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Darkest Before the Dawn
The most recent brutality for gold and silver began Tuesday afternoon when the Access Market opened for after-hours trading. Gold and silver continued relentlessly lower throughout the evening in overseas trading. It appears the short-sellers are determined to turn the speculators into sellers and force further liquidations. Taking the metals down while the COMEX was closed also trapped many traders that weren’t able to sell. (Note that commodity accounts must be managed quite differently than stocks and bonds.) As I write, gold is getting pounded to around $390 and silver is trashed below $6.50. I have to believe that even the highest quality silver stocks will be hammered and I’ve got some cash ready. Back on March 10th I wrote, “Proceed With Caution” wherein I suggested it was a good idea to listen to the wisdom of the years and increase your cash position by taking some money off the table. Warren Buffet and Richard Russell were both cautioning investors to get out of the way and go to cash. Their investment strategies are not driven by greed and their experience told them something is out of place with the markets overall. Patience is a very difficult lesson, but the markets will either teach us or separate us from our money. Most investors have the idea they have to be fully invested all the time. This also means you are fully exposed to market risks all the time. When predictability is unclear and probabilities are difficult to quantify, just get out of the way! I’m glad I’ve saved some ammo for what I am expecting to see tomorrow morning. Manage Fear with Perspective This is not a time to be consumed with fear if you are invested in gold and silver stocks. I expect this take-down to be sharp from a price perspective, but short in duration. Hopefully you have some high quality core holdings that will weather the storm better than most and are prepared to buy some of the great bargains. If you believe in the buy low—sell high method to profits, this should prove to be a good buying opportunity. Cash management also comes into play to minimize losses, but if you’ve been riding out this correction since January, now is not the time to panic. This is precisely why I suggested an increase in cash. If we are fully invested, the best we can do is ride it out or sell our gold and silver stocks at these low prices. The best investors have proven to be contrarians; it’s just difficult to manage the fear and greed emotions as they play games with our minds. When I find myself in a fearful investment situation, I tend to go back and look at some long-term charts to see if I still have the same core convictions for the big picture. The chart that got me focused on precious metals back in 1997 was a hundred-year chart of the Dow/Gold Ratio. It appeared obvious we were getting close to a major turning point and I believed I had a high probability of being correct. Historical Highs and Lows During the blow-off of the Roaring Twenties the Dow/Gold Ratio hit a peak of 18.4 (it took just over 18 ounces of gold to buy the Dow Jones Industrial Average). After the crash it only took 2 ounces of gold to buy the Dow. On the next run for stocks that topped-out in the early Sixties, it took 28.3 ounces of gold to buy the Dow. The cycle turned south once again and in 1980 it took just over one ounce of gold to buy the Dow. This last time around with the stock mania of the Nineties, the Dow cost a whopping 45 ounces of gold in 1999! From a relative valuation standpoint it was obvious that either stocks were way overvalued, or gold was way undervalued. In 1999 I began my strategy by putting one-third of my money into a short stock fund, a third into precious metals funds and kept the last third in cash. Since then my focus has shifted to picking the best of the precious metals stocks, especially the juniors. Please notice that historically speaking, the Dow/Gold Ratio has bottomed every time around one or two. I expect it to happen again, but we’re still a few years away. Right now the ratio is about 26, and even if you look at the bottom from a very conservative standpoint somewhere below 5, we still need to see the Dow fall and/or gold rise significantly to arrive near the historical lows. Over the last hundred years, if you throw out the major peaks and valleys, the ratio has remained in a range from 3 to 10. From a historical perspective, we’re still in the nosebleed section at 26.
