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The market took a breather yesterday with many previously strong indexes and commodities selling off. The decline in silver was especially pronounced and produced a reverse hammer candlestick which has obviously bearish connotations.

Of course, yesterday the CME raised the margin requirements for silver from $5000 to $6500. While this is being credited with causing the reversal, I don't think that it completely explains what happened. It definitely contributed to it but often we grasp at news or reasons for the market's moves when all you need to do is watch the price action itself.

Anyone paying even cursory attention would know that the precious metal was already extremely overstretched to the upside and had been sporting extreme bullish sentiment for some time. I outlined just how extreme in late September when silver reached a new 30 year (nominal) high accompanied by a 95% bullish DSI.

Silver managed to shrugged that off and went on a parabolic rise peeking above $29. Personally I was expecting it to reach the nice round number $30 before reversing. But it doesn't look like it is going to now.

There is currently a rare technical occurrence in silver: the relative distance from its medium-term and long-term moving averages is at an upside extreme. In the past 30 years, that has only happened 6 other times and all of them were instances of a major top:

silver parabolic chart Nov 2010

Needless to say, the RSI indicator also reached an extreme overbought level yet again. Note that I'm ignoring instances where either one or the other is at an extreme and looking at just instances where they are both signaling an overbought condition. This confluence of overbought extremes identified the major tops in silver in the following years: 1982, 1987, 1998, 2004, 2006 and 2008. The current condition remains to be seen but historical precedent would suggest this is a major inflection point.

Interestingly enough, the large commercial hedgers have slowly reduced their large net short exposure since late September. They are still maintaining a large chunk of contracts short (54,811 net short) as of November 2nd, 2010 which is the latest data available. Meanwhile, small speculators are net long with 16,257 contracts.

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Since I've been a curmudgeon about the incessant rise of gold, I'm trying to force myself to look at the other side of the ledger. The last time we looked at the old relic commodity, it was to grudgingly accept that even if gold is in a bubble, it has quite a ways to go still.

Sentimental Fools
We looked at the cross-currents in gold sentiment in the middle of May. Since then my timidity hasn't been incorrect. Price has retraced a bit and basically gone sideways. Now it has floated back to where we left it. Sentiment right now is still positive but not extremely so.

We have the anecdotal magazine cover stories (Thanks to Steffan, our trusty man from Germany) and Market Vane's Bullish Consensus is still hovering around 70%. As well the gold closed-end fund CEF is trading at a 9.86% premium. Finally, the bullish percent index for the sector has collapsed from 77.4% to 52% (after falling to a low of 42% in late May). That means that gold stocks could enjoy a rally before becoming overbought.

And if you just can't get enough of gold sentiment indicators, I pity you, fool! Then quit your jibba-jabba and check out the Mr. T Gold Indicator, courtesy of Minyanville.

Parabolic Goodness
While I've benefited from identifying the parabolic blow-offs in gold, I've missed out on what happens next. As you can see from the chart below, the recurring pattern after the parabolic tops has been a retracement and then a sideways range which forms a cup and handle technical formation.

Click to see a larger chart in a new tab:
gold cup and handle formations Jun 2010

Cup & Handle with Care
The formation can be a bit sloppy but the criteria for it is defined as a counter-trend retracement that lasts several months and takes prices down to the long term trend line. Price then recovers to the previous high only to then enter a second retracement that lasts a much shorter time frame and is much shallower.

The result is that resistance is eroded and the next upleg begins after a break above the previous high. This is similar to the view that Adam Hewison shares in this short 2 minute video about gold with a focus on the $1240 level to provide a potential breakout to the upside.

Bubble Target
The difference between a bubble and a bull market is that in the former you're a spectator and in the latter you're an investor. If gold is in a bubble, then it would still have to rise to about $3000 (give or take a few oz.) to equal the trajectory of other bubbles like the housing market or the Nasdaq tech bubble. That dovetails nicely with this chart, courtesy of David Rosenberg of Gluskin Sheff, showing the Dow Jones Gold ratio:

dow gold ratio long term chart Jun 2010

A true bubble top would take this ratio back to 2-3 where it has bottomed before - not inconsequentially at the end of secular bear markets. As well, parabolic blow-offs like the ones in the chart above are good short term technical signs of exhaustion but if we look at the long term chart of gold (say from 2000 to now) the trend is still very much linear. When this long term trend itself goes parabolic, then I think we'll have a good indication of the end of the gold secular bull market.

