Are We Finally Starting To See A Healthy Market Again?

Sector rotation has been the name of the game to start 2012 for the stock market.  The lagging sectors from 2011, including the financials, homebuilders, industrials, and materials, have been the leading sectors to start the year.  This is exactly what the market needed to start establishing a more healthy structure.  The market did not have a chance of making a legitimate move to the upside in 2012 without seeing money rotate out of defensive sectors that led during 2011.  The following are some of the bullish signs the market has been displaying since putting in an important low in early October last year:

Rotation Out of Defensive Sectors

The rotation out of utilities, consumer staples, and health care and into more growth oriented sectors can be seen on the next two charts.  In 2011 double-digit returns were achieved in the three defensive sectors while other sectors struggled.

Since the early October bottom money has piled into more offensive sectors at a faster pace than the defensive sectors.  This can be seen on the next chart showing performance since early October of 2011.

Part of the performance of the offensive sectors out of the October low was due to them being oversold and ripe for a bounce.  But they’ve continued to outperform the defensive sectors to start 2012.  The next chart shows just the performance since the start of the year.  Utilities and consumer staples are actually down, while homebuilders, materials, and financials are leading the way.

Fewer Downtrends in World Markets

The early October low continues to be a major low across world markets.  The longer this low holds in place, the more likely the Stage 4 downtrend that attempted to start last year will have terminated at that low.  The next table shows a list of world markets and their relationship to their October low.  As can be seen from the table the majority of world markets are still holding strong above their October lows.

Some world markets are a lot closer to their October lows than others.  Due to the fact that U.S. markets have performed so well against world markets over the last year, I think that if the bear market were to resume, it would more than likely originate from foreign markets.  Some foreign markets that are reaching inflection points on their charts include Australia, Brazil, India, Japan and China.  The direction that these markets move should provide clues as to the future direction of other markets across the world, including U.S. markets.

The chart of the Australian market is tracing a symmetric triangle with momentum still to the upside since October.

Brazil seems to have formed a significant double bottom in August and October of last year, and is now in an ascending triangle with momentum to the upside.

India looked like it was starting to breakdown further at the end of last year, but has rallied during the first two weeks of the year.  The chart now looks like a falling wedge with a positive divergence in momentum.  This is typically a bullish chart pattern.

The Japanese Nikkei is coiled into a triangle with momentum ever so slightly trying to cross to the upside.

The Chinese market has been one of the worst performers over the last year, and ended 2011 with an astonishing 9 down weeks in a row.  Momentum is still clearly to the downside but a significant new low in price hasn’t been seen for almost a month now.

Renewed Speculation in Small Cap Stocks

Another bullish sign is more speculation in small cap stocks.  When money piles into large cap and defensive names it tends to flow away from higher risk small cap stocks, and it also means money is more adverse to speculation in general.  This creates more of a “market of stocks”, and not a stock market, where it is imperative to pick the right stocks in order to be successful.  This is exactly what happened in 2011.  But when speculation returns, there’s more opportunities to find rising stocks since more money is entering the market.

The next chart shows the ratio of the Russell 2000 to the Dow Jones Industrial Average.  Notice that from 2009 until early 2011 small cap stocks outperformed large cap Dow stocks.  Then the ratio made no further progress to the upside in early 2011 and started trending lower.  This was a warning sign of money getting more defensive.  Since the October bottom the ratio has slowly moved higher with positive momentum, and has traced a symmetric triangle on the chart.

Fluctuations in volume on the small cap Canadian Venture exchange is another sign as to the amount of speculation going on in the market.  On the next chart you can see that in 2009 and 2010 there was heavy speculation and upside volume in the Canadian Venture exchange leading to the market trending strongly higher.  In 2011 that buying pressure dried up, and the poor performance of the small caps in Canada mirrored the poor performance of small caps in the U.S.  Recently there has finally been some higher than average weekly volume on the upside though which is what the bulls want to see for the trend to change direction back higher.

There are other signs bulls would like to see for this market to continue acting healthy.  Leading stocks need to continuing moving higher, an expansion in new highs and contraction in new lows, and formation of leadership sectors that help drive the market higher.  This could also turn out to be another phony rally if the conditions laid out above don’t work out.  A quote from the great book How To Make Money In Stocks by William J. O’Neil kind of sums up the current situation:

“The key to staying on top of the stock market is not predicting or knowing what the market is going to do.  It’s knowing and understanding what the market has actually done in the past few weeks and what it is currently doing now.”

