Commodities

The continuing platinum plunge

Many commodities are immersed in waterfall declines. These declines look climactic and could be setting the stage for major turns to the upside in the near future. However, even if their bear markets are not complete, which is a distinct possibility given the evidence that the Dollar Index has turned higher on an intermediate-term basis, the extent to which many commodities are now 'oversold' creates the potential for sizeable rebounds. The platinum market is a good example.

We mentioned platinum last week and speculated that it would make a multi-month price bottom at $1290-$1300, an important area of support defined by last year's low. Platinum's price continued its plunge last week and is now testing the aforementioned support at a time when its daily RSI is at a rarely-seen extreme.

There is clearly no evidence that a bottom is in place, but, as we said above, the action looks climactic.



The uranium divergence just got bigger

Last week we pointed out that the uranium price had just experienced its best rally in more than three years, whereas URA, a proxy for uranium-mining equities, looked set to break below support at $14 to a new multi-year low. This was an interesting, and rather strange, divergence between the commodity and the stocks of companies that produce the commodity.

The divergence became more interesting and even stranger last week, as the uranium price continued its rally and URA broke solidly below $14. The relevant weekly charts are displayed below. The uranium price is now up by almost 30% from its low, but it seems that traders of uranium-mining equities are unaware of this fact.

Last week's performance by URA ushers in the possibility that we are seeing the sort of short-lived break below major support that can mark the end of a multi-year decline. However, for this to be the case there will obviously have to be an upward reversal in the near future and a quick return to above $14.

A reliable recession indicator won't work next time

There was an inversion of the US yield curve, meaning that short-term interest rates moved above long-term interest rates, ahead of every official US recession of the past several decades. Consequently, a popular assumption is that there will be no need to worry about a future US recession until after the spread between short-term and long-term interest rates has shrunk to zero and the yield curve is on the verge of becoming inverted. In our opinion, this assumption will prove to be wrong. Due to Zero Interest Rate Policy (ZIRP), the US economy's next transition from growth to recession will almost certainly occur while the US yield curve remains positively sloped.

"It's different this time" is usually a dangerous idea, but it really is different this time. The Fed has recently taken interest-rate manipulation way beyond anything it has previously attempted. Given this fact, is it unreasonable to expect that interest-rate relationships that worked in the past will not work in the future?

When it comes to the ability of the yield curve to forecast recessions, it is actually more reasonable to expect that the future will be different from the past than it is to assume that past is prologue. With the Fed committed to keeping its targeted overnight interest rate at zero for at least 9 more months and highly likely to move in 'baby steps' after a rate-hiking program eventually begins, there is almost no chance of short-term T-Note yields moving above long-term T-Note yields within the next two years. Moreover, although the Fed's current stance is unprecedented, a precedent is provided by Japan's experience.

A yield-curve inversion was a reliable leading indicator of recession in Japan until the mid-1990s, when the BOJ embarked on a program involving near-zero administered interest rates. Since that time, none of Japan's economic recessions (there have been five of them) have been preceded by an inverted yield curve. This point is discussed in the article posted HERE and illustrated by the chart displayed below. With regard to this chart, Japan's yield curve is considered to be positively sloped when the black line is above the red line.



In summary, the extreme interest-rate manipulation being conducted by the Fed makes it very unlikely that the next US recession will be telegraphed by an inverted yield curve. Regardless of whether the US economy is growing or shrinking or somewhere in between, it's a good bet that the US yield curve will remain positively sloped for a very long time to come. However, it will probably become flatter (less positively-sloped) ahead of recessions.

Gold Stocks

The upper half of the following chart shows that the HUI has moved up to the top of its major basing pattern. A solid weekly close above 250 would complete the base and provide additional evidence that a new bull market is underway. Note: We have little doubt that a new cyclical bull market began last December, but additional evidence to support this view is always welcome.

The HUI's return to the top of its major basing pattern has been accompanied by two conflicting signals: a signal that an upside breakout is imminent and a signal that there will be more consolidation prior to an upside breakout. The bullish signal is this week's break to a new high for the year by the HUI/gold ratio, as illustrated by the lower half of the following chart. The signal pointing to additional consolidation is the decline in the GDXJ/GDX ratio to a new multi-week low.



There's no way of knowing which of the aforementioned signals will turn out to be correct, but in the grand scheme of things it shouldn't make a difference. Our expectation is that the HUI will either break out to the upside within the next few days or consolidate for up to two more weeks before breaking out to the upside.

We continue to think that the HUI will trade at 300 by the end of September.

US Economic Numbers Update

The ISM Manufacturing numbers for July were reported last Friday, and they were strong. Of particular significance, the following chart shows that the ISM New Orders Index, in our opinion the single best indicator of the US economy's current and likely near-term performance, has risen to near its highs of the past few years.



The latest monthly employment numbers were also reported last Friday. They were apparently a little weaker than expected, but not by enough to affect the Fed's actions.

As explained in previous commentaries, the only practical significance of the employment numbers is the extent to which they influence the Fed. As indicators of current or future economic performance they are useless because they are inaccurate and backward-looking. In effect, the employment numbers provide an inaccurate look at how the economy was performing a few months ago and provide no information about likely future economic performance.

