It was a very draining and emotional week. If you invest in stock indices, you were reminded prudence doesn't pay. In an increasing risky environment, the stock market was buoyed by Fed interventions. On the other hand, if you invest in commodities or commodity ETF's, you were reminded that investing in financial assets can be a risky business. Gold had its worst one day drop in over 28 years in what seemingly was a news vacuum.

Prudence: A Four Letter Word

Webster's Concise Dictionary of the English Language defines prudence as: "the exercise of thoughtful care, sound judgment, or discretion; cautious wisdom".

My "sound judgment" or "cautious wisdom" is in recognizing the fact that investing in equities in this market environment is risky business, and it is more risky than normal. How did I come to this conclusion? The data I presented several weeks ago (see this link on Safe Haven: http://www.safehaven.com/showarticle.cfm?id=9655) showing that breaks below support levels while investor sentiment was bearish was compelling enough to suggest that risk was escalating. I have reproduced that table in figure 1, and I have dubbed these times as "price failures".

Figure 1. Table 1. Price Failures

Over the past 40 years, extremes in market sentiment turned bearish about two times per year, and looking at table 1, we note there have been 14 times in the past (or about 20% of the time) where the bounce never really materialized despite the extremes in investor sentiment. And in 50% of these failed signals (or about 10% of all the signals), prices kept sliding further. To me, this represents real risk.

Or to spin the data another way, 80% of the time betting against the herd works and it works with reasonable efficiency. There are times to speculate and times to speculate. For me, the time to speculate was 8 weeks ago when investor sentiment first turned bearish. The current market environment, which has been defined by this price failure, is now a time to sit on my hands.

Although I rarely play blackjack, I often liken my market philosophy to counting cards and betting in blackjack. Despite the extremes in investor sentiment, this is not the market environment where I want to double down. If I was counting cards, I would state, "The deck is not favorable. Play cautiously, bet low."

Ahh, so why is prudence a four letter word? Because being prudent doesn't pay. Despite well defined increasing risks, investors believe that the Federal Reserve will continue to bail them out. Lower prices are seen as either one step closer to the bottom or another reason for Fed intervention. Therefore, lower prices are a reason to buy. Why be concerned with risk when you have a backstop to catch your misses?

For me, this isn't about the moral hazard issue or even Fed bailouts, it is about acting responsibly (i.e., with prudence) in a potentially hostile market environment. It is frustrating to "do the right thing" and not be rewarded for your actions.

I am not complaining, but let's just recognize that this is the hand we have been dealt, so let's deal with it.

So what are the signposts that I am following? In the S&P500, a close back above 1323.87 (which has occurred) is reason to be constructive; for the NASDAQ this level is at 2318.74. A close back above resistance (old support) suggests that the price failure was a fake out. I would then expect market breadth to confirm such a price move.

Risk: A Four Letter Word

While risks are ignored in the equities markets, we are reminded this past week that financial instruments actually do have risks as gold closed lower by about 10%. The Reuters/ Jefferies CRB Index (symbol: $CRB) was down nearly 8%. Surprisingly, this was in the face of what would seem like positive news for commodities as the Federal Reserve continues to show its determination to be the lender of last resort and provide liquidity to the credit markets.

In searching for possible explanations as to why commodities sold off I was particularly amused by those who suggested that the Federal Reserve has become a staunch inflation fighter because they only cut the Fed Funds rate by 75 basis points as opposed to the expected 100. Wow! Who would have thought? Then again if inflation really was contained, one would think that the Fed would have just lowered by 100 bps and there would have been zero dissenters.

Another explanation, which we can put in the "How stupid can I be?....jeez, I should have known category" comes from the Commitment of Traders data. The "smart money" or commercial hedger was net short gold futures while the speculators or "dumb money" were very long. The only problem with this explanation is that the "smart money" has been short gold (to an extreme) since October, 2007 when gold was $750 an ounce. I guess I should have done my homework.

Another explanation offered was that this was the "popping of the bubble" seen in the commodity markets. While there may have been some speculative froth, this is not a bubble in commodities. I would define a bubble as prices becoming extremely divorced or out of balance from the underlying fundamentals. Prices may have gotten ahead of themselves, but the fundamental picture for the commodity complex remains extremely favorable. Favorable tailwinds include: 1) increasing global inflation; 2) currency devaluation and central bank intervention as global growth decreases; 3) negative real interest rates; 4) favorable supply demand as increasing demand is likely to outstrip a finite supply; 5) geo-political pressures. The major headwind is slowing global growth (i.e., recession); recessions are deflationary, but deflationary pressures will be countered by central bank interventions and further currency devaluations.

So why did commodities sell off? Three explanations are offered: 1) prices did get ahead of themselves, but they are not divorced from the fundamental picture; this is the "nothing ever grows to the sky" theory; 2) as a corollary to this theory, the "hot money" may just be rotating from the over crowded commodity space to the lesser crowded equity space; 3) traders may have had to raise liquidity in the face of losses in other markets.

Whatever the explanation, from a technical perspective, I don't see this as an end to the commodities bull market. For gold, there may be an extended period of consolidation or range trading. Support levels can be found at $900, $850 and $825.

To learn more about our quantitative and disciplined investment approach please visit www.thetechnicaltake.com and sign up for our free weekly newsletter and downloads.