Get Set! – and Go!

September 19, 2005 – The title of the last newsletter was “Get Ready!” I intended this one to be entitled “Get Set!”, with “Go!” for the third letter coming after that in early October. However, gold has moved up more quickly than I anticipated, so for this letter, two titles are being rolled into one because gold is ready to ‘go‘ higher. Indeed, it has already started by closing at a new 17-year high this past Friday.

I noted in the last letter two possible alternative courses that gold may take:

“So my conclusion is that gold is ready to climb higher, and it will do so in either of two ways. The least likely outcome is that central banks will try forcing gold lower once more. I think they recognize that they are losing the war. But if they do try it, gold may drop to test support around $432 for one last time. Gold will then reverse course and shoot higher like a rocket, carried initially by short covering but also by solid new buying from investors.

The more likely alternative is that gold just starts climbing from here, slowly but surely and relentlessly. This climb will put growing pressure on the shorts, and they will eventually be forced to run for cover, but probably not until gold climbs above $456.”

As it turns out, I guessed wrong. Gold took what I considered to be the least likely alternative by dipping once more back into support.

After closing on August 30^th at $431.20, gold has climbed $28.30, an impressive 6.6% jump over just twelve trading days. What’s more, on eleven of those days gold closed higher than the day before, including an impressive stretch of closing higher eight days in a row. That type of performance is fairly rare, so I guess my comment that gold would “shoot higher like a rocket” was an accurate description.

The important point though is that this gold rocket has just launched. It is just getting started. So continue to expect higher prices over the next few weeks (see my commentary on page 4).

There’s one other point I would like to make about the lead article in the last newsletter. Specifically, it’s my comment about the stock market:

“The DJIA is now below its 200-day moving average, and as of last week has broken down through the uptrend line that has marked its progress over the past three years. I expect the Dow to trade back under 10,000 within the next few weeks.”

As we all know, so far it has not happened that way. The Dow Jones Industrial Average has bounced back up to 10,642, and is once again above its 200-day moving average, which is presently at 10,542. Just when it looked like the stock market was about to fall off the edge of the table, it staged another one of its miraculous comebacks, which have been conspicuously frequent of late.

I have written from time to time about the government’s Working Group on Financial Markets, which was formed after the 1987 crash. Ostensibly, it was created to provide orderly markets and liquidity in case of another market meltdown. But rumor has it that its role has changed. No longer is it designed just to provide orderly markets and liquidity in a meltdown – it is now supposed to stop the meltdown from occurring in the first place. Consequently, wags have dubbed it the “Plunge Protection Team”, or PPT for short.

Some market observers have suggested that the PPT has been very active in recent months. The government is not saying anything, and I have no knowledge of the PPT’s inner workings. But the action of the market says a lot, and it looks to me that the PPT has indeed been in the market and is probably in there up to its elbows. The ‘logic’ – although it seems a gross misuse of that word – for the PPT’s actions is simple. The last thing the federal government wants to face now given the growing uncertainty about the economy and the outlook for the US dollar is a slumping stock market, let alone a crashing one. So rumor has it that the PPT has been pumping up the stock market, and I don’t doubt that. But there is more to this story. Two other points need mention.

First, even though the PPT may be a powerful force, it cannot change the primary trend of the market. If the primary trend is down (and I have repeatedly demonstrated in these letters that it is), sooner or later the primary trend will re-assert itself. For this reason I watch indicators such as market breadth and pay a lot of attention to divergences between different market averages. I also follow the trend, and in this regard, look at the above chart of SPY, the exchange traded fund of the S&P 500.

Because the S&P 500 is an index of 500 stocks, rather than just 30 like the Dow, I consider the S&P 500 to be more representative of the underlying strength – or weakness – of the stock market as a whole. This chart shows that the S&P is in a bear market rally, not a new bull market.

Whether it breaks the downtrend line going back to the 2000 high, only time will tell. The important point is that this chart smacks of distribution, not accumulation. It is distribution of stocks that occurs at market tops, and the accumulation that occurs at market bottoms. Regardless of how hard the PPT may try, it can’t change that basic fact.

The second point is – as the old adage goes – it’s not a stock market, but rather, a market of stocks. In this regard the PPT is being helped by the flow of money into certain sectors of the market, particularly energy producers in general and ‘big oil’ in particular. However, while the oil stocks may be helping to keep the DJIA and S&P 500 from heading lower, neither the PPT nor the government can change the stock market’s primary trend.

There is one other point worth mentioning. To identify the primary trend, I also like to look at so-called ‘bellwethers’, key stocks that are important to the overall market because of their high capitalization, huge shareholder base and/or other reasons. And the king of the bellwethers is GE.

I mentioned GE back in Letter No. 291, noting the puff-piece in The Wall Street Journal about Jack Welch’s retirement. I drew attention to the GE chart that appeared in the article, noting that it was forming a classic textbook ‘head-and-shoulders’ pattern, with the neckline right around $40. Clearly, Welch was leaving at a good time, i.e., the top in GE was in place. My letter was published on September 10th, 2001, and we all know what happened the next day. When the NYSE re-opened, GE quickly fell through $40, a move that is clearly visible on the accompanying chart.

I followed up with another GE article in Letter No. 302 published on April 1^st, 2002. GE had bounced back to the neckline of its head-and-shoulders pattern, and I observed that GE “now looks poised to move back toward the post-9/11 low.” It actually fell much further, into the low-$20’s by February 2003 before bouncing back.

GE has now fallen below its 40-week moving average again, and looks ready to fall hard from here. The warning signs are there for everyone to see, including the PPT, but the PPT cannot stop the message from this chart. That message is to stay away from financial stocks, like the banks, Fannie Mae and GE. Yes, I consider GE to be a financial stock. Having moved far beyond its origin in manufacturing, three-fourths of GE is now in effect one big hedge fund, borrowing short and lending long, which is the classic pattern by which financial firms get into trouble. The above chart is saying that GE is facing some perilous times ahead.

One final word about the stock market. I have repeatedly stated in past letters that I would rather have my money in stocks (selected ones anyway) than on deposit in a bank. This point of view reflects the growing credit risks to which banks are exposed and the fact that I want to avoid all dollar-denominated assets because the dollar will continue to lose purchasing power. I think some money is flowing into the stock market for this reason, i.e., stocks are better than bank deposits, which is also helping the PPT keep stocks up in the air.

Nevertheless, the longer the stock market defies gravity, the harder it will fall when it finally heads back to reality.