Financial Market Commentary by Simit Patel

Why Now is the Wrong Time to Smoke THC

2009-08-20T11:56:00.000-07:00

Tenet Healthcare (THC), a publicly traded company focused on providing quality healthcare via hospitals, has been on a tear this year. Its stock price has risen by over 300%, and the trend is clearly upwards. The rise in price may be partially attributable to improvement's in the company's financials: while the company did post a loss in the second quarter of 2009, its revenue continues to grow. Moreover, if discontinued operations were excluded from financials, the company would be profitable. This suggests the company may be on the right track.

Economic woes, however, affect all industries -- including healthcare. Will the Obama plan for creating more health insurance options help companies like THC? Perhaps, although government handouts typically come at the expense of greater regulatory scrutiny. Government handouts also increase the likelihood that political connections will impact how regulations are structured. Given that Tenet Healthcare has not been the best friend of the US government -- in 2006, the company settled on charges that it was overcharging the US federal government for Medicare expenses, paying $725 million in cash to the government while foregoing an additional $175 million in fees -- the company may not have the political connections needed to get the most out of proposed government-led healthcare reforms. Moreover, Trevor Fetter, CEO of THC, has expressed skepticism towards the Obama administration's healthcare plans, suggesting that hospitals will be forced to bear too much of the burden.

Fundamentally, I think the picture is a bit mixed, and is dependent much upon pending government legislation. Technically, however, I think THC, which has been on a strong uptrend, is due for a correction. The chart below, a weekly chart of THC, shows RSI overbought and declining, the price near the upper Bollinger band, and a doji as the most recent candlestick. With this in mind, this may be an opportunity for short-term short sellers. Alternatively, those bullish on THC may benefit from waiting for a pullback before going long.

Disclosure: No position.

Six Things for Gold Traders to Watch

2009-08-19T15:29:00.000-07:00

Here are six things I'm personally keeping an eye on to gauge the direction of the price of gold:

1. COT report. AceFX shared with us gold COT data. This report shows that commercial traders -- generally believed to be "smart money" traders involved in day-to-day operations of the commodity in question -- are short gold. The commercial traders are increasingly short while others are increasingly long; in such a scenario, when the non-commercials run out of fuel in their trend, they will start liquidating, and the commercials can see this as an opportunity to add to their short positions and push the market further down.

Below is the chart Ace shared with us in the thread he started on this subject.

Click to See Enlarged Chart

2. Consolidation on daily chart. Below is a daily chart. We see consolidation via a pennant formation -- a formation that often precedes a sharp breakout. Accordingly, I think there could be a sharp breakout if the market can break above resistance at $980 or support near $925.

3. US banking system still under stress. US banks are still failing, and more may be on the way. Bank failures increase the need for safe havens, which gold, with its long history of serving as a stable monetary commodity, can provide.

4. The Federal Reserve is still aggressively monetizing. The Federal Reserve has stated they will continue to print money and buy assets through the end of October. Additional money creation without the creation of additional productivity stands to devalue the currency, and is the kind of event that can precipitate a run on a currency. Currency devaluation, particularly when it stems from monetary policy put forth by governmental/quasi-governmental agencies, is bullish for gold, as gold is regarded as a hedge against currency devaluation resulting from central banking policies.

5. Financial fraud rising. Courtesy of Jesse comes the chart below, which shows that financial fraud is rising in the US. Fraud weakens the US dollar and the political economy it stems from, and thus could be seen as bullish for gold.

Click to View Enlarged Chart

6. Financial Fraud in Comex. Comex recently permitted gold futures contracts to be settled not only with physical delivery, but with delivery of shares of gold exchange-traded funds like GLD. GATA explains how this inflates the amount of paper gold, much of which may not be backed by real physical gold. This may result in a split in the gold market -- prices for physical delivery and prices for paper gold.

