Equities versus Gold Feb 2002 Update

In my last article (see reference [1]), I presented an assessment of the status of the long period cycle associated with the flow of investment capital between equities and other paper assets and hard assets such as gold and silver. Over the last 20+ years, investment capital has flowed from hard assets into paper assets such as equities. Using the principles of Classical Charting (see references [2], [3]), evidence was presented that while there is no technical confirmation of a reversal in this trend, it is showing signs of weakness. This article presents an update of the current technical situation from the perspective of Classical Charting.

Equities versus Gold

To analyze these cycles from the perspective of Classical Charting I presented my interpretation of the chart of the Dow Jones Industrial Average to Gold ratio. Very little has changed as the best interpretation of the weekly Dow to Gold ratio chart continues to be a possible Head and Shoulders Top pattern. Since the Dow Jones Industrial Average is by nature a facade of the US equity markets, designed to showcase the best performing stocks, I thought it would be instructive to feature a different ratio using an index that provides a much broader measure of US equity performance. With that in mind, the weekly Standard and Poor's 500 Index to Gold ratio chart seemed like a good choice (shown below).

The chart shows that the same interpretation applies, but with a slightly more bearish bias as the neckline is much flatter. As always, a close below the neckline would be required to complete the pattern. Should that happen, the target value for the ratio would be a little below the 2.0 level.

US Equities Market

In my last review of the chart of the Dow Jones Industrial Average, I noted that the reaction lows in September 2001 had violated the long term trendline of the secular bull market that began in the fall of 1982. I also suggested that the best interpretation for the weekly chart of the Dow Jones Industrial Average was a possible Head and Shoulders Top pattern.

After weighing all the evidence from the US equity index charts, the scales still seem to be tipped in the favor of the bears. However, any impartial chartist would have to award some above average scores to the US equity bulls for aspects of their performance since the lows made in September 2001. The following observations were notable.

• I had previously noted that the Geometric Value Line Index had completed aDescending Right Triangle Top pattern. The principles of Classical Charting suggested that the 340 to 350 level would function as overhead resistance. The market surprised us when it rallied right through that level, and climbed all the way to 379.63 on 7 Jan, 2002 before turning lower again.
• The least bearish of the weekly US equity index charts is probably that of the Arithmetic Value Line Index. The index had reached an all time high of 1311.09 in May of 2001. The index collapsed along with everything else after the events of September 2001, but the rally from that low looks impressive on the chart. The index recently climbed as high as 1283.3 on 7 Jan, 2002 but has since turned lower. It's much too early to be drawing any meaningful conclusions from this chart, but it is starting to hint at the possibility of an eventual Double Top pattern. (Chart courtesy of Yahoo!)

At the time of this writing, the best interpretation of the weekly chart of the Dow Jones Industrial Average continues to be a possible Head and Shoulders Top pattern. Many of the other major equity index charts have almost identical chart structure; the Standard and Poor's 100 and 500 and the Russell 1000 and 3000 to name just a few. In the case of the Russell 3000 Index (shown below), this pattern has a slightly more bearish bias than that of the Dow Jones Industrial Average because the neckline is much flatter.

The market appears to be in the early stages of rolling over to complete the formation of the right shoulder of the pattern. A weekly close below the neckline is required to confirm the pattern. At that point the price target would be in the 315-320 range depending on where the breakdown occurs as the neckline has a gentle slope to it.

Symmetry considerations would suggest we might be roughly half way through the formation of the right shoulder. The left shoulder is about 37 weeks long (or perhaps even longer depending on your interpretation). We are currently 20 weeks into the right shoulder, while 37 weeks projects to early June 2002. If the pattern were to be completed well before that time, it would suggest prices might reach the price target rather quickly. Further evidence of market weakness in this index can be seen by examining the relative height of the left and right shoulders. An inspection of the line from the peak of the left shoulder and parallel to the neckline suggests that there is room for more upside movement without damaging the interpretation.

Gold Bullion

Last time, I suggested that the best interpretation of the monthly gold chart (not shown) was a possible 20+ year 3 Fan Correction pattern that extended all the way back to the high of $850 made in Jan 1980. Should this pattern be completed by a breakout above the 3rd fanline, the implied swing target of this pattern would be about $7845. Using the bull market in gold bullion that preceded the Jan 1980 top for some guidance, such a move might take roughly 5 to 10 years to unfold.

There is only a minor change to my interpretation of the weekly gold chart which is shown below. The pullback to the $272.20 level in early December 2001 was disappointing for many in view of the events of September 2001, but it did little to damage the chart structure. In fact, the current interpretation is perhaps a little less ambiguous. We can clearly see a possible Head and Shoulders Bottom pattern if we interpret this recent reaction as the right shoulder of the pattern. The head of the pattern can be interpreted as an uncompleted Rounding or Saucer Bottom pattern.

