Gold Market Radar (April 16, 2012)

Sunday, April 15th, 2012

Gold Market Radar (April 16, 2012)

For the week, spot gold closed at $1,657.35 up $21.12 per ounce, or 1.6 percent from Thursday’s close before Good Friday. Gold stocks, as measured by the NYSE Arca Golds BUGS Index, rose 2.7 percent. The U.S. Trade-Weighted Dollar Index declined 0.3 percent for the week.

Strengths

• On again, off again speculation that the Federal Reserve may need to intervene with more stimulus to shore up the economy led gold to a relatively good week. Both China and the U.S. posted weaker economic data. China’s trade surplus came in at $5.35 billion, substantially greater than the median projection of a $3.15 billion deficit. The weak numbers raised concerns that the world’s second-largest economy faces a deeper slowdown than originally forecasted. In the U.S., nonfarm payrolls rose 120,000 in March, well below market forecasts and a possible sign that momentum in the job market is slowing.
• Randgold Resources jumped 9 percent on Monday on news that a political settlement appears to have been brokered in Mali. Leaders of the recent coup have come to an agreement with the military junta to reinstate the country’s constitution.
• In other positive news, jewelers in India called off their three-week strike over the prior weekend. The Indian government said it would consider scrapping a budget proposal to levy an excise duty on unbranded jewelry. Industry representatives said that if the tax rollback does not materialize the strike would resume on May 11.

Weaknesses

• Technically, silver prices are not following through with the same price strength as gold.  Analysts cite record-high mine supply and demand concerns. In addition, the huge price volatility last year, when the metal crashed 35 percent in a matter of days on two occasions, has dampened silver’s appeal to investors as a cheaper alternative to gold.
• For the second time since February, the CME Group, the largest operator of futures exchanges in the U.S., announced a cut in margin requirements for COMEX silver futures in an attempt to boost liquidity. However, analysts note that margins are still higher than they were last year and it would take some significant interest from investors to drive the price higher.
• The latest Gold Fields Mineral Services (GFMS) report noted that gold prices are expected to be driven by eurozone debt concerns and the prospects of additional monetary stimulus. In their view, gold has the potential to breach the $2,000 per ounce level in 2013. The report also said total cash costs increased 15 percent in 2011 to $643 per ounce, up from $560 per ounce in 2010. Declining mine grades are the largest contributing factor to the increase, contributing $28 of the $83 per ounce net increase. All-in costs (including depreciation as well as general and administrative charges) increased 22 percent.

Opportunities

• Positive economic signs and the rollover of bad European debts through their long-term refinancing operations (LTRO) program pushed the S&P 500 to good returns in the first quarter. However, it is unlikely the recent bright spots are enough for the world’s two great fiat currencies to regain trust from Asia, Russia and the Persian Gulf states. Short-term liquidity issues have been addressed but unsustainable levels of sovereign debt still remain. Western central banks will likely have to keep printing money for some time and those countries with surpluses will have to find a suitable place to park their growing foreign reserves. Currency devaluation has historically been a major policy tool for extinguishing national debt but it also leads to a higher gold price.
• Russia has publicly stated it is raising its gold weighting to 10 percent of its reserves. China, which would like to raise the renminbi to reserve currency status, is eying large gold reserves as well. With official gold reserves sitting at 1,054 tons, China has a long way to go before it can catch up to the 8,000 tons of gold held by the U.S. and the 11,000 tons of gold held by the eurozone. China would likely need to boost the country’s gold holdings in a significant way in order to make its currency competitive in world markets.
• HSBC gold analyst James Steel says that the marginal cost for mining gold, when miners leave low-grade ore in the ground, is about $1,450. Despite a four-fold increase in investment, a lack of great new gold discoveries has made peak gold production a closer reality than peak oil. With world gold output stuck at 2,700 tons for a decade, this creates a natural floor, of sorts, for gold prices.

Threats

• David Rosenberg had some interesting comments on incomes and prospects for a strong recovery in the household sector. The sector has recently been going through the healing process, but is still far from healed. Rosenberg also notes that current real disposable incomes are actually lower than in May 2008 on a per capita basis, $32,600 today versus $34,631 then. Rosenberg says, “You can see why it is that for most people, it is very difficult to talk about economic recovery when real personal incomes have done so poorly and for so long.”
• A recent paper from the African Development Bank (ADB) titled “Gold Mining in Africa: Maximizing Economic Returns for Countries,” points out that gold mining is significant activity in at least 34 of the continent’s 54 countries. The paper notes Africa’s annual gold production is 480 metric tons, 20 percent of annual global output, but concession agreements signed by the governments are unfair. This particularly applies to the royalty rate stated in these agreements. Despite spiraling prices for precious metals, the ADB believes Africa is not cashing in enough from its large gold resources. These agreements severely limit gains from gold mining activity in gold producing countries. However, only a limited number of African countries have actually taken equity stakes in the mines within their borders. It’s worth pointing out that one can only gain access to market returns by risking capital to invest.

