Life’s Unintended Consequences

As most of you know by now I live and work in Lima, Peru. When I first started this business back in 2001 I was actually living in Italy. After a three year absence I moved back to Lima in 2002 and took my ten or so clients with me. How come I only had ten clients? I suppose it had something to do with the fact that I specialized in gold and silver and would tell anyone with ears that gold was going to US $3,000 an ounce. When you say something like that, you are immediately labeled “one of those”. My prediction sounded a lot crazier in 2002 than it does now. As gold has gone up so has my client base. Life in Lima probably sounds ‘exotic’ and ‘tropical’ but it really isn’t. It’s really quite harsh, dirty, disorderly, and corrupt. It’s kind of like Detroit but with an attitude. I live in Lima due to convenience, habit, and because that’s where the Universities are. My daughter is in her freshman year and I don’t want her to go overseas just yet. When she’s gone, and my grandson goes with her, I know the ‘nest’ will be empty and that part of my life will be over. It’s not something I look forward to so I guess I’m trying to postpone the inevitable. That’s human nature!

When I want to escape the trials and tribulations of everyday existence in Lima and ponder life’s mysteries, I leave the Capital and go to a place called Lunahuana. It’s a little berg located 175 kilometers south and east of Lima. There’s almost no crime and it’s really quite clean. I have a small hotel situated at the base of a mountain overlooking the Cañete river rapids. These rapids are fairly well known throughout Europe, and from my perch on the top floor I can watch the tourists rush by; sometimes upside down. Usually it’s a comical sight but every once in a while comedy turns to tragedy. Someone’s head collides with a boulder and the boulder almost always wins. Personally, I like my water in a glass right next to another glass of good single malt whisky (never mix the two or millions of Scottish ghosts will haunt you for eternity). That’s as adventurous as I care to get.

I’m in Lunahuana right now and as I said before I come here to ponder and I have been doing a lot of pondering lately. People are really confused right now and that confuses me. Here’s an example: more than one client has told me that he/she is really worried about gold and by implication thought I should be too. I told them I was worried about a lot of things in life, but gold was one of the few things that doesn’t worry me. What causes me to ponder is the very phrase “worried about gold”. It displays a lack of understanding as to just what gold is and the purpose it serves. Gold is a store of wealth, the only true store of wealth in today’s world, and it is insurance against real problems. Although it’s been around for five thousand years, it can be manipulated over the short run, but it cannot be debased over the long run. Like an old farmer once told me, the cream always rises to the top and gold is the financial cream. To worry about gold is the equivalent of worrying if the sun is going to come up tomorrow morning. I don’t worry about gold, but I do worry why gold is rising in such a relentless fashion[1]. What does gold see in our future that is so bad that is has almost tripled in price over a six year period (almost unnoticed I might add)? Additionally it has many intelligent analysts projecting that it will triple again by the end of the decade if not sooner. I don’t know, no one does, but I do know I will find out and that is scary to say the least. If I had to guess I would say it has to do with two things: a serious escalation in Middle Eastern tensions, and its by-product, massive debt in the US. Mind you, this is just a guess.

As an aside, I would like to say that I almost never worry about any investment once I’ve placed my money. I do all my worrying before hand, but never after. I take great pains to turn over every stone possible before I make my bet. There is nothing worse than missing that little fact that was dangling right under your nose and would have warned you of impending financial indigestion. We’ve all done that at various times in our lives and it’s not a pleasant feeling. There is no better teacher than a margin call!

So what else bothers me? Bush along with US domestic and foreign policy just scare the hell out of me. Did you ever know an accident was about to occur before it did? That’s the way I view US policy. I could be selfish and say that what Bush does probably won’t affect life here in Lunahuana much, if at all. But I have children and grandchildren who are going to grow up in the world Mr. Bush leaves behind and that is a troublesome thought to say the least. Unlike their father, they’ll probably view Lunahuana as way too confining. The world is their oyster and there is nothing worse than an oyster gone bad. They just don’t go down well at all. For as long as I can remember, I have always been able to project well out into the future and the things I see now are quite frightening. My fear is aggravated by the extremely high level of complacency that exists in absolutely every fiber of American society. How do you measure complacency? The market has its barometer and it’s called the VIX which is short for Volatility Index. Take a look:

I’ve been in the investment business for a while now and I don’t recall such a prolonged period of high PER’s, low dividend yields, and low VIX readings. Either everyone has ice water running through their veins or everyone is piled over on the wrong side of the boat. Any bets on how that will end?

