by Jim Welsh

MacroTides Monthly Report 07 April 2016

U.S. Economy

Since the end of 2014 a growing gap has developed between pro forma earnings and earnings based on Generally Accepted Accounting Practices (GAAP), according to figures from Factset and S&P Dow Jones Indices.

Pro forma earnings for companies in the S&P 500 were 59% above GAAP earnings in the fourth quarter, compared to the end of 2014. For the year of 2015, pro forma earnings were $1.04 trillion, 32.5% more than the $787 billion of GAAP earnings. Pro forma earnings rose .4% in 2015, but GAAP earnings per share actually fell by -12.7%. The last time the spread between pro forma and GAAP earnings was this large was in 2001, 2002, and 2008, which weren't particularly great years for U.S. equities.

Of the $256 billion difference between pro forma earnings and GAAP earnings, energy accounted for $93 billion, materials $43 billion, health care $43 billion, and $42 came from technology firms. The remaining $25 billion was spread out among the other 5 sectors of the S&P 500. Excluding energy, the gap between pro forma and GAAP earnings was 14%, the highest since 2008.

Since 1985 the stock market has experienced declines of 20% or more whenever year-over-year corporate profits have been negative (1987, 1998, 2001, 2002, 2008, and now?). After-tax profits as a share of gross domestic income, a good proxy for economy-wide profit margins, were 7.5% in the fourth quarter. After tax profits peaked in the second quarter of 2013 at 10%.

The 50-year average of employee compensation as a percent of gross domestic income is 55.8%. In 2015 it rose to 53.6% from 52.8% at the end of 2014. Despite the improvement in 2015 it is still 4% below the 50-year average. Given these statistics, one must wonder why the S&P has been able to hold up so well, and still only 3% from an all time high.

Simple answer: Monetary policy intervention has never been so dominant a factor as it is now. Equity investors around the world have learned that when a central banker says "We're easing monetary policy even more", investors hear JUMP, and only ask "How high?"

Based on pro forma earnings the S&P 500 is selling at modestly inflated P/E of 17.5, compared to 24 based on GAAP earnings. In addition to the shift to fuzzier accounting, financial engineering through corporate stock buybacks have also made the stock market appear less expensive than it is.

Based on Warren Buffet's favorite valuation metric, stock market capitalization as a percent of GDP, the stock market is at the third most expensive level since 1900. (Chart compliments of Advisor Perspective and Doug Short at dshort.com.) In order for the U.S. stock market to appreciate from current levels, real GAAP earnings will have to grow in 2016, something they have not in the last three quarters.

GDP growth has slowed from 2.0% in the third quarter of 2015, to 1.4% in Q4, and is estimated to have grown just .4% in the first quarter as of April 5, according to the Atlanta Federal Reserve's GDP Now forecast. Despite this trend most economists are sanguine about the economy's prospects in 2016 and point to an improving labor market and decent consumer spending. I don't think the U.S. economy is on the cusp of a recession, but growth above 2.5% is not in the cards either.

Most economic data is seasonably adjusted to account for the impact of weather and other factors. More home construction occurs in summer than in winter, so seasonal adjustments are used to smooth out the raw data. Three of the past five winters were unusually harsh and weighed on first quarter growth in those years. The Polar Vortex was MIA this year, which means seasonal adjustments lifted the raw data, which was already stronger than in prior years due to the mild winter.

There's a good chance seasonal adjustments inflated the Labor Department's estimates of retail jobs in the first quarter. In January, retailers added 59,000 positions, 32,000 more in February, and an additional 47,700 jobs in March. The increase of 137,700 retail jobs in the first quarter seems unduly large, since holiday sales were only up 3.1% in 2015, compared to an increase of 4.0% in 2015. January retail sales, excluding autos and gasoline, were down -.1% and up a modest +.3% in February. The year over year increase in retail sales was 3.1% in March, excluding auto and gasoline sales. Keep in mind that March's Y-O-Y increase was compared to the frigid first quarter of 2015. Note the plunge in retail sales in the first quarter of 2014 and 2015 in the Retail Sales chart.