In a show of strength, prices have again moved above the bear trendline T1 (defined by the peak in early 1996, and the peak in September of 1999 that coincided with the Washington Agreement). Because the market has recently rallied enough to make the right shoulder almost complete, this creates a "do or die" situation. In this case, a breakdown below the $270 to $272 level would force one to interpret the chart as aHead and Shoulders Bottom Failure pattern, and would strongly suggest that we would revisit the lows made in early 2001 around the $256 level.

A weekly close above $292 would be required to complete the Head and Shoulders Bottom pattern, and the measured price target would then be $333. Other technical features suggest that the target of $333 may be perhaps a little optimistic. It would not be surprising if the market encountered resistance at the third fanline F3. Also note the character of the brief rally in February 2000 that preceded the left shoulder. From symmetry considerations, it would not be surprising for a breakout to be similar in a qualitative sense. This would suggest a somewhat lower target of about $316 which is just below the third fanline F3 at this time. No two situations ever unfold in exactly the same manner, but Classical Charting helps provide some possible scenarios as to how things might unfold. As always, only time will tell.

Many gold bulls were very disappointed when gold bullion failed to breakout above the $292 level in the wake of the events of September 2001. Many opponents of gold pointed to this as further evidence that gold is a relic of the past and no longer has a role in our monetary system. As strange as it might seem I would personally prefer to see such a breakout occur in the absence of such a news event. It is certainly in our human nature to want to know why markets behave the way they do. However, when a breakout occurs in concert with a news event that motivates money to move from the sidelines and into the market, the questions looms large if the trend is really sustainable or just a "knee jerk" reaction to the news event. On the other hand, when breakouts occur without any obvious explanation, the relative strengths of buying and selling forces is less ambiguous. I am hoping that if we do see a breakout above the $292 level, it "just happens" without any particular news to explain why.

Gold Stock Market

Many of the gold stock issues that trade on the North American exchanges have recently awoke from their extended period of consolidation that began in May 2001. All of the gold stock indices currently show good gains relative to the lows they made in November 2001. With the exception of the Philadelphia Gold and Silver Index, all of them have surpassed their respective highs made in May 2001 on a closing basis. The Amex Gold BUGS Index (Basket of Unhedged Gold Stocks) continues to lead the pack when viewed in terms of its price change relative to its respective low made in November 2000. At the time of this writing, none of the indices have yet managed to close above their respective highs made in September 1999, (following the announcement of the Washington Agreement). The relevant data for all the North American indices can be found in the following table.

The strong relative performance of the Amex Gold BUGS Index is only one voice in a chorus that is sending a clear message to mining company executives; "If you want investment capital, you had better not have a big hedge book". The Enron debacle has only increased the resolve of gold stock investors who feel that mining companies should believe in the future of their product, and abandon the use of forward sales, a practice that was encouraged and popularized by Wall Street banks. Some of the mining companies who had a strong pro-hedging stance in the past have signaled that they may be becoming more inclined to leave banking to bankers by buying back some of their forward sales.

While none of the gold stock indices have yet managed to close above their respective highs made in September 1999, the list of individual gold stocks and mutual funds that have managed to do just that grows daily. The table below shows some of the stocks and funds traded on US exchanges that have recently made new closing highs for the period of February 1999 to the present. The list was constructed from the issues I follow on a regular basis, and should not be construed as being absolutely complete. As you can see, the list is largely populated by the mid size producers who have taken a vocal stance against the use of forward sales.

The following table shows some of the gold stocks traded on Canadian exchanges that have recently made new closing highs for the period of February 1999 to the present. The list includes many of the same producers from the previous list, together with some junior miners. As before, the list was constructed from the issues I follow on a regular basis, and should not be construed as being absolutely complete.

While gold stocks have made some impressive gains, the performance of gold bullion hasn't been very exciting in comparison. It is only natural to ask if this difference in relative performance is something to be concerned with? First, it should be pointed out that gold stocks inherently provide additional leverage with respect to upward movements in the price of gold bullion. (The very reason why some investors prefer gold stocks over bullion as an investment vehicle). For those that might not understand why this is so, consider the following scenario. Suppose that a mining company produces gold at a cost of $250/oz and sells it on the open market for $300/oz for a profit of $50/oz. If the market price for bullion were to rise by 33% to $400/oz, the company's profits would increase by 200% to $150/oz. A leverage of 6 to 1. This effect is most pronounced when market prices are marginally above production costs and becomes less pronounced as the difference between bullion prices and production costs expands. With many mines currently closed because they are unprofitable at today's historically low bullion prices, the recent performance of gold stocks relative to bullion would not be entirely unexpected. While this argument is clear enough, the fact remains that bullion has yet to make a significant upside move. Only time will tell, but one possible explanation is that the gold shares are rising now in anticipation of future upside movement in gold bullion.

