Good Times Ahead for Gold..AGAIN!

One of my favorite form of technical analysis: intermarket analysis. Intermarket analysis takes traditional technical analysis much further. Normally, I would look at a market by itself. I'll look at its price action, its potential patterns, and its momentum. Intermarket analysis takes this a step beyond by comparing the market at hand to various other markets. It gives us an idea of what is really going on and where market leadership is.

In regards to gold, intermarket analysis is even more important. Gold is the type of market or asset that thrives when other asset classes are not performing well. Rarely does gold perform well if there is persistent strength in another asset class such as stocks or bonds. We are in a gold bull market, so gold will outperform other asset classes over time. However, it is an important exercise in trying to gauge the near-term outlook for the yellow metal.

Above, I graphed gold against the various asset classes: commodities, bonds and stocks. And also graphed gold against currencies, as it is the currency of last resort.

We can see that gold has already broken out against both corporate and Treasury bonds. The breakout against corporates is very significant as it comes after a two-year base. Meanwhile, gold has just broken out against currencies (ex: US dollar) and a breakout against stocks appears imminent. Commodities are the only group holding up against gold.

The conclusion: In the near future, money will move out of Treasuries, corporates, currencies, and stocks and go into gold and likely commodities. The last time gold looked this strong in relative terms was in the third quarter of 2009 when it began a move to $1,220/oz. With this type of relative strength, it is very likely that gold makes another big move into 2011.

Europe Driving Interest US Rates Higher?

Interest rates, across the board, have actually been spiking since the announcement of the QE2 program on November 3. Not to anyone surprise, the Fed was more or less powerless to lower rates from prevailing levels. I argued that QE2 was really not designed to drive rates down from prevailing levels but merely to “accommodate” the fiscal deficit and prevent a rise in rates that would otherwise occur due to crowding out and other effects.

The bottom line was that the real risk was that interest rates throughout the US economy would rise after the announcement of QE2. Indeed, I believe that the US is currently in a situation anticipated in QE2 May Not Prevent a Rout in US Bond Markets, in which I asked: “How much panic would it create if quantitative easing (QE2) is announced, the Fed starts purchasing Treasuries, and bond yields actually start to rise?”

10-Year US Treasury yields (TNX) have risen almost 60 basis points since the announcement of QE2, municipal bond yields have spiked, corporate bond yields have risen, and mortgage rates have spiked. Indeed, overall, interest rates across the board are actually higher than they were before financial markets began to discount the prospect of QE2.

Having said that, it's important to note that although rates have risen, they are still well below levels that could jeopardize the economic recovery. The question is what happens next.

In the short term, a few issues need to be monitored. For starters, investors should be aware of the fact that the crisis in Europe is actually “bailing out” the US in some sense. In the global competition for capital, troubles in Europe make the US seem like a relative safe haven thereby facilitating the financing of the US fiscal deficit. Furthermore, troubles in Europe will tend to depress global growth expectations and ease fears of commodity-driven inflation. Thus, the situation in Europe will be a key driver in US interest rate dynamics.

Second, any whiff of accelerating inflation in the US could have a dramatic impact on the bond markets. Again, developments in global commodities markets are key in this regard.

Finally, at some point, investor scrutiny is going to be turned toward congressional and presidential action with respect to the US fiscal deficit and sovereign debt fundamentals. Today’s news of the failure of the presidential deficit commission to garner the necessary votes to issue an official recommendation is a worrisome development in this regard.

Conclusion

US interest rates are supposed to be falling, not rising. At least that's what we were led to believe a few months ago when market consensus was excited about QE2 and the Fed’s power to stimulate the economy.

It's now becoming clear what I had been emphasizing prior to the implementation of QE2: The Fed is not really in control of US interest rates.

This sense that the Fed has lost control of interest rate dynamics could add an important element of uncertainty into financial markets in the coming months.

This is particularly important in a context in which investors generally are over-exposed to bonds.

A long bear market in US bonds has probably already begun. Bad news out of Europe is probably the only factor that will be able to sporadically arrest the upward assent of US interest rates in the coming weeks and months.