With the headline threats of the European financial mess, calls for a recession in different parts of the world and political turmoil, it’s hard to believe the market could continue to act well.  But underneath the covers that’s what some of the signs are so far in 2012.

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After A Rough Year For Gold Stocks, What’s Next For 2012?

Of the legions of investors who are welcoming a fresh start to the year after the choppy and directionless market of 2011, perhaps gold stock investors are the most eager.  Gold stocks had a volatile year last year with no progress made on the upside.  The HUI Gold Bugs Index was rangebound between 500 and 600 for the whole year, with 3 failed breakouts above 600.  As if to put a cherry on top of a depressing year for gold stock investors, the HUI closed down -14.7% for the month of December, which was the worst December for the HUI since the beginning of this gold bull market.

Taking a look at the performance of the HUI this past year compared to previous years, it’s interesting to note that gold stocks had only their second negative performance for the last 6 months of the year going all the way back to 2003.  The only other time since 2003 gold stocks didn’t produce positive returns during the second half of the year was during the stock market panic in 2008.  2011 was also the first year since 2003 where gold stocks had negative returns for both the first half and second half of the year.

Gold meanwhile produced positive returns during both the first half and second half of 2011.  But gold had it’s 3rd weakest performance for the second half of the year since 2003.  Gold has tended to perform better in the second half of the year than the first half of the year, but 2011 was an exception.

Looking at the relative performance of the HUI vs. gold, the HUI performed almost as poorly against gold last year as it did in 2008!  As a result of this poor perfomance gold stocks are almost as cheap relative to gold as they were during the panic in 2008.

Now why did gold stocks struggle so much in 2011?  Since gold stocks are still stocks, they are greatly affected by the action in the stock market.  Negative action in the stock market can cause gold stocks to perform poorly against gold.  When gold is rising and the stock market is falling, the stock market can act like a lead weight on gold stocks and hold them down.  And when gold and the stock market are falling simultaneously gold stocks can get crushed.  On the bright side, when gold and the stock market are both rising you can get huge upside moves in gold stocks.

The two main moments that contributed to the rangebound nature of gold stocks for 2011 was the stock market top in May 2011 and the top in gold in September 2011.  The top in gold in September was particularly nasty since it coincided with a falling stock market.  This caused a violent move lower in the HUI over a two week period at the end of September where the HUI plummeted from 630 to almost 480.  After that plunge, gold and the stock market both recovered in October which drove gold stocks higher, but then gold sold off starting in November and continuing into the end of the year.  This drove gold stocks to close at the low end of the range in December.

For 2012 obviously the two main threats to gold stocks continue to be: 1) a falling gold price and 2) a falling stock market.  A falling gold price looks to be a lesser threat to start 2012, as gold is overdue for a bounce after having a dismal December.  Sentiment levels on gold are extremely bearish.  The Commitment of Traders report is showing a reduced commercial net short position against gold, which typically occurs when gold gets close to a bottom.  It is also showing the lowest level in open interest in more than a year, which indicates a lack of speculative activity and also coincides with a bottoming in price.

There is also a bullish falling wedge on the gold chart with a positive divergence in momentum.  This is another sign gold is due for a potential short term bounce.

Moving further into 2012, the threat of a continued bear market in stocks could keep a lid on gold stocks, even if the gold price firms.  The stock market made a low volume push from the last week of November until the end of December.  In order for it to fight through the overhead resistance that was established in the first half of 2011, there needs to be more conviction on the buy side.

There also needs to be a rotation back out of defensive sectors and into growth stocks.  Consumer staples for instance continued to outperform the tech sector during the last two months of the year, and that trend has been going on since February.  That was one of the earlier signs of the risk off trade that occurred during 2011 along with the early 2011 top in financials.

So the bottoming process in gold stocks could continue for an extended period of time if the overall stock market moves lower during the first half of 2012.  One other thing to look for is a majority of gold stocks moving higher once a bottom is established.  During 2011 the gold stock sector was fragmented during the breakout attempts, with many gold stocks continuing to move lower while other gold stocks attempted to breakout.  Contrast that with what happened in the second half of 2010 where the entire gold sector was lined up for a powerful breakout at the same time.  When most gold stocks move higher together it adds legitimacy and sustainability to their move.

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