A more quantitative approach to this issue is to examine the ratio of gold bullion prices to the prices of a specific gold stock or index. The Gold to Philadelphia Gold and Silver Index ratio has been a popular choice among technicians. In view of the strong performance by the unhedged gold stocks I decided to present the Gold to Amex Gold BUGS Index instead. As the weekly chart below shows, the ratio peaked at a value of 7.39 in November 2000. This can be interpreted to mean that if we exchanged 1 oz of gold for US dollars, and immediately invested the proceeds in the index, we would have bought 7.39 shares. That point in time coincided with an extreme in pessimism towards gold stocks. Since the Amex Gold BUGS Index is relatively new, the available history to compare to is somewhat limited. However, it is clear we have yet to get close to the values near 2.0 seen in early 1997 when investor attitudes towards gold stocks were much more optimistic.

>From a perspective of Classical Charting there are several noteworthy developments. The ratio recently completed a 6 month Flag consolidation formation and has reached new lows for the current move down. While flag patterns are more commonly associated with daily charts, they do sometimes make appearances on weekly charts. As flags have a tendency to "fly at half mast", there is a strong possibility the ratio will continue to trend sharply lower over the coming weeks in a manner similar to the down leg from November 2000 to May 2001. Symmetry considerations suggest the ratio may reach its predicted target of a little less than 2.5 sometime around June 2002, give or take some. Of course, there is also a good possibility of some some sharp but short lived bounces along the way. An inspection of the chart suggests that the 3.5 and 3.0 levels are areas where such temporary support might be expected.

To put the suggested target value for the ratio of 2.5 in perspective, if gold were to remain unchanged at roughly $285 per ounce, the implied value of the Amex Gold BUGS Index would be 114. If gold can muster a rally to the $320 per ounce level, the implied value for the index would be 128. Only time will tell, but this chart strongly hints at the possibility of a very good performance by the unhedged gold stocks in the coming weeks.

Summary and Conclusions

The bull trend of the Dow Jones Industrial Average to Gold ratio that began in Jan 1980 is still technically intact. However, evidence continues to mount that the US equity markets are growing weaker, and that gold bullion is gaining strength.

The trendline on the monthly chart of the Dow Jones Industrial Average that is associated with the secular bull market that began in the fall of 1982 was temporarily violated by the sell off in September 2001. Both the NASDAQ and Geometric Value Line Index have completed reversal top chart patterns. The charts of many of the other US equity indices are best interpreted as mature, but as yet uncompleted Head and Shoulders Top patterns. My own guess is that these reversal patterns will be completed sometime before June 2002.

The gold bullion market has yet to provide any hard technical evidence that the trend has turned from sideways to up. The advanced stage of the possible Head and Shoulders Bottom pattern has created a "do or die" situation. A convincing breakout above the $292 level suggests a move to roughly $333, although the $316 level is an alternate target. A breakdown below the $270 level suggests that we would revisit the lows made in early 2000 around the $258 level.

The recent strong performance by the unhedged gold stocks may be a leading indicator that gold bullion will soon awake from its slumber. The charts of many of these stocks as well as that of the Gold to Amex Gold BUGS Index ratio suggest that this strong performance could continue into late May or early June 2002. The magnitude of the move could be quite dramatic if gold bullion can muster a sustained breakout above the $292 level.

NEWS FLASH !!! I finished writing this article late Monday evening and decided to get some rest before my final proof reading. As a result of the dynamic trading session on Tuesday, the following corrections should be noted. As you all know by now, gold bullion charged right through the $292 level with little opposition. I am delighted that this breakout did not occur in concert with some dramatic news that might cast doubt on the real underlying strength of the move. Note also that the Philadelphia Gold and Silver Index joined the other gold stock indices by closing above its May 2001 high close.

John Peterson

<[email protected]>

05 Feb, 2002

Copyright © 2002, John Peterson, All rights reserved. This article may be freely distributed in whole.

References

1. The Bigger They Are, The Harder They Fall, by John Peterson, 30 Oct, 2001
2. Technical Analysis and Stock Market Profits, by Richard W. Schabacker, 2nd Edition, 1937, ISBN 0-273630-95-4
3. Technical Analysis of Stock Trends, by Robert D. Edwards and John Magee, 16-th Edition, 1987, ISBN 0-910944-00-8

Disclaimer

The above statements are personal observations and opinions, and should not be interpreted as investment advice or as a solicitation to buy or sell securities. The charts and data presented were derived from sources that were believed to be accurate. However, no warranty, expressed or implied is made as to their accuracy.