Sell in May or stay?

Two Mondays ago gold took a 10% hit and all because China reported 7.7% GDP instead of the expected 8% the night before. That's not really a big miss and so such a catalyst doesn't seem justify that kind of damage but I guess since this "bad news" came at a time when gold was already trading very weak breaking major support, it doesn't take much to trigger an avalanche of selling with margin calls fueling the fire. I'm not surprised to see the rebound that gold has had and I suspect a full retracement of that panic sell off will take place. I'm kicking myself a bit for not buying calls on GLD a few days ago. My finger was on the trigger but I just couldn't pull it.

Gold the "commodity" is another thing I wanted to talk about in my previous post.. In the 2000's commodities became "financialized" as institutional investors embraced it as a major asset class. As a result we have seen large "investment demand" of commodities via commodity futures and commodity backed ETFs for the past 10 years. There have been debates as to how much impact this had in driving commodity prices. I suspect it had a lot of impact both on the upside and downside. Gold was right in the thick of things went it came to the financialization of commodities. The arrival of GLD in 2004 was the primary conduit for "investment demand" to flow into. GLD has been responsible for massive accumulation of physical gold (since its required to be backed by gold) which no doubt drove the price up. Gold bulls have enjoyed the tailwind of the investment demand for about a decade and make no mistake about it, the investment demand for gold is responsible for the vast majority of the rise in the price of gold - I'd say 80% or more (jewerly demand has been flat and  the drop in the dollar mathematically only justified about a doubling in the gold price from its low at $260 ).  But if you live by the sword you die by the sword. If the investment demand has peaked and is now heading south, then gold bulls are in for a world of hurt longer term.

Gold is such a debated topic. You can find strong arguments pro and con. At first I was going to go through some of the major points of these arguments but I'm going to cut to chase and talk about what counts - where is the price headed.  I think in the short to intermediate term, gold will continue to rebound as it got very ST/IT oversold at its recent low and sentiment as measured by trader type indicators, got extremely negative. Longer term, I believe there's a good chance we have seen the end of the bull run that began in 2001 and here's why...

At the very beginning of a secular bull market for any asset, conditions had been bleak for it for quite some time to the point where nobody wants to own it and the price had been taking a beating to the point where it's significantly undervalued, which of course is the best time to be buying. That's where gold was in 2000. Equities had been in a 10 year bull run, unemployment was at record lows, central banks were selling and the US dollar was king. At a major top/beggining of a bear  it's the opposite. Things look the most promising, the price had been going parabolic and by then everyone who ever wanted to buy has bought, which of course it the best time to sell/short. I believe this situation is where we stand with gold.

Gold had a 10 year run from 2001-2011 without a down year gaining about 550%  from the bottom. Constrast the conditions I mentioned above for gold which prevailed in 2000 just prior to its epic bull run to now. It's the total opposite. During the span of these last 10 years you had a significant decline in the value of the US dollar, 2 huge bear markets in equities, a once in a century meltdown of the global financial system, central banks buying, the most accommodating Fed in history, stubbornly high employment, ongoing concerns of a European collapse and I'm sure I'm missing some other major negatives that support the "gold is a safe haven" notion. Aside from a collapse in the fiat monetary system, things pretty much can't be better for gold and so I think most of the people who ever wanted to own gold owns it by now. So, if we're at that point there's only way for the price to go longer term that that's down....all it takes is the unwinding of one of the major supporting catalysts to trigger the transition.

I've been reading stories about how there have been line ups of people buying physical gold on the dip in Asia. You might think this is a bullish thing but it's not. Shorter term, yes, but not longer term because it shows the type of behavior you see in the first major decline of a bear market - denial. When you see people embrace a big decline like that it's a bad sign longer term. These dip buyers probably represent the last bastion of buyers who have always wanted to buy gold but have been waiting for a "pullback". Once these dip buyers are exhausted the downtrend will resume but in the interim, there could very well be a strong rebound. When the tech bubble burst the initial decline was about 40% but that decline was followed by a 40% rally before the real damage took place!

