DOW THEORY ANALYSIS SAC
Daily Report (1/28/08)
More to Come!

Enrico Orlandini
Dow Theory Analysis
Jan 29, 2008

It was a very interesting week, full of twists and turns that faked a lot of investors out of their positions (and money), and full of intrigue thanks to Bush and Bernanke. We had an emergency rate cut of seventy-five basis points together with an economic stimulus package worth an estimated US $150 billion. I'm giving away my age but I can remember when a million dollars was real money, and now we throw out the word "trillion" as if it meant nothing. In truth I guess it really doesn't mean that much since it's just so many dead trees [Editor's note: Dollar bills are made from linen and cotton NOT trees] and so much printer's ink. If you stop to think about it, we really didn't learn very much from our history. This country began with the Continental, a fiat currency that became worthless in a very short period of time, and now we have Federal Reserve notes backed by the full faith and credit of the US government. When considering the "guarantee", I would like you to meditate on the fact that the US is the largest debtor nation in the world and exercises absolutely no fiscal restraint whatsoever. In short, we've come full circle and I have to wonder what the two plus centuries of sacrifice was all about. We now are left with what may very well go down in history as the most inept administration ever. Under Mr. Bush's leadership, we're mired in two unwinnable wars and may very well end up in a depression. This complete lack of awareness, mixed with a healthy dose of arrogance and greed, has spilled over into the very fabric of society itself. This leads to uncertainty and that accounts for the volatility we now see the market place.

There were warning signs. Two immediately come to mind: the six year rise in the price of gold together with the six year drop in the US Dollar Index. Take a look at their historic charts below:

I haven't done all of the math but I can tell you from experience that anyone who bought gold is 2002, and likewise sold the US dollar short that same year, is a lot wealthier in real terms than any of their friends who chose a different investment alternative. For anyone with financial sense, gold has always been a harbinger of trouble and the so-called smart money pays attention when gold starts to move. Smart money began taking a position in gold way back in 2001 when Mr. Gordon Brown was giving half of England's gold hoard away at the rock-bottom price of US $252.00/ounce. On Friday the February gold futures contract managed to close out the week at US $910.70. As a reward the English saw fit to make Mr. Brown their Prime Minister last year. Go figure!

With respect to the yellow metal, you can see that the price has risen all the way from the 2001 low of $252.00 on up to last Friday's new all-time closing high of 910.70, based on the February futures contract, and it has done so with little or no fanfare. In fact I think that it would be honest to say that almost all movement has been against a strong central bank wind. For example, former Fed Chairman Greenspan has called gold a barbarous relic and was one of the instigators of the Washington accord whereby a group of central banks agreed to sell 400 tons a year in order to "stabilize" the price. Then you have a group of US institutions that continually sold tens of thousands of futures contracts short in order to suppress the gold (and silver) price. Gold has little or no strategic value so it begs the question why spend so much time and effort to knock the price down? Oil, copper, and grains are much more important to the economy and yet we do little or nothing comparatively to suppress the price. The reason gold is manipulated has a lot to do with the fact that people know a rising price signals trouble. Think of it as a harbor light you turn on when rough seas or fog approach. Lately it has been blinking out warnings twenty-four hours a day!

On Friday not only did February gold close at a new all-time high, but it also posted a higher intraday all-time high (924.70) as well as a lower high and has completely recovered from last week's misunderstood 7.2% reaction. There were scary moments on Friday as the February gold fell all the way down to 906.00, down 18.0 from the early morning intraday high, before rallying into the close. Just the boys playing their games and making the new kids pay the price of admission. Actually, February gold was up another 6.0 at 915.80 on the Globex late Friday before everybody went home for the weekend. Decent support is down at 905.60 and really good Fibonacci support won't come into play until we hit 891.40. Everybody keeps on saying that gold is way overbought and a correction is imminent, and if they say it long enough, I suppose it will eventually come true. In the meantime, there is no doubt that gold will see a 931.50 print sooner rather than later and I suspect we'll continue to march higher, maybe even as high as 1060.00. Along the way we'll more than likely see another 7.5% correction that will shake the trees.

