FSO Editorials: "'Da Bottom' for Gold Stocks?" by Frank Barbera 05/19/2005

Over the last few weeks, commodity prices have tumbled as concerns have increased over decelerating global growth. Domestically, a flattening yield curve, continued Fed rate hikes, slowing manufacturing. And high gasoline prices, have all led to lower a trend of slowing growth. Amid this economic “soft spot,” commodity stocks, the former high fliers of the cyclical bull have experienced a sharp decline. Within the group of commodity leaders, steels, base metals and energy stocks have all retraced much of their early 2005 advance. Benefiting from the commodity market weakness and higher short term rates has been the U.S. Dollar, which has soared to multi-month highs. As is commonly understood, Dollar strength often leads to weakness in Gold, which has a strong inverse correlation. Rarely, has this been more correct than over the last few weeks where the Dollar Index has advanced for 5 consecutive weeks, while both Gold and the Gold Stocks have moved steadily lower.

Rumblings In The Market

Liquidity Vacuum
In my view, while I believe the recent “growth scare” may indeed be well founded when viewed in a longer-term context, at the same time, it is equally clear that in many cases, the extent of recent declines in many stocks has been an example of a rather severe downside over-reaction. Put simply, while global growth does appear to be consistently slowing, there are also plenty of other indications that growth is not falling off the table either. During last week, concerns were also voiced about a potential hedge fund debacle in the making—suggesting that a large broker-dealer may have sustained some serious trading losses for its own accounts. This, in turn, may have accounted for some of the liquidity vacuum, which developed in many cyclical names in the weeks just past.

Flattening Yield Curve
The general thinking expressed within the hedged community runs along the lines that since Oil, Steel and Base Metals were hot names recently, margin-related issues may have surfaced over the last two weeks forcing some liquidation in these shares. This was evident in the XOI which fell last Friday, even as Crude Oil closed with a gain of $.13. Yet another troubling factor has been the consistent narrowing of the Treasury Yield Curve, which late in the week, nearly inverted with the 2 Year Treasury yielding 3.62 and the 10 Year Bond yielding 4.10, a razor thin spread of just .48 basis points. As a gauge of liquidity, the ultra-flat yield curve is the market's mechanism for communicating to Fed Chairman Greenspan that he should stop raising interest rates at once. Think about it, another ¼ point hike in June would lift Fed Funds to 3.25% and probably press the 2 Year Note toward 3.80%. At that point, the 2 Yr-10Yr spread could be as thin as just .20 to .25 basis points.

Greenspan's Conundrum
At that point, the Fed Chairman would be asking for serious trouble with the Bond market “carry trade,” which could unwind abruptly. That would pose large systemic risks that could potentially begin to cause major dislocations in Greenspan’s last 10 months in office. Normally, when the 2 Year – 10 year Treasury Curve flattens to this extreme degree, it is an excellent leading indicator for a building economic slowdown with payrolls declining in forward months and manufacturing and purchasing manager activity slowly sharply in its wake. Does Chairman Greenspan truly want a recession and stock market collapse, and maybe even a major derivatives debacle unfolding on his watch—at the end of his long term in office?

Maybe, but I would tend to doubt it. As a result, with growth clearly slowing as reflected by the ISM Index now nearing a 21-month low, rumors flying about mounting hedge fund problems, concerns over deteriorating corporate debt quality (GM,F), liquidity concerns in credit default swaps, along with the dollar stabilized, and Oil (a proxy for inflation pressures) now clearly in decline—the Fed should now have room to take a pass on a rate hike at its next meeting. If not, at the very least, the odds would seem to strongly favor the Fed altering it’s wording to reflect an eased tension with regard to inflation fears. In looking at the forward June to December 2005 Eurodollar contract, the spread has narrowed to only .41 basis points, the lowest since February. This tells me that the market is now pricing in only 1 full ¼ point hike, and less than two ¼ point hikes (.50), for the first time in a long time. To me, this means that maybe we get one more ¼ point hike from the Fed in June and along with it, an announcement of a policy change.

Stronger US Dollar
For Gold Stock investors, the problem of the last several months has been, largely, the strong Dollar. In that regard, much of the Dollar strength stems from the fact that the Federal Reserve has been steadily raising short-term rates, while the European Central Bank has held rates at 2%. 6 Months ago, that spread was zero with Fed Funds at 2.00% and the ECB Rate at 2.00%. Flash forward to present day. We have seen four ¼ point hikes in 6 months from the Fed, which now leave a 100 basis point, or 1% Dollar positive spread. For short-term money, this helps stabilize the Dollar—especially with the forward curve still pricing in more Fed rate hikes. What needs to develop on a fundamental level in the near term is an about-face in Fed policy, which I believe will develop imminently. In fact, quite often with the release of economic data in coming weeks, Fed governors could speak out, at which point an opportunity could present itself to begin reshaping the market view. On May 24th, the FOMC is scheduled to release the minutes of its May 3rd meeting at 2PM EST, which could be an important market moving event.