I believe that US bond rallies due to instability in Europe should be utilized to initiate short positions in various categories of US bonds.

PIIGS Crisis Is Benefiting Japan.

Marc Faber's "bowl of liquidity" analogy, showed us how as a result of the European sovereign debt crisis, money could flow out of PIIGS debt and into equities. I wanted to provide a little more color given the events of the past couple weeks as the crisis has moved from Ireland and Portugal to Spain and Italy.

In the chart above, tells a different story. Here, the Euro Stoxx chart is in orange, the S&P 500 is in white, and the Nikkei is in green. And we see that since the Spain/Germany spread bottomed on October 26, the Euro Stoxx is down 6.5%, the S&P 500 is up 0.2%, and the Nikkei is up a whopping 8.0%! Whoa, what's going on?

What I believe to be happening is that with the current crisis being one more of solvency than liquidity (though Spain may have something to say about that), instead of markets being simply "risk on" or "risk off," idiosyncratic factors are coming into play as global asset allocators evaluate their options. Due to the PIIGS crisis, borrowing costs are rising for the European sovereign market -- yesterday was scary because not only did Spanish 10-year yields rise 25bps, but German 10-year yields also rose -- which feeds back into the private market for European borrowers in the form of more expensive credit. Austerity measures impact growth prospects. And allocators, aware of this, are moving money out of Europe -- not just sovereign debt but equities as well. European-focused funds may be experiencing redemptions, and oftentimes portfolio managers are forced to sell their most valuable assets that still have liquidity (equities) instead of the distressed ones they'd like to unload (sovereign debt). And this money is finding its way not just into real safe havens like US, German, and Japanese debt, but the US and Japanese equity markets as well. After being neglected for so long by investors, the smallest trickle of inflows into the Japanese equity market could create a surge along the likes of the commodities market in the earlier part of the last decade.

This is not to say that it's time to load the boat with Japanese and US equities. The crisis has still not passed. If Spain or Italy seizes up it could do untold damage to all asset markets with the liquidity crisis returning for awhile. But I believe that correlations are breaking down as the crisis shifts from one of liquidity to one of solvency, and when solvency crises intermittently create liquidity crises it's time for investors to think about what to own while assets with true value are being treated no differently than ones that truly might go to zero.

The Fed Could Be Wrong This Time.

Every precious metals investor should be concerned about China, one of the world's fastest growing economies, raising its rates and rising yields. Changes in the rates affect stock prices. China is leading the world and we can see the fears are profound as sell-offs this week were much stronger than any of the relief rallies. If China’s market corrects then the commodity market, which was fueling the equity market, could experience a severe correction. It's a domino effect.

Despite the Fed’s enthusiastic plan to monetize debt and artificially keep interest rates low through bond purchases, yields have risen aggressively for the last 13 weeks. The QE2 program was designed to lower interest rates to improve borrowing and liquidity. Instead the opposite occurred, QE2 is initiating higher borrowing costs. I don’t believe it is coincidence that Ireland’s debt problems surfaced following QE2. China is now on the verge of raising rates to combat imported cheap dollars to bid up Chinese assets, which is putting pressure on markets globally. Rising rates kills equity and commodity markets, which are heavily built on margin borrowing.

The Long Term Treasury ETF (TLT) (above)broke through the trend it had from May until the end of August. This previous trend was largely a result of a deflationary crisis where investors ran from risky assets like the euro to the dollar, and long-term Treasuries were pushing yields to ridiculously low levels. As fear in the markets decreased, due to a temporary stabilization in Europe and the US, investors ran to equities and commodities.

International reaction to QE2 has not been positive. There is an increased risk of emerging markets combating inflation, which may slow down the global recovery. Fears of China and emerging markets raising rates make investors unsure where to turn.

Asset classes have reacted negatively to China’s expected move. Distribution is apparent through many sectors and many international markets. Rising interest rates have a direct influence on corporate profits and prices of commodities and equities.

When studying interest rates it's not the level that is important, it's the rate of change. Interest rates have had a dramatic increase these past two months and we may see that affecting the fundamentals in the economy shortly.