There are rumblings in the US political scene right now that have an ominous look to it. Bush has said he will not sign any spending bill that includes a timetable for an Iraq pullout and that includes emergency spending bills. Here’s a man that’s been fighting in Afghanistan and Iraq for almost five years, has nothing to show for it, and yet he’s arrogant enough to say “it’s my way or the highway”. Polls asking Americans if the feel safer today than they did five years ago show the majority answer in the negative. Thanks to the prior Congress’s stupidity, the President enjoyed a free ride at the expense of the American public and the American soldier, and now that the silver spoon has been taken away, he’s not a happy camper. What could be running through his mind right now? He knows that a veto will cause the US government to run out of money and that will cause a significant portion of US activity to grind to a halt. I think the IRS alone employs almost one million people and I’m sure they’ve become accustomed to taking a paycheck home on a regular basis. And what happens to the soldiers abandoned in Iraq if the US can’t pay its bills for any reason? Then we have the political repercussions. There is already a move underway to impeach Bush and it’s not just Democrats behind it. There are certain elements within the Republican Party that would be willing to support such a measure under certain circumstances and Bush is aware of this. This is not good and I am not the only one to pick up on this. This quote is from last week’s Economist:

"Many people will rejoice at the sight of a besieged White House and Mr. Bush and Dick Cheney ducking for cover. But regardless of what you think about the most inept of presidencies, the current civil war in Washington has the making of a tragedy -- both for America and for millions of people around the globe. For instance, the Doha trade round, with which so many Democrats are keen to play politics, could lift millions of the world's most wretched inhabitants out of poverty, there is a huge amount that president and Congress would and should collaborate on, from immigration reform to the care of the elderly. For such huge gains to be sacrificed, voters will surely demand good reasons."

As intelligent as this comment seems, I think it grossly underestimates Bush as a person. He is a man on a mission and he isn’t about to fold up his tent and go quietly into the night.

Well, if he isn’t willing to negotiate and he isn’t willing to take no for an answer, then what’s left? I have a thought on the subject and I am going to share it with you even though I may be way off. Bush is bound and determined to do things his way and I don’t see him changing at this late stage. He does have one alternative: if Congress doesn’t give him what he wants he could declare martial law, suspend the US Constitution and Congress along with it, and virtually rule as a Dictator. At the same time he could/would introduce some sweeping Patriot Act like changes including travel restrictions, confiscation of certain assets like gold and silver, a prohibition on the transfer of funds overseas, limiting freedom of the press (even more than it already is), and much more. There would be no fourth Amendment rights, no right to legal council, no right to bear arms, and so on… In short, Guantanamo would come to the US. I keep on turning this over in my mind and I see the path he’s taken and look outward and I just don’t see any other way for him to go and still be true to himself. It’s always possible that when push comes to shove, he’ll find a new religion and choose a different path. It seems to me that such a conversion will be no less than an admission of failure and the crowning fiasco in what could possibly go down in history as one of the worse Presidencies ever. Mr. Bush has his ego and I just can’t see him going through the rest of his life with that cross on his shoulder. Nixon was able to handle it, and even overcome it to a degree, but Bush is no Nixon.

Finally, I would like to close with the one thing that really worries me. During the Cold War the Russians, Americans, and Chinese spent fortunes inventing all types of horrible weapons; some we know about but most we don’t. The old Soviet Union spent so much money building weapons of mass destruction that it actually came apart at the seams. Now we are left with modern day Russia and a bunch of satellites run by various thugs and thieves. Some would even go so far as to argue the Russia is run by a thug. My point is this: no one knows where all of these weapons are and there are people out there willing to sell anything and everything for and account in Switzerland with six zeros behind a number. There are also people out there with a real (or perceived) ax to grind and they are willing to die in order to do it. Our problem as westerners is that we tend to focus on everything with an ethnocentric pair of glasses. Other cultures don’t have that problem. Having lived in a third world country (some would argue that it’s a fourth world country) for more than two decades, I’ve come to recognize a major difference: life has little or no meaning for most people in these countries. When I first came to Peru, I used to wonder how people could just step out into oncoming traffic and cross a busy highway without so much as a glance. I thought it was a local phenomenon but then I experienced the same thing in Bolivia and Ecuador. It finally dawned on me that to die simply puts an end to their suffering. Every morning they get out of bed, they struggle to find food, shelter, and clothing, and on most days they fail. To make matters worse they have a wife and children whom they can’t help. Death puts an end to all of that… a better life is how some religious groups refer to it[2].