Since all markets are forward looking barometers, and gold is more forward looking and sensitive than most, it's always interesting but never easy to try and discern the coming problem. Besides, the perception of coming problems is never a necessary prerequisite to making money in the stock market. For those of you who require a reason in order to sleep better at night, I don't think you have to look any further than the current debt crisis. A number of large American financial institutions took it upon themselves to package and sell trillions of dollars of worthless paper instruments (OTC derivatives) to an unsuspecting world. Whether or not the world should have known better is a discussion left for another day. Every day we see a little bit more of the problem and that creates uncertainty. The markets hate uncertainty and gold is certainly reacting to all of that, but I suspect there is something much deeper. Maybe financially related, and maybe not. Whatever it is, we'll bump into it somewhere in the coming night and it will definitely hurt.

What was interesting about today's gold rally is that it flew in the face of US dollar strength. The March US Dollar Index rallied .24 to end the session and the week at 76.11 as it backed away from strong Fibonacci support found at 75.72.

There is no real resistance in the March US Dollar Index until we hit 76.68 and that really defines the trading range we're in at this point in time. As you can see in the preceding daily chart the Dollar Index is being squeezed into a tighter and tighter trading range, and given the indisputable fact that the greenback is in a bear market, there is a strong possibility that we'll see a significant break-out to the down side. (You may recall that this is the inverse of what happened with gold during the first 7.5% correction.) That downside breakout will occur with a close below 75.30 and should produce a fast and violent trip down to strong Fibonacci support at 71.95. Only then, in my opinion, will we see some sort of decent upward reaction.

To understand the impact of a declining dollar, you need to look at it as if it was the common share of stock of the United States of America. When your share price is on the rise, everything is peaches and cream, but if it falls investors become disgruntled. If it falls too much, they sell en masse and if it continues to fall, you go bankrupt. In my opinion we are about to reach the level where they sell en masse! What can be done to stem the downward tide? It's really quite simple: turn off the printing press and live within your means. Of course such action would almost assuredly drive the United States into a deep depression, but it just might save it as well. Bernanke is a scholar of the depression and most assuredly will not go down this road. So he'll lower rates, somewhere between 25 and 50 bases points this week, and continue to flood the world with liquidity that very few can use. I originally thought rates could fall down to 2.75% but now believe they may very well fall below 2%. Then he'll continue to lower rates and print dollars, driving the dollar down and the US further into an economic hole, until the roof falls in. That's why the markets are reacting so poorly to the Bush/Bernanke bail-out, and that's why I continue to say that it doesn't matter what they do. Bernanke is damned if he does, and damned if he doesn't.

With respect to the stock market itself, the Dow suffered considerably in the Globex sessions during Monday's holiday and we saw that reflected on Tuesday as Wall Street went back to work. The difference being that on Tuesday the decline stopped at 11,637 and just below strong Fibonacci support at 11,638. This was well above Monday's Globex low of 11,456 and is a very good example of why I do not put a lot of stock in what happens in the overnight session.

What I do put a lot of stock in though are monthly charts, and as you can see in the preceding monthly chart of the Dow, it has broken down. You can see the RSI, MACD, and the histogram have all turned down and we've broken the bottom band of the trend line that stretches back to 1982! If you know anything about markets, you'll look at this chart and recognize the beginnings of a bear market. This is what they look like and it will be neither short nor pretty. How do I know that? You do not follow up a twenty-five year once-in-a-lifetime bull market with a simple case of indigestion and then move on to new all-time highs; especially a market so completely bloated by distortions at every level. Most bear markets will have a minimum duration of 25% of the preceding bull market. That translates to a five year decline at the very least. I don't know if this bear market will follow the rules, but I do know it will not end anytime soon.