From a big picture perspective, the best LEADING indicator of US economic performance we know of is Real Gross Private Domestic Investment. This is the blue line on the following chart. If you look closely at this chart you should be able to see that Real Gross Private Domestic Investment has reversed downward at least a few months prior to the start of every official US recession since 1970. The same chart shows that employment (the red line) never reverses downward until sometime after an official recession has begun.

Unfortunately, the Real Gross Private Domestic Investment number is only updated quarterly with a lag of one month, which means that it can be up to four months out of date. Furthermore, a trend change in this number will take at least two quarters to unfold. That's why we generally discuss it at TSI only a couple of times per year.

The Real Gross Private Domestic Investment number for Q1-2014 opened up the possibility that a downward trend reversal had occurred, but the number for Q2-2014, which was reported last week, eliminated this possibility.



The combination of the ISM New Orders Index and the Real Gross Private Domestic Investment number tells us that the start of the next official US recession lies at least 6 months into the future.

Gold and Real Interest Rates

The real interest rate is one of the most important determinants of whether the financial landscape is bullish or bearish for gold, where the real interest rate is the default-free nominal interest rate minus the EXPECTED rate of currency depreciation.

The trouble, for those of us who care about the true fundamental drivers of the gold price, is that the rate of currency depreciation expected by the market cannot be accurately measured, which means that the real interest rate cannot be accurately measured. However, the yields on Treasury Inflation-Protected Securities (TIPS) are ballpark estimates of real interest rates and should trend in the same directions as real interest rates. The following chart of the 10-year TIPS yield therefore gives a rough indication of the performance of the real US 10-year interest rate.



Since the real interest rate is not the only determinant of whether the financial landscape is bullish or bearish for gold, the gold price doesn't always trend in the opposite direction to the TIPS yield. However, note that the two most significant declines in the gold price over the past 8 years (the price plunges that occurred during Aug-Nov of 2008 and Apr-Jun of 2013) happened concurrently with, and can therefore be explained by, sharp advances in the 10-year TIPS yield.

The H1-2013 sharp increase in real long-term interest rates was difficult to anticipate, although gold was acutely vulnerable at the time due to the fact that other important fundamental drivers (credit spreads, the yield curve and the BKX/SPX ratio, for example) were bearish. We should have paid more attention to these other drivers.

The real US long-term interest rate leveled off (that is, stopped getting more gold-bearish) during the second half of last year and began to drift downward (that is, started getting more gold-bullish) in December. The downward drift will probably continue over the next several months due to a continuing downward trend in the nominal 10-year T-Note yield and a small increase in inflation expectations.

Goldman's Gold Forecast

Last week, a Goldman Sachs analyst reiterated his forecast for the gold price to drop to $1050/oz by the end of this year.

The Goldman Sachs gold-market analysis is much better than the gold-market analysis of Eric Sprott and many other high-profile gold bulls, because at least Goldman is looking in the right direction for clues as to what the future holds in store for gold. Many gold bulls, on the other hand, haven't the foggiest idea about gold's fundamental drivers.

Goldman's gold forecast has little chance of being correct, though, because it is predicated on a strengthening US economy and because gold's true fundamentals are trending in a bullish direction. Of particular importance, we note that:

a) The BKX/SPX ratio, a measure of how the banking sector is performing relative to the broad US stock market, gradually began to turn gold-bullish (meaning: bank stocks gradually started to weaken relative to the overall market) in early-July of last year and turned decisively gold-bullish in April of this year. This influential ratio will remain supportive for gold as long as it is making lower highs and lower lows.

Here's a daily chart comparing gold and the BKX/SPX ratio over the past four years.



b) The HYG/TLT ratio, a measure of US credit spreads, began to move in gold's favour (meaning: credit spreads began to widen, causing the HYG/TLT ratio to decline) at the end of last year and made a new 52-week extreme last week. As is the case with the BKX/SPX ratio, the HYG/TLT ratio will remain supportive for gold as long as it is making lower highs and lower lows.

Here's a daily chart comparing gold and the HYG/TLT ratio over the past four years.



Our guess is that the gold price will end this year in the $1400-$1500 range.

Gold

Speculators versus Commercials

Speculators, not commercial traders, drive price trends in the gold market. The proof of this is the simple fact that the speculative net-long position in gold futures almost always trends in the same direction as the gold price (an increase in the speculative net-long position almost always accompanies an increase in price and a decrease in the speculative net-long position almost always accompanies a decrease in price). It is therefore fair to say that in the gold market, speculators are price makers and commercials are price takers.

An example is the 2-week period ended 1st July 2014. During this period a definitive upward reversal in the short-term price trend coincided with a large increase in the speculative net-long position. Specifically, the price quickly rose from $1272 to $1328 while the speculative net-long position in COMEX gold futures jumped by about 80K contracts.

As dictated by basic arithmetic, the 80K-contract increase in the speculative net-long position during the 2-week period ended 1st July went hand-in-hand with an 80K-contract increase in the commercial net-short position. These changes in the speculative and commercial positions are two sides of the same coin. One would not be possible without the other.

