DOW THEORY ANALYSIS SAC
September Newsletter
Inflation or Deflation
Enrico Orlandini
Oct 4, 2006
From most if not all aspects, it's been an interesting month. We are heading toward a mid-term election in the United States and that figures heavily into the market equation. If you are a Republican, you have to tell everyone what a wonderful job you're doing and make it believable. A Democrat on the other hand, must shine a light on all of the current administration's errors and it seems to me that the Bush White House is making their job a lot easier than it should be. You have the President saying that the US is safer because of the war in Iraq while, at the same time, the White House is releasing a study that shows that the war in Iraq is actually serving to increase the chances of terrorism in the U.S. Go figure! From an outsider's perspective, the U.S. made a fatal error: they looked at everything through American rose colored glasses. Thinking outside of the box was neither wanted nor was it allowed. Only "yes men" need apply. Obviously someone forgot to read their history books or they would have remembered the valuable lessons taught by the Bay of Pigs invasion.
What does the Bay of Pigs have to do with the current situation? Plenty as far as I can tell! You see back in the early 60's, all of Kennedy's advisors locked themselves in a room and debated the wisdom of invading Cuba. To a man they were all against it, and to a man not one spoke up because each one was afraid that he would be the only one to express a negative opinion. So they unanimously agreed to the invasion and it proved to be a disaster. The end result was that all the troops we armed and sent over there were slaughtered on captured on the beach and Castro is still leading Cuba forty years later. Today's situation is a little bit different but the outcome will be the same. You have the closed-to-the-public Cheney/Rumsfeld clique with an agenda that has little or nothing to do with a better and safer United States [1], dominating any and all policy decisions. Opinions to the contrary are not required nor accepted if one is interested in long term gainful employment. What is required is blind faith mixed with a modicum of intelligence and a willingness to openly violate the U.S. Constitution whenever the clique deems it necessary. You have a sitting President of the United States admitting to secret prisons, holding people without benefit of an attorney and access to the legal system for years, illegal search and seizures, illegal wiretaps, and that all seems to be peachy keen. At the risk of getting ten thousand unwanted e-mails, I seem to recall the Nazis doing the same thing. All I can say is wait until there is a knock on your door at 4 am and they take you away. It will be too late to object then.
Assuming that you're willing to accept these violations of your rights, along with your shrinking freedom, as part of the cost of a "safer" United States, and most Americans are willing to make that trade-off [2], you need to understand that there is another cost. That cost is economic and it is out of control. The current administration's policy of shop-until-you-drop, mixed with shrinking tax revenues and a slowing economy, has Depression written all over it. To the best of my knowledge this administration has never vetoed a spending bill. Never! Meanwhile the trade deficit hits a new record high every couple of months and then there is the cost of the two wars. Everybody thought Afghanistan was over and done with, but that doesn't seem to be the case anymore as the Taliban found new life. Anyone who has a good working knowledge of the Arab culture could have told you how this would have played out but I suspect that wasn't one of the prerequisites for membership in the Cheney/Rumsfeld club. So expenses are through the roof, income is declining, I need to pay my bills, and my bank of last resort (Asia) seems unwilling to give me all their hard earned saving like they did in the past. What do I do? There are no secrets here folks; you have three choices if you are a government: spend less, borrow more, or print money! There is no magic involved here. No mysterious remedies to fall back on. Just plain old common sense alternatives that you and I face every day of our lives.
