By David Brady, CFA

Sept 19,2018

The U.S. imposed new tariffs on China this week that were close to the worst possible scenario, despite mainstream media comments to the contrary. The fact that China responded with nothing more than 5-10% tariffs on $60bln of U.S. imports soothed the markets, and stocks rallied. The mistake being made, however, is that China is unlikely done retaliating just yet, and there is likely more to come. What is clear is that neither side is willing to back down in this trade war, so it is probably going to get worse. This is why I still see a risk of higher USD/CNY (despite recent comments from the Chinese Premier to the contrary) and lower Gold prices ahead. The bigger question is: when does it all end? When does Gold finally bottom and rally?

In last week’s article, “When The U.S. Stock Market Crashes, Buy Gold”, I explained why I believe that a U.S. stock market crash is coming. I also shared why this would be followed by a Fed reversal in policy to stimulus on steroids and that this would mean a peak and fall in the dollar, including USD/CNY. This would signal the beginning of the end to the trade war, because a weaker dollar would succeed where tariffs have failed in reducing the U.S. trade deficit with China. A more immediate effect of a return to quantitative easing combined with a decline in USD/CNY would be a soaring Gold price. Silver, Platinum, and especially the Miners would follow suit and then pass Gold on the way up.

Having already explained why I expect a stock market crash in the U.S., this week I want to share with you the market signals I am monitoring that indicate such a crash is about to occur. This crash will launch a series of events that cause Gold to rally beyond its 2016 high and then some, in my opinion.

S&P 500 NEGATIVE DIVERGENCE

A negative divergence occurs when price hits a higher high but it is not confirmed by a higher high in the RSI, MACD Histogram or MACD Line. Such divergence on a monthly basis occurred at the peaks in the S&P in March 2000, October 2007, and we are seeing it again now, given that the S&P is hitting new all-time highs. This does not mean that the S&P has peaked yet, but does suggest that it is close. This tells me we’re in the “sell zone”. However, we obviously cannot rely on one signal alone.

NEGATIVELY DIVERGENT SENTIMENT

You can also get a negative divergence based on a higher high in price but a lower high in sentiment. My preferred measure of sentiment is the daily sentiment index, or DSI.

In May 2007, the spot DSI peaked at 93 and the 21-day moving average DSI at 89. Price rose to a higher high in October 2007, but the spot DSI peaked at a lower high of 88 and the 21-day moving average at 83. This is what I mean by a negatively divergent higher high in price, which typically signals that price is about to fall.

The S&P peaked in October 2007 at 1576 and then proceeded to crash to 666 in March 2009. We could see the same negative divergence play out soon.

In January this year, the S&P peaked at 2873. The spot DSI peaked at 96 and the 21-day moving average at 88.

For 2007/08 to play out again, I am looking for the spot DSI to peak in the high 80s, preferably 90 or so, and the 21-day moving average to peak in the low 80s. If we see such sentiment numbers, I’ll be expecting a crash in stocks to follow soon after.

Peak in 10-Year Bond Yields

Another signal to watch is a negatively divergent peak and fall in the 10-Year yield, just as in July 2007, three months before stocks peaked in October of that year. I don’t expect the lag time to be anywhere near as long this time around.

I’ve been expecting the 10Y yield to rise to 3.30-3.50% before collapsing, but it could happen ahead of that. Recent highs are already negatively divergent on the RSI and MACD Histogram, but the MACD Line has yet to join in.

I’ll summarize the other signals I’m watching as follows…

YIELD CURVE HOCKEY STICK

Bottom in the 2Y-10Y yield curve, and then it starts to rise—as in early 2000 and 2007.

USD/JPY PEAKS and FALLS

Peak and drop in USD/JPY—started in June 2007.

HIGH YIELD SPREADS WIDEN

Widening high yield and/or investment grade credit spreads. Credit leads equities. High yield spreads bottomed in May 2007, months before stocks peaked. Note that they peaked before stocks bottomed also.

HIGHER LOWS IN VIX

Having trended downward in 2006, the VIX bottomed in January 2007 and started setting higher lows and higher highs before stocks peaked in October. The VIX also bottomed in September 2017 and could be in the process of doing the same thing all over again. Another signal of a pending stock market crash when it turns up again.

INTERNALS / BREADTH

My preferred measure is the equal weighted S&P 500 (“RSP”) relative to the official S&P 500 index (“SPX”). When the RSP falls ahead of the SPX, the ratio declines. This is a warning sign that the internals or breadth of the stock market is declining: fewer stocks are rising, and the market is being led higher by a smaller number of stocks. A clear sign of trouble, as we saw in February 2007 when the RSP:SPX ratio peaked and fell as the S&P continued to rise. This was eight months before the S&P peaked in October.

The RSP:SPX ratio has already been underperforming the S&P since November 2016, which is a clear warning sign that the S&P is approaching a major top. It’s only a matter of time now. A drop in the RSP:SPX ratio below the February low earlier this year would be a break of trend (higher lows) and a clear red flag.

All of these signals do not have to be present in order to indicate the coming crash in stocks is imminent, but a combination of a few of them likely will. Again, I expect a crash in the U.S. stock market of 30-40% will force the Fed to reverse policy to stimulus on steroids. This will cause a peak and drop in the dollar, including USD/CNY. At that point, I believe Gold, Silver, Platinum, and the Miners will all soar.

Lastly, Gold peaked in March 2008 and fell, long after stocks had peaked in October 2007. But it also bottomed in October 2008, six months ahead of stocks in March 2009. When stocks crash this time around, Gold could bottom ahead of the coming Fed reversal in policy because, like in 2008, Gold anticipates it. So when stocks do begin to crash and are down 20%, that is time to start loading up on Gold, other precious metals, and miners, for the truly spectacular rally to follow, in my opinion. Patience will finally be rewarded.

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