Gold Stocks As A Leading Indicator - by Xiphos
There are several technical and fundamental inconsistencies I have been unable to resolve with respect to the broader markets over the past couple of years. I’m talking intermarket technical and fundamental relationships between commodities (gold), debt (bonds), currencies and equity markets. The fabric and flow of the market’s outfit per se. A couple of concepts I had chosen to put aside, to discount the alternative possibilities. After all, who really knows where the price of any asset will be in 6 months or 5 years from now?
I was deeply in the inflation camp during 2001 – 2007 and justifiably so. I started having my doubts about the rate of inflation toward the beginning to middle of 2007. I bet on housing and a banking collapse which would begin to put the brakes on recent inflation and it proved to come about. There are two primary destroyers of wealth – inflation and deflation. There are of course several other destroyers of wealth – like stupidity and war and often these are one and the same. Ordinary disinflation is not a destroyer of wealth. Stability is the ideal; extreme volatility in prices and confidence is the enemy. This is why the Fed’s mandate is “price stability”.
I have a theory that GOLD STOCKS are one of the BEST LEADING INDICATORS in the entire market – hands down. I can’t explain fully why this tiny sector is one of the best leading indicators, but I do hold considerable faith in this concept. I believe that the price and performance of gold equities reflects reality. I cannot think of any conspiracy theories to which I subscribe. I consider myself a realist. I believe markets are efficient and effective; that there is a rational explanation for everything – even if we don’t know what it is (yet). I had chosen to discount this long held belief for roughly the last six months. Simply said: it didn’t jive with my belief that we were in a new secular bull market for inflation after the last 25 years of disinflationary trend.
Below is a 20 year chart of the performance of large cap gold mining stocks ($XAU) relative to the price of the commodity for which they mine. I would encourage you to take this ratio further back another 20 years to see what it looked like. I was not able to do this, but I believe that the ratio has not been dropping for the last 40 years. Also, included on the chart is the long term interest rate on the 30yr US Treasury bond. Long term interest rates have always been extremely sensitive to future inflation expectations.
Gold Stocks Relative to the Price of Gold and LT Interest Rates
Separate, or together, both of these trend expectations continue to be highly disinflationary – not inflationary. That is, the current expectations of large cap, institutional gold stock investors and that of the largest investors in the world – bond investors – continue to be deflationary in character. I do believe a long term high in this bond price is likely already in place, but neither am I ruling out a double top later this year.
It would seem that there is depreciating leverage for holding large cap gold stocks ($XAU) to the point of negative leverage to the price of gold as of late. Over the last 12 months, most of the largest gold companies have badly underperformed the price of GLD itself (see ABX, KGC, HMY, NEM relative to GLD – comparison chart).
This is a major red flag and considerable risk that a fundamental problems exist. During long bull markets, big cap gold stocks will tend to consistently outperform the price of gold – not the opposite. You own gold stocks for the leverage they provide relative to the price of gold – otherwise you would only buy the “risk free” metal alternative. There is of course lots of risk with (not) owning gold or silver itself – the risk that the price will go considerably down (or up without you for that matter).
I do believe that the gold stocks have been and continue to be in a new secular bull market since the turn of the century. I still believe that these mining equities are signaling eventual mass inflation. We enjoyed a marvelous run for seven good years to dizzying new highs leading up to early 2008. What followed was a brutal, near total collapse in the sector that destroyed many investors when deflation fears led to wholesale, often forced, liquidation of the shares.
The recovery in the share price was stunningly impressive as they rose, on the average, roughly 270% from their October 2008 lows into last November. Some of the smaller, intermediate producers we owned rose as much as 850% during this period. The unhedged gold equity index fought all the way back to the old highs in very short order. A trader’s dream and a heart attack for the average investor.
I’m no Elliot Wave (EW) or Gann expert, but I do subscribe to long term wave patterns and relationships between asset classes. Broad, macro concepts need to reconcile over time between asset classes. Long term charts document these important interrelationships. Conspiracy theories, however, are not reflected in charts – only the facts. The facts are always there, but sometimes very wrong assumptions are used to explain the price action and trend direction.
The last couple of years I’ve not seen an EW count of gold stocks relative to gold or silver counts that made much sense to me. Many technicians seem to disagree or have wave counts that differ drastically between gold and the gold stocks. The majority seem to have gold (possibly the gold stocks) well into Wave III of a V wave structure. Most claim that the Wave II correction in gold lasted for only 9 months - or approximately 9% of the time that Wave I took to complete. Say what? It may have corrected enough in price, but I do not believe the time criteria for length of correction has been fully met yet. This has continued to throw up red flags for me; surely there are some missing pieces in the overall puzzle?
What’s this all adding up to? Back to this theory that major gold producers are an important leading indicator.
[HUI/Gold Wave I and II (including the ABC correction)]
{edit 1.31.10: slight update to HUI/Gold Wave I and II}
I think that if this final C correction of Wave II decides to play out (see above chart), it will nullify the large head and shoulders pattern on gold currently with a neckline around 1040. I very much doubt that the price of gold would crash more than a couple of hundred dollars, but gold equities would experience tough times again. It would coincide with a sharp correction in the stock market and a top in bond prices. The recent double top in the gold stock index and relative under performance to the price of gold itself seems to indicate that a return to a deflationary collapse is still very much a possibility.
How far down gold, the mining stocks or broader stocks will likely go is debatable. The Wave I gold rally lasted about 89 months (a Fibonacci number). The first Wave A of the correction lasted 7 months, followed by a 14 month Wave B counter trend. If the proposed Wave C down lasts for an equal 7 month decline relative to A, then the total ABC Wave II correction will take about 28 months or 31% of the Wave I as far as time is concerned. This seems very reasonable. It could also last longer - perhaps a 13 month C correction which would mean the entire ABC would last 34 months (another Fibonacci) or 38% of Wave I, an important Fibonacci retracement level also makes sense to me. I’m leaning towards the longer correction.
The HUI, gold, yen carry trade [a measure of global risk taking] and several other important indexes would be on the same/similar cycles. Gold’s last high at 1226 could end up proving to be an irregular ABC correction high (the top of B wave) off of Wave I’s high of 1033 and the A bottom near 700.
There are lots of possible scenarios, but I see the current risk is to the downside- perhaps even a repeat collapse to a certain degree. The confidence of investors is already on very shaky, uncertain ground. This time around investors know it ‘can’ happen and really ‘did’ happen – unlike before. There are lots of alternative possibilities that will nullify this scenario and I definitely wouldn’t mind to see one of those either. However, this is my working thesis at the moment - until it proves itself unrealistic.
