While the past week witnessed more of the same in terms of increases in broad equity gauges, signs are beginning to emerge that the market may be nearing a tipping point, at least in the context of a correction. The S&P 500 advanced .28% for the week, its smallest gain since the last week of January. However, other indices and gauges of investor sentiment seem to be rolling over to the downside.
In a noteworthy divergence, the Russell 2000, which measures the performance of small cap stocks, has now been negative for the past 2 weeks, turning in a worrying -2.96% performance last week even while the S&P rose fractionally. The Russell is a key gauge of investor sentiment, as small cap stocks are inherently riskier and more speculative than their larger brethren. Small cap stocks also pay much less in dividends than large caps, so their performance is more closely tied to attitudes towards risk rather than dividend payouts.
Also interesting is that Asian stocks appear to be falling along with the Russell. As Asia is where most of the world’s hope for growth is nowadays (India, China, Indonesia, Vietnam, etc.), the fact that Asian investors do not want their own country’s stocks has to be concerning. The word out of China seems to be changing on a monthly basis nowadays, as 9% GDP growth last year gives way to 7.5%, and all the while policymakers ease monetary policy more and more. If 6% growth is considered a “hard landing” in China, then this squarely negative scenario is clearly not very far off. If the government misses their GDP goal by just 1%, China’s worst fears will have been realized.
Central to hypotheses on emerging markets are commodities, so posted below are the CRB RIND and GSCI Index as usual.
As can be seen, the GSCI index has now paused along with the CRB RIND. As crude oil is the largest determinant of the GSCI, it would not be unrealistic to view a scenario of a rising GSCI coupled with worsening economic fundamentals, similar to the commodity run-up from early to mid-2008. Middle East unrest appears unlikely to disappear any time soon, so crude oil could maintain a bid even if risk assets embark on a long overdue correction.
As we analyze action in commodities, the week’s big movers were gold and silver, and we believe more pain may be in store for the precious metals complex.
Gold and Silver
Gold and silver both took large, unexpected tumbles on Wednesday, with gold dropping over 4% on the day and silver ending 7% lower. To make the drops even more surprising was that gold and silver were standout performers thus far in the year, and even in the day prior to the fall.
The scapegoat for the quick correction was Bernanke’s testimony in front of Congress that seemed to indicate a reduced likelihood of QE3 being enacted. However, this is a very weak reason for gold to have such a drastic move, and is likely more indicative of the general speculative froth that had entered the market. Bernanke has spoken to Congress numerous times using near-identical language compared to his statements this past week. Furthermore, the fact that Bernanke is not itching to initiate QE3 with the S&P hovering near 1400 should not be news to any traders. The more likely reason for gold’s selloff was an inability to pierce through critical resistance, and a continuation of downside movement appears inevitable.
The following chart shows the price of gold.
As can be seen, the 1800 level is critical for gold. This is the level which gold rallied to after its collapse in late September, only to fail and fall even further in subsequent months. The fact that gold approached this level so closely (rising to as high as 1792 in the past few days) and could not penetrate it is a very telling sign. Because ownership of gold is so widespread, and because gold’s value is purely psychological, large movements in its price can be self-fulfilling. While there may be plenty of buyers for GE stock if it gets cheap enough based on certain metrics, gold is only worth what the next buyer is willing to pay, and if the certainty of its price rising is now called into question, this is a very serious problem for gold bulls.
The following charts show the speculative net positions of gold and silver traders.
As can be seen, interest in long positions in precious metals has spiked as of late, with silver net longs the highest they have been since fall 2010. Gold managed money longs are at their highest point since the collapse in September. It is important to keep in mind that these numbers are accurate only as of Tuesday, so they do not include Wednesday’s fall, but given the quick partial recovery of prices on Thursday, the bullish sentiment has not come close to dissipating.
It is our view that gold and silver remain in a larger bear pattern, with prices unable to break out due to the large number of investors who purchased these metals at significantly higher prices. While risk aversion seems to have come back to the equity markets, many commodity and fixed-income markets are indicating otherwise.
From gold to silver to wheat to US treasury bond yields, many markets besides equities are not showing a reflationary economic recovery. This is in stark contrast to the rally in late 2010/early 2011 when commodities and risk assets were moving in lockstep as a response to increased Fed stimulus. We believe that any sort of correction in stocks and riskier assets could bring a renewed wave of selling in the precious metals complex. Eventually, we foresee prices challenging the late 2011 lows, with gold possibly trading down to below 1500 and silver below 25.
We recommend shorting gold futures at a price of 1712 or better and silver at a price of 34.80 or better. Stops of 1740 for gold and 36 for silver could be used to limit risk, as a trade above these levels could indicate a resumption of the bull trend.
Tomorrow’s Reserve Bank of Australia meeting could move prices for the Australian dollar. The table below shows the expectations for Australian interest rates from analysts.
Mar. 6 Apr. 3 May. 1 Jun. 5 Q3-12 Q4-12 Q1-13 Q2-13
Median 4.25% 4.25% 4.00% 4.00% 4.00% 4.00% 4.25% 4.25%
High 4.25% 4.25% 4.25% 4.25% 4.25% 4.75% 5.00% 5.25%
Low Forecast 4.25% 4.25% 4.00% 3.75% 3.75% 3.75% 3.75% 3.75%
Replies at Median 2424 15 13 8 88 7
As can be seen, the vast majority of analysts are in the bull camp for interest rates, believing that the RBA will wait until at least May to lower interest rates, and then leave them there for the remainder of the year. We believe that tight consumer conditions and the divergence of Australia’s two-speed economy will force the RBA’s hand in lowering interest rates much more aggressively than currently priced. Recent market action indicates that the market may finally be warming to this notion as well.
The following chart shows the AUD against the S&P 500 normalized for percentage.
As can be seen, while the AUD and SPX rallied in tandem for the first 5 weeks of the year, recently their performance has diverged. The AUD has plateaued while the SPX has continued to advance. We believe the relative underperformance in the AUD is due to the market’s realization that the interest rate outlook for Australia is not one of rising rates but rather falling rates. Given that the carry rate will be compressed, albeit an uncertain amount, traders must factor this loss of forward interest rate carry into their pricing. For this reason, it seems extremely unlikely that the all-time high level of 1.1081 will be pierced, because at that time, the RBA was still expected to raise rates. The AUD appears extremely stretched, and has run out of fuel even with the stock market powering higher. Any correction in stocks and other extended risk assets should cause a quick 3-5% down move in the AUD.
Also, the long position in the AUD has become very crowded. The following chart shows the net non-commercial longs on the AUD.
As can be seen, Managed Money has their largest net long AUD position on since July, and is within less than 10k contracts of the net long position reached when the AUD hit a record. For the reasons discussed above, we believe a move to the all-time high is unlikely, and therefore the current long position as very close to a top.
We recommend shorting the Australian dollar at a price of 1.0726 or better. A stop of 1.0856, the 1-month high, could be used as a stop to limit risk.