Gap through the trend

Last month I pointed out the gap through the trend on the financial ETF. This often signals a fundamental change in the market. Now a month later we can see that the financials are still locked in a downtrend. Today we have the potential for the SPY to gap through the trend line. If the gap holds and we close below the trend line today then the odds are probably on the side that this intermediate rally is done. This rally was born from the Fed cutting rates 125 basis points. So far no cuts have worked to support the market. Pure and simple we have two problems. The first one is spiking inflation especially energy costs. The rate cuts are just making this problem worse not better. The second problem is foreclosures in the real estate market are hurting the financial system. I think that in order to put in a bottom the market is going to have to see some kind of end in sight for this bleeding in the housing market. Unfortunately I don't think we are there yet. With a large supply of ARMs adjusting this year we could see another wave of stress in the real estate market. At this point it's probably to early to have an idea how big this foreclosure cycle is going to be. Until this uncertainty is clarified I believe we are still going to see stress in the financial sector.

Hyperinflation here we come

Subconsciously I knew the Fed was going to opt for this since they have been going down this road for 7 years but I still find it hard to believe. The dollar has now broken to new lows. In an attempt to save the markets and wall street banks the Fed has now opted for hyperinflation. The process of devaluing the dollar to inflate the markets that has been in cruise control since 01 has now gone into overdrive. We now have a front row seat to a massive explosion in inflation coming down the road. The question is simply how fast the liquidity is going to leak into commodities. We've already seen the CPI and PPI show the largest jumps in years and that's the governments version of inflation. The question as to how fast this will crush the economy is how fast and far the price of oil rises. It has already broken out of a very large consolidation and closed over $101. Platinum, Palladium and now silver are all trading parabolic. Copper is trading parabolic and most of the softs are moving up in parabolas. Gasoline has jumped 20 cents at the pump in the last 2 weeks. The Fed is now guaranteeing that the slowing economy is going to be pushed into a very severe recession.

Now how can we have a rising stock market if the economy is going into a recession? Why are stocks moving up on bad news? The answer is right there in the chart. The Fed is creating artificial demand by pumping the money supply. We aren't at the bottom of a recession yet. That's when stocks are cheap and represent good value. That's the time when real demand will come in. The current rally is soley due to massive amounts of currency being injected into the markets. It is now a race between how much money the Fed can print and how fast it will leak into hard assets.

Think of it this way. Let's say instead of paper dollars the medium for currency was sand. Well sand is pretty abundant right. You can just go out and scoop up a bucket full of it. Well if anyone can obtain as much as they want why would you sell your products at a fixed price? The answer is of course you wouldn't. If everyone has access to the beach then you are going to start raising your prices. Well in the world we live in we don't all have access to the beach but the governments do. Believe me they are scooping sand like crazy right now. The laws of supply and demand will still apply. If the Fed wants to flood the world with money then people are going to want more and more of those dollars for their real products. Here's an example that I already find myself doing. The price of gas as everyone has probably noticed is rising. I now find myself stopping even if I don't need to fill up at a station that hasn't raised prices yet. All that means is that station will run out of gas faster and will quickly be raising prices since they can't keep the tanks full at these lower prices. We see the magic of inflation at work in real life. I do the same thing at the store. Anything on sale I buy it now instead of waiting till next week when the price has increased.

Historic bull market in commodites

We've got a 4 year cycle low coming sometime in the first half of this year I suspect. As I pointed out in the previous thread when this final low comes in it usually takes down everything and that includes commodities. I'll say right now that commodities are going to hold up better than the paper markets. They certainly have held up much better during the first leg down. The second leg is going to be when the real panic will be generated. This will probably play havoc with margin calls and everything is going to get hit including commodities. We'll see all the old familiar faces coming out and predicting the end of the commodity bull. The media will tell you that commodities were in a bubble and it's now bursting, yada, yada, yada. It will all be baloney and here's why.

Take a look at the first chart. This is the S&P/CRB ratio. What we see is a historic rise from 1980 to 99 in the price of paper assets compared to commodities. From 99 to the present we see a major trend change from paper to hard assets. Now let me digress for a second and remind everyone how human nature works. Our emotions take us from one extreme to another. The larger the extreme in one direction the larger will be the swing back the other way. We don't go from one extreme to average back to extreme. It would be much better if we did but that's just not how human emotions work. So now we are in the process of swinging back to extreme overvaluation in hard assets. Keep in mind the run from 1980 to 1999 was the biggest in history...by a long shot. So far we haven't even come close to approaching the level we saw in 1980. We're only half way there and 8 years have gone by. Now the average for a hard asset cycle is between 15 and 20 years. The shortest was 9 years from 71-80. At best we're likely only half way through this commodity cycle and if human nature unfolds like I'm sure it will, we will correct the historic undervaluation from 80-99 with a move to historic overvaluation before this is over. This bull should make the 71-80 commodity bull look like child's play. This makes sense as we are now seeing a huge segment of the global population expanding at a tremendous rate of growth. Fuel for this growth has to come from somewhere. It needs energy for one thing. Energy that hasn't expanded it's infrastructure or found a giant oilfield in 40 years. It needs basic materials. Again an area that has not expanded as the devastating bear market crushed prices for almost 20 years. If the price of what you sell is consistently going down I can tell you that you are probably not in a big hurry to find more of this cheap stuff. It costs a lot of time and money to bring more production online in the commodity bussiness. Not a big priority if you are barely hanging on to profitability.

