Below is a study that originally appeared at Treasure Chests for the benefit of subscribers on Wednesday, November 15th, 2006.
Originally I intended to publish only a portion of the study below. But then it occurred to me many of you are not aware of the full array of daily services provided for subscribers at Treasure Chests by both Dave Petch and myself. And while I will not go into all the details right now in consideration how long this read is already, I did want to point out that on top of more concise and comprehensive macro-related pieces that appear on the site weekly, once a month you can look forward to a monster like the one below. So, give it a read. And if you like what you see, give us a try. I'm sure you will not regret it. Here we go now.
We are going to do it again. We are going to write about that thing that never happens. We are going to write the financial calamity that so many others also write about, but never seems to arrive. And I must admit, to the average Joe out there who just stumbles through life simply reacting to the next stimulus in front of his nose, all this talk about a 'grand reckoning' at some point in the not too distant future must seem a bit overdone considering it never arrives. And let's face it; whether it be a six-pack of beer or a six-pack of Champaign, either is still well within the means of most Joe's right now, even though it may have to be put on credit. So, in the words of Bugs Bunny, we cannot blame the average Joe for asking, 'what's all the hubbub about?' What's more, conformists would say you alarmist types are nothing but 'fear mongers', preying on the frailties of the paranoid because my life is good. I have a job, I have credit, and I'm living well. So what you talking about - boy?
Well, in answer to Joe's question, what we are talking about will arrive one day, as unlikely as this may seem to some today. That's right, what we are talking about is not fiction, or some surreal world reserved exclusively for financial commentators who get their jollies by scaring the begeezes out the paranoid. No, one day not only will the average Joe actually notice the party is over when all the 'free money' (credit) runs out, what will be worse is the realization he's actually on the hook for all that other credit already owing, and based on the current salary of his new job as a bus boy at the soup kitchen, it's going to take about 100-years to pay it off, Japanese style. Of course he would be one of the lucky ones, because many will be unable to find work, and therefore will not be able to make any payments. That will be the reality for many who get over their heads in debt during the party years. These people face the prospect of losing everything. Oops, there we go again talking about calamities that will never happen again right? This isn't the 30's right? Indeed, stop with the fiction right?
Of course the observant man would say that's not fiction. How can that be fiction when it's already happening? Here's the conformist again. Yes, but average house prices are still trending higher, and real estate loans are still growing, albeit at a slower pace. Back to the observant man, who is also an observant financial commentator. He would say while that may be true, at what cost does this surreal prosperity come to us given growing numbers of consumers appear tapped-out? Moreover, he would also say it's unfortunate most will likely never hear the truth, or comprehend the current situation, because most do not understand the nature of inflation, and even fewer understand inflation cycles.
The degree of irony found in the current situation would make for good humor if found in fiction, but because we are talking about reality, and a serious reality at that, one that will affect countless lives in the future at some point, we are not laughing. Oh no, what we are doing is endeavoring to protect ourselves (and you) from the ravages of inflation, where it's this inflation, the inflation of the monetary base that lifts all boats when its rising, allowing the Joe six-pack's of the world to speculate 'if things are so bad out there, why does the stock market keep going up?' In this regard one must realize the average Joe out there does not understand how the system works. He doesn't understand government is in the business of confiscating your wealth, not protecting it. What's more, he doesn't understand government is actually in the inflation business, and that government is in fact the source of inflation through its central bank.
You would of course never know this by listening to what either they or their central bankers have to say about inflation. In this respect there is one thing safe to say about their dialogues however; they are rarely based in reality. Just look at what the Fed had to say the other day. They must be getting ready to really let money supply measures run wild because Bernanke was out telling everybody how much monetary growth rates don't matter anymore, and that policy is only loosely correlated to them now. Again if the situation were not so serious it would be funny in that it appears either the Fed is preparing to flood the system with money, or they are going 'loose in the head'. Either way it's not good long term for anybody.
