Gold Versus Paper

Turning paper into Gold August 11th, 2012 1. LONG TERM PICTURE (months to years) We are perfectly set up for an “inversion” cycle where Gold and Gold stocks go the opposite of the general stock markets of the world. The current cyclical bull market in common stocks, which is within the context of a secular bear market, is now long in the tooth for those global common stock indices that are not already in a bear market. I believe the globe as a whole, when using indices such as the global Dow ($GDOW), Morgan Stanley World Index ($MSWORLD) and Dow Jones World Stock Index ($DJW), is already in a cyclical bear market. In fact, the blue chip US stock market indices are some of the few left in the world that are not yet in a bearish alignment. As a Gold investor, I don’t really care. I have zero percent of my investment assets in common stocks “for the long haul.” However, many Gold and precious metal (PM) mining stock investors fear cyclical bear markets in common stocks because Gold stocks will often track the general market direction. This is what happened in 2008 after the March top in the PM sector. However, what these investors often ignore is the late August 2007 thru March 2008 period as well as other examples in history such as the late 2000 thru mid-2002 and the 1973-1975 periods. These were important periods where Gold stocks acted as countercyclical assets and went the opposite direction of the stock market. Though I realize I may sound like a broken record on this concept, it is where big money can be made as a speculator and investor. Bear markets can be tricky to trade and they often contain big countertrend moves that keep the “slope of hope” alive. If one can instead trade or invest in a bull market, the profits come much easier and require fewer good timing decisions. There are some very important and in fact critical reasons for wanting to invest or speculate in Gold stocks right now from the long side. In no particular order, here they are: 1) The “real” price of Gold (i.e. price of Gold divided by the price of a basket of general commodities) tends to rise during recessions, which roughly correspond with common stock bear markets. This improves operating margins at producing Gold mines, as the cost of energy and other needed commodities falls relative to the revenue obtained by selling their Gold. We are currently near record highs in the “real” price of Gold when using the CCI commodities index as the denominator (i.e. $GOLD:$CCI ratio). If we are going even higher, then margins should increase considerably for producing Gold mines:

2) Senior Gold stocks (using the $XAU as a proxy) are massively oversold relative to the Gold price.

3) Senior Gold stocks (using the $XAU as a proxy) are majorly oversold and have just had a 40% bear market (which I believe to be already over as of the mid-May 2012 low) and are also at very long term support:

4) Gold stocks are majorly oversold relative to common stocks (using the S&P 500 as a proxy for common stocks), which implies that in order to revert to the mean, Gold stocks can go up while common stocks go down. This ratio chart is key to understanding why Gold stock investors don’t need to fear a falling S&P 500 (on balance) derailing the bull case for Gold stocks. Only a true market panic/crash could derail this budding new cyclical bull and that would likely only be temporarily:

5) Valuations on Gold stocks are at severely depressed levels. There are different metrics one can use to measure this such as price to earnings ratios, price to cash flows or valuation per ounce of “confirmed” Gold held by a mining company. They are all at rock bottom levels seen only at the beginning of the secular bull in late 2000 and at the end of

the Great Fall Panic of 2008. Below is a chart I have shown before of the price to cash flows for senior Gold miners (the dark blue line is the line of interest):

ets

Fig. 57: P/CF – Senior Producers (N.A.)

Source: BMO Capital Markets

13 6) Sentiment has hit rock bottom levels over the past several months. All markets tend to swing from depressed to manic (and back again) as human emotions haven’t changed all that much over the past few centuries. When sentiment is suicidal and you are in a secular bull market, that’s when you step up and buy. Here’s a sentiment indicator I have shown before updated through Friday’s close - that of the net asset value (i.e. value of the fund based on money put in and price changes in the assets held) of the Rydex Precious Metals Fund:
RYDEX PM MUTUAL FUND NET ASSET VALUE SINCE 1/1/2003

Notice how we have started the turn higher already at the very end of the chart from levels that have marked historic buying opportunities in Gold stocks (i.e. spring of 2003 and end of 2008). 7) The “Gold to common stocks” ratio (e.g., my favored Dow to Gold ratio) is at levels that have always marked major turning points in the past. When Gold is rising relative to common stocks, Gold stocks are usually along for the ride. Since I just showed this chart in last week’s letter (among others) I won’t reprint it here. I believe Gold stocks will outperform Gold and silver at least for the next several months. I believe we have begun a big cyclical bull market in Gold stocks. I believe that if we get the “big picture” right, the trading profits will come steadily over the next several months by simply holding on and only taking profits when things get majorly overbought. I will continue to act as a trader and use risk management every step of the way, as there are no guarantees in markets. However, I believe we have started “one of those” bull markets in Gold stocks that you don’t want to miss. In fact, it may begin to accelerate precisely when the global common stock markets begin to top out again. We will soon find out.

