A Test of Patience …
Actually, we are obviously not qualified to answer the question posed in the title of this post. We published an article entitled “Gold & Gold Stocks – Potentially Bullish Developments”, early last week which turned out to be particularly ill-timed. Both the metals and the mining stocks got whacked almost as soon as the proverbial ink on it was dry.
We hope that the overarching topic of the article, which was inspired by divergences and sector-internal relative performance data still made it worth reading. We are specifically referring to the ideas regarding how cyclical gold bear markets end, how early stage bull markets develop, and why there is a certain sequence of events that can usually be observed when that happens.
As to a sell-off starting right after we mentioned bullish developments, this mainly demonstrates that anything is possible in the short term. Luckily we did not neglect to mention potential negatives – after all, the future is always uncertain.
The gold market was ambushed last week by a very strong ISM report (which was so strong it strikes us as a contrary indicator), and the ECB’s assault on the euro, which helped an already very stretched dollar index to become even more stretched (the RSI on the daily chart briefly touched the 85 level last week). This has certainly introduced fresh uncertainties, as the dollar index is actually close to breaking through a long term resistance level.
The dollar index monthly. Close to besting resistance, and there is actually an MACD buy signal on the monthly chart now. Note also the MACD/Price divergence that was set up between 2005-2008. Interestingly, gold is tantalizingly close to giving a monthly MACD buy signal as well – click to enlarge.
Obviously the markets are currently discounting the idea that both the BoJ and the ECB will move ahead of the Fed in the confetti debasement race. It is however important to keep in mind that currency debasement remains the name of the game, and which central bank is more proficient at it at any given point in time does not alter the basic fact that they are all doing it. It is noteworthy in this context that gold in terms of the euro, the yen and cable does not display a short term support breakdown similar to that evident in dollar terms.
Gold in euro, yen and pound sterling terms – short term support has held so far – click to enlarge.
A strong and rising dollar is certainly a negative for gold, but the dollar is only one of several factors driving the gold price. For instance, gold nearly doubled from its 2008 high to its 2011 high, even though the dollar rebounded from its 2008 low concurrently. The short term outlook has nevertheless become more uncertain, and with it also the medium term outlook, for the simple reason that there remain only two notable short/medium term lateral support levels for gold in dollar terms. This is a parallel to the similarly uncertain situation experienced in May. Gold and silver in dollar terms are depicted below. As can be seen, they have formed another downwardly sloped wedge, and are once again poised just above support:
Gold and silver wedges. Both metals are close to support areas – click to enlarge.
As soon as the most recent support break in gold happened, the financial press was brimming with bearish pronouncements again, with Goldman Sachs reiterating its $1,050 target for the umpteenth time since June 2013. Naturally, we cannot rule this possibility out. The level is a potential price attractor, as this was roughly where the 2008 peak was put in.
On the other hand, this target can only come into play if the risk asset bubble continues unabated, and no doubts creep in with respect to central bank policies. Consider in this context that the gold market as a rule tends to reflect such doubts long before any other markets are doing so. E.g. the 1999-2000 double bottom (the low was actually made in 1999) occurred in parallel with the late 90’s stock market bubble going parabolic and Mr. Greenspan being addressed as the “Maestro”. So the Goldman Sachs price target is strongly dependent on faith in central banks continuing to hold up for a considerable time period from here on out. This seems somewhat unlikely on the grounds that enormous economic distortions have been put into place by their policies, but it is presumably not impossible.
Gold Stocks – Down, But Not Out Just Yet
In spite of the fact that mining costs at most producers have been declining for several quarters, they remain quite close to current gold prices in many cases. These still relatively thin margins have both advantages and disadvantages for investors. The advantage is huge earnings leverage in the event of a gold price rally. To illustrate this with a simple example: imagine a company mining gold at $1,200/oz. all in. At a price of $1,300, its margin will be $100 per ounce. If the gold price rallies from $1,300 to $1,400 – an increase of 7.7% – the earnings margin of our hypothetical miner will double.
The disadvantage is obviously that it won’t take much of a price decline to move this hypothetical operation toward producing losses. It is therefore not too surprising that gold stocks are currently especially volatile in both directions. The sector has also broken a short term support level in the course of last week’s sell-off, but it has continued to maintain a divergence with the gold price relative to the last sell-off in May.
This is to say: so far. There is no guarantee that this will continue to be the case, but it was interesting that Tuesday’s small bounce in the gold price back to the unchanged level from an earlier sell-off immediately brought some buying interest back to the sector. Since this may merely have been tactical short covering, one probably shouldn’t read too much into it. Whether it is meaningful will depend on follow-through, which may or may not happen.
Below are two charts illustrating the situation. Gold in dollar terms compared to the HUI, which shows that in spite of their short term underperformance last week, gold stocks still diverge positively in the medium term. Obviously though, they now have to overcome additional resistance, similar to gold itself. The second chart shows GDXJ, the HUI and the HUI-gold ratio. GDXJ is interesting because it has tended to be a relative strength leader during rallies this year and the 200 dma seems to have stopped its decline for now.
Gold daily vs. the HUI. Both have violated lateral supports, but the HUI continues to diverge positively relative to its lows in late May – click to enlarge.
GDXJ, HUI and the HUI-gold ratio. The red dotted lines indicate the short term support that has failed with the decline from the blue rectangles. In HUI-gold a short term uptrend has failed as well. The one-day bounce may not mean anything, but was achieved in spite of gold merely returning to the unchanged level on the day – click to enlarge.
Obviously, the fact that gold has lost the near term support around 1280 is bad news for gold bulls. However, this market hasn’t only fooled the bulls during its consolidation since 2013. Since it has essentially no trend, it has done the same to the bears, who have yet to see their projections fulfilled more than a year after the June 2013 low. In the short term, the bears appear to have the upper hand, but this can easily change again.
Still, the action has made the medium term outlook more uncertain. Note in this context that prices have moved in a very large triangle since mid 2013, and from a technical perspective it cannot be ruled out that this is the prelude to another leg down in prices. Note though that one major factor remains gold-supportive, namely credit spreads. The TLT-HYG ratio (a proxy for credit spreads) remains in an uptrend in spite of a recent recovery in HYG and a back-up in treasury yields (HYG has recently begun to decline again from a lower high). The ratio has trended higher all year, which represents a strong warning sign for risk assets as well.
The TLT-HYG ratio, a proxy for credit spreads – click to enlarge.