DOW THEORY ANALYSIS SAC
The July Newsletter
Playing With Fire!

Enrico Orlandini
3 Aug, 2006

I am writing this Newsletter as Peru prepares for its Independence Day celebration. This is a four day long affair that is a cross between a drunken fest and a political game of liar's poker. This particular Independence Day will usher in a new president, Alan Garcia Perez, who actually isn't so new. Mr. Garcia just happened to be president from 1985 to 1990, and when he left office in 1990 he was considered to be the worst president in Peruvian history. He left the country with a 400%/month inflation rate, negative reserves in the Central Bank, and on the verge of civil war. The Shining Path (Sendero Luminoso) terrorist group was literally blowing up Lima one city block at a time. Did I forget to mention that he probably stole more than one billion dollars while he was president? All of this begs the question of just how such a man could become president again? It would be easy to say that it's just the way the world is today, but that explanation leaves a lot to be desired. In Peru's case, I would chalk it up to voter ignorance brought about by years of poor diet, lack of proper medical care, and a less than adequate educational system. This deadly combination seems to have produced a society that can't think beyond today or remember the day before yesterday. I have been here twenty-five years and it's like living in the land time forgot. Probably in all of human history, there has never been a country so rich in raw materials and so poor in human capital as Peru is today. Put five million Japanese or Chinese in Peru and you would have an economic paradise in short order. It's a sad state of affairs!

As tragic as the plight of Peru sounds, it is nothing compared to what is going on in the Middle East. For almost a year I have been attributing the rise in gold to the fact that the yellow metal senses some future event of really tragic proportions. I also said that I didn't have any idea as to what it could be related to. I am sorry to say that is no longer the case. Supply and demand factors aside, gold has focused its attention squarely on the Middle East conflict, an event orchestrated in large part by some insane policy implemented by the present US administration and supported by Israel. Some feel that it's really Israel that's calling the shots, but it doesn't matter¹. What matters is the course they're on and the results they'll produce. At the present moment Israel is busy laying waste to Lebanon and it is doing so in such a fashion as to provoke and attack from one or more of its Arab neighbors, specifically Iran with help from Syria. An Iranian attack would be "just cause" for US military intervention, and since they lack the manpower for such an action, it would mean the US would probably play their nuclear card. Think about this for a minute. The US is the first country to develop a nuclear weapon, the first and only country to use such a weapon, and now sixty-one years later they seem to want to do it again. The justification is that Iran possesses, or is on the verge of possessing, weapons of mass destruction. Does that sound familiar? Remember Colin Powell showing the world all the indisputable proof that Iraq possessed such weapons? We never found any did we? I have news for you; you won't find any this time around either.

Just for a moment, I want to turn this argument around and suppose that Iran actually possesses nuclear weapons. Given their religious beliefs, culture, and history just how do you think they'll react? I'm not an expert on the Middle East, but I think I can figure it out by myself. If they've got it, they'll use it! Who do you think they'll direct their rage against? Why Israel of course! Do you have any idea what kind of mess this is going to create? There will be no winners here; only those who go down in flames. Both sides are going to risk everything, they are going to lose everything and what is worse, both sides are going to inflict tremendous suffering on the rest of the world.

Why would anyone want to go down such a dangerous road? Well, for the US a lot of it has to do with oil whereas for Israel it would be a chance to settle some old scores once and for all. I have no idea who threw the first stone in the Middle East some three thousand years ago, but if George Jr. is dumb enough to start dropping nuclear ordinance on the Arabs, and I think he is, you will be fighting the next war throwing stones from your respective caves². Anyone who thinks China and Russia will sit quietly by while the US goes about the confiscation of +/- 50% of the world's oil is more than a few bricks shy of a full load. So far they have been content to let America kill innocent men, women, and children in Iraq and Afghanistan, all in the name of democracy, because they know full well it's a war we can't win. Russia can write volumes about going down to defeat in Afghanistan. The implementation of nuclear weapons changes all that, even low grade nuclear weapons, as the Arab nations would be powerless to fight back. At least over the sort run. Over the run long the United States would reap what it sows as the Al Qaeda would find some way to explode a nuclear weapon on American soil. It's worth remember that throughout the course of human history, whenever a bully has started throwing stones, someone eventually comes along with a bigger stone. The process of retribution often takes years, or even decades, but it inevitably happens. Mr. Bush will find that out the hard way.