When things start falling apart however, as this inflation cannot go on forever, then Joe six-pack will want some answers based in reality, ones that will match the more stark one he will then be facing. It's too bad for him however he will have no power to do anything about anything, because those that are overextended in debt will most likely end up being penniless slaves to the bank for the rest of their lives. They will be too busy worrying about where the money will come from to make the payments. Of course at some point they will fail in this regard, and the larger credit system (bubble) will fail, and inflation will reverse course. This is called deflation, and is officialdom's worst enemy, which is why they are putting up such a good fight to defer it for as long as possible. Some even believe it can be put off indefinitely (neocons), but they will discover what others who attempted the same leaned before them long ago, all fiat currency systems fail at some point.
Along the way however, fortunes can be made. And I believe we are at one of those junctures right now as this notion applies to the fate(s) of precious metals. In this respect one must understand that the global financial system under the direction of US hegemony is currently in decline, and that eventually the trend towards a 'new world order' will likely fail, with both local economies and currencies returning to prominence as a desired organizational framework. This is what we expect to see when all this funny money floating around under the guise of foreign currency reserves is reneged on. How would you like it if somebody stiffed you for about 20-years worth of work? That will be a question you will be able to ask the Chinese with reference to US foreign currency reserves in a few years if we are correct in our assertions. That would throw a monkey wrench into the US globalization model, along with a few other things, like the financial markets, dollar ($), etc.
Moving into a look at the markets now in an attempt to define how we can benefit from all this, or perhaps a better way to look at things is 'how we will survive the onslaught', it's a good idea to know where you are in the 'big picture', which was partially the purpose of that rather verbose rant above, because not knowing this could have one zigging when you should be zagging, and that could prove expensive. Here, what we are referring to is the relationship inflation has with financial markets (internals), and how these relationships actually produce price trends in the various markets in which we participate. As an example of what we mean, lets pick a constructive situation, one we can expand on afterward as a practical application in bringing us closer to our ultimate goal, which is figuring out what to do with our money moving forward.
Turning this corner then, what we are referring to in the above is that accelerating monetary inflation, which happening now, will have different effects on different markets at different times, and it's generally a good idea to know where you are in the larger sequence, even if one is a long-term investor, and even if only in timing portfolio additions to participate in the trend. Of course at times it's also a good idea to contemplate retreat as well, because while it's true inflation generally tends to lead to higher prices in equities, sometimes there are lags (and failures), especially if investors in mature market environments have been gaming prices higher in anticipation of inflationary effects (rising prices), and are placing excessive bets on what is perceived to be a guaranteed outcome.
In this respect, say for example sentiment regarding US stocks was to turn pervasively bullish soon (it's bearish now), as evidenced by open interest put / call ratios on the major indices falling, but money supply growth rates were to turn noticeably higher (due to a weakening economy), where they have been drifting lower for some time. This is in fact what is happening right now. Here, it's important to note that even if more a result of bearish speculator exhaustion than anything else (investors are not actually bullish, but the bearish ones are exhausted), where the opposite was true for so long, and with this working to support prices while measurable monetary debasement rates were subdued (think M1, M2, MZM, etc.), just because the Fed starts stepping up the process, don't expect stocks to cooperate right away if sentiment doesn't cooperate as well. This is because sentiment will have a more dramatic effect on prices than monetary growth rates for a period of time, especially if a market was stretched too far to the upside for a long period of time. (i.e. think bubble.) We got a good taste of this in the 2000 - 2002 sequence, where it took the Fed dropping rates to 1-percent and heaping doses of monetary inflation evidenced across all measures to shock the patient back to life that time.
And guess what, wouldn't you know it, right now the stock market appears to be repeating history for obvious reasons, where as the economy appears to be slowing, more stringent inflation measures are taken by monetary authorities while investors are still betting on a bearish outcome (as evidenced in record high short sales and still lofty put / call ratios), which is sponsoring another short squeeze (and bubble) in stocks. Of course eventually process will take its course, where bearish investors will become exhausted after being squeezed one to many times. This scenario is what appears to be approaching, and at a minimum will be very similar to that of the more recent 2000 -2002 corrective sequence (crash) associated with the technology bubble, but on a broader scale. [i.e. this time the blue chips, real estate, and the economy could suffer Super-cycle (big) corrections as well.] What's more, because of the likelihood this is a higher degree turn from an Elliott Wave Theory (EWT) perspective (possibly Grand Super-cycle Degree), what may be seen afterward is a post bubble pattern better compared to that of the 30's and 40's. (i.e. the last such example.)