In general terms, speculators, as a group, could never increase their long exposure to gold futures unless commercial traders (primarily bullion banks), as a group, were prepared to take the other side of the trade and increase their short exposure to gold futures, and speculators could never reduce their net-long position (or become net-short) unless commercials were prepared to reduce their net-short position (or become net-long). This means that those commentators who rail against the short-selling of gold futures by bullion banks and other commercial traders are effectively railing against the buying of gold futures by speculators.

Moving on, a superficial comparison of the gold price and the commercial net-position in gold futures could lead to the conclusion that the commercials are always on the wrong side of the market, except at short-term price extremes. For example, 'the commercials' were relentlessly net-long during the final six years of gold's 1980-2001 secular bear market and have been relentlessly net-short since the beginning of gold's secular bull market. Looking only at futures positioning could therefore lead to the impression that the commercials have lost a fortune trading gold, but such an impression would be wrong. The reality is that the bullion banks (the biggest commercial traders) generally don't care which way the gold price trends, because they generally don't make their money by betting on price trends. Instead, their goal is to make money regardless of price direction by taking advantage of spreads (for example, spreads between the cash and futures prices and spreads between different futures contracts) and the charging of commissions.

Current Market Situation

Gold did enough last week to provide us with more evidence of a major reversal to the upside. Specifically and as illustrated by the following chart, it has just achieved a weekly close above its 65-week moving average (the blue line on the chart) and intermediate-term channel resistance.



We doubt that this obvious and belated confirmation of strength will lead to a significant immediate extension of the rally. The reason is that at this early stage of the new cyclical bull market, gold, silver and the silver/gold ratio will probably have to 'correct' their 'overbought' conditions before powering higher. That gold and silver are stretched to the upside on a short-term basis is indicated by the elevated levels of daily RSIs and the high level -- relative to where it has been over the past 12 months -- of the speculative net-long position in COMEX gold futures.

That being said, a substantial correction is unlikely at this time. The 65-week moving average should now provide strong support, which suggests that gold should remain above $1310 on a weekly closing basis. The shorter-term moving averages of importance (the 50-day, 150-day and 200-day moving averages) are now either into the $1290s or should move into the $1290s within the next three weeks, which suggests that the $1290s is probably now the worst case for an intra-day downward spike.

The bottom line is that some consolidation is likely over the coming 2 weeks, but there remains a good chance that gold will trade in the $1400s before the end of September. We therefore remain short-term bullish.

Gold

Current Market Situation

The gold price broke out to the upside last Thursday, signaling an end to the correction that began in March. The upward reversal was not surprising, but its exact timing was unpredictable.

The gold market is likely to test resistance at $1400 within the next two months and could trade as high as $1500 before year-end, but we have no opinion on what it will do over the next two weeks. The RSI shown at the bottom of the following daily chart reveals that the market is now short-term 'overbought', but this only means that a 1-2 week consolidation would not be out of the ordinary. It doesn't mean that the price won't continue to move higher. For example, the gold price continued to move higher for about three weeks after the daily RSI reached a similar 'overbought' level in February.

What we can say is that the 50-day and 200-day moving averages, which are currently in the $1285-$1290 range, should act as a price floor if a pullback begins in the near future.



By the way, while the historical record indicated that the so-called "Golden Cross" (the 50-day MA crossing from below to above the 200-day MA) that occurred in March would probably mark a short-term price high and that the so-called "Death Cross" (the 50-day MA crossing from above to below the 200-day MA) that occurred at the end of May would probably mark a short-term price low, the next Golden Cross -- which is likely to occur within the coming month -- will have no predictive value.

The reason for the gold reversal

Despite much press coverage putting last week's sharp rise in the gold price down to increasing Iraq-related tensions and/or the Fed's confirmation that official US interest rates would not be raised for a long time, neither explanation rings true. First, increasing tension in Iraq would affect the oil market more than the gold market and would also affect the equity and bond markets, but there were no signs of heightened concerns about Iraq in any of these markets. Second, the Fed's plan to keep its targeted interest rate near zero for the foreseeable future is not news. Everyone was already aware of this.

It could be argued that by emphasising her devotion to hopelessly flawed Keynesian ideas at a press conference last Wednesday, Janet Yellen gave a gentle downward push to confidence in the Fed. Given that gold's perceived value is the reciprocal of confidence in the Fed, this could have helped to 'get the gold ball rolling'. However, last Thursday's surge in the gold price had been telegraphed well in advance by the performance of the gold-mining sector, so we don't think it makes sense to attribute the rise to any particular piece of recent news.

We think the upward reversal can be adequately explained by the combination of fundamental drivers and a bullish mismatch between sentiment and price action (sentiment had become far more bearish than warranted by the price action). As stated in the 9th June Weekly Update: "It seems that almost every 'technical analyst' on the planet is calling for gold and the gold-mining indices to make new lows within the next few months. The long-term bulls expect a final decline to marginal new lows prior to the start of a multi-year upward trend, whereas the long-term bears expect a decline to well below last year's lows as part of a continuing bear market. Enough strength over the weeks ahead to confirm that the March-June decline was a correction to a new upward trend rather than the continuation of the 2011-2013 downward trend would therefore catch the maximum number of chart-huggers and price-followers off guard. This doesn't mean that gold is about to reverse course and prove the majority wrong, but it does mean that there is plenty of sentiment-related fuel to propel the price upward. As discussed in previous commentaries, there is also now plenty of fundamentals-related fuel for a gold rally..."

