On a purely technical basis, gold has signaled a reversal of its downtrend today. It needed to get above $1350, and today’s close has achieved that target. Gold’s break above $1350 confirms the higher low that was made last week. While gold is now in a confirmed intermediate-term uptrend, conditions are still needed to officially call a long-term bottom. What’s needed? Time and price.
Gold has been in a downtrend for the past nine months. It began a topping process between October and February of this year when it finally broke down and confirmed a downtrend in February based on Chinese economic data and bond-purchase-tapering-talk from the Fed. Further pressure came in April due to rumors spread by Reuters that Central Banks in Europe could sell their gold reserves to shore up capital imbalances like Cyprus was rumored to have done. Gold broke a key technical level at $1550 and looks to have made its low for this cycle near $1224.
While the intermediate-term bottom has been confirmed by a break above 50, a long-term bottom will take both time and price to confirm a bullish trend. The bottom in gold from the 2008 correction took a while before it could be confirmed as a long-term bottom. Long-term bottoms take time to establish. Usually, you see price go sideways for a number of months as supply dwindles and demand steps in to create support. Long-term moving averages flatten. Above we see that the 150-day moving average is still in decline on gold. It will take higher prices or more sideways trading in gold for that moving average to flatten. At that point, we say that gold is trying to bottom, long-term. Netflix (NFLX) shows an excellent example of this process over the past two years, as seen below.
Netflix shows the consecutive stages of a security forming a top as buyers are exhausted and sentiment shifts. It formed a top in 2011 when it tried to change its business structure. Stockholders lost confidence and it began a downtrend. Take note of the intermediate-term bottom in early 2012. The stock rose approximately 115% from 62 to 133. The problem with this bottom was that the long-term moving average was still in decline and there hadn’t been enough time to exhaust the sellers. Over the next six months, these sellers were flushed out and NFLX formed a true bottom. How many investors completely forgot about NFLX in the second half of 2012? I know I did. That’s how a long-term bottom is formed.
Many large-cap mining stocks show intermediate-term bottom patterns on their charts. This is identified by a higher low and confirmed by a higher high. An example of this is in Goldcorp (GG) or Silver Wheaton (SLW) – both of which had breakout days today.
Usually, when securities have breakout days, they get extended very quickly and typically retest their breakout. In fact, it’s the last step of a top or bottom pattern.
So now that you have enough technical analysis to get an idea of the difference between intermediate and long-term bottoms, let’s talk about some of the drivers behind the latest move in gold. I believe there are four drivers supporting a trade in precious metals and mining stocks right now:
- They were oversold and shorts are covering
- China’s economics are improving
- Dovish comments from Fed doves
- U.S. economics strengthening – i.e. the business cycle still has relevance
Oversold and Shorts Covering
There’s no question in my mind that many precious metal investors capitulated after April. Gold finally broke 50, as many technicians were predicting in March and April, and a slaughter in mining stocks commenced. You can see this in the drop in the net position of large and small traders in the Commitment of Traders report by the U.S. Commodity Futures Trading Commission (CFTC). Here I show the net futures position on a weekly basis over the last six months for gold. Note that there was a large decline after March in the net position of large traders, but the trend is on the rise again over the last month.
The CoT report last week (not shown in the chart above) showed a small decrease in the net position of large traders, but the small trader short position in futures dropped by 37,751 contracts to 31,581 – covering more than half of their short in one week!
China Stabilizing
- Industrial Production up 9.7% from a year ago (July); beat expectations for a 9% gain
- Producer Price Index down 2.3% from a year ago (July); worse than 2.2% expectation
- Exports rose 5.1% from a year ago (July) compared to 3.1% drop in June
- Imports rose 10.9% from a year ago (July) versus a drop of 0.7% in June
- Chinese electricity consumption jumps 8.8% over a year ago (July)
Doves Will Be Doves
We’ve seen some of the Fed doves discuss concern over the United States’ low inflation numbers and/or the need to keep the current level of purchases in Treasuries and Agency-backed securities. Atlanta Federal Reserve President Dennis Lockhart downplayed rumors the Fed will begin tapering its purchases of bonds as early as September when he spoke on Tuesday. James Bullard, President of the St. Louis Fed, recently said, “Inflation has been running very low. I have been concerned about low inflation.” Recall that last month’s Fed Policy statement specifically discussed that members are concerned about the risks that prolonged low price pressures would hurt the economy. Bullard had said yesterday that the committee has set an inflation target of 2% and that to remain credible they’ll have to attain it.
Stronger Economics
Material stocks in general, besides fertilizers, have been strong as of late. Gold isn’t the only metal that has been rallying. Copper has risen from .04 to near .36 in August on stronger manufacturing and jobs data. Today’s industrial production announcement showed a 2.1% increase in mining production following a 1% increase in June. Earlier weakness in production has left manufacturing inventories lean. Today’s IP number, which fell 0.1% overall despite the strength in mining, shows that while manufacturing is improving, the pace is still slow.
In addition to copper, energy prices continue to be firmly seated with crude at 7, well above 0. This is obviously a concern down the road. Every time we’ve seen oil reach between 0 and 0, we’ve seen a sell-off in the market as the economy slows. You can see a slight glimpse of this issue when charting the relationship of the transports to oil (a ratio). Note the reversal in this relationship as oil has begun to outperform against the transports. While I was bullish on this area of the market in October, I’m no longer as bullish as I once was.
Despite the warning of high energy prices, I continue to see a rotation out of non-cyclicals into cyclical stocks. Now, the big push into cyclicals that started in April is spilling into materials and energy service stocks as well.
Conclusion
Material stocks and commodities have established an intermediate-term bottom. As such, you need to have the mentality that it’s a trade. If long-term trends show a bottoming process based on time and price, well, that trade can then become an investment. There are still a lot of unknowns. Will the Fed taper purchases in September or not? Is China going to ramp up production and reaccelerate its economic growth or will it continue to decelerate? These questions will be answered in time, likely over the next four months.
