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This
essay is based on the Premium Update
posted on July 1st, 2010
At times daily
volatility can cause one to lose the big picture from sight - focusing on trees is ok as far as
one doesn't forget about the whole
forest. This universal approach can be applied today since we
have just seen a massive decline in the prices of gold, silver, and mining
stocks. In this case, we would like to provide you with our thoughts on
something that might influence the precious metals sector (not every part
thereof to the same extent) - the head-and-shoulders formation on the general
stock market (charts courtesy of http://stockcharts.com.)
Let's begin with the
long-term SPY ETF chart.
 
This week’s SPY
chart clearly shows a continuation of the bearish trends, which were
prevalent to last week. There has been continued development of the
head-and-shoulders pattern and this has been confirmed by an increase in
volume. The long-term chart above suggests that the pattern has yet to complete.
Note the low point is
below two previous bottoms. Also, note the pattern in the chart of weekly
volume levels. This bearish head-and-shoulders formation has and will
probably continue to spell trouble for the general stock market. More details
will be seen on the short-term charts.
The final confirmation
of pattern completion will likely come from price movement in the SPY ETF or
directly from the main stock indices such as the Dow Jones Industrial
Average. Visible
declining below the neck level (SPY: $103) and then increasing only slightly,
accompanied by low volume increase would be a final confirmation of the
bearish trend. Subscribers who seek to short the general
stock market may wish to watch these signals closely as there may well be
some good profit opportunities in this speculative activity.
This week’s
short-term chart reveals that the June top is slightly below the one seen
during in January. Since the right shoulder in the pattern is lower than the
left, the neck is likely skewed as well.
The price would need to
move below the solid blue line in the chart for completion of the formation.
Without this type of movement, the breakdown is not complete although it may
appear to be.
The RSI is presently in
the 30 range, which corresponded to local bottoms in early May and February.
However the late January RSI in this range did not result in a local bottom
until a week later. In late May the 30 level in RSI did not mark the final
bottom either.
Consequently, the RSI
alone does not imply that the bottom is imminent. If price were to move
sideways and then lower or simply move lower immediately the implications
would likely result in the SPY ETF below a level of $103 and then moving up
on low volume would be a bearish signal.
The DIA ETF, a proxy
for the Dow Jones Industrial Average confirms the above comments about the
non-existence of the breakdown at this point. The left and right shoulders
are relatively equal - no breakdown has yet been seen here.
The Broker-Dealer Index
this week indicates the likelihood of a breakdown. The financials have been
very weak for several months and especially in recent days. This is normally
a clear indication that declines will follow in the main stock indices.
Consequently, the odds
favor a breakdown from the recent head and shoulders pattern in a continued
move downward. Although this is not a certainty, it is probable. If the
general stock market moves below the neck in this pattern and then rises
slightly on low volume, shorting SPY ETF could be profitable. Part of the
precious metals sector, namely silver and mining stocks are at particular
risk when the general stock market is trending in ways seen today.
We have frequently
commented on comparisons between gold and silver investments. While writing
about gold being preferred over silver we have meant much more than just the
profit potential of both markets. It simply indicated that silver and mining
stocks are more vulnerable to general stock market's weakness and therefore
carry a higher probability of not moving higher. This can also be stated as a
higher risk to reward ratio.
Caution: the following
is an example to be used only for illustrative purposes. The quantities,
percentages and dollar amounts quoted are not in any way implied to be
meaningful except in explaining the risk to reward ratio.
Let us say, for
example, that gold has a 90% likelihood of increasing in price, silver has a
70% chance and mining stocks have a 60% chance and all of these markets would
move up or down by the same amount during the move. All would be likely to move higher
since, in this example, all percentages are greater than 50. Since gold is
the most probable to go higher, it would be less risky. Therefore, gold would
be preferable over silver and mining stocks even if all of them are likely to
rise.
To address the subject
of risk to reward ratio, let us go a step further with our previous
illustration. Suppose that we invested $1,000 in each of the situations
above. Let us further hypothesize that the upside
potential or likely profits were $400 for each if our investments
all reached their full potential.