Focusing on this sequence then, the '29 top in stocks can be compared to that of 2000 in that public participation rates were high in both instances, with the manias grounded in the new technologies of the day. But past this, it gets a little tricky endeavoring to identify similarities found in the 30's from an EWT perspective across all pertinent measures, as the Dow is only now hitting new highs in the current Super-cycle sequence. This is of course why we are likely witnessing a Grand Super-cycle Degree top in stocks, real estate, and the economy. It all just fits too neatly together in my view, from the globalization of the world's economy to the crescendo of the oil age; it appears the human condition is in for some radical changes coming up. How we progress past this point over the next 5 to 10 years in the stock market doesn't have to diverge to far away from the experience witness in the 30's and 40's however, where the similarity of the current pattern in the S&P 500 (SPX) compared to that of the Dow back then is also too close to ignore. Of course the Dow is very close in this regard as well (not surprisingly), but because we want to show you some technicals specific to the SPX below, we will focus on it for now.
In this regard, Figures 1, 2, and 3 of the attached analog charts show that whether one is counting in calendar or trading days, if history repeats in measuring the extent of the current bullish impulse in US stocks, this coming March should produce a profound top in the market. What's more, and as alluded to above, this picture also fits together in looking at the technicals associated with a weekly snapshot of the SPX in that Fibonacci resonance related signatures present on both Accumulation / Distribution (Accum / Dist) and On Balance Volume (OBV) Indicators (both key internal strength measures) appear to have more upside before being fully traced out. Add to this the Relative Strength Indicator (RSI) diamond breakout, which should sponsor a meaningful impulse, and a very strong case can be made for the SPX to take a stab at a double top before it's all over. Notice an anticipated count and projected patterning that should lead to a double top in coming months is also shown below. (i.e. if it's going to happen.) (See Figure 1)
More recently I was under the impression this scenario was unlikely given volatility, as measured by the CBOE Volatility Index (VIX), does not look like it will remain contained until next year, and I took that as a sign this necessarily meant stocks should be topping sooner, like anytime now. But, what I failed to realize is that only a 'loose' relationship exists between volatility and price these days as evidenced by the fact the SPX / VIX Ratio did not top out until August in the 2000 sequence, where the SPX itself topped in March. Here is an updated view of the weekly plot of this ratio showing just how close we are to appears to be a lasting top, again, if the 2000 sequence is a good guide. (See Figure 2)
In putting all the pieces of this puzzle together however, as mentioned above, just because this ratio (relationship) may be turning a corner doesn't mean prices will peak at the same time. What can happen is volatility can pick up, which could cause even more shorting of stocks, and buying of calls on the VIX (sold by brokerage house volatility insurance specialists), which in itself can bring volatility back down again. We witnessed a good example of this over the past couple of weeks with the December options related ceiling price for the VIX coming down to 12 from 14. This is suggestive the ride in December will be smoother than we thought just a few weeks back.
Add to this stepped up efforts by the 'powers that be' to keep prices rising through interventions in the futures markets and money supply, and I wouldn't be surprised for a minute if the current parabolic move was maintained until March, as suggested above. Furthermore, just take a look at a daily snapshot of the SPX / VIX Ratio, shown below. This is not a chart one sells based on the technical feats it's pulled off over the past year, like the construction of a strong Fibonacci resonance signature that suggests values are heading much higher. (See Figure 3)
Now this is all fine and dandy in terms of speculating when a top in stocks should be upon us, educated as it may be, but what about after the top is in, whenever that happens in coming days. What can we expect from the stock market after that? Is this to be a 'Grand' top in stocks, or should we expect higher stock markets within our generation in coming years? And if this is a 'Grand' top in stocks approaching, then what should we expect out of our precious metals investments as well? These are all good questions that will affect our portfolios, so we will deal with them one by one.
