Source: Neil Charnock, GoldOz (9/21/11)
"It's not too late to get set at base levels in an ongoing bull market."
If I told you that we have a number of gold stocks breaking new highs at the moment in this market would you sit up and listen? Operational issues for a larger gold stock are hiding the overall sector performance in the weighted ASX–XGD index. This one stock distorts the real picture on the index because the stock is overweighted in the index. I am not saying there is a mistake; I am saying the disproportionate influence of one stock is clouding the picture for investors who do not closely analyze the ASX–XGD index like I do. Most mainstream investors only watch the Top 20, therefore they are missing the overall sector performance and activity.
There is no doubt that economic sentiment in Europe and the U.S. has been dragging on our market here in Australia. The Dow is crashing, Greece has defaulted and the smell of contagion is in the air. When I look at the Dow, however, I see that after months of fear and gnashing of teeth it is still sitting up at 11,400 this morning. A correction is needed you say well one observation I have made is that if you adjusted the current dow level for inflation of just 3%, then the high of 14,000 in late 2007 is equivalent to 15,757 now. This adjusts the current level and correction significantly with it equating to a fall of 27.6% from the inflation adjusted high. Gold traders know well that inflation measured by the official rate is a massaged price inflation measure not a monetary inflation measure.
Monetary inflation is measured by the increase in debt, which is an increase in the money supply. We live with a debt based monetary system. Money is created as new debt. The brilliant work at shadowstats.com shows us that money supply (as measured by the broadest measure M3) was still increasing at an average of approximately 13% in 2008. In 2009 the rate of increase in M3 money supply was falling rapidly however it still averaged around 4-5% as it fell from a 10% increase in supply to an actual decrease in supply by the end of that year.
This was caused by deleveraging; the greatest debt bubble in history is unwinding as the corporate and private sectors bunker down and repair their balance sheet. The actual supply of money has effectively flattened since mid-2008, which is why we are back to more historic growth rates. Higher growth rates in former years were turbocharged by the debt binge. Eventually the corporate and private sectors became debt saturated and had to back off, take a breather.
Governments have taken on the job of borrowing to keep the game going. This is now coming into question as seen in the news of recent times. Sovereign debt levels are very serious yet countries are actively trying to weaken their own currencies for competitive reasons so they dig deeper into debt. This government borrowing has also offset the monetary destruction caused when people actually pay off some debt. Create money via new debt; destroy money by paying debt levels down.
There is another aspect to all this however and it is the driver of all markets. Capital waves in this day and age are extreme due to the massive amount of debt/money in the system. I hope you have all seen the charts on monetary growth since 1913. Now M3 is not a perfect measure of money in the system yet is the best we have. It shows we are still hovering at nosebleed highs after the debt binge that accelerated this supply after 2001. All this money is now in the system at least for now and it seeks a home, which will be determined by sentiment. Sentiment drives the direction of money in between asset classes. The money has to go somewhere and at present the talk is of a banking crisis. Do you really feel safe with cash in the bank during a banking crisis? A portion of this money is working out where to go, trying to pick a trend.
The U.S. Treasuries have seen a massive inflow of late pushing yields to record lows. This is likely to reverse soon even if yields do fall a little further. Talk about a trade getting over crowded. I called a top approaching and time for a reversal signal to form when we first reached these highs a number of weeks back. This will reverse eventually as all crowded trades do.
Fear in the system has resulted in a rising gold price due to the safe haven trade. This is not only reason gold has been going up in price just an added factor lately. This fear is also leading to cash hoarding by corporations and individuals who see lower growth or recession on the horizon. A massive amount of capital has sloshed over to the Treasuries. We are talking about trillions of dollars being liberated when this eventually reverses and the cash sitting in bank accounts will also get nervous if fear of bank default rises back to extreme levels.
The direction of capital flow depends on what the market is fearful about at the time because it all comes down to sentiment. Gold will benefit from the fear whichever way the capital flows are headed on this fear trade. Until the imbalances and uncertainty in the financial markets are sorted out; gold and fear will remain in bull market trends. This will remain volatile.
