THE OUTLOOK FOR GOLD, 
STOCKS AND GLOBAL INFLATION
by Clif Droke
July 16, 2007

In last week’s commentary I wrote that “When bearish headlines show up on the editorial page it heightens the significance of the fear and is always bullish for stocks.”  This statement was driven home by the expansion in negative and fear-laden news headlines that showed up in the leading financial papers even as the stock market made new highs this past week.  

Here is a sampling of headlines from just the last two days in the Financial Times newspaper:  “Investors step up their flight from risk,” “Investors shaken by latest chapter in credit saga,” “Retail and financial gloom is backdrop for broad declines,” “ ‘Supply crunch’ talk sends oil to 11-month peak,” “Subprime bond alert triggers sell-off,” “Subprime concerns dominate choppy trading session,” “Greenback is humbled by fear of falling interest in U.S. assets.”  Even as the major indices are making new all-time highs the headlines continually grow more bearish.  From a contrarian standpoint, this tells me the bull market lives on.

Why is it that the higher equities prices go, the more bearish the public becomes?  I believe it’s attributable to the negativity in the mainstream headline news.  How can the average investor be expected to see the bullish undercurrents of this market when all he ever looks at is the major news media? When he has read the news headlines this year what has he been greeted with?  One pessimistic headline after another!  Sub-prime mortgage meltdown, global credit bubble, real estate collapse, dollar weakness, rising oil/gas prices, Year Seven Phenomenon, etc.  With “news” like this who needs to go to the movie theater to see a horror film?  A horror fan can get his fix by just reading the daily news!

I also pointed out last week that the recent breakout to a higher high in the NASDAQ 100 Index (NDX) would bode well for the rest of the market.  When the NASDAQ is bullish it leads the way for the rest of the market and it's always positive to see the NDX making a new high, even if the other major indices are lagging behind a bit.  The rest of the major averages finally caught up with the NASDAQ this week and the benchmark S&P 500 closed at an all-time high of 1552.  The Semiconductor ETF (SMH) also made a higher high as expected as the incredible short interest in the semiconductor sector made for an easy upward path for the semis in recent weeks.  I’d look to book some profits in SMH and the winning semiconductors in your portfolio at this time.

The spot gold index closed on Friday, July 13, at $665.90.  The 10-month rate of change indicator for gold has once again reached a normal, healthy reading and is even somewhat “oversold.”  This important longer-term indicator hit a very high “overbought” reading in May-June 2006 and since then gold has been in various states of correcting itself internally and is still below its May 2006 high of $720.  The near term resistance for spot gold begins at $670 extending to about $680.  That looks to be a tough obstacle for gold to chew through this summer (although my near term target for gold is $680-ish).  By September the rate of change for the gold price (based on the 10-month ROC oscillator) is expected to enter decisively into “oversold” territory, thus setting up a potentially stronger gold rally based on the markedly improved internal condition the market should be in by that time.  Seasonally, the September-October tends to be a positive turning point for the gold price as well.

Turning our attention to the gold stocks, in the immediate term, the gold stocks are overbought as defined by the 5/10/20-day price oscillators for the XAU index.  The XAU rallied strongly this week, reaching its high of the year of 151 on Friday.  The latest rally was predicted by the positive divergence in the XAU volume indicator as discussed in a recent report.  Now the gold stocks as a group are understandably in an overbought technical condition as defined by the price oscillators.  When these indicators reach the “red zone” it means a pullback can be expected.  Now would be a good time to take some profits on those gold stocks in your portfolio that have shown strong profits lately.

The gold and silver stocks are being propelled right now by the same principle that is moving the broad stock market, namely the momentum of the new highs versus new lows.  The 200-day internal momentum indicator for the gold stock sector reversed strongly beginning in late June and has helped to push the leading gold stocks higher in the last two weeks.  The stocks that have benefited the most have been those that are closest to their highs for the year, i.e. those that have shown the greatest relative strength.  This is true for the stocks in the overall NYSE and NASDAQ stock universes as well.  The laggards have generally continued to lag while the leaders continue to lead.  It’s not a market for bottom fishing; instead, the best strategy has been to find the stocks with the most relative strength and stick with them.

Another outstanding feature of the gold stock market has been the steadfast strength in two of the most important leading indicators among the mining stocks, namely Freeport Copper & Gold (FCX) and Inmet Mining (IMN:TSX).  Over the years I’ve come to rely on these two stalwarts to provide confirmation and/or leading signals at major turnaround points for the overall PM stock sector.  They’ve done a great job every step along the way.  Earlier this summer when things looked forlorn for the PM sector, particularly the silvers, FCX and IMN kept on making new highs and this, it turned out, was a sign of strength.  FCX still haven’t given a reversal signal and have continued their respective upward paths through the current week.  It’s especially useful to watch these stocks in relation to the 30-day moving averages for short-term trading signals.

