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Sunday, May 02, 2010


Portfolio Re-allocation: Sell Stocks, Buy Gold and Silver

From our last Great Trades blog update, in March:

If recent history repeats itself, we should soon see a short-term pullback, which should be followed by new highs in the S&P 500.

The previous 10 times this EMA has peaked over 600 in the past year, the market has had a short-term pullback. Every one of those pullbacks has proven to be a buying opportunity, followed by new highs in the S&P 500.

Unlike the previous 10 times the TICK 10-day EMA peaked over 600, this time the market pullbacks were very brief, primarily limited to intra-day sell-offs. After this EMA dipped back under 200, it bounced back up toward 600 as the S&P 500 (SPX) rallied to a new high, peaking at 1219.80 this past Monday.

On the next day, Tuesday, something happened that we warned about in the last update:

However, a break of 20 resistance in the VIX could again spur a sharper pullback in the market.

Tuesday's break of 20 resistance in the VIX coincided with the largest market drop in months, as the SPX dropped from near 1220 on Monday to near 1180 on Tuesday. Since that VIX spike sent the VIX well above its upper Bollinger Band, and also sent other short-term indicators into very oversold territory (e.g., TRIN), the SPX bounced back to as high as 1209.36 on Wednesday and Thursday, dropping the VIX back under 19. On Friday, the VIX broke through 20 resistance again, as the market plunged again, with the SPX closing at 1186.69, closing out the week with a bearish engulfing candlestick sell signal on the weekly chart.

Now, the VIX is again above its upper Bollinger Band, but only slightly, at 22.05 vs. 21.59. The upper Bollinger Band is rising sharply, so the VIX can likely continue higher and still stay near its upper Bollinger Band. The TICK 10-day EMA is back under 200, but it can go significantly negative before rebounding, as it did in February, October, and a number of times in the previous 12 months.

The key level to watch for now is this past week's low, which was 1181.62 on the SPX. The Russell 2000 has already broken below its Tuesday low by over 3 points, and that small-cap index has been leading the market higher in recent months. If the other market indices follow, we should see a more significant market pullback. As this article points out, the three to one ratio of bullish to bearish newsletter writers is a red flag warning that could mean the market is in for a sizable correction.

On the Nasdaq 100 (NDX or QQQQ), the rising wedge uptrend since the February low was finally broken on Friday:

This breakdown from the rising wedge, along with the weekly bearish engulfing candlestick, VIX breakout over 20, and the excessive bullishness of newsletter writers, increases the likelihood that the market is in for more selling. A number of other indicators point to more selling to come, though there's a possibility of a short-term bounce first after Friday's sharp sell-off. Any market bounce should be used to sell non-mining stocks.

While the stock market looks like it's in for some more selling, the gold and silver markets look very strong. We've advocated accumulating gold, silver, and quality mining stocks on pullbacks, and that strategy has worked quite well:

Considering the longer-term trend higher in gold in its powerful bull market, this pullback should prove to be a great buying opportunity for longer term, for gold and silver as well as quality mining stocks.

After the strong rally in stocks over the past year+, this looks like a particularly good time to reallocate portfolio assets from non-mining stocks into gold and silver. While stocks look like they could be in for more selling, gold is breaking out to new highs on the year, and is very close to breaking out to new all-time highs.

Holding a portfolio allocation of long gold and short the Nasdaq 100 from early 2000 for 9 years would have made over 10 times your money, with similar results for silver:

Shifting portfolio allocation from gold and silver to the Nasdaq 100 and back based on stochastics signals (bottom pane) would have yielded even much better results, particularly when combined with the 36-month EMA and Bollinger Bands. Moving from gold to the Nasdaq 100 when this ratio was well above its upper Bollinger Band and the faster black stochastics line crossed below the slower red stochastics line above the 80 level, and then moving from the Nasdaq 100 back to gold when this ratio came back to meet the 36-month EMA while the stochastics lines were below the 20 level would have yielded tremendous returns with very little drawdown, and particularly strong outperformance during market corrections.

Right now, this portfolio re-allocation strategy indicates a shift to long gold and short the Nasdaq 100 should be made. This ratio is just coming off the 36-month EMA, and the stochastics lines are oversold below 20, and look like they should cross back up soon. Quality gold and silver mining stocks are also recovering from their financial crisis lows, and those that are well-financed with large deposits are poised to move up much faster than gold and silver because of their leverage. Mining juniors that have survived the financial crisis while maintaining large deposits and improving or maintaining healthy cash positions may perform the best of all because of their extreme leverage.

Silver has been more volatile than gold in recent years, but remains severely undervalued relative to gold on a historical basis. Currently, the gold/silver ratio is around 63.5, but the historical average over the centuries has been around 16. That means that if silver returns to its historical ratio with gold, it should quadruple relative to gold, even if gold is headed to much higher levels. This article discusses some reasons silver should move much higher relative to gold. For long-term investors, silver and silver mining stocks, particularly quality juniors with large deposits, could have exponential returns if the precious metals bull market continues.

As for fundamentals, the sovereign debt crisis around the world is starting to evidence itself with the crisis in Greece and the downgrades of Spain and Portuguese debt. As sovereign debt issues decrease the value of paper currencies around the world, the value of the hard currencies, gold and silver (the word for money in many languages is the same as the word for silver), will increase significantly.

This article describes the fundamental issues pointing to much higher gold and silver prices

This NY Post article from April 11 described the gold and silver price manipulation to keep prices down.

This article from this weekend points out that the Department of Justice Antitrust Division is now considering launching an investigation into silver market manipulation by JP Morgan. Could such an investigation be the catalyst that propels silver back up toward its historic ratio with gold?

Given the current technicals as well as the fundamentals, it looks like a strategic shift of portfolio allocation from stocks to gold and silver will likely pay off handsomely, especially if anything comes of any DOJ investigation into silver market manipulation. Aggressive traders can go short the Nasdaq 100 while going long gold and silver to fully participate in this ratio strategy. Even if the stock market continues higher unabated, the likely faster increase in gold and silver should reward investors who make this shift. If stocks should finally experience a significant pullback while gold and silver break out, this shift could be a life changer for some.

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