Gold

We've written that gold needs to get back above $1280 on a daily closing basis to confirm that the short-term trend has reversed from down to up, but $1292 is actually a more significant price level. A daily close above $1292 would break gold above its short-term channel top as well as its 50-day, 150-day and 200-day moving averages. This is a feat that has already been accomplished by GDXJ and has almost been accomplished by the HUI. We expect that it will be accomplished by gold bullion within the next three weeks, but hopefully not in response to news from Iraq.



When the gold price rose to around $1350 in late February we thought it was due for a correction that could take it down as far as the $1270s. The Ukraine drama then began, which quickly pushed the gold price up to almost $1400 in early March. We said at the time that as is always the case when gold is bid-up in reaction to international military conflict or the increasing threat of international military conflict, all the price gains achieved by gold on the back of the Ukraine news would be relinquished. This turned out to be so, but with the clarity that only hindsight can provide we now see that the upward price spike in reaction to the Ukraine drama had a much larger effect than originally anticipated. In a financial-market version of Newton's Third Law of Motion (for every action there is an equal and opposite reaction), the surge of uninformed gold-buying prompted by the Ukraine news set the stage for a deeper and longer correction than would otherwise have happened.

Due to the latest developments in Iraq, with Sunni jihadist militants have taken control of the country's second-largest city and a further escalation of violence seemingly on the cards, understanding how gold typically responds to increasing geopolitical instability could be of near-term importance. That's why we just revisited gold's reaction to the Ukraine drama.

The recent upturn in gold-related investments does not appear to be due to the latest developments in Iraq, but if gold spikes upward in the near future in response to a worsening situation in Iraq then the start of the next multi-month advance in the gold price would likely be postponed. This is because any Iraq-related gains would subsequently be given back and because the surge of uninformed buying would weaken the structure of the market.

Now, if the situation in Iraq were to worsen to the point where it provoked another large-scale US military intervention, then the backdrop would become increasingly gold-bullish. This would not be directly due to the military action itself, but due to the damage to the US economy inflicted by the government wasting a lot more resources on another counter-productive escapade. However, history teaches us that even in this case the initial price gains would likely be given back in full.

The Stock Market

...We are surprised that the stock market's upward trend has extended into June. This opens up the possibility that the overall topping process could continue into the final quarter of this year, with a significant decline during the next couple of months followed by a rally to test the high later in the year.

On a short-term basis, however, the recent price action has only increased the downside risk, in that the strength that has enabled the NASDAQ100 Index (NDX) to confirm the new highs in the S&P500 Index (SPX) has led to the senior stock indices becoming very 'overbought'. As an example, the Dow Jones World Stock Index (DJW) has risen on 10 of the past 12 trading days. The daily advances have all been small, but, as illustrated by the following daily chart, the result is that DJW is now at the top of its intermediate-term price channel and DJW's daily RSI(14) is now at a 2-year high.



Also worth noting is that a put/call sell signal was generated at the end of last week in the US stock market. We define a put/call sell signal as the 10-day moving average of the equity put/call ratio moving to the vicinity of its 3-year low concurrently with the 10-day MA of the OEX (S&P100 Index) put/call ratio moving to the vicinity of its 3-year high. Such signals usually occur no more than twice per year and are short-term bearish omens because they indicate a lack of concern about downside risk on the part of the 'dumb money' (the dominant influence on equity option volumes) combined with a heightened level of concern about downside risk on the part of the 'smart money' (the dominant influence on OEX option volumes).



Therefore, although the stock market has defied our expectations over the past few weeks, this is not a good time to become more short-term bullish.

Gold

The "Golden Cross" and the "Death Cross"

There was a "Golden Cross" in the gold market during the second half of March. It worked the way that the historical record indicated it would work (it marked a high of at least short-term importance), which happens to be the opposite of the way that most commentators and analysts believe it is supposed to work. To further explain, here is an excerpt from our 19th March commentary:

"While on the subject of false beliefs, another one that will soon come into play in the gold market is the "Golden Cross". A Golden Cross is defined as a move -- in any market -- by the 50-day MA from below to above the 200-day MA. Its opposite (a move by the 50-day MA from above to below the 200-day MA) is often referred to as a Death Cross.

There is widespread belief that Death Crosses are bearish and Golden Crosses are bullish, but nobody who has bothered to check the historical record could hold this belief. Here are the facts:

1) A sizeable majority of Death Crosses in major financial markets occur near lows of at least short-term importance. A Death Cross therefore tends to be a BULLISH signal.

2) On average, a Golden Cross has no predictive value. The historical record suggests that it is neither reliably bullish nor reliably bearish. However, in the gold market a particular type of Golden Cross has generally occurred near a high of at least short-term importance. We are referring to the situation where the cross occurs after the 50-day MA has risen from a long way below the 200-day MA. This is the situation we will be dealing with if -- as is very likely -- the gold market achieves a Golden Cross in the near future."

