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December 05, 2007

Leading Signals for Bonds, Stocks and Gold Stocks
by Clif Droke

After an extraordinary run off the June lows, the bond market has shown the first signs of encountering resistance.

The run-up in bond prices has been mainly a function of the insane fear that has gripped investors by the throat since last June. As bond prices have risen dramatically over the last five-and-a-half months, the level of investor fear has risen in proportion to prove that this is no ordinary rally. It is the result of investors seeking safety from the financial storms that have hit them in recent months.

Using the action of the 20+ Year Treasury Bond index fund (TLT), let's examine the internal structure of the bond market.

After establishing an intermediate-term uptrend channel off the June lows, the TLT made two upside "channel busters", one in August and the other in September (see circled areas in above chart). In both cases, as the upside violation of the trend channel suggested, there was a sharp pullback inside the channel to correct this excessive rally in bond prices.

After two upside channel busters (which represent buyer exhaustion), it was time for a deeper correction in the TLT. This happened, as you can see in the chart, in October when TLT temporarily fell below the extreme lower boundary of the uptrend channel. This is typical of a correction that follows an exhaustion move in the midst of a powerful bull market. By falling below the trend channel floor, the bond market became super oversold and was ripe for another run to the upside.

The move off the October lows in TLT pushed the price line to an extraordinary high near the 96 level in late November. In making this nearly vertical rally, TLT once again reached the point of exhaustion and made yet another upside channel buster (see circled area of chart). A mild pullback followed into early December, which takes us to the present.

The lower boundary of the interim uptrend channel in TLT intersects very close to the 92 level as shown in the above chart. The 92 level is also the vicinity of where the important 30-day moving average intersects. This underscores the technical significance of 92, and if 92 is broken on the downside, while it would temporarily exhaust the selling pressure, would also break the interim uptrend. This would likely serve as an exit signal to the safe-haven bond investors would in turn beat a hasty retreat.

Even if the 92 level isn't broken, at the very least there should be a corrective pause or consolidation in the bond trend following the latest channel buster. This would result in a lengthy lateral market until all the internal excesses from the previous bond rally can be wrung out.

The inverse of the bond price trend is seen in the trend of Treasury yields. Notice that in the benchmark 10-year Treasury Yield index (TNX) a downside channel buster occurred in early September coincident with the upside channel buster in the TLT. This served as a strong indication that the decline in TNX would be temporarily reversed, as it was, and TNX proceeded to make a recoil rally to the upper boundary of its downtrend channel into October (see chart below).

In doing so, however, it produced a throw-over above the established downtrend channel which in turn signified a resumption of the decline would shortly ensue. You can see by these examples how using the channel buster is a wonderful tool in its simplicity and usefulness. You might want to remember this the next time you're scanning the charts.

The latest downside channel buster in the TNX occurred in late November (see circled area in above chart). This signified a temporary exhaustion of the decline in TNX and has so far allowed TNX a pause to consolidate and an attempt at building a base of support. How long this base of support will hold up is open for discussion but with the 10-month oscillator for bond yields sending a decisively sold out signal (see below), this strongly suggests a corrective rally in yields (and a correction in bond prices) is ahead.

The interim rally in the TLT and the corresponding drop in yields as seen in the TNX has been mainly a function of the high level of investor fear over the credit crisis. Yet it has been strong enough in and of itself to signal that the stock market is due a vibrant rally in the interim. For whenever the 10-year yield drops by one full percent or greater, the stock market always rallies in the months that follow.

So you can see how the TLT super rally and the corresponding TNX decline, despite the fear it represented in 2007, has bullish implications for stocks heading into 2008.

Another message the bond market is sending is that monetary conditions are in the process of improving. Indeed, the big improvement in monetary condition combined with the super-strong Wall of Worry and the massive undervaluation of stocks compared to bonds, will provide a major boost to the stock market.

"Scared investors rush for money market funds," blared the headline last week in the Financial Times. It doesn't get much better than that from a contrarian standpoint and it's a beautiful headline to add to our growing "fear collage" (as featured in last week's commentary). The article goes on to state that "Assets in US money market mutual funds soared to a record $3,031bn this week as investors sought safe harbour from the widening mortgage fallout."

This is yet another indicator that help is on the way for the stock market, for when "scared investors" begin rushing to the perceived safety of cash and those money market funds soar, it only takes a lifting of the headline fear before that scared money comes rushing back into the stock market.

When their judgment isn't being clouded by fear, investors always chase the highest bidder. Once the fear subsides investors will realize that a 7% S&P 500 earnings yield is far superior to a 3.90% yield on the 10-year Note.

Gold Stocks

A nice pattern is shaping up in the leading indicator stock for the PM sector, Freeport Copper & Gold (FCX, $101.60). Notice that FCX has closed four consecutive days above its 15-day moving average and is trying to establish support above the 10-day MA. Wednesday was a good day for FCX as the stock was up 4.34% and has now established a pattern of higher highs. This is similar to the pattern FCX made following its August correction low. The MACD indicator is also in a deeper oversold position than it was at the August low, which is technically bullish and is a positive harbinger for the gold stock sector in the near term.

Speaking of the PM stocks, I was forwarded a comment by gold analyst Adrian Douglas who wrote, "...precious metal equity investors are frightened of their own shadows. I have received many e-mails that would lead me to think that these investors own sub-prime CDO's not mining shares! ...The near paranoia among mining equity investors is a good contrarian indicator."

Indeed, sentiment on the gold stocks is very negative right now as investors have turned their back on this group. This puts a bullish tilt on the market from a psychological standpoint.

**********

Ode to Undervaluation

The bears have been growling louder each day,
For over a month now they've had their say.
"A crash is coming!" they loudly proclaim,
Yet their arguments are shallow and lame.

Stocks are undervalued, so says IBES,
Not in 15 years have they sold for less.
The smart money's buying hand over fist,
And soon by the bull those stocks will be kissed.

As prices climb, those headline fears will fade,
Buying the lows is where fortunes are made.
Running from value is a bear's mistake.
The values are real but the fear is fake.

**********

Clif Droke
ClifDroke.com

Clif Droke is the editor of Gold Strategies Review., providing forecasts and analysis of the leading North American small cap, mid-tier and senior mining stocks from a short- and intermediate-term technical standpoint since 1998. He is also the author of numerous books, including "Channel Buster: How to Trade the Most Profitable Chart Pattern" For more information visit www.clifdroke.com