The recent downgrade on US debt from China, signals demand for US debt has been waning. This rise in interest rates puts further pressure on the recovery as the cost of borrowing increases. Economic conditions are worsening in Europe and emerging markets in reaction to quantitative easing and imported inflation. Concerns of sovereign debt issues are weighing in Europe. As yields rise so do defaults and margin calls.

If the 200-day is unable to hold the bond decline and continue to collapse, then rising interest rates could negatively affect the economic recovery. Borrowing costs to insure government debt are reaching record levels internationally. Ireland is expected to take a bailout. Greece, Spain, and Portugal are in danger as well.

Commodities have significantly moved higher along with the equity market for September and October as investors left Treasuries to return to risky assets due to the fear of debt monetization through QE2. Global equity markets have been rising. But the question is, how long? This makes investors reluctant to take on debt, which is the exact opposite of what the Fed’s goals were. Rising yields could lead to a liquidity trap and deflationary pressures.

Bubbles, Signs.. And All Things Nice!

What other bubbles are lurking out there in the global economy?

1. Gold: The price of gold bullion has risen from $294 an ounce in 1998 to $1,404 last week, an increase of 377%. "It's the biggest, baddest bubble of them all," says Robert Wiedemer, author of Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown. Gold has no intrinsic value. A telltale indicator that gold is a bubble: incessant cocktail party chatter about buying gold and endless investment banks offering to sell gold derivatives. The SPDR Gold Trust ETF (look to your left) is up 28% since the beginning of the year.

2. Real estate in China: Chinese real estate prices are up only 9.1% this year, which may seem more frothy than bubbly. But rising prices are generating rising demand, which is a clear sign of a bubble, says Vikram Mansharamani, whose book, Boombustology: Spotting Financial Bubbles Before They Burst, will be published early next year. The participation of amateur investors like waiters and maids in the property boom is a clear sign of a property bubble in China. The fact that developers are building more apartments than there are buyers is another giveaway.

3. Alternative energy: Solar technology is still uneconomic, yet governments all over the world are subsidizing solar energy firms. "There are plenty of people who shouldn't be in the solar energy industry who are," says Mansharamani. Do we really need 250 venture-capital-backed solar cell companies? The Market Sectors Solar Energy ETF had a 100% gain this year, before dropping back.

4. Commodities: Blame it on the weather, China or the dollar or the Fed, but commodities have shot higher in recent months. Wheat is up 60% this year, and other food commodities like corn have also risen dramatically. "The focus is on the food category for bubbles," says Wiedemer, but industrial metals like copper are also very frothy.

5. Emerging market stocks: As an asset class, these shares have risen 146% in the past two years. "We're only halfway along the way to a gigantic eventual bubble in the emerging markets," says Barton Biggs, the former Morgan Stanley Asset Management chairman who accurately predicted the US stock market bubble in the late 1990s. These countries, such as Indonesia, Australia, Russia and Brazil, are growing wildly even though there's no growth in the world economy. Much of their gains is backed by commodity prices, which are also a bubble (see item No. 4). "I have every reason to believe this will turn into a bubble," says Mansharamani.

6. The US dollar: Although the dollar is down 10% against the euro so far this year, Wiedemer believes the greenback is firmly in bubble territory. He believes it will pop when foreigners stop buying US assets such as stocks and bonds. "Foreigners say, 'I'm worried about inflation -- you're going to pay me back in dollars worth less than when I invested'." While China may hold its dollar bonds forever, he says, pension funds in Japan and insurance companies in Europe will start dumping dollars as US inflation climbs.

7. US government debt: "When this bubble pops you're out of bubbles -- nothing is too big to fail any more," says Wiedemer. The debt bubble is growing very rapidly and will continue to grow, he says. Basically, there's no way the US government can ever pay back the $13.7 trillion it currently owes (mainly to foreigners), and eventually they will stop buying. The bubble pops when the government has trouble selling its debt -- just like Ireland and Greece are experiencing at the moment. Instead of borrowing money, the government starts printing money, which is what's happening now. The Fed's balance sheet has gone from $800 billion in 2008 to $2.2 trillion, and the central bank just announced it was printing another $600 billion. Says Wiedemer: "The medicine starts to become poison." - All these, just when bewildered, lost uncles and aunties are learning from your local research houses' market outlook roadshows about what's QE2!