As illustrated by the following daily chart, the gold market's March-2014 Golden Cross occurred about one week after a multi-month price high. There has since been sufficient price weakness to pull the 50-day MA below the 200-day MA, creating a so-called Death Cross. The Death Cross occurred last week. Contrary to popular belief, the historical record indicates that this is a bullish signal.

Gold Stocks

The HUI is staggering along near its lows of the past two months, frustrating the bulls by not showing any sign of strength and frustrating the bears by not accelerating downward. Beneath the surface, however, there is evidence that the downward correction of the past two months is about to end. We are referring to the fact that a bullish divergence has developed between the HUI and the GDXJ/GDX ratio (junior gold stocks relative to senior gold stocks).

The following chart shows the aforementioned bullish divergence as well as the bearish divergence that formed during February-March and the bullish divergence that formed in December. In this case, a bullish divergence involves lower lows in the HUI in parallel with higher lows in GDXJ/GDX, while a bearish divergence involves higher highs in the HUI in parallel with lower highs in GDXJ/GDX.



Even if the gold-mining sector is about to begin a new short-term upward trend (we think it is), a 'cleansing' spike down to 210 could precede a sustainable upturn.

Gold Stocks

Updated comparisons with the 1970s

Updated charts comparing the BGMI (Barrons Gold Mining Index) from its 1967 and 1974 peaks with the current HUI are displayed below. The current price action continues to be most similar to 1977 (the second of the following charts).

If the current price action continues to follow the 1977 path then an upward reversal will occur this week, perhaps following a spike to a new correction low.

Money Velocity, Supply and Demand

"Money Velocity" is NOT a useful concept in economics or financial-market speculation. The reasons have been discussed numerous times in TSI commentaries over the years, but in response to some emails received over the past few weeks it is time for a brief recap.

As is the case with the price of anything, the price of money is determined by supply and demand. Supply and demand are always equal, with the price adjusting to maintain the balance. A greater supply will often lead to a lower price, but it doesn't have to. Whether it does or not depends on demand. For example, if supply is rising and demand is attempting to rise even faster, then in order to maintain the supply-demand balance the price will rise despite the increase in supply.

When it comes to price, the main difference between money and everything else is that money doesn't have a single price. Due to the fact that money is on one side of almost every economic transaction, there will be many (perhaps millions of) prices for money at any given time. In one transaction the price of a unit of money could be one potato, whereas in another transaction happening at the same time the price of a unit of money could be 1/30,000th of a car. This, by the way, is why all attempts to come up with a single number -- such as a CPI or PPI -- to represent the price of money are misguided at best.

To summarise, in the real world there is money supply and there is money demand; there is no money "velocity". Why, then, do so many economists and commentators on the economy harp on about the "velocity of money"?

The answer is that the velocity of money is part of the very popular equation of exchange, which can be expressed as M*V = P*Q where M is the money supply, V is the velocity of money, Q is the total quantity of transactions in the economy and P is the average price per transaction. The equation is a tautology, in that it says nothing other than the total monetary value of all transactions in the economy equals the total monetary value of all transactions in the economy. In this ultra-simplistic tautological equation, V is whatever it needs to be to make the left hand side equal to the right hand side.

Another way to express the equation of exchange is M*V = nominal GDP, or V = GDP/M. Whenever you see a chart of V, all you are seeing is a chart of nominal GDP divided by money supply. That's why a large increase in the money supply will usually go hand-in-hand with a large decline in V.

In conclusion, V (money velocity) does not exist outside of a mathematical equation that, due to its simplistic and tautological nature, cannot explain real-world phenomena.

Gold fundamentals now bullish

The fundamental backdrop was unequivocally gold-bearish during the first half of last year. Around the middle of last year it began to shift in gold's favour with the upside breakout in the US yield-spread (the difference between 10-year Treasury yields and 2-year Treasury yields) and the rolling over of the BKX/SPX ratio, but at the beginning of this year it could best be described as mixed (neither definitively bullish nor definitively bearish). It remained 'mixed' throughout the first quarter, but due to two recent developments it is now bullish. One of these developments is the downside breakout in the BKX/SPX ratio discussed in last week's Interim Update. The other is the downside breakout in the HYG/TLT ratio, a credit-spread indicator. HYG/TLT rises when credit spreads are contracting (indicating rising economic confidence, which is bearish for gold) and falls when credit spreads are expanding (indicating declining economic confidence, which is bullish for gold).

Here is a chart comparing the gold price and the HYG/TLT ratio. The inverse relationship of the past 3.5 years is clear.



By the way, in addition to being a bullish omen for gold, last week's downside breakout in the HYG/TLT ratio is a bearish omen for the broad stock market.

Monetary Inflation Update

The ECB got around to publishing its money-supply data for February late last week, enabling us to update our euro and G2 (US plus euro-zone) True Money Supply (TMS) charts.

Our first chart shows the year-over-year (YOY) percentage change in euro TMS. The ECB is coming under pressure to do more on the monetary inflation front, but recently it hasn't done much. Over the past two months the YOY rate of change in euro TMS flatlined at around 6%.

