While we follow literally hundreds of indicators, relationships, and charts thereof in order to provide us with perspectives as it pertains to the financial markets, it is safe to say that some are much more important than others in relation to specific sectors, where amongst the population, changes therein are sufficient to 'tip the balance' in terms of overall opinion within the mix. And although not apparent in the price action of broad stock indices in mature environments over the past six months, as they have been predominantly range bound, there have been some fairly dramatic sectoral rotations because of changes within inter-market relationships, where the precious metals group has suffered a 'bone jarring' correction characteristic of post euphoric conditions.
The question then arises, 'within the full body of influences that affect precious metals, and looking for pivotal factors capable of swinging favorable winds in the right direction, is there reason to speculate the correction might be exhausted?' In a word, the answer to this question is 'yes', but one must remember that even if this were true, which is definitely not conclusive as of yet, the 'bottoming' of any market is a process, and subject to fits a starts as speculative influences and consensus views amongst those capable of moving a market align to create the appropriate condition set for a resurgence of the potential trend.
Before we delve into the meat of the discussion, and in an effort to provide an appropriate context, we would like to make a few comments on some 'big picture' observations that are key in fortifying our view the precious metals sector is in the process of potentially making a turn higher once again. Therein, it's a complicated world we live in these days, especially as it pertains to the all important financial markets, where as global economies continue to more fully integrate, localized currency swings can have a dramatic effect on investment performance on those concerned, as they seemingly balance capital flows in what appears to be somewhat of a 'zero sum' game, and characterized by what could be considered tepid overall growth at best, as the process matures. In this regard, it would not be a stretch to hypothecate investors view the ultimate outcome as one of deflation currently, which is evidenced in the relationship gold holds against key variables within the grid, not the least of which being it's current ratio trend to that of stocks, as measured by the S&P 500 (SPX). (See Figure 1)
As you can see above, I have used the Amex Gold Bugs Index (HUI) as a proxy for gold. The reasoning behind this alternation is two fold, where changes in sentiment are first seen in noticeable fashion amongst paper proxies these days, even as it pertains to the precious metals arena; and, the HUI also best delineates pricing characteristics resulting from localized currency conditions in that it is both directly and immediately effected by ebb and flow. Therein, and because of the geographic diversity of producers found in the HUI, this index's overall performance is largely effected by swings in currencies because of gold's current pricing metrics, where it would require a period of relative strength against all fiat representations to supersede 'ratio box' related constraints. (See Figure 2)
Evidencing this condition, and apparent in the bull move precious metals enjoyed from the year 2000 through 2003, culminating with silver's stellar performance earlier this year, one can dissect the influence of currency related performance characteristics by comparing when a particular geography tends to outperform, which of course depends entirely on relative fiat flamboyance within the box. Therein, and for future reference purposes as this excursus develops, it should be noted that in general, South African producers led the move out of the 2000 lows while generally under-performing thereafter, with Canadian and Australian producers outperforming sequentially afterward, followed by companies deriving their profits in US Dollars pulling up the rear. Therefore, when one views the following chart, you should realize the absolute necessity for gold to begin performing better against the currency related 'ratio box' immediately, as if current support metrics are breached, the deflationary implications are quite profound. (See Figure 3)
Comprised of an equal weighting of shares in the world's major producing counties, the above chart is not the full story, as when we extend the view into a longer-term monthly time frame, an element of optimism must be maintained with a breach of current support, noting the 'slanted pattern' denoted in blue annotations, where there would be nothing abnormal about an 'inverse head and shoulders pattern' defining the move, to say the least. This perspective suggests buying at current levels is a reasonable proposition, given the downside is limited. (See Figure 4)
Before we get too far ahead of ourselves, we need to cover a few more 'big picture' items, so that when it comes time to drawing some conclusions, and although the list may not be fully comprehensive, one will at least have an idea of how the various key factors appear today. In this regard, one thing is for sure, the precious metals market certainly doesn't like the prospect of a constraining rising rate environment. We know this because of the severity in the correction of the group, where for example the HUI has already undergone a full 38 percent retracement of its bull run, which of course telegraphed a likely similar outcome in the 'yield curve'. (See Figure 5)
With the effects of the Presidential Cycle in full swing now, which is to be expected in an election year, the Fed is predisposed to attempting a reversal in monetary policy while the markets will allow for it, as when 2006 rolls around (i.e. the bottom of the cycle), if not sooner, there is no doubt they would like to have a few more arrows in their quiver, so don't be surprised if they pull the trigger more than once. Knowing this, and in usual manic fashion these days, the market has left little to chance in the futures as it pertains to the risk of negative real rates becoming a thing of the past, in spite of stalled real wage gains, and a true employment picture not clearly reflected in official data. (See Figure 6)
This leaves room for volatility not only in the futures markets, but in the cash markets as well, where from a technical perspective (i.e. seen above), the yield curve has room to retrace much of its recent plunge, which will revitalize a growth mentality amongst market participants, and provide a solid foundation for at least a near-term sentiment swing in the precious metals complex, where we will be able to more fully gauge the likely severity of the full corrective sequence based on the impulsiveness found in move. This is why you are seeing strength in the complex at present, not because of geopolitical events, or any other non-fundamental reasons that merely act as catalysts. Therein, if the interpretations found in Figure 6 play out, one can expect the US Dollar (USD) to weaken near-term, as demand will wane with a falling market rate environment. (See Figure 7)