Early this week, we saw the first coming attractions as the March Dow fell down to strong Fibonacci support at 11,638 and rebounded. I say strong support because it represents a 38.1% retracement back down to the 2002 lows. I told you several weeks ago that I thought it would hold and it did. Now I would expect this market to retrace no more than 61.8% of the decline from the recent 13,650 high and that means a top at 12,811 although there is a decent chance we'll see a 50% retracement and a top at 12,553. Many investors are pointing to the fact that we turned down on Friday after only two up days and saying the reaction is over. Although it's possible, I disagree. The main reason it that the Transports still managed to close in positive territory on Friday in spite of the late day slaughter. Try to remember that the Transports failed to confirm the new lows in the Dow last week and again on Tuesday, turning up before the Dow. The Transports led the Dow all the way down and they will lead the Dow up during this reaction. Friday's 1.25 point rally, in spite of a 171 point decline in the Dow, is an indicator that we'll see some higher numbers before we turn down. Would I buy the Dow? One of my rules to live by is that I almost never go long in a bear market and this will not be the exception to the rule. I will begin to sell the Dow short at 12,550 and then heavily sell the Dow short when it surpasses 12,750. Until then, I will watch quietly.

Now I would like to discuss some of the long term implications of a bear market in stocks. There are two levels of support to be encountered on the way down: those created on the way up from the 2002 low, and those created on the way up from the 1982 bear market lows. They are as follows:

Please note that I highlighted two numbers: 10,795 and 7,665. The former is important because it represents a 50% retracement back down to the 2002 low and any close below it would be a strong indication that we'll test said lows. Likewise, the 7,665 represents a 50% retracement back down to the 1982 bear market low and any close below it would indicate that we are going much lower. It is my belief that a test of 11,638 will produce a rebound up to 12,811 later this coming week and that will in turn be followed by a run down to the critical 10,795 support. I suspect that support will hold and produce a decent rebound lasting 30 to 45 days and recuperating 38.1% of the entire decline. This bear market rally will fool a lot of people into thinking the bear market is over and they will be slaughtered in the ensuing run down to 7,665. I believe we'll see a test of 7,665 sometime by year's end, or early next year at the very latest. My final target for a bear market bottom is 6,089 although this Dow could fall all the way down to 4,327. Only then will an investor find real value, i.e., a PER below 8 and an average dividend paying more than 6%.

Finally I would like to talk a little bit about the ramifications regarding a significant decline in the Dow. As of late it seems that gold is somewhat tied to the ups and downs of the Dow and it would not surprise me to see gold top out shortly after the Dow reaches the 12,811 mark. This implies a top in gold somewhere around the 968.00 mark. Once the Dow begins to head down to my 10,795 area, I would expect to see gold specifically, and commodities in general, deflate.

Once gold tops, I am convinced we'll see a 20% correction. Most gold bugs are now so caught up in the euphoria of the rally that they can't see the windshield coming toward them at 100 mph. The only word that comes to mind is "splat"! Once gold and the commodities begin to correct, you'll have your first indication of what a full blown deflation would look like. Gold, commodities, stocks, and the US dollar all headed south at the same time. I will of course hang on to my gold but I will sell short the grains, oil, and copper as they fall from grace. Similarly, once the Dow tops at 12,811 I would expect to see a significant rally in bonds that take the March bond up to 124.00 at the very least. That's why I will buy the bonds once the reaction in stocks comes to an end. As far as selling commodities short, I see the grains as offering the best opportunity to make money on the down side.

As you can see in the preceding chart, the grain rally has consistently been in overbought territory for what seems like forever. The entire grain complex (corn, wheat, soybeans, bean oil and bean meal) have been on a real rampage and this type of action tends to make investors think the party can last indefinitely. I can tell we're close to a top because CNN and Bloomberg are talking up the grains on a daily basis and the so-called "experts" are saying that grains can/will go a lot higher. They are most certainly right; grains can go a lot higher but first the market will provide them with a little dose of reality. I don't often play the short side in a bull market, but I think the gains here will be significant and well worth the risk.

In conclusion, I am convinced that the uncertainty regarding the future will only increase from here on out and that will only serve to increase the volatility along with the downward pressure on stock prices. We saw similar pressure back in 1997, 1998 and again in early 2002, and each time the government was able to drive the devil away from the door. I am convinced that will not be the case this time around. All of our excesses combined with a complete lack of leadership on all levels (legal, economic, financial, political, and moral) will combine to provide one of the greatest investment opportunities of all time; the ability to sell short the Dow just before the oncoming collapse of stock prices.

Shades of Jesse Livermore in 1907! I bet he's watching.

Jan 27, 2008
-Enrico Orlandini

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