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.
More promising hunting may be found elsewhere.
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.
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.
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.
But, we can also use the gold/oil ratio to give us clues about nominal yields sixteen months later.
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.
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.
Moreover, based on market patterns established since the end of Bretton Woods, I believe that the Dow should continue outperforming gold.
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.
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.
Additional disclosure: I am short Dec 2012 gold and Sept 2012 Dow and S&P 500 futures, as well as AUDCHF and AUDJPY.