Since stocks in general were putting in their highs and gold bottomed-out between 1999 and 2001, I thought it would be constructive to see where we are relative to the turning points. Looking at the charts above, the first thing I noticed is the unusual megaphone shape of the Dow Industrials. A quote from Mr. John Murphy’s most excellent book, “Technical Analysis of the Financial Markets” would be most fitting to describe the trading behavior of the stock index. Under the illustration Mr. Murphy writes, “A broadening top. This type of expanding triangle usually occurs at major tops.” He goes on to say, “This situation represents a market that is out of control and usually emotional. Because this pattern also represents an unusual amount of public participation, it most often occurs at major market tops. The expanding pattern, therefore, is usually a bearish formation. It generally appears near the end of a major bull market.” Look at the number of key words that perfectly describe today’s market such as “emotional,” “out of control,” “public participation,” “major tops” and “major bull markets.” I promise you they will not point this out on CNBC. I like to keep it simple when looking at the gold chart. In general it looks like an orderly progression of a bull market with higher highs and higher lows. So far the 50-week moving average has provided support on the way up, so it shouldn’t surprise any of us if the moving average is tested once again. The number now stands at $385.97, so we’re not far away. If that breaks down, which I don’t think will happen, even stronger support will come from the 100-week moving average around $360. It is gut wrenching to go through these consolidations, but it’s all part of riding the bull market in precious metals. On the third chart we see the relative valuation of stocks and gold represented by the Dow/Gold Ratio. Since the middle of 2002 the ratio has been range-bound between 21 and 28. It is now getting very close to decision time to see how the symmetrical triangle will resolve. Needless to say, I believe it will prove to be a continuation pattern where we will see the continuation of the bear market in stocks and the bull market for precious metals. Even if we get a false breakout to the upside, I will be shocked to see the ratio move above the red horizontal line at 28.26. The red line represents the all-time high from the last bull market in stocks the ended in the Sixties. The three-and-a-half years you are looking at with the ratio above the line is the ONLY time it has been there through all financial history. Another View of Relative Values It’s fascinating for me to isolate the period 1980 – 1985 in contrast to where things are today. I’m sure most of you can remember twenty years back. Maybe you were in your early school years, or senior enough to remember it vividly like me. It just wasn’t all that long ago! The Dow was safely below 1,000 and you could buy the index with one ounce of gold. Through the ‘80-‘85 window, you can throw out the blow-off top for gold at $850 an ounce and use the low of $290 and the high of about $510 per ounce. It’s roughly $400 today. Please tell me how many things you can buy today that cost the same amount twenty years ago. You could get a nice car for about ten grand back then, and today you would spend twenty to thirty thousand for the same ride. How about a house…big difference! When my wife and I bought our first house in the Eighties we were paying a 13% mortgage rate, while today rates are below 6%. Gold and silver are still way undervalued when compared to other assets twenty years ago. Back in the late Sixties, the London Gold Pool tried to manage the price of gold to keep it low and stable thereby giving credibility to fiat paper money, but it failed miserably. Nixon was forced to change the rules by not allowing foreign governments to redeem their dollars for gold at $35 per once. Charles de Gaulle was in the process of emptying Fort Knox by exchanging dollars for gold on behalf of France, so Nixon had to cut him off and set gold free. I find that little fact even more captivating in light of the recently announced gold sales by France. The things that are happening today with government interventions are nothing new. They have tried to control the price of gold to make fiat currencies appear more valuable than they really are and it appears governments around the globe are doing it again. It’s the same old game, and they will fail like they have every time in the past. The biggest difference today is that the powers that be now have enormous leverage via derivatives and unlimited cash via the proverbial printing press to throw their muscle around. That’s probably why Mr. Buffett refers to derivatives as financial weapons of mass destruction. When investors get tired of seeing “paper” assets (stocks, bonds & currencies) continue to lose value they will go to the ultimate asset of last resort in a last ditch effort to preserve wealth. The establishment forces are quite powerful, so we shall see how they manage their way through the inflationary pressures with dollars that are losing value. It’s always darkest before the dawn, so hang in there and don’t play into the hands of the desperate shorts. I still believe truth and justice will prevail in the end! Today’s Market Just when it looked like gold could bounce back to close around $395 and silver could get support in the $6.40 area, somebody got out the ugly-stick to ram them lower for the close. At the end of the COMEX session the June gold contract closed at $391.40 dropping $6.90 and May silver lost a huge $0.77 or 11% to close at $6.17. I truly didn’t think silver would close the gap at $5.80, but one more smack would do it. I did in fact do some shopping today, especially with the best of the silver stocks. I was pleased to see that most of the mining stocks closed well above their lows. This tells me the money wants in! From this point forward, a short covering rally could be the impetus needed to embark on the next up-leg for the gold and silver bull. Bonds were mixed today with the 30-year bond holding ground to end the day right around break-even, while the shorter maturities ended fractionally lower. On face value it looks like market forces were supporting the long end of the curve to keep a temporary lid on interest rates. Mortgage applications were down again for a fifth straight week and the MBA reports refinancing has declined almost 50% in just the last four weeks. Stimulus from tax cuts and extra cash from refinancing is drawing to a close, so we have to keep an eye on consumer spending since it is the primary driving force for the economy. Stocks ended the day slightly positive with the Dow Jones Industrial Average adding a scant two points to 10,317, the NASDAQ Composite gained 17 points to 1,995, and the S&P 500 tacked-on five points to close at 1,124. Stocks could continue to hang on as we move through the balance of earnings season, but I’m anticipating a resumption of the primary bear market within the next few weeks. I believe timing is a bit more difficult because we are facing election year politics and support of the financial markets to keep the incumbents in office. I still believe patience will be rewarded for longer-sighted gold and silver investors. Some of the best PM stocks actually finished with gains for the day! I hope all PM investors can weather the storm. Have a great evening! Mike Hartman Charts courtesy of StockCharts.com
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