Since we are alienating most of our friends, and at the same time sounding our ethnocentric trumpets, I suspect that borrowing large sums of money will be next to impossible. This will be further complicated by the fact that the U.S. Federal Reserve Bank apparently wants to lower interest rates, just when the rest of the world is raising their rates. You see when you buy some one else's debt, you weigh three things: time, risk and the interest rate paid on the debt. The risk is growing, the interest rate is not competitive, and the future is uncertain at best so it's a hard sell. Cutting expenses is something no politician will ever recommend. I think it must be genetic by now. The first rule in the politician's handbook is that you must hand out money if you want to get elected, and in that respect both Democrats and Republicans read from the same book. So selling debt and cutting expenses are at best inadequate, and at worst totally out of the question. That only leaves the tool of last resort, i.e., the printing press. And print they will my friends! I believe once the November elections are over you will see a deluge of money coming out of the Federal Reserve banks the likes of which you could never have imagined. For the last couple of months the current administration has been busy painting happy faces on the economy. The Dow is very close to a new high, the price of oil is down almost twenty dollars from its Spring high, and the decline in the CRB typifies a general slide in commodities prices. All just in time for the election!
Many of my clients feel that this is all orchestrated by the present administration and will continue until the November elections. That very well may be the government's intention, I don't know, but I have studied the market long enough to know one thing: the market will almost always do what you don't want it to do just when you don't want it do to it. That's part of the law of unintended consequences. You tamper with it to make a dime and it strikes back costing you a dollar. A lot of people are under the illusion that people like the Rothschild's control and manipulate the markets for their own benefit. I disagree! People like the Rothschild's have made, and maintained, there fortunes anticipating the major political, economic, and financial moves in the world [3]. They would be among the first to take a position and then they would just sit and wait for the inevitable to happen. I know it seems too simple, but that's how the "smart money" does it. Get in early and sit tight!
Over the last month or so I have noticed what appears to be accumulation in a number of commodities including gold, silver, and copper. I've also noticed that wheat and corn have broken out over the last week and oil has experienced an upside reversal. All very strange behavior if you expect a recession given the decline in economic activity that we see in the U.S. Finally, while everyone is busy talking about the decline in housing, the Philadelphia Housing Index ($HGX) has quietly been rebounding to the upside. Take a look at the Weekly Chart below:
Note how the RSI, MACD, and histograms have all turned up. Don't jump to the conclusion that the housing boom is alive and well because that isn't the case. The fat lady has sung for housing and this is just a reaction. Put the resurgence in housing together with the other things I mentioned above and it is very strange behavior indeed! How do I explain these contrasts? In one word: stagflation. A simple definition of stagflation is rising prices coupled with a slowing economy. Why would prices rise? Too much money chasing too few goods and it is a direct result of strong demand from almost three billion Asians.
Right about now, it would be worth mentioning that the U.S. consumer is also holding up his end of the log with a relentless spending spree. Take a good long look at the best and most relentless bull market you will ever see, the Weekly Chart of the Morgan Stanley Consumer Index ($CMR):
The only word that can adequately describe this is relentless. Not even a hint of correction in an extremely overbought market. Think of it as the house that debt built. There is an end in sight though and I believe you'll see it in October, on or about the 17th to be exact [4], and then you'll really see the printing presses heat up. I have wondered out loud for the past several months just how the US plans to finance their debt with a loose money policy when the rest of the world is tightening. Well the answer is the one I didn't want to acknowledge: they are going to print their own money and buy their own debt through the Caribbean Money Centers. The Fed is so afraid of the affects deflation can have on the heaping, steaming pile of debt in the U.S., that they are willing to drive the U.S. economy into a hyperinflationary crisis in order to avoid it. Hyperinflation will eliminate the debt but it will also destroy the economy.
