ALL CURRENCIES ARE SUSPECT

A comment on the blog last week got me to wondering. One of our Canadian friends made the comment that he's made nothing off of gold because the Canadian dollar has been strong. I think he was insinuating that the price of gold was only rising in the US and that only because the Fed is destroying the US dollar.

After looking at the preceding chart I have to conclude our Canadian friend is simply a poor trader :-) Actually as we all know gold is a very volatile asset and pretty tough to trade successfully so his mistake was probably that he was trading instead of holding. Even priced in a strong (relatively speaking) Canadian dollar gold is still up 200%.

The next set of charts speak volumes about the global monetary policy.

Every country in the world is printing at a furious rate. No one is innocent.

Recently the Australian and New Zealand central banks are showing a bit more commonsense than most, but it's certainly only a recent occurrence as gold rose 300% before backing off a bit. Besides who knows how long commonsense will last? Probably only until politicians start to feel the heat again.

THE SKY IS FALLING

I know it seems like the losses in miners are so huge that we will never be able to recover. Like I said projecting the past into the future is just human nature.

But nothing could be further from the truth. If you want to get an idea of how violently miners can rally all you have to do is take a look at November.

From almost the exact same level they are at now miners rallied to new highs in one month. Don't forget this was an advancing bull leg that was getting mature. A rally from extreme oversold conditions back to old highs can unfold much more violently than a final leg up as hot money floods into a beaten down sector. (Just look what has transpired since the Nov. `08 low)

Once the selling pressure coming off the stock market exhausts I have no doubt miners will quickly get back to the business of correcting the massive mispricing compared to gold.

Liquidity always finds its way into undervalued sectors.

END OF THE BULL?

So are we witnessing the end of the cyclical bull market? Probably not.

All bull markets go through corrective phases. They all break trend lines. We've already broken three of them in this bull market.

The previous bull market broke four major trend lines. None of them being anything more than a temporay pullback.

I've been calling for at least a 10% correction for several months now to separate the second leg of this bull from the third.

Birinyi and Ass. point out that of the 117 corrections greater than 5% since 1945. Only 11 of those 117 actually turned into a new bear market. So the odds of this correction signaling the end of the bull are 9.4%. Not great odds to say the least.

We can probably expect a move down to at least the 1040ish level. But once we exhaust the selling pressure the odds are very good we will see new highs.

As I mentioned in last night's report, it's becoming apparent this is not only an intermediate level correction, but it's stretched far enough that this should also be the yearly cycle low. The only time selling pressure is greater than at a yearly cycle bottom is at a 4 year cycle low.

So while they are certainly scary and tend to exert tremendous pressure on everything they also tend to show the most powerful rebounds once the cycle bottoms.

The average rally out of a yearly cycle low is 19% with the median gain for the last 7 yearly cycle lows coming in at 15%. Since we are obviously in a cyclical bull, and the odds are against this correction signaling the beginning of a new bear, we can probably expect the rally out of this bottom to take the market to new highs.

WHY JUST ONE?

I want to start off today and talk about something that…I wouldn’t say bothers me, maybe puzzles me is a better way to put it. Of all the different tools we as investors and traders can use to give ourselves an edge almost without exception, when asked, any individual will almost always have one he trusts or relies upon when making his investment decisions.


For some it’s big picture fundamentals. Smart money investors tend to choose this path. People like Jim Rogers, Warren Buffett, George Soros, etc. These are people with lots of money and patience. When they see a fundamental shift in the market they get on board and just hold on till the secular move has run its course. Needless to say there is a reason these people are rich. Riding a secular wave is the easiest way to amass a fortune. But unless you have the patience of a Buffett or Rogers it’s hard to do. Most people tend to get knocked out during the corrections… and there are always some doozies in any secular bull.

There are others who follow sentiment. They attempt to time the markets based on extreme sentiment levels, taking the opposite side of the trend as a contrarian play when sentiment levels get stretched too far in one direction. www.sentimentrader.com is an excellent source for monitoring sentiment levels.

Some watch market cycles. Because human emotions move through periods of ups and downs, and let’s face it the markets are really just a reflection of human emotions, cycles are often a pretty decent tool for timing market moves as they tend to occur with fairly predictable regularity.

Others follow the smart money, i.e. the COT reports and WSJ money flows. Knowing that big money players are probably privy to information that the rest of us don’t have, it makes sense to watch what these players are doing. Since this group controls most of the money in the market it's probably safer to follow behind the train instead of standing in front of it.