Negative real interest rates create a certain loss for bank deposits. This is also what we see at present. Conditions are gearing up for a change in market conditions again in the near future. The capital wave will slosh back the other way and you have to be asking which way will it flow next? Which asset classes will benefit next? Gold is facing the strong seasonal demand from India now and you have to combine this with Chinese demand to calculate price support or appreciation over the near term. The gold equities (gold stocks) are now recognised to be in bargain territory compared to gold. Should gold continue to remain bid and up near these levels or higher things will quickly get interesting in this space.
The action on the dow lately and in the European stock markets has suggested a negative capital flow. In fact this has been in force for some time. We have seen a greater correction in inflation adjusted terms than is evident by the raw data. Chances are the next capital wave will seek yield and capital growth as risk off swings back to risk on. Then again it might just be that the bonds start to sell off on severe U.S. dollar selling, yields spike back upwards in the sell off and the capital wave leaves bonds in the process. This capital wave has to go somewhere.
There are limited options, limited choices. The likely policy "solutions" to emerge from current political and regulatory debate will involve more money debasement in the form of stimulus, tax cuts and continued low official Central Bank rates which will keep gold bid.
Where Am I Going with All This?
There is an opportunity of such magnitude before you now, if all market participants realized the upside potential of this Australian gold index right now it would rally from market open to the end of settlement every day. Rallies often begin in the grip of fear and rally into a wall of more fear. Sentiment is changing/has changed on the gold stocks and some excellent research is emerging to support this view.
My long study of the sector has taught me the signs to look for and more importantly the optimum strategies to exploit such opportunities. The first thing to establish in order to communicate this message effectively is to provide a backdrop. My research indicates that the last time we faced such an opportunity was in about March 2005.
That year the larger gold stocks started to rise aggressively. We saw them take off one by one from around the end of March. Firstly they broke out of base formations and then through old resistance levels. By July the more prospective mid-cap stocks and many explorers began to move with the larger low cost producers. The rally took on a life of its own at this point. Most days saw a sea of green arrows (rises) as the index was pushed higher. Of course nothing goes up in a straight line so this was punctuated by brief pullbacks that threw those who were not in tune with the market.
By November all boats were floating higher as small cap explorers joined the party. They rose with the rising tide as the excitement spread through the sector, then came the December lull. The mixed nature of the activity, defined as share price behavior (SPB) was sufficient to fool some investors as the rally progressed. However on balance the sector as a whole was making strong steady gains. I now see a repetition of that early SPB at this time and this masks what is before us.
Some stocks were even moving in between Christmas and New Year in 2005, as hardly anybody looked. The New Year started with a blast upwards, right from the opening bell in early January. Yet most investors in Australia were not looking so they missed it. By the end of January this sector rally had spread widely as greed entered the equation. Investors got back from the Christmas break only to find stocks had moved higher. Into mid-February however, the gold index (XGD) started to sell off as gold maintained its ground.
A second gold price up-leg pushed gold up from March to highs of US$730 by May 2006 however many of the stocks refused to follow through. There was strong movement in the XGD however unless you understood the sector as a whole it would have been harder to interpret or make a profit. By April we saw an XGD top over 120% higher than a year earlier, at just below 5000 before a sell off into May of 20%. A different selection of the stocks rallied into that second up-leg, most of the early movers failed to rally higher however as the savvy market players sold off into the late demand created by the new comers. A second group of newcomers were dazzled by strong gains and bought this second group of movers. You do not want to be one of these new comers at the end of this new rally. This is the time to seek help if you are not certain how to maximize this opportunity.
I digress, sorry back to 2006 and the story. Gold kept going in its long "step up" rally formation after an "earth shattering" 25.6% sell off from the May high of $730. If you look back at the chart now it looks minor. Get used to this phenomenon if you are new to this GBM because us long termers have seen it many times. The gold stocks remained strong at times after that initial sell off into the second half of 2006. The stronger companies recovered lost ground rising higher towards August 2007 where a sell of 15.5% reversed by the end of the month. These events have been quite common for gold stock investors as well throughout this GBM. In September 2007 we launched again however it was a mixed rally.
We reached a new XGD high by January 2007 at 6940 as Newcrest Mining hit $39.75. Gold powered to new record highs at $1030.80 by March 2008 however the stocks failed to join the excitement as equity investors savvy enough to be watching the debt markets sold off their shares. The 2008 melt down then took hold all the way into the October and November period for gold stocks and March 2009 for the broader market.
