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November 23, 2008

Dollar Watch

I've spent the last couple of days pondering the question put forth in the last two paragraphs of Thursday's post: what form will this secular bear market ultimately take? Can we use the 1930s depression scenario? What about 1990s Japan or the 1970s inflation model? Perhaps none of these will be a good fit and something entirely new will unfold. I'd be interested to know everyone's opinion and have posted a poll on the home page for this purpose.

Obviously, it is tempting to use the 1930s model since the Depression was the last period to see such a spectacular stock market bust after a period of enormous credit expansion. If you're curious about the details, I highly recommend Murray Rothbard's America's Great Depression. The behavior of our central bank during the 1920s was spookily similar to the misdeeds that created the current crisis. However, using the 1930s as a model has one major flaw: the 1929 crash was preceded by 9 months of monetary contraction which continued into the early 30s, whereas our current Fed unleashed a monetary maelstrom at the first signs of trouble last year and have continued to pump new money into the system hand over fist. If one is to use the stock market's behavior leading into the Depression as a model for current times, one must consider adjusting for monetary factors such as money supply or trailing PEs.

On the other hand, Japan responded in similar fashion after the 1990 bust, printing yen out the wazoo (we're outdoing them, by the way), and yet their market still behaved just like America's 1929: a violent 30% rally after the initial crash followed by another nasty fall and then a decade of erosive churning. Japan, much like the U.S. is doing now, failed to allow market forces to clean the system. The Nikkei chart offers a sullen picture of a mismanaged economy.

There are, of course, strong similarities between the current period and the 1970s, as well. When Nixon took us off the gold standard, the move constituted an implicit default on U.S. debt, and the result was a decade of nasty inflation. The current monetization of our financial situation is nothing less than a default and will no doubt be followed by years of inflationary pressures. Maybe we should just all focus on making our fortunes the easy way... being long gold... rather than spinning our wheels trying to outguess the equity markets.

Anyway, on to current setups. U.S. equities staged their third large upward reversal in five weeks. The last two failed, and I get the impression most people expect this bounce to fail quickly, as well. I will now share one of my personal insights on the stock market: the market gods will frequently condition traders by repeating a pattern twice within a short period of time, then serve the setup a third time, only with a different result. Given this empirically-supported hypothesis along with the technical analysis below, I intend to rebuild my long positions. I dabbled hesitantly late Friday, and will add to them as the action permits.

And now another personal insight. Let's zoom in on the crash:

index chart

We are witnessing a common ending pattern where price forms two loops under a trend line. This pattern is typically followed by a breakout which tests the trend line in one of two ways. In scenario "A" we get a crawl beneath the line as it is approached, followed by a runaway move higher (most common). Scenario "B" offers a strong impulse through the trend line followed by a backtest to shake out weak hands. The least common outcome shown as scenario "C" is a failure of the pattern and results in a rapid decline. This last outcome would constitute the disaster scenario that takes the SPX down to the 600-650 zone.

I currently expect either A or B to unfold and intend to position myself accordingly unless we get the telltale sign of scenario "C"... a rejection by the trend line on strong volume a session or two after it is first tested. You may be interested to know that the minimum target for positive resolution is the top of the formation: SPX 1250. It may seem unfathomable given the scope of the financial mess we face, but a 67% rally is really not out of the question. The post-shock rally of 1929-30 posted a 50% gain in the face of a contracting money supply!

Another sign that relief may be on the way is the recent action in gold. The yellow metal defied gravity last week by posting a 7% gain.

gold chart

The unexpected move in gold could indicate the dollar is ready to weaken, and a weaker dollar would support the bullish scenarios for equities. A general rule of technical analysis, of which many traders are unaware or find extremely difficult to practice, is that failed setups are actually more potent trading opportunities than the setup itself. In other words, this pop in gold occurring just when the chart was suggesting the opposite could indicate a powerful move has begun.

What about silver? Well, it doesn't take a rocket scientist to realize that silver has been grossly underperforming its partner in crime. The cost of an ounce of gold has risen from 51 to 83 ounces of silver since July. In large part, this realignment has been the result of the unwinding of paired trades (long silver/short gold) as the rush for cash took place. Another factor is the industrial demand component of which silver has a vastly higher share as a percentage of harvest, and it is industrial demand that will betray when we commodity bulls should follow a bullish move in a big way. The current monetization efforts of our central bank will set the groundwork for massive inflation, but expansionary demand is what will drive prices higher. Until I see signs of an industrial pickup, I will assume that any rally in metals will occur within the context of a cyclical bear.

silver chart

Another sector under the microscopic view of worldly TA is, of course, banking. There are signs of a bottom in the BKX:

index chart

You all know... and probably share... my belief that the market cannot sustain a rally without the banks on board. The technicals are supportive, but keep in mind that oscillators such as MACD may be meaningless in extreme environments.

I am currently long GDX, BP, UYG, and RJA. I am also long oil via options. If the action continues to unfold bullishly, I intend to add larger positions via NDX futures (since I believe the NDX will outperform) and perhaps moderate positions in gold or silver futures.

With Thanksgiving coming up... a holiday my family tends to turn into a week-long raid on our wine cellars... my posting will no doubt be sporadic, but if something material changes in the outlook, I will definitely post.


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