my firm's previous essay entitled Significant Breakdown in Gold or a Short-term Bottom in Platinum? we mentioned that the recent breakdown in the price of gold from the yen perspective should make gold investors concerned about the health of the bull market as there was a good fundamental explanation behind this phenomenon. The price has reversed quickly and is back in the rising trend channel, so there are no longer any short-term bearish signals coming from this market whatsoever. Before moving on to the timing-related part of the essay, we would like to comment on one of the interesting concepts that we’ve read recently.

Namely, that the destruction from Japan's tragic earthquake will be the catalyst for rebuilding that might jump-start the country's economy as it did after World War II. This is the belief that the destruction of wealth fuels its creation.

We would like to put this “broken window fallacy" to rest. Frederic Bastiat, a 19th century economist explains the fallacy by means of an allegory that goes like this: When a kid throws a rock at a shop window and breaks it, everyone in the vicinity regrets the unfortunate incident. But a man who happens upon the scene points out that this is not a bad thing after all. The man fixing the window will get money for doing so. The money might be spent on a new suit, and so the tailor too will get money. The tailor will spend money on other items, and the circle of rising prosperity will expand without end.

In the 1946 book Economics in One Lesson, Austrian School economist Henry Hazlitt exposed the fallacy. No man burns down his own house on the theory that the need to rebuild it will stimulate his energies. One cannot argue the massive destruction will be a net benefit to the Japanese economy. Hazlitt wrote: The wanton destruction of anything of real value is always a net loss, a misfortune, or a disaster, and whatever the offsetting considerations are in a particular instance, they can never be, on net balance, a boon or a blessing.

If the broken window really produces wealth, why not break all windows up and down the whole city block?

The only “beneficiary” for the disaster in Japan might be Australia which exports to Japan essential goods such as iron, meat, sugar, coal and natural gas. And Japan will most likely need coal and natural gas for its energy needs. After the Kobe earthquake, Australia’s exports to Japan rose by 10%.

With so much happening around the globe, let’s move to the timing-related part of the essay. We will begin with the correlation matrix analysis.



In the short term, significant negative correlations are seen between precious metals and the USD. The bearish implications going forward for the USD Index will likely mean bullish news for gold, silver, and gold & silver mining stocks. Silver has been somewhat positively correlated with the general stock market in the medium term, but overall, the metals have been rather weakly correlated with stocks in the short term.

A quick bounce in stocks is still likely lead to higher precious metals prices as well (note very high correlation between the HUI Index and stocks in the 10-day column). Although the implications are not clear at this moment, they are in place. They are much clearer for the short run for metals and the USD. To have a clear picture on this, let’s have a look into the performance of the USD Index (charts courtesy of http://stockcharts.com).



On the above chart, we see that the recent breakdown below the rising support line has now been verified. This increases the odds that further declines will be seen from here with the 2009 low as the next significant level to be reached. This would be slightly above the 74 level and the next resistance would be slightly below 72, which was the 2008 low.

The outlook is rather bearish and if some sideways movement is seen, followed by further declines, then the situation will turn to clearly bearish. There are no bullish signals here for the time being. Keeping in mind what we mentioned while analyzing the correlation between gold and the USD, we see that the situation is now bullish for gold.



Turning to the long-term chart for gold itself, we see that its price has moved to the long-term support level and bounced a bit. Since this level was reached, we have seen a significant bounce, and right now gold is once again testing its previous highs. Gold is not making the headlines right now, so it seems that there is a lot of capital waiting on the sidelines that could fuel the rally once previous highs are taken out.

Consequently, the situation appears quite bullish and it will become much more bullish if we see a confirmed breakout above the previous highs.

There are several bullish signs present, and in the following part of the essay we will present two of them. First, let’s take a look at the relative performance of gold stocks to gold itself.



In the HUI:Gold chart above, which represents the above-mentioned ratio, we see that a move to the level of recent local bottoms has been reached. This often coincided with local bottoms in gold, silver, and mining stocks as well. So, since history often rhymes, we may have just seen a local bottom in the precious metals sector.

On the other hand, it might seem that the pattern between September 2010 and today could be viewed as a head-and-shoulders pattern, but we would take the bearish implications into account only if we see a significant move below the current level. Overall, gold and silver mining stocks appear to be ready to move higher.

The bullish scenario is further confirmed by the SP Gold Stock Extreme Indicator.



We’ve lately seen a quick move above the upper dotted line. This has coincided with local bottoms for gold stocks every time this line was crossed since 2008. As we can see, not each and every bottom was indicated, but when we have actually seen the SP Gold Stock Extreme Indicator flashing a signal, each time a short-term rally followed. This happened on most occasions prior to 2008 but every time since. While it doesn’t prove that all signals will always be correct, the 2008-until-today 100% accuracy simply cannot be ignored!

Summing up, if the local bottom is in, then the trend is up, and the situation is bullish -- simple as that. We've seen a rally since March 17, but based on today’s bullish price action (gold and silver moving to new highs) it seems that the rally isn't over yet.


No positions in stocks mentioned.