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I don't want to harp on gold too much but since we discussed the various gold sentiment measures recently and the Rydex traders rushing out at the shallow correction, I wanted to also provide a long term perspective.

Back when taxi drivers were becoming daytraders and when any public corporation could depend on a pop in their stock price just by adding ".com" to the end of their name, gold was being shunned by the general public. The double bottom which launched the secular bull market was formed when gold fell to a low of ~$250 in 1999 and again in 2001. In the ensuing decade it rose almost five fold:

gold futures correction Feb 2010 long term perspective

The long term trend line (green) goes back to 2001 but it accelerated (the slope steepened) in 2005 (blue line). This also coincides with the start of the parabolic spikes in price of gold.

Most importantly, this long term chart puts into perspective how shallow the retracement has been so far this year. But nevertheless, it has caused the "dumb money" to flee for the hills. That is bullish in the short term. But if gold were to turn up here and just ramp higher we would be right back in a parabolic situation just like we've seen 3 times already.

A correction to $900 - crashing through the psychological $1000 level - would still allow gold to remain at the accelerated trend line from 2005. And a super-bearish decline all the way to $760 would only take us back to the very long term trend line which goes back to the beginning of this bull market.

Can you imagine how demoralized the "gold bugs" would be if gold does indeed fall 18-30% more from here? The last two times that gold went parabolic it was followed by a 20% correction (2006) and a 30% correction (2008). So a decline of that magnitude is neither uncharacteristic nor devastating.

In fact, a lasting trend needs to be moderate in tone. If gold corrects to the $1000 level and then bounces off it strongly as it did in 2008 off the $700 level, it will only set up a third accelerated trend line. While the bulls may cheer such a move, it will put the secular gold bull market in jeopardy. In such a scenario, the long term picture will itself become parabolic - rather than just containing small bouts of parabolic activity.

So to sum up, my crystal ball is telling me: short term gold is higher, medium term, lower. And long term, still a secular bull market. But then again, maybe I'm reading it wrong :)

For another perspective, check out this video by Adam Hewison: Is Gold Poised to Go Higher or Lower?

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We recently looked at a valuation methodology from Ford Equity Research which suggested that right now, the stock market is approximately fairly valued.

Since the most recent components of Tobin's ratio (also known as Tobin's Q) have been released by the Federal Reserve, I thought we would check in on the updated chart for it:

tobins Q ratio chart update Jan 2010

If you're not familiar with this method of valuation, you should read "Valuing Wall Street" by Smithers & Wright.

As you can see, this method of valuation is also suggesting that we are close to parity. The most recent data point is for June 2009 at 0.91 (which by the way, will probably be declared as the end of the great recession).

Since then, the S&P 500 has risen approximately 24% so we can guesstimate that the present Tobin's Q ratio is slightly higher; perhaps even above 1. In contrast, the lowest Tobin's Q ratio during the bear market was for January 2009 at 0.64. But that didn't last long. Contrast this with the time period from 1974 to 1984 when it hovered around 0.40.

Finally, isn't it interesting to see the same parabolic rise and blow-off pattern in this economic indicator that we see so often in stock and commodity markets? Probably the most important iteration of this technical formation was the gold parabolic climax in late 2009. The price of gold still has not recovered that level.

