That Sinking Feeling (Part 3)

Gold is at a crossroads. No the gold chart is not “that sinking feeling” but gold has reached point where it must either break out or fail. That would turn gold into that “sinking feeling”. The bullhorn pattern is rather interesting. I first learned about the bullhorn pattern from Thirdeyeopentrades (Bob Cote). Bob has a public place at www.stockcharts.com. What the pattern is suggesting is that gold has a lot further to rise. Gold has been through a considerable shakeout over the past two plus years. It has shaken the confidence of many and the result has seen many exit the market possibly for good.

Charts created using Omega TradeStation 2000i. Chart data supplied by Dial Data

However, if the pattern is correct gold could rise to $3,000 to $5,000 in the next major wave to the upside. On the other hand, it could fail here and bust through the bottom of the uptrend line currently near $1,200. The 200-week exponential moving average (EMA) acted as major support during the long rise from 2001 to the top in September 2011. It busted down through the 200 WEMA in April 2013. The rise last August failed at the key EMA and this week gold prices approached the EMA once again and then pulled back. The 200-week EMA is currently at $1,389. The recent gold futures high was at $1,382.

Bullhorn patterns have busted before. The Dow Jones Industrials (DJI) appeared to form what may have been a bullhorn during its long bull market from 1982 to 2000. The DJI failed to reach the top channel of the bullhorn when it topped in 2000. The top channel was formed by joining the high of 1982 with the top in 1987. The bottom channel was formed connecting the 1982 low with the 1994 low. The 48-month EMA provided support during the long bull market (the 48 MEMA is roughly equivalent to the 200 WEMA). The bottom of the channel first broke down in 2001 and for good in 2002. Since then the DJI has been forming what appears as a huge broadening pattern. Currently the DJI is at the top of the broadening pattern. The bottom of the channel is currently just below 6,000.

Charts created using Omega TradeStation 2000i. Chart data supplied by Dial Data

If one starts with the low of 1987 it does draw a nice channel line along the 1990 low, the 1994 low and catches the 2001 low. Preference was to use the 1982 stock market low as that was the last important low before the bull market of 1982-2000. The rising trendline also marked the top in 2007. Note how the DJI did manage to break above its 48 MEMA for at least a brief period following the 2001 low. Its failure to hold the EMA was a sign that a bear market was to come.

Even if one wants to believe all the bearish reports on gold, gold should take out its 200 WEMA for a period similar to the DJI in 2001-2002 following the 2001 low. A return back under the 200 WEMA would signal that gold could be entering a longer-term bear market. Gold needs to break above the downtrend line from the 2011 top that connects with the 2012 top in order to make the final confirmation that the bull market has resumed. That point is currently around $1,640.

Earlier this week gold and gold stocks sold off while the stock market rebounded back to the upside following the referendum in Crimea over the weekend. Gold sold off and stocks rallied most likely because they were relieved that the sanctions placed on Russia were quite mild and that the Crimea referendum went off without a hitch and the results were as expected. During the week, there were some clashes between Ukrainian and Russian military in Crimea although it appeared to have little impact on the market.

The FOMC meeting this week was Janet Yellen’s first as the new Fed Chairman. Her debut was deemed a bit of a disappointment. The Fed “tapered” another $10 billion as was expected but what the market did not expect was a tilt toward potentially higher interest rates for late 2015 early 2016. This caused stocks and gold to fall, and interest rates and the US$ to rise. The week also saw a series of better than expected economic numbers that encouraged the market.

But the real issue remains the crisis in Ukraine/Russia. The Ukraine/Russia crisis is one that could destabilize global economies and spark a financial crisis. The likelihood of the crisis being over is probably low. The EU and the IMF are trying to find a way to assist Ukraine. Ukraine is in dire economic straights and is most likely sitting on the edge of default. Offers have been made to Ukraine but they come with strings attached. The EU is meeting with Ukraine officials to try to work out an “Association Agreement”. Loans and closer ties with the EU would come with austerity measures for Ukraine. It has been noted that retirement payments could be cut in half and gas prices could rise sharply. Austerity measures could cause considerable hardship in the country as they most likely could plunge the economy into a deep recession and potentially trigger social unrest.

NATO and the US have pledged security assistance to Ukraine. Ukraine is in the process of beefing up their military, which is expected to include members of the “Right Sector”. The Ukraine’s “Right Sector” are well known nationalist organizations with neo fascist views. NATO has beefed up patrols in the Balkan countries and Poland, all NATO members. The head of NATO has stated that the Crimea referendum is illegal and that Russia’s moves in the Ukraine are a “wake up call”. According to a NY Times story NATO is weighing assistance for Ukraine in order to dissuade Russia from further moves. The US has told eastern European leaders that the missile defense plans remain. The missile defense plan was to put missiles in Poland allegedly meant to deter an attack from Iran but that Russia had believed were meant for them.

