By
John Overstreet
:
At the beginning of August,
I wrote
that we should be on the look-out for a few things over the course
of the remainder of the year, and that August would likely give us
a very good idea of whether or not that outlook would indeed pan
out.
In short, I expected a rise in crude oil prices (more precisely,
a spike in year-on-year WTI prices peaking in the late summer), a
sharp rise in treasury rates (peaking at the end of the year), and
continued downward pressure on stocks (also until the end of the
year), as well as gold weakness. I also argued for a rise in
volatility and weakness in commodity currencies like the Aussie
dollar (
FXA
) vis-a-vis safe-havens such as the Swiss franc (
FXF
) and the yen (
FXY
).
Although one can never feel absolute confidence when predicting
anything as complex as the market, and I can hardly declare
anything like vindication, in general, my calls remain intact.
1. Crude oil (
USO
)
I wrote in my first couple of Seeking Alpha articles back in
June that the gold/oil ratio suggested a possible 'Leeb oil shock'
(an 80% rise in year-on-year WTI) late this summer, most likely
August, but that the yield curve did not.
The summer is certainly not over, and it's not hard to imagine
scenarios that would push oil much higher, but the threat of a
spike appears to be diminishing. A small position in crude may
still be warranted, but the 20-25% rise since June also seems to be
a good place to take some profits.
(click to enlarge)
More promising hunting may be found elsewhere.
2. Stocks ([[DOG]], [[SPY]])
I have suggested before that the gold/copper ratio tends to
foreshadow real interest rates sixteen months down the road and
that sudden spikes in that ratio have often been followed by stock
market weakness or lethargy. Since we experienced a spike in that
ratio this time last year, we can use the copper/gold ratio to give
us some idea of what to expect this year in the stock indexes.
(click to enlarge)
As I mentioned in previous articles, it is not a tick-by-tick
prediction of stock market levels or timing, rather a guide to
market momentum.
Were we to use this for timing purposes, the chart above
suggests that we should have seen a market bottom in October 2011,
a rally until May 2012, and then a bottom in February 2013, with
the greatest downward pressure beginning in the autumn of this
year.
(click to enlarge)
I do not believe this market can make any significant headway
against the resistance of the spring highs set earlier this year.
Therefore, although the market may merely be flat for the remainder
of the year, the Dow at or above the 13000 level seems to be a good
place to sit out the market or short it.
Volatility (
VXX
) and safe-haven currencies also seem quite promising, as indicated
above.
3. Bonds (IEF)
Over the last decade or so, we have seen a number of bubbles
burst. Even gold has had trouble finding traction this year. But,
bonds have rumbled forward. I have no means of judging when bonds
will ultimately top out, but we have a number of means of
predicting treasury yields over shorter time-spans.
The spike in the gold/copper ratio promises higher real interest
rates, especially from this fall.
(click to enlarge)
But, we can also use the gold/oil ratio to give us clues about
nominal yields sixteen months later.
(click to enlarge)
(click to enlarge)
Again, this technique is primarily useful for determining
momentum rather than specific levels. There is no one-to-one
correspondence in terms of timing or levels.
In any case, the spike in the gold/oil ratio last year crossed a
number of historically key levels, and this gives us somewhat
greater confidence in arguing that we should expect rising rates
throughout the remainder of 2012.
The gold/oil ratio was also the basis of our warning of a
possible Leeb shock, although the timing generally differs (twelve
months with respect to oil, sixteen months for treasury rates).
And, therefore, we expected that a rise in year-on-year oil prices
might coincide with the turn in interest rates, although interest
rates would be expected to continue to rise after even after oil
markets calmed.
(click to enlarge)
So far, much of this has held up, and I expect that treasury
yields will resume their rise in relatively short order.
But, how high will rates go? And are we at the generational low?
It is hard to say, but we have good reason to believe that we are
in the trough phase of treasury rates' five-year cycles. Normally,
one would expect that trough to come in 2013, but I believe that
the behavior of the deep lows in gold/commodity ratios last year
suggests it is coming early this time.
Every trough in the
five-year cycle
has been followed by a sharp snapback in interest rates. Over the
last thirty years, no snapback has managed to violate the levels
set by the peaks prior to the trough. If rates should clear the
3.75-level high of 2011, that might be the signal that the
generational bond bull is dead.
But, that is a somewhat different matter than we are considering
now, and in any case, I would argue that the risk of a calamitous
unwinding of the bond trade is greater than the potential benefits
of incremental bond strength. Further gains may manifest themselves
going into 2013, but with every passing week, the danger grows of a
sharp reversal.
4. Gold (GLD)
Secular pressure should be restraining gold. That should be
especially true if we see rising real interest rates, and
especially if that rise should come from both ends, i.e. a
simultaneous rise in treasury yields and fall in prices.
(click to enlarge)
Moreover, based on market patterns established since the end of
Bretton Woods, I believe that the Dow should continue outperforming
gold.
(click to enlarge)
But, you can see that the Dow/gold ratio has had trouble
breaching the 8.25 level since the spring. Even so, a repeat of
last year's 20% fall in equities is hard to imagine in the absence
of an oil shock. And, if rates should rise, that is going to
significantly curtail any breakouts in the yellow metal.
For these reasons, I see little reason to expect that market
softness over the remainder of the year will do gold any great good
and, until we see a dramatic rise in the oil/gold ratio, there will
be little upside to gold and lots of potential downside.
Conclusion
As I argued a month ago, I continue to see weakness in virtually
every asset class: stocks, bonds, and commodities. Although the
threat of an oil spike remains, it appears to be diminishing.
The single most decisive factor in this market for the remainder
of the year would appear to be treasury yields. And, we want to
keep our eyes not only on their direction but on their speed. If
rates merely stabilize in the manner that they did late last year,
then it would suggest that the five-year cyclical trough may indeed
await us in 2013, however doubtful I am on that point at the
moment.
In any case, in my next piece, I hope to finally write about
another aspect of market cycles that should do something to refine
our analysis of the treasury market.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
Additional disclosure:
I am short Dec 2012 gold and Sept 2012 Dow and S&P 500 futures,
as well as AUDCHF and AUDJPY.
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