This of course will improve market sentiment for precious metals considerably, potentially drawing the swing money (i.e. hedge funds) back into the sector, a development that appears to be unfolding as we speak. With cash levels in the funds at historic lows presently however, coupled with the ongoing problem of continuously low put / call ratios in both the metals and shares, which is an indication of excessive bullishness within the participating population, gold will likely face stiff resistance once again as it endeavors to hurdle and hold a vault over the psychologically important $400 mark, where at best one would be unwise under these conditions to think the opposite until a sufficient quantity of the bullish bets have been burned off. As it stands today, and allowing for a good deal of volatility along the way, there is a better than even chance gold will not finish the year over $400 based on the degree of bullish options related bets being placed at the mark. That being said, if gold is able to hold above $400 for an extended period, and the calls are paid, one would be foolish to ignore such a statement. (See Figure 8)
Complimenting this schooled opinion, and consistent with robust bottoming conditions in the complex, conditions where the serious capital will be draw back into the picture because of potential meaningful gains intermediate to long-term, we already know this rally sequence is likely to fail at some point in similar fashion, as silver still has some work to do against gold on a comparative basis, which is understandable given the run-up earlier this year. (See Figure 9)
Some may be thinking there is no serious money out there to come back into the markets because cash levels in the funds are at historically low levels, the average consumer is drowning in debt, and the economy is walking a 'stimulus based' tight rope recovery, destined to fail sooner than later. While all of these concerns are valid, and rounding off our look at some of the key factors that affect precious metals, there must be a fairly large contingency of intelligent and rational investors out there still with us, because one would have difficulty explaining otherwise as it pertains to growth rates in broader monetary aggregate measures (i.e. M2 and M3), where when faced with a tightening cycle dead ahead, money market and short-term fixed instruments became all the rage. (See Figure 10)
Indeed, we have been reading many accounts as to why M2 and M3 have been growing rapidly over the past six months, attributing this condition to the direct efforts of the Fed, but in fact it was the past doings of these jolly fellows, not the present, that will one day likely come out of these safe havens and back into the game, at least to some extent considering the effects of an aging population. This is where we are today, and why we must remain vigilant in our search for clues the process is beginning.
Evidence the markets sense a positive outcome in this regard, where regenerative forces will one day characterize macro-conditions once again, is the fact we can have such dramatic sectoral corrections while the broader averages remain relatively unchanged. While largely due to the outsized negative bets many of the hedge funds have placed in index related derivatives (i.e. the floor in the market), and a large part of the reason regulation does not extend into this avenue, the end result will never the less likely be an unexpected turn of events in terms of the majority consensus within the participating population, with a bullish resolution that defies gravity. This understanding provides the foundation for a close look at clues as to when we can expect a turn higher for real in the metals, which as alluded to in our opening remarks, will likely have much to do with how the South African condition performs over the next little while. So far, and as you may have already surmised by the extremely negative sentiment found within this sub-sector, there is good reason to believe the bottoming process has at least begun in terms of an appropriate time window, where we are not speaking in terms of 'dog' years, a word commonly used these days in conversations concerning South African gold stocks. (See Figure 11)
As you can see above, the South African experience appears to be failing, where significant support metrics have already been violated, but where a degree of triangular support still remains on the whole at current pricing metrics. Knowing this, and recognizing that many of the measures in the group have already penetrated 'Golden Ratio' retracements (i.e. 61.8%), which is suggestive of further declines in the offing, there never the less exists growing evidence the drivers that have perpetuated the underperformance in the South African's may be exhausted, which will ultimately be reflected in Rand Gold pricing.
And although for the purposes of this study we will not be able to delve into the reasons behind the move, it is sufficient to know that there is a great deal of technical downward pressure now being exerted on the local currency in South Africa, where as you may be aware, the degree of it's ascent while external gold was pushing through $400 actually caused local pricing to decline, which is reflected in the chart above, and a function of its negative correlation to the USD, a condition with a double-edged sword at the moment. (See Figure 12)
Knowing the path of least resistance for the Rand is down, gives rise to a degree of optimism toward local commodity pricing, which is evident in the positive divergences found in South African Gold pricing indicators. (See Figure 13)
With this condition present, and in the absence of collapsing external gold pricing, where while there is significant options related resistance at $400, there is good derivatives based support at $380, if the Rand were to embark on a journey lower against the Dollar soon, local gold pricing should rise, the degree of which garnered by respective velocities as it pertains to the variables. Knowing sentiment is very negative toward the group presently, and in light of the above understanding, at a minimum it makes a tremendous amount of sense to be overweight the South Africans at this juncture, where the surprises are more likely to be on the upside rather than the down, at least for now.