For those of you who feel safe living in your log cabins nestled in the mountains of Montana, complete with solar power, a ten acre vegetable garden, your own well, and a satellite dish, I have one thing to say: think again! Don't be so naive as to believe you can simply explode a few nuclear bombs on the other side of the world and go on with your life as if nothing happened. More years ago than I care to admit, I took a biology course from a professor who was a bit of a rebel. In the middle of the semester, he dedicated a week's worth or lectures to a topic most people in today's world know nothing about, nuclear winter. It surprised me to learn that it was only necessary to explode half a dozen nuclear bombs on our globe to seriously alter for many decades the earth's weather patterns. In short, you would see snow at the Equator during the summer months and temperatures would hit freezing. I live just below the Equator in a city of ten million people where half the houses don't have roofs (it rains once every twenty years in Lima so most feel a roof is a luxury they can live without). Maybe 1% of the houses have a heating system. Nuclear winter would probably kill half the people in Lima within a week.

Having spent the first eighteen years of my life in the US, I find it difficult to relate what I see today with the values instilled in me by the late fifties/early sixties Midwestern culture I was exposed to as a child. The adult influences of my youth were hardened by the Depression and World War II. They knew what it meant to suffer and they were no strangers to hard work. They also had compassion, something that is lacking in today's generation. Too much X-box I guess. My grandfather left the house at 6 am every morning and didn't come home until 7 pm, and he was happy to do it. He built a multi-million dollar business on his word and a hand shake; not once did I ever see him sign a contract (except when he bought land). Among other things he owned a furniture and appliance store where he sold everything on credit. He never asked you to fill out a form or requested references. Instead he would go to your house, sit in your kitchen for thirty minutes to an hour, and just talk to you. When he walked out of the house, he knew if he was going to finance your purchase or not. Quite often he sold to people who were quite poor and couldn't get credit from anyone else, and did so at one to two percent above prime. In the forty years he ran the business, his company never had bad debt in access of one-tenth of one percent of his gross sales. Never! Sometimes he would go two or three years at a time without any clients missing a payment. In spite of the distortions that exist, I'm convinced he would do just as well in today's world. He worked until the day he died, and the sad part is that his offspring destroyed a lifetime's work in just a few short years.

I'm way off the track here, so let's get back to gold and the message it's trying to deliver. Gold has been smelling disaster for months now and that's why the last rally went beyond just about anyone's expectations. It's also why the recent correction of 25% was so short time wise. Everyone in New York and Washington has carefully sidestepped gold's message in an effort to paint a "business as usual" scenario. Things are fine in Iraq, and Iran is an "isolated" case. Spin, spin, and more spin! The yellow metal has been around for five thousand years, and there isn't much under the sun that it hasn't seen. The George Bush's of the world have come and gone while gold has stood the test of time. Like Mother Nature, you just can't fool it. If I am right, and we are standing on the edge of the abyss, you are going to see gold rise farther and faster than just about anyone could have thought. Unless I miss my guess, a new all-time high will be seen by year's end, and that will be just the beginning. The administration will do everything in their power, including confiscation, to paint a picture of satisfaction and contentment, but they'll fail in the end. You can outlaw the truth, but only for so long.

We've been on the edge before, and cooler heads have always prevailed, but I just can't get past the feeling that this time is different. There are very few people in Congress, the Senate, and the White House who have suffered hard times. The few that exist, like Charles Byrd from West Virginia, seem to have given up. Kennedy isn't even the shadow of his brother Robert, but given what happened to his family, I suppose it's understandable. He learned the hard way that you just don't tilt against windmills. I had high hopes for McCain but he seems to have chosen a different path. He ceased being an individual and became a politician somewhere along the way. If I'm right and government fails the people, where do you turn to? How does one protect himself from the four horsemen? Personally, I only see one way out. Any and all improvement, and there will be improvement, will be on an individual level. Institutions and political parties will be of little or no help. Don't forget that America began with just fifty-four individuals locked in a room, ready to sacrifice everything, in order to build a republic. They succeeded. The same thing happened with the Depression and World War II, and will happen again as there will be some individuals who will step to the front, lead by example, and leave the country a better place. The US will not go the way of Rome and Carthage, at least not yet. The pain and suffering that I see on the horizon will leave the US a much better place. The United States will become a Republic again, as it was intended to be. But as usual, there will be a big price to pay.

