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Which Way the Volumes

The gravity theory applied to stocks: if there is no volume, they tend to fall (Bruce Stratton)

I'll buy that, with caveats; like in the short run they can drift upward too.

However, it's obviously true that in a bull market volumes invariably must return to the upside by definition. In contrast, in a bear they don't have to return at all, theoretically, except as a hook - when some longs want off for instance. In some isolated cases I have seen stocks fall by up to half before a material bid showed up to allow anyone with a sizeable position out. But it is rare.

For the most part, bear markets produce high volume selling panics and climaxes regularly depicting a circumstance where everyone is trying to get out at the same time, through a crevasse. Still, that doesn't refute the gravity theory, or what it means.

It only proves that there is indeed a price for everything, or more accurately, a price at which exchange is always mutually beneficial; where sellers find buyers or vice versa, buying and selling for different reasons - short term, long term, their outlook for earnings, interest rates, politics, or whatever. If that were not true then selling panics would probably be volume-less, all the way to zero. The lack of volume says nothing about the main trend; the way prices behave relative to it is more revealing - as to which way the volumes are likely to manifest when they arrive for instance.

Volumes have been declining on the NYSE all year long, this week marking their lowest yet. Monday represented the lowest regular session volume of trading in almost a year.

Nobody knows quite what it means, but they are quick to write it off as summer doldrums. However, we think it is reminiscent of something more, like perhaps an extended summer past the election, or an imminent reversal.

Whereas the market rallied on bullish earnings news AFTER three of four quarters last year, this year the trend has been to sell the news.

Applying the law of diminishing returns to the art of speculation we could argue on that basis alone that there is not going to be as many traders willing to take out a bullish bet on the next quarter - particularly since the quarters represent increasingly tougher comparisons and stocks are priced for success anyway. And that's besides taking into account the uncertainty related to the election both politically, and in terms of a potential act of terror surrounding it.

Don't worry about the last part though; the chiefs say the world is a safer place today. On the other hand, seasonal factors and history suggest the odds are almost good for a pre-election September rally. And heaven knows that if it can be influenced, it will be tried. I'm not sure it can.

So far, it has been an awful year for most (but not all) stocks - including the gold variety - which is what we expected to some extent in our forecast for 2004.

To be sure, we didn't expect gold stocks to LEAD the Dow, as they have been doing even in the short term inexplicably, or for the gold sector correction to last this long.

Our concern was just that the gold sector was overbought and vulnerable to a broad market rollover, which we were also forecasting during the last quarter of 2003. Notwithstanding the fact that we did not get our bounce in the gold shares - since writing that the worst was over in April - and that our 2004 gold price target remains elusive, the price extent of the correction in gold and gold stocks has remained roughly within our expectations& perhaps a little steeper than expected.

Originally, I expected the $390 handle to provide a floor, and for the HUI to find support at about 200. Gold itself has held up better than the shares in this correction, which is precisely what we were calling for as early as last September.

The surprises in my view include the fact that gold prices did not confirm our upside targets (like the gold shares did and which they were discounting at their highs); the broad stock market has fallen too slowly to matter to the dollar; the relative strength in the SA Rand (up to last month at any rate); and bond yields seem to have remained somewhat more capped than I expected.

Almost nothing else that occurred in the big picture was much of a surprise except for maybe the collapse in the grains complex this year, and the resilience of bank stocks in the face of a serious uptick in litigation related write offs. But owing to the misconception that bank stocks are safe, perhaps we should view their recent strength as a defensive maneuver.

Most of the broader action would still confirm the bearish case.

Technically, the broad market averages failed to reverse their primary bearish sequences. The reversal points (or controlling bear market variables) for the Dow and S&P are their March 2002 highs (see graph above) - which represent the last lowest highs in the primary bearish sequence.

The nine month long bear market rally that began last April was no doubt the best bullish retort since the bear market began; but it stopped just short of relinquishing the reins from the bears. What's more, the implied technical objectives of that move - measured on the basis of the size of the preceding bottom (Jul '02 - Apr '03) - are a fait accompli.