Here are some recent comments from David Rosenberg (of Gluskin Sheff) on valuation:

  • The median level of the S&P from our models is 970 based, on Q4 data inputs; and 1,120 based on Q1 estimates (based on credit spreads, earnings estimates/revisions, money supply and yield curve — credit spread improvement and yield curve steepening have had a big impact this quarter).
  • Based on the Shiller normalized P/E ratio, the S&P 500 is 27% overvalued presently. That would put fair-value at 840. Note, however, that on average, the final blowoff phase to rallies takes the degree of overvaluation to 50%, which would be 1,350 on the S&P 500.
  • On a Tobin Q replacement cost comparison, the S&P 500 is trading 22% above the long-run average. This would put fair-value at 890.
  • Applying what would be a normal earnings increase in the context of 5% nominal GDP growth for 2009 would imply $65 for operating EPS. Applying a typical one-year forward multiple of 15x on that earnings stream would generate a 975 fair value estimate for the S&P 500.
  • Technically, the market has just successfully broken through the 50% retracement level from the March lows — it did so at 1,120 on the S&P 500. Next critical Fibonocci retracement of 61.8% would imply a test of 1,225 on the index.
  • So we have a combination of valuation and technical factors that would imply a low of 840 and a high of 1,350. The S&P 500 is around the 1,150 mark so it is 17% shy of what could be construed as a bubble peak; and 27% away from what could be construed as a natural corrective phase after a parabolic move from an oversold bottom.
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This is the next installment of my retrospective. I'm choosing the most relevant, interesting and useful commentary from each month and them in these posts as a means to both recap the roller coaster year we just went through, as well as to learn from past mistakes and savor the sweet, sweet victories.

If you've missed the previous one's here they are:

January - February - March - April - May - June - July - August - September - October

Heading into the home stretch now! Here are the highlights from November 2009:

  • Selling Vacuum Supports Uptrend
    Lowry Research and InvesTech both have a proprietary measure of "selling pressure" in the stock market and recently they both have signaled a major inflection point. While almost everyone looks on incredulously as the stock market climbs higher, the answer may be that there is a selling vacuum. The long term chart of this metric certainly suggests that's what we are seeing.
  • What If Wall St. Threw A Party, And Nobody Came?
    Retail investors have ignored the equity bull market entirely and instead, diverted their assets into fixed income mutual funds. This is remarkable and speaks to the toll this recent bear market inflicted. In the medium term, as contrarians, we can interpret this as a positive for the continuation of the rally but in the long term, the stock market needs new asset inflows.
  • Stocks Have Little Room To The Upside
    Turning a third time to the gap between the daily close and its 200 day moving average, the S&P 500 index once again approached top-heavy levels at 1100 in November. It was flat for the rest of the month and most of December. And even with the Santa Claus rally, it only climbed 2%.
  • Isolating Gold From US Dollar Weakness
    Have you ever wondered how much the fluctuations in the price of gold have to do with the weakness or strength of the dollar and how much they have to do with the actual supply and demand dynamic of the gold market? Here's one way to tell them apart.
  • New Highs For The Year But Market Breadth Stinks
    Even as the stock market was peeking at new highs, the underlying momentum as measured by the advance decline numbers were surprisingly weak. This suggested that there isn't much power behind a potential move the upside.
  • Canadian REITs Recover: Time To Exit
    Back at the start of the year I was bullish on the Canadian REITs as they were the proverbial baby being thrown out with the bathwater of the financial crisis. Fast forward a few months and we have a huge winning trade as prices bounced back strongly and as monthly distributions continued to be paid monthly.
  • Treasury 3 Month Bill Yields Fall To Negative
    You thought the credit markets were thawed, didn't you? And then suddenly the short term government paper goes to zero and slightly negative - meaning that people were actually paying the government to hold their money! Astonishing. Since then the 3 month T-bills have fallen in price and rates have risen to more 'normal' levels.
  • Dollar Carry Trade Correlates All Risky Assets
    Did you notice that 2009 was a year where all sorts of disparate asset classes were correlated? where almost every single asset class went up? You can thank the Fed induced US dollar carry trade.
  • Losing The Generals: Market Leadership Deteriorates II
    This was the second part of an analysis of the waning momentum and breadth in the general stock market. My premise was wrong as small caps roared back to life in December, hitting new highs for the year.
  • Gold Goes Parabolic Again & Again & Again
    Everything about gold in November was a screaming sell: the manic sentiment, the parabolic chart, the overcrowded trade as shown by the Commitment of Traders data, the distance of daily close from its long term moving average, etc. Gold pushed higher valiantly into early December but it was futile.

Jan - February - March - April - May - June - July - Aug - Sept - October - December

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