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December 21, 2009

Fictional Reserve Lending

I had a nice post in mind for the weekend, but just couldn't manufacture a block of time to sit down for its construction. I warned a while back that the weeks leading up to my shackling... err, wedding day... would produce a spotty schedule for posting. Anyway, the idea was simple: the rise in the buck is overdone, so we should see a pull-back or consolidation in the DX. This pull-back would give equity bulls a premise for executing (<== carefully chosen word) a final short-squeeze, which would then rapidly develop into a sell-off.

I only got it half right... at least thus far. Despite an overdone state, the DX rally got more overdone. And, of course, equities rallied merrily along. Let's run through our favorite charts and hypothesize what could happen if the DX played out an A-B-C corrective rally. Keep in mind I'm not predicting anything, only trying to develop a framework for expectations.

us dollar index chart

A pull-back could go as low as the 76 pivot, but the important moment will be a test of the 200DMA in January because if that test coincides with proper bottoming action in metals (a panic day and/or huge upside reversal), I will be purchasing precious metals assets fast enough to set my keyboard on fire.

s&p 500 daily chart

It is said the market will screw as many people as possible. I'm paraphrasing, but imagine how difficult it would be for bears to remain short over New Year's weekend if the S&P 500 were pushing rally highs. The first few days of a new year are typically volatile. Who has the nerve to sit on big losses over a 3-day weekend a potentially see those losses quickly get more huge? In fact, I expect the serious part of the sell-off to commence with the new year in order to trap those timid traders out of their glory. By the time they are ready to chase the market lower, the correction will be over.

Now don't ask me if the SPX will set new rally highs on the other side of the correction. For one, I don't care. I intend to be fully invested in PM positions by then, and by "fully" I mean with at least as much leverage as I've enjoyed on previous parabolic moves. When it comes to equities, I'm more interested in the other side of the final rally than the upcoming correction. I suspect we will enter the death-by-thousand-paper-cuts phase of the bear market whereby equities trickle down to new nominal bear market lows over 12-18 months. I plan to sell those 12-18 months about 2 months at a time... selling calls, that is. I'll discuss this game plan in more detail when it becomes more pertinent.

gold chart

Gold has been moving fairly reliably inversely to the dollar, so if the DX is about to pause, gold and silver should see a little pop. The view on gold is perhaps the most important part of this construct because we must be cautious not to jump on the tracks too to quickly. We want to catch the train, not get run over by it. I expect the next pop in gold prices to be nothing but a bug zapper. Eager gold bugs just can't resist those quick pops.

gold miners stock chart

It is possible GDX will decline to the lower bound of the expanding wedge. Such a move would certainly make jelly out of the stomachs of many supposedly long-term holders. Doesn't really matter to me. I just want to buy in the neighborhood of the bottom.

So that's it for now. The main task for a prudent trader here is patience. I know it is tempting to try to make a little extra side cash out of the wiggles. I've been there, and most of the time I only managed to reduce my firing power for the big moves. Instead, let's just leave the wiggles to those without better things to do than watch a monitor through the holidays.

Today's clever title, by the way, was borrowed from a post by Mish entitled, "Fictional Reserve Lending And The Myth Of Excess Reserves." The post is superb, and I highly recommend its study.


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