The increase in retail jobs represented more than 20% of all jobs created in the first quarter. Retailers are under pressure to control costs and the increase in sales during the first quarter hardly justified the addition of 137,700 new workers, as reported by the Labor Department. This seasonally adjusted estimate of retail job growth contrasts with WalMart announcing it will close 269 stores, Aeropostale 84 stores, J.C. Penney 47 stores, Macy's 36 stores, and the Gap planning to shut 175 stores. I suspect the seasonal adjustments for other sectors also inflated first quarter job growth, so the labor market is probably not quite as strong as most economists believe.

Wages in March increased 2.25%, not much different than the annual average since March 2010. In February, the average work week fell by -.2 to 34.4 hours per week, and was unchanged in March. The drop of .2 in hours worked doesn't sound like much, but when spread over the 77.2 million hourly workers in the U.S., it equates to the loss of almost 160,000 jobs, which is a big deal. The spread between the official U3 unemployment rate and the broader U6 rate was 4.8% in March, unchanged from February. My research shows that wage gains pick up as the U3-U6 spread falls to 3.85%. This suggests that any acceleration in wages will be modest in coming months. Unless wage growth truly improves, consumer confidence will continue to flat line as it has for the past 15 months.

Vehicle sales have been a growing sector within the economy since 2010, but there are signs it is slowing. In February, vehicle sales were up 3.5% from a year ago and an annual pace of 17.5 million. In March, sales slowed to a gain of 3% from a year ago, and an adjusted annual rate 16.57 million vehicles. The dip in vehicle sales was noteworthy since there were 2 additional selling days in March and the weather was milder than in 2015. According to J.D. Power, an increase in sales to car rental agencies, and loans of 84 months or longer along with aggressive lease deals weren't enough to maintain February's sales pace. The average lease in March included a discount of $6,432 to make leasing attractive, an increase of 8% from a year ago and 29% higher than in 2009. More than 30% of all new car purchases are leased. As more cars come off their lease, used car prices are falling. In February, the average used car sold for $10,345, down 1.5% from a year ago and the second monthly decline, according to Manheim

Inc. Manheim, which tracks used car prices, expects prices to fall for the next two years, especially for large sedan's and compact cars. Historically, a decline in used car prices has pressured new car prices, which will be good for consumers but not car manufacturers

In early 2015, my guess was that consumers would spend 1/3 of their savings from falling gas prices, save 1/3, and pay down debt with the remaining 1/3. That view was in contrast to most economists who expected the decline in gasoline prices to spur retail sales in 2015, especially since gas prices continued to fall throughout the year. In late 2014 retail sales were increasing at a 5% annual rate, but by the end of 2015 had slowed to an increase of 3.1%. This is striking since savings from the plunge in gasoline prices was expected to be spent, which clearly didn't happen. In February consumer spending rose just .1% for the third consecutive month. The personal savings rate rose to 5.4%, the highest since early 2012.

Volatility in the stock market during February probably dampened consumer's willingness to spend, but weak wage growth will continue to keep a lid on spending in coming months. With GDP growth unlikely to surpass 2.5% anytime soon, business investment, which has been weak during this recovery, is unlikely to increase.

Although the dollar has declined 5% in recent months, it is still up almost 20% since mid 2014, so the headwind from the dollar will remain a factor in keeping export growth modest. The bottom line is economic growth will remain subpar and there will be no recession. That's the good news. The bad news is that corporate earnings are not going to increase enough to justify higher stock prices.

Global Risks

In a speech at the Economic Club of New York on March 29, Janet Yellen said, "The major thing that's changed between December and March that affects the baseline outlook is a slightly weaker projected pace of global growth. Global developments pose ongoing risks," citing the dangers from the slowdown in China and plunge in oil prices.