Tags: Budget Proposal, Comex Silver, Dollar Index, Excise Duty, Futures Exchanges, Gold Market, gold stocks, Jewelry Industry, Margin Requirements, Market Forecasts, Market Radar, Military Junta, Nonfarm Payrolls, Nyse Arca, Political Settlement, Price Strength, Price Volatility, Randgold Resources, Silver Prices, Spot Gold, Tax Rollback, Two Occasions
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Understanding the New Price of Oil (Martenson)

Wednesday, March 14th, 2012

by Gregor Macdonald via Chris Martenson

Understanding The New Price Of Oil

In the Spring of 2011, when Libyan oil production — over 1 million barrels a day (mpd) — was suddenly taken offline, the world received its first real-time test of the global pricing system for oil since the crash lows of 2009.

Oil prices, already at the $85 level for WTIC, bolted above $100, and eventually hit a high near $115 over the following two months.

More importantly, however, is that — save for a brief eight week period in the autumn — oil prices have stubbornly remained over the $85 pre-Libya level ever since. Even as the debt crisis in Europe has flared.

As usual, the mainstream view on the world’s ability to make up for the loss has been wrong. How could the removal of “only” 1.3% of total global production affect the oil price in any prolonged way?, was the universal view of “experts.”

Answering that question requires that we modernize, effectively, our understanding of how oil’s numerous price discovery mechanisms now operate. The past decade has seen a number of enormous shifts, not only in supply and demand, but in market perceptions about spare capacity. All these were very much at play last year.

And, they are at play right now as oil prices rise once again as the global economy tries to strengthen.

The Subordination of Cushing

Through the dominant force of its own demand, the US economy largely controlled the oil price for many decades. For years, it was common practice therefore to gauge world demand through the weekly updates to oil storage at Cushing, Oklahoma as well as total oil storage in the United States. If the US was demanding more oil from the global market, and thus either not adding to oil inventories or drawing them down, then a signal was given, pointing to future oil price strength.

But this dynamic began to break down coming into 2005-2007. That was the period when US oil demand — because of rising prices — began its current decline. Now that US oil demand is down over 12% from its mid-decade peak, the fluctuation of oil inventories in the US no longer drive prices.

The chart below shows that US inventories have been on an upward trend since 2005, and are now near decadal highs above 300 million barrels even though oil prices are back above $100:

What we’re now seeing is that US inventories and US demand are now subordinate to numerous other factors, ranging from emerging market demand, to market perception of spare capacity.

Lessons of Libya

A useful fact learned during last year’s Libyan civil war is that Saudi Arabia does not necessarily posses the 2-3 mbpd of spare capacity which most have assumed for years. Moreover, Saudi Arabia ceded the position of top world oil producer to Russia over 5 years ago in 2006. Indeed, Saudi Arabia made no production response to the loss of Libyan oil last spring. Producing near 9 mbpd, it was only by June that Saudi production was lifted by 600 thousand barrels a day (kbpd). That is a hefty production increase to be sure, but it raised questions as to how quickly spare capacity in the world can be brought online.

By the time Saudi Arabia had lifted production, the OECD countries led by the IEA in Paris had already decided to release oil from official inventories. But this, too, did little to calm oil prices — and as I pointed out last June, only created further problems. In The Dark Side of the OECD Oil Inventory Release, I explained that, by lowering OECD inventories, the market would correctly deduce that safety buffers had been reduced further. Combined with the Saudi increase in production, this only reduced spare capacity further.

The result was even stronger prices as WTIC ran back to $100 (until all global markets floundered on a flare-up in the EU financial crisis). Indeed, it is no longer US inventories of crude oil but the fluctuations in the emergency cushion of all inventories in the OECD (of which the US is part) that is now the more important factor in oil prices:

The loss of Libyan production caused a dramatic drawdown of OECD total oil stocks, which were already in a downward trend starting the previous summer in 2010. OECD inventories fell on both an absolute basis and on a comparative basis to the trailing 5 Year Average as the above chart shows. Taking these inventories from a high of 2800 mb to 2600 mb only 6 months later, combined with unrest across the entire Middle East, was more than enough support to boost WTIC oil prices from $85 to above $100 last spring. Additionally, as we can see in the chart, the decline in OECD oil inventories was maintained into the end of 2011.

