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Horse Shoes and Hand Grenades

There's an old saying that just about everybody's heard at one time or another, "close only counts in horse shoes and hand grenades", which may be an appropriate descriptor to characterize people's attitude towards the seemingly virtuous cycle of excesses our society has thrust upon itself in an effort to maintain "the good times." Therein, with every "boom" period, a corrective period must follow. The bigger the boom, no matter what element of finance or economy you examine, the more severe the bust afterwards. Based on an inter-market analysis of the United States of America (US) real estate market I have just performed, we may be getting very close to finally seeing some hand grenades tossed its way, which will benefit precious metal investors as a counterpoised alternative. Let me share what I have learned with you now.

There are many bubbles in financial markets around the world at present. None of them are more important right now, in my opinion, than the low interest rate induced real estate bubble in the US. With the stock boom gone bust, investors and individuals seemingly reflexed from one mania to another in real estate, concentrating excessively high percentages of their assets and income into what is perhaps perceived as a "safe haven." This has done much to support the financial system on the whole, as real estate values have appreciated substantially on paper over the past couple of years in most parts of the country, sponsoring a "refinancing boom" as well. Americans, like no other people on the globe, have been spending the hypothetical equity in their homes and real estate investments on consumption at an alarmingly robust and increasing rate. Just look at the growth rate trend in mortgage financing, provided to us by the inexhaustible efforts of David Tice and crew, from the Prudent Bear website. (See Figure 1)


As you can see above, individuals in the US have been on a tear in this regard of late. Now I could take you through an exhaustive/exhausting statistical examination of all the macro-conditions and implications associated with the real estate bubble present in the US today, but that would distract us from getting to the primary purpose of this study, which is to present a meaningful and concise strategy to help you protect your existing wealth, while benefiting from emerging growth opportunities in the precious metals market. In fact, all of the information we would have learned in such an exhaustive study will be present in our conclusions from examining the charts below, as the markets are a reflection of the conditions present underneath the surface of the matrix.

The key assumption underpinning the thesis this work is asserting centres around the trend in interest rates, more specifically long-term interest rates, but not exclusive to the implications associated with short rates. What does that gobbledy-gook mean? It means that if long-term rates were to begin rising into the future as a trend, this would invariably drag rates up all along the curve. This would be a very big problem for real estate values on a cash flow/ability to carry debt basis, which would most assuredly put a sizeable dent into market valuations across the entire spectrum of terra-firma in the US, not just residential property exclusively, not to mention what these conditions would do to consumer spending / borrowing practices on a macro basis, as well.

It is my contention that interest rates are about to start trending higher across the board in the US, and as a result abroad. And although there is no iron clad identifiable causal relation that can be attributed to this assertion, the markets are sending the message this is about to occur. The basis of the understanding one must know in order to grasp the core of this thesis is that dollars are actually a form of debt, and a call on the net worth of the US financial system. Quite the gigantic and growing problem present these days. (See Figure 2)


Why is the growth in monetary aggregates an important factor in determining interest rates? The reason is because sooner or later, and in spite of efforts by some to overt such an occurrence, inflation in the money supply has tended to produce higher prices for commodities. And when one factors in the influence of a declining currency on a particular domestic locale, in this case the US specifically, commodity prices in US dollar terms could accelerate higher at quite an alarming rate. This is not what the doctor ordered with debt levels at perilously high levels across the full spectrum of the US financial system. These are the kinds of conditions that "crashes" are derived from, and indeed that is exactly what I am contending is about to happen to real estate, and financial assets in general, in the not too distant future. This should begin the "waking up" process for growing numbers in the population that life styles are about to be drastically altered for most, and as these numbers grow, more and more of them will seek the safety / hedge provided in the precious metals arena.