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The Case for Shorting BAC (Bank of America)

2009-08-18T18:00:00.000-07:00

Should the bear market in US equities resume in the coming months, which I think it will, BAC (Bank of America) may be an excellent shorting opportunity. Here's why:

1. The stock has a beta of 2.41 -- quite high. High beta stocks will be appealing to short for those who are very confident in a forthcoming bear market, as a higher beta suggests greater volatility and a more powerful move in the direction of the overall market trend.

2. A P/E ratio of 38.18, more than twice that of the S&P 500, seems a bit excessive in my opinion -- doubly so when one considers that BAC is a mature company in a troubled industry (banking). Based on P/E ratio alone, I would expect price to fall by 50%.

3. The technicals are particularly appealing, in my opinion. Below is a daily chart. Note the RSI divergence -- prices make new highs, but RSI does not. This suggests the uptrend is running out of strength. We also see a doji and an inverted hammer in the last two candles -- this fact, coupled with the rangebound price action, also suggest the uptrend is running out.

On the weekly chart (see below), we also see RSI divergence. The weekly chart also shows resistance at around 18.30, with support at 12.30. This creates an opportunity to short at a favorable risk/reward ratio -- the stop-loss order can be placed just above resistance, with the profit target being support.

Disclosure: No position.

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The Case for Shorting Google

2009-08-17T14:36:00.000-07:00

Today's sharp drop in US equities has permabears asking: has the next leg down for US equities begun?

From a fundamental perspective:

1. Google is a mature company in an industry of questionable growth potential. While the company is in a league of its own, its league -- CPC/CPM advertising -- is on the way out, and Google's size and maturity hinders its ability to adapt accordingly. I expect new ad networks and publishing networks to slowly eat away at Google's primary revenue source -- text link advertising -- while revenue from text link advertising declines due to macroeconomic woes. New ad networks that can find ways to deliver engaging promotional material without relying on CPC/CPM pricing fit into the context of a disruptive innovation, in that they compete on a dimension that the incumbent -- Google -- cannot compete on. Specifically, something like a gaming company that offers in-game advertising, is the kind of model that could disrupt Google's position as emperor of online advertising.

2. The company's P/E ratio is currently at 30.87 -- the average of the S&P 500 is currently 16.93, according to Robert Shiller. As bears do what they do best -- put the smackdown on overvalued assets -- I expect Google's P/E to fall noticeably, so that it is closer to the S&P 500.

From a technical perspective:

The daily chart is interesting. While volume is low -- attributed to seasonality, and the lower volume that typically comes with August -- we do see a doji candle from several days ago. We also see MACD just turn bearish, which could signal the onset of a new short-term bear trend.

The weekly chart is a bit more sobering for permabears, and suggests bears may need to wait a bit longer before dining on bulls. A rising wedge suggests the market is still bullish on Google, and MACD remains bullish.

Ideas for Trading Google

More conservative bears may wish to wait for a pullback to the upper trendline on the weekly chart, which would happen at around 500. However, such a pullback may not occur. Alternatively, bears may wish to short now, with a protective stop loss order right above the high of Monday's candle which gapped down. The target profit would be the trendline drawn on the daily chart. This would only be a risk/reward ratio of 1:1, so perhaps not the best trade. However, if we are ready for the next leg down, we may see a break below that trendline. As a result, traders who scale into positions may wish to enter some now, and add to their position on a close below the lower trendline.

Disclosure: No position.

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In Spite of Prolonged Rally, Top Permabears Still Sticking To Their Story -- Here's Why

2009-08-11T09:06:00.000-07:00

As a permabear, my natural inclination is to be bearish on US equities. However, even hardcore permabears like myself are forced to acknowledge an uptrend, and clearly an uptrend exists on the S&P. Below is a weekly chart of SPY, an ETF that tracks the S&P 500. Since March of 2009, we've been in a clear uptrend.

However, let's look at some arguments why it may not last:

1. You will hear many arguments about recovery will be W-shaped, U-shaped, V-shaped, etc. Personally, I agree with fellow permabear Eric Janzsen, who noted that we need to look to the Cyrillic alphabet to find a letter whose shape corresponds to the current economic cycle in the US. Janzsen argues for a Cheh-shaped progression. Basically, that while we may have some seemingly strong bull trends, as we did during the Great Depression, the ultimate trend is still bearish.