These are important conditions to consider when trying to understand how oil prices now, in early 2012, are once again on the rise.

The Decline of Spare Production Capacity

The latest global production data shows that Saudi Arabia was producing 9.4 mbpd on average during 2011, an increase of 500 kbpd over 2010. To accomplish this, The Saudis had to increase production from 9 mbpd in 1H 2011 to 9.8 mbpd during 2H of 2011. But paradoxically, this production increase has only made the global oil market even tighter, as spare capacity shrinks further.

Let’s recall that nearly 60% of global oil supply comes from outside of OPEC from countries like the US, Canada, Brazil, Mexico, China, Australia, and the big producer—Russia. There is no spare capacity in this non-OPEC grouping and there hasn’t been for years. Sure, there is oil to be developed in non-OPEC countries; but that is not production capacity (meaning it is not supply that can be brought online quickly).

Moreover, Russia, the country that single-handedly saved non-OPEC production from going into steep decline, massively increased its contribution to world supply in 2002. But in the past two years, it has seen its production growth taper off and flatten, to just shy of 10 mbpd.

That leaves the oil market, tasked with the job of pricing, to figure out the ongoing mystery that is the “true” spare production capacity in OPEC. That it took 4-5 months for Saudi Arabia to increase production is a concern. Such delays should seriously give pause to those analysts who’ve regurgitated the belief over years that Saudi has 2-3 mbpd that can be brought on quickly.

Although EIA Washington currently judges OPEC spare capacity to be higher than during the lows of 2003-2008, it’s historic figures show that spare capacity has been declining since a 2009 high.

Moreover, the failure of non-OPEC production to increase within last decade counts as a true surprise to the global oil market. The faith in non-OPEC supply over the last decade helped to keep prices subdued, until that faith was shattered by 2007′s wild spike.

The problem now is that the oil market has been re-educated. Faith in the non-OPEC countries’ ability to increase supply is no more. Meanwhile, the great deceleration in Russian oil supply growth, has spooked the market. Combined, a market with 74 mbpd of production and a theoretical spare capacity of 3 mbpd simply creates too much uncertainty.

And consider this: the amount of total spare capacity is now equal to the 3 mbpd of demand that’s been taken offline in Europe, Japan, and the United States over the past 7 years, as oil prices have risen from $40 to the $100 level. Thus the oil market has quite correctly rationed supply, at higher prices. If prices were to fall to $50 or $60, the world’s lost demand could be rebuilt rather quickly.

Killing discretionary demand is now the proper function of the oil market in an age of flat supply growth.

Quantitative Easing and Granger Causality

We should also remember that the global economy would be mired in a textbook deflationary depression were it not for the continual and gargantuan US$ trillions that have been provided by central banks since 2008.

Early 2009 saw oil prices slip briefly below $40. But, of course, that’s the price level appropriate to a world during an industrial crash — with reduced shipping, halted economies, and dislocated consumer demand. The world can have those prices again, if it chooses. But it must also be willing to accept a global recession to achieve such low oil prices.

Thus, there is a misconception that currency debasement is the main driver of oil prices. However, given the new supply realities, that simply isn’t true any longer.

The chart below is helpful in explaining why. There is no question that coming out of 2000, the decline of the US Dollar as expressed by the USD Index was a true component of the rising oil price. During that period, as the USD was falling, global oil supply was still increasing. The descent of the US Dollar was unquestionably part of the repricing process, as the USD Index fell from a high of 120.00 in 2002 to 80.00 in 2005:

But see how the most ferocious part of oil’s price advance started to unfold after 2005, when, as the USD continued falling, the global supply of oil stopped growing.

If we think of this comprehensively, we have to conclude that the debasement of currencies is no longer the primary factor in the price of oil on a valuation basis. Rather, it is that quantitative easing prevents a deflationary industrial collapse, thus keeping the global economy alive and able to consume more energy.

We can therefore say that in our post-credit bubble collapse era, and with global oil supply now flat, that quantitative easing causes higher oil prices (through Granger causality). It keeps economies from collapsing (for now) and thus brings demand up against very tight supply. As we can see from the chart above, the USD Index has for 3 years now been bouncing off the bottom it first reached in 2008. In a way, this is helpful because it brings to light the new dominant factor in global oil prices: supply.