Most sectors have turned down now; the only bullish trends left have been occurring in the Commodity related (ex gold), Building materials, Steel, Household products, Energy related issues, the Transports (ex airlines), and the Utilities stocks.

Most breadth indicators peaked in March, and other internals have begun to erode now too. The New high/low indexes for the NYSE, AMEX, as well as for the NASDAQ peaked between April and June. Perhaps the most bullish thing we could say about the market is that the bearish sentiment appears sticky - as you can see in the put/call ratio here (a reading of more than 1 implies too many bears, while a reading of below 0.60 usually means too many bulls). What the bear market would undoubtedly like to see is a crumbling of this wall of worry that the bulls are climbing right now - the kind of shake out of pessimism that only a good rally can bring.

The market's intermediate technicals being what they are, a push below 0.60 at this point would provide an incredible sell signal in my opinion.

The intermediate sequences have certainly turned down for most of the important stock market averages: the DJIA, the S&P 500, 400, and 600, as well as the NASDAQ and Russell, and along with some of the key foreign indexes especially in Europe; all of them extended their six month intermediate bearish sequences in August.

The NYSE composite, Dow Transports & Utilities, and the AMEX averages have resisted this downtrend so far, but I'm not sure if it refutes our main point, that the bullish leadership in stocks is getting narrower and weaker. Besides, the fact that they haven't made a lower low bodes well for the argument that they're topping.

Further, the lower lows the other averages have made are significant in their own right. In the case of the Dow Industrials, the bulls are struggling to hold 10000 for instance, which is an important psychological barrier. But in terms of the big picture, the action is regressive, meaning that most stocks are moving back towards their underlying trends rather than influencing them.

The hard part is figuring out what happens next. In other words, now that we've regressed to trend in most all markets, which ones will reverse the trend and which ones will confirm it? Our gut says that the bulls want to try and rally this thing sometime in September, but that they'd fail because the dollar would fall apart on them - or at least that's what gold is telling us by bouncing strongly off its primary trendline.

Look at That, "Everyone" Was Right
The controlling fundamentally psychological variable right now has been oil.

The markets are grappling with the meaning of the oil rally for the economy, profits, the dollar, and stock prices. We've discussed this in recent issues, but suffice it here to say that what it really means is to rebuff the Fed's assertions of low inflation and price stability - to strike at its ability to manage long term inflation expectations in other words& and hence to reaffirm the trend that has displaced stocks as an asset preference. In any case, our view on oil at the moment is that this oil correction was overly telegraphed and that it is going higher yet. The lethargy in stock prices could be evidence of this potential truth.

Our original target for this oil move was $50, but the momentum in the chart among other technicals suggests that while we're indeed close to a top of an intermediate sort, the ultimate high in this move is still likely to be somewhere over $50.

It is probably too early for the geopolitical risk premium to erode, but also, only temporary rhetorical factors have knocked it down so far. If one were looking for a catalyst that could draw fresh selling volumes into Wall Street, and they bet on the main trends, it is clear that oil is still in the game. Support above $42.50 in the oil contract reinforces this outlook (intermediate bullish support is closer to $38 but if the market went there it would weaken it).

If the latest slip through Dow 10000 signaled the end of the bear market rally, then the bulls should have trouble getting through 10250, turn south, and head for 9600.

Watch for this to happen next week.

If it does, chances are that the pre-election rally gambit is off.

In order to get a good rally in the Dow, I would suggest the bulls must show better signs of support around the psychologically crucial 10000 handle first.

So far we can't say the tests have inspired any kind of bullish confidence because volumes haven't arrived. The key, obviously, is to guess which way the volumes will come in, and when they'll return. More than likely trading volumes will stay relatively quiet until after the election, reflecting investor's preferences to not put on any significant bets beforehand - except if there's a unique buying opportunity of course arising from the sudden cancellation of bullish bets.