2. Stefan Karlsson notes that stocks are still overvalued from a fundamental perspective, noting that earnings of broad baskets of stocks are down 30% while prices are down just 20%.

3. Strict adherents to Austrian economics will note that a recovery cannot really happen so long as malinvestments are not liquidated. Bailouts prevent the liquidation of malinvestments and the return of asset prices to appropriate levels; so long as this situation maintains, a recovery seems unlikely. I agree with this notion from a philosophical perspective, although from a financial perspective, it does not seem to be particularly meaningful. We can have a rally in the stock market and a plagued economy; the two are not mutually exclusive.

Personally I focus on trading the US dollar, though my bias is to short the S&P as it approaches strong resistance levels.

Tracking the Collapse of the US Dollar

2009-05-25T10:11:00.000-07:00

The case for a severe weakening, and perhaps even total collapse, of the US dollar is something I've been making for some time on my blog. As the dollar has begun experiencing some deeper bouts of weakness and has given back all of its gains since October 2008, I wanted to step back and take a big picture look at where we are on the path to dollar collapse -- and re-evaluate whether or not we will stay on this path.

The first big picture event we should look at is the price of gold. A new bull market in gold began in 2001. This is a long-term trend, I believe the next leg of this trend will start shortly.

The second big picture event worth noting is the collapse of the US stock market in 2008, particularly the second half of the year. Remember there are two sides to a currency crisis: (1) an overproduction of supply of the currency and (2) a loss of confidence and demand for the currency. The Federal Reserve's monetary policy is, in my opinion, the primary contributor to the oversupply of currency, and the corresponding price inflation/currency weakness we've seen over the past decade. The stock market collapse reflects a weaker demand for US financial assets, and thus a weaker demand for the US dollar -- particularly when one considers that the finance industry is a major component of the US economy.

At this point, we should ask ourselves if these trends have reversed: has monetary policy sought to tighten money supply? And has the US economy repaired its banking sector? In my opinion, the answer to those questions is no. Bernanke is firmly committed to inflation as a monetary policy, and the Obama-led stimulus packages has already resulted in an increase in broad measures money supply like MZM. So fundamentally, I think we're still on the track to dollar devaluation.

Recent Milestones in Treasury Bonds and the Dollar

There are two milestones which recently occurred which suggest the US dollar devaluation trend may be set to accelerate. Those trends are:

1. Treasury yields have spiked sharply. This suggests bond buyers are now demanding a greater rate of return on the money they lend. The reason for this, in my opinion, is concerns regarding a weaker dollar in the near future.

2. UUP, the ETF which tracks the US dollar index, is on the verge of breaking a major support level. See the chart below.

Trading This Environment

My trading outlook remains the same, in that dollar devaluation is the primary trend, and that it is here. I favor buying precious metals, commodities, and commodity currencies. I favor shorting the US dollar and US Treasury bonds. At this point, I view it as a relatively safe bet that long gold/short long-term Treasury bonds will likely end up as the trade of the year.

Disclosure: Long gold, silver, and Canadian dollars. Short US dollar.

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The Best Current Short Dollar Trade Currently in the Market

2009-04-14T14:05:00.000-07:00

All may seem calm to the casual observer, and there may even be indications of a recovery: the Dow and S&P have outperformed Treasury bonds and precious metals, and the dollar has remained stable. Is this the beginning of a new bull market? Is it time for permabears to pack it up and go home? The chart below illustrates the situation.

To my fellow permabears: fear not, for contrary to what the always happy-go-lucky bulls may think, this is simply a rally within a bear market. Short-term traders may find it enjoyable, but the buy and holders? Well, now remains a good time to continue accruing precious metals.

