2016 Market Preview: Metals - Part III

<< Read More: 2016 Market Preview – Part I

This is the third of three parts of the 2016 preview that appeared in HRA Journal Issue 245-246. This part deals with the outlook for various metals. The assumptions about what the economy will do (see Part I) underlie the discussions on metals though each has unique supply/demand issues. In most cases the supply demand balance looked better than expected though, obviously, market sentiment will drive markets short term. Volatility will be high.

Gold: It’s Different This time. (no, seriously)

I know, I know. I can’t believe I wrote that either. The most dangerous phrase in finance and for good reason. The backdrop for the gold market and the market internals themselves really are quite different this time however.

I’ve seen plenty of comparisons to 2008 recently. There is concern that we’ll see a sell off like we did then if markets in NY really drop. That’s certainly what happened to gold equities in 2008. When margin calls hit everything got sold. Importantly however, it’s not really what happened to gold itself.

The two charts above show gold prices leading up to and through the 2008-2009 bear market and a chart of similar duration ending now. Before looking at them in any detail a fairly obvious fact jumps out at you, namely that the top chart is depicting a bull market while the lower chart is clearly a bear. At the most basic level the backdrop and backstory of the gold market is very different from the time leading up to the Great Recession.

The red vertical bars on the two graphs denote the bull market highs for the SPX (assuming, as I do, that we won’t see a new one for a while) while the shaded box in the top chart is the “crash phase” of the 2008-2009 bear market.

As you can see, overall gold performed quite well through the last bear market. It wasn’t straight up by any means. There was heavy selling “post-Lehman” when the real panic set in and traders were throwing everything overboard. Importantly however, gold didn’t follow equities all the way down in late 2008, early 2009. Gold was spared the final December to March down leg. Gold bottomed four months in advance of the SPX. By the time New York hit its 2009 low gold had already moved up over 30% from its earlier bottom and 20% from the levels it traded at when the real bear market kicked in.

Gold miner stocks didn’t fare as well, at least in terms of their overall drop. Charts for the gold miners ETF for similar periods are shown below. Significantly however gold miners also bottomed four months in advance of the SPX and had taken back all of their post Lehman losses by the time New York bottomed. Keep in mind that all of this happened before QE started. Those gains came later.

Like the gold chart, the current version of the GDX chart is just plain ugly. The relatively flat performance through the past six months is the first show of stability since 2014 but it’s at rock bottom levels. Gold and gold miners have a lot to prove at this point.

Chartists and technical analysts continue to insist gold needs one more price breakdown to complete its bear market. Notwithstanding recent market gyrations most are still calling for a low in the $900-950 range to “complete” the pattern.

They could be right but I’m not a technical analyst so I don’t consider “the chart says so” to be a real reason. We have to view gold in context. We may get a repeat of 2008 but I will be surprised if it happens.

As the charts for both gold and the GDX make clear the current situation is diametrically opposed to the 2006-2009 market backdrop. Gold and gold stocks were a “baby with the bathwater” situation in 2008. Markets were falling apart and margin calls were flying. As a widely owned sector (then) gold miners were popular sells when margins had to be covered.

This time around the sector is despised and most institutions are out. There will be someselling if we get a crash but nothing like 2008. Funds have to own the stuff to be able to sell it and, right now, most just don’t.

The top chart on this page shows gold ETF holdings through the past year. The pattern is the same here. There has been a bit of renewed buying since the start of the year but it’s coming off a very low base. Fickle ETF speculators are not my favorite gold holders. That said, it’s a vehicle that allows a lot of gold to be taken out of play fast if prices start running.

Gold gets traded/priced as a currency and a way to avoid systemic risk. I’ve laid out the reasons I think the USD could weaken earlier in this issue. That is one potential mover for gold. The other is gold’s status as a vote of non-confidence in the financial system.

It’s no coincidence the most recent small spike in the gold price took place while the US Fed was disappointing the market. When traders start thinking the financial system is messed up an asset with no counterparty risk like gold sounds good. Periods of lower risk tolerance favor gold. As the VIX chart above shows traders are still not that worried. That will change if markets continue to decline.

If the US market evolves into an “official” bear market as I expect increased buying of gold and gold miners and perhaps other miners as well. Even though the sector has been “cheap” that is not enticement enough when there is easy money to be made on the big board. As traders there accept that the overvaluation issue is real and companies get into trouble as easy debt financings dry up traders will be looking for things that really are cheap and oversold already. Gold miners certainly fit that bill. We don’t need a mass exodus from Wall St. Even a tiny fraction of the money crossing the tape in NY could have a huge impact. The same is true for bullion. The Fed’s wilting credibility could be gold’s gain.

Copper: Confounding

Copper is by far the most important and closely watched base metal. It’s widely considered a meaningful barometer of the world’s economic health even though its track record in this regard seems far from stellar.

The current state of the copper market is a perfect example of the contradictions inherent in the metals market. I’m sure you’re all too familiar with the cooper chart on this page. It’s ugly. I started out 2015 mildly bearish on copper, expecting a drop in price of 10% or so.

Turns out I wasn’t nearly bearish enough. Copper has now dropped to around $2 a pound and has been flat lining near that level since the start of 2016.

Traders remain very bearish on copper though as the year progressed the market internals for the red metal (other than price) actually started to improve.

If you only watch daily copper prices you might be surprised by the lower chart on this page which displays LME warehouse stocks for copper. Copper at LME warehouses has declined about 120,000 tonnes since mid-year. The level hasn’t declined for the past few weeks which may add to trader’s nervousness even though the absolute level well into the lower portion of the five year range.