A central pillar of the Dow Theory is the description of the phases of a bull market. According to Dow the three phases reflect the confidence of the investors:
- 1. Accumulation
- 2. Participation of the public
- 3. Distribution
The first phase is dominated by a drawn-out process. We think that this phase was happening in 1999 to 2003. At the beginning, only “early adaptors” are invested. The fundamental picture tends to be bleak, and there is a selling overhang. The longer this phase takes, the stronger the development in phases 2 and 3. For example, the oil price was traded within a bandwidth of USD 10-35 for more than 25 years. In 2004 it broke out of this range and increased to USD 147/barrel within four years. Something similar happened on the equity markets. The Dow Jones index traded within a bandwidth of 600 to 1,000 points from 1962 to 1982. The outbreak was followed by 18 years of bull market, which took the index to 11,700 points or +1,400% (annualised performance 16.5%). This is the nature of a bull market.
The second trend phase is characterised by improved fundamentals, higher confidence, and new groups of investors. And lastly, phase 3 is the euphoric phase that culminates in a “blow-off”, i.e. in a parabolic increase. At the end of each cycle the smart money is distributed.
The following chart, depicting the sharply rising volume of contracts at the COMEX, highlights the soaring interest that is integral to a bull market.
Net long positions (COMEX)
Sources: Bloomberg, Erste Group Research
From our point of view we are currently located at the transition from phase 2 to phase 3. Gold is getting gradually more accepted as an investment vehicle. Legendary investors such as Paul Tudor Jones, John Paulson, and David Einhorn have reported purchases of gold, the turnover is increasing, and numerous new products are being launched. In addition, gold is becoming more and more important in the asset allocation of institutional investors. We think that the passing of the “magic” USD (or EUR) 1,000/ounce mark heralds the imminent start of the trend acceleration phase. We saw a similar situation when oil increased above USD 100/barrel.
If we compare the current bull market to the most recent big gold rush, we can see a pronounced distribution phase that ended in a parabolic “blow-off”. The finale phase ended in January 1980 at a high of USD 850/ounce. In the course of the previous ten trading days the price increased by 35%, in the previous six weeks the price had almost doubled (+94%). The same thing might occur in the final phase of the current bull market.
Gold price (indexed from 100) 1970-1980 and 1999 to date
Sources: Datastream, Erste Group Research
“Buying the dips” seems to be the motto of the current phase. Within the corrections, gold moves from weaker to stronger hands. Consolidations in the current bull market have become shorter and less pronounced in terms of the underlying trend. We have seen this very development since the beginning of 2009. As soon as the corrections turn really small, the market will probably make the transition to its final phase. The transformation definitely has psychological reasons. The unshakeable myths and misunderstandings (gold does not pay interest, buying physical gold is expensive, gold is speculative and volatile…) are being de-mystified. Given that many of such arguments, defamations, and convictions were deeply engrained after a 20-years’ bear market, the change of heart is accordingly drawn-out and tedious.
Corrections since the beginning of the bull market
Sources: Datastream, Erste Group Research
Gold is a gauge for risk, and thus the currency of fear. In that sense, both fear and greed can trigger the often-quoted “irrational exuberance” and thus the parabolic increase in the final phase.
It is a fact that gold is certainly no contrarian investment anymore, as opposed to 2000, although investors are still sceptical, and the same old arguments still abound in the market. Having a closer look at the sentiment, we find that we are far from anything like euphoria, so gold is definitely no mainstream investment. In comparison with the Nasdaq at the beginning of 2000, gold is certainly more of a dark horse. If one were to ask ten people for names of three gold mining shares, chances are they would not know any. This is a stark contrast to the situation a couple of years ago when the vast majority of people were talking about technology shares and invested in highly speculative start-ups, or US consumers who were taking out mortgages, hoping to benefit from continuously rising property prices.
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The numbers, too, substantiate the notion that the parabolic phase of gold should still be ahead of us. For example, the Nasdaq 100 index increased by 85% in 1998 and by even 102% in 1999. It rose by an additional 27% in 2000 before collapsing at the end of March. At the end of the bull market, 30 shares had gained more than 1,000% by 1999. Is the comparison of trends in different asset classes admissible? We certainly think so, given that human behaviour patterns and emotions in extreme phases are the same. Greed and fear determine the beginning and the end of bull markets. Therefore we assume that gold and gold shares could show a similar performance to the one of the Nasdaq at the end of the 1990s.
The last bull market came to an abrupt end in 1980. The then chairman of the Federal Reserve, Paul Volcker, increased the key lending rates to 20% within only a few months. Could this be possible today? Definitely not! In 1980 the USA was one of the biggest creditor nations in the world and had a positive trade balance. On top of that, the financial industry was substantially smaller in terms of the GDP, and excessive debt was neither in the private nor in the public sector an issue.
By. Ronald Stoeferle of Erste Group
Erste Group is the leading financial provider in the Eastern EU. More than 50,000 employees serve 17.4 million clients in 3,200 branches in 8 countries (Austria, Czech Republic, Slovakia, Romania, Hungary, Croatia, Serbia, Ukraine). As of 31 December 2010 Erste Group has reached EUR 205.9 billion in total assets, a net profit of EUR 1,015.4 million and cost-income-ratio of 48.9%.
