Mar. 11, 2016, Weekly Summary:This Rally Still Has Legs

This Rally Still Has Legs
The well-worn market adage ‘no two markets are alike’ is certainly true, but so is the fact that all markets have common characteristics. These commonalities arise mostly from human emotions which stay constant through time. The present bull market that began in 2009, is like no other market that came before it, but at the same time it is just like every other market in the past. Despite existing in a unique economic environment of zero bound interest rates and commodity price collapse, its functioning is still a reflection of human mass psychology.

Since the beginning of this year, we have been promulgating our probability calculations which are based on indicators that function as proxies for human emotions; investor sentiment and Rydex Fund Assets are two of the more consistent indicators. We never want to imply that we can predict the future (unlike some commentators), but rather we search for historical patterns that provide a probabilistic view of the future.

Since the start of this year’s down-turn, our calculations consistently demonstrated that the market’s emotional state was not that of an over-heated market that was about to enter a new extended bear cycle. Over the last three weeks the market has proven itself to be following our probability path.

We also have been calculating that the market is unlikely to make new highs soon, but rather settle into a trading range, the limits of which are still to be established. We are watching the sentiment indicators and our PRICE Modelling System in order to gage when the present rally reaches its upper limit.

The graph below shows the Rydex bear and bull asset levels, as well the bear and bull sentiment percentages. Notice that both the bear assets and the bear sentiment have fallen more than the bull assets and bull sentiment have risen. This increases the likelihood that the rally still has some legs and will rise further before correcting. As we pointed out last week, the bears have started to scatter, but the bullish sentiment and asset purchases have not been excessive, indicating that the bulls are still cautious. Again, this increases the probability that there is still more upside to be had.

In the chart below, the blue lines highlight the correlation between the Bull and Bear sentiment and the rallies that occurred after the local bottoms (green arrows) on the SPX. The red lines show the correlation between sentiment and the breakdown of the SPX. Notice also how the Rydex Bull Assets top out (green circles) at two of the major tops. The situation at the moment does not yet display topping behaviour. We are watching for a rise in Bull Fund levels, and a drop in Bull sentiment to signal a top in the present rally.

The monetary statements of the ECB this week demonstrated how unsure the markets are. Draghi unleashed another round of interest rate cuts, and increased asset purchases that went as far as to include investment grade corporate debt, but when he commented that the interest rates would likely not be cut in the future, everyone headed for the exits. A move that made no sense and which was quickly taken advantage of by those looking to buy the dips. This further supports our position that the rally is not over just yet.

The CME FED Funds tool is still reading a very high probability (96.1%) of no change to interest rates, but the minority view has shifted from a small percentage for a hike, to a small percentage for a cut in interest rates (3.9%). We will see what the FED egos deliver on March 16th, but it is unlikely that they will move on interest rates until June, and then it would likely be an increase which will be damaging to gold. We are of the view that gold is headed down between now and the middle of the year.

The chart below compares the gold price with that of the 30 year US Bond. Notice how a divergence (green lines inside the circles) precedes a change in the direction of the gold price. In the most recent divergence, gold has risen, while the Bonds have fallen. This means either that gold will drop, or that Bonds will rise (i.e. lower interest rates), and since it is unlikely that rates will drop in the next six months, we hold that gold will trend down.