Should the economy take a turn for the worse, Yellen said the Fed could reassure markets with "forward guidance" or launch a new round of asset purchases. Her comment about forward guidance is a real laugher since each week brings a different perspective on monetary policy from one of the FOMC members or one of the twelve Federal Reserve presidents. Two days after Yellen's speech, Dennis Lockhart, president of the Atlanta Fed, told the Nikkei Asian Review on March 31:

"There is sufficient momentum evidenced by the economic data to justify a further step at one of the coming meetings, possibly as early as the meeting scheduled for the end of April."

Janet Yellen is the chair of the Fed and Dennis Lockhart is not a voting member this year, so Yellen's perspective should be weighted accordingly. These diverging views diminish the coherence of the Fed's forward guidance, especially as Fed members remind investors at every turn that the Fed is data dependent.

I have no doubt the Fed would launch another round of asset purchases should the economy take a turn for the worse. Why investors should draw comfort from Yellen's comment is mystifying, since three rounds of QE resulted in paltry GDP growth of 2.3% in the past four years, pathetic annual wage growth of 2.2% since 2010, and would have proved insufficient to prevent a turn for the worse should it come to pass.

According to the IMF, 80% of equity market movements in 2015 were attributable to market events in other countries, compared with a 50% linkage in 1995. The IMF identified stronger trade links and increased market integration between emerging and developed economies. In 1995, it was virtually impossible to invest in emerging markets or China, unless the investment was being made by an international mutual fund. Today, financial advisors and individual investors can easily buy and sell ETFs that provide access to many emerging economies.

The IMF found that China appears to have a special ability to trigger market moves in other countries. This shouldn't come as a complete surprise since China and emerging economies have been responsible for most of the increase in global GDP over the past decade.

The Bank of America/Merrill Lynch Global Liquidity Tracker (GLT) is a composite indicator of conditions in emerging and developed economies. A reading of zero indicates liquidity at its long-run average while activity between -3 and +3 represents the standard deviation from this average. As of March 18, the GLT was -1.96. Since 2000 the S&P500 has had a high correlation with the GLT. When the GLT was below zero, starting in the fourth quarter of 2000 and the end of the first quarter of 2003, the S&P500 fared poorly. The S&P zoomed after the GLT turned positive in the spring of 2003.

The GLT turned negative in late 2007, long before the S&P was crushed by the financial crisis. The S&P then bottomed a few months after the GLT began to improve significantly in late 2008.

After falling 19% in the third quarter of 2011, the S&P recovered quickly, even though the GLT didn't turn positive until the third quarter of 2012. This was possible since the global economy was in decent shape led by emerging economies, the Federal Reserve was employing QE, and the ECB decided to expand its balance sheet.

The GLT dropped below zero in late spring last year and is now at its lowest level since 2009. The dip into negative territory coincided with the highs in the S&P500 and Russell 2000 in May and June. The global equity markets would have fared far worse over the past year, if it wasn't for the aggressive intervention by the ECB, Bank of Japan, the Peoples Bank of China, and the Fed's reticence to normalize rates. The U.S. stock market is at its third highest valuation since 1900, and global liquidity is negative and deteriorating. The risk versus reward for U.S. stocks is not great. How's that for an understatement!

China

Throwing good money after bad" is a phrase that is abhorrent to bank regulators and most bankers in the U.S., but not China. Five years ago, Chinese companies were generating excess cash to pay off debt, so new borrowing could be used to invest and add to GDP growth. According to analysis by Deutsche Bank, Chinese company's principal and interest payments, less operating cash flow and newly issued equity, had a massive shortfall of 10% on their corporate debt last year. State owned companies, with large amount of excess capacity, have been the most dependent on 'evergreening', where banks roll over loans simply to pay off old debt. The net result is that debt continues to grow faster than GDP, which is simply unsustainable.