Switching gears now to the equity markets. We are now approaching the "Sell in May and go away" period. For the past 3 years this strategy worked out pretty well. I've been saying since early this year that we would probably not see a significant correction begin until sometime around May. I gotta tell you though, as of right now, conditions do not support anything more than just a minor dip. AAII has shown 3 consecutive weeks of bears outnumbering bulls by a significant margin, bonds have been very strong for a month and retail inflows into equities has been flat for a month as well. In fact, despite the strong market this week, there was a sizable outflow! I've never seen a major correction begin with such conditions..it instead suggests that the market will go higher still or go sideways with only modest dips.  Perhaps people have been catching on to the "Sell in May and go away" notion and if that's the case, it makes it less likely to work this year!

On the fundamental side of things, everyone's talking about the slowdown in emerging markets and it's no secret that Europe is in recession. Lot's of people are also saying that the weakness in commodities, especially copper, is ominious for the global economy/market. I say that's bullshit. I say the action in commodities is a coincident/lagging indicator.  Look at every significant top in the past few years and you will see "Dr. Copper"  gave no such warnings.  The most flagrant example was how copper and other commodities were making new highs in the first half of 2008 while equity markets were rolling over. What signal did that give? I believe commodity weakness in the face a strong equity market is bullish not bearish for lower prices are economically stimulative. We have seen strong rallies get short circuited anytime commodities run up too much like in the spring of 2010 and 2011 as it provided an economic drag.

The following charts shows the recent state of the global economy.

This doesn't look too great, but the market doesn't care about what just happened, it cares about what's going to happen. This chart shows that the global picture will be a lot brighter in the near future.

Perhaps this brighter outlook as per the leading indicator above, is why the global markets (especially in Europe) have held their own despite the economic data having been piss poor in recent months. The brighter outlook for the global economy also bodes well for commodities in general which would be a tailwind for gold.  I think commodities bottomed this week.

Bottom line: Unlike last the 3 years, conditions are not suggestive at this point that a major correction is going to begin in May. The market seems poised to either go sideways or higher at this point. If conditions change I will change with them.

Infection points

Quite an eventful week! Lot's to talk about. The SPX powered its way to a fresh all time high and is closing in on 1600 yet all I see is more whining and complaining. The latest complaint is that it's the "defensive" names that are leading the market and so the rally is false. Then of course you have the perennial "the bull market is phony because it's all due to the fed" complaint.  Back in 2009 and 2010 there was a lot of complaining about how the advance was occurring on low volume and yet another complaint was that the rally was occurring at the expense of the US dollar and so the bull market was false. Complaining, whining and staying angry at the Fed -that's all people seem to be able to do. By the way the market is up 140% from the bottom and the dollar is only down about 6% from that point and so the "rally is phony" argument is total bs.

A really bizarre thing happened this week with AAII sentiment. Despite the market making fresh all time highs, the bull/bear ratio plummeted to .35  which is the lowest level since March 2009! When I first saw this number I was shocked and I figured it had to be an error but it's not! Normally you see such extremes in bearish sentiment when the market has been getting hammered. I have never seen such a extreme bearish reading like this when the market has been so strong not to mention making all time highs. On a stand alone basis this has enormous bullish contrarian implications but you should never hang your hat on just one indicator. Other measures of sentiment aren't nearly as bullish, but there are some corroborating indicators which suggest that in the ST the market still has the fuel to power higher still. Bonds once again are indicative of this which are in the same condition as  I pointed out last week which led to a ST bottom as I expected. Fund flows into equities have been quiet the past 3 weeks which again supports the notion that shorter term, the road is cleared for the market to make a further advance. One thing's for sure....there's no way I'm going to play the short side with the above mentioned conditions for it suggests that any downside from here will be limited...for now.