Next take a look at the ratio of the S&P to commodity related equities. We see a steady move down as the S&P consistently under performs commodity based companies year after year.

In the last chart we see the Dow/Gold ratio for the last three great secular bull markets from 21-29 the gold ratio declined to almost 20/1. Meaning that it took 20 oz. of gold to buy 1 share of the Dow. When the trend changed that ratio declined to almost 2/1. Then the next great secular bull market from 32 till 66 took the Dow/Gold ratio back up to 28 oz. of gold for 1 share of the Dow. This was followed by another commodity bull cycle and a trip back down to 1:1 on the Dow/gold ratio. Then we have the greatest secular bull market of all from 82 to 2000. Gold was crushed to the point where it took 45 oz. to buy one share of Dow paper. Now we are in the process of correcting this gross undervaluation. I have no doubt that we will see the Dow/Gold ratio approach 1:1 again and if the extreme nature of the undervaluation is any indication then we could very easily see gold surpass the Dow this time.

Second legs down

Today I’m going to go over second legs down in bear markets. First off let’s go over the historic stats. The average gain for final legs up in bull markets is roughly 34% if my memory serves me right. As you can see from the chart we logged in a 29% gain which was pretty close. Something else that is important and that I’ve pointed out on the chart is the nominal new high in Oct. Remember me pointing out the huge net long position in the COT’s that kept getting bigger as the market dove into the Aug. lows. With hindsight we see that the long position was justified as the market hadn’t made that nominal new high yet. Now look at the 02 low and you will see the same pattern of nominal new lows that was the springboard for this cyclical bull market. These nominal new highs and new lows are pretty typical as investors become euphoric and buy the breakout or panic and sell the breakdown. Remember me pointing out the big reduction of longs in Sept. right before the final top? Some of that smart money was sneaking out the backdoor as the top was being put in.

Now we’ve had the first leg down in the bear market. The average decline for all bear market first legs down is 20% in about 4 months. The S&P logged in a 19% loss in 3 months. Pretty close. At the moment we are in the counter trend rally that should separate the first leg from the second leg down. The average decline for second legs down is roughly 19% in about 4 months.

I'll elaborate in today's update for subcribers with some historic charts and a look at some specific sectors.

NDX charts

I've been watching the charts of the cubes. I've noticed that the price pattern over the last month has been much weaker than the rest of the market. This is starting to look like a midpoint consolidation in a larger technical rule #1 move. Moving to the weekly chart we see the pennant pattern forming. Again these typically form about half way through a move. Also notice that the NDX didn't close below the 07 seasonal cycle low like the rest of the market. I suspect it eventually will, it's just a matter of time. The first half of the year has been a weak time for tech. We can see on the 5 year chart that the Jan. lows were never the final lows for any of the preceding 5 years of this bull. This has actually been the case for the last 7 years. Now that we are in a bear market I really doubt that the Jan. lows are going to hold on the tech stocks during a seasonally bad time of year, during a slowing economy and one that likely is already in a recession.

Jim Rogers on commodities

I pay attention when Jim Rogers speaks. He has his own money and unlike many analysts or CNBC guests has no ulterior motives and no one he has to answer to. He tells it like it is. Here is his latest interview and his views on oil, gold and the commodity markets in general.

Yen still correcting

The breakdown out of the Pennant is still intact. IMO the strong Yen was the thorn in the Fed's side. No matter how much money they threw at the markets as long as the 1.2 trillion in carry trades were unwinding it wasn't going to do any good. Now the Yen is correcting the last advance. As long as this continues then I suspect the market should continue to drift upwards as the Fed unloads massive amounts of liquidity on to the markets. The key words here are "drift higher". The problem is that a great amount of this liquidity is leaking faster and faster into the commodity markets. When inflation starts to rear it's ugly head money will start to gravitate towards real things and away from paper assets. Sound familiar? Like maybe something we've been seeing for 6-7 years now. Only now it's starting to accelerate. ouch!

I will be watching for the Yen to approach that long term uptrend line and reverse as a sign to intiate shorts again.