The most cash strapped companies have been issuing a torrent of corporate bonds to fund operations. Chinese corporate debt now amounts to 160% of GDP, up from 98% in 2008, according to estimates by Standard & Poors. Ten years ago increased debt lifted GDP growth but as growth has slowed, cash flow to service debt is sapping growth. The medicine being given to the patient - more- debt - is only making the patient sicker.

The practice of 'evergreening' is allowing unprofitable companies to remain open, which keeps excess capacity high and contributes to falling prices. China's government has vowed to close unprofitable state owned enterprises or force consolidations to shrink excess capacity in steel, cement, and other sectors. According to the European Commission, China produces 325 million metric tons of excess steel, almost twice the total steel production of Europe.

I expect China's efforts to reduce excess capacity will fall well short of what is needed, since closing firms will slow GDP growth in the short run, increase unemployment, and risk a backlash against the government. In 2015, there were more than 2,700 strikes and protests, double the total in 2014, according to the China Labor Bulletin, a labor rights group in Hong Kong. The backbones of politicians in China are no stronger than those in the U.S., so real progress on structural problems will be postponed as long as possible.

The practice of 'evergreening' is hurting the profitability of China's banks and caused banks' ratio of nonperforming loans to soar 51% in 2015. Commercial banks net profit fell to just 2.43% at the end of 2015, compared to 30% at the end of 2011, when GDP growth was comfortably above 10%.

A recent stress test by Goldman Sachs found that Chinese banks may need to raise more than $1 trillion to handle the coming surge in loan losses. Chinese companies' ability to pay interest on their debt is now at levels last seen in 2003, when the ratio of non-performing loans reached 9.5%, five times higher than at the end of 2015. In early March, Moody's Investor Service downgraded its outlook for China's sovereign debt, 25 financial institutions, and 38 state owned enterprises.

Even China can't afford to keep throwing good money after bad loans. When growth fails to improve in coming months, I expect China to follow the Bank of Japan and the ECB and lower the value of their currency more. As noted earlier, China appears to have a special ability to trigger market moves in other countries. If China devalues the Yuan as I expect in coming months, equity markets will experience another sinking spell and higher volatility.

Super Heroes and Protectionism

In June 1930, Congress passed the Smoot-Hawley Tariff Act, despite being opposed by 1,028 economists, many U.S. business leaders, and 23 trading partners. The goal of the legislation was to protect U.S. jobs and farmers. The Tariff Act raised the "dutiable tariff rate" on 20,000 imported goods to 59.1% in 1932, second only to the 61.7% rate of 1830. Within two years 24 countries retaliated with their own "Beggar-thy-Neighbor" tariffs.

By 1932 trade between the U.S. and Europe had plunged 66% and overall global trade fell by more than 60%. When the Smoot-Hawley Act was passed in 1930, the unemployment rate was 8%, and reached 25% in 1933. Protectionism was a reaction to weak economic growth, so it didn't cause the Depression. But it did deepen and lengthen the Depression, and more importantly, protectionism in the 1930's destroyed far more jobs than it protected.

I find it interesting that so many Super Heroes were born during the 1930's. After so many years of economic distress suffered by millions of Americans, the concept that a Super Hero could address the ills of society, provide a distraction from the drudgery of daily life, and offer hope for the future was wonderful. Here is a list of the Super Heroes that made their first appearance in the 1930's. The Green Hornet 1933, Flash Gordon 1934, The Phantom 1936, Superman 1938, and Batman in 1939.

The recovery since 2009 has been about 60% as strong as the average post World War II recovery in terms of GDP growth, and job and wage growth. It is no wonder that the rhetoric of Trump and Sanders is resonating with people whose incomes haven't grown in real terms for 16 years, and the 'unfairness' of society today stirs the idealism of young voters. The reemergence of Super Heroes in recent years is not a surprise in this context. What is a surprise is that in the newest Super Hero movie, Batman v Superman: Dawn of Justice, Superman dies. What does that say about this country's future?

