Market Wrap

Week Ending 5/29/09

The following excerpt was taken in part from the 5/29/09 market and wrap and the 6/05/09 report. Both can be read in their entirety by visiting the Honest Money Gold & Silver Report website.

Inter-Market Dynamics

In past market wraps I have discussed various inter-market relationships and the fact that some of them have changed, while others keep oscillating back and forth: sometimes tracking one another in the same direction; and at other times moving inversely to each other.

These changing inter-market dynamics are the signature of a paradigm shift that is taking place: the death of paper money (and related assets) and the re-emergence of gold and silver as the ultimate store of purchasing power and value over time.

Other tangible commodities are also being chosen as viable alternatives. China is the leader of this movement, as they continue to exchange paper money for commodities that they are storing, almost to the point of hoarding. They have a long history of survival, and the many ways and means thereof. This instinct should not go unnoticed.

Back in March I wrote a paper, The Road to Hell (click link for access) that discussed China's call for a new global reserve currency other than the U.S. dollar. One of several reasons for this call for change is the fact that China is concerned with the value (purchasing power) of their large holdings of U.S. Treasury bonds; as well they should be. It is this concern over U.S. debt and its ramifications that I want to focus on.

As everyone knows, a financial debacle has been unfolding since 2008, with the downfall of Lehman Brothers supposedly marking the start. This catalytic event is open to debate, however, it suffices to illustrate the fact that something occurred in 2008 that the markets did not like. It has since been dubbed a financial crisis.

We are going to look at six (6) markets and their reaction to the crisis, as well as the inter-market relationships between them. They are:

• Oil
• CRB
• Gold
• S&P 500
• U.S. Dollar
• U.S. 10 Year Treasury bond

As the chart below shows, around late summer to early fall of 2008, both stocks and commodities plummeted. Commodities, as represented by the CCI equally rated index, hit their low early in Dec. of 2008, while stocks kept falling into March of 2009.

The CRB index made its low in March of 2009; however, it is not an equally weighted index and is skewed by the price of oil. Oil made its low late in Dec. of 2008.

Notice that while stocks, commodities, and oil were falling since mid-2008, Treasury bonds, the U.S. dollar, and gold were rising.

It is impossible to know exactly why these markets acted as they did, nevertheless, a bit of common sense offers some strong probabilities.

Investors were obviously spooked by Lehman Brothers, AIG, and the related deleveraging of the mortgage markets and unwinding of toxic derivatives. All told there were many ingredients thrown into the pot - a veritable witch's brew that did not go down easily, regardless of how many spoonfuls of sugar were added to the messings.

It is said that ultimately greed and fear move the markets; and in this particular case there was a whole lot of fear hanging in the air. Investors around the world sold stocks and commodities and ran to the perceived safe havens afforded by gold, Treasury bonds, and the U.S. dollar - a strange brew in and of itself. Risk was repriced. The return on money was no longer the concern - the return of money had taken center stage. The latter is the key point.

There are two main schools of thought on the flight to safety theory. One extols the simple maxim of the return of one's investment or money. Gold has always been considered the safest of all assets whenever turmoil roils the markets.

The move into the U.S. dollar and Treasury bonds as a safe haven was based on the assumption that since the solvency of many markets was being questioned, it was thought that the U.S. government would be the last to go under, hence the dollar and Treasury bonds would be the last assets (other than gold) to go down.

Gold is not subject to going under, as it is outside of the system of debt obligations. Gold is no one's debt or obligation. This is why gold is the ultimate safe haven.

Be that as it may, there may be more to the story, which brings up the second school of thought on the run from risk to safety theory. When panic and fear set in everyone started selling. During such times liquidity becomes the main concern. Margin clerks were smiling as the baby was thrown out with the bath water.

Any safe haven must be liquid and easily entered into and out of. It must be able to be bought and sold in large quantities. This is where the U.S. dollar and the Treasury market come to the fore. They are both huge markets that can handle massive amounts of buying and selling.

