Stock Market

July 27, 2009 – I have updated the same chart of the Dow Jones Industrials Average presented in recent letters, but also made an important change by re-drawing the red line that had been marking overhead resistance. Please take a close look at the following chart.

It is clear that the red line has become the neckline of a ‘head & shoulders’ bottom completed by the DJIA. And the Dow has completed this pattern convincingly. The Dow Jones Industrial Average broke through its 200-day moving average as well as the neckline by putting in its biggest 2-week gain since 2000. So it would appear that there has been a lot of good economic news to drive the market higher since the last newsletter just two short weeks ago. But what has changed?

Is the stock market rising because of good economic conditions? Can it really see some so-called ‘green shoots’ across the valley? Or is the stock market rising for some other reason?

Readers know that I have been expecting the Dow and other major averages to eventually start rising because of inflation. All the trillions of dollars being created by the Federal Reserve and the banking system to fund the federal government’s out of control spending have to end up somewhere, and the stock market is a logical choice.

The dollars being created are indeed ending up in the stock market, and for good reason. The interest rate one can earn today on dollars is not sufficient to offset the loss of purchasing power from inflation, plus you have the counterparty risk of whoever is promising to pay that interest and return your principal to you.

Many banks are still insolvent; you don’t want their counterparty risk. And the federal government is broke and going deeper into debt, so you don’t want its counterparty risk either.

The point is that instead of owning anything dollar denominated you are better off owning shares of oil companies and other commodity producers as well as shares of companies whose products are in demand. Shares of many companies will soar in nominal dollar terms because the shares represent ownership of a wealth producing franchise, and if it is a well-run company, it will generate returns for its owners regardless what happens to the dollar.

When a currency collapses, stocks rise. Just look at the spectacular gains Zimbabwe stocks have been posting in terms of Zimbabwean currency, or the gains made by Argentine stocks in local currency terms when its currency hyperinflated in the early 1990s.

The stock market is not rising because of good earnings, as illustrated in the following chart from Chart of the Day.

Here is what Chart of the Day had to say last week: “Today, several companies (i.e. Ford, eBay and AT&T) reported better than expected earnings and as a result the stock market rallied on the news. While some companies have reported better than expected earnings for Q2 2009, others have struggled. Today’s chart provides some perspective on the current earnings environment by focusing on 12-month, as reported S&P 500 earnings. Today’s chart illustrates how earnings are expected (38% of S&P 500 companies have reported for Q2 2009) to have declined over 98% since peaking in Q3 2007, making this by far the largest decline on record (the data goes back to 1936). In fact, real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative.”

So for now, I continue to recommend that investors stay out of the stock market (except for my recommended stocks). Continue to hold ‘gold-cash’, not ‘dollar-cash’, thereby keeping your money safe and sound in bullion until stock prices fall to more reasonable levels when measured in terms of gold. I do not have any trading recommendations at the moment.