Saturday, January 26, 2013

Dow Theory Special Issue: Assessing the primary bear market signal for gold and silver miners ETFs

Should we heed the Dow Theory when applied to ETFs?

As you could read in this post, the Dow Theory has recently signaled a primary bear market for GDX and SIL (the gold and silver miners ETFs).

Here you have a chart depicting recent price action. The pink lines are the secondary reaction lows that once they got violated by both ETFs flashed a primary bear market signal.

The miners are in a primary bear market under the Dow Theory
As I always insist, the primary bear market was in existence well before the Dow Theory signal was flashed a couple of days ago. As with any timing system, the Dow Theory cannot say in real time when a new bull or bear market has been born. Thus, I’d say that the primary bear market started in September when the last jointly made highs were made. On October 4, 2012, SIL made a higher high that was not confirmed by GDX. Thus, I conclude that the last gasp of bullish action (shown with jointly made higher highs) was made on September 19, 2012. However, such bear market became recognizable on January 23, 2013.

As promised, I’d like to delve further into this primary bear market signal and its implications for investors.

First of all, I’d like to make one thing clear: I put less stock in the Dow Theory applied to mining stocks as compared to the Dow Theory applied to the Industrials, Transports and SPY. The reason is obvious: We lack a long track record. Thus, when applying the Dow Theory to the ETFs we don’t have the benefit of multiple past observations.

Furthermore, we are dealing with a very different animal. Gold and silver miners do not highly correlate with common stocks.

On the other hand, technical analysis is technical analysis, and hence, I am of the opinion that the Dow Theory patterns are widely applicable to extraneous markets. I wrote extensively about the applicability of the Dow Theory to other markets in my post “Can Dow Theory be applied to foreign and to non-stock markets?” which you can find here.

Thus, while I think I am doing sound technical analysis of SIL and GDX, I am also aware that I don’t have the benefit of a statistical track record of +115 years backing my assumptions. With the ETFs I am on uncharted waters. However, there is nothing wrong with that. As I have written, I am a blend of “apriorist” and “empirical” thought. As I wrote here and here:

As far as the Dow Theory is concerned, all of its rules make aprioristically sense. They are just not happenstances. Of course, to understand the valid aprioristic assumptions of the Dow Theory, it is a must to read the original writings of Charles Dow and his colorful explanations of how market participants shape with their actions and tactics the patterns we see reflected in the charts. Again, there is no substitute for hard work.

However, even the best aprioristic rules have to pass the test of reality. By this, I mean that performance must support the assumptions made. In other words, empirically the system has to be proven right. Here, again, the Dow Theory excels, and its real-life  track record is excellent.

Bearing the preceding musings in mind, I am firmly convinced that the rules and patterns of the Dow Theory make rational sense and are universally applicable to all markets, be they ETFs or stocks. However, when dealing with ETFs I lack the “empirical” observation (track record). Thus, when dealing with ETFs I must assume that the aprioristic Dow Theory rules will work. However, I lack a sufficiently long track record to prove me right.

Thus, when dealing with ETFs I cannot give indications as to the likely duration or extent of the primary bear market. We are left with pure technical action to guide us.

The only thing is clear to me is that I don’t need an empirical track record to get out when a Dow Theory primary bear market signal has been flashed. I would never stay in front of an upcoming freight train wondering about the empirical track record of crashes.

My issues with the gold and silver miners ETFs don’t finish here.

Even though I shroud myself with a technical blanket, I also have feelings and, to my utter dislike, fundamental opinions. Thus, I cannot ignore two voices I deeply respect, which seem to be in disagreement.

On the one hand, Mr. Sinclair (of Mineset), legendary trader and mine developer is of the opinion that the current meltdown is sheer manipulation. Thus, he urges his readers not to sell out and hold. He gives plenty of reasons which, at least for the short and medium term, make sense. Thus, he is of the opinion that gold and silver will go up (at least $ 3500), and the miners will enormously benefit from it.

On the other hand, renowned blogger FOFOA  is of the opinion that gold will go up but to such a huge extent that it will become too precious. So valuable that the miners will face governmental confiscation (or something akin to this like a 95% tax on windfall profits). FOFOA doesn’t rule out gold going as high as $ 55,000 (in current value terms). However, such massive revaluation of physical gold will spell trouble for silver and for all kinds of gold and silver miners. If the FOFOA scenario plays out, then the primary bear market signal is the real thing.
So fundamentally, I am in a quandary. Two persons I highly respect, both with an articulate discourse, are in the antipodes. Whom should I follow fundamentally?

However, the technical beast that inhabits in me tells me to heed the Dow Theory signals. If FOFOA is right and eventually the stocks miners will plummet, then the current bear market signal is a faithful harbinger of things to come, If Sinclair is right, then the current signal will eventually prove to be a failed signal. In such a case, sooner or later we will get a primary bull market signal (hopefully at a lower price), and we will ride the new bull. If Sinclair is right mining stocks should go up manifold ($ 3500 gold as he predicts, would imply mining stocks going up at least four fold from current prices). Should stocks prices go up four fold, then we shouldn’t worry about realizing some minor losses (or getting back aboard a bit late), since they pale by comparison to the huge rewards waiting for us. To some extent, I see the small realized loss or the likely small gain lost in the future by re-entering the trade later when a new primary bull signal is announced as the small risk premium to pay in case mining stocks take a big nosedive. If eventually Sinclair is right, the Dow Theory will give us ample opportunity to extract a good chunk of the future bullish trend. However, if something nasty is around the corner for such stocks, the best thing to do is to heed the primary bear market signal and get out.

Furthermore, I have a general rule with stocks: Companies will come and go. We cannot predict the future, and we never know whether our beloved companies will eventually go belly up. Thus, I’d never commit serious money to individual stocks on a "buy and hold" basis. While miners ETFs are not individual stocks, I see the group as a whole as being highly vulnerable if FOFOA is right, and, hence, I’d never make a “secular” trend commitment with them. If the Dow Theory tells me, they are in a primary bull market, then I will stick with them. However, I won’t make fundamental calls (i.e. hold them in spite of a primary bear market signal) with them.

This is very personal, but I see very few asset classes to be hold on a fundamental basis and with a buy and hold perspective. In a future post of this Dow Theory blog, I will delve further into this subject. However, right now it suffices to say that the miners EFTs are certainly not the asset class I would hold on an exclusive fundamental basis and without paying due attention to technical warnings.

Maybe one exception would be if I deeply believed in one mining company. Then such stock would not normally be in a brokers account (with margin and hence susceptible to rehypothecation) but in custody with a bank. Of course, if it is with a bank, and I want to “trade” with it, I am going to be ripped off by commissions. With such a leap of faith in one individual company, I would leave my stock sleep until it lives up to its promises of riches, or until it falls prey to Chapter 11. It goes without saying that for me this would be “speculation," because I see more dangers in “buy and hold” than in tactically timing when to be “in” and “out." The goal is not being the good long term oriented guy. The goal is to survive financially.

Therefore, I distinguish between “trading” vehicles in a margin account (which allows me to even short in very rare instances) from “long-term investing" in which case, I will shun rehypothecation and will insist in a safe custody. We have to have clear ideas.

Have a nice weekend.


The Dow Theorist

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