Market Wrap Week Ending 5/29/09

by Douglas V. Gnazzo, Honey Money Report | June 1, 2009

Inter-Market Dynamics

In past market wraps I have discussed various inter-market relationships and the fact that some of them have changed, while others keep oscillating back and forth: sometimes tracking one another in the same direction; and at other times moving inversely to each other.

These changing inter-market dynamics are the signature of a paradigm shift that is taking place: the death of paper money (and related assets) and the re-emergence of gold and silver as the ultimate store of purchasing power and value over time.

Other tangible commodities are also being chosen as viable alternatives. China is the leader of this movement, as they continue to exchange paper money for commodities that they are storing, almost to the point of hoarding. They have a long history of survival, and the many ways and means thereof. This instinct should not go unnoticed.

Back in March I wrote a paper, The Road to Hell (click link for access) that discussed China’s call for a new global reserve currency other than the U.S. dollar. One of several reasons for this call for change is the fact that China is concerned with the value (purchasing power) of their large holdings of U.S. Treasury bonds; as well they should be. It is this concern over U.S. debt and its ramifications that I want to focus on.

As everyone knows, a financial debacle has been unfolding since 2008, with the downfall of Lehman Brothers supposedly marking the start. This catalytic event is open to debate, however, it suffices to illustrate the fact that something occurred in 2008 that the markets did not like. It has since been dubbed a financial crisis.

We are going to look at six (6) markets and their reaction to the crisis, as well as the inter-market relationships between them. They are:

Oil
CRB
Gold
S&P 500
U.S. Dollar
U.S. 10 Year Treasury bond

As the chart below shows, around late summer to early fall of 2008, both stocks and commodities plummeted. Commodities, as represented by the CCI equally rated index, hit their low early in Dec. of 2008, while stocks kept falling into March of 2009.

The CRB index made its low in March of 2009; however, it is not an equally weighted index and is skewed by the price of oil. Oil made its low late in Dec. of 2008.

Notice that while stocks, commodities, and oil were falling since mid-2008, Treasury bonds, the U.S. dollar, and gold were rising. It is impossible to know exactly why these markets acted as they did, nevertheless, a bit of common sense offers some strong probabilities.

Investors were obviously spooked by Lehman Brothers, AIG, and the related deleveraging of the mortgage markets and unwinding of toxic derivatives. All told there were many ingredients thrown into the pot – a veritable witch’s brew that did not go down easily, regardless of how many spoonfuls of sugar were added to the messings.

It is said that ultimately greed and fear move the markets; and in this particular case there was a whole lot of fear hanging in the air. Investors around the world sold stocks and commodities and ran to the perceived safe havens afforded by gold, Treasury bonds, and the U.S. dollar – a strange brew in and of itself. Risk was repriced. The return on money was no longer the concern – the return of money had taken center stage. The latter is the key point.

There are two main schools of thought on the flight to safety theory. One extols the simple maxim of the return of one’s investment or money. Gold has always been considered the safest of all assets whenever turmoil roils the markets.

The move into the U.S. dollar and Treasury bonds as a safe haven was based on the assumption that since the solvency of many markets was being questioned, it was thought that the U.S. government would be the last to go under, hence the dollar and Treasury bonds would be the last assets (other than gold) to go down.

Gold is not subject to going under, as it is outside of the system of debt obligations. Gold is no one’s debt or obligation. This is why gold is the ultimate safe haven.
Be that as it may, there may be more to the story, which brings up the second school of thought on the run from risk to safety theory. When panic and fear set in everyone started selling. During such times liquidity becomes the main concern. Margin clerks were smiling as the baby was thrown out with the bath water.

Any safe haven must be liquid and easily entered into and out of. It must be able to be bought and sold in large quantities. This is where the U.S. dollar and the Treasury market come to the fore. They are both huge markets that can handle massive amounts of buying and selling.

This brings into focus the penultimate distinction between gold and other perceived safe havens such as the U.S. dollar and Treasuries. Gold is an extremely liquid market because it is always accepted anywhere in the world at anytime – and it has been for thousands of years. But gold is not a large market quantity-wise. It is a very small market in terms of supply.

As a matter of fact, this is what makes gold so “valuable” – its stocks to flow ratio dwarfs all other markets. At the present rate of yearly production, it would take over 75 years to produce the existing above ground supplies of gold. Other goods have a stocks to flow ratio of one year or thereabouts. Most other commodities are consumed – gold is not. This is what makes gold so “precious” – its unparalleled quality, and limited quantity.

On the other hand, it is the exact opposite reasoning that supports the second school of thought on the flight to safety theory regarding the rush into the dollar and Treasuries during the deleveraging and global liquidity crisis.

It was the huge supply of both dollars and Treasuries that made them so desirable from a liquidity point of view. It was their quantity more than their quality that was at play, although their quality was also perceived to be worthy and factored considerably into the equation.