MARKET COMMENTARY

It has been an interesting month to say the least. The DJIA was suppose to rally to new highs and never did while gold was suppose to fall to new lows and didn't Bonds and the dollar stayed range bound while the CRB is making noises like it wants to break out to the upside. To me it all smacks like the calm before the storm. The calm could drag on for another month or two but look out in October and November as history looks like its going to repeat itself. Let's take a look:

DJIA - The Dow closed out the month at 11,185.68 and within a few points of where it began thirty-one days earlier. On the surface it appears not much happened but things aren't always what they seem to be. Take a look at the usual suspects below, the Daily Charts of the cash DJIA and the Transportation Index, and several things jump out at you.

First and foremost, those who truly follow the market knows that the Transportation Index has been leading the Dow for almost four years. All of the sudden it seems that the Transports are breaking down after making an all-time high that still remains unconfirmed by the Dow. That non-confirmation sticks out like a sore thumb. Now the shoe is on the other foot as the Transports made a new low for this move down several days ago and that low is now unconfirmed by the Dow.

From a technical point of view, these two charts are like day and night. The DJIA topped out in early May and then made a series of three lower highs and two lower lows. The second lower low was not confirmed by RSI, MACD, or the histograms. Note how the DJIA is currently trading above both the 50-dma and 200-dma and appears to be slightly overbought. The Transports, on the other hand, seem to have put in a textbook double top³ and have since fallen below both the 50-dma as well as the 200-dma. Unlike the DJIA, the Transports are considerably oversold. I do not see how we can have a significant move, one way or the other, until these two major indexes are both on the same page, i.e., until they confirm each other. I don't see that happening right now and that means the highest probability is that the DJIA continues to trade within a range. I calculate that range to be from 10,637 on the low side to 11,427 on the high side. We could stay in this range for another sixty to ninety days. There is nothing to convince me that we will make a new all-time high in the DJIA and I firmly believe that the next move will be down and down hard. The key support numbers to watch will be 4,180 in the Transports and 10,417 in the Dow Jones Industrial Average. In the cash S & P, the number I am looking for would be 1175.00.

GRAINS - Here is a fascinating study in frustration and patience. It's the commodities version of the famous Chinese water torture. The grains in general and soybeans in particular, were one of the first commodity groups to really take off. Beans went from less than 5.00 to almost 11.00 in rocket-like fashion and then came back down to earth just as fast.

Since then the grains have trended sideways, threatening at times to take off, but never really getting the job done. Most analysts chose to follow a particular member, or members, of the grain complex and I do analyze specific grains but I always check out the Daily Chart of the Dow Jones AIG Grains Spot Index before I draw any conclusions. For your reading pleasure, I have included it below:

Pay attention to how the Index has made a series of higher lows and higher highs. It closed out the month at 122.76, appears to be bouncing off of good support at 121.98, and I would not be surprised to see it hold. Below this level we have excellent support at 119.72 and 119.93. The latter is the 50-wma and I would expect it to hold under any foreseeable circumstance.

Although I may have jumped the gun a bit, I like grains here and that's why I took a small position in both corn and soybeans a week ago. With respect to the grain Index above, both the histograms and RSI have turned up and I think the MACD will follow suite shortly. From an individual point of view, corn is trending up and has been since mid-2005 although it doesn't feel like it. Our current trading range is 239.20 to 276.4 and we are dragging across the bottom of that range now. The same can be said for soybeans with a range of 5.71 to 6.57. If inflation truly exists, the grain complex has to be a beneficiary sooner or later. Given the fact that more than two billion Chinese and Indians are improving their standard of living, it can't be any other way. The internal demand generated by these countries will be sufficient to drive grain prices for many, many months. Therefore I will just sit tight and wait for the laws of supply and demand to exert their pressures.