But before we go any further in this regard we just want to say one thing to qualify our big picture view. The 'big unknown' here is 'extent' in terms of how far authorities will go regarding inflation efforts to keep all boats afloat as the current (inflation) cycle matures. Do we see measurable hyperinflationary conditions develop? Is hyperinflation, by definition, possible within a global context? Because we are already witnessing this within isolated situations, do we see more localized hyperinflationary situations develop, which continue to fuel macro-fires (global) longer than seems possible at present. And then there are questions regarding effect. What effect on prices would all this have? Can simple monetary inflation last past a few years with no meaningful economic multipliers in the background to support it? Of course the answer to this last question no, because by nature hyperinflations exhaust themselves rapidly (in just a few years) once this part of the larger inflation cycle arrives. It should be noted we are getting closer and closer to such a condition every day, which is of course why gold should perform well in coming years.
In returning to the task at hand now, which is attempting to visualize what to expect after the impending top in stocks that is most assuredly approaching, after the blow-off, if we are to expect the same as the top in '37 at a minimum, which appears to be a good bet given the tight correlation displayed in the analogue charts attached above, equities will be hit very hard. This should be easily understandable given the actual state of the economy (now a non-regenerative service based economy), as well as from a cyclical perspective, as described above. So if history is a good guide then, and in using the post '37 experience as our primary comparative, the SPX should return to the (crash) lows seen in 2000, meaning in general terms, they should be cut in half from the top. Further to this, it should be pointed out that this would not only be consistent with the post '37 experience, but also the '73 - '74 slide in stocks that is associated with the monetary inflation cycle witnessed during the 70's when the US first came off the gold standard. Here is a snapshot of the SPX spanning the 30's showing an abrupt halving of the index post '37, including the reaction (bounce) higher into decade's end. (See Figure 4)
Source: The Chart Store
What is not shown above however is slide back down to the lows once again into the mid - 40's (war related), or the rapid rise thereafter, which was the discounting of post war rebuilding, all fuelled on a fiat currency credit cycle of course. And there's the rub in terms of what we can expect this time around after prices begin the big slide, where the top witnessed in coming days could be a lasting top then, it's the credit cycle that's the problem, because it's done like dinner, and likely over-cooked. That is to say, unlike the 40's, 50's, and 60's, not only do we not have the likely prospect of a conventional war on our hands that will wipe out a good portion of the world's population to make room for the next generation, if anything, the larger degree credit cycle will likely be contracting for some time after it tops out here, which in itself will not allow the facilitation of asset bubbles afterwards, being the primary factor within the formula. And in applying this understanding into a formula measuring the impending top in stocks we are about to witness, based on the totality of evidence and logic presented above, at a minimum, one should at least be concerned this might be the 'big one' in my opinion.
At the same time however, because this is a 'Grand' top in the making, which is a higher degree than a mere Super-cycle Degree top, one must remain open to the notion authorities will continue to inflate the system sufficiently to extend the present Super-cycle longer than the two previous sequences. If this is true, and as pointed out previously within our work (see Figure 2), if the present Super-cycle extends on trend in only linear fashion past the previous two cycles, then one should not expect to see a lasting top in stocks until January of 2009. Again however, this is all speculation, where one should be prepared for whatever comes through appropriate portfolio planning.
