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As Good as Gold?

(August 21, 2011)

Dear Subscribers and Readers,

Our concept of “reality” isn't what it truly is, although I personally believe that “perception affects/is reality” and that it doesn't matter much on a day-to-day basis.  That said, for the spiritually included who are interested in highly esoteric matters, last week's “video of the week” describing “The Holographic Principle”  is a must-see.  Famed physicists/string theorists Peter Galison, Brian Greene, and Cumrun Vafa postulate how our 3-D concept of reality may be just a “holographic projection” from a 2-D “cosmic horizon” through an analogy of how information of an object is imprinted on the (2-D) “event horizon” when it falls into a black hole (where it subsequently gets “destroyed”).  That is, the information gets “imprinted” on the event horizon when an object falls into the black hole, since information cannot be destroyed (note that the event horizon is effectively “the point of no return”—and is the point where the laws of general relativity and quantum mechanics do not reconcile).  It is only a postulate—although it has been proven a black hole's event horizon gets larger when an object falls into it.  For more details on “The Holographic Principle” and String Theory (which requires spacetime to have 11 dimensions), I highly recommend Brian Greene's latest (non-technical) work “The Hidden Reality: Parallel Universes and the Deep Laws of the Cosmos.”  For those with no exposure to theoretical physics (or ironically, various spiritual texts), this will revolutionize your ideas of how the universe really works.

Let us now begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

Despite the mass liquidation of global equities over the last four weeks (MSCI World Index down -16.1%; the DJIA -14.7%; and the DJTA -22.2%), investors' sentiment remains overly bullish.  For example, the 10-day MA of the equity put/call ratio stands at 0.85—an oversold level but still not close to the >0.90 levels during late 2008/early 2009, or for that matter, during the recent mid-June correction.  Similarly, the Ticker Sense Blogger Sentiment Poll (released last Monday) is only 31.03% bearish, although this could change when the latest poll is released tomorrow.  The NAAIM Sentiment Poll is pretty oversold at 28.78% net long, but this reading actually bounced from 21.40% net long from the week prior.  Based on these (and other sentiment indicators that we cover below), there is no reason to believe the mass flight from global equities is done.  That said, the markets are very oversold based on our short-term technical indicators.  We thus may initiate a 50% long position in our DJIA Timing System should the market decline this week—if only for a trade.  We will email you a real-time “Special Alert” should we initiate a 50% long position.  Subscribers please stay tuned.

In our November 2, 2008 commentary (“A Golden Opportunity?”), we asserted that due to the various global liquidity injections and fiscal stimulus packages, gold prices did not have much to fall.  At the time, gold traded at around $725 an ounce.  That was a lucky call—as that represented a major bottom for gold—gold would effectively rally non-stop by nearly 160% over the next 34 months.  That said, we were actually not that interested in the precious metal, but in the GDX (the Market Vectors Gold Miners).  Quoting our November 2, 2008 commentary:

Note that this author isn't going to buy any gold here, as gold prices had not been hit as much as other asset classes in the recent global liquidation/panic.  The “golden opportunity” that I want to discuss is the gold miners – or more specifically, the GDX ETF.  Given the recent decline in fuel prices and the strength in the U.S. Dollar (note that much of the gold miners' production are overseas), the cash cost of mining gold should decline across the board in the fourth quarter (this decline should more than offset the weakness in the prices of the “bi-products” that come with mining gold such as copper and nickel).  In reality, the prices of gold miners (as exemplified by the GDX) has plunged, as hedge funds and retail investors alike liquidated equities in the materials and mining sector over the last four months, despite the fact we never saw a corresponding decline in gold prices.  This intense liquidation has resulted in the GDX/Gold price ratio declining to its lowest level since late 2000…

As an aside, this author went heavily long gold mining stocks (both the majors and the juniors) in late 2000, when both the XAU and the HUI declined to an all-time low level of 40.  To this day, I still remember reading the many messages that the die-hard goldbugs posted on the Yahoo! Message boards.  One author that I distinctly remember stated that he had sold all his gold mining shares after a decade-long holding period, and that it represented “the total capitulation of a goldbug.”  As it turned out, many of the gold mining shares that I had bought in late 2000 came from folks who had held to their shares for 10, if not 20 years.  While we will never get such a buying opportunity again, my sense is that the latest sell-off will provide a decent opportunity for those who want to go long the GDX.

