DOW THEORY ANALYSIS SAC
March Newsletter
How Bad Will It Get?

Enrico Orlandini
Mar 12, 2007
written on Mar 8, 2007

If you have any involvement in the equities markets, I'm sure you've noticed that things were a bit rough last week and have yet to really settle down. The reason du jour is China. If you read the comments coming out of Washington lately you'll know that China is responsible for everything from global warming to the common cold. Supposedly they are going to slow their economy down and that will lead to less of everything for everybody. I'm not sure I buy that argument, but it was in all the papers. Right behind China in the blame game, we have what is euphemistically referred to as the "Yen carry trade". That's where you borrow money from Japan at very low rates and loan it out at much high rates. Major players and beneficiaries of this financial version of musical chairs include J. P. Morgan Chase (JPM), Goldman Sachs (GS), and Merrill Lynch (MER) whose weekly chart is included below:

These companies have done nothing but rally for the better part of four years thanks to a central bank generated flood of liquidity the likes of which has never been seen before. Notice how Merrill actually started to roll over weeks before the flood gates opened last week. The carry trade contributed billions and billions of dollars to the bottom line of these companies.

The carry trade is especially lucrative when the Yen is devaluating against the dollar as it has been for quite some time. Unfortunately the Japanese had the bad taste to take away the punch bowl, first by raising rates and then by inflating the Yen. I am not an expert on orient thought but I find it strange, better yet ominous, that both China and Japan would be engaging in this type of behavior simultaneously. I think something, or someone, upset them and they decided to send a coordinated message. It was a not so subtle reminder that the people with the money make the rules and, if I had to guess, I suppose it was directed toward the United States.

There is always the possibility that China and Japan had nothing to do with the market decline. Then what? Well, some time ago I told you that markets are forward looking instruments. Think of it as a crystal ball that actually works. People a lot smarter than me have estimated that the markets are discounting events that will take place six to nine months from now. If the market wasn't reacting to the tag-team of China and Japan, then it has to be discounting the future and whatever it is, it must be ugly. For those of you who are interested, I do have a few ideas. The first thought that comes to mind is debt, followed by debt, debt, and debt. The United States is just swimming in it. On every and all levels: state and local governments, companies like GM with billions in unfunded pension liabilities, trade deficits that are reaching seventy billion dollars a month, and twin wars costing half a trillion dollars a year are some prominent examples. Companies like GM and Ford owe a lot more to their pension funds than they are worth. In the old day's we would have said they are bankrupt but that's not politically correct today. Now we say they are looking for new directions. Eventually both of these companies will disappear, and they won't be the only ones either. It's easy to blame it on labor costs in the US, or cheap Chinese labor, but companies like BMW, Mercedes, and Porsche all pay high wages and still manage to produce a profit without sacrificing quality. Finally we have the American consumer who's maxed out with three mortgages and a pocket full of credit cards with the numbers worn off.

For a real glimpse into the consumer's world, you need to focus on two things: consumer spending and housing. If you think of the United States as a car, consumer spending and housing would be the motor and transmission respectively. Without them you won't be going very far. Let's take a look at the weekly chart of the Consumer Index ($CMR):

Notice the blow-off to the upside and then the sharp decline last week. Now take a gander at the weekly chart of the Housing Index ($HGX):

If the motor (the consumer) is smoking, the transmission (the housing sector) is in flames. After topping out in late 2005 (not shown), it made a lower high in April 2006 and yet another lower high just last month. Now it's all the rage to talk about the subprime mortgage sector being in trouble and rumors abound that New Century Financial Corp. (NEW.N), a large subprime lender, will go belly-up soon.