How can I be so sure this will occur? Well, you have to know where to look; and, be able to read the signs. This is what I have done below in the chart of the Commodity Research Board's (CRB) broad measure of commodity prices. (See Figure 3)

Figure 3

Deflationists may want to take careful note of the messages contained in the above chart, as while current price / valuation imbalances present in US financial assets (i.e. real estate) are unwound over the next decade or so, liquidity in the financial system will find its way into the commodity sectors with growing force, propelling prices substantially higher in the years to come. It is beyond the scope of this study to talk of the implications this condition will impugn on corporate profits, but I can quickly say its not good. To be forewarned is to be prepared.

There have been numerous theories bantered around recently, as to the primary reason US treasuries have been selling off so dramatically of late. Some have attributed the apparent "key reversal" in long-term bond prices this month to a sell recommendation Richard Russell made recently. While I have the utmost respect for Mr. Russell, as I read his commentary every day, and while some sales could have been triggered because of this, the primary reason treasuries are now declining dramatically in price is because the test of the breakout on the CRB is almost complete. (See Figure 3)

Compounding the probable perilous plight of long bond prices into the future are the burgeoning deficits in the US financial system, which extend the full spectrum of the country's pertinent income statements, and call into question "ability to pay" considerations on the part of lenders both domestic and foreign. For this reason, and the fact that higher commodity prices will only exacerbate these conditions into the future, it is definitely time to give serious consideration to your views on where long bond prices are heading in the US. Correspondingly, of course, this will absolutely destroy real estate values, as higher rates will eat into the consumers ability to pay increasing finance costs, so we had better take a look at the bond chart, to make sure we are on the right track. (See Figure 4)

Figure 4

Special Note: The 30-year Treasury Bond (USB) is being utilized for inter-marketstudy purposes, even though it is understood mortgage rates generally follow10-year T-Notes (UST). It is therefore assumed that both prices and yields ofthe USB's and UST's will trend in the same directions proportionally, and thatone acts as a proxy for the other in this study.

Without commenting on every aspect denoted above, certainly the "big picture" message you should take away at first glance is the symmetry associated with the dual five-year progression sequences that are almost identical in structure. When you combine the totality of the entire move from 1990, you have a classic bearish formation that should release its energy to the downside. Falling bond prices mean higher rates, and once the bottom rail on the triangle above is penetrated to the downside, it will become very apparent to everyone that things have changed for the worse, as bond-holders will be demanding substantially higher yields than present to compensate them for the growing risks associated with holding US paper. This event will be a "death blow" to real estate prices in the United States of America.

Now I know that my views are diametrically opposed to the main stream present in the market, media, and even that of the Federal Reserve (Fed). But, the Fed's jawboning of late, pertaining to their future policy directives only encourages my resolve the above views are correct. They are petrified over the prospects of run-away price inflation, as it will hamper their ability to affect simulative policy, and in all likelihood pop a few more bubbles they don't seem to be able to recognize as they construct them.

Bubbles are very bad things, as essentially they are very pronounced divergences, which means that a certain relationship set(s) have been pushed into an unstable situation (value range). The other important characteristic about divergences is they have a tendency to be corrected abruptly, and with at least equal force and scope in the counter move. When we apply this understanding to the current bubble in the US real estate market, recognizing that future interest rate considerations are not properly reflected in prices as of yet, it becomes more clear property holders are probably in for a rough ride starting some time in the near future.

So how bad is the overvalued situation in US based real estate? Well, if the initial crash target I have indicated on the next chart is any indication, roughly ~ 30% for starters, with further declines in the years ahead, if the Japanese experience is a reasonable indicator. (See Figure 5)

Figure 5

As you can see, I have selected the Morgan Stanley REIT Index (RMS) as a proxy for US real estate values, and a general indicator of pricing conditions across the scope of the asset class. The first message one should take away from the above is that property values have been progressing in well defined and primarily symmetrical sequences over the past several years until recently, when the index shot up through the top of the definitional cell barrier. More specifically, and of utmost importance, one should note that the lunge in prices through the cell barrier is divergent to the trend, and opens a strong possibility that this divergence will correct at least an equal degree through the bottom of the cell barrier, to the ~ 320 area, which would be an ~ 30% correction from present levels. Incidentally, I fully expect the RMS to continue higher for a period, while treasuries consolidate some of their recent losses, with ultimate high values printing in the ~525 area. And as suggested in the study of the chart above, the entire cycle of top to bottom action should occur by approximately the beginning of the second quarter in 2004.