The basis for this opinion is of course hinged on assuming deflationary forces are not about to overwhelm us, where based on much of the ratio work we do, there does remain a risk in this regard. In fact, there is evidence of this belief in the trade of the South African's themselves, where one never really knows whether the impulsiveness of the move is more a function of reality or simply fear and speculative forces. Here is a view of the South African Gold Mining Index that clearly demonstrates we are currently counting down in fives, which from an Elliott Wave Theory perspective suggests the move lower is the trend, at least until proven otherwise. (See Figure 14)
Again, extending this view out utilizing the weekly chart over a longer time interval, we can see that if fact there is the potential for 'fifth wave failure' with a breakout test from current levels (i.e. a zigzag) as the year progresses, which would be consistent with the understanding selling should now abate at least temporarily, and where there will be as good a chance than not further downside past current support metrics would be negated in subsequent cycle-down sequences. This hypothesis is supported in the fact the group is within an acceptable variance from the 'Golden Ratio' retracement, which is a standard condition found in a flat, and consistent with count. (See Figure 15)
In other words, even if the HUI for example were to go lower, where there is reason to believe other components and sub-groups within the complex should see further corrective action, it is very possible the South African's will now begin to outperform, minimizing downside considerations, and suggestive a longer-term positive view should now be ascribed to the group. This hypothesis is fortified considerably in this next chart, where Harmony Gold (HMY: NYSE) is now exhibiting a 'buy signal' against the complex from a technical perspective. (See Figure 16)
Harmony's chart itself is also at a very interesting juncture from a technical perspective on several fronts, with the most significant feature that being the potentially bullish and rare rectangle that has formed. (See Figure 17)
Further to this condition set, and as indicated above, HMY is about to trigger a 'strong' buy signal with a reversal and close above $10, the large round number and 50 percent retracement mark, where a close above the 200 weeks moving average (WMA) indicates a measured move (MM) to $14.75 off an inverse bottoming pattern. Here is another view of HMY via its daily chart, which by all accounts from a technical perspective appears 'good for go', and where I would like to highlight the important technical accomplished a push back above the 38 percent retracement mark would be in the big picture, as this would signal a move back to the highs at a minimum, and probably beyond. (See Figure 18)
Here is a snapshot of Gold Fields (GFI: NYSE) that predominantly mirrors the technical condition in HMY. There are many bulls long the calls at $10 however, a condition that extends until October, so don't expect much out of this one until they are burned off. I cannot emphasize this enough, stop buying calls on gold and its related equities and we may have a really strong bull move one day. (See Figure 19)
We would be amiss not covering Durban Deep (DROOY: Nasdaq) in a look at the South Africans considering it is widely held amongst many investors in the gold community, so here is a peek at how the technicals stand today, where it is currently testing right shoulder support on a 'slanted inverse head and shoulders pattern' coincident with the 200 WMA. (See Figure 20)
Against the box, which in this case is the HUI since it is the closest approximation of an index representing un-hedged shares, DROOY appears to be a reasonable speculation at this point, especially considering it has been to these levels several times before throughout its corrective process, which means it has been exhibiting relative strength against the group, and now the other South African producers as well. (See Figure 21)
And when we examine the ratio of Harmony against DROOY we see that HMY could begin to outperform at this point a la the 'inverse head and shoulders pattern' in the chart which is suggestive large liquid shares are still preferred at this point, but that at worst once the measured move is complete, the Roodeport Rocket should kick in the after boosters. (See Figure 22)
The message this ratio is giving us right now, as DROOY may actually continue to outperform, is that the risks associated with accumulating South African gold shares is relatively low at this point, and that additions of these shares to core positions with the objective of holding for the intermediate to long-term is a reasonable proposition now. But as mentioned above, one should remember that this statement is being made in the context of likely further bottoming in the precious metals complex, where other sub-groups within the mix still likely need further consolidation(s), and where silver should be the last to bottom.
To sum things up briefly then, it appears we may be in the process of bottoming in the precious metals complex, where South African gold shares are customarily leading characterized by volume confirmed reversals at either 'signatured' or 'Golden Ratio' retracement measures, where the patterns and counts are supported utilizing Elliott Wave Theory. As I see it, the shares are generally leading, with geography / currency related considerations integrated, which extends to their respective relationships to local metals pricing. Therein, and providing macro-conditions unfold favorably throughout the remainder of the year, where although USD gold pricing may predominantly be confined to a range extending between $375 to $425, a very solid long-term bottoming process now appears likely to develop, one where we may be able to look back on and identify the present as 'the beginning of the end' in what should be considered a perfectly normal corrective process.
And there you have it, where we would like to extend our views further at this time, but find this excursus may be getting a little long in the tooth for practical reasons, and where we hope we didn't loose you along the way. The above is an example of the kind of analysis that appears on our web site every week, so if you would like to follow how this potential precious metals bull market is unfolding throughout the balance of the year, please give us a visit at the link provided below.
Until the next time, good investing all.