The Rout Picks Up Momentum

July 15, 2002 – The slide in the stock market really picked up some momentum this past week. The Dow Jones Industrials Average dropped 7.4%. The broader S&P Index of 500 stocks dropped 6.8%. These are huge one-week declines.

Because of this big drop in stock prices, I am again presenting the accompanying two charts of the Dow Industrials Average. These are the same charts that appeared in the last letter. They both present the Dow Industrials Average, but the top chart shows it as we normally view it in terms of dollars. The bottom chart presents the Dow in terms of GoldGrams.

Note that I have made one change compared to the way these charts were presented in the last letter. I have added an additional line to make comparisons between these two charts easier. The horizontal line I have added marks the low prices reached after September 11.

Some key points have been broken on these two charts. And importantly, this new horizontal line makes it easier to see the relatively different performance of the Dow when measured in these two ways.

There are some important observations to be made from these two charts. These include:

1) The GoldGram Dow has clearly broken down through its 22-year uptrend channel. The nominal Dow this past week broke through its 20-year uptrend channel as well, but so far the break is small. In other words, it’s still too close to call. Consequently, I’ll reserve judgement for another week or two as to whether or not the nominal Dow has really broken its major uptrend channel.

2) The nominal Dow is still above the low reached after September 11^th. In contrast, the GoldGram Dow has broken below this point. Though it is hard to see on the chart, this past Friday the GoldGram Dow closed at 855.89, which is 2.5% below its post-September 11^th low of 877.57. However, this break is also too close to call. Consequently, we need to watch this chart carefully as well for another week or two to see whether or not the break deepens, or conversely, whether the GoldGram Dow can rally back above 877.57.

I do not expect the GoldGram Dow to rally much from here. As readers know, we have been very bearish about the relative performance of the Dow compared to gold, and consequently, we have been watching this top form. This recent breakdown below the September 11^th low is just further indication that a major top is now in place. Therefore, any rally from here in the GoldGram Dow will just be a bear market rally. Nothing more.

So in summary, the bear market of the GoldGram Dow continues. We may now also have a begun a new downtrend in the nominal Dow, which is contrary to my expectations.

As readers know, I have been expecting the nominal Dow to trade sideways in a trading range as investors seek safe-havens as they flee from the dollar. That investors are fleeing from the US dollar is clear, as the ‘greenback’ sinks on the foreign exchange markets. However, so far there has been more money flowing into bonds than the stock market, which seems perverse.

Given the fact that bonds are dollar-denominated, why would investors not move out of bonds at the same time as well? After all, bonds are not a safe-haven from a dollar tanking on the foreign exchange markets.

Here’s what seems to be happening. US investors, not foreign investors, are dominating the money flows so far. In other words, US investors are oblivious to or don’t care about the decline in the dollar’s foreign exchange value. They measure their performance in dollar terms, as opposed to what’s really happening to their global purchasing power.

For example, if by buying bonds these investors avoid a stock market rout, they are happy. That the dollar is dropping against the other major currencies is of secondary importance to them. They don’t immediately see or feel this loss in global purchasing power. In short, the decline of the dollar has so far had little impact on US investors.

This reality about US investors also affects the actions of foreign investors. Because money flowing from the stock market has supported bond prices, the loss to foreign investors on their bond holdings from a declining dollar has been muted. Rising bond prices have offset to some extent a declining dollar. So bonds in their own perverse way – and just for the time being I expect – are being viewed as a safe haven.

Does this flight into bonds affect my long-term thinking about a flight out of the dollar? No, although I continue to watch the markets closely to see whether I should change my thinking. My view remains that this flight into bonds is probably just a short-term phenomenon, that shouldn’t last more than a few months at most.

As I noted in the last letter: “The picture for long-term interest rates remains bearish. The dollar is falling, commodity prices are rising, and most importantly, the federal government budget deficit is exploding.” This unfolding picture is ultimately bearish for bonds. And I remain focused on this ‘big picture’ view, because I think it is this big picture that will eventually determine the next big trend for bond prices – which will be down as the dollar continues to collapse on the foreign exchange markets and federal government deficits and debt continue to explode.

Consequently, while my expectation that selective blue chip stocks will provide a refuge for money moving out of the Dollar is now being tested, there is not sufficient evidence YET to cause me to change my view. I expect that the nominal Dow will tread water in a sideways trading range, while the Dow in terms of GoldGrams will continue to fall. And there is some reason to expect this outcome from indications that we are receiving from stock prices themselves.

As noted above, the Dow this past week dropped 7.4%, while the S&P 500 Index dropped 6.8%. The Dow Industrials only has 30 stocks, while there are 500 stocks in the S&P. This slightly better performance of the broader S&P Index may be an indication that the slide is nearing an end. In other words, many stocks have already punched themselves out, so they have little downside from here.

That this broader index did not drop as much as the Dow may be an indication that the downside selling is narrowing and therefore drying up. So it may be that the battered bulls will get a reprieve. But in any case, they are not going to get for a long time another bull market.