In retrospect, going long the GDX (which closed at 20.95 on October 31, 2008) was more profitable than going long spot gold, as the GDX has since appreciated to 61.26 (excluding a current dividend yield of 0.70%)—for an appreciation of 192%.  That said, as shown in the below chart (courtesy of, the relative price of GDX to the price of spot gold has again declined to its lowest level since late 2008.

While the price of gold has continued to soar, the price of GDX has remained stagnant since late last year, as the global equity liquidation overwhelmed valuations.  Note that the price of gold production has also declined in recent weeks, given the decline in input prices, such as crude oil.  With the price of gold now severely overbought, however, potential buyers of GDX may want to be careful.  That said, I don't see any end to the “blowoff” in the price of gold just yet.

As a slight aside, I believe the price of gold will at least rally to the point where the Dow-to-Gold Ratio hits 5.0.  The 5.0 level is situated at the lower rising purple line in the chart below (courtesy of Fred's Intelligence Bear website). My best guess is that the Dow-to-Gold ratio will hit the 4.5 to 5.0 range over the next couple of months—leading to a corresponding gold price of $1,950 to $2,275 and a DJIA level of 9,750 to 10,250.  Note that this “prediction” is highly variable given the potential policy interventions by the Federal Reserve (note Bernanke's speech at the Jackson Hole meeting later this week), European Central Bank secondary purchases of Italian and Spanish sovereign debt, and potential currency interventions by the Bank of Japan.

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from January 2008 to the present:

For the week ending August 19, 2011, the Dow Industrials declined 451.37 points, while the Dow Transports declined 400.98 points.  Over the last four weeks, the Dow Industrials and the Dow Transports have declined by 14.7% and 22.2%, respectively.  Since hitting an all-time high in early July, the Dow Transports has declined a whopping 24.9%.  While both Dow indices are now immensely oversold in the short-run (suggesting a technical bounce going into Labor Day weekend), our longer-term technical indicators are still not very oversold.  Although the market's valuation is very attractive, the combination of our weak liquidity, the festering European sovereign debt crisis, and the stubbornly optimistic investors' sentiment suggests the market action is likely to remain tough this summer. We remain neutral in our DJIA Timing System; although we will likely initiate a 50% long position should the market decline again this week.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The four-week moving average of these sentiment indicators decreased from a reading of 8.4% to 5.1% for the week ending August 19, 2011.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 2001 to the present:

While this sentiment indicator is getting a little oversold, it is still not as oversold as it was on July 1st.  After peaking at 30.8% (its highest reading since late February 2007) in late January, the four-week MA declined to 3.5% on July 1st—near its most oversold level since mid-September last year. Since then, it has bounced to as high as 17.3%, and is now at 5.1%.  Despite this dip, the four-week MA is still overly optimistic given the global economic slowdown and the market action over the last four weeks.  Given this overly bullish sentiment, we will retain our neutral position in our DJIA Timing System, although we may initiate a 50% long position in our DJIA Timing System should the market decline again this week.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

The 20 DMA declined from 109.3 to 96.8 last week—declining below the recent low of 97.6 five weeks ago—and is now at its most oversold level since early July 2010.  Meanwhile, the 50 DMA declined to a new low five weeks ago, has bounced slightly, and is still near its most oversold level since early August 2010.  Both the 20 DMA and 50 DMA remain highly oversold.  While this indicator's oversold conditions suggest the market should rally (we expect a technical bounce going into Labor Day weekend), the fact that our other sentiment indicators is not as oversold is troubling—and suggests caution is warranted, especially given the weak liquidity and technical conditions.  However, if the market declines again this week, we will likely initiate a 50% long position in our DJIA Timing System.

Conclusion: The price of gold miners (GDX) has been stagnant since late last year as the global equity liquidation overwhelmed the attractiveness of higher gold prices.  The GDX/gold ratio is now at its lowest level since late 2008.  As such, the GDX may be a good relative buy, especially since input prices (e.g. oil prices) have declined with everything else.  In the meantime, investor's sentiment remains overly bullish—while our longer-term technical indicators have only recently gotten oversold—suggesting the U.S. stock market hasn't made a sustainable bottom, and will likely consolidate further this summer. However, should the market decline again this week, we will likely initiate a 50% long position.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA


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