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If you have any involvement in the equities markets,
I'm sure you've noticed that things were a bit rough last week and have yet to
really settle down. The reason du jour is China. If you read the comments
coming out of Washington lately you'll know
that China
is responsible for everything from global warming to the common cold.
Supposedly they are going to slow their economy down and that will lead to
less of everything for everybody. I'm not sure I buy that argument, but it
was in all the papers. Right behind China in the blame game, we have
what is euphemistically referred to as the "Yen carry trade".
That's where you borrow money from Japan at very low rates and loan
it out at much high rates. Major players and beneficiaries of this financial
version of musical chairs include J. P. Morgan Chase (JPM), Goldman Sachs
(GS), and Merrill Lynch (MER) whose weekly chart is included below:
These companies have done nothing but rally for the
better part of four years thanks to a central bank generated flood of
liquidity the likes of which has never been seen before. Notice how Merrill
actually started to roll over weeks before the flood gates opened last week.
The carry trade contributed billions and billions of dollars to the bottom
line of these companies.
The carry trade is especially lucrative when the Yen
is devaluating against the dollar as it has been for quite some time.
Unfortunately the Japanese had the bad taste to take away the punch bowl,
first by raising rates and then by inflating the Yen. I am not an expert on
orient thought but I find it strange, better yet ominous, that both China and
Japan would be engaging in this type of behavior
simultaneously. I think something, or someone, upset them and they decided to
send a coordinated message. It was a not so subtle reminder that the people
with the money make the rules and, if I had to guess, I suppose it was
directed toward the United
States.
There is always the possibility that China and Japan had nothing to do with the
market decline. Then what? Well, some time ago I told you that markets are
forward looking instruments. Think of it as a crystal ball that actually
works. People a lot smarter than me have estimated that the markets are
discounting events that will take place six to nine months from now. If the
market wasn't reacting to the tag-team of China
and Japan,
then it has to be discounting the future and whatever it is, it must be ugly.
For those of you who are interested, I do have a few ideas. The first thought
that comes to mind is debt, followed by debt, debt, and debt. The United States
is just swimming in it. On every and all levels: state and local governments,
companies like GM with billions in unfunded pension liabilities, trade
deficits that are reaching seventy billion dollars a month, and twin wars
costing half a trillion dollars a year are some prominent examples. Companies
like GM and Ford owe a lot more to their pension funds than they are worth.
In the old day's we would have said they are bankrupt but that's not
politically correct today. Now we say they are looking for new directions. Eventually
both of these companies will disappear, and they won't be the only ones
either. It's easy to blame it on labor costs in the
US, or cheap Chinese labor, but companies like BMW,
Mercedes, and Porsche all pay high wages and still manage to produce a profit
without sacrificing quality. Finally we have the American consumer who's
maxed out with three mortgages and a pocket full of credit cards with the
numbers worn off.
For a real glimpse into the consumer's world, you
need to focus on two things: consumer spending and housing. If you think of
the United States
as a car, consumer spending and housing would be the motor and transmission
respectively. Without them you won't be going very far. Let's take a look at
the weekly chart of the Consumer Index ($CMR):
Notice the blow-off to the upside and then the sharp
decline last week. Now take a gander at the weekly chart of the Housing Index
($HGX):
If the motor (the consumer) is smoking, the
transmission (the housing sector) is in flames. After topping out in late
2005 (not shown), it made a lower high in April 2006 and yet another lower
high just last month. Now it's all the rage to talk about the subprime mortgage sector being in trouble and rumors abound that New Century Financial Corp. (NEW.N), a
large subprime lender, will go belly-up soon.
For anyone with a brain, this should not come as a
surprise. You can't keep on financing the purchase of three hundred thousand
dollar houses for people working in McDonalds. The real surprise will come
with all the unintended consequences. There will be a number of mortgage
companies and small financial institutions that will get caught in the down
draft. The rubber will meet the road though when the derivatives start to
unwind and everyone is shocked to see that no one is on the other end.
Remember all of those off-shore companies Enron formed that had no assets yet
their shares were valued at hundreds of millions of dollar in their balance
sheet? It's the same thing except its now come ashore! To make matters worse,
housing has financed consumption. By that I mean the year after year appreciation
in home values allowed consumers to refinance their mortgages time and again.
