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Watch the Giant Head-Fake

Put your party hats on ‘cause they’re breakin’ out the champagne on Wall Street! This is beautiful. The headlines today read, “Dow Surges Over 10,000” and “Stocks Reclaim the High Ground!” Hewlett-Packard led the gainers today with a massive gap higher after reporting a 34% jump in second quarter profits to $884 million on revenue of $20.1 billion, well ahead of analysts’ revenue forecasts of $19.3 billion. Applied Materials reported an 82% jump in second quarter sales to $2.02 billion and STMicro raised its outlook for the chip industry, saying it now expects 2004 revenue growth of 30% compared with their earlier estimates of 24%. Tech stocks are off and runnin’ out of the gate with the NASDAQ Computer Index up more than 2% and the Semi-conductor Index higher by more than 3.5%. I’ll be back on this later to report the closing numbers, but for now you can rest assured the media spin will work to suck the unsuspecting retail investor back to putting their money into stocks.

Once the stock market began moving higher, it was reinforced early going with the spin that oil prices were moving lower which would support consumer confidence for continued spending. One commentator noted, “A fresh dip in oil prices underpinned the positive tone to the market.” Crude oil dipped below $40 per barrel to $39.90, but it didn’t last for long once the Energy Department announced a drop in crude inventories of 1.1 million barrels with confirmation from the American Petroleum Institute reporting a decline of one million barrels. Gasoline inventories were reported higher than last week with the Energy Department claiming an increase of 1.2 million barrels and the API estimating an increase of 2.1 million barrels.

Most recently, refineries have been shifting production away from heating oil and other distillates toward higher output of gasoline to satisfy the growing demand. Wouldn’t you be shocked if you pulled into the gas station and the attendant told you, “Sorry, not today ‘cause we’re waiting for our next delivery.” With refineries running at full tilt we just have to wait and see when peak demand hits with the summer driving season. By the end of the trading session, the June crude contract rose by almost a dollar to $41.50 and June unleaded gas was higher by six cents to close at $1.45, a new all-time high. The energy problem is not going away soon.

Inflation Caused by Global Demand

Just a couple weeks ago there was a great deal of disinformation in the popular media that China was going to curtail their rate of growth with higher interest rates and increased capital requirements for new construction projects. This is proving to be mostly jaw-boning to reduce inflation expectations here in the US. China has an enormous level of momentum to build infrastructure for a rapidly expanding economy. These people are HUNGRY!! They are just beginning to get a taste of the good life that middle-class America takes for granted. The Chinese people are migrating to the cities because they can actually get hot running water and flip a switch to turn the lights on. What a concept! For the things we assume are just a natural part of life, they are willing to work for pennies on the dollar. This is for real folks. There is now a tremendous amount of competition for the world’s resources. When you include India, Africa, South America, and all the other developing nations, you can see we don’t have an “exclusive” for wanting the niceties that can come from hard work.

If you want to read a really good article on what is going on in China, please click on this link and get a perspective from John Ing’s, “Gold: The China Syndrome.” He was actually in China a few weeks ago and offers first hand knowledge of the current developments. To wet your appetite here’s a few brief excerpts. “China is now the number one consumer in the world of copper, platinum, steel, zinc and iron. They produce more steel than the US and Japan combined. And there are more cell phone users and beer drinkers than in the United States…Chinese consumer demand, which is currently among the lowest in the Far East, is expected to grow significantly…China has the largest population in the world, with 1.3 billion people representing 25% of the world’s population. China has over 30 cities with populations over five million…Over 60% of China’s labor force remains in the countryside, but there is a steady migration…to the cities…China is also suffering a chronic shortage of electricity and plans to install 42 gigawatts of generating plant capacity this year alone, equivalent to the UK’s entire installed capacity....Of more concern, as goes the Chinese economy, so goes America’s financial markets. By becoming the world’s largest debtor nation, America has unknowingly allowed itself to be governed by the newest superpower, China.”