Nonetheless, how things change over time, which is the point of this discussion: the changing of various inter-market relationships.

Gold and the U.S. dollar have a long history of moving inversely to one another: if gold is up, the dollar is down. If the dollar is up, gold is down. For decades this relationship has stood the test of time.

However, starting in 2009 both gold and the dollar moved in tandem, both began tracking each other in the same direction – to the upside. Once again, this was supposedly due to the flight to safety. Things were bad from bad to worst in most markets. The financial system was freezing up, and investors rushed into gold and the dollar at the same time. The chart below shows the inverse relationship between gold and the dollar going back for a decade, until the start of 2009.

Let’s hone in on the price action beginning the very first of the New Year – 2009. During late Dec. of 2008, gold and the dollar began to move up together in tandem. This is most unusual for the two. Generally they move opposite to one another. So what gives?

It was the flight to safety dynamic, spurred on by the large liquidity issues, and the belief that the U.S. would be the last sovereign nation to default on its debt obligations that were at play.

Suddenly it became a technique of self-survival against the margin clerks; when everyone was selling anything they could get their hands on. The good was sold with the bad. The baby was tossed out the window with the bath water. No quarter was given, although many a plea was made. The margin clerks stood their ground.

But now we are having another inter-market trend change: since Mid-April the U.S. dollar has been dropping, while gold has been rising, returning to the inverse relationship of old.

Bonds topped off at the beginning of the year and have been getting hit pretty soundly pelted to the downside. Apparently the safe haven concern has dissipated – at least for time being.

Both U.S. Treasury bonds and the U.S. dollar are down significantly. Why are they down when a short while ago they were the go to plays in the flight to safety? Are the markets simply willing to take on more risk now and are no longer concerned with safety? If that is the case, why is gold still performing as a safe haven? I think it goes back to the quality versus quantity issue.
Because the Treasury Dept. has to issue huge supplies of debt going forward to fund its various stimulus and bailout schemes, the bond vigilantes are starting to smell inflation and they want to be compensated for the increased risk of lending their money to a self-addicted borrower.

The bond vigilantes are demanding more interest be paid to make up for the increased risk. This has sent Treasury bond rates higher and bond prices lower, as the next two charts indicate. Recall a couple of months ago I mentioned that Treasury bonds might be the next bubble to burst. It looks like that may be coming true, although a short term rally is not out of the question.

It is starting to dawn on the Fed that the markets are bigger than they are. They may be able to steer or direct certain markets in certain directions for certain amounts of time, but to think they have complete control over all markets is a mugs game at best.

The market is a law unto itself and it will not be denied. We are starting to see this law exert itself in full array. I expect to see more of the same as time passes: old paradigms will give way to new ways and means. It is the passing of history from one epoch to another. Life stops for no man, it keeps on moving – inexorably into the future.

So, it is simply a case that investors are willing to accept more risk now and are moving money into stocks and commodities, while moving it out of Treasury bonds and the dollar?

As the following charts show – interest rates on Treasury bonds are rising, while prices are falling. Treasury bonds have felt the wrath of the bond vigilantes and it may reverberate throughout other markets. The charts are quite clear on what is taking place: the price of risk has gone up in T-bond land.

My take is that money is moving out of the bond market and the dollar market because of increased risk. The fact that so much debt (supply) has to be issued, is now forcing buyers to demand higher interest rates to compensate for the perceived increase in risk.

To attract enough buyers (demand) the Fed has to either raise rates (which the market will actually do of its own accord); or the Fed will have to step up to the plate and become the buyer of last resort, doomed to having to monetize large sums of debt that others dare not buy.

Such monetization of debt will further debase (destroy the purchasing power) an already weakening dollar. This dynamic is what the Chinese are concerned about, as they hold tons of dollars and lots of Treasury debt. China should be concerned – very concerned.

Also, it must be remembered that gold is going up smack dab in the middle of all this, so somebody somewhere perceives increased risk in the markets; otherwise, why would gold be going up; and why would interest rates be rising?

It is true that commodity and stocks have gained during this same time, and for several reasons: money that flows out of bonds and the dollar needs to go somewhere; and there are certain investors that perceive things are getting better in the global economy and that we may soon be pulling out of the recession (if that is what we are in – the point is arguably debatable).

I think this is a false assumption, however, and that it will be brought to the public’s attention during an up and coming bond auction that fails, sometime in the not too distant future, perhaps as early as next week, when the long bond goes up for bid. It will be interesting to see who shows up, to what degree they show up, and what price they are willing to pay.

Gold

Gold added $21.90 for a gain of +2.29%, closing the week out at $979.30 (continuous contract). This was gold’s highest weekly close since Feb. 20, 2009 when it closed at $1002.20.

It is interesting to note that the rise is occurring without much fanfare at all. Even on my own website the “excitement” is subdued (which I like from a contrarian perspective).

However, the daily chart is hitting overbought levels, but bull markets can remain overbought for extended periods of time (or not).