Unfortunately, this is bad news for the average American family. This however, is not the case for investors in precious metals and its related equities. So it would make a lot of sense for the average American to diversify some of his / her assets into the precious metals complex presently, and although the numbers actually participating are probably going to be a small percentage on the whole, this advent can never-the-less have quite a pronounced impact on absolute price gains in such a tiny market. Exactly how dramatic the effect of asset flows contracting away from countervailing opportunities and towards gold, in terms of absolute price gains in the metal, can be measured in the ratio between the two markets concerned. Hence, we will now examine the past volatility characteristics of the Gold / USB Ratio over the past 13 years, in order to aid us in absolute future pricing probabilities. (See Figure 6)

Figure 6

Although not denoted above, one should first notice the overall appearance of the energy structure in the Gold / USB Ratio over the time measured in Figure 6 is that of an inverse head and shoulders pattern. Moreover, if one were to digress all the way back to 1980, the structure is characterized by a descending / contracting triangle, with both formations exhibiting strong upward tendencies once long-term resistance is broken. Looking more closely at what the numerics of the regression / progression sequences impugn for the future, one can state the following.

  • Within the time measured in Figure 6, the descent of the Gold / USB Ratio has been characterized by regression sequences of ~ .5 (phi) from previous sequence lows, and therefore establishes a link of consistency found in other measures pertaining to gold's volatility characteristics and price behaviour. See the attached for comparison / verification purposes.
  • Consistent with the parameters of the Fibonacci based model well established in previous work concerning the gold complex, it appears a progression sequence in the Gold / USB Ratio is now underway, and that confirmation of this occurrence will come with a penetration of long-term resistance denoted above. Upon this development, it is expected we will witness a progression sequence characterized by a coefficient factor of Phi (2X), propelling the ratio up to the 5.0 level sometime in the April of 2004 area.
  • Working off of previous studies placing gold at ~ $500 US per ounce, one would expect the US long-bond to be trading in the ~100 area at the time. (500 / 100 = 5)

As you can see from the above, absolute price targets can be derived utilizing inter-market cross verification techniques, providing compelling evidence it is indeed likely that major trend changes have occurred concerning interest rates and gold. Therein, it can be hypothesized that these trend changes may be long-term in nature, and if this were to be the case, indicative of a potentially significant bull market in gold, and its related equities. Moreover, it is the observation of this author that during periods where long-term rates are on the rise, while in the presence of abundant monetary liquidity such as we have today in the US, increasing proportions of investment capital gradually gravitate into the paper related investment vehicles within the precious metals arena causing a heightened leverage effect compared to the percentage gains encountered in the metal itself. This condition is most pronounced in the early stages of the bull phase normally, and has a tendency to be almost completely removed by the final stages. This is why it is very important for investors to capitalize on the exponential gains possible in precious metals equities at present, because just as money will flow away from bonds in favour of gold in the commodity markets, the same will be true of gold / silver stocks, as they pertain to the stock markets as an alternative to deteriorating sectors.

