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June 26, 2010

If a falling dollar were to help stocks avoid sinking under the May low, Friday's action did not inspire much confidence. With the U.S. Dollar Index shedding a half percent, the S&P 500 managed all of a 3-handle gain. Behind the scenes, evidence continues to mount that the secular bear market in equities is about to resume its bite:

Baltic Dry Index

The BDI is a leading indicator, so don't go piling on the shorts based on this chart alone. I suspect that whether or not the SPX breaks the May low, we will see another attempt higher before the real damage gets done. The fact that the BDI is rolling over is just a warning that such an attempt will fail to reach new highs.

I wrote in Thursday's post that successful trading requires waiting for the market to trap itself within an interpretation before making any aggressive moves. The current setup in equities provides an excellent example. There is no probabilistic advantage in trading the S&P 500 right now because there is a chance that the May low marked a premature intermediate cycle low and that stocks are now unfolding a very tricky countertrend bounce. We know from history that the initial declines off cyclical bull peaks tend to get halted by the 75-week moving average. History also shows a tendency for a large (failed) rally developing from that initial decline.

From the current vantage point, traders who have an inkling to go short, thinking an intermediate low is still ahead, risk getting caught in such a rally if they are wrong. So in an attempt to capture maybe 60-70 handles (down to the 75WMA), a trader is risking a potential 100-handle drawdown. Likewise, those who think we are already in the countertrend bounce and want to be long are risking 60-70 handles to make maybe 100. Neither risk/reward scenario looks very appealing to me. Perhaps a straddle would make sense, except that with the VIX still near 30, option spreads are pricey.

Now for our trap: given our knowledge that the first intermediate cycle after a yearly low in equities tends to last 18-24 weeks and that initial declines off bull peaks get halted by the 75WMA, we can simply wait to see if those conditions arise. A large reversal session concurrent with those circumstances would be a major tip-off to the bottom. In fact, we can narrow our timing expectations using the daily cycle, which should stretch at least 8 more sessions before finding its low.

SPX Daily

We should see sentiment readings in the abyss at an intermediate low, and such sentiment will fuel the potential 15-20% move typical of rallies out of these lows. I don't know about you, but buying that low, with cycles, sentiment, and history in my favor, with a close stop based on the panic reversal, and with a potential 15% rally just ahead, seems like a much better prospect than taking an instinctive guess. If stocks do not sink into that low, then no matter. We can just await another opportunity. The point here is just to be mentally prepared so we don't get caught up in the emotion of the moment.

In the meantime, gold continues to perform well.

Gold Daily

The strength seen in mining shares is another big clue that gold's daily cycle is beginning, not ending. However, I am refraining from marking a new cycle until gold sets a new high because we never saw a close beneath the cycle trend line. In other words, a little further confirmation is in order.

Of much greater interest to gold bulls is the state of the intermediate cycle. If the cycle bottomed on Week 15, we can sit on cruise control at least until a weekly swing high is formed. Otherwise, we must be on guard for an intermediate decline. I have another bit of evidence that Week 15 did, indeed, mark an intermediate low:

Gold Weekly

The Week 15 decline was preceded by the usual 4-week rally. It differed from other declines in that the cycle trend line was not violated, but perhaps this should not be so surprising for a shortened cycle. Of course, gold has rallied in 4 of the last 5 weeks, but the gains have not been as strong as is typical of a peaking intermediate cycle. In fact, new intermediate cycles in gold tend to begin with rather timid gains... and don't forget we were looking for a shortened cycle to follow the unusually long 30-week cycle.

All things considered, the evidence strongly favors a Week 15 intermediate low, and so I think it's time we label it. This recognition puts us going into Week 6 of a new cycle. The good news is we haven't missed anything. The swing low that marked the new cycle was formed at $1243. Gold closed Friday at $1255.. only 1% higher.

I will now detail what I expect to unfold. Let's begin with our updated intermediate view:

Gold Weekly New

If you will remember from previous posts, there are also multiple price patterns projecting to the $1375-1400 range. Given the intermediate cycle state, it seems probable we are on the verge of striking at those projections. I suspect this new intermediate cycle is about to experience its 4-week rally into a peak. We should then enter consolidation mode, and consolidation mode implies a left-translated cycle. Peaking at Week 9 or 10, this intermediate cycle should decline for 10-12 weeks into an low sometime in late September or early October. The following cycle would then rally gold back to a consolidation break-out.

Seasonality supports this view since precious metals tend to roll into significant lows sometime in the autumn. You can see the puzzle pieces all fitting together quite well in this scenario. Given the prospect of a month of solid gains, I am contemplating the reacquisition of some gold calls on Monday. As usual, I will notify Members of any portfolio changes in the nightly letter.

Let's have a peak at the dollar before wrapping up because its cycle view supports our gold scenario.

DX Daily

I've been discussing since even before the current cycle began the prospect of seeing an extremely left-translated daily cycle during an intermediate decline. An ELT cycle firmly supports the notion of a strong move higher coming for gold. Furthermore, the current daily cycle is 4 days old, meaning it should find a bottom in... guess what?... about 4 weeks.

The buck's intermediate cycle, however, needs more than 4 weeks to find a bottom. At Week 9, we should see an intermediate DX cycle bottom at least 6 weeks out. This scenario with relation to gold has played out before. The gold cycle will peak as the current daily DX cycle bottoms. The bounce by the DX out of its daily low will coincide with gold's initial decline into an intermediate low. As the buck then declines to a marginal new low to set its intermediate low, gold will experience a reactionary rally that fails to set a new high, thereby confirming the decline and the left-translated nature of its cycle.

We now have solid frameworks of expectations for both gold and equities. Let's see how the actions progresses and trade accordingly.

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