People who fit into this category are actively being recruited by other people who are less than scrupulous and some of these recruiters have real money. Here’s where my fear comes into play. It is not all that difficult to buy a significant weapon. Then you put it in the hands of a group of individuals who have nothing to lose and they detonate it. Once that genie is out of the bottle, you will never get it back in. Meanwhile Bush is nation-building, whatever that is, and alienating people left and right. We live in very dangerous times and we are making enemies at an alarming rate. It’s just a question of time before there is an incident that will change the world, the way we perceive each other, and the way we interact. That is a change I am not looking forward to.

MARKET COMMENTARY

I find the debate regarding the future path of interest rates to be one of the most fascinating issues going on in today’s markets. The futures have priced in two to three rate cuts later this year and yet bond prices continue to fall. As of late the tide has begun to shift and some are talking about possible rate hikes. Even some of the Federal Reserve presidents have implied that the threat of inflation may require eventual rate hikes and the bonds seem to confirm that; at least for the moment. The direction that rates choose will be very, very important and will have consequences, intended and otherwise. These consequences are a real dilemma for the Federal Reserve and I don’t believe there are any simple answers. Interest rates and housing are joined at the hip and housing isn’t doing too well as the following weekly chart of the Housing Index demonstrates:

Keep in mind this chart is dealing with history and probably has yet to factor in the full affects of the “sub-prime” debacle. Sub-prime has to do with “no income verification” loans as well as other types of mortgages that allow people to get in way over their heads. A person with a forty thousand dollar a year income can buy a two hundred thousand dollar house and initially make payments of less than one hundred dollars a month. Before the housing market topped these buyers would refinance and take the extra cash from an appreciated asset. Appreciating home values are the only thing that has fueled consumption for a number of years now. Now these same assets are depreciating while mortgage rates have risen somewhat and the monthly payments have skyrocketed. That has led to a large number of defaults. A further increase in rates by the Federal Reserve could make a bad situation far worse than most imagine.

What happens if the Fed doesn’t raise rates or even decides to lower them as the futures market seems to indicate? On the plus side you may postpone a disaster in the housing sector while on the negative side there is a lot of competition for foreign capital. It now appears other central banks around the world don’t have any compunction about raising rates. It is now becoming painfully obvious that foreign capital is now searching out other ports[3]. That is going to make placement of US debt a difficult task. As I see it, the US Fed will have no choice but to monetarize US debt. Monetarization occurs when you print dollars to buy your own bonds and is very inflationary. I think the Fed is coming to realize that it is the only way out. Take a look at the weekly chart for the US bond:

Note the ominous head-and-shoulders formation on the right hand side of the chart and Friday’s close below the 200-wma. On Thursday the June bond futures contract closed down .08 at 111.01 and that is below the critical Fibonacci support at 111.05. That support now becomes resistance and there is further resistance at 112.11 while strong support is at 109.30 and 108.26. As coincidence would have it, the 108.26 also corresponding to the neckline formed by the aforementioned head-and-shoulders formation and will be critical.

In all honesty I was somewhat surprised to see the break of 111.05 as it represents the 50% retracement from the 260-day high back down to the 260-day low. I will be more than interested to see if we can close below it again on Monday. Right now we have RSI, MACD, and the histograms all headed in the same direction and that’s down. Bonds are not even close to being oversold so the decline could still have legs. I have been short the bonds from 113.06 in spite of the fact that I believe the Fed will eventually be forced to lower rates. That will be a blow to the dollar and lower bond prices will eventually act as a drag on stocks. These are the unintended consequences I referred to earlier and it will be interesting to see how the Fed handles the transition. Lower rates are an admission that Fed policy failed and I don’t think markets will take kindly to it. Although lower rates could be a short-term boom to bonds, I believe it will be a long-term bust as it will make bonds unappealing. Currently bonds could fall a bit more but I would be very surprised if we tested the neckline much less broke down through it. In fact I am seriously thinking of taking my profits on Monday and taking a seat on the sidelines.

Next we have the Dow which has taken a decidedly different turn (yet again) from what I would have imagined in early March. The June 07 Dow futures contract topped at 12,910 on February 20^th and then began to fall off a cliff less than a week later. An intraday low of 12,035 was posted on March 14^th and since then we’ve been in rally mode. Take a look at the daily chart for the cash Dow:

Since posting the March 14^th low, we have traced out a series of higher lows and higher highs. On Thursday the June Dow futures contract closed up 27 points at 12,622 and back within striking distance of the all-time high. I was originally looking for an 11,732 low and then a rally back up to a lower high on or about April 12^th. That scenario is now in danger of collapsing and the key will be 12,671 in the June contract. Good Fibonacci support comes in at 12,433 and then 12,184. Finally, the February 27^th break left a large gap down on the open. That gap runs from 12740 down to 12,690 and any attempt to fill it will more than likely lead to a test of the all-time high.