The bear market case for stocks in our view is that valuation multiples continue to incorrectly reflect the new economy / goldilocks monetary environments of the past rather than the increasingly conspicuous emerging bearish monetary trends - gold, dollar, and interest rates - which suggest that the profit boom is anything but genuine or sustainable. All it takes to thwart an election rally is for a few more persons to catch on to this, and any further gains in gold or oil, or unexpected weakness in the dollar could do it at this point.

Divergences in Gold/Dollar/Gold Stocks

The US dollar too has regressed back to trend. But unlike gold, which has been trying to extend its trend, dollar bulls are struggling to reverse the bear market trend in the trade weighted dollar index that the gold action continues to anticipate going forth, downward.

Traders have done well to key off gold's leadership in the past but one can never know for certain whether the correlation will hold good in the future. In any case, the technicals in dollar/gold are divergent. And in spite of the dollar's bounce and gold's sharp pullback on Friday, gold shares continued to rally - closing up on the day. The action is puzzling because it is encouraging to the bullish case for gold yet the dollar appears to want to extend its gains on the chart too.

But we must remember I suppose that the gold share indexes - unlike gold - are struggling to get back above their 200-day moving averages.

To the extent that they don't, for those that believe gold shares always lead gold prices, it confirms the bullish action in the dollar, and consequently, holds out a warning sign for gold prices. On the other hand, should the HUI break out through 215 on this run; it would provide an excellent sell signal for the dollar, and buy signal for gold.

I hasten to add that for now, gold shares are essentially confirming gold's strength with higher short term highs of their own; and also that even though in hindsight it is obvious that they did not confirm gold's new highs in January (thus stopped legitimately acting as a leading indicator), that their charts certainly looked bullish at the time and no one could say with certainty that they weren't going to continue making new highs based on the charts alone. There were no obvious bearish patterns - we were just selling into strength and on account that our targets were met.

The patterns were all bullish until gold turned down itself. In fact sentiment was so bullish that typically smart people said the most stupid things I distinctly recall - like gold shares were so strong that even a stock market crash couldn't hurt them. We're all a little less sanguine today.

Conversely, today, as in many past instances of like corrections during the bull run in the gold sector to date, the patterns look bearish - or they did up until a few weeks ago when gold broke up through $400 and ended up putting in a higher short term high too, which in my opinion totally rejects the previous bearish interpretation of the gold chart; the double top hypothesis.

I believe that in a bull market it is the bears that are deceived and vice versa. We have watched bearish patterns in gold stocks resolve bullishly all the way up.

This correction was more severe than the rest, and a key trendline was broken by the HUI. It was steep enough to encourage us to add to our long term holdings just before summer, but I think it was also a warning shot across the bow for early next year perhaps.

Our current outlook is that gold shares will outperform gold in the short and long term, but we're still not so sure about the medium term - one year outlook. My target for the HUI before yearend is 260-275, and for gold it is still $475-$500. After that anything could happen, including an even greater gold sector liquidation (percentage-wise) than anything we've seen so far. Or maybe not.

We don't know.

One obstacle for our short term outlook that I foresee is a psychological one. The new central bank gold sales agreement goes into effect at the end of next month, and I wouldn't be surprised to see some fears surface. But we feel they'd be unwarranted because the banks aren't likely to sell until after the election unless gold demand rages due to some unexpected financial shock.

Moreover, besides the bullish seasonal factor, there is also the expectation that the Asian central banks are going to be looking to beef up their gold reserves over the next few years. And as we suggested in a recent report, they aren't likely to come into the market until the other central banks start selling. Still, intervention is the most bearish factor for the near term gold outlook - whether in gold itself or on foreign exchange markets. Our strategy is to be overweight bullion itself.

Aggressive traders can trade bullion through futures markets, conservative investors could buy it in physical quantities. Anyone in between could buy a "covered" bullion trust for exposure. We have recommended the Central Fund of Canada in the past, which trades on exchanges in both Canada and the US.

But the fund trades at an expensive premium to the underlying asset and has been accumulating silver - we're more bullish on gold from these levels.

