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September 13, 2010

Bond Watch

In recent posts I've outlined expectations for a renewed bear market in equities. Several characteristics of the daily and intermediate stock cycles strongly suggest the market is in the process of rolling over. Most obviously, the February yearly low has already failed, implying that the current yearly cycle must have already peaked. There are a couple of proprietary indicators I share with Members which support this notion, but suffice it to say, the evidence is persuasive.

Naturally, there is a caveat to this interpretation, as is always the case when the initial analysis seems cut-and-dry. The dollar is due for a 3-year cycle low next spring. The declines into those lows tend to be particularly vicious, and there is a better-than-even chance the coming decline will see the DX take out not just the 2009 low, but the 2008 low, as well. Therefore, in order for stocks to roll into bear mode, they will have to break their inverse correlation with the buck.

There are two ways this discrepancy can be reconciled. First, the interpretation of a yearly low having formed in February could prove to be false. A re-phasing of the yearly low to July would open the door for stocks to surge higher as the dollar plummets into 2011. However, both cycle counts and sentiment readings support the February interpretation, so one would have to give this path to reconciliation a low probability.

The second possibility would be to see the plunge of the dollar itself become a catalyst for crisis, thereby dragging down stocks in commiseration. Such an exodus would imply a flight from dollar-based assets in general. The question then becomes how to spot the approach of such an inflection in the dollar/equity relationship. The answer, of course, lies in the bond market.

bond market crash

Bonds tend to sniff out trouble ahead of the equity market, and if Treasuries continue to fall in the face of worsening economic conditions, we will have an important sign that big players are trying to divest themselves of the dollar. It has been my contention that the bond rally out of April constituted nothing more than a test of the low for the secular bear market in interest rates which began in the early 1980s. If Treasuries now unwind the recent rally as quickly as it formed, we will receive a a strong indication that my suspicions are accurate.

Another reason the bond market is so important pertains to our little yellow friend, gold. If traders are trying to flee dollar-based assets, Treasuries will not serve as the flight-to-safety play they typically enjoy during crises. Instead, panicking traders will seek a safer footing in precious metals, and the relatively thin markets of gold and silver simply will not handle such a flow of funds without a tremendous price adjustment. Consider that previous periods witnessing a shift of capital allocation from financial assets to commodities typically ended with gold and gold mining equities standing at between 25-30% of global assets. The present ratio sits at approximately 1% (Source: Hinde Capital).

Gold's cycles are currently suggesting a tremendous move higher in the near future, and as soon as the bond market betrays its hand... showing that the U.S. Dollar has become a hot potato... the capital allocation ratio for precious metals as a percentage of global assets will surge. Of course, the path to the 25-30% range will involve both a rise in precious metals prices and a fall in financial assets, and I believe the plunge of the dollar into its 3-year cycle low is likely to spur the next stage of this asset realignment.


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