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August 17, 2006

End of Eternity

Markets edged higher for a third straight session of gains. Though the action did not run away to the upside as was the case in the last two days, the bulls still appeared to be in control. During the first half of the day, every little trickle to the downside was immediately bought, and despite very overbought conditions, a strong midday swoon failed to gain any traction.

Gold and silver were hammered again for no apparent reason other than technical follow-thru. Three cheers for those chartists who are getting metals prices down so we can pick them up more cheaply. I have an itchy trigger finger with my sights on some Newmont calls, but am practicing restraint at the moment.

At the risk of triteness, it is worth remembering that all the reasons supporting a fall in equity prices and a continuation of a bull market in commodities are still present. The existence of a housing bubble, which so many doubted throughout 2005 and into early 2006, is now apodictic, as is the issue of its demise. The popular press is revealing a burgeoning number of horror stories about people trapped with negative equity, many of whom are knocking seven figures off their asking prices and still receiving no bids.

It will get much worse.

The full effect of the housing downturn on our consumption-based economy is yet to be felt, but already personal bankruptcy filings doubled between the first two quarters of 2006. With the consumer rapidly weakening, manufacturers of components for their favorite gadgets have not slowed production. Companies like Intel and SanDisk have monster inventories, yet are increasing capacity. Suppliers such as Lam Research will receive body blows to their balance sheets as stuffed channels start to back flow.

The argument can be extended to retailers as well as the banking sector, but I will spare readers further repetition of what they already know. The point is that I believe this week's rally is nothing more than a reaction within a bear market. Any student of market history knows that bear markets are littered with violent counter-rallies, especially near the beginnings and ends of major downswings. I also believe that once this reaction runs its course, equities will fall harder and longer than during the May to July swoon.

When this counter-rally began, I wrote that the upswing would last long enough to instill great confidence in the bulls while making bears feel they had been duped once again. With so many bears, including myself, feeling giddy after Monday's reversal, it should have been apparent that the trap had not fully sprung. Now that we are feeling pain, I believe the next inflection point may be near.

More surprises lie ahead. As the next downswing ensues, bears burned by this rally will be quick to take profits or happily get out even on currently losing positions. Bulls will hold fast believing that all will be well, bolstered with memories of this rally. The surprise for both sides at that point will be a market that just won't stop falling.

Disclosure: Short INTC, SNDK, LRCX; Long INTC, SNDK Puts; Short NEM Puts


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