USD, The Confetti In Wallets After QE 2.

Forget about fundamentals or technicals: just follow the bouncing buck.

Strategists emphasize that a new theme has emerged in the investment markets, which is that the risk-on/risk-off trade is taking its cue increasingly from the US dollar. The correlations, market pros say, are high, intensifying, and actually now unprecedented.

For example, according to Gluskin Sheff’s David Rosenberg, over the past two months, 90% of the time that the dollar moved in one direction, the S&P 500 moved in the other. The inverse correlation, over the same time period between the dollar and emerging market equities, was 92%; it’s now running at 95% for the CRB index.

Interesting positive correlations are also now firming dramatically. For instance, over the past two months, the dollar and corporate spreads moved in the same direction 80% of the time. The dollar and the VIX, which tracks expected volatility in the stock market, moved in the same direction 80% of the time.

In other words, ignore the politics, economic data and technical levels. Maybe right now all money-making traders and investors need to do is follow the dollar. It’s a simple tune whistling through the canyons of lower Manhattan: dollar down, everything else up.

“Hard to believe it’s that easy, but this seems to be the environment that Ben Bernanke have managed to create in their quest to reflate the global economy,” Rosenberg says.

Historically, say strategists, these correlations weren’t this pronounced, but that changed when the Federal Reserve began buying Treasury securities. Last week, the Fed announced that it will print another $600 billion to buy Treasuries through mid-2011. That’s in addition to the roughly $2 trillion it printed to buy Treasuries and mortgage debt during the financial crisis.

The point of the program is to keep long term interest rates low, encouraging borrowing and spending by consumers and companies. The idea, if Bernanke and his FOMC allies are right, is that yields will tumble and people will start buying homes again. Expecting greater inflation ahead, they’ll also buy more stuff at the mall. In turn, companies can start hiring and unemployment will fall.

Of course, investors also know that vastly increasing the supply of dollars means each dollar is worth less when measured against other things. So they’re concerned about the real worth of all that confetti in their wallets, and they’re looking to protect themselves by diversifying into other assets.

Since August 27, when Bernanke suggested that another round of monetary stimulus was on the way, the dollar index (DXY), a measure of the dollar against a basket of currencies, is down 8.4% Gold was up 12.5%.

“This is part of the same trade we’ve seen since March 18, 2009 when Bernanke said he was going to start buying Treasuries,” says Miller Tabak’s Peter Boockvar, as investors look to protect themselves from a lower dollar by loading up on the stocks of big exporters, emerging market equities, hard assets, and foreign currencies. “Maybe now it’s just intensified,” he says.

Critically, says S&P’s Alec Young, the point isn’t just that the Fed is printing another $600 billion, but that central bankers also left the door open to keep printing more money if necessary.

“That was a green light for the risk trade,” he says. “It means an open-ended amount of dollar printing. So the dollar is tanking and commodities, gold, bonds and stocks go up. It reinforces all those trades.”

At some point a few months from now, Young says, investors will want to see real evidence that all this monetary experimentation worked. If they don’t see the economic benefits then they could sell stocks and commodities in anticipation of another leg down. But, for now, he argues, it’s unwise to violate the first rule of Investing 101: Don’t fight the Fed.

“There could be a correction next year when people are disappointed at what this actually accomplished,” Young says. “But that’s the next trade. Right now, the Fed gets the benefit of the doubt. You could be right and all this won’t do any economic good but, in the meantime, you could also miss out on the rally.”

But, if the risk-on/risk-off trade is taking its cue increasingly from the U.S. dollar, when might that relationship fade?

That happens, says Young, when we generate a stable, self-sustaining recovery. “It breaks when the U.S. economy finally gets on its feet and doesn’t need the Fed to keep printing a ton of money,” he says. “If QE2 works then that marks some kind of bottom for the dollar.”

The Dollar Correlation Myth.