For anyone with a brain, this should not come as a surprise. You can't keep on financing the purchase of three hundred thousand dollar houses for people working in McDonalds. The real surprise will come with all the unintended consequences. There will be a number of mortgage companies and small financial institutions that will get caught in the down draft. The rubber will meet the road though when the derivatives start to unwind and everyone is shocked to see that no one is on the other end. Remember all of those off-shore companies Enron formed that had no assets yet their shares were valued at hundreds of millions of dollar in their balance sheet? It's the same thing except its now come ashore! To make matters worse, housing has financed consumption. By that I mean the year after year appreciation in home values allowed consumers to refinance their mortgages time and again. They would then take this excess liquidity and convert it into HUV's, vacations, flat screen TV's, second houses, and whatever else came to mind. Savings never entered the equation as the US has had a negative savings rate for quite some time now. Nope, borrow and spend has been the consumers axiom for more than a decade. Here's a news flash for you: that game is now over. If consumers draw in their horns, and they are, the shock will be felt throughout the United States. Most people think a cold in the United States will lead to pneumonia in Asia in general and China in particular, but I don't share that view. It's not that they won't suffer because they will, but India and China have succeeded in developing domestic demand and that was unimaginable just five years ago. If just 5% of the more than 2.5 billion citizens of these two countries increased their spending by 10%, it would be more than sufficient to replace part or even the entire US shortfall. No folks, I think it's America that's coming down with pneumonia. China and the rest of the world will struggle, but they will work it out. That's one of the reasons I don't buy the scenario that China wants to slow down their economy. They know the US slowdown is all but a given. If anything, I think they just may try to rev it up a notch before the wheels come off.

Lately we've seen numerous signs of a slowdown in the US economy including a sharp drop in productivity and retail sales as well as weak job growth. On the other hand unit labor costs were revised sharply higher and oil is on the rise again. A slowing economy and an increase in prices. In other words, stagflation! Not good news for the US Federal Reserve and not good news for business. Rising costs and decreasing sales. If that's the case, we should be able to see some signs in the Dow. The market has been on a roll for all of four years and this secondary reaction is very long in the tooth so it wouldn't take much to tip the whole mess over. Last week the DJIA plunged 416 points on Tuesday, and after a dead cat bounce on Wednesday, proceeded to give up more ground until yesterday's triple-digit gain. Unfortunately, there was no follow through today as we sold off into the close. Take a look below:

This chart is similar in almost every aspect to the consumer chart. So what does it mean? I think it means that the market has finally topped but other than that, there's not much else you can draw from this. A lot of people suddenly discovered the "c" word, i.e., crash, but I can't see that at all. The recent decline in the Dow is probably not over. We have good Fibonacci support at 11,871 and again at 11,648. We also broke out from 11,670 and we have the 50-wma coming in at 11,732. I suspect this reaction will fizzle in another eight days or so, bottoming in the 11,640 to 11,732 range.

We have two separate issues to deal with here. The first is the top and the other is the possibility of a crash. I believe the top is in because this decline is completely out of character with every other decline we've experienced since the breakout almost one year ago. We've fallen further, deeper, and faster than any previous reaction. A significant change in character is a good indicator of a change in direction. Just what kind of change now becomes the question. I see almost no chance of a crash because there has been little or no distribution. After such a long rally, distribution is a requirement. So the odds favor a bottom around 11,670 followed by a rally. The quality of this rally will be the key. If I am right and the top is in, we should rally to a lower high on or about April 18th. Somewhere around 12,422 to 12,514 would be my guess. Then we'll distribute; for two to three months. Maybe even longer! That brings us into the middle of summer for the northern hemisphere and there has never been a market crash in July. There is always a first time but given the length of this secondary rally, distribution could last into October. That would be my bet unless Unless what? Unless this administration attacks Iran and then all bets are off.

Okay, the consumer is pulling in his horns, the housing market is toast, and the Dow may have topped in an economy suffering from stagflation. What does that mean for the rest of the markets? To begin with, it means really bad things for the US dollar and really good things for the currencies of countries with commodity based economies. Take a look at the weekly chart of the US dollar:

After topping out early last year we have made a series of ominous lower highs and lower lows, and the latest lower high was put in just last month at 85.25. There is a lot of foreign investment in both bonds and stocks, and every day the dollar drops, they're worth just a little less. Do you see how it's all interconnected? Here's another newsflash for you; the dollar is going to drop a lot more. Key Fibonacci support is at 83.71 and we've been playing with it for two weeks. Key Fibonacci resistance is at 84.66 and we're currently range bound. I'm convinced we'll break to the downside and that will lead to an eventual test of the 80.50 historical bottom.

