Saturday, January 18, 2014

The gold/interest rate paradigm

Markets started off the week with a scare as the market suffered its first 1%+ sell off for 2014 and the first weakness of any sort since October, 2013.  I stated in last week's commentary that I didn't see any weakness in stocks as my technical and sentiment indicators were predicting higher highs in the coming weeks.  As I watched the price action on Monday it was totally different than the typical pattern of weakness we saw in 2013.  As the S&P penetrated short term support lines there was hardly any pause and the pressure to the downside was relentless although we did have a small bounce into the close.

I did state that an exogenous shock could take the market by surprise and, in a sense, it got one on Monday.  Atlanta Fed President Dennis Lockhart stated in a speech to the Rotary Club of America that he supported "similar tapering steps" as the one taken last month by the FOMC (reducing asset purchases by 10 billion dollars).  Almost as the words left his mouth the market started its swoon right into the close of trading.

Obviously his remarks (which were not anything that anyone didn't already know) on top of a very weak employment report the previous Friday were the catalysts for the sell off.  Here's a five minute chart of the S&P inclusive of Friday's (1/10) and Tuesday's (1/14) price action:

(click on chart for larger image)

The market is more concerned when Fed governors who they perceive as "monetary doves" make harsh statements regarding taking away the punch bowl than when the "hawks" do it.  On Wednesday, two hawks on the board, Fischer and Plosser, made some remarks stating they were in favor of being much more aggressive on the pace of tapering and the market ignored their comments.  Why?  Because voting on the FOMC is not binding.  The chairperson has the final say on monetary policy and can override a majority vote on the board.  And Janet Yellen is perceived to be a "monetary dove".  I went into some detail in last week's commentary on the changing face of the FOMC to which I attribute the market choppiness since the beginning of the year.  I do believe Monday's reaction does vindicate my thesis to some extent.

The major averages finished the week mixed (either fractionally higher or lower) although the S&P 500 did make a new all time high on Wednesday (1848.38).  Here's a daily chart of the S&P 500:

(click on chart for larger image)

Even though we made an all time new high on Wednesday it was by a mere .02 points.  The red arrow delineates Wednesday's price action and the white arrow was the price action on Friday.

Here's a weekly chart of the Russell 2000 small cap index:

(click on chart for larger image)

There are slight divergences on the momentum indicators on the chart above but these divergences are not universally apparent on the other major averages. 

Despite all the choppiness and concern on the street about how the way the first trading month of the year is unfolding, all technical and sentiment indicators I follow are still pointing to a healthy market.  We do have a potential double top on the S&P but the operative word is "potential" because it's not a double top until a support line is penetrated and that support line is 1810. And if such support were penetrated it would not be a catastrophic signal but only a short term double top.  This market can fall to the 1740 level on the S&P before there is real concern that we might be seeing a trend reversal. 

There is no debate that stocks are facing some headwinds that are manifesting themselves in the kind of vicious downdraft we experienced on Monday but traders on the floor of the NYSE are not seeing any significant selling pressure on the down days.  It's more an absence of buyers.  All the small pullbacks we've seen are orderly (no panic selling) and are met with buying or, in the case of Monday, a significant bounce to the upside the following trading day.  However, it would be dangerous to ignore Monday's price action.  Clearly, market psychology has changed.

I won't rehash last week's commentary as I believe the factors I pointed to in explaining this choppy market are still very relevant but we are seeing interesting developments in both the Treasury and Gold market which I want to highlight in this commentary.  The following is a monthly line chart of the price of gold (red-black line) with an area chart of the Ten Year Treasury yield (black area) superimposed behind it:

(click on chart for larger image)

The bottom panel shows the correlation between gold and the Ten Year Treasury yield since 2001.  As you can see there has been a traditional inverse correlation between gold and the Ten Year yield for most of the time during this period.  And that appears to be continuing as interest rates start trending lower again while gold has experienced what was thought by many as a "dead cat" bounce after the brutal drubbing it experienced in 2013.