So my preference has swayed towards the Central Gold Trust, which trades only on Canadian markets as far as I can tell (TSX symbol is GTU.UN), and which only buys gold.

The liquidity pales in comparison to the CEF though, so it's probably only appropriate for individuals - provided it meets their risk profile and financial circumstances of course.

Both are essentially closed end funds, a little riskier than owning bullion, but not as risky as a bank stock in my humble opinion.

The Significance of the Embry Report on Manipulation
Just when I was starting to persuade myself there was nothing new to write about, investment manager Sprott Asset Management published John Embry's endorsement of GATA's claims that the manipulation of gold continues to exist to this day. This has significance for a few reasons.

As manager of the Royal Bank of Canada's precious metals fund (which was the best performing fund in North America while he managed it) John Embry first broke his silence on this view in a confidential letter to clients that the Royal Bank later repudiated. He then migrated to his current post at Sprott to manage their gold fund.

The current publication (Not Free, Not Fair: The Long Term Manipulation of the Gold Price) is his first fully public expose - and hence the first real endorsement of the suppression scheme by an industry insider - since.

But there is an even greater significance& its timing.

The money center banks took a big hit in the second quarter as they wrote off billions of dollars in future litigation costs. Citigroup announced it would settle on WorldCom litigation by providing a $2.65 billion aftertax fund for investors to claim "without announcing any wrongdoing." I guess it's cheaper that way.

JP Morgan too wrote off $3.7 billion to its own litigation reserve in the second quarter, increasing it to $4.7 billion. Management trumpeted its earnings as if that reserve would never be spent. But it did not attribute the increased reserve to anything specific.

In its 10Q, Morgan listed litigation related to Enron, WorldCom, the failed issue of (CSFI) debt, IPO allocations, research-analyst conflicts, some contingent liabilities and regulatory infractions associated with Bank One, and "other legal actions." Now, Morgan is one of two defendants (Barrick is the other) in a price fixing case brought against it by the Blanchard group. But NOTHING was mentioned about the case in its 10Q or elsewhere.

The omission was powerful enough to catch my attention because I had heard nothing on when the next hearing was going to be. And as far as we knew it was still on - after the Judge had denied several dismissal motions by both defendants as recently as May 2004. Blanchard's people confirmed that the process is still in discovery, but that the next hearing is scheduled for September 1st. That's right, Wednesday.

So the banks buff up their litigation reserves just ahead of this trial without alluding to it, and at the same time, the Embry report comes out& just a week ahead of the hearing. Hence, the second significance of the Embry report, which essentially supports Blanchard right before the hearing.

Now, the reason for Morgan's omission might well be that they regard any reference to it as potentially inflaming what they perceive as an incredulous claim. But, as any Austrian Schooled economist would know, a decision not to act is also a meaningful action. In this case it is so.

By deliberately managing the significance which the public attaches to the case, it is by definition more significant than the notes to the financials suggest. If it were truly insignificant, the note would be but a helpful disclosure. What is significant is that the capitalization of JP Morgan's litigation reserves is enormous by historic standards - representing more than 10 percent of annual revenues. The banks are spending an enormous amount of money to settle charges of manipulation or regulatory infractions against them, without admitting any guilt.

Outstanding accomplishment.

Even more outstanding is that the press regularly talks about how the central bank manages interest rates, how the government manages certain commodities and currencies, and how bankers/brokers are guilty of one infraction or another, increasingly many. Why on earth would anyone suspect these blokes to be guilty of manipulating anything let alone gold? Incredulous, as they would say.

Even more incredulous is how many people don't know why.

Mr. Embry sums it up nicely in his expose:

The mere suggestion of gold price suppression draws ridicule from the detractors of gold who deride any notion that the gold market is anything but totally free. The words that evoke the strongest emotions with respect to this issue are "conspiracy" and "manipulation". A gentleman by the name of Brian Bloom attempted to explain the situation in a recent essay in which he stated, "I want to differentiate here between the meaning of the word 'manage' and that of the words 'conspiracy' and 'manipulate'. The latter are emotive words that imply joint clandestine action, or anti-social behavior, whereas 'manage' implies joint overt and legitimate action". He then went on to add that "there is no secret that the world's central bankers are involved in 'managing' markets", suggesting that they were acting in the best interest of society and therefore their actions were justified. While appreciating Mr. Bloom's attempt to clarify the matter, we at SAM are not terribly interested in semantics, believing that markets are either free or they are not free, irrespective of what terms are used to describe their lack of freedom.

