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All Bubbles eventually burst

Richard Russell
Dow Theory Letters
May 24, 2004

Extracted from the May 21, 2004 edition of Richard's Remarks

Gold -- The smartest economists and the smartest investors are all debating (quietly or publicly) one thesis. The thesis is -- inflation or deflation?

Those who favor inflation insist that there cannot be any real deflation. They point to the Fed's ability to create unlimited liquidity. They point to the Fed's ability to hold short rates down to where rates are even negative (below the rate of inflation, as now). They point to the fact that, if necessary, the Fed can buy bonds and thereby hold long rates down. The Fed, states Fed Governor Bernanke, can drop money from planes if need be (we assume he was kidding, of course). Furthermore, states Bernanke, "we have the printing presses," so if you're worried about deflation, we won't let it happen. It can't happen.

Those who believe that deflation is our fate note that neither the Fed nor the President nor Congress can control the minds of the Great American Consumer. And they ask -- what if the consumer is tapped out? What if the consumer can't take on any more debt? What if the consumer becomes frightened and decides to save? What if the American consumer has taken on so much debt that he decides that he simply can't take on any more? What if the rising price of the things that consumers need (medical, insurance, gas and oil, food, entertainment) become so expensive that the consumer says, "It's all too much, I've got to cut back. I've got to start paying off my debts." If that happens, there's not a hell of a lot the Fed can do about it. That would be the economic nightmare that even the Fed couldn't wiggle out of.

This is where the markets come in. Suppose (I know this sounds absolutely "impossible") but just suppose that the stock market starts down in earnest? Suppose. between now and November, the Dow breaks down to 7500? How would consumers react to a market decline of another 2500 points? Suppose, just suppose, that the consumer's reaction to a major market decline is "Hey, something is really wrong. I'm going to cool it. No more fancy vacations and Starbuck's coffee and SUVs for me, I'm going to clamp down on my spending."

Yeah, I know that whole scenario sounds pretty implausible, but I'll tell you something. On occasions, on rare occasions, the stock market does something totally unexpected. It's called -- going down, and parting the public from its money. It happens. In my half century of watching markets, I've seen it happen -- a number of times.

But how could it happen today with the government spending like crazy (remember, there's a war on), and the Fed doing everything in its power to ward off contraction and disinflation?

Here's how it could happen. You see, in its frenzy to ward off the forces of deflation, the Greenspan Fed has created a series of bubbles -- bubbles in real estate, bubbles in bonds, bubbles in stocks, bubbles in investor optimism -- and maybe most dangerous of all, bubbles in debt.

All bubbles eventually burst. That's the problem with bubbles -- they eventually burst. And when they burst, everything changes. Inflation can turn to deflation, expanding M-3 turns to contracting M-3, optimism turns to pessimism, and rising stocks become falling stocks. It's a damn shame, but unfortunately it happens.

Anyway, I've outlined the two schools of thought as best I can. I don't know how it's all going to work out. Will it be more inflation and then deflation? Will it be a direct move into deflation. Will we have stagflation which is a combination of a stagnant economy and inflation? Or will be have rip-roaring inflation while at the same time the purchasing power of the dollar collapses?

One other item comes to my mind. The whole "prosperity" of the US depends on the dollar enjoying "reserve status." The rest of the world accepts dollars, uses them as reserves just as the nations of the world used to use gold as reserves. But no nation can expect to keep a reserve currency if it continues to run huge budget and trade deficits. The US is running half-trillion dollar trade deficits and half-trillion dollar budget deficits, and both are getting worse. On this basis, I don't see how the US dollar can stand up as the world's reserve currency. It's only a matter of time, in my opinion, before the world starts to question the wisdom of taking in US dollars as reserves.

If doubts arise about the wisdom of taking in US dollars as reserves, the game is over. US "prosperity" is literally based on the dollar continuing to be accepted as the world's reserve currency. But as I say, no currency can retain reserve status in the face of enormous and continuing deficits. It's something to think about, although I doubt if anyone except died-in-the-wool "gold-bugs" have given this area much thought.

Now I want to show a weekly chart of gold. The daily charts are important, but the weekly charts are more important, because it takes more action and more consistent action to turn a weekly chart bullish or bearish.

It appears that gold has gone through another "gut check," which is a powerful reaction calculated to separate all but the most dedicated from their positions. The chart below goes back to 2002. Note that MACD (heavy black line) at the bottom of the chart has sunk deeply into oversold territory, even further down than the similar correction of March-May 2003. But what's really important here is that the weekly histograms (blue bars) are starting to contract towards zero. Once this process starts, the odds are high that the histogram contraction will continue until MACD crosses above its shorter moving average (think black line) at which time the histograms will turn positive and above zero.

All of which makes me believe that the gold correction has come to an end, and that the direction of gold and gold shares will now be to higher levels.

I mentioned earlier in the week on the P&F chart, when HUI touched the 190 box that was a signal that HUI had turned bullish. As I write this morning, HUI is trading at 191.09 and all 20 of the gold and silver stocks that make up my gold advance-decline line are higher.

Richard Russell
Dow Theory Letters

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