know that initially, when the Fed surprised the markets in September by not commencing the cutback on their asset purchases, gold continued to react negatively, which was a very bearish sign for the yellow metal.  At that point, I believed that we could eventually test $900.00 and that the $1,200.00 level was a "do or die" level that the metal must hold in order not to plunge quickly to $1,050.00.  The thesis behind these predictions was that deflationary pressures were (and are) dominant in the global economy and that, in the absence of global financial or economic tail risk, there was no reason to hold an asset that doesn't provide yield in a slowly rising interest rate environment where inflationary pressures are non existent.

Inflationary pressures in the developed economies (US & EU) are dangerously low at this point with our PCE deflator at 1.2% annually and Europe having challenges maintaining enough currency in their banking system to sustain even moderate growth.  So, nothing fundamentally has changed since last week when I predicted $900.00 gold.  But sentiment has markedly changed!

This week, Deutsche Bank caused quite a stir among market followers and analysts when it released a commentary in which their US interest rate strategist, Dominic Konstam, stated that he thought the Fed had only a short window in which to taper because of cyclical headwinds which would soon negatively impact the US economy.  He intimated there would be a fair chance that the Fed would not even taper in 2014!  

Gold seemed to have anticipated his thinking because it started rallying a week before his statement.  This is a daily chart of the spot Gold price:

(click on chart for larger image)

Gold had a huge mysterious surge on Thursday, October 17th, that I alluded to in last week's commentary and has not looked back since.  Here's a weekly and monthly chart below with support and resistance levels to give my readers an historical perspective:

(click on chart for larger image)

Note on the weekly chart above that Gold successfully tested the $1200.00 level but has come nowhere near that level since.

(click on chart for larger image)

My point in presenting these charts and the recent history behind gold is to amend my thesis.  Simply, my prediction of $900.00 gold was premature based on market developments over the past week and what I believe is a significant turn in market sentiment toward the precious metal.  

Mr. Konstam's remarks this week was a tacit admission that the Fed is caught between a rock and a hard place.  I addressed this issue back on September when the Fed surprised the market by refusing to commence tapering and it is gaining broader credence on the street.

Gold's fortunes are still dependent on the Fed in the sense that if Bernanke/Yellen and company were to surprise the markets and commence tapering of US Treasuries and MBS (mortgage backed securities) this year, the yellow metal would initially do an about face and move significantly lower.  However, with the growing opinion that the Fed cannot ease up on the liquidity gas pedal, there is the prospect that inflationary pressures could start to build in the US economy.

The implications of these developments cannot be overstated.  First of all, if this scenario plays out as it is seen now, it means that the Fed policy has failed.  I know a lot of people already believe this but I'm not yet one of them.  The Fed always knew that their policies in the wake of the 2008 debacle could only forestall a deflationary depression.  The hope always was that massive liquidity injections would initially mitigate the gargantuan deflationary forces that were facing the global economy at that time (which it did) and secondly, "buy time" in order for the US and the global economy to heal.  But gold's new message seems to be that time may be running out.

I've mentioned liquidity traps in my past commentaries and I do believe we're at a moment of truth that the central bank will have to face in 2014.  Will they bite the bullet and deny the market the "hopium" it's been hooked on since 2009?  The potential implications of such a decision are huge.

At this juncture, there are two scenarios people tend to embrace.  The first is the opinion that any recovery we've seemed to have since 2009 is "smoke and mirrors" and that inflated asset prices are the only success story that the central bank can brag about.  If the Fed takes away the punch bowl the financial markets will implode.  While I don't fall into this camp I cannot dismiss this thesis either.  Gold's present message is that continued Fed liquidity coupled with ongoing slow growth implies stagflation.  With weak economic growth, high structural unemployment and rising prices because of excess liquidity in the system, the economy will continue to stagnate while inflationary pressures build and we will have the worst of all worlds.

Under scenario number two, our economy and Europe are doing incrementally better since 2009.  In Europe, deflationary pressures are rampant but economic activity is out of the recessionary category.  In this country, there are encouraging signs of continued tepid growth that anyone can see by googling US economic data.  The fact that we haven't seen greater progress is because monetary accommodation  has not been complemented by pro growth fiscal policy.  Corporate balance sheets are flush with trillions of dollars in cash which are ready to be put to work in capital formation when a business friendly environment comes back to Washington.  In the meantime, all that cash means more stock buy backs and increased dividends for shareholders which is another bullish indication for stocks.

In closing, some of my readers may look at the charts above and say I'm too early to change my view on gold.  Gold has only started to bounce and is nowhere near challenging any significant resistance levels.  At the same time, I follow these markets too closely to ignore what my intuition is telling me is a significant change in sentiment toward gold.

We'll know whether my new thesis is on the right track if gold surpasses the $1400 level.  After that my target will be the $1525-1550 level.

Have a great week!