CRB INDEX - As most of you know by now, I was a deflation hawk for almost five years. Then in late 2005, I modified my position and stated that I thought stagflation was going to be the order of the day. This is where we see rising prices and a slowing economy. In all honesty it's a position that keeps me up at night, but when I have doubts I pull out the following Historical Chart of the CRB Index and try not to drool all over it:

It is impressive and extremely important at the same time. From an intellectual point of view, you can't look at this chart and not see inflation. As a matter of fact, it screams inflation!

The August CRB futures contract closed out the month of July at 392.00 and it now appears to be shaping up for a test of the May 11th high of 412.00. Once that high was put in, we corrected down to support at the 50-wma and then began to trade within a range (376 to 397). I believe we are ready to break out of that range, propelled by oil, copper, the precious metals, cotton, and the grains, and we'll make new highs. Strong support is at 376.60 while good resistance is at 397.70. Once we can make two consecutive closes above 397.70, I believe we'll be off to the races. How high will we go? There will be resistance at 430.68 but I believe we'll work through it and reach one of three possible targets: 458.37, 476.82, or 487.39. Given the fact that this is a once in a lifetime bull market for commodities, we'll probably hit the higher target sometime in late 2006 or early 2007.

TREASURY BOND - To say that the bond market is deceptive is being generous. What's more the bond pit seems to have a mind of its own. The Federal Reserve has been raising rates for more than two years now, and yet bond prices have been going up, meaning interest rates were declining for most of that time. Take a look at the following Historical Chart for the Treasury Bond and you'll see what I mean:

At the beginning of the year, everyone began to speculate that the Fed was about done with rate increases, so what did the bonds do? Why prices started to drop and the bond pit increased rates of course. Put that in your pipe and smoke it, Mr. Bernanke! It is my opinion that bond prices will continue to decline and interest rates will continue to rise, and I don't think the Federal Reserve will have much to say about it.

What does the bond pit see that the Fed can't or won't see? Well to start with they see rising prices as indicated in the previous CRB chart, but that's a secondary concern. Keep in mind that bond prices are a function of supply and demand. Given mounting US debt, supply is huge. No problem there baby, you want bonds? The US government will give you all the bonds you want. Demand? Well that's a horse of a different color. What makes a bond attractive? Yield! Poor Bernanke has the bad taste to want to lower yield just when the rest of the world is raising yield! Throw in the fact that the US is a bad risk, and getting worse every day, and you can see a little problem here. The bonds smell this and will, sooner or later, plumb the depths in terms of price. Currently, I see bonds in a trading range that extends from 102.15 on the low side to 109.28 on the high side. Once the 102.15 support is violated, look out below. As most of my clients know, I have been short bonds for almost a year now and see no reason to change.

US DOLLAR/SWISS FRANC - Nothing new under the sun here. You can put a dress on a pig (the dollar), but it's still a pig! As is the case with pigs, the final destination will be the slaughter house.

In this Historical Chart of the US Dollar you can see the top in mid-2001, a retest of the top in 2002, and then the fall. We bottomed in late 2004 at 80.5 and then spent a year in a counter trend move that reached resistance at 92.60. Now we are going to see a retest of the 80.50 support at the very least, and I expect a violation of this support before the year is out.

What is the problem with the dollar? For starters, there are way too many dollars floating around out there. Remember Alan Greenspan? He was a sneaky little devil. All the time he was raising rates (tight money policy), he was busy printing dollars (lose money policy) like there was no tomorrow. He printed more dollars than all the other Federal Reserve Chairman's put together. That's quite a legacy! The next problem with the dollar has to do with faith. Since we've gone off the gold standard, the dollar has been backed by the "full faith and credit" of the United States government. Let's examine this phrase full faith and credit for a minute. Take the word credit: the US is the largest debtor nation in the history of the world. There is no credit, only debt! The word credit should be changed to debit. Now look at the word faith. The Spanish version of Newsweek came out this week with a picture of the US base at Guantánamo on the cover, and a caption that reads "The New Auschwitz!" That's how the world sees the US. Not a lot of faith there as far as I can tell. No, over the long run the dollar has only one way to go. Down! Down into the trash can of history along with every other fraudulent fiat currency that came before it. I am short the dollar and see absolutely no reason to change⁴.