I cannot make any predictions on the outcome of the hearing. My optimism is restrained by the many facts of life. I would consider it a wild card. But victory for gold bulls - in this case - need not even come in court. It's the publicity that'll hurt.

Therein lies the third significance of the Embry report, an offspring of the second no doubt. The omission of this particular litigation from Morgan's 10Q plus the confidentiality agreements that Morgan has enforced on all parties in this case is enough to suggest its significance is greater than it appears, and perhaps greater than even we imagine.

In summary, the report and hearing are probably bullish events for gold. The reason I say that is not because I think Blanchard might win, but rather, because hardly anyone was aware of the hearing date. A gold rally hasn't materialized on this basis yet.

Thus, unless the case is thrown right out of court, it is probably bullish.

The Naked Truth
How many different ways can there be to write "buy gold"?

Before this decade is out it will hit our $2000 mark, and nobody will remember that we were one of the very first to call for it because there will be thousands of forecasts calling for much higher numbers by then& by the nation's blue chip analysts no doubt.

More and more people will be right as the gold bull gets on. Ultimately, who was first won't matter 'tall. In this business, the saying goes; you're only as good as you're last trade. Hence, traders live and die by the margin, both literally as well as in the context of utility theory.

That also applies to newsletter writers, analysts, money managers, and gurus - a guru is one of the aforementioned that happens to get on a good roll. However, in this business, as almost any other, taking losses is an inevitable part of any successful trading program.

When I tell people that, specifically those that are new to the investment scene, I often get a blank stare. They don't know whether to believe me.

I've heard countless "stories" about this or that person that has traded and never lost; but after 20 years in the industry I have yet to meet any single one of these gurus. Of the thousands of industry professionals and clients that I'd ever met or spoken with, not one has avoided taking losses. In fact, whole books have been written on the subject that the biggest key to trading is knowing to cut your losses. Just imagine how rich one could be if they profited from every single trade they ever made.

More relevantly, imagine the kind of discipline that trader would need to avoid the inevitable loss - each trade becomes harder and harder to contain the ego! In this business, prior success begets losses more than any other factor.

Without fail, I have heard such tales from only two sources - from those with little experience, and from those that promote something. And without fail, one of the leading causes of failure in the business of investing or trading is the inability to realize mistakes and to take losses.

A good trader is merely someone that is capable of perceiving his/her own weaknesses and strengths; a bad trader does not have a handle on his own worst enemy.

This came to me through experience, but also, there is a story. A long, long time ago, when I was still a buck, my passion to excel at this sport led me to cold call one of the nation's top traders. I did not expect to get through, but I did.

My goal was to find a way to work for him despite the technical barriers in my way - geographical, qualifications, good looks, etc. His name was Ed too. Paraphrasing because my memory on it is vague, I said something like, "Ed, you're an icon (I may have said acorn) and I want to be one too." He replied, "well, then what you've got to do is go stand in front of the mirror all day in your birthday suit, then call me back." I did, at least for half an hour anyway.

I stood there, puzzled and bored, wondering, how the hell am I going to beat my competition standing here naked? I started to think the guy had pulled the wool over my eyes - that he must be rolling around on the floor thinking he got some young pup to run around nude all day in search of the holy grail of trading. Hah, hah, hah. As it happened, he wasn't accessible, which confirmed my fears that the joke was on me.

It wasn't until years later that my epiphany came and I finally understood why I had failed the test. I didn't understand that what he was really telling me was that the defining characteristic of a good trader was one who could withstand looking at all their own flaws. I had figured that out the hard way.

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