Supply is now Primary

Supply, and the recognition of supply, are now the dominant factor in the oil price. A point so obvious, it hardly seems worth making. However, the developed world is still largely operating on the classical economic view that higher prices will make new oil resources available.

That is true. But, it’s just not true in the way most anticipate.

While higher prices have brought on new supply, these resources have been slow to develop, are more difficult to extract, and generally flow at lower rates of production. As the older oil fields of the world decline, the price of oil must reflect the economics of this new tranche of oil resources. There are no vast, new supplies of oil that will come online in 2013, 2014, and 2015 at the scale to negate existing global declines.

During the entire time that global oil supply has been held at a ceiling of 74 mbpd, since 2005, a lot of new production in the Americas and Africa especially has come online. But it has not not enough to increase total world supply. And the price of oil has finally started to price in that new reality.

Here Comes Volatility in Oil Prices

The pricing dynamic discussed above is accentuated by the crisis cycle: the repetitive oscillation between acute and chronic phases of the ongoing debt crisis, mitigated by central bank reflationary policies.

In Part II: Get Ready for Oil Price Volatility to Kill the ‘Recovery’, we forecast how today’s protractly high recent oil prices are already sending a signal that a new hit to global demand is underway.

Generally, it appears that the oil price is making its move too early in the year — which will likely serve as a sucker punch to the fragile world economy — thus making spectacularly high prices before year end less likely, and a sharp market correction and return to economic recession more so.

Investors will be wise to take prudent precautions before this nasty wake-up call arrives.

Click here to access Part II of this report (free executive summary; enrollment required for full access).

Tags: Cushing Oklahoma, Debt Crisis, Dominant Force, Global Economy, Global Production, Gregor Macdonald, Lows, Mainstream View, Market Perceptions, Martenson, Oil Demand, Oil Inventories, Oil Price, Oil Prices, Oil Storage, Price Discovery, Price Of Oil, Price Strength, Russia, Time Test, Universal View, Wtic
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Goldman’s Jim O’Neill on Commodities, Equities, Currency

Monday, May 9th, 2011

by ZeroHedge.com

Jim “BRIC” O’Neill predicts the opposite of everything his other colleagues at Goldman anticipate. Indeed, in his latest note, the BRICster not only directly contradicts David Greely’s latest note that the long-term prospects for commodities are strong as ever by saying that “This suggests to me that commodity prices could weaken further.” (for what “this” is, read the note). As for Thomas Stolper’s soon to be stopped out prediction of a EURUSD hitting 1.50, O’Neill has some contrarian cold water for that too: “In my book, even with the likelihood that the Fed will remain friendly post QE2 termination, the Euro belongs in a 1.20-1.40 range.” So there you have it: one firm, an infinite number of outlooks.

From Jim O’Neill.

Can Equities Rally Without Commodities?

What a week! In last weekend’s Viewpoint, in addition to highlighting the historical tendencies of markets in May, I suggested that commodity price strength didn’t make much sense to me. One week later, after the stunning correction to many commodities, I am struggling to get my head around the question: why does commodity price weakness go hand in hand with equity weakness? Put another way, if equities are to develop another leg to the rally that has been taking place since 2009, it will probably have to be led by something other than commodities.

ECONOMICS, EQUITY AND COMMODITY MARKETS.

There was a day when commodities, as an asset class, were seen as an alternative to both fixed income and equities. I know that many of my colleagues from various parts of the GS family can statistically prove that this remains the case. However, at times during the past decade, it has seemed that commodity prices have been a “bellwether” about the world. Furthermore, strength in commodity prices has been related to strength in many equity markets (as well as a major influence on some other markets such as some currencies).

From an economic perspective, at its most basic level, the price of any commodity is determined by its supply and demand and expectations about both. An increase in the price of a commodity can happen because of a rise in demand relative to supply, or a decline in supply, or some combination of both. In the years before the global credit crunch, it was often perceived that commodity prices were rising because of very strong global growth and limited supplies. Post credit crunch, the same general mood has prevailed.

Linked to this thesis, application of the GS long term 2050 growth projections and the potential rise of the BRIC economies suggest a general environment of very strong demand for commodities relative to supply. The GS Economics, Commodities and Strategy (ECS) department have published a number of articles to show this. In particular, Global Paper Number 118, October 12th, 2004; Crude, Cars and Capital, authored by D.  Wilson, R. Purushothaman and T. Fiotakis applied the original 2050 projections to the crude oil markets, and one of its conclusions was that there was likely to be a major supply and demand imbalance between 2005 and 2020.