Friday’s gap up above overhead resistance is quite bullish if it obtains. Broken resistance has now become support, which needs to be tested and hold. If it does, a move to challenge February’s high is likely. Volume has not been impressive so far – it needs to expand more if the rally is to last.

The weekly chart is quite impressive, and shows significant potential if the head and shoulders formation completes, and breaks out on expanding volume; and if resistance holds as support. If such occurs it will herald in the next major leg up in the gold bull market.

For whatever the reason, let’s call it intuition, I do not think it will be straight forward and easy. I suspect there will be something that “confounds” and complicates the situation. Bull markets like to throw as many off their backs as possible.

But then again, a bull market that just keeps stealthily advancing without much fanfare can confound those waiting for the pullback that never comes. Nobody said it would be easy – it never is; which is what makes it so interesting.

Everything on the weekly chart looks good, except for volume. The most important ingredient to confirm an inverted head and shoulders breakout is that it must occur on expanding volume.

Notice the expanding volume during the move out of the head formation in November. That type of increased volume is exactly what we want to see if and when price breaks above the neckline. Otherwise the breakout will be suspect and could fail; or at least retest and then confirm on expanding volume.

Silver

Silver had another big week, adding on $1.06, to close at $15.73, for a +7.23% gain. Since Dec. 31, 2008, SLV is up 28.75%, outperforming GLD by almost 3 to 1.

It is interesting to note that silver is considered more of an industrial metal than gold is. Obviously, someone is accumulating silver, and I don’t think it’s for its industrial use.

Several weeks ago, one of the market wraps featured the long term gold to silver ratio. It showed that silver was at the extreme end of undervaluation compared to gold, but that it was starting to move. It has continued to move, and significantly so.

Several of the silver stocks on the stock watch list and in the email alerts have made huge moves the past several weeks, along with other portfolio holdings.

Precious Metal Stocks

The precious metal stocks, as represented by the GDX index, had another good week, gaining 5%. Since its Oct. lows, the index has gained almost 200%, rallying from 15.83 to 44.16.

As the chart below shows, the breakout was impressive and the gap on Friday occurred on expanding volume. Follow through confirmation is needed, however.

RSI and STO are in overbought territory, but bull markets can remain overbought for long periods of time (or not). STO appears to have put in a double top.

Next up is the weekly chart of the GDX. First things first: The GDX made its all time high back in March of 2008, just under a reading of 57. As of Friday (5/29) the index closed at 44, so it is 13 points below its all time high; or about 30% - not an insignificant amount.

The GDX made its low in Oct. of 2008, at 15.83. It fell 41 points in 7 months time; or 72%. That was one hell of a drop. Since making its Oct. low at 15.83 the index has rallied to 44.24 for a 28.41 point gain or 179%. Although the rally is impressive, remember – the index is still 30% below its all time high.

The weekly chart shows that the index has recouped just over 62% of its loss off its high, which is just above a significant Fibonacci retracement level.

The various Fib levels off the all time highs are denoted in black and are to the left. Over to the far right are the Fib levels off the Oct. low to Friday’s close. A correction back towards 30-35 would not be unwarranted.

The latest full-length version of this week’s market wrap (49 pgs) is available on the Honest Money Gold & Silver Report website. All major markets are covered with the emphasis on precious metals. Stop by and check out our stock watch list, model portfolio, and free audio-book Honest Money. There is a live bulletin board and many other resources, including live charts and links to central banks and international news reports.

Good luck. Good trading. Good health, and that’s a wrap.

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About the author: Douglas V. Gnazzo writes for numerous websites and his work appears both here and abroad. Just recently he was honored by being chosen as a Foundation Scholar for the Foundation for the Advancement of Monetary Education (FAME).

Disclaimer: The contents of this article represent the opinions of Douglas V. Gnazzo. Nothing contained herein is intended as investment advice or recommendations for specific investment decisions, and you should not rely on it as such. Douglas V. Gnazzo is not a registered investment advisor. Information and analysis above are derived from sources and using methods believed to be reliable, but Douglas. V. Gnazzo cannot accept responsibility for any trading losses you may incur as a result of your reliance on this analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions. This article may contain information that is confidential and/or protected by law. The purpose of this article is intended to be used as an educational discussion of the issues involved. Douglas V. Gnazzo is not a lawyer or a legal scholar. Information and analysis derived from the quoted sources are believed to be reliable and are offered in good faith. Only a highly trained and certified and registered legal professional should be regarded as an authority on the issues involved; and all those seeking such an authoritative opinion should do their own due diligence and seek out the advice of a legal professional. Lastly Douglas V. Gnazzo believes that The United States of America is the greatest country on Earth, but that it can yet become greater. This article is written to help facilitate that greater becoming. God Bless America.

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Douglas V. Gnazzo | Honest Money Gold & Silver Report, LLC
Canton Center, CT USA | Email | Website

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