Lots of buzz about gold this week and its 20% slide into "bear market territory" as the media is calling it. Readers of this blog know that I've not been a fan of gold for some time but anytime it had a setback I was quick to admit that it looked like a correction rather than the start of a bear. This time however, we could actually be looking at the start of a bear market and if it is...better hang on your hats! First of all, I don't automatically assume a 20% drop constitutes a bear market. It all depends on how that 20% drop takes place. A sudden decline of 20% of a market that had been climbing relentlessly most likely represents a steep correction in an ongoing bull market rather than the start of a new bear market. Examples of such are the 1987 crash, the 1998 correction and the correction in 2011. The 20% decline in gold did not occur this way. It  dropped to its most recent low in a multi-month downward trending fashion characterized by lower lows and lower highs - that's bear market action. It also registered a 21 month low and that's something you tend to see in the early stages of a bear market - not a bull market correction.

Let's look at the explanations for the drop in the gold price. From what I've gathered the main explanation is that  the drop is due to the restoration of confidence in the US and in the dollar which is the result of the relative strength of the US economy and its equity markets.   Last week's drop in gold was probably exacerbated by Goldman's downgrade of gold and the news that Cyprus might sell reserves, but since gold had been declining prior to this, I don't think these factors are soley responsible - they simply added fuel to the fire that was already burning. Basically, I believe that the decline in gold price could be summed as the unwinding of pessimism towards the US and the dollar.

Now having said all this, there are a number of signs that suggest the negativity towards Gold is at a ST extreme. I turned on BNN Friday and all they talked about was the decline in gold and it's not just them; there's tons of coverage out there in the financial media pointing out how gold has dropped by 20% . I read an article in the Globe and Mail  Friday titled "All shine and no substance: the reality of gold." Talk about kicking someone where they're down.  I also noticed every single "technician" out there is expecting a lot more downside this week now that  gold closed below a key support level. Volume in the GLD etf spiked to an extreme which is often indicative of capitulation. GTU is trading at a 6% discount to NAV. The last time this happened was late April-early May 2011 when gold had a sharp but short lived pullback. So, I think there's a good chance that this breakdown in the gold price last week could end up being a massive bear trap and a vicious snapback to 1550-1600 could take place. I may intend to play this I get the right set up. We could be in a situation with gold similar to that of March 2008 in the equity market when the market dropped 20% before making an IT bottom which lead to a strong rebound for 2 months. It's also possible of course that all we are seeing here with gold is a lengthy consolidation/shakeout phase which began in August 2011.If you pull up a LT chart you could make the case that, with the exception of Friday's close, the gold price has been going sideways for several months.

Gold bulls have their reasons to remain bullish the main one being that there is unprecedented "money printing" going on all over the globe via QE and it's just a matter of time before the inflationary impacts of this gets unleashed. Well, first of all, QE is not money printing per se because it doesn't permanently raise the supply of dollars for the Fed can reverse QE and therefore "destroy" the money they created at will.  Gold bugs have been warning about hyperinflation for over a decade now and it hasn't happened. We never had an inflation problem. If we did, it would be reflected in the bond markets via high interest rates and rates have been historically low even before QE. If you want to see a period of high inflation look to the 70's where interest rates were double digits and there was broad based inflation in all goods and services. Yes, we saw a dramatic rise in energy prices over the past 13 years but that was primarily the result of supply/demand dynamics of commodities namely a surge in emerging market demand - not monetary policy and the commodity price spike didn't spill over much into the general prices of goods and services. I'm sure you can find exceptions but for the most part, you can't honestly say we've had an inflation problem in North America. And if monetary policy was the main driver of commodity prices explain to me how the prices of coffee, natural gas, orange juice, olive oil and other commodities have plummeted in value over the past few years to multi-year lows. Easy money probably has an exacerbating effect on a bullish supply/demand situation for a commodity or any asset class but it's not the primary driver...at least that's my view. Anyhow, I digress

Getting back to gold. When I first turned bullish on gold in late 2000 it was because confidence in the US was just starting to roll over from an all time high and I figured that since I believed a big bear market in stocks was underway, the status of the US being the economic powerhouse of the world would fade considerably along with confidence in the US dollar as a reserve currency. Basically,  I believed that there would be a gold bull market due to a substantial rise in pessimism towards the US in general which would make people flock to gold which at the time was very under owned. Also, the avg cost of producing gold was well above the gold price at the time ($260/oz) which meant that gold strictly as a commodity was undervalued . We all know what happened afterwards (and by the way I got off the gold train waaaaaay to early).