They would then take this excess liquidity and convert it into HUV's, vacations, flat screen TV's, second houses, and
whatever else came to mind. Savings never entered the equation as the US
has had a negative savings rate for quite some time now. Nope, borrow and
spend has been the consumers axiom for more than a decade. Here's a news
flash for you: that game is now over. If consumers draw in their horns, and
they are, the shock will be felt throughout the United States. Most people think
a cold in the United States
will lead to pneumonia in Asia in general and China in particular, but I don't
share that view. It's not that they won't suffer because they will, but India and China have succeeded in
developing domestic demand and that was unimaginable just five years ago. If
just 5% of the more than 2.5 billion citizens of these two countries
increased their spending by 10%, it would be more than sufficient to replace
part or even the entire US
shortfall. No folks, I think it's America that's coming down with
pneumonia. China
and the rest of the world will struggle, but they will work it out. That's
one of the reasons I don't buy the scenario that China wants to slow down their
economy. They know the US
slowdown is all but a given. If anything, I think they just may try to rev it
up a notch before the wheels come off.
Lately we've seen numerous signs of a slowdown in
the US
economy including a sharp drop in productivity and retail sales as well as
weak job growth. On the other hand unit labor costs
were revised sharply higher and oil is on the rise again. A slowing economy
and an increase in prices. In other words, stagflation! Not good news for the
US Federal Reserve and not good news for business. Rising costs and
decreasing sales. If that's the case, we should be able to see some signs in
the Dow. The market has been on a roll for all of four years and this
secondary reaction is very long in the tooth so it wouldn't take much to tip
the whole mess over. Last week the DJIA plunged 416 points on Tuesday, and
after a dead cat bounce on Wednesday, proceeded to give up more ground until
yesterday's triple-digit gain. Unfortunately, there was no follow through
today as we sold off into the close. Take
a look below:
This chart is similar in almost every aspect to the
consumer chart. So what does it mean? I think it means that the market has
finally topped but other than that, there's not much else you can draw from
this. A lot of people suddenly discovered the "c" word, i.e.,
crash, but I can't see that at all. The recent decline in the Dow is probably
not over. We have good Fibonacci support at 11,871 and again at 11,648. We
also broke out from 11,670 and we have the 50-wma coming in at 11,732. I
suspect this reaction will fizzle in another eight days or so, bottoming in
the 11,640 to 11,732 range.
We have two separate issues to deal with here. The
first is the top and the other is the possibility of a crash. I believe the
top is in because this decline is completely out of character with every
other decline we've experienced since the breakout almost one year ago. We've
fallen further, deeper, and faster than any previous reaction. A significant
change in character is a good indicator of a change in direction. Just what
kind of change now becomes the question. I see
almost no chance of a crash because there has been little or no distribution.
After such a long rally, distribution is a requirement. So the odds favor a bottom around 11,670 followed by a rally. The
quality of this rally will be the key. If I am right and the top is in, we
should rally to a lower high on or about April 18th. Somewhere around 12,422
to 12,514 would be my guess. Then we'll distribute; for two to three months.
Maybe even longer! That brings us into the middle of summer for the northern
hemisphere and there has never been a market crash in July. There is always a
first time but given the length of this secondary rally, distribution could
last into October. That would be my bet unless… Unless what? Unless
this administration attacks Iran
and then all bets are off.
Okay, the consumer is pulling in his horns, the
housing market is toast, and the Dow may have topped in an economy suffering
from stagflation. What does that mean for the rest of the markets? To begin
with, it means really bad things for the US dollar and really good things for
the currencies of countries with commodity based economies. Take a look at
the weekly chart of the US dollar:
After topping out early last year we have made a
series of ominous lower highs and lower lows, and the latest lower high was
put in just last month at 85.25. There is a lot of foreign investment in both
bonds and stocks, and every day the dollar drops, they're worth just a little
less. Do you see how it's all interconnected? Here's another newsflash for
you; the dollar is going to drop a lot more. Key Fibonacci support is at
83.71 and we've been playing with it for two weeks. Key Fibonacci resistance
is at 84.66 and we're currently range bound. I'm convinced we'll break to the
downside and that will lead to an eventual test of the 80.50 historical bottom.
Bonds are a similar and very interesting story. In a
normal world we would have either a recession or inflation and that's a piece
of cake for the Fed. Lower rates with the former and raise rates with the
latter. Unfortunately for the Fed stagflation is the worst of all possible
worlds and its complicated by the fact that most major countries are raising
rates. Why is that so important? We live in a very competitive world and the
Fed isn't excluded from that competition. They have to sell their junk paper
to the rest of humanity and the only way they can get that done is to
restrict supply or raise rates. Restricting supply means spending less money
and that would drive the country into a deflationary tailspin. That leaves
raising rates. I was convinced for months that Bernanke
would choose that path, but now I have serious doubts. A slowing debt-ridden
economy and expanding rates would lead to the same deflationary scenario. The
Fed has tried to sing the bull to sleep by printing money like there is no
tomorrow, but we're at the point where it's not enough. I now suspect that
they will be forced to lower rates in an all out attempt to fend off not only
deflation but a debt crisis. Inflate and then inflate some more! There are
going to inflate debt away and in the process they'll destroy the bond and
the dollar. Neither can survive for very long with lower rates, especially
the dollar. A sharply devalued dollar would eliminate a lot of debt.