GOLD - Where do I start? I will start by saying that I am extremely bullish gold at this point in time. Surprise! The August Gold futures contract closed out the month at 634.20 and that was up about 15.00 for the month. Given how bearish everyone was, and still is, that's not too bad.

Since everyone is so 'today' oriented, I have put up a Daily Chart of gold. You can readily identify the June bottom that ended the one month, 25% correction that scared the hell out of most gold bugs. Since then we rallied to test resistance at 664.20, corrected back down to test good support at 602.70, and then headed back up again. Many 'analysts' continue to call for a retest of the June lows, but I just don't see it. Better yet, I think they are praying for a retest because they missed the boat.

Note how the histograms, RSI, and MACD are all turning up. I believe we are on the verge of a second test of resistance at 644.50 and then 664.20. Once we get through these areas, we'll test 686.20 and then 728.00. Given the lack of fiscal responsibility, supply/demand concerns, the Middle East debacle, and growing inflationary pressures, I believe that gold will be at a new all-time high by Christmas Naturally I am long gold and will stay that way. In fact, once we close above 664.20, I will add on.

SILVER - Gold's poor relative just can't seem to get any respect. There is an old saying: what goes around comes around. Silver will have its day although it is still a ways off. The September Silver futures contract ended the month of July at 1137.00 and was up slightly.

Note how silver has been consolidated and building a base for the last month. Whenever silver does this, good things almost always follow, and this will not be an exception. The histograms, RSI, and MACD tend to follow this reasoning. The key resistance will be at 1169.5 while the key support will be at 1025.7. Once we get through 1169.5, and we will, it will be up, up, and way.

GOLD STOCKS - There is good news and bad news. The bad news is, at least over the short run, gold stocks will be subject to the highs and lows of the DJIA more than the price of gold. The good news is that, over the long run, gold stocks will follow the price of gold just as it did during the Depression. I am long, and will remain long, BVN, CDE, GG, GLG, NEM, RGLD, and SLW. Patience is required here!

OIL - There are three investments, on the long side, that really interest me: gold, the CRB, and oil in that order. Like gold, I am extremely bullish oil here and now. The September Oil contract ended the month at 74.35 but did manage to make a new all-time high of 79.86 back on July 14th. Oil is a commodity filled with political commentary and I find the easiest way to get down to what is important, is to strip all of that out. To do so, I rely on Point & Figure charts which eliminate everything but the price action, and that is what is really important. Take a look at the following P & F Chart for oil:

It is strong to say the least, and the price objective is 100.00. With respect to any downside pressure, we have held support at 73.45 over the past weeks and 68.45 has held up like its set in stone. Upside resistance will be found at the 79.86 high and then at 83.64, 91.73, 97.13, and finally 100.21. I have been calling for a test of 91.73 for several months now and nothing has happened to change my mind.

CLOSING REMARKS

The markets remind me of a kid I knew years ago. He used to drive like a bat out of hell. One day we were traveling together, he was driving, and I dosed off. I woke up an hour later, looked at the speedometer which was pegged at 120 mph, and asked where the hell we were at? He responded "I don't know, but we're making great time!" There's a wreck coming, it will take place in the Middle East, and it will be very, very bad. Try to protect yourself as best as possible.

References

¹ Please understand that I am not passing judgment in favor of one side or the other. For ´purposes of this analysis, blame is irrelevant. Besides, you would have to go back two thousand years in order to assess blame, and it still wouldn't do any good.
² I'm not smart enough to think of that analogy by myself. Einstein said that more than fifty years ago when someone asked him how the next war will be fought. He responded that he didn't know the answer, but he did know how the one after that would be fought. When pressed for an answer, he said "with stones"!.
³ I am not a great believer in "double tops" as they seem to fail as often as the hold true.
⁴ Inversely I am long the Swiss Franc as I have been for five years. I realize it is a paper currency but the Swiss try to maintain a responsible fiscal and monetary policy. Everyone has to have some paper currency to put in their pocket and I view the CHF as the lesser of all evils.

30 July, 2006
-Enrico Orlandini

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