Many market themes that have played out over recent years often relate to the basic tenet of this paper. Simply stated, Mr. Market seems to regard strength of commodity prices as a symbol of world economic strength, and weakness of commodity prices as a symbol of economic weakness.

THINGS ARE CHANGING?

Many market participants appear to have forgotten the days of the 1980’s and 1990’s where economic strength was not symbolized through rising commodity prices. During that time, we had two decades of declining commodity prices and, while there were periods of recession, we experienced two decades of global economic expansion. Could such days ever return?

Over the past 12 months, three different economic issues have developed in my mind that lead me to wonder whether things might be changing.
First, as commodity prices recovered sharply post the global credit crisis, headline inflation has, in turn, risen in many countries. And, in those less wealthy nations, including many of the Growth Market and emerging countries, rising commodity prices are a real challenge. In some developed economies that were most challenged after the credit crisis, rising commodity prices are quite a burden for those societies too. A feeling of  unsustainability about this has been going through my mind for much of this year.

At a minimum, we are likely to encounter more mini periods of volatility, where rising commodity prices, food and energy in particular, choke off some economic activity as consumers and business adjust to the higher costs. In countries where overall inflation rises more because of these rising prices and central banks tighten monetary policy, subsequent tightening financial conditions will slow down growth and probably lessen their contribution to the demand for the commodities in the first place. It appears as though we might be going through such a period right now.

Suddenly, economic data in many economies has disappointed, and while there could be a number of explanations, it seems quite feasible that the degree of increase in energy and food prices might be a guilty culprit.

Second, and linked to the first point, as I mentioned last week, the role of China in particular is key. GS has a proprietary GDP indicator for China called the GSCA, the GS China Activity indicator. In recent years, it has had a very good relationship with commodity prices, presumably signaling the critical role that Chinese demand plays in the commodity markets. In recent months, the GSCA has slowed a lot, and yet, commodity prices – at least until the past week – hadn’t. This suggests to me that commodity prices could weaken further.

More broadly, softening in key global leading indicators following the release of many May PMI and ISM indices would suggest the same trend.

Third, bringing it back to China, and getting really specific to energy and oil in particular, China’s long term economic planning is increasingly based on a world different from the one modeled by ourselves in 2004. If you reanalyze global oil demand assuming that China will deliver on the energy consumption plans it has unveiled as part of its latest 5-year plan, their oil demand will not grow even close to the magnitude shown in Dominic and team’s 2004 paper. Indeed, Anna Stupnytska and I showed in another paper, Global Paper Number 192, The Long Term Outlook for the BRICs and N11 Post Crisis, December 2009, if you substitute the Chinese plans into the same equations as the 2004 paper, 2050 global oil demand would be 20 pct less.

If I think about all three of these things together, what happened in commodity markets last week was not surprising at all, and more weakness in the near term wouldn’t be that surprising either.

MARKETS NEED TO BEHAVE FOR THEIR OWN DETERMINANTS.

As this relates to other markets, it doesn’t necessarily follow that any additional weakness in commodity prices will translate into more equity market weakness, except in the obvious cases where commodity companies are a major market component. It certainly shouldn’t follow that correlated risk reduction on the back of commodity price declines should have lasting consequences for other market prices, for example additional Yen strength. This would seem somewhat ludicrous and, if needed, I suspect G7 policymakers may have to act again.

As it relates to the directional trend of equity markets, however, the last week’s events do draw me to a conclusion that if equities are to develop another leg into higher prices, it probably won’t be sustained if it is simply the result of commodity prices recovering. If commodity prices go straight back up, it will add renewed pressure to headline consumer prices in China and elsewhere, probably resulting in additional monetary tightening.

If commodity prices don’t move back up, one of the beneficial consequences is that it will make it probable that a number of central banks won’t need to tighten as much as otherwise, possibly not at all, including China and maybe also the ECB. It is interesting that ECB President Trichet didn’t utter the magical phrase “strong vigilance “at this week’s press conference.

Can equity markets rally without leadership of commodity companies and prices? Of course they can, but I shall leave the sectors most likely to all of you to ponder.

EURO WOES.

There is one other topic that I need to touch upon. After already showing a big response to Trichet’s less hawkish stance than expected, the Euro took another hit late Friday as rumours circulated of a special meeting to discuss Greece and a possible debt restructuring and even talk of them exiting the Euro. Not surprisingly, these rumours were denied but, despite this, the Euro ended close to its lows for the week, having given back 6 big figures of its latest strength. I am not overly surprised by this Euro decline either, as the case for the ECB tightening further has just been weakened. And, it continues to seem to me that some risk premia is warranted, as Europe’s leaders struggle to come to grips with the immense challenges of creating a more credible and successful European Monetary Union. In my book, even with the likelihood that the Fed will remain friendly post QE2 termination, the Euro belongs in a 1.20-1.40 range.