Last Friday, is year-end for many funds. Monday they can "legally" sell.

Monday also begins the first week of November when the three-week bias we mentioned at the beginning of the month culminates. While the market has held up into month-end, fiscal-year end, it hasn't blown off. It’s been choppy and mixed with earnings providing more than the usual Gapism.

Once again, Friday’s early strength was faded but longs came in with a late-day buy program to rescue the session as the S&P was magnetized to the pivotal point of 1184 on the close. Remember 1184 is opposite the time of the late August low and squares the important January high to open the year as it's 90 degrees from that price high of 1150. It's also roughly 90 degrees from the 1220 April high, which is by definition then opposite the end of October.

These squares may be playing out in a six-month top-to-top cycle.

In addition, 1184 is opposite 1115, which is the midpoint of this year’s range.

The March ’09 S&P low at 666 was a 75-point "undercut" of the November 21 low of 741. A 75-point "overthrow" of the midpoint or balance point of the year is 1190. The S&P has been oscillating around 1180 to 1190 all week.

Previous Friday’s close was 1183. Last Friday’s close was 1184.

If gold itself doesn’t start back up strongly by Monday, it suggests it will pullback for another three weeks or so possibly testing the 1230ish level.

The dollar seems to dictate the direction of everything lately. But is this inverse correlation to a declining dollar and rising equity prices overcrowded? Is the notion even true? Does the notion of the dollar devaluation/asset inflation trade always hold true to form?

Let’s look at a weekly chart (above) of the dollar from 2008 versus a weekly chart of the S&P from 2008.

The dollar declined into March/April 2008 in concert with stocks (A).

Notable is the marginal overthrow by the dollar in the first week in March 2009 that marked the precise low tick in stocks. The high tick in the dollar corresponded to the low tick in the S&P (D).

The November 2009 low in the dollar preceded the January high in stocks (E).

Note that the April high in stocks (F) didn't coincide with a top in the dollar. The dollar continued higher to challenge the 2008/2009 highs. The dollar/stocks correlation broke down April to June as the euro got smashed. There were other concerns. "Other" concerns could cause an unwinding again. It is interesting that the decoupling in question this past spring covered the period when the flash crash occurred. Happenstance?

From point E to point F the stocks and dollar advance is positively correlated. Both rose in unison. However, the dollar accelerated strongly in April as stocks topped and declined. Both the dollar and stocks topped in unison (G) in April and declined into the summer.

From the summer into October this year the dollar turned down again while stocks turned decidedly higher: The inverse correlation resumed.

While the market has essentially advanced from March 2009, the dollar has made two round trips.

The tip-off that March 2009 was a low in stocks was the marginal overthrow by the dollar that month over the prior swing high at 88.46 and the outside down week in March 2009.

If there's anything I've learned in my trading career it's that correlations come and correlations go and when they become too popular, they can get unwound violently.

It may be that the inverse correlation resumes here with the dollar staging a rally and stocks going lower, but they could just as easily go their separate ways.

With the election, FOMC, and G-20 in November where leaders will tackle the race to debase their respective currencies, volatility could explode.

Moreover, it's the two-year anniversary of the November 2008 crash low. We got a spring 2009 undercut of the November 2008 spike low. Is it possible we're getting a November spike high to a spring pivot in 2010.

Checking the weekly chart of the S&P and drawing a live angle up from the "true" low of November 2008 and tagging the important July 2009 low shows what may be a bearish backtest. In other words, following the break of this live angle in the summer, the S&P has snapped back to kiss the underbelly of this angle. However, the first "kiss" was rejected in early August while the jury is still out on the second "kiss." Will the second "kiss" get the cheese or the prize?

This may be at the mother of all inflection points. Either the market could extend from here substantially in time and price or it's headed meaningfully lower. And by substantially higher, as you know, I'm not referring to the possibility of a tag and inverse head-and-shoulders projection to 1250 S&P being satisfied going into January. This could play out and still be an overthrow of this live angle. Substantial, in this case, refers to a revisit of the prior all-time highs. This period here in November and then again in January will give us indications as to which way the pendulum will swing.