This brings into focus the penultimate distinction between gold and other perceived safe havens such as the U.S. dollar and Treasuries. Gold is an extremely liquid market because it is always accepted anywhere in the world at anytime - and it has been for thousands of years. But gold is not a large market quantity-wise. It is a very small market in terms of supply.

As a matter of fact, this is what makes gold so "valuable" - its stocks to flow ratio dwarfs all other markets. At the present rate of yearly production, it would take over 75 years to produce the existing above ground supplies of gold. Other goods have a stocks to flow ratio of one year or thereabouts. Most other commodities are consumed - gold is not. This is what makes gold so "precious" - its unparalleled quality, and limited quantity.

On the other hand, it is the exact opposite reasoning that supports the second school of thought on the flight to safety theory regarding the rush into the dollar and Treasuries during the deleveraging and global liquidity crisis.

It was the huge supply of both dollars and Treasuries that made them so desirable from a liquidity point of view. It was their quantity more than their quality that was at play, although their quality was also perceived to be worthy and factored considerably into the equation.

Nevertheless, how things change over time, which is the point of this discussion: the changing of various inter-market relationships.

Gold and the U.S. dollar have a long history of moving inversely to one another: if gold is up, the dollar is down. If the dollar is up, gold is down. For decades this relationship has stood the test of time.

However, starting in 2009 both gold and the dollar moved in tandem, both began tracking each other in the same direction - to the upside. Once again, this was supposedly due to the flight to safety. Things went from bad to worse in most markets. The financial system was freezing up, and investors rushed into gold and the dollar at the same time. The chart below shows the inverse relationship between gold and the dollar going back for a decade, until the start of 2009.

Let's hone in on the price action beginning the very first of the New Year - 2009. During late Dec. of 2008, gold and the dollar began to move up together in tandem. This is most unusual for the two. Generally they move opposite to one another. So what gives?

It was the flight to safety dynamic, spurred on by the large liquidity issues, and the belief that the U.S. would be the last sovereign nation to default on its debt obligations that were at play.

Suddenly it became a technique of self-survival against the margin clerks; when everyone was selling anything they could get their hands on. The good was sold with the bad. The baby was tossed out the window with the bath water. No quarter was given, although many a plea was made. The margin clerks stood their ground.

But now we are having another inter-market trend change: since Mid-April the U.S. dollar has been dropping, while gold has been rising, returning to the inverse relationship of old.

Bonds topped off at the beginning of the year and have been getting hit pretty soundly pelted to the downside. Apparently the safe haven concern has dissipated - at least for time being.

Both U.S. Treasury bonds and the U.S. dollar are down significantly. Why are they down when a short while ago they were the go to plays in the flight to safety? Are the markets simply willing to take on more risk now and are no longer concerned with safety? If that is the case, why is gold still performing as a safe haven? I think it goes back to the quality versus quantity issue.

Because the Treasury Dept. has to issue huge supplies of debt going forward to fund its various stimulus and bailout schemes, the bond vigilantes are starting to smell inflation and they want to be compensated for the increased risk of lending their money to a self-addicted borrower.

The bond vigilantes are demanding more interest be paid to make up for the increased risk. This has sent Treasury bond rates higher and bond prices lower, as the next two charts indicate. Recall a couple of months ago I mentioned that Treasury bonds might be the next bubble to burst. It looks like that may be coming true, although a short term rally is not out of the question.

It is starting to dawn on the Fed that the markets are bigger than they are. They may be able to steer or direct certain markets in certain directions for certain amounts of time, but to think they have complete control over all markets is a mugs game at best.

The market is a law unto itself and it will not be denied. We are starting to see this law exert itself in full array. I expect to see more of the same as time passes: old paradigms will give way to new ways and means. It is the passing of history from one epoch to another. Life stops for no man, it keeps on moving - inexorably into the future.

So, it is simply a case that investors are willing to accept more risk now and are moving money into stocks and commodities, while moving it out of Treasury bonds and the dollar?