And then there are the multitudes that base their investment decisions on technical indicators. These are people who believe the future can be discounted by looking at lines, patterns or indicators on a chart.

Whatever tool one uses, the point I want to make is that almost without fail investors will fall into one of those categories. What I’m puzzled about is why? Why do most investors limit themselves to only one or two tools? Is it because of some misguided search for the holy grail of investment? When we find something that works for a while do we then make the mistake of assuming that it’s always going to work?

Every single one of those tools I outlined above (fundamentals, sentiment, cycles, smart money, and technicals) are useful in achieving an edge in the market. Why would one throw out any of those in favor of only one?

My one real talent for most of my life, other than a moderate ability to hang on to the side of a cliff and, when I was a younger man, the skill to lift fairly heavy weights over my head, has been to see the big picture. To see how all the parts fit together. So I have to ask why not use all of the tools at our disposal? That is of course what I attempt to do. Sometimes with pretty good success, and sometimes... not so much ;-)

To start off I think everyone simply must be able to see the big fundamental picture. If you can’t or won’t do that then how are you going to know when a major shift in the market has occurred. When it does it could affect every other tool in your arsenal. In my opinion the big picture fundamentals for the market changed in 2000. At that time we entered a long term bear market for paper assets and a long term secular bull market for commodities. As long as this fundamental underpinning remains I don’t really want to buy stocks and I do want to buy commodities.

After the big picture fundamentals I would say it’s a toss up between cycles and sentiment as my next most useful tool. Both are excellent tools for the most part but both have their limitations if a fundamental shift occurs. As an example, during the crash last year extreme sentiment levels had no bearing on market behavior. The underlying fundamental driver of the market was so strong that it really made no difference that sentiment had reached extreme bearish levels, the market just kept on falling. The same can be said to some extent for the rally out of the March bottom. There was so much liquidity in the system that extreme bullish sentiment really had no bearing on market direction other than occasional short term corrections.

The same could be said for cycles. As the market rallied out of the March lows the unimaginable amount of liquidity accomplished something that’s never been done before. It aborted the path of a left translated 4 year cycle. I’m completely guilty of missing that this summer. At the time I knew the Fed had pumped trillions of dollars into the markets but I just didn’t believe it would be able to alter the path of a 4 year cycle. I put too much trust in one single tool at the expense of ignoring a major major fundamental change.

Following the smart money is another useful tool. Except just like everything else it too fails from time to time. The COT reports used to be one of my most trusted tools. Except in 07 when they basically stopped working as a timing tool for the stock market. Watching money flows in the WSJ has also been a pretty dependable tool for spotting trend changes except sometimes the signals come too early. During the crash in `08 we saw several days of heavy buying on weakness but none of those led to anything other than a brief bounce. The recent sell signal was first given in Nov. yet we had to wait till the middle of January before anything became of it.

I think we all know the limitations on purely technical signals. For one they can be easily overridden by any of the other tools, (fundamentals, smart money, sentiment or cycles). Secondly, it’s pretty easy for big money players to run trend lines and support/resistance levels in order to get the typical retail technical trader to do what they want. Those stuck using purely technical signals are always going to be at the mercy of the big boys pulling their chains.

All in all every tool we use has its limitations and from time to time market conditions pop up that will completely negate some or all of our tools. But in my opinion the least likely way to succeed is to pick only one tool and trust it to give you an edge in every market environment.

I think a much higher success rate can be achieved if one uses all the tools at our disposal, especially when most of those tools are telling the same story.

INFLATION TRADE MAY BE STARTING

For a while now I've been of the opinion that Bernanke's massive flood of liquidity last year is going to have unintended consequences. I think those consequences are going to manifest as a huge inflationary surge in commodity prices this year.

I understand the deflationary argument. I think even the deflationists believe we are going to see inflation become a problem, they just think that it will come after the deflationary phase.

Recent history would seem to contradict that theory though. From `03 to `08 we saw inflationary pressures gradually building until they finally came to a head as the tax rebates hit the economy and spiked the price of oil over $147 and the price of gasoline over $4.00.

Combined with the collapsing real estate and credit bubbles these severe inflationary pressures collapsed the global economy and led to the worst recession since the Great Depression. For about 6 months we experienced a severe deflationary period.

Take note that the deflationary period followed, not led, the inflationary period. It seems like a contradiction but inflationary pressures lead to deflation not the other way around. As the price of energy spikes strapped consumers shut down and demand for everything except necessities grinds to a halt. Prices plummet as demand collapses. Deflation!