THE BEAUTIFUL GAME.

Actually there is one other topic too, my usual favourite. May 28th will now see arguably the two best European football clubs slugging it out again when Manchester United meets Barcelona at Wembley. What an evening in prospect and what a build-up the next 3 weeks will be. Will it attract as many viewers as the Royal Wedding? Apologies to all those of you asking me for help with tickets, it is exceptionally difficult.

Jim O’Neill
Chairman, Goldman Sachs Asset Management

Tags: asset class, Bellwether, BRIC, Cold Water, Commodities, Commodity Markets, Commodity Price, Commodity Prices, Crude Oil, David Greely, Economic Perspective, Eurusd, Fixed Income, Gold, Goldman, Infinite Number, O Neill, Outlooks, Price Strength, Stolper, Term Prospects, Viewpoint
Posted in Emerging Markets, Markets, Oil and Gas | Comments Off

What is Seasonal Investing? (Brooke Thackray)

Thursday, February 3rd, 2011

Brooke Thackray, CFP, CIM, Research Analyst, JovInvestment Management Inc. explains, 1) seasonal investing, 2) three trades used in the Horizons Alphapro Seasonal Rotation ETF (HAC:TSX), reveals 3) how decisions are made in the fund, and finally 4) his 2011 outlook in the following 4 short videos, which you can watch here, or here.

This additional information is courtesy of Don Vialoux’s TimingTheMarket.ca. Don Vialoux and Brooke Thackray are advisors to the Horizons AlphaPro Seasonal Rotation ETF (HAC-TSX)
By definition, seasonal investing includes:

• A start date for an investment
• An end date
• Either price strength or weakness between the start and end dates for the chosen equity, sector, index or commodity.

A seasonality study preferably uses at least 10 years of data. Most of our studies use 15-20 years of data However, data may not always be available for 10 years. Studies using less than ten years of data can be used, but they tend to be less reliable. Results of shorter term studies have a higher chance of being skewed by a single data point.

Results using at least ten year of data tend to be stable for long periods of time, particularly when annual recurring fundamental reasons causing seasonality are unchanged. However, “statistical” slippage can occur. For example, the U.S. high tech sector has a period of seasonal strength from the end of September to a time between the end of December and the end January. On average, the sector peaks between start of the annual Las Vegas consumer electronics show in the second week in January and start of fourth quarter earnings reports near the end of January. Optimal time to own high tech securities for a seasonal trade based on month end statistical data over a 10 year period frequently flips back and forth from the end of December to the end of January. Seasonality studies on equity indices, sectors and commodities need to be re-examined once a year to see if slippage has occurred.

Time length for intermediate periods of seasonal strength or weakness ranges from five weeks to seven months. In addition, special short term periods often related to holidays have been identified. Examples include strength just before and after U.S. Thanksgiving and strength from just before Christmas until just after the New Year. Also, longer term “cyclical” periods lasting several years have been identified. Most notable is the four year economic or “presidential” cycle. Data for longer term cyclical periods frequently can be overlaid with annual data to refine seasonal entry and exit points.

Some sectors and commodities have more than one period of seasonal strength. A good example is the Canadian financial services sector. Its periods of seasonal strength are from the end of September to the end of December and from the end of February to the end of May. Investors frequently will combine the two periods. Traders with a shorter time horizon may choose one or both periods based on fundamental and technical considerations.

Most periods of seasonal strength are NOT followed by a periods of seasonal weakness. In most cases, periods of seasonal strength are followed by a period of random performance. Markets moving from a period of seasonal strength to a period of seasonal weakness are rare.

Measuring Seasonality

Seasonality is measured in three ways:

• Average return during the chosen period expressed as a percent
• Reliability expressed by the number of profitable periods out of at least the past ten periods.
• Performance relative to a major equity index such as the S&P 500 Index or the TSX Composite Index.

A seasonal investment by definition is profitable more than 50% of the time. If frequency of profitable trades is 50% and frequency of unprofitable trades is 50%, results are random. Confidence in a seasonal trade increases with the frequency of profitable trades. A confidence level for a seasonal trade exceeding is 70% is preferred. A confidence level of 80% frequently is available. A confidence level of 90% is relatively rare. A confidence level of 100% is extremely rare.

