Open-Ended Rally In Gold, Silver & Stocks?

There was plenty of hoopla last week. The Federal Reserve's announcement Thursday of a third round of quantitative easing sent investors scrambling for gold and silver. The Fed injected a liquidity fix by announcing the purchase of an additional $40 billion per month in mortgage-backed securities, increasing its holdings of longer-term securities by about $85 million each month through the end of the year, as well as keeping interest rates "exceptionally low" until 2015. In a race to debase the Bank of Japan joined the party this week announcing an asset buying program intended to stimulate spending. This month, European Central Bank President Mario Draghi gave details on a plan to buy debt of member states, while China approved infrastructure spending. As Milton Friedman once said, "Only government can take perfectly good paper, cover it with perfectly good ink and make the combination worthless."

In a recent interview Peter Schiff was asked how high the price of gold may reach. He answered that there is no ceiling for the precious metal, because there is no limit on how much money will be printed. He's right again. In its latest announcement the Fed basically said as much. Let's keep in mind that no market moves in a straight line up or down, and the above only refers to the long-term trend.

The thing to notice here is that QE 3 is open-ended, in the words of the Fed "will remain appropriate for a considerable time after the economic recovery strengthens." In other words, the Fed is promising that it won't start raising interest rates as soon as the economy looks like it is recovering but will wait until the economy is actually prospering.

Apparently, this is the first open-ended QE program in the Federal Reserve's history.

While Keynesians and Austrians may debate the pros and cons of this new round of QE, it is clearly good news for precious metals investors. Even though the expectation for stimulus was, to a certain degree, already priced in, precious metals went on a binge.

The Fed standard operating procedure for dealing with a weak economy is to buy short-term U.S. government debt from banks which adds to bank reserves and enables the banks to lend money to consumers and business. This is supposed to give the economy a booster shot. The former QE rounds didn't work because the banks had little incentive to lend money due to the low interest rates that they can earn. So, they prefer to sit on their reserves. But the Fed announcement is supposed to change that.

Paul Krugman in his recent column in the New York Times explains this nicely:

The idea here is that by indicating its willingness to let the economy rip for a while, the Fed can encourage more private-sector spending right away. Potential home buyers will be encouraged by the prospect of moderately higher inflation that will make their debt easier to repay; corporations will be encouraged by the prospect of higher future sales; stocks will rise, increasing wealth, and the dollar will fall, making U.S. exports more competitive.

Let us now proceed to today's technical part and see how the announcement of the open-ended QE impacted the general stock market (charts courtesy by http://stockcharts.com). After that, we will move on how this can impact the precious metals prices in the following weeks.

In the very long-term S&P 500 Index chart we see a situation more or less the same as what we had last week. Stocks are less than a half percentage point below last week's closing price level. We have seen some consolidation recently, but, given the size of the previous rally, it seems that this is not the end of it. The RSI level reflects a reading very close to 70 and the situation is quite overbought on a short-term basis. The next significant resistance line is at the 2007 highs, at 1550. A move to this point appears to be very much in the cards although a consolidation could be seen first.

The analysis of any market is strengthened if different proxies for a given asset lead to the same outcome. In this case, for confirmation (or invalidation of the above) let's now have a look at the Dow Jones Industrial Average's proxy - the DIA ETF.

In the short-term DIA chart we see the confirmation of the reverse head-and-shoulders pattern - a bullish phenomenon and an indication that stocks will trade higher in a few weeks. This chart, however, does not tell us if the short-term consolidation is over or not. It could be the case that we've seen enough to verify the breakout and have the rally resume, or we could see a short-term decline from here, especially if the USD Index moves higher.

Let's take a look how the above can impact the precious metals market.

The Correlation Matrix is a tool which we have developed to analyze the impact of the currency markets and the general stock market upon the precious metals sector. If you are not sure how to interpret the above numbers, you can learn more about the Correlation Matrix in our Dictionary and you can watch thevideo about gold & silver correlations in the Multimedia section on our website. Moving back to this week's analysis, the question is: what picture does our previous analysis of stocks (above) paint for the precious metals market?

The answer is that stocks' current impact on the precious metals sector is very bullish for the medium term (3 weeks or more) but rather unclear for the short run (up to 3 weeks or so). The reason is that the significant and positive correlation between precious metals and stocks makes the situation similar to the precious metals as it is for stocks. It seems that the events mentioned in the first part of this essay contributed greatly to this situation - after all open-ended QE3 is something that is likely to positively impact almost all asset prices - except for the USD Index.

Summing up, the outlook for the stocks in general is bullish for the medium term and rather unclear for the short term. Because of the shape of correlation between precious metals and the general stock market, this translates into a rather unclear short-term outlook for precious metals and a bullish medium-term one. The situation on the precious metals market is very overbought from the short-term perspective, so traders should be careful if they wish to bet on the immediate continuation of the rally.

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Przemyslaw Radomski, CFA

Editor

www.SunshineProfits.com