Anywhere along the line, a few comments well placed would be all that is needed to reverse the downtrend in commodity stocks and accentuate the renewed advance in the overall stock market. This would also simultaneously begin to chip away at the Dollar’s strength leading to an upside reversal in Gold and Gold Stocks.

Future Downward Trend Could Affect Gold Stocks
Importantly, once the Fed moves its policy stance back toward “neutral” and away from further tightening, the odds will grow enormously that the Dollar will once again begin to slide. In my view, the extreme technical readings we are seeing in many markets over the last two weeks, are foreshadowing the larger trend reversal, which is soon approaching. In all likelihood, the Gold Stocks will be among the prime beneficiaries of a change in Fed policy in the weeks immediately ahead.

Why "Da Bottom" in Gold Stock Prices?

While it would be unprofessional for any investment advisor to attempt to "pick THE low” in a market, the selloff seen last week certainly “felt” like a major bottom to me. In fact, I am titling this letter “Da Bottom” for those of you who remember the old Saturday Night Live sketch with the Chicago Bears “Da Bears”.

Gold Stocks Close to Major Long-Term Low
Why “Da Bottom?” In a nutshell, we are still looking at record oversold technical readings for the gold stocks. Further, and of major significance, is the fact that the decline seen last Thursday forced the XAU down to its lower 50-week trading band, which as of last Thursday’s close ended at 80.49 with the XAU closing just below that band with a reading of 80.33. Last Friday, the XAU also closed outside the lower band with a reading of 78.99 versus the lower band at 80.32. This was very important because the XAU will normally not go longer than two to three years without hitting this lower 50-week band. In the most recent instance, it has been over 4 years, since November 2000 when the XAU last hit its 50-week lower band. For many months, this event has been overdue and is now complete and behind the market. What’s more, there are now positive divergences present in the Gold Stocks, with a number of indicators failing to make new and lower lows with the indices late last week . These include the Short Term Ratio of Up-to-Down Volume, the McClellan Oscillator, and 9 day RSI along with (on its inverted scale) and the New TRIN. Does this guarantee that Friday was THE bottom for Gold Stocks? Obviously, in the markets there are never any guarantees. However, I do believe that whether or not, last Friday was the final in the XAU, the odds are high that the gold stocks are close, if not right on, a major long-term low.

History Does Repeat itself
In fact, if we go back and look at the bottom seen in the Gold Stocks in May 2004, we note a number of striking similarities. Who says that history does not repeat??? Looking back at last year’s market bottom for the XAU, we saw a panic low at Point 1 (81.24 on April 28, 2004), followed by an anemic bounce lasting 4 trading days toward 86.46 on May 4, 2004 for a rally of +5.22 XAU points. This was then followed by a 3-day plunge into the final low at Point 3, which saw the XAU bottom at 76.79 on an intra-day basis and 78.13 on a closing basis. The closing low was May 7, 2004 (78.13) with the intra-day low on May 10, 2004 at 76.79.

Now, flash forward to 2005 and we once again see a panic low on April 28, 2005 at 81.79, followed by a 4-day rally peaking on May 4th (sound familiar?) followed a few days later by an aggressive 4-day decline with the XAU closing at 78.99 on Friday, May 13th. The only reason this sequence isn’t a virtual duplication of last year's bottom was that for the 3 days of May 5, 6, and 9, the XAU traded in a tight range near 86 before beginning its final decline. Aside from that, the action over the last 2 weeks is a virtual carbon copy of the May 2004 bottom, with dates and prices nearly the same as 2004!

A Review of Technical Indicators
At the same time, many short-term technical indicators are at virtually the same kind of oversold levels as was seen at the bottom in 2004. Consequently, I expect to see the trading rally, which began early this week continue on the upside very soon potentially lifting the XAU up toward the 86.50 to 87.50 zone between now and late May. At that point, a “would be” Head of a potential developing Inverted Head and Shoulder Base will be complete. From there, the XAU could then begin another, shallower decline. This “right shoulder” decline should then come back down—depressing the XAU toward 82.00 to 81.50 one final time, which would make a symmetrical right shoulder low. From there, a powerful medium-term advance should explode off the bottom—beginning sometime in early to mid-June and quickly lift the XAU up and thru the resistance benchmark of 86.50, which will have been the developed neckline for the Head and Shoulder base (see hourly chart below first printed on Friday, May 13, 2005 ).

