Still a Methodical Advance
This is the second time this week we feel the urge to write about gold stocks, which may be a short term negative contrarian signal. However, we are quite pleased with the classical stair-step advance that has occurred in the sector so far this year. It lacks the extreme volatility that was on display during the previous bear market period and keeps tracing out well-established bullish patterns, which so far continue to lead to follow-through moves. Even better, in spite of the fact that the sector remains one of the best-performing market sectors this year, its rally is barely eliciting comment outside of 'gold bug' circles. In other words, it hasn't even been noticed yet, which is quite remarkable considering GDX is up over 36% since its late December low. GDXJ has surged by an even more impressive 55.5% since then.
As we have pointed out earlier this week, many of the 'old hands' in gold-bug land are cautious as well. Sooner or later there will of course be a setback correcting the advance, but the fact that it hasn't produced a great deal of enthusiasm so far strikes us as a bullish sign. On Thursday, gold stocks once again rallied to a new high for the move, breaking out of the pennant/triangle formation we discussed on Tuesday. In fact, the sector has in the meantime already moved to the next lateral resistance level. This is all the more remarkable as Thursday's move higher coincided with the DJIA shedding 230 points on the day. It seems that funds are rotating out of stock market sectors that have hitherto done well and are partly being redeployed in the gold sector - which is traditionally negatively correlated with the broader stock market in the long term and has incidentally been among last year's biggest losers. Here is what things looked like as of Thursday's close:
The chart certainly looks good at this juncture. Admittedly, the biggest test is still ahead. The red dotted lines highlight the most important lateral resistance zone, including the 'gap resistance' stemming from the April 2013 gap down. This gap has stopped a number of previous rally attempts. Even if the rally continues in the short term (which actually looks likely), one should probably expect it to at least stall out and pause for breath around these levels, this is to say, the 280-300 points area in the HUI.
Another point worth mentioning is that the advance quite clearly looks like an impulse wave by now. If one looks closely, it could well be that the second impulse wave (i.e., wave 3) of the sequence is already underway (we will take a closer look at the wave count labeling possibilities in our next update).
Along with the rise in gold stocks, the HUI-gold ratio has also risen from the grave and has just attained its best level since September. This is an important confirming indicator. Rallies in gold usually need to be accompanied by an expansion in this ratio to be validated. And yet, in spite of its recent rise, the ratio remains at what is a quite depressed level historically. In other words, there is still lots of room for further expansion in the medium to long term.
The GDM bullish percent index currently rests at the 40 level – a further improvement, but still far from what would be considered an 'overbought' condition (the index measures the percentage of stocks in the index that are currently sporting a point & figure buy signal).
Another Look at the Sentiment Backdrop
We already discussed a number of gold and gold stock sentiment measures on Tuesday, inter alia the assets held by the Rydex precious metals fund and the percentage of all Rydex assets they currently represent. Nothing has changed on that front, so there is no point in showing that particular chart again. However, there is another feature of the Rydex precious metals fund that is worth pondering, namely the cumulative net cash flows into the fund. We would actually like to see an increase in these flows at some point, as that would confirm that confidence in the new trend is beginning to rise.
However, at this stage we are not worried yet by the fact that new inflows are so far lacking. The later they happen, the further the rally is likely to travel. Moreover, we like the contrast between today's situation and the rally in Q3 2012, when traders couldn't get their money in fast enough. That rally failed rather spectacularly as we now know, and it did so in a rather devious manner (at first it appeared as though a mere routine pullback was in the works, but then things took a sudden turn for the worse). The differences between the two periods are highlighted below:
For the moment we are interpreting the lack of inflows as a sign of indifference that is likely due to the string of previous disappointments. Recall in this context that the stock market had to rally for more than three years in a row before the public took notice and began to throw money at fund managers again. Few people want to invest in a sector that has only just started to move up after suffering grievous losses for three years in a row. And yet, it is precisely this statistic that inter alia tells us that this year should be a good one. The gold sector has never suffered a decline for three years in a row that was not followed by a sizable rally (admittedly, the current rally is already sizable, at least in percentage terms. However, one must keep in mind that it has started from an extremely low base).
Skepticism is also revealed by another batch of indicators we have occasionally discussed in the past. During the bottoming period between July and December 2013 we have pointed out that strong pessimism on precious metals was inter alia reflected by the fact that closed-end bullion funds were continually trading at historically large discounts to their net asset value. These NAV discounts continue to persist in both GTU (a gold bullion fund) and CEF (a mixed gold and silver bullion fund). The discounts have recently tightened a bit and we actually want to see them eventually disappear. However, it is not a problem if that takes a little while. The longer the advance retains its 'stealth' characteristics, the better it probably is.
Conclusion:
In summary, there is a technically quite solid looking rally underway that is so far greeted with a mixture of skepticism and indifference. That actually increases the probability that it will continue. However, it is clear that there will be a sizable setback at some point to correct the advance. The upcoming FOMC meeting could possibly provide the trigger for such a correction, as the central bank is highly likely to stick with its 'tapering' course for the moment. However, regardless of any near term gyrations that may occur, it still appears likely to us that the sector has finally turned the corner for good.
The HUI-SPX ratio has turned around this year as well – click to enlarge.
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