Blame it on China!

Remember back when you were a child and you refused to eat your broccoli for dinner?  Your mother would say, “You’d better eat your vegetables!  Think of all those poor, starving children in China.”?  How ironic is it that today, when the prices of those same vegetables go up at the grocery store, it’s being blamed on the Chinese?  Only this time it’s allegedly because those formerly poor, starving Chinese are increasingly well fed and their demand for food is responsible for the rise in global prices.

Recently there has been a lot of talk in the financial press about long-term rising food prices with growing demand from China and India as one of the fundamental reasons for it.  “Nestle’ chief fears ‘significant and long-lasting’ food price inflation” was a headline from the July 6 Financial Times.  A report by the United Nation’s Food and Agriculture Organization (FAO) and the Organization for Economic Cooperation (OECD) predicted that food prices will rise by 20-50 percent in the coming decade in response to demand from emerging markets including China and India.  The increased demand for crops such as corn, wheat and soybeans in producing biofuel is another reason being blamed for food price inflation.  

But how much of the current hoopla over rising wheat and soybean prices is just an after-the-fact explanation of a cyclical trend?  I recall hearing the same scare stories about perpetually rising crop prices back in 1996, which was the last time there was a huge spike in the wheat price.  The experts were all saying that China would drive wheat prices continuously higher for years to come.  Instead, the wheat price fell back to its long-term trading range low and didn’t turn around until 2002.  That’s not to say we’ll see a repeat of the 1996-2002 experience, only that it pays to exercise a little discretion when reading the financial headlines.  Fear can be just as prevalent in the market for commodities as it can in the stock market (as we talked about earlier).

Technical analysis vs. fundamental analysis…

Over the years I’ve heard quite a few high-profile financial writers make the statement that “technical analysis is bunk” or words to that effect.  It’s funny because you never hear them balancing their bias against TA by pointing out the many successes that some of its practitioners enjoy, even over long period of time.  No, it’s always some over-the-top statement to the effect that TA is bogus and can never, ever work for anyone.  

In the July 7/8 edition of the Financial Times, columnist Arne Alsin (who also happens to be a portfolio manager for the Turnaround Fund) weighed in on the technical analysis debate with his opinion.  “Technical analysis is an oxymoron,” he proclaimed.  “It sounds technical, but it is not analysis.  It is rubbish, plain and simple.”  Is that so, Mr. Alsin?

He goes on to state, “There is not one single money manager or mutual fund who has generated an impressive long-term record using technical analysis.  Nor a single academic study that indicates technical analysis offers any utility to investors.  It is the stock market’s version of snake oil.”

That’s a pretty extreme statement to make, and like most extreme statements, it’s extremely wrong.  There are enough successful investors and portfolio managers who rely on technical analysis to disprove Mr. Alsin’s categorical condemnation of TA.  The best long-term results in any investment campaign always come from a judicious mixture of technical and fundamental analysis.  Neither disciple used alone can guarantee long-lasting benefits to one’s portfolio.  But a proper balance of the two disciplines is a powerful 1-2 combination that is hard to beat.

Over the years I’ve found that most of the money managers who eschew technical analysis tend to lag the S&P in their portfolio’s performance.  It’s a classic case of “those who live in glass houses…”  The reason for this performance lag is that fundamental analysis can work fine in a long-term bull market when the main trend is up.  It can even work in a trading range environment such as the one we saw in 2004 and 2005, assuming the analyst really knows his stuff.  But employing a trading or investing strategy based solely on fundamental analysis in a bear market is like playing Russian Roulette with a derringer -- an investor is signing his own financial death warrant!

The Turnaround Fund has lagged the S&P 500 over a 3 ½-year period.  Meanwhile, quite a few fund managers that use technical analysis have kept pace with or even beat the S&P over that same time period.  I realize Mr. Alsin’s fund is a long-term oriented investment vehicle, and that investing in distressed “turnaround” type securities is a risky business that takes time to pay off.  Given the bullish environment of the past four years, however, a better performance could possibly have been achieved by combining fundamental with technical analysis.  Perhaps utilizing a little more TA would help improve the fund’s long-term performance.  

I wonder what’s going to happen to the Turnaround Fund’s performance when the next cyclical bear market comes along?  Without any technical analysis I seriously doubt it will beat the S&P.  Instead of bashing technical analysis, perhaps Mr. Alsin would be better served in learning what TA can do to benefit turnaround investors and finding the optimal blend of fundamental and technical analysis for maximum results.