When Will the Stock Market Fall?

July 24, 2006 – Many thanks to Adrian Douglas for the accompanying chart of the price of gold plotted against the Dow Jones Industrials Average. Adrian first presented this chart in a commentary he submitted on July 7^th to www.lemetropolecafe.com.

Adrian says in his article: “I nearly fell off my chair when I plotted this!” So did I when I saw it.

This chart shows the price of the DJIA each day beginning in 2001 cross-plotted against the price of gold on the same day. For example, on June 30^th the DJIA closed at 11,150 and gold closed at $613.50. So if you look at the intersection of these two prices, there is a blue dot marking this data point.

Here’s how Adrian explains this chart: “The red line shows the early part of this bull market [in gold]. As expected gold is anti-correlated to the DJIA, so as the DJIA was falling the gold price was rising, until, that is, gold reached $350/oz. Then amazingly a strange thing happened… [Since then] the DJIA has been rising in a very strong correlation with gold. Despite these two asset classes being typically anti-correlated and having [been] so for the last quarter of a century, the DJIA suddenly levitates in perfect correlation with gold.”

Adrian’s conclusion is that: “If ever anyone wanted a picture that tells the story of stock market intervention this is it. The Dow is being bought as part of a plan to keep attracting foreign investment, which supports the dollar and keeps interest rates low, and allows the US to keep living beyond its means.” In other words, the DJIA is being manipulated; it is being artificially supported. By doing so the government is attempting through the world’s most widely watched stock index to provide some semblance of normality. As long as the DJIA is not falling, people can be led to believe that the structural imbalances of today’s monetary system can continue without end -or at least that is what the government seems to think.

I have written before about the so-called Plunge Protection Team, which is formally known as the federal government’s Working Group on Financial Markets. So I think Adrian’s point is a good one. The manipulation (or call it ‘intervention’ if you prefer the term the government itself uses) of various markets is very real.

Recently (and particularly since 9/11) it seems like every time the Dow dips, mysterious buying props up the Dow. Can the government possibly justify this intervention by claiming it is in the national interest to keep the DJIA at a lofty level? Why not? After all, the government these days uses its interpretation of the so-called national interest to justify almost anything. What’s more, the mysterious buying that miraculously saves the Dow from collapse at key moments is now a well-established fact.

This mysterious buying typically appears initially in the S&P futures pit, to apparently to take advantage of the leverage made possible through futures. As the shorts run for cover, the result invariably is a buying panic, which soon carries over into the purchase of stocks on the different exchanges. But something different is now happening.

Notice that the slope of the yellow line is increasing. Gold is now rising much faster than the DJIA, which Adrian says is “good news” because it means “the manipulation game is being over-powered.” I wholeheartedly agree, but in my view, it may also mean something else -something very important. The upward trajectory of the yellow line is not just increasing; it’s becoming parabolic. Why is that?

Long-time readers to these letters know that I have two very different scenarios for the DJIA, each of which depends upon the time frame being considered. In the short-term I have been expecting the stock market to sell-off, which explains why we have been trading it from the short side. The reason for the sell-off is that stocks are overvalued and historical experience shows that repeated interest rate increases by the Federal Reserve do three things.

First, it makes dividend yields on stocks look less attractive, compared to the rising interest rate yield available on government and corporate paper. Second, it dampens economic activity, thereby putting pressure on stock earnings and making returns on stocks less attractive compared to other investments. Third, interest rates increases tend to reduce liquidity, which puts selling pressure on stocks. Basically, interest rate increases usually signal that a bear market in stocks is underway and that falling stock market P/Es can be expected.

So while I have been expecting the stock market to fall in the short-term, a different picture emerges in the long term because the problems with the dollar will eventually lead to a currency collapse. In a currency collapse wealth flees the currency and moves into safer forms. It’s a flight from currency, because the currency is spent in order to moves one’s wealth into whatever assets that are available and deemed to be safer than holding the currency.

High on the list of everyone’s safest asset is of course gold and then other tangibles, but in a flight from currency stocks will rise as well at least in nominal terms. In other words, you will be better off holding gold than the DJIA, but you will do better holding the DJIA instead of dollar denominated assets like bank accounts, government debt instruments (i.e., Treasury bills, notes and bonds) and corporate paper. The reason is that with stocks you own equity in a company that produces goods and services, and if those products are in demand, people will buy them regardless what happens to the currency.

For example, shares in Exxon are not a dollar denominated asset. We may use dollars to trade it on the NYSE and Exxon may report its balance sheet in dollars, but if the dollar collapses, both Exxon and the NYSE will just simply begin using a new currency.

So what is the yellow parabolic line on the page-1 chart really telling us? I myself find this hard to believe, which is a surprise because readers of these letters know how bearish I am on the dollar. But it seems clear to me that we are much closer to a collapse in the dollar than even I expected. The acceleration of the parabola in the page-1 chart means that we probably have 6 to 12 months before the collapse in the dollar begins to accelerate so intensely that its fall becomes visible to the entire world. It will be headline news, which of course will spread panic and hasten the flight out of the dollar.

Here are the two key points to watch for. We need both of them to happen in order to confirm that there is enough weakness in the dollar that it is starting on its final path down. First, the US Dollar Index needs to break below 80, its all-time record low to date. Second, gold has to move into 4-digits. When these two events happen, expect a dollar crisis that will lead in relatively short order to the collapse of the dollar.

What’s really worrying though is the parabola on the page-1 chart. It suggests that the flight from the dollar is already well underway. We are perhaps much closer to the dollar’s collapse than we realize.