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The long and the short of it

Steve Saville
28 Oct, 2005

Below is an extract from a commentary posted at www.speculative-investor.com.

Secular Trends

One of the best ways to lose money in the stock market is to try to make a lot of money quickly. This is because attempts to make a lot of money quickly will lead to the taking of excessive risks. Stock market gamblers -- people who place large bets on short-term outcomes and/or high-risk situations -- might be very successful for a while depending on the market environment in which they are operating and how lucky they happen to be, but they are unlikely to keep the money they make. Like all gamblers, stock market gamblers have a subconscious desire to lose and will continue to push their luck until it runs out. It is, however, possible to make and KEEP a lot of money by a) understanding the secular trends and keeping one's investment position in synch with these trends, b) being patient (not trying to make a lot of money quickly), and c) doing the opposite of the manic-depressive crowd (increasing exposure to a long-term bull market when the crowd becomes depressed and reducing exposure when it becomes manic).

One of today's clearest and most important secular trends is the upward trend in the gold sector of the stock market relative to the overall market. By using the Dow Industrials Index to represent the overall stock market and the Barrons Gold Mining Index (BGMI) to represent the gold sector we've attempted to illustrate the situation on the following chart. Notice that a 20-year downtrend in the Dow/BGMI ratio ended in 1980 and that this secular bear market in the Dow relative to the BGMI was followed by a secular bull market in the Dow relative to the BGMI (a 20-year upward trend in the Dow/BGMI ratio). Notice, as well, that the long-term trend clearly changed again near the start of the current decade and that Dow/BGMI is now about 5 years into a secular bear market (a long-term upward trend in the gold sector relative to the broad stock market). Secular trends always last at least 10 years and if past is prologue then the current Dow/BGMI trend will last 20 years, so the gold sector will be trending higher relative to the broad market for at least another 5 years and potentially another 15 years.

Interestingly, although the secular trend change that occurred near the beginning of this decade is obvious on the below chart and is consistent with long-term trends in inflation and stock market valuations, few people are aware of it. This is not actually unusual, though, because it is typically only during the last few years of a secular trend that the public becomes a true believer in the trend. It is, in fact, the public's 'falling in love' with a trend that inevitably pushes valuations to extremes and sets the scene for the next major trend change.

Two years of consolidation or two years of topping?

The period since the beginning of 2004 has been unusually frustrating because consistent trends have been few and far between. The following weekly charts, for instance, show that both the Dow Industrials Index and the AMEX Gold BUGS Index (HUI) have moved back-and-forth within horizontal ranges during this 22-month period and that both were higher at the beginning of 2004 than they are today.

The patterns shown on the above charts could represent either mid-cycle consolidations or top formations. Actually, we think both possibilities are represented with the Dow slowly rolling over prior to the start of the next major downward leg in its secular bear market and the HUI immersed in a drawn-out consolidation prior to the start of the next major upward leg in its secular bull market. Looking at the situation another way, we think the rallies in the Dow over the past two years have provided investors with opportunities to exit at what will prove to be high prices (relative to where the Dow is likely to trade over the coming 12-18 months) whereas the declines in the HUI have provided investors with opportunities to enter at what will ultimately prove to be relatively low prices.

One of the main reasons why these patterns are taking such a long time to play-out is that the financial world has remained awash in liquidity. Some central banks -- most notably the US Federal Reserve -- have adopted a 'tightening' posture, but the monetary tightening has been so gradual and so widely anticipated that its effects have been muted up until now. Also, while the Fed has been slowly tightening the monetary reins other central banks have been increasing the slack by soaking up US debt using newly-printed currency. And as if that wasn't enough, the downward pressure on consumer spending that would normally have resulted from the much higher oil price has been significantly reduced by the supportive effects of having hundreds of billions of "petro-dollars" re-cycled into global stock and bond markets. In other words, forces that would normally be expected to bring about a reduction in liquidity have, to a large extent, been countermanded.

We don't think it's wise to bet on the notion that financial liquidity will remain abundant for much longer, though, because the political time-window during which the Fed must get all of its monetary tightening out of the way extends for a maximum of only 3 more quarters. That is, if the monetary tightening doesn't take its toll on the financial markets within the next few months then the pace of the tightening will have to accelerate.

Current Stock Market Situation

While the Dow's trading pattern is open to interpretation -- it could be rolling over (our view) or it could just be consolidating within the context of a longer-term advance (the majority view) -- there is less ambiguity in the following chart of the Bank Index (BKX). It looks like the BKX is in the process of completing a major top.

With reference to the 3-year weekly chart of the Dow Industrials Index included above, although we anticipate an eventual downside breakout from the trading range of the past two years we don't think that such a breakout will occur this year. Instead, we expect that support at around 9800 will hold if it is tested within the next few weeks and that any drop to near this intermediate-term support will be followed by a decent rebound. There are a number of reasons for this, such as: a) liquidity is still plentiful, b) short-term sentiment indicators have recently hit 'oversold' extremes at a time of the year when declines often end, and c) the NASDAQ100 Index has recently begun to show relative strength.

We plan to exit at least half of our bearish positions if the aforementioned support is tested over the coming weeks.

Steve Saville
email: sas888_hk@yahoo.com
Hong Kong

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