Between 1992 and 2008 exports, as a percent of total world economic output, grew from 20% to 30%. The increase in global trade added to the growth rate of global GDP and lifted the standard of living for countless millions of workers in emerging countries. Since 2008, more than 3,500 protectionist measures have been introduced around the world, according to the Peterson Institute for International Economics. Many of the measures are laws requiring governments to buy domestic products and not outright tariffs. The shift toward protectionism is in reaction to the slowdown in global GDP from 5.2% in 2007 to 3% in 2015. Global exports as a share of global GDP have flat lined at 30% since 2008, in part due to increase in protectionist measures, the growing impotency of monetary policy, and the inability of governments in advanced economies to address structural problems.

U.S. exports as a share of world GDP fell from 12.0% in 2000 to 8.5% in 2008, where it has stabilized. Much of this decline is attributable to the faster growth in emerging economies relative to slower growth in all advanced economies including the U.S. China was the engine of emerging economic growth, and there is no question that it led to the loss of American jobs. After China joined the World Trade Organization in 2000, the U.S. lost 2.0 to 2.4 million jobs to Chinese import competition, according to research by the University of California, San Diego. This part of the equation is easy to grasp and why the anti-trade tirades of Donald Trump and Bernie Sanders have resonated with blue collar workers most affected by job losses and young idealistic college students. The issue of trade is not as black and white as either candidate suggests.

What is never mentioned in their speeches is the benefit of lower prices consumers received from less expensive imported products. For the 100 million American shoppers who visit WalMart every week (and other retailers), the annual savings amount to $1,000 to $2,000. In February 2016, median income adjusted for inflation was $57,288, -.2% lower than in 2000, and just 1% higher than in December 2007. Making each paycheck stretch further by paying less for goods imported from China and other low cost producers is a big deal when income growth stagnates for 16 years. I suspect the consumer savings from imported lower priced products likely offset most if not all of the loss of income from jobs lost due to trade.

Acknowledging this positive offset of global trade doesn't serve the interest of politicians more interested in taking advantage of voter's lack of knowledge than addressing the issue of trade with an intelligent solution. The savings 100 million consumers realized was no consolation for the 2 million plus workers who lost their jobs. A more constructive position on trade would be to support trade agreements, but also provide funding for job training for those who are negatively affected.

In 2002, President Bush approved a politically motivated tariff of 8% to 30% on several types of imported steel to protect the jobs of 1,700 steel workers. The tariffs caused the domestic price for steel products to rise by up to 40%, which negatively impacted the U.S. auto industry, its suppliers, and heavy construction equipment manufacturers. As companies using steel were forced to raise prices, and become less competitive in domestic and international markets, they were forced to lay off more than 4,500 workers, according to estimates by the Consuming Industries Trade Action Coalition. This is another example of protectionism failing to protect jobs, just like the Smoot-Hawley Tariff Act resulted in net job losses.

If tariffs are enacted, as suggested by Trump and Sanders, U.S. consumers will be the ones paying for it through higher prices. I doubt those voting for Trump and Sanders understand this, or the irony. Targeted tariffs won't bring jobs back to the U.S. since production will shift from China to Viet Nam, Malaysia, and other countries whose wages are less than China's. Unfortunately, most Americans are far more knowledgeable and concerned about sports, fantasy leagues, reality T.V., shopping trips, and social media than basic economics. I suspect very few of those supporting Trump or Sanders (and voters in general) could explain the law of supply and demand and how they affect prices. Of course, the same could be said about the members of Congress and the current administration.

U.S. Stocks

As discussed previously, the stock market is at its third most expensive valuation since 1900, companies are increasingly relying on pro forma earnings rather than GAAP earnings, which show that corporate earnings have been falling. Global growth has slowed and is not likely to improve much. In the U.S., weak wage growth, business investment, and the uncertainty surrounding future monetary policy and the election will keep growth from picking up much in coming months. In this environment, surprises are more likely to be negative than positive.