My point has been made by quoting John Ing’s paper, but to really see the whole picture please read the whole thing. For the gold and silver investors out there, he also goes into great detail on China’s impact to the precious metals sector. And speaking of gold and silver, they had the best trading day in many months today! I was obviously early in calling for a bottom and time to buy a few weeks ago, but it looks like we’re there now. June gold settled at $383.00, up a very nice $7.10 for the day and July silver added $.247 to close at $5.927. It’s about time! Those that have been following the Commitment of Traders know that the specs were on the short side with the commercials building long positions for the next run north. We had a clue yesterday with money moving into the gold shares late in the session and silver stocks adding 3-4% with the metal barely moving. It appears the shorts were covering in anticipation of the move today. If you are one to look at charts, you could also see the momentum indicators turning positive in divergence to the lower metals prices over the last four weeks on the daily charts.

Big Picture Look

The long term fundamentals have not changed a bit for gold, silver, bonds, the US dollar, and even stocks. Inflation is here to stay for the foreseeable future based on global demand for raw materials. Interest rates have been maintained at artificially low levels. Stocks are overvalued based on all historical precedents. The dollar is virtually guaranteed to drop another 20-30%, but not all at once. I will have to say that we are not completely out of the woods yet for gold and silver until the dollar breaks its short-term up-trend decisively.

I posted the daily chart of the US Dollar Index last week, but think it’s important to monitor its direction very closely at this point in the game….OOPS, I just blew it!!! Darn. I fully intended to add to my short position for the broad stock market today, but I’ve been in this “word document” typing with a few interruptions on the telephone. That is why I titled today’s WrapUp “Watch the Giant Head-Fake.” The spin on CNBC was just too much! The way they were talking, you would have bet the farm on stocks today. I thought a good portion of the hype was to keep the stock indexes propped-up until options expiration on Friday. I also thought a good portion of the advance this morning was due to short covering, especially for those that were short technology stocks.

Most of all, I believe the big money players have been trying to exit the stock market, but they need someone to buy the stocks from them! The “blue skies and sunny days” spin looked like pure propaganda to pass the hot potato for the institutional investors to the retail investors. On face value it looks like I was correct, but I missed my second entry for short positions. One of my cohorts at FSO even called me today (Martin Goldberg) and said, “This is it…here’s a great entry point to short the…..” (I’m not allowed to give specific investment advice in the public domain of the internet because I am a licensed broker. I would have to know each investor’s particular financial situation to know if a specific investment is considered “suitable” for their investment objectives. Going short is not suitable for all investors, so please don’t take this as advice. I can only offer specifics to current clients.)

We’ll have to see what tomorrow brings, but for now it’s easy to say the stock market couldn’t hang on to the gains. The Dow Industrials ended-up losing 30 points to 9,937, the NASDAQ had no change to close at 1,898 and the S&P 500 fell two points for a close of 1,088. The NASDAQ Computer Index I mentioned earlier coughed-up all its gains to close at breakeven for the day and the SOX Index added four points to close at 457. The stock market overall has shown deteriorating internal strength. Downside momentum has been picking up steam with advancing issues lagging way behind declining issues. The popular indexes have been holding-up with support coming from a handful of big-cap stocks, but it looks like the party could be over. This could get very ugly if everybody tries to head for the exits at the same time.

Back to the Bigger Picture

I watch the dollar closely because of my exposure to gold and silver stocks. The Fed has been pumping the money supply aggressively to keep asset prices inflated. For Mr. Greenspan it’s like trying to blow-up a balloon with holes in it. You have to keep blowing harder and harder, and if you stop, the balloon goes back to its original size. The balloon (or bubble) that most investors are painfully familiar with is the stock market. Take a look at the 14-year weekly chart of the S&P 500 Index. This is not a “done-deal” yet, but this is my current take on where we are headed in general. I still believe strongly we are in a long-term bear market for stocks and a long-term bull market for gold and commodities. Since the Fed popped the stock bubble by raising interest rates back in 1999-2000, the great stock bull market of 20 years has died.

Looking at the chart you can see the S&P 500 declined for about two and a half years, and over the last year and a half stocks have been in a counter-trend rally that has retraced roughly half of the prior decline. From an Elliott Wave perspective starting at the top, I count wave one down, wave two up, and now the beginning of wave three down. It’s fascinating to me that the counter-trend rally lines up almost exactly to the prior up-trend channel before stocks went into high gear back in 1995. From a technical perspective, the index should never have broken the neckline of the massive head and shoulders pattern. The H&S pattern is the most reliable in all of technical analysis and statistically speaking only had a 5% chance of being broken to the upside. The popping of the NASDAQ bubble brought the index down, and the supporting of the big-cap Dow Industrial Index drove the index back above the neckline.