Among a number of important technical gauges, my Medium Term A/D Oscillator shows consistently higher lows over the last few weeks indicating a positive divergence with the lower lows seen on the XAU. This gauge, which is normally overbought above +30% and oversold below –30%, has seen readings as follows over the last three weeks. On Friday, May 13th, with the XAU at 78.99, this gauge closed at –33.56. Prior to this, there were troughs at –42.01% on 4/28 with XAU at 82.13, -44.92% on 4/15/05 with XAU at 86.39, and –45.08% on 3/29/05 with XAU at 91.90. Thus, over the last few weeks, we have seen four lower closes on the XAU, with four higher, less negative readings on A/D Oscillator. This shows us that the decline in the gold stocks was “internally” packing less punch, even though the XAU kept moving lower. It also implies that the upside reversal seen this week has an excellent chance of recording a major, long term low.

Moving on, another gauge which is historically oversold is the McClellan Summation for Gold Stocks, which closed last Friday at –590.21. Importantly, at that reading of –590.21, the Summation Index was also still holding above its recent lows of -884.53 seen on 5/02/05.

Even a casual glance at the chart above shows the Gold Stocks to be oversold as was seen at the major bottoms of Nov. 2000, January 1993, August 1988, December 1984, and April 1982.

Saving The Best For Last
Under the header of saving “the Best for Last”, the following charts really drive home the point about what kind of bottom we are looking for in the Gold Stocks at the present time. On the next chart, I show a proprietary timing gauge, which uses a Rate of Change calculations from a Composite Timing Model, which is composed of 24 separate individual, short and medium term timing gauges. Historically, this Rate of Change gauge finds major bottoms below –175.

Looking back at the action on this gauge over the last 25 years, the bottoms accompanying readings below:

–175 have been huge “life altering” opportunities to make money in the Gold Stocks

Starting with the –215.38 reading on June 25, 1982 with the XAU at 42.45.
By June 25, 1983, the index was up 93.86 XAU points, or +222.15% in 1Year!!!
On April 16, 1992, the gauge closed at –219.96 with the XAU at 68.34.
By April 16, 1993, the XAU was at 84.72 up 23.96%
By July 30, 1993 the XAU was trading at 129.56, up 89.49% from the April 1992 bottom.
December 1, 1994 another reading below –175 with the gauge bottoming at –181.86 and the XAU at 102.59.
By February 7, 1996, approximately 14 months later, the XAU was at 155.60, up 51.67%.
December 10, 1997 the gauge at its historically low extreme, during the final collapse of the Great 1996-2000 Bear Market in Gold Stocks we saw a negative value of –269.57. At the time, the XAU bottomed at 67.63.
By April 24, 1998, only 5 months later, the XAU was at 90.34 up 33.57% in 5 MONTHS !!!
This was followed by another signal at the Bear Market bottom on November 7, 2002 with the gauge at –177.12 and the XAU at 44.47.
By June 4, 2002, 19 months later, the XAU was trading at 89.11, up +100.38%.
Next we see the May 2004 low at –200.17 with the XAU at 81.46.
By November 2004, the XAU is at 111.50, up 36.87% in just 6 months.

How often can you make 30% or more on your money in 6 months? That’s a tough proposition for any market to deliver that kind of return, but in the Gold Stocks it can be done with regularity using some market timing. Looking at a close up of this gauge during the last few weeks, the low last Friday was a reading of –192.16. At the present, this gauge, which uses an accompanying moving average cross-over system, has just rendered a final buy, which was accomplished on Wednesday of this week with an upward cross-over of its moving average signal line.

Close up View – ROC Timing Model

Recovery Rally Right Around The Corner
Finally, I want to end with a chart of my Medium Term Dollar Weighted Put-Call Ratio for Gold Stocks. It finished Friday at a reading of 2.11, which was a new all time high. Put another way, this tells us that Gold investors have never been more fearful of a continued decline than they are right now. Literally, over the last few weeks—as fear has increased—everyone has moved to the same side of the boat ,which normally means a recovery rally is just around the corner.

In conclusion, while I know that many Gold investors are extremely distressed by the action over the last few weeks and the cumulative action of the last few months, the bottom line for now is that the Gold Stocks are near a long-term bottom and this is the time to focus on adding money into this market as it begins to turn around and begins to prove itself on the upside. This will develop soon as the technical weight of the evidence is simply overwhelming that a major long-term low is at hand. Personally, I believe a great bull market is about to lift off with a power and ferocity rivaled only by the Internet boom of several years ago. Get ready to have some fun as this should be an exciting ride….

Frank