Another head wind for the stock market is the contraction in margin debt, which is highly correlated to trends in the stock market. Margin debt peaked in March 2000, the same month the S&P topped. Although the S&P held up until August, the S&P ultimately lost 50% of its value by October 2002. In July 2007, margin debt reached a high just after the advance/decline line peaked on June 4, and three months before the S&P topped out. The S&P subsequently suffered a decline of 57% during the financial crisis. Margin debt has fallen 9% since it hit its high last April, which is when the advance/decline topped. The S&P achieved its all time high on May 20, and the Russell 2000 topped on June 23. (Chart courtesy of Doug Short atdshort.com.)

The stocks of companies with the lowest returns on equity gained 41% versus a gain of 12% for the S&P between the low on February 11 and March 17, when the S&P closed at 2040.59. These stocks have the weakest profit growth and balance sheets, but were the most oversold and the most shorted stocks. This suggests short covering played a huge role in the rally.

Since the S&P bottomed on February 11, central banks have done much through actions and words to lift equity prices, but further moves aren't likely for months. The stock market will now have to stand on its own two feet, a balancing act that could prove challenging without further support from central banks.

I don't think the stock market will receive much solace from upcoming earnings reports, if I'm correct about the dollar's negative impact on revenue and earnings.

A number of prominent strategists in recent months have noted that the annual rate of change in the dollar index has dropped from a peak in March 2015 of more than +25%, to -3.8% on April 7. The dollar index has fallen from 100.00 in March 2015 to 94.52 on April 7, so the annual rate of change has indeed turned negative.

Strategists have concluded that since the annual rate of change in the dollar index has turned negative, the headwind for revenue growth has abated for U.S. companies that derive 40% or more of their revenue from international sales. They expect revenue growth to improve due to the lower dollar and result in higher earnings. Investors are thus going to be surprised by the good news as first quarter revenue and earnings growth exceeds expectations, which is why these strategists expect equity prices to rise.

While it's factually true that the annual rate of change has fallen below 0% (top panel in above chart), this 'fact' is meaningless in the real world for U.S. companies selling products in the European Union. Since June 2014, the dollar is still almost 20% higher versus the Euro. When a U.S. sales person tries to sell their products to an EU based customer, they can tout all the great features of their product, but the annual rate of change in the dollar index is not one of them. At the end of the day, the EU customer will point out that U.S. products still cost 15% to 20% more than the comparable EU products. Unless the U.S. sales person is willing to cut prices, there will be fewer sales due to the strength in the dollar. This reality is being repeated in many countries whose currency has lost value versus the dollar.

Nike, Inc. is the world's largest supplier and manufacturer of athletic shoes, apparel and other sports equipment. Nike is well managed and is the dominant company in its sector, and gets more than 50% of its revenues from overseas. Nike reported its results for its third quarter which ended on February 29 on March 22, 2016. Revenue was up 8% which is impressive given global GDP is only growing 3%, and U.S GDP is not even growing 2.0%. However, excluding currency changes, revenue growth would have been up 14% or 75% faster than the 8% reported increase.

This suggests than the increase in the dollar since June 2014 is still a significant headwind for companies that derive a large portion of their revenue from international sales. If there is going to be a surprise as companies report first quarter earnings en masse after mid April, it is likely to be a negative surprise, as numerous companies continue to cite the strength in the dollar for their weak revenue growth.

Technically, a close below 2020 on the S&P would confirm a short term high, and a close below 1969 would likely lead to a quick drop below 1900. If investors are provided reasons to sell (dollar rallies, oil drops below $34 a barrel, China devalues the Yuan, U.S. earnings disappoint, GDP growth remains under 2.0%, and European banks continue to falter), the S&P could retest the February low at 1810. Since the reasons cited are likely to occur to some degree, I think the odds of a retest are better than 50%.

Dollar

In March 2015, just about everyone was bullish the dollar. With the Fed backing away from increasing rates 4 times in 2016, sentiment toward the dollar has swung significantly. The increase in negative sentiment has been reinforced by the recent decline in the dollar. In the January issue of Macro Tides published on January 26, I thought the dollar was poised for a correction. In the March 21 Weekly Technical Review I thought the dollar had made a low on March 17 and expected the dollar to rally.