 So, if the gold bull market was to have ended and a new secular bear has begun I ask myself do we have an inverse of the conditions that I noted back in late 2000?  The answer to that is yes!  Let's first look at factors I outlined above

1)confidence in the US/dollar.

There's no doubt in my mind that pessimism towards the US and the dollar hit extremes these past few years. There's is the notion that the US is in a state of decline equivalent to the fall of the Roman Empire. The dollar has been beyond trashed and it's status as the world's reserve currency severely weakened as central banks have looked to diversify out of dollars and into Euros and gold these past few years....the same gold by the way that they were willing to sell en masse in the 1990's for sub $400/oz. Despite all the trashing of the dollar and how the fed has been "debasing" it,  it's about the same level as it was 6 years ago (trade weighted as per ticker $USD) and has been on an uptrend for about 2 years which started right about the same time gold peaked. I doubt this is a coincidence. There have been many reasons cited as to what drives gold but it's  been my opinion that the main factor is the US dollar.  Gold as a "reserve currency" or "safe haven" has only one major competitor and that's the US dollar.

2) ownership level of gold

A secular bull market begins when an asset class is under owned like gold was in 2001. Only the hard core gold bugs held gold and/or gold stocks. I cited here a few times how in 2001 when gold started rising I specifically recalled the "pros" on CNBC dismissing the move saying gold should be traded not invested in.. That notion has been completely reversed. In recent years the pros have stated that gold is in a LT uptrend and should be a component of one's portfolio at all times to protect them from upheaval and central bank "money printing." They also said that gold will do well in inflation or deflation conditions. lol! What a crock of shit that statement is. Investment demand in gold surged over the past 10 years especially since 2008 and so it's definitely not under owned anymore. I don't think it's as over owned like tech stocks were in 2000 but I think there's enough people "in the pool" to fuel a big bear market should they start unloading gold.

3) avg cost of production

This one is a bit tough to ascertain  From what I can gather the avg cash cost of gold production is about $950/oz give or take but the "all in cost" could be average about $1250.  That suggests that the gold price isn't over inflated on a commodity level. This suggests we shouldn't see a complete collapse in the gold price should there be a gold bear market but if things get bad for gold a fall to $800-$1000 is quite doable as bear markets often send a commodity below the cost of production...sometimes well below it. Just look at what happened to nat gas.

WTF? For some reason blogger didn't save what I had written after the above paragraph. Well, it's too late to rewrite it now...I'm off to bed!

Weekend Ramblings

I don't want to get caught up in the ST market action too much  but I can't resist making some comments about what transpired this past week. Given the run we've had in the market since November, the bears had every reason to really hammer the market on this  very weak jobs number and all they did was land a jab. There's a pretty good chance Friday marked a ST bottom if you look  at not only how the market clawed back more than half the losses but also if you look at the big spike in bond prices. Pull up a chart of TLT and you will see that ST stock market tops and bottoms (especially the latter) are marked by steep ST drops and spikes in TLT respectively. Friday's spike in TLT was huge and so that suggests either a ST bottom in the market was made Friday or we're very close to one.