What all this would appear to imply is that NATO is continuing its encirclement of Russia and NATO’s hope is that Russia might back down. Worse, instead it could provoke a military response from Russia. There has been considerable unrest in Eastern Ukraine where there is a sizable Russian population. According to some polls upwards of three-quarters of the population in Eastern Ukraine, reject the Kiev government. Some fear that Russia might come to their aid. Civil war might also break out in Eastern Ukraine. Already there have been deadly clashes in Eastern Ukraine between pro-Russian and pro-Ukraine supporters.

It was well-known following the intercept of the telephone conversation between Assistant Secretary Nuland and US Ambassador to Ukraine Pyatt that the US was coordinating and funding the unrest that resulted in the overthrow of former Ukraine Prime Minister Yanukovych. Instead of a military response, Russia could fund unrest in countries where there are sizable ethnic Russian population just as the US funded unrest in Ukraine. Latvia and Estonia come to mind where over 25% of the population are ethnic Russians. Both are NATO members. Russia has already built up a sizable contingent of troops on the borders of the Balkan countries, on the eastern borders of Ukraine and as well, they have troops in Transnistria a province in Eastern Moldova that is on the western border of Ukraine and itself contains a sizable ethnic Russian population.

The real danger to the global economy would be the escalation of sanctions. Thus far, the sanctions have only targeted individuals. The US has targeted 20 Russians but in a tit-for-tat Russia is also applying sanctions to a number of US officials including John McCain, Harry Reid and John Boehner. It may be a game and largely symbolic given that many (if any) have assets outside the country that can be seized. Many believe that the Russian officials have already pulled any assets out that the may be holding outside of Russia. The US officials will not be visiting Russia any time soon.

The real danger lies in trade sanctions including sanctions that target the seizure of assets. Germany has considerable trade with Russia. Germany imports some 30% of its energy needs from Russia. Some believe that the west should cut off Russia energy. The EU would pay a high price, as there is no immediate solution to supply the EU its energy needs. There is not a lot of support for that option.

Russian/German trade totals some €80 billion. Russian/Italian trade totals roughly €40 billion and Russian/French trade totals at least €20 billion. Major German, Italian and French firms have significant investments in Russia. There are US corporations especially energy firms that also have significant investments in Russia. Any attempt to seize assets by the US and the EU could result in a seizure of western assets in Russia. The Russian Duma has already passed legislation that would allow that. Canada’s trade with Russia is small but there are Canadian firms with investments in Russia including Kinross Mining (K-TSX). US, Canadian and EU corporations have warned that sanctions could cause them serious harm and are asking their governments to move cautiously on sanctions.

Western banks have considerable exposure to Russian debt. It is estimated that US banks have at least $75 billion in Russian debt and EU banks upwards of $150 billion. The EU banks in particular that have already had to deal with billions of $ of bad debt in EU countries such as Greece and Spain could ill afford more defaults. It is unknown how much there is outstanding of other bonds including corporates. There is also the fear of contagion as the debt problems could spread to other countries. Just the threat of sanctions has triggered the withdrawal of billions out of western banks particularly in London. $105 billion of Treasury securities have been sold since March 1 out of the Fed’s custody account for foreigners. All the withdrawals are most likely from Russia.

Russia has also threatened to end use of the US$ for trade purposes or payment of energy. This could in turn put further downward pressure on the US$. While the west notes that they could put the Russian economy into bankruptcy, a default by Russia could trigger a financial crisis in the west that could be worse than that seen in 2008 at the time of the Lehman Brothers collapse. One is again reminded it was a Russian default that triggered the 1998 financial meltdown that resulted in the bankruptcy of Long Term Capital Management (LTCM) and almost caused a banking collapse. Finally, sanctions against Russia might not be supported by China. So far, China has been quite neutral. If that were the case then Russia might have a way of getting around sanctions.

NATO exercises on Russia’s borders, Russian troop buildup in the Balkans and along Ukraine’s border; stringent requirements from the IMF and the EU for the Ukraine to gain access to the west that could result austerity in the Ukraine and escalating social unrest; the potential for further unrest and clashes in Eastern Ukraine and even in adjoin states with sizable ethnic Russian populations; the potential for an escalation in sanctions that in a worst case scenario could result in the seizure of both Russian and Western assets or a Russian default and a financial crisis on the scale of 2008; all of these are negative signs that should give one a sinking feeling. Further, there is the ongoing dispute between China/Japan and clashes between Syria and Israel.

The crisis is most likely going to play itself out over a period of months. It will ebb and flow. But one thing the charts of gold and the DJI appear to suggest no matter what might happen in the short term the longer term looks potentially positive for gold and negative for stocks. Gold only looks positive to the extent that it can regain and hold above first $1,400, then $1,430 (the August 2013 high), $1,525 the major break down point in April 2013 and above $1,640. That would give us a silver lining to offset the sinking feeling.

Copyright 2014 All rights reserved David Chapman

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