The dollar has so far held above the stop at 93.80 and I still think the dollar is very close to a trading low based on technical analysis. The low on March 17 was 94.76 and the RSI was 29.6. (Bottom panel on the dollar chart above.) When the dollar closed at 94.52 on April 4, the RSI was 32.8 and 33.0 when the dollar closed at 94.44 on April 6. The higher level of the RSI even as the dollar has dropped to lower lows represents a positive momentum 'divergence'. A close above 95.11 will turn the short term trend positive. If the dollar begins to rally to 98.0 to 99.0 as I expect, investors will have another reason to sell, since so many strategists have cited dollar weakness as a big positive.

Oil

In the March 21 Weekly Technical Review, I thought oil was topping out and getting ready to decline. "The pattern from the low looks complete as a 5 wave rally. Even if oil has bottomed, it looks vulnerable to a decline of $6 to $8 a barrel in coming weeks and a rout if OPEC fails to agree on any meaningful freeze or reduction in output. I will be surprised if Saudia Arabia agrees to a freeze and allows Iran to continue to boost its production at the April 17 meeting.

As it turned out, oil made its high on March 18 at $42.49 a barrel on the May contract. If nothing constructive comes from the OPEC meeting on April 17, oil could drop below $33.00 a barrel. The fundamental problem of too much supply and not enough demand will continue to weigh on oil prices. The decline of shale oil production in the U.S. is going to be offset by rising production from Iran in coming months, so supply is not likely to drop enough to support prices. If I'm right about sluggish growth globally and in the U.S., demand for oil is not likely to help narrow the gap between supply and demand either.

This suggests that the surplus of oil that has plagued the oil market since the summer of 2014 will not be eliminated as quickly as expected. This leaves the door open for new lows in oil prices, or at least a test of $30 a barrel. I think it is noteworthy that as the dollar declined -1.67% between March 24 and today April 7, oil dropped -9.1% and copper fell -7.0%.

Gold and Gold Stocks

In my March 6 update on gold and gold stocks entitled, "The Coming Correction In Gold and Gold Stocks", I discussed why I thought gold and gold stocks were likely to experience a correction in coming months. On March 7, gold traded in a range of $1260 to $1274.90 before closing at $1265.10. The gold stock ETF GDX traded in a range of $19.92 to $20.73 before closing at $20.40.

According to the Commitment of Traders report as of March 29, the trend following 'dumb' money is long more gold than it was last October, just before gold dropped from $1,180 to under $1,080 in less than five weeks. Large speculators (green line middle panel) were long +189,806 contracts in the March 29 report compared to being long +157,434 contracts last October, and managed money (blue line bottom panel) was long +154,205 compared to +116,344 contracts in October. This indicates that those who use trend following strategies have become quite bullish gold, which from a contrary opinion perspective is bearish.

More importantly, the 'smart' money is short more contracts than they were last October. Commercial speculators (commercial specs, red line middle panel) are now short -207,964 contracts vs. -165,848 in October. Producers have increased their shorts from -102,946 in October to -126,495 as of March 29.

Technically, gold is beginning to form a potential head and shoulders top, with the low at $1206 representing the neckline and the head at $1,287.80. Should gold close below $1206, it would target a decline to $1124.40. Gold rallied from $1046.20 to $1287.80, a gain of $241.60. If it retraces 61.8% of the rally, gold would fall to $1138.50.

If gold does decline by 6% to 8% in coming months, gold stocks are likely to fall 2 to 3 times as much. On March 30, I recommended a 10% in the inverse gold ETF DGZ, which is NOT leveraged. I would use a close in gold above $1274.00 and a close below $14.00 on DGZ as a stop. DGZ closed today at $14.38. I would sell 50% of the position in DGZ if it trades above $15.45.