The rest of the indexes (Transports, S & P, Banking, and Consumer) are also at various stages of recovery. The Consumer index is the strongest and is the engine that has been driving the economy for four years now and is followed closely by the S & P Index. Transports seem to be having more difficulties than the Dow. Take a look below:

Unlike the Dow, the Transports did not make a higher high this week and that is important as it was the Transportation Index that led the Dow to its all-time high. Now it’s the Dow leading the way and that is another change in character. These changes are important as they usually signal a top is in, or at the very least, being formed.

One of the surprising changes has to do with the Banking Index. Its rise was just as relentless as the Consumer Index, but unlike the Consumer Index, it has yet to recover. Take a look at the daily chart below for the Banking Index:

Thursday saw a test and marginal close above the 200-dma and I have to ask myself what this means. Initially, you could have attributed it to the loss of the Yen carry trade but I now believe it goes deeper than that. For four years the Fed has literally guaranteed banks a “free lunch” as they dropped rates to historic lows. This allowed banks a source of cheap money that they loaned out to US consumers at much higher rates. The banks made the spread and grew fat in the process. Think of it as the Greenspan Carry Trade! Although it’s too early to tell, the chart above seems to be saying that the party is over. A combination of higher rates and a sub-prime hangover may be too much for the banks bottom line.

In conclusion, I believe there will be an attempt to fill the gap in the Dow and it should occur within the next two to three trading days. If we do manage to close it, we’ll probably rally to a higher high, around 1,491.00 or even 1,521.00 in the cash S & P and it should come in on June 12^th which would be 90 days from the low. This market has stuck to the 90 day cycle throughout and I don’t expect that to change. Meanwhile I am short the Dow from 12,450 and will stay that way unless I see a new high.

Gold is one of my favorite subjects and I can never get enough of it. The June 07 Gold futures contract went into the Easter holiday at 679.4 and that is a new closing high for this leg up. Some months back I advised you that gold was going to a minimum of 775.0 before we would run out of steam and nothing has changed my mind. I also told you that we would have two 7% corrections and that is just what happened. Now I am going to tell you that gold is on the threshold of an explosive move to the upside; the type of move where you could see an advance of 100.0 within a seven to ten day period. We have overcome good resistance at 667.1, 672.5, and 687.0 is the next target followed by a test of the significant Fibonacci resistance at 696.0. It was this resistance that turned back the last rally but I don’t think it will stop gold this time around. Here are the magic Fibonacci numbers with respect to the June 07 gold futures contract:

The 775.0 resistance number I referred to earlier is with respect to the spot price for gold and it should be enough to stop the current leg up, but that doesn’t mean that it will. As usual, I like to put gold’s activity into perspective and the best way to do that is to view the historical chart:

This entire rally is nothing short of spectacular and what is even more fascinating is that the best is yet to come. You can see the May 2006 high of 732.0 and we are now within shouting distance ten months later. If there is one thing that makes me believe that we could go higher than 775.0, it is the fact that we have been consolidating gains for ten months. That could/should provide a powerful base for rally that may go well beyond 775.0 and could even challenge the all-time high at 882.5 but we’ll just have to wait and see.

Silver, and to a lesser degree gold stocks are following in gold’s footsteps. The May Silver futures contract closed up 12.0 at 1374.0 on Thursday and that is a new closing high for this leg up. Like gold, silver has a set of important Fibonacci numbers as well. They are as follows:

In all honesty, I see more upward potential in silver tight now than I do in gold and the following P & F chart for silver tends to agree with me:

We have a bullish price objective of 21.5 and that is slightly above my 20.73 objective and more than 40% above Thursday’s close. Silver appears to be leading gold at this point in time while gold stocks appear to be following both; or maybe dragged would be a better word. On Thursday the HUI closed down 1.87 to end the week at 354.15 and that is just below good Fibonacci resistance at 354.84. There is good Fibonacci support at 351.59 and 336.11. I have been vacillating about the future of gold stocks to the point that I sold 25% of my portfolio some weeks back. I still hold the same portfolio that I bought in September 2004 and it is as follows:

BUENAVENTURA (BVN) = 20%

COEUR D’ALENE (CDE) = 5%

GOLDCORP (GG) = 15%

NEWMONT (NEM) = 10%

ROYAL GOLD (RGLD) = 20%

SILVER WHEATON (SLW) = 5%

CASH = 25%

Actually the cash component is a bit misleading as I used it to but gold on the futures market. Take a look at the following weekly chart of the HUI:

I have been wondering for weeks now if the HUI will follow gold up or the Dow down. As of today I do not have a definitive answer but as you can see above, the HUI is being compressed into a tighter and tighter range with a series of higher lows and lower highs. We are coming to a crucial moment in time where there will be a breakout in one direction or the other. Given the fact that this is a bull market, the odds heavily favor a breakout to the upside but the fly in the ointment could be the Dow. If the Dow rallies until mid-June than I suspect new highs will be made but if the Dow turns down this week, it might be a different story. We’ll just have to wait and see. In the meantime I am long gold, silver, and gold stocks and that will not change.