In moving on to a brief look at gold now, with all this background information on the stock market to work with (and where we will employ a look at the Dow as it's the convention in this regard), it then becomes possible to draw relative probability pictures here too, at a point we know it appears stocks are heading for a halving in the not too distant future. In knowing this then, and in assuming the Dow / Gold Ratio is going to unity at approximately 1 if history repeats in the present Super-cycle, if the Dow tops somewhere between 12,000 and 13,000, and then drops to half, we then know that gold is heading for a target somewhere between $6,000 - $6,500 over the next 5 to 10 years, which would please many of you, of this I am sure. To tide you over in the meantime however, below is a gold plot displaying a very tight Fibonacci resonance related (signatured) projection up into the four-digits to get the ball rolling in this regard. (See Figure 5)
Such an outcome of course depends on central bankers being able to continue inflating the credit bubble ultimately, which as you know from our discussions above is questionable. In this respect, and in addition to the above, it must be pointed out that unlike the 30's, and thereafter, rapid population growth is no longer possible given physical constraints present in the world today. In fact, it could be argued just the opposite is more likely all things taken into consideration, like an approaching conclusion to the 'oil age'. Of course as we know it's not that they won't try anyway, simply by inflating money supply through monetization efforts (etc.), but this can only go on for so long as well. This understanding is predicated on the notion whenever the Chinese pull out of the US fashioned globalization model is when it hits the fan for real. Shortly after this the US will likely announce some form of moratorium on foreign debt. Of course on the plus side of the ledger, this is when the intrinsic value of gold (and silver) will be seen in terms of purchasing power. (i.e. 1 oz. of gold could buy you a car, etc.) And if expressed in today's $'s, this could mean gold trading in the tens of thousands, if not more considering its scarcity factor.
And what of precious metals shares under such circumstances, well, if the current harmonic signature remains in tact until the larger sequence is completed (see Figure 8), then only limited deference should be placed on potential liquidity concerns in the broader context, and more should be attributed to the influences of anticipated buoyant commodity pricing, along with the still tiny over all market capitalization in the sector. Did you know that all the precious metals shares in the world can still fit within the market capitalization of Microsoft, which is of course just one company? And by the end of a typical inflation cycle, which is what we are in today, and that's putting it mildly, precious metals shares have typically comprised in excess of 25-percent of the entire market's over all capitalization, meaning that on a comparative basis, the larger degree move is still in its infancy.
Continuing along these lines, and in an effort to wrap things up for this discussion, it should be noted that after their initial 700-percent surge into the mid - 30's as part of re-inflation efforts associated with the 'New Deal', like the rest of the stock market, precious metals shares didn't go anywhere after that for a very long time. Of course the price of gold was also frozen until the 70's in conjunction with this, which is definitely not the situation today. At the same time however, the same can be said about their relative performance during the 60's and 70's bear market, where here too for the most part they simply followed the trend in the broad market.
Fast-forward to today and what do we see? Not surprisingly, precious metals shares have been out-performing the stock market handily since 2000, where we need only look at the Dow / XAU Ratio to discern this, with an approximate 10-bagger (in the shares) from the bottom still in hand. What therefore, should we conclude from these observations concerning precious metals shares? To me, the fact we already have a 10-fold increase in the shares (unlike the last two Super-cycle tops in stocks), along with EWT related considerations (see attached HUI study above), and let's not forget we are now entering a new Presidential Election related inflation cycle, amongst other inflation related positives, and prospects concerning precious metals shares going forward appear quite promising in my books. It's the inflation you see. It's the credit growth, which in turn fuels money supply growth. Of course in periods when we stop getting this (in a slowing economy like now), that's when monetary authorities pick up the pace in currency inflation. And that's where we are now.
And that's when gold out-performs, along with just about anything else people think will escape the inflation. Again, to me precious metals shares appear to be a natural in this regard. What's more, as we know from our larger degree EWT count on the shares, they should be seeing blue skies (big gains) any day now, extending into 2008, or so many are thinking, those under an assumption Primary Wave B of the larger sequence is done. The problem with this understanding is this pesky comparison. Therein, although precious metals shares would be anticipated to both recover and carry-on to projected bullish trajectories ultimately, prior to this occurring, they may have to suffer from a little market risk. But would that be so bad? That's just the way the ball bounces sometimes.
Of course if on the other hand equities remain inflated next year, and the inflation party kicks into high gear, then you will find out why one must keep a good strong core position under present circumstances. This is because if you don't get paid now, you will get paid later, which is what investing in strong secular trends is all about.
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Good investing all.