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January 24, 2009

From Crisis to Depression

Today's post will start with a discussion of gold rather than equities since we have some very interesting dynamics playing out in precious metals and commodities in general. As you know, gold surged $40 Friday, slicing right through the lower trend line. My game plan for gold was to re-apply a moderate short position as the metal approached the trend lines containing its decline off the high of last March.

gold chart

Fortunately, I wasn't paying close enough attention to attempt a short at the lower trend line. However, I am now wondering if I will even bother with an attempt at the upper. Here are the deterrents:

silver chart

oil chart

commodity index chart

I have to admit that for the most part the technicals are not supporting my view that gold will take a final plunge into the low $600s before the bull market returns. However, I'm not shelving the idea until we see the breakouts. Also, it would be dangerous to underestimate the power of deflation. The banks are in no better shape than before our politicians poured a trillion dollars down their gullets, and if we experience another forced liquidation event, everything will be sold in favor of bonds.

Admittedly, it is rare to have back-to-back crises. Crisis mode played out last autumn, and given a typical playbook, we should be working our way through depression mode for at least a couple years... perhaps longer, depending on what other atrocities our politicians unleash. The point is that it's going to be very important to correctly identify the nature of the next down leg in equities and the economy in general. A steady decline in equities could easily be accompanied by the return of the commodity bull (see 2001-2003) while another panic could send another shock through the commodity sector.

Equities have been giving everyone a fit over the last few sessions, and I've observed a rapid shift in stance on several blogs from, "We're cliff-diving" to "Hey, maybe we'll get the big rally, after all." I am not bullish on equities and see no reason to get aggressive on the long side.

stock index chart

However, there are two reasons not to be short equities right now. First, if the SPX is forming a mid-point consolidation, we're looking at a target of SPX 700. There will be plenty of downside to catch once the consolidation breaks, so there is no sense putting capital at risk until we get confirmation. Second, and redundantly obvious, is the fact that a bounce here gives us the opportunity to sell at higher prices. Unless price/volume patterns speak differently as the action develops, I would expect any rally to die either at the 65DMA or the downtrend line, and if we see confluent indicators of topping action... such as a heavy selling into strength day... I will open shorts at those resistance points.

I said I would not get aggressively long here, but I may snag a handful of positions in the commodity sector, such as GDX, DIG, CF, DBA, and others along those lines. If the commodity breakouts coincide with even a moderate equity rally, those issues should rocket.


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