Note that while we have no opinion about the euro's likely performance on the foreign exchange market over the weeks immediately ahead, we are intermediate-term bullish on this currency (relative to the US$). The primary reason is our expectation that the low valuations of European equities relative to US equities will lead to outperformance by the former, boosting the investment/speculative demand for the euro. A secondary reason is that despite the Fed's "tapering" and the apparent intention of the ECB to do more on the monetary inflation front, the ECB could end up doing less than needed, in the face of substantial natural deflationary pressures, to create the sort of "price inflation" that bad economists and central bankers believe to be beneficial.



Our second chart shows the YOY percentage change in G2 TMS -- in our opinion the most useful leading indicator of the global boom-bust economic cycle. The last two economic busts commenced about 6 months after the annual growth rate of G2 TMS dropped to 5%. At around 7% the current growth rate is only slightly above its low of the past 4 years, but still comfortably above the level that ushered-in the previous two busts.



The UK's YOY rate of money-supply growth has been stable at 5.5%-6.5% for almost 18 months. This is inflationary, but not as inflationary as the money-supply growth rates in many other countries. Also, the average rate of increase in the supply of British Pounds was relatively low during 2009-2012. This goes part of the way towards explaining the strength in the Pound's exchange rate over the past 12 months and should continue to create a tail-wind for the Pound over the coming 12 months.

Gold

Unfounded Beliefs

In the latest Weekly Update we warned that the Ukraine situation created near-term downside risk rather than near-term upside potential for gold. Based on the historical record it was almost inevitable that gold would fully retrace any gains made in reaction to the heightened threat of military conflict in Ukraine, with $30/oz being our guess as to the amount of Ukraine premium in the price as at the end of last week.

When it became apparent at the beginning of this week that the Ukraine conflict was not going to immediately escalate, the gold price quickly dropped $30.

The Ukraine-related conflict between Russia and the "West" could escalate in the future, causing the gold price to surge. If it does, the same will apply: any price gain made by gold on the back of such news would almost certainly be retraced in full.

The upshot is that contrary to popular belief, international military conflict or increasing risk of such conflict never creates a short-term buying opportunity in the gold market. However, it sometimes creates a short-term selling opportunity.

While on the subject of false beliefs, another one that will soon come into play in the gold market is the "Golden Cross". A Golden Cross is defined as a move -- in any market -- by the 50-day MA from below to above the 200-day MA. Its opposite (a move by the 50-day MA from above to below the 200-day MA) is often referred to as a Death Cross.

There is widespread belief that Death Crosses are bearish and Golden Crosses are bullish, but nobody who has bothered to check the historical record could hold this belief. Here are the facts:

1) A sizeable majority of Death Crosses in major financial markets occur near lows of at least short-term importance. A Death Cross therefore tends to be a BULLISH signal.

2) On average, a Golden Cross has no predictive value. The historical record suggests that it is neither reliably bullish nor reliably bearish. However, in the gold market a particular type of Golden Cross has generally occurred near a high of at least short-term importance. We are referring to the situation where the cross occurs after the 50-day MA has risen from a long way below the 200-day MA. This is the situation we will be dealing with if -- as is very likely -- the gold market achieves a Golden Cross in the near future.

The 20-year gold-market history of the type of Golden Cross mentioned above (the type where the cross occurs after the 50-day MA has risen from a long way below the 200-day MA) contains only five examples. Here they are:

1) In April of 1995, a Golden Cross occurred about one week after an intermediate-term price high. An intermediate-term price low was then marked by a Death Cross in October of the same year.



2) In October of 1999, a Golden Cross coincided with an intermediate-term price peak.



3) In June of 2001, a Golden Cross coincided with a short-term price peak. If Golden Crosses are supposed to be bullish signals then the June-2001 cross was the least wrong of our examples.



4) In February of 2009, a Golden Cross occurred about one week prior to a price high that held for 6 months.



5) In September of 2012, a Golden Cross occurred just prior to an intermediate-term price high. If Golden Crosses are supposed to be bullish signals then the September-2012 cross was the biggest failure of the past 20 years due to the fact that it occurred near the beginning of a large 9-month price decline.

Gold

If we use a magnifying glass we see that gold broke out to the upside last Friday, but if you have to use a magnifying glass to see a breakout then a breakout hasn't really happened. The US$ gold price is clearly very close to providing us with preliminary evidence of an upward trend reversal by breaking above its channel top and its December-2013 rebound peak, but some additional strength is required.

A weekly close above $1300 would be conclusive evidence of an upward trend reversal.



In A$ terms, gold bottomed last April and has since made a sequence of higher lows. This price action should lead to relatively good results for gold producers with operations in Australia.



In the 6th January Weekly Update, we wrote:

"Gold's fundamentals turned more bullish in mid-2013 and in our opinion will become increasingly so over the next 6 months, but right now the fundamental backdrop for gold can best be described as mixed. The reason, in a nutshell, is that there is still a lot of economic optimism and confidence in both the Fed and the ECB. That's why credit spreads have been relentlessly narrowing since June of 2012 and are now almost as narrow as they ever get.

The narrowing of credit spreads is indicated on the first of the following charts by the upward trend in the HYG/TLT ratio (high-yield bonds relative to Treasury bonds), because HYG outperforms TLT when investors become less risk averse and bid-up high-yield (junk) bonds relative to US government bonds. The HYG/TLT ratio probably can't go much higher, but it needs to start trending lower to become 'gold bullish'. A break below 0.85 would confirm a downward trend reversal."