In conclusion, it appears to me that a combination of poor fiscal management, bad foreign policy, and political myopia are all about to combine into some sort of strange brew at precisely the worse time, and it will lead to a financial crisis. This crisis will be worse than the Depression of 1929 owing to the staggering amount of debt in the U.S. In 1929, the US was a creditor nation and had the resources to deal with the problem. That is obviously not the case now. The only "solution" will be to print money, and at first it will work like a drug addict's fix bringing temporary relief, but the end result will be economic death. I also believe that people in the Fed as well as the government know this is going to happen and are making "contingency plans". It won't be pretty and it will lead to social unrest. You can't pull away the punch bowl from three hundred million American's and expect to slide through on you good looks and a few witty remarks. Things will change and it won't be for the better. How long this takes to unfold will be anyone's guess; weeks, months, or even a couple of years. But I believe it will start now and you will be able to identify it if you really want to. Given the predominance of the internet, I believe we are looking at weeks or months rather than years. Throw in trillions of dollars of unregistered over-the-counter derivatives that very few people understand and even fewer can quantify, and a bad situation could turn down right ugly in days. I think that goes a long way toward explaining the record volume seen in the gold pit recently. The smart money is quietly picking up all they can get while the getting is still good. It is better to trade all the fiat paper you can for the only true store of wealth that has stood the test of time. My best advice is to bundle up because it is going to be a long, cold, crude winter.
MARKET COMMENTARY
Given everything I've said above, I feel there are very few options available to the average investor. Most Americans are not students of the market and wouldn't take the time to learn about it even if the opportunity were presented to them. They've been trained to blindly hand over there life's savings to people and institutions they know little or nothing about because CNN tells them to. I know that's precisely how I make my living, but I really have a hard time understanding that. When a new client approaches me to make an investment I offer to provide my service free of charge in an effort to educate him and, at the same time, help him understand why I make the decisions I do. Most of my US clients refuse the information saying they just want the statement and aren't the least bit interested in how I go about it. By contrast, almost all of my European and Asian clients request the information and will complain if it doesn't arrive before the U.S. market opens. Their statement can arrive a day late and they don't say a word, but the analysis is five minutes late and I get a hundred e-mails. What a difference in priorities! The average U.S. investor is not going to short the DJIA, and he's not going to short bonds, and he's certain not going to buy corn or the CRB. Just the thought of it makes him cringe. He will buy gold stocks though and with some luck he'll drive over to his neighborhood coin shop and buy a few Maple Leafs. With that in mind, I would line to begin with my favorite item... gold.
GOLD - It has been a tough summer for the yellow metal as prices fell from the May 11th high of $742.00 (bases the October 2006 gold futures contract) to the June 14th low of $551.50. Since then gold has undergone a period of accumulation that has led to several false starts and dashed hopes as gold bugs piled on to soon and paid for it. In mid-September we tested the June low and made what appears to be a higher low at $571.00 and that is important, especially when you consider that we are due to begin the seasonal rally. If you take a close look at the historical chart for gold below, you'll see that beginning in 2001, the price of gold has rallied in the Fall. The rally usually begins in September and lasts until January although last year's rally began in August and lasted until May. I believe that change marked the beginning of the second phase of our once-in-a-lifetime bull market for gold. The first phase lasted an extraordinarily long time, beginning in 1999 with the bottom and ending in 2005, and was highlighted by "smart monies" accumulation of gold. The still new-born second phase will be driven by institutional buying as the J. P. Morgan's of the world begin to sing the praises of gold. Eventually we'll have the third phase whereby the man-on-the-street piles on and gold prices are driven skyward [5].
Another even more important thing to wheedle out from the chart above is the fact that, in spite of the recent downward reaction, the bull market in gold is very much alive and well. It will remain so as long as we remain above the spot price of $545.00 on a closing basis.
Over the short run, I expect a lot of volatility and maybe even another test of the recent $571.00 low in the October 2006 futures contract ($569.70 in the spot price) although it becomes less likely with each passing day. Within a week or so, I expect a test of a trend line that passes through $615.00 and an eventual close above it. That will signify a break out and we should be off to the races with a close above 728.00 by year's end. There will be hurdles along the way with significant resistance at $644.50 and decent resistance at $664.20 and $686.20 (all using the spot price) but I don't think anything can stop gold from breaking through $728.60 by the end of the year. Furthermore, I believe we'll see significant advances after the November elections and there is a chance for a new all-time high if the rally extends into the Spring as it did last year. In my opinion, this is the last best opportunity to buy one of the cheapest things on the planet, i.e., gold!
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