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March 6, 2006

Red Flags

Bears had a feast today as markets unwound and broke some critical levels. The Nasdaq 100 broke out of its bear flag formation to the downside. The S&P 500 also broke downward following its bearish hammer Friday. Both indices are giving the appearance of heading significantly lower in the near-term.

So what is causing all this weakness? A plunging bond market, for one thing. I raised a red flag in Friday's post regarding falling bond prices. Bonds appeared to be testing support which, based on today's action, was no support at all. Today marked the 4th straight day of sharply lower bond prices, and yields have now risen above 4.75% on the 10-year note. This type of plunge has to be watched carefully. A lot of smart money has been anticipating a break in bond prices, and the appearances of the beginning of such a break could spur large holders of government securities, such as financial institutions and foreign central banks, to dump holdings in order to avoid being left holding the proverbial bag.

I have also pointed out on occasion that long-term rates have a closer correlation to stock prices than do short-term rates. All the attention given to Federal Reserve policy has been misplaced. Although long rates tend to move in the same direction as short rates, there are divergences (read: conundrums), and those who lose sight of the appropriate correlations are bound to make mistakes. If equities are to firm up here, U.S. Treasury prices, along with the dollar, are going to have to lead the way.

Gold and silver prices took big hits today, to the tune of 2% and 3%, respectively. These drops strike me curiously. In recent history, global financial crises have spurred flights to quality, with quality being perceived as dollar-based assets like U.S. Treasuries. It's been my contention that the next global financial crisis will be caused by trouble with the U.S. Dollar, and therefore some other asset class will be the target of the flight to quality. I expect the chosen asset class to be precious metals. The big clue I expect to see as such a crisis approaches primarily involves falling bond prices in conjunction with rising metals prices. The fact that metals prices fell sharply today could be a clue that the current slide in Treasuries is not the start of a bigger unwinding. On the other hand, it is only one day. Everything could change tomorrow, but I wanted to bring up the point so readers would know what sorts of indicators I'm watching.

With regard to Newmont Mining shares, today's weakness in gold was akin to kicking someone while they were down. NEM slipped more than 4%. The drop is not fun to experience, but is nevertheless not too discouraging from my viewpoint. The shares held long-term support near $50 and look to be oversold. While I would rather have added to my calls at today's prices rather than two days ago, I do not plan to add more here. My exposure is already near the maximum with which I am comfortable.

Housing and financial stocks took hits today, likely in reaction to rising rates. My favorite play on the housing theme, Building Materials Holding, plunged 6%. For the record, I covered my short into today's weakness. I had built up a tidy profit and decided it was time to take some off the table. BMHC is also looking short-term oversold. I plan to re-short it when the odds appear to be back in my favor. I hope I'm not being to clever here. I suspect that at some point these shares will unwind in a big way, and I fully understand that by covering at this juncture, I may miss a big move down. However, experience has shown that playing for home runs on the short side is an easy way to lose a lot of capital.

On a final note, I got a kick out of the fact that Research in Motion announced a settlement of their suit with NTP simultaneously with an earnings release. It was a very clever way to cover up an otherwise disappointing report, and I have little doubt the settlement was orchestrated so they could pose the announcement with the report. A couple of readers have written asking if I immediately shorted RIMM. The answer is no. Although I wrote about shorting into the settlement bounce, I prefer to open positions when I feel I have a clear picture of a stock's action. Maybe I'll see something tomorrow or maybe two weeks from now. I have no doubt that I will be short RIMM shares in the near future, and I will note it here when I make the trade.

Disclosure: Long NEM Calls; Long RIMM Puts


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