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?

HERE WE GO AGAIN

When the tech bubble burst in 2000 it took the Fed two years to get the bear back under control. Actually two to two and a half years seems to be about as long as most bears can be sustained. So it probably had nothing to do with the Fed. The bear just ran out of sellers. But eventually when the bottom was reached it arrived at that point with a whole lot of liquidity sloshing around from the Fed’s printing presses. The result was a very powerful bull market that, thanks to continued liquidity injections, lasted longer than all but one bull market in history. Unfortunately the unintended consequences of the Fed’s interventions in the market came back to bite us in the ass.

Ultimately what we ended up with was the largest real estate and credit bubbles the world had ever seen. The fallout from the bursting of those two bubbles has not been pleasant to say the least and the mess that was created is going to be with us for a long time.

Anyway it’s pretty easy to see the effects of printing billions of dollars. A spectacular bull market lasting over five years followed by one of the worst market crashes in history.

So now Bernanke, following in Greenspan’s footsteps, has decided to go down the same path again. Only this time the intervention isn’t measured in billions, it’s measured in multi trillions. Let’s step back and take a look at the effect this insane monetary policy has had so far. What we see is a much more violent rally than what happened during the last cyclical bull. This is a bull on steroids.

When viewed from a longer term perspective the current correction can be seen for what it really is, a minor blip so far. As I’ve said all along, this is just a profit taking event in an ongoing liquidity fueled cyclical bull. But instead of being fueled by billions of dollars this bull is being fueled by trillions of dollars. If you look back at the earlier chart you will notice the last bull “tested” the lows in March `03. This bull has been powered by so much money that no test of the bottom was even vaguely possible. That alone should be a clue that something unnatural was happening.

Now here’s what I hear from most analysts. By far most people are in the camp of a continued bull, but one where the gains come much slower. Something similar to what happened from `04 to `07. The other camp believes this is the beginning of another leg down in the secular bear market.

Here’s what I think is probably going to happen. Both camps are going to be right, but they are also going to be wrong. Let me explain.

First off there’s no question we are in a secular bear market. One that still hasn’t reached true secular bear market bottom valuations yet. In that context yes the market is going back down. Let’s face it, all the printing didn’t stop the bear last time. All it did was give us a temporary high followed by a much bigger headache than we had to begin with. Does anyone seriously think the same formula only 1000 times bigger is going to produce a different result? Well I guess Bernanke does, but in his defense I think he’s probably insane. In any case I can assure you that it will not achieve a better outcome. As a matter of fact it’s going to produce an outcome many multiples worse than what we just went through.

So yes, we are going back down eventually, but to think that the trillions of dollars being pumped into the market is going to only produce a meager 10 month two leg rally is probably unreasonable. We’ve already seen those multi trillion dollars produce one of the most violent rallies in history. I would say the odds of this bull market ending here are slim. Especially considering that Bernanke has no qualms about printing another trillion or two or twenty if need be. No, I think the bulls are going to be correct on the continuation of the bull. Where I think they are going to be wrong is the speed in which this bull unfolds. I’m beginning to question whether the next stage of the bull is going to “slow down” like it did from `04 to `07. As a matter of fact I think there’s a decent chance the massive liquidity condenses the rest of this cyclical bull into one more leg up that may take the market close to the old highs.

Bull markets tend to see the most rapid advances at the beginning and end. The first leg up tacked on 300 points. The second leg 200 points. Is it really all that hard to imagine another move of 300 points over the next 4 or 5 months resulting in a three legged bull market. I’m guessing that no one is expecting that scenario. Most bulls are hiding in the corner right now and most of the bears are planning for Armageddon. Both will be completely unprepared for a third powerful push higher. I’ll also say that no one will be prepared for the massive catastrophe that will surely follow.

GETTING CLOSE

The waterfall decline the market is experiencing is now in the second leg down. These second legs tend to burn out fairly quickly, usually lasting from 3-5 days.

Friday was day two. So I don't think I would be looking for a bottom just yet. Probably Tuesday or Wednesday are more likely targets.

