Going the distance on gold

PORTFOLIO POINT: As markets hope for QE3, there's value to be had in gold stocks based on recent price action.

I don’t know about you, but the last week has felt pretty scary to me. The technical destruction of so many indices is quite remarkable and despite markets being deeply oversold, they refuse to rally in any meaningful way. That’s what I call dangerous.

However, investor sentiment actually improved this week, as measured by the American Association of Individual Investors Bull/Bear Index. Last Friday, the index was sitting at -22.39; it improved to -8.2 this week. While the Bull/Bear Index is still in negative territory, the market feels complacent to me.

The chart below represents the number of 52-week highs minus the number of 52-week lows on the NYSE. The red horizontal line is the zero point; obviously it’s better for the market when this index is in positive territory. It has now gone into the negative, indicating that there are more stocks making 52-week lows than are making 52-week highs.

But at this stage, there has been no real panic like we saw in August and October of 2011, when negative readings turned extreme (perhaps that lies ahead).

While there was some glimmer of hope last night, with US futures staging a final 30-minute burst to finish on their highs, the macro picture continues to deteriorate. Last night, French and German PMI manufacturing data came out and both sets disappointed, printing 44.4 and 45 respectively.

The German IFO Business Climate Index also was released. This index is based on “7000 monthly survey responses of firms in manufacturing, construction, wholesaling and retailing. The firms are asked to give their assessments of the current business situation and their expectations for the next six months”.

All three IFO indices – business climate, current assessment and expectations – came in worse than consensus. Below is the Citi Surprise Index for the eurozone; it is now deep in negative territory. This is telling us that economic releases in the future are going to disappoint the market’s expectation.

With data deteriorating at such a rapid rate, you now have European leaders screaming for the ECB to intervene and Fed officials hinting at QE. This is one reason why risk markets have managed to stabilise at current levels.

However, markets are impatient and the data will continue to disappoint. It appears that the fundamentals and the technical picture have become unhinged incredibly quickly. The only thing that markets will respond to is central bank intervention and they are begging for it.

The question is, when do they get it? It’s an election year in the States and Bernanke will have to tread carefully. QE3 will be a highly politicised affair. He will have to grease some palms well before he pulls the trigger. But if I was to hazard a guess, my QE3 target would be 1175 to 1225 on the S&P500, which is where we are heading.

Bernanke, being the astute observer of the stockmarket that he is (I think he watches it more closely than I do), will be very keen to stop the S&P500 breaking below last year’s lows. The 1200 level is key and Bernanke knows it.

Interestingly, many people forget that the NYSE Gold BUGS Index bottomed out in October of 2008 and the S&P500 fell another 30% from October 2008 to bottom out five months later, in March 2009. In other words, gold stocks sensed the liquidity lead rally in risk markets early.

The Gold BUGS Index “is a modified equal-dollar weighted index of companies involved in major gold mining. The index was designed to give investors significant exposure to near term movements in gold prices by including companies that do not hedge their gold production beyond 1½½ years”.

Below is the daily chart of the Gold BUGS Index, which has broken up through a downward sloping trendline.

The next chart is the weekly chart of the Gold BUGS Index going back to 2008. From its intraday high in 2011 to its recent low, the Gold BUGS Index has fallen 41.5%. It has, however, managed to hold above its 2010 low and if it could regain its 200 weekly moving average, the technical picture would be a lot more constructive.

Down under, the price of gold in Australian dollar terms has only dropped 13% from its all-time high, yet our gold index has also dropped 42% from last year’s record high to recent lows. For longer term investors, it certainly feels like there is some value to be had (for more about gold stocks, see Tim Treadgold's article on low-cost producers).

It’s always hard to work out what someone is thinking, but the price action of gold stocks might be the best way inside Ben Bernanke’s head. I dipped my toe into gold stocks for the third time in two months yesterday; once again stops are needed, as nothing in this market is guaranteed apart from volatility.

Investors need to remain defensive and traders should be looking to sell this rally in risk.

Tom Lovell is an independent strategist, trader and adviser with boutique advisory firm Pulse Markets and is the author of Lovellslandscape. His note is prepared for general information only. It does not have regard to a reader’s specific investment objectives, financial situation and/or his/her particular needs regarding the appropriateness of investing in any securities or investment strategies discussed or recommended herein. Readers should understand that statements regarding future returns may not be realised. So please do not act on any recommendations in this report without seeking independent advice.