Last month we saw the first tell tale signs of
things to come. The possibility of lower rates coupled with a declining
dollar led to a fifty billion dollar shortfall in the flow of funds into the US.
You see the United States
needs almost three billion dollars a day of other people's money to survive
and we didn't get it. So where did the difference come from? The printing
press, and that's why the Fed decided to no longer publish the M-3 figures. I
guess that's on a need-to-know basis and the American people don't need to
know. As unusual as it sounds, lower rates in a world where everyone else is
raising them will drive bond prices up over the short run but eventually make
the bonds quite unattractive over the long run. So you can't buy bonds,
dollars, or stocks. What does that leave? In a word: commodities!
Commodities are tangible assets versus the three
classes of paper assets mentioned in the previous paragraph. They're real and
I can get my hands on them. Of course some are more desirable than others,
like gold for instance. I have been bullish gold for seven years. Back in
November 2006, I wrote that gold had begun a new leg up that would eventually
take us to US $775.00/ounce. I also stated that we would have two 7%
corrections along the way. In the weekly chart below you'll observe a decline
from the US $655.50
high to the $603.00
low for our first 7.4% correction. Then on February 27th we began a decline
from the $689.80 closing high down to the $639.20 closing low on March 5th
for a 7.32% decline. You can see that in every case, going back to September
2005, we bounced off the 50-wma. As gold rallies we'll encounter a number of
Fibonacci resistance levels beginning with $664.2, $686.2, and $728.6. Then
we'll test the $730.40 high registered back on May 11, 2006. After that it's
on to the last line in the sand at $775.00.
Before I move on, I would like to say a few words
about gold stocks. I have been holding Buenaventura (BVN), Coeur D Alene (CDE), Goldcorp (GG), Newmont (NEM), Royal Gold
(RGLD), and Silver Wheaton (SLW) for three years. Then last week I sold 25%
of my portfolio and I may sell as much as 25% more tomorrow. How can I be
bullish gold and bearish gold stocks? It's not as complicated as it sounds.
Gold is reacting to rising prices, among other things, while the gold stocks
are reacting to a falling Dow. I postulated some time ago that once the Dow
rolls over, gold stocks could fall for as long as six months as people throw
the baby out with the bath water. They sell what's liquid in order to pay off
what isn't (mortgages, credit card debt, margin calls, etc.,…).
Nothing I've seen to date has changed my mind.
I don't know if we'll stop at $775 or continue on up
to the all-time high of $882.50 posted almost three decades ago, and it
really doesn't matter. What does matter is that we are in a bull market for
gold, and that bull market will last until well into the next decade, and may
even reach as high as US $3,000/ounce. And gold won't be there alone either.
Silver, copper, oil, the grains, cotton, sugar, and coffee will be right
there beside it.
Conclusion
I've been walking this earth for over half a century
and I see things now that I never would have believed as little as ten years
ago. I see the world's greatest nation in decay, and not just economic decay,
but political and moral decay as well. I see a crazed administration engaged
on something called "nation building" and if they've got to kill a
couple hundred Iraqis a day so be it. Obviously no one in Washington
has a history book because if they did, and they would turn to the paragraph
on a police action called Viet
Nam, they would see that that particular
approach failed miserably. I've lived in Latin America
for the better part of twenty-five years and for the first time, people don't
want dollars. They actually prefer their own currency. Here's my last news
flash for you. If a fellow with no education, a poor diet, and inadequate
medical treatment living at 3,500 meters above sea level can figure out
that the US dollar is undesirable as a store of wealth, how much longer do
you think it can last as the world's reserve currency? The short answer is
that the party is over and all things dollar related will go up the stack with
it. What we saw last week is the equivalent of the first drops in a storm
destined to last more than forty days and forty nights.
Enrico Orlandini
Website : Dow Theory Analysis
Dow Theory Analysis S.A.C.
Lima, Peru
Phone:
001-51-56-973-5599
Email: ebo@dowtheoryanalysis.com
For those of you interested in receiving
information on the Funds we manage, please feel free to e-mail us at ebo@dowtheoryanalysis.com and we will respond as soon as possible.
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