In order for a deflationary period to spawn inflation we have to have the government print money. Which we have in spades I might add. In order for deflation to begin all we need is for the governement to allow the inflationary pressures to get out of control. At that point the process will complete all on it's own.

Now we are starting the process all over again. I think the completely outsized moves in energy, gold and stocks the last two days compared to the rather small decline in the dollar are suggesting this isn't just a short term top in the dollar.

I think there's a high probability that the inflation trade I've been expecting is about to begin.

This, and not another credit event, is what I think will be the catalyst for the next leg down in the secular bear market and the next deflationary scare.

A STORY OF RISK

I'm going to tell you a story about a fella I once knew. He was a young lad, full of confidence ...full of testosterone :)

During his first trip to Vegas this young man discovered a brilliant way to "beat the odds". He figured out that if you can continue to double down on your bet you will always walk out of the casino with a profit.

Here's an example let's say you bet $5 on blackjack and you lose your first hand. Your next bet is $10. If you win that hand you will recover your loss from the original bet and make $5. The same logic applies whether your bet is $10, $20, $40, etc. As soon as you win a hand you will increase your stash by $5.

And let's face it how many hands can one lose in a row? Maybe 5 or 6 if you're really unlucky?

Well as you can guess his initial foray into the blackjack pits was successful, wildly so. He tripled his money in almost no time at all.

Then he got to thinking why in the world am I playing $5 chips, that's going to take me forever to make a fortune. He had visions of owning the strip by this time :) $25 chips would get me where I want to go much much faster.

You probably see where the story is going by now. It didn't take very many losses before our young hero was down $1000, which at the time was a lot of money. At that point he ran out of money and had to retire for the night.

Completely dejected that his fool proof system had let him down so badly our hero decide to buy a deck of cards and run a little test. He wanted to see just how often one runs into a large losing streak, one that would be deeper than his pockets could cover.

To his amazement he discovered that in blackjack one will run into a 15 hand losing streak about every hour or two.

Now if you hit a 15 hand losing streak and are playing $5 chips you have to be willing to bet $163,000 to make a measly $5.

Our hero just learned his most valuable lesson in leverage and odds on that day in the casino.

Now when I hear about these fantastic returns traders are making I know they are in the casino. They're doubling down (leverage) and at some point the market is going to take the system, that they believe is fool proof, away from them (large losing streak). When that happens the massive leverage is going to destroy their account in the blink of an eye. And if they are really leveraged like 20-1 it doesn't take 15 losing hands in a row to do it. You can easily blow out in 4 or 5 trades.

Now let me say this, if and this is a critical if, you are young you could take a very leveraged bet. Knowing that if you are wrong you have the rest of your life to recover from your mistake.

If that bet pays off then you have to be satisfied and return to sound investing principles for the rest of your career. That's the only way you are going to be assured of keeping those gains.

For us older folks there's just no way we can take that kind of risk. We don't have enough time to recover from a fatal mistake.

So when you hear these fantastic tales of monstrous profits take it with a grain of salt. I've heard it all before. And I can tell you that not one single trader who chose this path was able to step off the path after a big score. Once the dark side gets it's claws in you, it's very hard to shake loose. Not one single one of the "big winners" is still around. The odds always get them.

That young man by the way, in case you haven't already guessed, was me.

TIME IS RUNNING OUT FOR THE DOLLAR

A while back I opined that the market would not be able to sustain upward momentum in the face of a stronger dollar. So far that's pretty much what's been happening. 

Other than a minor 30 point blip up as the dollar worked its way down into the last daily cycle low the market has basically gone nowhere since the dollar rally began.

I think if Bernanke wants to keep asset prices inflated he's going to have to get the dollar headed back down just like Greenspan had to do in `04 to get the market headed higher again.

The average duration for a yearly cycle counter trend rally is 50 days. Friday was day 46, so in that sense the dollar is in a live area for a final top in what I believe is just another counter trend move in an ongoing secular bear market.

Commercial traders now have the largest short position on the dollar that they've had in over a year and a half and sentiment has gone from extreme bearishness at the beginning of Dec. to levels of bullishness that have the marked tops of previous yearly cycle counter trend rallies.

Duration wise and sentiment wise the dollar is now setup to resume the secular trend. If Bernanke wants asset prices to continue rising he's going to have to continue pumping liquidity.

With real unemployment stubbornly holding over 15-17% does anyone really think Ben is going to start withdrawing liquidity?