What if ... a rising gold price forces a short cover rally ???

Key Points

US equity markets at all time highs again
Asian markets still surging
Gold price jumps from recent 54 month lows
Gold stocks surging from 10 year lows
Coal market turning?

The US equity markets have continued to make new highs on strong earnings and economic data and on improving employment sentiment measures. The stocks performances in the US are encouraging their counterparts in Europe and Asia along, as the various market indices also hit all time or new rally highs. Economic data in the US, Europe and Asia are encouraging but are generally at odds with what has happened with the out of favour basic industries and commodities. Growing GDP and Industrial Production usually is good for commodities and the supply/demand pictures for most commodities are generally in balance, but there has been obvious new supply in commodities such as iron ore, coal and oil that has coincided with a short term slowing in demand from some quarters and the recent surge in the US$ has encouraged some market players to conclude that commodities must fall more. But if the recovery is now quite clear should there be further falls? Market action is now suggesting that the 44 month decline (basis CRB CCI) in commodity prices may now be bottoming out with agricultural commodities generally making lows in September, industrial commodities (LME metals, nat gas) in October and oil, coal and precious metals in November.

# gains from November lows Interesting to see that agricultural commodities fell about 15% to make their lows in September while the USDX rose 4% and subsequently recouped all their losses while the USDX rose. Industrial commodities made their 6-12% lows in Oct and then rose with the USDX. Precious metals and oil made lows in November and sharp gains have been made since those lows. The markets have had at least 44 months to play the bear side and now the world is fully convinced that war, plague and debt will continue to cut demand, China will slow down sharply and Europe will be in recession for ever. And of course that the silly mining industry will continue to increase supply. But what if? What if the Dawes Points view that the US is doing very well as indicated by a strong stock market and GDP data and that positive attention might now be paid to commodities as demand is seen to no longer be falling? Short cover rally anyone? Note the very positive action in the US equity markets this week. What is a Short Cover Rally? Well, some traders have sold assets that they hope to buy lower and make a profit. If you are `short’ in futures or securities markets you have to buy them back or face unlimited losses. Other have sold and gone to cash. Others have just not bought so are underweight or underrepresented. To cover `shorts’, stock needs to be bought back. Underweight investors need to add to positions and then new money comes in. Can be explosive.

What could this short cover rally actually mean?

First, there should be a bottoming in gold which is a proxy for all things commodity. Did we get that last week when, as the last Dawes Points suggested, that gold was being `hammered into an important low’? Demand is so strong and physical metal is hard to find. Coins have been sold out from the mints. The extreme low valuation positions of gold equities give a lot of credibility to that possibility of an important low. Platinum also made a key daily 'reversal' of making a new low then closing above the previous day's high on Friday. Higher gold might solve a lot of problems. Then other commodities should start to improve. As shown above, sugar, wheat, corn and soy beans have already jumped well off their lows. The LME metals and natural gas are higher today than in their October lows. Oil may have also made a very important low last week after a 32% fall since July, and note that the oil majors Exxon, Conoco and Chevron made their lows in mid October, a month before this low in oil. US Lumber made its 2014 low in June and now could be very strong as housing starts continue to pick up. Iron ore looks to be still weakening through oversupply. I was amazed at this graphic. Housing starts have fallen so much that it will take years to catch up to the need for another 1.5 million new units per year. The Philadelphia Housing Sector Index made an 11 month low in October but has bounced back to almost make a new all time high.

The industrial sensitive stocks and mining stocks should start to rally as short positions are unwound and bought back. Alcoa, Boeing, US Steel and Caterpillar are all bouncing. BHP, RIO and Freeport have improved from recent lows. Then the bond market needs to reassess itself. Those holding low yielding bonds will be asking questions about how they will be able to sell them. And where will the money go? And where will all the cash sitting on corporate balance sheets go? Where will the bank deposits go? Probably chasing real assets. These numbers were discussed in the last Dawes Points. The amounts of cash and bond holdings are way bigger than equities today. A short cover rally could ignite a much stronger market response. What will the remainder of the year bring us? I understand many `value investors’ have reduced equity holdings in the US. These may be forced to change their views, especially since the Dow Theory is now bullish. Where will the US$ sit in all this? Where will the A$ go? You know my views. Now, let the markets do the talking.