 But why would interest rates be moving lower if the economy is growing?  Just the opposite should be occurring as economic momentum spurs greater credit demand, allowing banks to charge higher interest on the loans they make.  

In a previous commentary I discussed the possibility that negative real interest rates could explain gold's bounce in 2014.  That is, anticipating that inflationary pressures were imminent, the yield on Treasuries was not compensating for those inflationary pressures and so investors were back to getting negative real returns on their bonds.  Gold thrives in a negative real interest rate environment because it becomes financially viable to hold non interest bearing investments for potential capital appreciation since interest bearing investments are not returning any money.

Gold finished the week up 0.40% but looked a bit tired going into the close on Friday.  It seems snagged on Fibonacci resistance and we may be forming a double top.   If either thesis posited above is going to be correct we need to see a break out from the level I've pointed to on the chart below:

(click on chart for larger image)

I've also noticed that, on a very short term basis, gold has become positively correlated to stocks.  Generally speaking this was not the case during 2013 for obvious reasons as gold was under relentless selling pressure while the S&P returned around 30% on the year.  But since the beginning of 2014 the yellow metal seems to be closely tracking stocks.  This technical indication, if it were to persist, would be supportive of building inflationary or deflationary pressures in a growing economy.  

There is no doubt that the direction of gold is and will be predictive of the direction of global economic growth in the present macro economic environment we find ourselves.  Right now, I believe gold could be rallying for mainly two different reasons.  Either it's thesis #1 outlined above: negative real interest rates (which has deflationary implications) or thesis # 2: gold is anticipating real inflationary pressures in a strengthening global economy. 

Of course, both thesis 1 and 2 could be wrong and gold could be just experiencing a technical bounce in an ongoing bear market in which the metal is presently entangled.   I'm unwilling to cast my vote on which thesis I subscribe to until I see how gold does at present Fibonacci resistance.

In the weeks ahead we will need to see some follow through in both gold (upward) and Treasury yields (downward) as these two asset classes may be giving us some prescient messages about the true state of the US economy as well as the health of the stock market.

The only other issue I want to bring to my readers attention is China.  There is no doubt economic momentum is slowing over there but we did see some stabilization in the Shanghai Composite this week:

(click on chart for larger image)

The Shanghai is seeing some short term support at the 2000 level but it needs to hold to this level or the next stop is the 1850 level or even possibly the lows set in October, 2008.  I've already highlighted the challenges that China faces in previous commentaries but this is another source of concern for our market and could very well be another reason for the recent upward pressure on the price of gold.

We have a holiday shortened trading week coming up with no important economic reports until Thursday when we get weekly jobless claims and existing home sales.  Earnings season is upon us and the results are presently mixed.  However, in my opinion, the sentiment on the street towards this earnings season is decidedly negative.  

Everything in the market, at least in the short term, is based on perception.  And the prevailing perception is that this market needs some kind of meaningful corrective action.  It needn't be a bloodbath but we need to see something more than these shallow 1 to 3% pullbacks.  Of course, when it finally happens everyone will be clutching their chests as palpitations set in because it's been so long since we've seen any meaningful downside.  But it has to come.  However, as I stated above, there is nothing in the technical work I do that suggests that a correction is imminent.  On the contrary, some of my short term indicators are signaling a strengthening market.

I'm looking at February as a possible time for a correction.  And I base this on seasonal tendencies based on historical patterns going back to 2009.  The market has displayed some degree of weakness every February since 2009.  Fundamentally speaking, I believe there's a distinct possibility the commencement of such a correction could coincide with a Fed announcement after their next meeting to taper their asset buying program by another ten billion dollars.  The next FOMC meeting is January 28th & 29th.

 Regardless of the need for a correction to clean out the excesses, we are still in a bull market in stocks.  If and when I start seeing indications of a turn I'll be sure to alert my readers.

Have a great week!