I suspect great efforts will be made to keep the S&P 500 above the neckline or in the blue counter-trend channel until the presidential elections are done in November, but the red bear channel will dominate thereafter. The only hope the stock market has to remain at the higher levels is for inflation to go nuts. Corporate earnings will be pumped-up with “inflated” dollars, but you will need lots more of them because the purchasing power of those dollars will be chopped in half due to inflation.

Notice also that 1995 is the year that President Clinton began the “Strong Dollar Policy.” The policy was never defined, but I suspect it involved pumping-up paper assets and suppressing commodity prices for the purpose of flooding the world with US dollars. What countries would want to see the dollar decline if they are holding a ton of them as foreign exchange reserves? I believe global dollarization was the goal. The results are now being seen as unprecedented global inflation of fiat currencies that is now showing up as higher prices. Look at how many yen the Bank of Japan has created out of thin air just to sell in support of the dollar.

The supply of all paper currencies will inflate, but it will be very difficult to inflate the supply of gold and silver globally. Fiat monies are expanded with digital entries on a computer, but it takes a lot of hard work and energy resources to get “hard currencies” out of the ground. Limited supply of gold and silver with increasing demand implies much higher prices to come. With silver it’s even better because there are many businesses that require silver for the manufacturing process, especially for applications in the electronics industries. When investment demand increases as investors scramble to purchase assets that will work as a store of value, manufacturers that need silver will scramble to secure whatever available supplies remain. The factory that makes light switches and electrical conductors won’t care what price they pay for the silver, because without it they are out of business! Let the games begin!

I believe the outcomes outlined above are going to happen, but one of the big tricks is to know the specific timing of when they will happen. That is why the near-term direction of the US dollar is so very critical. The one-year daily chart of the US Dollar Index shows the bearish reversal formation of the rising wedge. According to the “Encyclopedia of Chart Patterns,” the probability of this pattern resolving to the downside is 76% with a price target 15% below the point of break-out. If the pattern breaks down at 90, the projected price puts the index at 76.5. To be conservative, let’s put it in the 78 to 82 range. If that happens it would put the index near its prior lows that were reached in the early 90’s, and as recently as 1995. I’ve provided a long-term chart of the Dollar Index so you can get a visual of what it would look like. I realize I’m sticking my neck out to go this far with the projected dollar decline, but it certainly supports the incredibly weak fundamentals that the dollar now exhibits. I’ve talked much about our debts and deficits, so I won’t beat the fundamentals to death.

In the long run I believe the Feds want to see a lower dollar so we can inflate our debts away. Historical precedent would certainly support that hypothesis. The big trick moving forward for the Fed will be how they can keep the bond market intact during a period of high inflation. In the very short-term, a falling stock market will push some of the scared money into bonds which will help to keep a floor on bond prices. If today is a precursor of what is in store for the stock market, we should see bonds hold fairly close to their recent losses. I’m confident the Fed will also monetize bonds in order to save the bond market should that become necessary. The whole process began a few years ago when the Treasury discontinued the issuance of the 30-year bond. With the lower supply of bonds at the long end it will be easier for the Fed to manage the long end of the curve. Without the bond market, we don’t have a monetary system. I believe the strength of the dollar will be sacrificed (meaning big inflation) to keep the status quo somewhere close to what we know today. Stocks and the dollar can go lower, but debt default in bonds is completely unacceptable if we are to maintain the system as we know it today.

Don’t lose heart for the prospects of a declining dollar and stock market, just do the best you can to protect the wealth you have accumulated. That is why most of the writers at FSO have been banging the drum loudly to protect your paper wealth with tangible assets. Gold, silver and commodities should fare well in this environment. Asset preservation should be a much higher priority than trying to pick the hottest stock of the day!

Have a Great Evening!

Mike Hartman

Charts courtesy of StockCharts.com

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