As the following charts show - interest rates on Treasury bonds are rising, while prices are falling. Treasury bonds have felt the wrath of the bond vigilantes and it may reverberate throughout other markets. The charts are quite clear on what is taking place: the price of risk has gone up in T-bond land.

My take is that money is moving out of the bond market and the dollar market because of increased risk. The fact that so much debt (supply) has to be issued, is now forcing buyers to demand higher interest rates to compensate for the perceived increase in risk.

To attract enough buyers (demand) the Fed has to either raise rates (which the market will actually do of its own accord); or the Fed will have to step up to the plate and become the buyer of last resort, doomed to having to monetize large sums of debt that others dare not buy.

Such monetization of debt will further debase (destroy the purchasing power) an already weakening dollar. This dynamic is what the Chinese are concerned about, as they hold tons of dollars and lots of Treasury debt. China should be concerned - very concerned.

Also, it must be remembered that gold is going up smack dab in the middle of all this, so somebody somewhere perceives increased risk in the markets; otherwise, why would gold be going up; and why would interest rates be rising?

It is true that commodity and stocks have gained during this same time, and for several reasons: money that flows out of bonds and the dollar needs to go somewhere; and there are certain investors that perceive things are getting better in the global economy and that we may soon be pulling out of the recession (if that is what we are in - the point is arguably debatable).

I think this is a false assumption, however, and that it will be brought to the public's attention during an up and coming bond auction that fails, sometime in the not too distant future, perhaps as early as next week, when the long bond goes up for bid. It will be interesting to see who shows up, to what degree they show up, and what price they are willing to pay.

The debate continues as to whether the economy has bottomed out or not. Some maintain that it is carving out a bottom out, while others believe that a bottom is further down the road. I am in the latter camp.

Recent economic data supports both sides of the coin: some reports show improvement and others show conditions are deteriorating. Of all the markets and indicators, the bond market is the key. The government can get money in one of two ways: collecting taxes and selling Treasury bonds (debt).

It is critical that the Treasury finds a buyer for all the debt it intends to issue. The various bailout schemes are just that - schemes; and they all entail the issuance of huge amounts of debt (bonds) by the Treasury. This is loan the U.S. the money it needs?

For years, Japan and China have been large buyers of U.S. Treasury bonds (debt). Together the two lend the U.S. almost half of all T-bonds sold.

If the Asian giants do not increase their purchases (demand) of our debt, while the U.S. increases its issuance (supply) of debt, there will be problems in paper fiat land: interest rates will go up as buyers (creditors) demand higher payments to make up for the increased risk that the huge supply of debt will never be paid back.

This has already started to occur. Japan and China have been buying less debt (T-bonds); and China has publicly raised concerns that the United States excessive borrowing (debt issuance) will cause the value of both bonds AND the U.S. dollar to drop. These concerns are not without merit.

The Fed has stated that it will buy the excess Treasury debt that is not purchased by the usual players in the bond market. However, such debt monetization causes the purchasing power or value of the dollar to drop, as witnessed by the recent fall of the U.S. dollar index (chart appears in the currency section).

Interest rates on Treasury bonds have been rising, while the value (price) of T-bonds has been dropping. If rates continue to rise, it will put pressure on the housing market and on consumers that are only able to consume by borrowing or going into debt. Rising rates will hurt consumer spending, which accounts for two thirds of the economy.

For years, Japan and China have been large buyers of U.S. Treasury bonds (debt). Together the two lend the U.S. almost half of all T-bonds sold.

If the Asian giants do not increase their purchases (demand) of our debt, while the U.S. increases its issuance (supply) of debt, there will be problems in paper fiat land: interest rates will go up as buyers (creditors) demand higher payments to make up for the increased risk that the huge supply of debt will never be paid back.

This has already started to occur. Japan and China have been buying less debt (T-bonds); and China has publicly raised concerns that the United States excessive borrowing (debt issuance) will cause the value of both bonds AND the U.S. dollar to drop. These concerns are not without merit.