Primary Factors Influencing Seasonality

Seasonality happens because of a series of annual recurring events. The job of a seasonality analyst is to examine if the annual events are likely to recur prior to a period of seasonal strength. If annual recurring events are less likely to occur, the seasonality analyst will avoid recommending a seasonal trade.

The classic example is a series of recurring events that trigger the annual period of seasonal strength in the Canadian equity market. The TSX Composite Index has an historic period of seasonal strength from the end of September to the end of April. The strategy is known as the “Buy when it snows, sell when it goes” strategy: Canadian equity markets historically start to move higher near the end of September when the first snowfalls frequently appear in many parts of southern Canada. Equity markets tend to reach a seasonal peak near the end of March/ middle of April when last of the snow melts away. U.S. equity markets as well as almost all equity markets in developed nations have a similar seasonal pattern.

Securities Suitable for Seasonal Equity Investing

Security suitability depends on the knowledge level achieved by the investor:

Investors with the least amount of investment knowledge should focus on Exchange Traded Funds (ETF) that track the seasonality of well known equity indices and sectors. A wide variety of ETFs currently are available. Over 800 equity ETFs currently are listed on North American exchanges. ETFs hold a basket of equities that track an index. Reasons to own ETFs include their diversification, low cost, tax efficiency and ease to buy and sell. Better known Exchange Traded Funds include DIAMONDS (i.e. Dow Jones Industrial Average tracking units), SPYDRS (i.e. S&P 500 Index Deposit Receipts), Qubes (i.e. NASDAQ 100 tracking units) and i60s (i.e. TSX 60 Index units).

Investors with access to reliable fundamental analysis sources can choose individual equity securities that track a period of seasonal strength. Top choices are individual equities with encouraging news making potential during the period of seasonal strength.

Similarly, investors with access to reliable technical analysis sources can choose individual equity securities that are developing favourable technical patterns during a period of seasonal strength.

Investors with greater investment knowledge can apply sophisticated strategies including various conservative listed option strategies that tie into periods of seasonal strength.

Combining Seasonality with Technical and Fundamental Analysis

Using seasonality as a “stand alone” tool to make investment decisions is NOT recommended. Seasonality is a useful analytical tool, but only when used in conjunction with fundamental and technical analysis. Trades based on seasonality alone are profitable in say seven or eight times out of 10, but are unprofitable in two or three times out of ten.

The same can be said for investment based on technical analysis. Reliable technical patterns such as head-and-shoulders patterns are accurate approximately 75% of the time. However, they are not accurate 25% of the time.

Trades based on fundamental analysis alone also are not recommended. Fundamental analyst picks may be profitable most of the time. However, results from a stock picking contest during 2006 run by the Globe and Mail showed that even the best fundamental analysts are far from perfect. The contest requested each participant to choose one stock to buy at the beginning of 2006 and to hold until the end of the year. Participants included a college student, a financial journalist and seven of Canada’s top fundamental analysts. You guessed it! The winner and only person to choose a stock that appreciated in 2006 was the college student.

Chances of a choosing a profitable seasonal trade are greatly enhanced if all three methods of analysis are combined. Of equal importance, chances of losing capital are greatly reduced.

Seasonality analysis is the bridge between fundamental and technical analysis:

• Fundamental analysis tells us what to buy and sell
• Technical analysis tells us when to buy and sell.
• Seasonality analysis tells us what and when to buy and sell.

Identifying Seasonal Trades

Several methods are available to identify periods of seasonal strength:

• Comments on seasonality made by fundamental analysts can be confirmed by completing a seasonality report based on data for 10 years or more. Fundamental analysts are notorious for commenting on seasonal trends based on 2-5 year data. Ten year studies will confirm or not confirm their comments. A few fundamental analysts on Bay and Wall Street are well aware of long term seasonal trends and base the timing of their recommendations at least partially on seasonality. They usually are analysts who have been in the financial service industry for 10 years or more.
• Recurring spikes can be examined on monthly price charts using 10 or more years of data. Recurring spikes at the same time each year either on the upside or downside can suggest the possibility of a seasonal trend.
• Companies and sectors can be examined when they have at least one quarter per year when revenues, earnings, cash flow and/or Earnings Before Interest, Depreciation and Amortization (EBITDA) are seasonally strong. Examples include retail merchandising and consumer electronic companies in the fourth quarter or airline companies in the summer. Seasonal strength in their share price normally begins just prior to their period of seasonal financial strength and ends just prior to the end of their seasonal period of financial strength.
• Data for 10 years or more can be screened to identify equities and sectors showing periods of above average strength relative to their benchmark index. Preferred benchmarks are the S&P 500 Index for U.S. equities and sectors and the TSX Composite Index for Canadian equities and sectors.

