February 1, 2010

Major US Equities vs Gold

(Click to enlarge the graphic).

Markets stumbled in Jan 10 against a sea of huge deficits and the threat of bank taxes, but is this a dip or deeper correction?

The weekly bar charts above plot the Dow Industrials (blue bars, top left) and S&P 500 (purple bars, top right) each versus the GLD gold ETF (gold, top of both charts). A ratio line, devised by dividing the cash price of the individual indices by the cash price of the gold ETF, is plotted in black (bottom of each chart). Horizontal dashed lines colored to match each instrument denote price levels of interest. Red horizontal dashed lines in the ratio area depict channel levels. Several vertical dashed lines denote dates, with colored circles intersecting time and price points for discussion. Finally, a Fibonacci price extension is plotted in grey for the GLD itself.

Clearly the recovery since Mar 09 has been impressive by any returns centric measure. Markets have effectively risen unabated since the precipitous sell off from Oct 07 highs. Looking back then merely at cash prices, long only equity's fall from grace - while volatile - may have been judged merely a correction at the time... perhaps even a dip. Fundamentally, many comparisons were made regarding then falling versus historical P/E ratios (accompanied by then falling interest rates) as forming a ripe condition for equities to rally. Unfortunately, these fundamentals proved to be false as earnings represented half of the equation, with their corresponding drop in fact actually raising P/E's in several instances.

What is technically clear from this chart, however, is that the channeling of the individual equity gold ratios broke to the downside intimating trouble ahead. Clearly, cash prices in both the Dow and S&P continued to rise for nearly a year (see red vertical dashed lines, Oct 06 - Oct 07) before the subsequent collapse. Few if any fundamentalists felt the calm before the storm, and optimism was abundant regarding equities. Almost contrarian in nature, one would have been hard pressed to find a pessimistic view regarding long term outlooks for stocks. Similar to the period of Oct 06 - Oct 07, cash prices in stocks have risen even though individual equity to gold ratios have channeled, with today's action mid channel in each chart.

We've remarked in weeks past that equities have effectively risen in the face of a falling US Dollar (see post on 04 Jan 10). Now, nearly a month since that observation, the decoupling of this relationship - spawned by a now rising US Dollar (while seen as a mere correction) - has appeared to take down equities if even for the short term. The jury may not be out, however, until the ratio line breaks from its current channel to the downside. As previously mentioned in these pages, markets can remain oversold or overbought longer than traders or investors can remain solvent (depending on one's position, long or short), so managing risk today becomes ever more paramount.

Accordingly, what could cause the gold ratio lines to break from their respective channels? Look closely at the cash price of gold - and note that the current price action lies at a critical 0.618 x AB=CD pivot level near 104.60. This price represents a polarity level (former resistance turned support) from Oct 09 and may offer a base from which gold can once again advance. Should gold indeed base here, a fall in equities combined with a continuation of the bullish advance in gold could drive the ratio line lower rather quickly. If not 104.60, then 99.00 near 1.00 x AB=CD represents the next polarity target from Feb 09.

As to reward versus risk, levels in the individual indices should be studied as well. Polarity prices in the Dow near 10,825 (from Jul 08) represents the next logical long target, with 8,875 (from Jun 09) forming the next short level. For the S&P, similar dates offer 1,200 to the long side, and 956 for shorts. Notice that dowsides are a long, long way from current price levels. Against this complexion, its surely advisable technicians revisit downside risk protection regarding longs. Leverage deployed to the long side should certainly be eased, and capital should be recommitted elsewhere. Alternatively, until the gold ratio lines breaks to the downside (should it break at all), shorts should remain leverage neutral.

Jeffery E. Lay, CMT
President
Talon Eight, LLC

Disclaimer: This post is intended solely to disseminate information, and is not, and shall not be construed to constitute financial, investment or other similar advice. All posted material should be independently verified for accuracy and current applicability. Readers of this post are referred to the Risk Disclosure for further information.

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