With this in mind, it now seems appropriate to examine where we are in this process as it pertains to the inter-market relationship real estate based equities display against precious metals related equities, considering the former group is approaching the end of their bull run, and the latter are still in the midst of their primary phase of advance. The primary purpose of this exercise is to help us identify some discernable absolute price targets for the future. In order maintain the established continuity present within this treatise, the logical relationship to measure in this regard is that between the RMS and the Amex Gold Bugs Index (HUI), as this endeavour will not only accomplish the task set forth above, it also allows one to cross verify the findings performed in our earlier studies utilizing the HUI as the measure of precious metals equities within the complex. (See Figure 7)

Figure 7

Within the above, one should first notice that the overall structure is easily identified as that of an inverse head and shoulders pattern. Equally so, it is very easy to compartmentalize the regression / progression sequences in the HUI / RMS Ratio over the past six plus years, as the volatility characteristics have been both fairly clean and pronounced. Without putting to text the obvious attributes already denoted above in Figure 7, lets get right to the difficult part of absolute price targets for the RMS and HUI over the next approximately seven to nine months as follows:

  • Based on the symmetrical proximity of the time cells identified in regression / progression sequences characterizing trend, the HUI / RMS Ratio should attain a value of ~ .43 by February of 2004, which would represent a value for the RMS of ~ 370 (the same level as '97 when the ratio was .43) and 159 for the HUI. (159 / 370 = .43) I doubt you like this outcome if you are bullish on gold.
  • Utilizing a cross verification / inter-market approach (see previous work attached above) with a value of ~ 350 for the HUI as the known quantity in the formula at the same time, a ratio of .43 would produce a value on the RMS of 815. (350 / 815 = .43) Again, not a very likely scenario concerning the RMS based on the full body of our work.

So what do I think is really going to happen based on the numbers we have to work with above? Working with what we have, the one basic understanding you should derive is that precious metals equities have been going up faster than real estate related equities since the end of 2000. With this understanding in mind, and that being the trend, it then becomes a question of velocity, and velocity is a matter of compression / divergence. And if utilize what we have learned in Figure 6, that being gold will likely be trading in the ~$500 area in April of 2004, there's a good chance what I am going to show you below pans out.

If you take a close look at Figure 7, one should notice two significant consolidation / compression building areas within the advance, with the bulk of the most recent trade occurring below .32, which is currently acting as resistance on the straight up and down inverse head and shoulders pattern. It is my contention that once this resistance is taken out, the pace at which the HUI is appreciating against the RMS will accelerate dramatically. And applying the basic formula from the Fibonacci model we have constructed previously, it appears we should expect a doubling of the previous point gain off the highs of the current progression sequence to commence at .32, taking the HUI / RMS Ratio up to the .64 level. Does it stop there? I don't think so.

I think we are about to witness a "melt down" in real estate and it's related equities that will only be a taste of what is to come in the long-term, but we'll leave that for another time. However, this time around will sure feel like the real McCoy if the HUI / RMS Ratio reaches it's full potential for this run. What would that be?

Well, if gold is heading up to the ~$500 area by 04 / 04, and based on our previous work, a corresponding print on the HUI hits a topping value of ~350, that would indicate the RMS would see lows for the first wave down in its long-term / potentially decades long bear market of ~ 272. (350 / 272 = 1.28) Notice, the HUI / RMS Ratio would have to double twice from current levels to make this a reality. (See Figure 7)

Is this realistic? While one can never say for sure, this kind of event is not without precedent in recent history. (See Figure 8)

Figure 8

One thing is for certain; it would definitely be fun and profitable watching price action like that in Figure 8 if one were short the RMS (See Figure 5 for "Possible Extreme Crash Low") and long precious metals.

In conclusion, and fully cognisant we have not covered the full breadth of material necessary to make exacting and statistically verified determinations, it is apparent something significant may be about to occur in US real estate markets that will benefit the precious metals markets. Just how significant? Well, if the RMS goes to 272 off of ~525 over the next seven to nine months, it would almost be halved. Correspondingly, if the HUI were to vault up to the ~ 350 area from current levels, that would be a double.

Impossible? Unlikely? I do not think so based the corresponding historical precedents being forged in the credit markets these days. And if the timing element found in this study has any predictive value, we may be very close to the trends discussed above being set in motion. So be careful out there, as "horse shoes and hand grenades" may not be the only things where close counts, and the real estate markets may not be the only ones crashing.

Good investing.

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