Seasonality Myths

One of the greatest myths on Wall Street and Bay Street is that North American equity markets usually experience a “summer rally”. Traders frequently start talking in May about the possibility of a rally in the stock market in the June to August period. Talk by traders normally escalates during a period when North American equity markets are experiencing a short term correction. The message is “Don’t worry, be happy. The market will come back”. A long term study of the TSX Composite Index and S&P 500 Index confirms that a rally lasting three weeks or more inevitably happens during the three month summer period. However, traders fail to mention that the three week rally period has no consistency. Timing of the appearance of the three week rally is random and can appear at any time during the three month period. Of greater importance, traders fail to mention that virtually all three month periods during the year record at least one period of recovery lasting three weeks or more regardless of season.

Another myth is the expression “Sell in May and go away”. The myth originated from an actual period of seasonal strength in the base metal sector. Base metal prices as well as base metal equity prices tended to peak early in May and bottom near the end of September. The main reason was the annual operating shut down by base metal smelters in Europe in July and August for Europe’s extended holiday season. Demand by smelters for base metal concentrates slowed in May and recovered in September. Currently, base metal prices continue to show this seasonal pattern, but the pattern has been muted over the years. Market share of base metal smelter capacity in Europe has declined while market share in the Far East and South America has increased. Over the past decade, the “Sell in May and go away” phrase became adopted by the media, but with a slightly different twist. The phrase was transformed into expectation for weakness by broadly based North American equity indices such as the S&P 500 Index and the TSX Composite Index from the end of May to the end of September. The myth is not supported by fact. The S&P 500 Index and the TSX Composite Index has gained in five of the past ten periods from the end of May to the end of September. Unlike the period of seasonal strength by North American equity markets from the end of September to the end of

April, performance in the May to September period is random. This period does not have a sufficient number of annual recurring events to influence equity markets.

Another myth is that the month of October is a weak and dangerous month for North American equity markets. The myth is based on the fact that substantial downdrafts in North American prices have occurred in the month of October. October 1929 and October 1987 are seared into the minds of traders. However, data during the past ten years suggests that fears of weakness in October no longer are founded. The S&P 500 Index has advanced in five of the past 10 periods and the TSX Composite Index has gained in seven of the past 10 periods. On the contrary! October frequently is the month of the year when important seasonal lows frequently are reached.

Identified Periods of Seasonal Strength for Equity Indices, Equity Sectors, Industrial Commodities and Selected Stocks as of June 1^st 2009

Lots of changes this year due to the big downdraft in equity markets during the past year! Most seasonal trades showed diminished returns based on data for the past 10 years. In addition, some seasonal trades experienced slippage (e.g. data showing that the optimal period for entering a seasonal trade moved from September to October). Seasonal trades that generated an average return of 5% were eliminated. New seasonal trades were added (e.g. Gold equities, Platinum). Following is the annual report:

Sectors

Exchange Traded Funds are available on all of the above sectors.

Following is seasonality for equivalent Canadian sectors:

** Exchange Traded Funds are available.

Equity Indices

** Exchange Traded Fund available

Commodities

** Exchange Traded Fund or Note available

Selected Periods of Seasonal Strength in Sectors Based On Identified Annual Recurring Events

U.S. Energy

• Strongest quarter for cash flow and earnings: First quarter
• Influenced by favourable seasonality in the price of crude oil and natural gas from February to May and by favourable seasonality in natural gas from August to December.

Information Technology

• Strongest revenue and earnings quarter: fourth quarter in response to consumer electronic sales prior to Christmas
• Climax often associated with the Las Vegas Consumer Electronic show in the second week in January

Health Care

• Key health care conferences usually are in September (Oncology conference) and January (JP Morgan health conference). The sector has a history of reaching a seasonal peak when the JP Morgan health care conference is held in mid January.
• A higher frequency of drug approval in the U.S. usually occurs just prior to year end

Philadelphia Gold and Silver (XAU)

• Strength in the July to September period corresponds to strength in gold. Gold strengthens when gold fabricators are buying gold to make jewelry for the Christmas and Dhaliwal seasons.
• Gold stocks and ETFs tend to be contra-cyclical. They move higher during periods of stock market weakness (particularly in summer months).

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