Bonds are a similar and very interesting story. In a normal world we would have either a recession or inflation and that's a piece of cake for the Fed. Lower rates with the former and raise rates with the latter. Unfortunately for the Fed stagflation is the worst of all possible worlds and its complicated by the fact that most major countries are raising rates. Why is that so important? We live in a very competitive world and the Fed isn't excluded from that competition. They have to sell their junk paper to the rest of humanity and the only way they can get that done is to restrict supply or raise rates. Restricting supply means spending less money and that would drive the country into a deflationary tailspin. That leaves raising rates. I was convinced for months that Bernanke would choose that path, but now I have serious doubts. A slowing debt-ridden economy and expanding rates would lead to the same deflationary scenario. The Fed has tried to sing the bull to sleep by printing money like there is no tomorrow, but we're at the point where it's not enough. I now suspect that they will be forced to lower rates in an all out attempt to fend off not only deflation but a debt crisis. Inflate and then inflate some more! There are going to inflate debt away and in the process they'll destroy the bond and the dollar. Neither can survive for very long with lower rates, especially the dollar. A sharply devalued dollar would eliminate a lot of debt.

Last month we saw the first tell tale signs of things to come. The possibility of lower rates coupled with a declining dollar led to a fifty billion dollar shortfall in the flow of funds into the US. You see the United States needs almost three billion dollars a day of other people's money to survive and we didn't get it. So where did the difference come from? The printing press, and that's why the Fed decided to no longer publish the M-3 figures. I guess that's on a need-to-know basis and the American people don't need to know. As unusual as it sounds, lower rates in a world where everyone else is raising them will drive bond prices up over the short run but eventually make the bonds quite unattractive over the long run. So you can't buy bonds, dollars, or stocks. What does that leave? In a word: commodities!

Commodities are tangible assets versus the three classes of paper assets mentioned in the previous paragraph. They're real and I can get my hands on them. Of course some are more desirable than others, like gold for instance. I have been bullish gold for seven years. Back in November 2006, I wrote that gold had begun a new leg up that would eventually take us to US $775.00/ounce. I also stated that we would have two 7% corrections along the way. In the weekly chart below you'll observe a decline from the US $655.50 high to the $603.00 low for our first 7.4% correction.

Then on February 27th we began a decline from the $689.80 closing high down to the $639.20 closing low on March 5th for a 7.32% decline. You can see that in every case, going back to September 2005, we bounced off the 50-wma. As gold rallies we'll encounter a number of Fibonacci resistance levels beginning with $664.2, $686.2, and $728.6. Then we'll test the $730.40 high registered back on May 11, 2006. After that it's on to the last line in the sand at $775.00.

Before I move on, I would like to say a few words about gold stocks. I have been holding Buenaventura (BVN), Coeur D Alene (CDE), Goldcorp (GG), Newmont (NEM), Royal Gold (RGLD), and Silver Wheaton (SLW) for three years. Then last week I sold 25% of my portfolio and I may sell as much as 25% more tomorrow. How can I be bullish gold and bearish gold stocks? It's not as complicated as it sounds. Gold is reacting to rising prices, among other things, while the gold stocks are reacting to a falling Dow. I postulated some time ago that once the Dow rolls over, gold stocks could fall for as long as six months as people throw the baby out with the bath water. They sell what's liquid in order to pay off what isn't (mortgages, credit card debt, margin calls, etc...,). Nothing I've seen to date has changed my mind.

I don't know if we'll stop at $775.00 or continue on up to the all-time high of $882.50 posted almost three decades ago, and it really doesn't matter. What does matter is that we are in a bull market for gold, and that bull market will last until well into the next decade, and may even reach as high as US $3,000/ounce. And gold won't be there alone either. Silver, copper, oil, the grains, cotton, sugar, and coffee will be right there beside it. Oil is a special case as it is politically sensitive. I noticed that while commodities in general were beat up pretty good last week, oil held its own. One reason is diminishing supply as several major oil fields in Russia and Venezuela are producing a lot less oil than projected. Take a look at the historical chart for oil:

In spite of the six month correction, oil is firmly in a bull market and there is no evidence to indicate that it will end any time soon. Additionally the firmness in price could be an indication of problems about to surface in the Middle East. The current administration is making the same noises about Iran that it did before it went into Iraq. I wouldn't be the least bit surprised to see a sojourn into Iran and a new front in the war before the summer ends.

From a technical point of view oil has very good Fibonacci support at 56.60 and 53.32 while good Fibonacci resistance is at 62.32 and 70.91. I now believe we are initiating a new leg up and it will eventually take us through the May 2006 high of 79.50 and test good resistance at 88.08. Any political unrest in the Middle East would only serve to accelerate the process. The key is Asian and Latin American demand. Are you surprised I mentioned the latter? The Latin countries produce a lot of metals and agricultural products and that requires petroleum. Almost 30% of a mines cost in Latin America is energy related.