We are getting close though. Sentiment is pushing extremes that were last seen at the March bottom on some indicators. The dumb money sentiment is now at levels lower than it was at the July intermediate cycle bottom. Smart money sentiment is now more  bullish than any other time during this cyclical bull.

I have to ask which side of the tracks would you prefer to be on? The side that trades based on emotion, charts and guesswork or the side that controls most of the money in the market and trades based on logic, inside information and statistically data?

Longs need to be prepared to hold on through a few more ugly days  though, as I expect the S&P is going to tag the 1040ish level before this selling climax exhausts itself.

It's not unusual to see an exhaustion move on the last day with a big intraday reversal. And once the bottom is in the snapback rally tends to be violent. Usually recovering all of the second leg down very quickly and if the market is in a cyclical bull like this one is, then it's usually not long before all the losses are erased and new highs are seen.

Actually the odds are very high that we will see new highs within a month. During the last intermediate cycle low in July the market was back at new highs 9 days after the final bottom was in.

We are already seeing signs of institutional buying on down days. Almost always a reliable sign of an impending bottom.

The average gain out of an intermediate cycle low is between 6% and 10% for the initial thrust out of the bottom.

So while I expect the next couple of days to be pretty ugly the rebound after the selling climax exhausts itself tends to be fairly violent.

WHAT DO YOU BELIEVE?

I've found that one's belief in an asset tends to be directly proportional to how well they time their entry. Just as an example let's say you are still in cash waiting to enter mining positions. I'm sure there are some in this position. My guess is that those people are drooling at the mouth waiting to get in. They believe!

Of course on the other side of the spectrum we have the guy who entered at $1225. This guy is freaking out. He's knows for a fact that the secular bull is dead. He can't wait to get out!

Now let me ask you this; pretend you have no position at all. Would you be a buyer or a seller of gold & miners at this level? If you would be a buyer with no position why in the world would you be a seller with a position?

Weirdly enough  a short seller will be more confident in his position at the moment of entry. The exact time he has the most risk, than if he's already into profits by a healthy margin.

So if you sold gold short at $1225 do you add to shorts here or are you looking to cover at these levels?

It's all in what you believe and that belief is heavily influenced by the accuracy of your entry.

WATERFALL DECLINE ENDGAME

The markets are entering what appears to be the second leg of a waterfall decline. I've noted in the past that the second leg of these kind of moves typically last 3-5 days. Yesterday was the first day of the breakdown out of the consolidation so if history is any indication we should see at least 2 more down days before this ends.

As strange as it sounds since I'm long, I want to see this move complete. I need to see this drop at least -8% peak to trough to be sure this is in fact the correction separating the second leg of the bull from the third.

I do expect at least three legs up in this bull market. Under similar conditions the Nikkei in the 90's managed at least 3 uplegs in each cyclical bull.

If this does continue it will confirm that this is in fact an intermediate degree correction. The initial thrust out of that kind of low once the selling pressure exhausts tends to be fairly explosive averaging +6% to +10%.

A further corrective move would also confirm this is the bottom of a very stretched intermediate cycle that started in July. That would open the door for another 10-15 weeks of higher prices before the next cycle low would be expected.

It would be much easier for the second stage of the C-wave to unfold if it doesn't have to fight a declining market.

GOLD BUBBLE?

The talk today is all about George Soros call that gold is in a bubble. First off let me remind everyone the Soros isn't an idiot. He's one of the most savvy investors in the world. I expect George knows what a bubble looks like and what it doesn't look like.

Currently less than 25% of all professional money managers have ever owned gold. Does that sound like a bubble?

I'm just guessing but I doubt that 1 in 100 average Joe's have ever owned a gold coin. (I'm being generous. I suspect the true number is less than 1 in 10,000). I doubt 99% of the population has ever even seen a gold coin. Does that sound like a bubble?

During the housing bubble it wasn't unusual to see people camped out overnight waiting to bid on real estate. Sometimes the builder hadn't even broken ground yet.

Has anyone seen a line in front of the local coin dealer waiting for the doors to open lately? When you do then we can talk about a bubble.

I suspect that wily `ole George is interested in knocking the price down so he can buy in at cheaper prices because I'm pretty sure George Soros knows what a real bubble looks like and it ain't gold.