Bigger picture wise, making a judgement about the state of the economy based upon a few data points that came in "weaker than expected" is not smart. There are however some things that support the bear case.  There will be a fiscal drag in the coming months as government spending is set to reign in due to "sequestration" which began in March. Perhaps this uncertainty is largely responsible for the weak jobs number in March...could be a just a coincidence though. $85 Billion in government spending will be cut this year alone. That represents about .5% of GDP....not huge but it's notable.  Then there are the tax hikes that took into effect early in the year which I've read could knock off another 1% this year. That's a 1.5% fiscal drag this year which in this slow growth economy is quite large. Bernanke expressed his concerns about the state of fiscal policy in US. Offsetting this fiscal drag is the tail wind of the housing sector in the US whereas unlike in previous years, housing looks poised to contribute to economic growth rather than subtract from it. I've read it could boost GDP 2% and so that makes it a wash when combined with the fiscal drag. There's always the possibility that some sort of deal takes place which improves the fiscal situation in the US but on the flip side, there's also the possibility that the US housing recovery stalls...lot's of unknowns but I don't see the threats as significant longer term at this point.

On the monetary policy side of this things, there is massive accommodation across the globe. Japan has  taken a page out of Bernanke's playbook and announced a very aggressive $1.5 Trillion  monetary stimulus measure by vowing to double its monetary base in 2 years i.e. a major QE operation. Like what Dragghi said last year, Kudora vows to do whatever it takes, and in this case, it's to break the back of deflation which has plagued Japan since the early 90s.  I'm sure this is going to bring about moans and groans from the permabear "intellectuals" who will claim you can't print your way to prosperity, it's a moral hazzard, blah, blah, blah but the fact of the matter is you now have the heads of the 3 major central banks of the world with the petal to the metal with most other central banks also in accommodative mode (but not as extreme). Bear markets simply don't begin with such conditions....they always began when monetary conditions were restrictive.

I've also been pointing out for sometime now that despite the markets having rallied strongly for 4 years, there's still plenty of skeptics without any of giddyness/greed you typically see at a bull market peak. Mind you, I could have (and did) say the same thing in 2011 before the market had a 20% correction...but I'm talking about long term here. John Templeton once said bull markets are born in pessimism, rise on skepticism, mature on optimism and die on euphoria. I think we're late in the skepticism stage with "green shoots" of  optimism. I came across this great chart which actually illustrates the validity of Templeton's market cycle and where we stand now. It uses over 40 inputs to derive a measure of investor "risk appetite".  There's 5 levels of risk appetite in this chart which fit well with Templeton's cycle . 1) Averse (pessimism). 2) Reluctant (skepticism) 3) Neutral (late skepticism/early optimism). 4) Seeking (optimism). 5) Loving (euphoria).

Right now risk appetite is only at neutral unlike the last 2 times the SPX hit 1550 at the bull market peaks of 2000 and 2007 when investors were risk loving. Another major difference between the market now vs 2000 and 2007 is that monetary policy is extremely accommodative whereas it was restrictive in the other 2 periods (rising interest rate environment leading to an inverted yield curve). I've said it before a few times, bull markets die when there is the lethal combination of greed and tight money. We are nowhere close to that right now. Does that mean we can't get nasty corrections some of which can be prolonged and last several months? No! What it does mean is that the correct posture is to be a LT optimist on the markets and position yourself accordingly i.e. looking for long side opportunities and avoiding the short side (aside for hedging).

Riding this bull market has NOT been easy. We've seen some crazy volatility at times including a nasty 15% and 20% correction in 2010 and 2011 respectively and I have had my doubts a few times but in the back of mind no matter how bleak things looked I always knew that prior to these corrections we did not see the classic conditions for a new bear market and so I never gave up on the bull thesis. We could very well see a situation this year again where serious doubts about the bull market come into question due a nasty correction. I personally however, am not going to hedge for a correction unless I'm quite certain one is imminent  Given my LT bullish outlook, I'd prefer to error on the side of being too bullish than too bearish.  Right now I don't see enough evidence  that a big correction is immanent especially since bonds have spiked so much. I have about 20% in cash and so for now that's my defensive position.

There's a few major opportunities I see out there and I'll about them next post.