Apart from the United States, almost every major country in the world and a lot of smaller economies too, has participated in flooding the world with liquidity. The Peruvian central bank alone spent one billion New Soles (+/- three hundred million dollars) in December supporting the dollar. That's unheard of! All this liquidity has served to bid up the price of copper, oil, and gold in the initial phase of our commodities bull market. Now it appears that the bull market has broadened out to include grains and softs (cotton, coffee, and sugar). That's not to say that we haven't seen fits and spurts in these areas before because we have, but now it appears we have the real deal. In particular, the grains have enjoyed a nice leg up. Take a look at the weekly chart for the Grain Index ($DJAGRS):

Composed mainly of corn, soybeans, and wheat, you can see that there was good accumulation leading to the break out from the 130.00 area. You can also see that we are now extremely overbought. The interesting thing about grains though is that the can stay overbought for very, very long periods of time. Also, given the length of the accumulation, it would not surprise me to see grains work off their overbought condition by simply moving sideways here. We have seen a mild correction down from the 182.46 high to 172.50 but that's nothing of any consequence. Strong support in the index comes in at 150.01 and 143.95 and I would at the very least expect a test of the former.

With respect to wheat, corn, and soybeans, the former led most of the way up while the latter took over the helm about a month ago. There is strong support at 435.5, 384..2, and 712.0 respectively and as recently as early last week all three came up to test strong Fibonacci resistance at 485.3, 428.7, and 779.5. It's possible that we will now move sideways within this range for a period of eight to sixteen weeks in preparation for the next leg up. A lot of investor's shy away from the futures market because they feel that it is too risky, so they don't really have a way to play the grain market. There are alternatives as this following weekly chart of Cresud SA (CRESY) demonstrates:

This is an Argentine company that's listed on the NASDAQ and offers a very good alternative. Another one is a Canadian company that goes by the name Saskatchewan Wheat Pool (SWP.TO). These are companies that should be accumulated little by little every month without regard to share price. If possible try to by them in their local markets and in their native currencies. Unlike gold stocks, I suspect these two companies will not feel the Dow's downdraft near as much since the general public is almost unaware of their existence.

With respect to the softs, I am very bullish on cotton, sugar, and coffee although I only recently took positions in the latter two. A look the historical chart for sugar below shows us that we have two very solid areas of support; at 10.69 and then lower at 10.05.

We recently tested and held the 10.69 area I took that as a sign to buy sugar and will hold my initial position as long as I do not see a close below 10.00. Assuming that I am right and we hold, good resistance will come in at 11.92 and 13.80 and I expect a test of the former by early summer.

Cotton is a similar story in that it tested very good support at 49.37 and held. I used that as a sign to buy into an initial position some months back and I've been sitting tight every since. There is good Fibonacci resistance at 56.91 and 60.24 and I will use a close above the latter to add on. Why am I bullish cotton, sugar, and coffee? Simply put, demand is outstripping supply. Latin America produces a lot of all three and countries like Peru and Brazil just can't keep up. Who are the buyers? Well, I don't know if it means anything or not but 90% of all the boats in the harbor have Asian registries.

CONCLUSION

I've been walking this earth for over half a century and I see things now that I never would have believed as little as ten years ago. I see the world's greatest nation in decay, and not just economic decay, but political and moral decay as well. I see a crazed administration engaged on something called "nation building" and if they've got to kill a couple hundred Iraqis a day so be it. Obviously no one in Washington has a history book because if they did, and they would turn to the paragraph on a police action called Viet Nam, they would see that that particular approach failed miserably. I've lived in Latin America for the better part of twenty-five years and for the first time, people don't want dollars. They actually prefer their own currency. Here's my last news flash for you. If a fellow with no education, a poor diet, and inadequate medical treatment living at 3,500 meters above sea level can figure out that the US dollar is undesirable as a store of wealth, how much longer do you think it can last as the world's reserve currency? The short answer is that the party is over and all things dollar related will go up the stack with it. What we saw last week is the equivalent of the first drops in a storm destined to last more than forty days and forty nights.

Mar 8, 2007
-Enrico Orlandini

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