Let’s talk commodities

Commodity prices should be all about supply and demand, and these factors are far more important than the level of the US$. Since the beginning of 2012 the USDX has risen 10% and the CCI has fallen 20%. Since the latest 10% rally in the USDX since 1 July, commodities, as shown by the CRB Index (basis – CCI), have fallen 12%. Not much of longer term correlation and the relative performances of agriculturals etc as noted above doesn't give much to rely on. At the margin, lower prices increase demand for commodities and reduce supply. This is happening now. Individual commodities have their own market patterns and the September lows of the agriculturals may be telling us something here. The industrial production data for China was >8%pa for Sept Qtr and India is looking at a GDP number in 2015 at >8%, higher than China. These two great nations are important keys in commodity demand. Demand for gold from China and India has most recent data running at extraordinary high levels and has kicked the gold price up an important US$50/oz. The world is generally short raw materials and despises gold. Gold shares hit a low last week and the ASX Gold Index was down to 83% below the April 2011 highs. Australian investors, however, are significantly underweight resources shares.

What about Equity Markets

The US markets are making new highs again today in what can be called a `bull hook’ - the left side of an inverted parabola that then just surges! Many of these US stocks are truly remarkable given their earnings and their strong performances over the past few years. The Dow Jones 30 Industrials have done well as has the S&P 500 but don’t forget that the Wilshire 5000 shows great strength in its breadth. Looking at the breadth and gains of these stocks it is hard to see how the market place could be negative on the US economy. It is worth reviewing the Dow 30 to see what is there now. Gains by Dow Jones 30 Stocks Market cap US5.0 trillion PER 15.75x

14 Nov 2014	US$	4 years	3 Years	2 Years	2104
Communications
AT&T	35.90	22%	19%	6%	2%
Verizon	51.50	44%	28%	19%	5%
Consumer
Disney	90.80	142%	142%	82%	19%
Home Depot	98.24	180%	134%	59%	19%
Coca Cola	42.73	30%	22%	18%	3%
MacDonalds	96.21	25%	-4%	9%	-1%
Nike	95.50	124%	98%	85%	21%
Proctor & Gamble	88.11	37%	32%	30%	8%
Walmart	82.96	54%	39%	22%	5%
Financial Services
American Express	90.67	111%	92%	58%	0%
Goldman Sachs	189.98	13%	110%	49%	7%
JP Morgan	60.28	42%	81%	37%	3%
Travellers	102.43	84%	73%	43%	13%
Visa	248.84	254%	145%	64%	12%
Health
Johnson & Johnson	108.16	75%	65%	54%	18%
Merck	59.07	64%	57%	44%	18%
Pfizer	30.34	73%	40%	21%	-1%
United Health	95.11	163%	88%	75%	26%
Manufacturing
Boeing	128.86	97%	76%	71%	-6%
Caterpillar	101.34	8%	12%	13%	12%
Du Pont	70.80	42%	55%	57%	9%
Gen Electric	26.46	45%	48%	26%	-6%
MMM	158.85	84%	94%	71%	13%
United Technologies	107.45	36%	47%	31%	-6%
Petroleum
Chevron	116.32	27%	9%	8%	-7%
Exxon	95.09	30%	12%	10%	-6%
Technology
Cisco	26.32	30%	46%	34%	17%
IBM	164.06	12%	-11%	-14%	-13%
Intel	33.95	61%	40%	65%	31%
Microsoft	49.58	78%	91%	86%	33%
Average		70%	59%	41%	8%
Dow Jones 30	17634	52%	44%	35%	5%
Russell 2000	1173.81	50%	58%	41%	1%

Some of the performances of these stocks are extraordinary and it is just about only the basic industries that have done badly in 2014. (IBM is the exception with its crazy stock buy back programme!). This table is worth spending a few moments on. As the economic numbers improve it should be these activity sensitive stocks that do better. And resources stocks. Asian markets are continuing their surges and Australia will eventually be following.

Gold

This has been discussed in Dawes Points but the extreme low levels for gold stocks are telling us that the lows for gold are probably very close (and probably behind us).

The 23% rally from the lows here is probably signalling a major change. Also, gold in other currencies looks ready to continue the long term uptrend, especially in Yen.

Gold is now all about demand from India and China. This demand is unprecedented and will change the way gold is viewed. Much higher prices are coming.

Resources stocks in Australia

The activity and optimism obvious in recent trips to China, Singapore, Kuala Lumpur and Bangkok contrasts greatly with the deep pessimism in Australia and the holdings and activity in resources stocks are well down on long term averages. You might say they are hated. Certainly despised. Some fund managers no longer hold BHP. It is now only 6% of market turnover- down at least 50%.