The crash of 2008 shocked investors causing horrible losses in superannuation funds and private share portfolios. Self-managed superannuation funds have proliferated since this time as investors took their capital into their own hands. This was a shocking event that still carries a stigma even for gold stocks. I was there telling investors to wait until we see the whites of their eyes. I wrote in September 2008 that the bottom was close which turned out to be true as the Aussie gold stocks reached their individual lows from late September through to November that year. I could not believe my eyes at the time, such were the extreme bargains. Yet investors sold or stayed away in fear.
Sentiment fell even harder than the stocks; investors stayed away and still fear a repeat of this event as we watch the trouble in the financial markets. What they fail to understand is that each new phase of this global debt collapse and gold rally brings new circumstances.
The XGD has gone on to make new post-crash highs however the same cannot be said for the broader market. History repeats however it is never exactly the same. Gold stocks may surprise many investors causing them to miss out this time if we do melt down.
What logic do I have to support the view that the gold stocks are set to rise? Over three and a half years after January 2008 we find the gold price has nearly doubled. The cataclysmic collapse of share prices and sentiment during the GFC saw extreme gold price lows. By the end of 2008 the XGD fell below 3000 briefly to a low of 2674.4, from a high of almost 7000 a year earlier. This almost took us back to March 2005 levels on the XGD when the AUD gold price was just $553 an ounce.
This was a distortion and a major dislocation in the gold stock rally that had to correct sooner or later because profits and resources were rising. This process is still not complete however and the recent gold price rise has distorted the relationship between the stocks and gold yet again.
When the XGD hit the 7000 area in March 2008 gold was under A$1100. We are currently sitting nearly 70% higher for the Australian dollar price of gold with no gain in the XGD. The fundamentals have changed up a gear for the gold stocks because costs are not rising anywhere as fast as the gold price. Margins have increased by far more than 70% however far more importantly sentiment is changing now.
The Australian gold stocks have not (so far) moved again as strongly as a coordinated group since March 2005. So you may ask what was it that caused that rally from mid-2005 and why do I suggest that this is a repeat or similar event? The GBM had just entered a new phase in mid-2005 as it began to appreciate substantially in all currencies. The leading gold stocks were telling us something in the early stages of that rally.
They are behaving the same way again. Gold looks to have started another new phase as well as evidenced by the larger than recent price rise. No previous single up-leg has pushed the price of gold up $500 in one hit. A similar change in price rises came very soon after the gold stocks took off in 2005. One could argue when the bottom was set at the beginning of this rally however we have traded into it based on our systems and signals to get set and in a nice profit at this stage. We consider the bottom was March 2011 this time and that a second bottom was set at the end of June as well.
It is easy for me to recognize the same early signs again, as I did over the past 8 months, because I have seen them before. You are about to get a heads up that such a time is again brewing. In fact my understanding and in depth analysis have progressed to a whole new level thanks to constant study. This is not a gloat it is a function of experience, practice and concentration.
As a high profile contact I recently spoke to said "the more you get involved in the markets the more you discover." My analysis tells me we are starting the second stage of the initial lift as the larger stocks make their initial move. This is very similar to the May 2005 conditions. It is not too late for you to get set at base levels; that is if you do move now and get your homework done you can take advantage of this opportunity. If you wait too long you may find yourself in the "newcomer" group at precisely the wrong time in several months' time. At this early stage I have no idea how long it will last only that the top will reveal itself when it arrives if you know what to look for.
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Good trading / investing.
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Neil Charnock is not a registered investment advisor. He is an experienced private investor who, in addition to his essay publication offerings, has now assembled a highly experienced panel to assist in the presentation of various research information services. The opinions and statements made in the above publication are the result of extensive research and are believed to be accurate and from reliable sources. The contents are his current opinion only, further more conditions may cause these opinions to change without notice. The insights herein published are made solely for international and educational purposes. The contents in this publication are not to be construed as solicitation or recommendation to be used for formulation of investment decisions in any type of market whatsoever. WARNING share market investment or speculation is a high risk activity. Investors enter such activity at their own risk and must conduct their own due diligence to research and verify all aspects of any investment decision, if necessary seeking competent professional assistance.