The likely gain, or
reward, would be $360 for gold since there is a 90% chance of the $400
profit, $280 for silver which has a 70% chance of the $400 profit, and $240
for mining stocks. Since the risk for each was the investment of
$1,000, the risk reward ratios would be 2.50, $1,000 divided by $360, 3.57, $1,000
divided by $280 and 4.20,
$1,000 divided by $240 respectively. The statement gold has a lower risk-to-reward
ratio that the other precious metals is thus supported by this
example.
Another example: gold
has a 90% likelihood of rising 10% higher (and if it moves lower, it would
move 10% lower), silver has 90% likelihood of rising 11% higher (and if it
moves lower it would move 50%
lower). Which of them has the better risk/reward ratio? Gold
- because even with higher profit potential for silver (11% vs. 10%) the real
difference is what happens if the move up does not materialize at all (only
10% probability). In this case gold investor loses 10%, while silver investor
loses 50%. We get the feeling that at this point you would have preferred to
own gold instead of silver even though it had smaller profit potential. Of
course, you cannot go back in time, so you need to take the negative outcome
into consideration before you put your money on the table. In this case it
would mean buying gold instead of silver even though it was likely to gain
less during an upswing. Moreover, those who invested in silver could brag
about their higher profits not mentioning the fact that they were risking 50%
of their money, while gold investors only risked 10%.
Let's run a simple
simulation for the above example. Speculation is not a one-time bet - it's a
set of many bets, and what matters is if you lose or gain money in the long
run. So, let's see what would happen if there were many similar situations to
the one described above.
With 10% of losing and
20 trades the average value of losing trades would equal 2, so we would have
on average 18 winning trades and 2 losing ones.
For 20 trades with the
abovementioned odds and gains/losses the gold investor would gain
1.10*1.10*1.10*…*1.10*0.9*0.9 (18 times winning 10% and 2 times losing
10%). So, in the end the effect would be 1.10^18 * 0.9^2 - 1 = 3.50 meaning
that the investor would gain 350% of their initial capital.
At the same time with
the abovementioned odds and gains/losses, the silver investors would gain
1.11*1.11*1.11*…*1.11*0.5*0.5 (18 times winning 11% and 2 times losing
50%). So, in the end the effect would be 1.11^18 * 0.5^2 - 1 = 0.64 meaning
that the investor would gain 64% of their initial capital.
Shocking isn't it? One
could achieve over 5 times bigger profits just by paying attention to the
"what if we're wrong" question. Moreover, if the gains and losses
were spread evenly, the first loss would occur after 9 winning trades. Please
recall that the profit potential alone was bigger for silver, meaning that if
we had only winning trades one would have biggest gains by investing in this
particular market. The point here is that up to this tenth trade gold
investor would have smaller gains than his silver colleague, and the latter
might argue that paying attention to losses makes no sense if markets are
moving only up, and that the gold investor is wrong for preferring the yellow
metal over the white one. The silver investor would have no idea that after
his next trade he will wish that he had joined his golden colleague in the
first place.
Please note that the
above situation is just an example, in the future it could be the case that
the risk/reward for silver is more profitable that the one present on the
gold market.
Consequently, we strongly
believe that the risk/reward ratio with focus on the long-term growth of
one's portfolio is the most profitable way to approach any market, and that
paying attention many factors instead of looking at the day-to-day gains will
eventually prove very useful. Please keep the above examples in mind while
examining the correlations matrix below.
The correlation matrix
has some changes this week. The positive relationship for silver and mining
stocks with the general stock market has declined somewhat. The corresponding
coefficient for gold with the general stock market still remains lower than the
other metals. What this means is that gold will generally be more resilient
during a downswing in the main stock indices; it will most likely hold its
value more so than silver and precious metals' stocks.
Summing up, gold itself continues
to be the preferred part of the precious metals sector at this point due to
the tense situation on the general stock market. Meanwhile, we have just sent
out a Market Alert to our Subsribers describing short- and long-term
implications of yesterday's downswing for Precious Metals Investors and
Traders.
Thank you for reading.
Have a great and profitable week!
Przemyslaw Radomski
Editor,
www.sunshineprofits.com
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