Now we come to commodities. I have been bullish the CRB for almost as long as I’ve been bullish gold and the results have been just as agreeable. Originally I started out buying the CRB Index and then branched out into oil, copper, the grains, and cotton. Only cotton has been a laggard. The strange thing about it all is after a significant correction both oil and copper have begun to rally in spite of a slowing economy in the United States. Let’s take a look at copper’s daily chart:

Last week’s rally took the June 07 Copper futures contract above what was strong Fibonacci resistance at 328.90 when it closed at 337.70 and that only leaves resistance at 346.40. We are also back above the 50-wma and not all that far away from the all-time high at 377.00. Oil is following a similar pattern and the reason is Asia. Actually, it has to do with our lenders changing dollars for commodities and I suspect there will be a lot more where that came from. That’s another one of those unintended consequences of printing dollars until the cows come home.

Grains are a relatively new position for me. After a couple of attempts at establishing a position, I finally had some success late last summer. I took initial positions in corn, wheat, and beans and added on as they rallied. Like all rallies, there have to be corrections and we have been experiencing one for the last five weeks. Actually wheat was the first to top out way back in October but it didn’t stop corn and soybeans from making new highs right up through late February. I didn’t add on because of wheat’s weakness. I’ve felt for some time that wheat must participate or any rally will be short lived. I was looking for a blow out to the downside and the US government was kind enough to oblige. How did they do that? It was quite simple really; they issued a report on March 30^th saying that farmers may have planted the most corn since 1944. That was all that was needed to produce a 20% correction and provide me with the first decent buying opportunity in quite some time. The same applies to soybeans. Take a look at the daily chart for the Grain index:

Last week’s government report led to a decline down to a 158.07 low before buyers finally showed up. We closed out on Thursday at 162.66 on fears of bad winter weather that could damage crops already in the ground. That weather materialized and I would not be surprised to see some more upside pressure early in the week. In any event, I am long grains and will stay that way for quite some time.

I would like to close out this newsletter with a discussion of the dollar, the king of unintended consequences. You see a declining US dollar makes US stocks and bonds a lot less attractive and it

also means that we import inflation as a cheaper dollar raises the price of imports. Likewise most commodities are priced in UD dollars and a cheaper dollar means that foreigners can buy more and that is inflationary. The US dollar has been deteriorating for years now but we are approaching a critical juncture. Since topping out at 92.00 early last year we have broken support level after support level. Now last week we moved below the 82.92 Fibonacci support level and all that is left is some lesser support at 82.35 which is marginally below last week’s intraweek low. The more I watch the dollar the more convinced I am that we will break below the multi-decade low of 80.50 sometime later this year.

So if you’re not into US dollars, what is the alternative? As most of you know by now, I have been long the Swiss Franc for almost as long as I’ve been long gold. Then late last year I diversified into a group of what I call commodity based currencies. These are the New Zealand dollar, the Australian dollar, and the Canadian dollar and the results have been worth the effort. The following chart of the New Zealand dollar shows you what I mean:

Just last week we made a new 260-day high, and although we are somewhat overbought, I don’t think we’ll see any significant correction until gold runs out of gas. Aside from any temporary lift it can get from employment reports and other government statistics, the dollar will continue to decline and these currencies will continue to rally. There will be no reprieve for the US dollar.

EBO

Dow Theory Analysis SAC

April 08, 2007

[1] Please don’t send me thousands of e-mails telling me that gold is stuck. I will simply refer you to gold’s historical chart in order to make my point.

[2] This is in no way a criticism of any organized religion.

[3] The world’s central Banks now hold the lowest percentage of dollars since 1999. It has dropped from 72.6% in 2002 to 64.7% in 2006. Recently many nations have made clear their intentions to diversify out of the dollar so this trend will only increase.

Enrico Orlandini

Dow Theory Analysis

Ignacio Merino 636, Santa Cruz, Miaflores, Peru
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