The HYG/TLT ratio hasn't yet become 'gold bullish' by confirming a downward trend reversal, but the following chart shows that it is now heading in the right direction.

Probably the most important fundamental [gold] driver right now

Given that gold is widely viewed as a hedge against problems in the financial system it makes sense that the relative strength of the banking sector tends to have a significant effect on the gold market. Over the past few years this effect has been much stronger than usual. In fact, we noted in a recent commentary that the banking sector's relative strength, as indicated by the BKX/SPX ratio, currently appears to be the most influential of gold's fundamental price drivers.

The strong inverse relationship between the US$ gold price and the BKX/SPX ratio is illustrated below. Notice that the major 2011 high for the gold price roughly coincided with a major low for the BKX/SPX ratio and that the late-June bottom for the gold price roughly coincided with a peak for BKX/SPX. The jury is still out as to whether the June-July 2013 extremes for the gold price and the BKX/SPX ratio were the major variety.



By the way, gold has tended to lead the BKX/SPX ratio by 1-3 months at significant turning points over the past three years. We are referring to the fact that gold turned lower about 3 months before BKX/SPX turned higher in late-2011, that gold turned higher about 1 month before BKX/SPX turned lower in mid-2013, and that gold turned lower about 2 months before BKX/SPX turned higher in Aug-Oct of 2013. At this time we have a late-December upward reversal in the gold price that should, if it is genuine, be confirmed by a downward reversal in BKX/SPX by the end of March.

Always one of the least important fundamental [gold] drivers

As explained in many TSI commentaries over the years, changes in annual gold production are so unimportant that they can safely be ignored when considering bullish and bearish influences on the gold price.

The gold market can be likened to a company that increases its share count by about 1.7% every year. In this analogy, the amount of new supply added by the mining industry to the aboveground gold inventory each year is equivalent to our hypothetical company's small annual addition to its share count. Some years the increase in the share count could be as high as 1.9% and some years it could be as low as 1.5%, but in terms of effect on the share price these variations in the number of new shares will be dwarfed by changes in sentiment, the performance of the broad stock market, company-specific fundamentals such as earnings, and economy-wide fundamentals such as monetary policy.

In the gold market, the small annual change in the total aboveground supply will always be trivial compared to influences such as central bank monetary machinations and changes in economic confidence. So, anyone who is currently basing a bullish gold view on the possibility that gold production will decline is probably going to be right for the wrong reason.

Gold

Although the gold price did very little last week, the price action helped to define the two price channels indicated on the following daily chart. Notice, in particular, that last week's intra-day low coincided with the bottom of a channel dating back to the late-August rebound high and the bottom of a narrower and more steeply-sloped channel dating back to the October rebound high.

Friday's close coincided with the top of the steeply-sloped channel dating back to the October high, so any additional price gain from here would create a minor upside breakout. However, more important resistance lies in the $1270s. A counter-trend rebound shouldn't do more than test this resistance, which is why we would interpret consecutive daily closes above $1280 as confirmation that an important bottom was in place.



Over the past 5 years, one of the most important gold-market 'fundamentals' has been the relative performance of the US banking sector as indicated by the BKX/SPX ratio. Gold tends to do well when the banking sector is weakening relative to the broad stock market and gold tends to do poorly when the banking sector is strengthening relative to the broad stock market. The following chart shows the performance of the BKX/SPX ratio.

There is preliminary evidence in the market action that the BKX/SPX ratio made a trend reversal of at least intermediate-term significance at the end of June-2013. Taking out the early-November low would provide conclusive evidence of such a development and would substantiate the view that the gold market commenced a major bottoming process in June.

Eric Sprott's Flawed Analysis

Great success in business or investing does not imply great understanding of macroeconomics or how the gold price is formed. This has been proved many times in the past by Warren Buffett. Recently, it has also been proved by Eric Sprott in an open letter to the World Gold Council (WGC). Sprott criticises the hopelessly-flawed supply-demand analysis of both the WGC and Gold Fields Mineral Services (GFMS), but not for the right reasons. He actually uses the same hopelessly-flawed methodology, the only differences being in some of the figures that are plugged into the analysis.

Sprott, the WGC and GFMS tally the amounts of gold bought by some parts of the gold market and call this quantity "demand", and tally the amounts of gold sold by other parts of the gold market and call this quantity "supply". They then compare the two tallies to determine whether the gold price should be rising or falling.

In this method of analysis, the gold-mining industry is by far the biggest seller. In fact, in this method of analysis the supply side of the equation is always represented by the 2400-2800 tonnes per year of gold produced by the mining industry plus the amounts of gold sold by a few relatively minor players. Over the past year the gold ETFs have collectively been one of these minor players on the supply side (physical gold has left the ETFs).

In the real world, however, the supply side of the equation is the total aboveground gold inventory, which is about 150,000 tonnes. Since all the gold is always held by someone, demand is also equal to the total aboveground inventory of (very roughly) 150,000 tonnes. In other words, at any given time supply equals demand equals 150,000 tonnes.

