Decline in Stocks and Gold, Silver, and Mining Stocks Investors' Profits
This essay is based on the Premium Update posted on June 18th, 2010
In our previous essay we have mentioned that it does not seem that the ultimate top for this gold rally is behind us. Consequently, this week we would like to provide more information on what may influence various segments of the precious metals market, and what you can do about it.
When speaking about any money-related topic it is always useful to back up one's arguments with numbers, and influence is no exception here. While correlation alone does not imply causation (meaning that the fact that something is correlated with something else doesn't automatically mean that one of them influences the other, but the analysis of correlation coefficients for the precious metals stocks market is still important, because we often know more about the shape of the relation from other sources. For instance, we know that gold mining companies' profits (and thus their stock prices, and the HUI Index) depends on the price of gold, not the other way around.
Having said that, let's take a look at our correlation matrix:
Two factors are worthy of notation in the correlation matrix this week. First, there has been a significant decline in the coefficient for Gold and USD. Previously, both were rallying and there was a relatively high positive correlation between them. In the past two weeks or so, this has changed. Whereas gold has continued its upward movement, the USD has declined slightly. At this point - since gold moved higher in the past weeks - this number further supports the strength of gold and the validity of its rally. The yellow metal has strong momentum and is likely to maintain its rally in spite of where stocks and currencies go.
The second observation we wish to make this week with respect to our correlation matrix is the positive relationship seen between the general stock market and silver / mining stocks. The 30-day coefficients are both above 0.7, which means that the correlation is strong.
Mining stocks and silver are currently driven, to a comparable extent, by the general stock market and gold. It follows that trouble for the general stock market can clearly spell trouble for the mining stocks. At the same time the value of the correlation coefficient between gold and stocks is lower - about 0.4, which suggests that any trouble on the general stock market are likely to hit gold in a much smaller way than it would be the case with silver and mining stocks.
Therefore, if the main stock indices would be likely to move much lower, then it could be a good idea to stay out of silver and mining stocks. In fact, we have been steering our Subscribers away from mining stocks and silver for some time now. Gold emerged as the clear choice a couple of weeks ago when considering risk and reward ratios and this is still the case today.
Since the situation on the general stock market is so important right now, let's take a closer look on the long-term SPY ETF chart (charts courtesy by http://stockcharts.com.)
On this week's long-term general stock market chart we see that the lower resistance line has been surpassed with an upward move. The shape of the current chart and the volume patterns as well seem to indicate that we could be seeing the formation of the familiar head-and-shoulders pattern. This is a crucial development if it comes to pass. This would be a strong, bearish indicator for the general stock market and for silver and mining stocks as well. We will continue to monitor this daily and advise our Subscribers accordingly as this becomes more clear in the days ahead.
Here is a brief synopsis of what we will be looking for. If the main stock indices move to levels seen early in 2010, in the range of 114-115 and then decline, this will confirm the formation of the pattern and declining volume along with higher prices will indeed spell trouble. The next confirmation would be to see the volume increase along with lower prices after they reach the 114-115 area.
The range of the future downturn can be estimated by the size of the head or top of the pattern, which also corresponds to the 50% retracement of the 2009-2010 rally - around the 94 level in the SPY ETF. So although at first glance some may be inclined towards bullish sentiment in reaction to recent moves, this is not really warranted at this point in time.
Taking into account the comments made previously - that the general stock market is very likely to rally in the third year of the Presidential Cycle we end up with the conclusion that the main stock indices may begin to decline in the next few weeks, and move lower throughout the summer only to move up again in the final part of the year.
On the short-term chart, we see a close approximation to the 61.8% Fibonacci retracement level as a resistance close to the January high, thus making this resistance level stronger. Although we may see slight increases in the coming days, it does not appear that this will be the likely case in the month ahead. Further confirmation of this can be seen on the next chart.
On the Broker-Dealer Index chart, note that the upward move today in the general stock market did not keep the financial sector from declining. Conversely, it moved to its previous support level, and decline afterwards thus further verifying it as a resistance. This is a bearish sign indicating that declines in the general stock market are quite likely from here, but not necessarily right away.
Summing up, the situation in the general stock market may look bullish at first glance. Taking a broad perspective into account and analyzing multiple factors, it appears that the formation of a head-and-shoulders pattern may be in progress. If the head-and-shoulders pattern does indeed complete, there may be an inclination to sell long-term investments in silver and mining stocks. This is not yet the case, nor is it advised at this time. However, this is a possible development over the next few weeks.
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Thank you for reading. Have a great and profitable week!