The Fed has stated that it will buy the excess Treasury debt that is not purchased by the usual players in the bond market. However, such debt monetization causes the purchasing power or value of the dollar to drop, as witnessed by the recent fall of the U.S. dollar index (chart appears in the currency section).

Interest rates on Treasury bonds have been rising, while the value (price) of T-bonds has been dropping. If rates continue to rise, it will put pressure on the housing market and on consumers that are only able to consume by borrowing or going into debt. Rising rates will hurt consumer spending, which accounts for two thirds of the economy.

The chart below shows that rates have been rising since the beginning of 2009. If the horizontal black resistance line at 41 is broken above, there will be a lot of hurt felt in the housing and related markets.

When interest rates rise bond prices fall, as the chart below shows. This is what has China so concerned with the huge holdings of T-bonds they hold. If support at 112.5 is taken out China will not be a happy camper; and the U.S. needs China to continue to subsidize our profligate ways of consumption. China is our sugar-daddy if you will.

Gold

On the weekly chart below, the bullish head & shoulder pattern dominates the chart. The black vertical lines connect overbought STO readings with prices topping out just before the next correction begins.

The chart shows that STO has room to advance higher if it wants to, before overbought territory is reached. Any correction should be short-lived, but could be quick and violent. It is possible for gold to test the $900-$920 spot price (90-92 GLD) level.

If and when gold does correct, it will be important to watch the volume figures. For an inverse head and shoulders formation to be valid, volume up and out of the right shoulder should expand and the breakout above the neckline MUST occur on expanding volume; otherwise a false breakout is possible.

This inverse head & shoulders could be very strong if it develops and makes a valid breakout that is confirmed by expanding volume.

Once the neckline is broken it is imperative that resistance turns into and holds as support. If this occurs the next major leg up in the gold bull will be starting.

The market likes to make it hard for as many players as it can. This leads me to believe that something may happen to make it harder to discern and time the breakout. Time will tell. For now we watch and prepare for the move.

Upside targets are at $1200-$­1300 if the formation is confirmed. The one thing that bothers me is that a lot of analysts have been talking about the formation. A couple of months ago there were only a few discussing the possibilities. Now there are many.

The market likes to make it hard for as many players as it can. This leads me to believe that something may happen to make it harder to discern and time the breakout. Time will tell. For now we watch and prepare for the move.

Gold Stocks

The Hui gold bugs index has been a strong performer since its January low near the 250 level, rallying up impressively to the 400 level. As mentioned in last week's report, the index is due for a correction, and one looks like it has begun.

RSI bounced off the oversold 70 level and is headed down, presently residing just above 50. The index closed below its lower diagonal support line.

Significant support resides at the 350 level indicated by the horizontal red line. MACD has made a negative crossover. If the stock market turns down, look for the gold stocks to tag along for the ride.

Next up is the weekly chart of the GDX index, which shows several indicators turning down signaling a correction is beginning. RSI never made it all the way to the overbought 70 level, but has turned down. STO is in overbought territory and is curling over, likely setting up for a negative crossover. The black horizontal line (37.50) is the first support level, with the various Fibonacci levels below. The 50% level is quite possible, especially if the overall stock market turns down and the dollar up. When it forms a short term bottom, it will offer a good buying opportunity.

The monthly chart of the GDM index looks promising. MACD is making a bullish crossover and the histograms are entering positive territory. This is a very constructive long term signal.

Note on the chart prices going back to the beginning of the bull market in 2001 and ascending up from the lower left hand corner of the chart to the upper right hand corner - a bullish signature. Then the big drop in 2008 that took the index out of its rising price channel.

MACD crossovers on the monthly chart always precede large moves - be they up or down. The positive crossover suggests that the next big move up is about to commence and it could be a killer.

The bottom line is that I'm expecting the stock market, commodities, and gold and silver to head down, while the dollar and bonds head back up. These will be short term moves - for now, until we see if they morph into something more substantial and sustainable. The markets appear to be at inflection points and patience is warranted.

Good luck. Good trading. Good health, and that's a wrap.

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