In the real world, the gold sold by the mining industry is no different to the gold sold by any of the current holders of gold. For example, if the gold price reaches a level at which Trader A wants to buy 1,000 ounces of gold, then Trader A's demand can be satisfied by a sale of gold on the part of any of the current holders of gold, including the mining industry.

Price is the quantity that changes to keep supply and demand in balance. If demand increases relative to supply at a certain price, the price will immediately adjust upward by as much as it takes to re-establish the balance. By the same token, if demand falls relative to supply at a certain price then the price will immediately adjust downward by as much as it takes to re-establish the balance. Price, therefore, is the only measure of whether the urgency to sell is rising or falling relative to the urgency to buy.

Here's another way to look at the situation: For every purchase there must be a sale. That is, the amount of gold sold must always be equal to the amount of gold bought (another reason, by the way, that it makes no sense to separately tally sales and purchases as if one could ever be larger than the other). What causes the price to change, therefore, isn't a greater volume of selling or buying, it's the relative eagerness of buyers and sellers. For example, if a large number of eager get-me-out-at-any-price sellers enter the market then the volume of trading will increase, meaning that the amount of gold sold and the amount of gold bought will increase by the same amount, and the price will fall. Some analysts will look at the increase in buying that accompanied the price decline and will be nonplussed, because they don't seem to understand that an increase in buying MUST go hand in hand with an increase in selling, and that the price decline tells you with 100% certainty that the sellers were more eager than the buyers.

Over the past six months we've probably devoted too much space in TSI commentaries to debunking the nonsensical gold supply-demand analysis that gets put out by GFMS, the WGC, and now Eric Sprott. However, it's an important issue, because gold bulls (including us) can't learn from past mistakes unless they understand why they were wrong. If you were bullish over the past year and you still believe that you were right to be bullish, then you haven't learned anything and you will almost certainly make the same mistake again.

The China-Gold Myth

Rather than cast doubt on the wrongheaded idea that China's buying is a cornerstone of the gold bull market, the fact that a major 2-year correction in gold's bull market has coincided with a large increase in the amount of gold flowing into China has only served to fuel conspiracy theories. After all, how could the gold price trend downward in parallel with a large increase in Chinese demand unless powerful, unnatural forces were at work?

The gold price is capable of trending downward in parallel with a large increase in Chinese demand because the change in China's demand for gold explains very little about past movements in the gold price and says very little about likely future movements in the gold price. In more general terms, the amount of gold flowing from one geographic region to another or from one set of holders to a different set of holders tells us nothing useful about gold's major price trend. The reason is that the flow of gold is an indicator of trading volume, which can increase or decrease in parallel with a rising or a falling price. The market-wide urgency to buy relative to the market-wide urgency to sell is what determines the price, and the only reliable indicator of whether buyers or sellers have greater urgency is the change in the price itself.

By way of further explanation, consider a model of the global gold market in which there are only two traders: China and the World Excluding China. We'll refer to China as Trader A and the World Excluding China as Trader B. Clearly, in order for Trader A to increase its gold exposure, Trader B must decrease its gold exposure, and vice versa. To put it another way, for A to be a net-buyer B must be a net seller, and for B to be a net-buyer A must be a net seller. Price is the force that keeps the change in A's demand in balance with the change in B's demand. This means that if B is not prepared to part with enough gold to satisfy an increase in A's demand at a gold price of X, then the price will rise to (X+Y) where Y is whatever it needs to be to bring the market into balance.

Those making the "China's buying is bound to drive the gold price to new highs" claim are, in effect, only looking at one side of the equation. They are looking at A's buying and forgetting about B's selling. They seem to be making the assumption that A is increasing its buying while B does nothing, but this assumption is patently wrong because A cannot possibly increase its buying unless B increases its selling. The change in price is the only valid indicator of which is the more important, A's buying or B's selling. Moreover, a net flow of gold from A to B or from B to A could be accompanied by either a rising or a falling gold price. In fact, not only is a net flow of gold from B (the World ex-China) to A (China) not inherently bullish, a net flow in the opposite direction would not be inherently bearish.

Another relevant point is that Trader B (World ex-China) is the proverbial gorilla in the gold market. To understand why, consider that in very rough terms there are probably at least 150,000 tonnes of aboveground gold in the world and probably no more than 10,000 tonnes of gold in China. This means that when total gold supply is taken into account, China is probably no more than 6.7% of the global market. This, in turn, means that it would take a 30% increase in China's gold demand to offset a 2% decrease in gold demand across the rest of the world. It is therefore fair to say that if the overall demand for gold outside China rises by at least a few percent then the gold price is going to rise, regardless of what's happening in China, and if the overall demand for gold outside China falls by at least a few percent then the gold price is going to fall, regardless of what's happening in China.

To sum up, we aren't saying that an increase or a decrease in China's gold demand is completely irrelevant. We are saying that a) China can only increase its gold ownership if the World Excluding China decreases its gold ownership, b) price is the only reliable indicator of the importance of China's gold demand relative to the gold demand of the World Excluding China, and c) China's gold demand is dwarfed -- in terms of effect on the gold price -- by the overall change in gold demand outside China.

As explained in many previous TSI commentaries, the overall change in gold demand outside China is largely determined by confidence in the senior central banks and the stock market's valuation trend.