2. INTERMEDIATE TERM PICTURE (weeks to months) Gold and silver Starting with senior Gold stocks (using GDX ETF as a proxy), let’s look at the weekly, daily and short-term pictures. First up, the weekly chart over the past 2 years. When you filter out the daily noise, it was a great week for Gold stocks:

Next up, the daily chart over the past 6 months:

And here’s the 60-minute intraday chart of GDX over the past 4 months thru Friday’s close:

Junior Gold stocks (using GDXJ ETF as a proxy) only slightly outperformed the seniors for the week, but this outperformance remains a healthy sign. As for the metals themselves, it was a rather boring affair for the week with little net progress made in either direction, but both silver and Gold were up roughly 1%. Gold needs to crack the $1630-$1640 price level as shown in last week’s letter, which I think could happen next week. It is also interesting to note that silver stocks (using the SIL

ETF as a proxy) continue to slightly outperform senior Gold stocks and have since the mid-May bottom. This is an interesting development as silver and silver stocks often lag early in the bull market cycle, particularly when in the setting of a common equity bear market. I continue to favor Gold stocks over silver stocks right now, but the silver market is always a bit of a wild card in the PM sector. Bottom line: things remain on track and I remain bullish on Gold stocks for the short, intermediate and long term time frames right now. I am also bullish (although less so) on Gold and silver as well. We will raise our stop level next week on our “long Gold stocks” trade if price action continues to be positive.

Common stocks The VIX (volatility or “fear” index”) did something on Friday that I have been waiting for: it broke below 15. This is a warning sign that we’ve probably only got a few more weeks left of “risk on” in global markets. Here’s a daily chart of the VIX over the past 3 years to show you what I mean:

You can also see how in the U.S. stock markets, there are divergences popping up all over. The transports and small caps (i.e. $RUT) are lagging as are many sectors (e.g., semiconductors). In other words, fewer stocks are participating in the advance and such fall off in breadth usually occurs before a significant top. Here is a chart of the “percent of stocks above their 200 day moving average” for the New York Stock Exchange ($NYA200R) to show you what I mean, with the S&P 500 plotted below, over the past 3.5 years:

Though I think we can drift a little higher and potentially even make a slightly higher high in the S&P 500 and Dow Jones Industrial Index above the spring of 2012 highs, this would simply be a shorting opportunity. Depending on what price action looks like if GDX gets to my target area of 50-51, I may be interested in a short trade. Since it is generally better to short weak rather than strong markets, I will likely want to short Europe or emerging markets if the opportunity is there. Fort now, though, I think risk

markets can continue to float a little higher over the next few weeks. Once August is over, though, I suspect the party on Wall Street will be as well.

Commodities The CCI commodity index stalled out and was flat for the week, while oil went higher. The base metals like copper have failed to participate in the party, which is a bad sign. Here is the weekly chart of industrial metals, using the $GYX index as a proxy, thru Friday’s close:

We could get a pop higher over the next week or so, but this chart is a bad sign for the global economy. The $ $GYX:$GOLD ratio chart shows a similar warning that the party may be about to end badly for common stocks and global economies in general, as it remains weak and failed to rally with the “risk on” party we have seen lately. Commodities should be able to move higher over the next few weeks with the Euro.

Bonds and Currencies The Euro index was down a little less than 1% for the week, but I remain bullish on the Euro and bearish on the US Dollar for the next few weeks or so. Longer-term, I am a US Dollar Index bull, but I think we can get some further correction in the US Dollar before it has a potentially big rally in the fall. Here’s a short-term 60-minute intraday chart of the Euro Index thru Friday’s close:

The US bond market continues to correct in price. The bears are coming out of the woodwork again declaring the bull market in bonds dead. We shall see. I think it is way too early to make such a call but expect perceived “safe” government bonds to continue to decline in price as long as risk assets continue to move higher.

3. TRADE RECOMMENDATIONS

I remain more than 100% (i.e. leveraged) long senior Gold stocks.

Remain in “long Gold stocks” trade with a full position. Maintain your stop loss at 42 on the GDX ETF. If GDX goes below 42.00, exit the “long Gold stocks” trade immediately.

I expect to see positive price action in the Gold stocks again next week. We will move up our stop loss on the current trade again if we get a continuing move higher in Gold stocks. Happy trading. Adam

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