But for traders like myself who are always looking for opportunities to trade their long-term perspective, know that the market is currently giving us a very good opportunity. Inflationists/Dollar bears have been eyeing commodities, and on the Australian dollar and the Canadian dollar -- currencies closely correlated with commodities.

Check the chart below on the Australian dollar.

And the chart below on the Canadian dollar.

Trading This Setup

I've already entered a short USDCAD trade, and will be scaling into this position as it moves in my favor. I would like to see a test of the 1.05 area. I'll add on the break below each key level, and will close out if there are signs the trend has reversed or is stagnating.

Simit Patel
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The Road to Hyperinflation

2009-03-19T14:48:00.000-07:00

As most of us who have been watching the financial markets know, yesterday was quite a day. The Federal Reserve announced they would print money to buy Treasuries and mortgage-backed securities.

The Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

The market promptly responded:

1. Gold shot up and stayed up; it is currently trading at $958 at the time of this writing. Silver is rallying as well, trading at $13.48 per ounce at the time of this writing.
2. The US dollar dropped sharply against all other major currencies.
3. Crude oil rallied above $50 per barrel.
4. Treasuries rallied.

From these events, we can deduce two things:

1. The Fed is clearly aggressively pursuing its an inflationary monetary policy. This is further evidence that the Fed can do what it wants; if the Fed is truly determined to inflate, it will be able to do so, regardless of whether or not banks will lend. Monetary policy is a fiat matter.

2. The market is clearly willing to run from the dollar in the face of outright monetization.

As money supply is expanding while demand for US dollars is collapsing, and as dissatisfaction with the political environment in the United States is at a nearly unprecedented level, it is clear the ingredients for hyperinflation are in place. See our previous analysis of hyperinflation for a more detailed explanation.

Moreover, CPI data released yesterday by the Labor Department in the US noted that consumer prices rose for the second consecutive month. Should this trend continue, it sets the stage for a price/wage spiral, whereby higher prices lead to higher wages, which in turn lead to higher prices, and so. Declines in demand due to higher prices may not be sufficient to stop prices from rising further should the Fed continue an inflationary policy.

The New Trading Environment

As we have discussed before, "playing defense" against monetary policy is crucial to wealth preservation in a centrally planned economy. Based on the signals the market and the monetary authorities have recently given us, here are some trading thoughts for the near future:

1. Gold and silver. I've advocated precious metals many times before, and continue to do so, as they are the conventional inflation hedge, and remain the market's monetary commodities of choice.

2. As the Fed is distorting the free market process in the Treasury market through intervention, Treasuries may be difficult to trade without technical analysis.

3. Watch oil. Should it continue to rise, which seems very likely to me, it would be further evidence of an inflationary spiral, as rising oil prices will lead to rising gas prices, which in turn will lead to rising prices, and a demand for rising wages. With that said, I find oil's behavior a bit perplexing, and thus I personally favor precious metals as an inflation hedge. Those with a larger capital base and a need to diversify, though, may seek solace in oil.

4. The stock market remains a trader's environment, even more so than before. Those who can use technical analysis to understand momentum will be best positioned to find profits in the stock market, in my opinion. Fundamental analysis will be less effective, as the Fed's interventionist behavior will make rational analysis difficult and perhaps fruitless.

Disclosure: Long gold and silver.

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The Case for the Australian Dollar as a Long-Term Trade

2009-03-18T10:18:00.000-07:00

One of my favorite currencies on a three year outlook is the Australian dollar. There are three reasons for this:

1. In light of the increase in US government spending and the diminishing tax base, I think substantial dollar devaluation is likely over the next 3-4 years. This increases pressure to "decouple" -- specifically for China to discontinue buying US Treasury bonds, and to invest that capital into its own economy, which it has been doing. As China invests more in its own domestic economy, it will boost the economies of geographically related countries that can export necessary commodities to China. That's where Australia comes in.

2. Australia's central bank, the Reserve Bank of Australia, currently has an interest rate target of 3.25%. In a world where zero percent interest rates are becoming the norm, this is quite appealing, and may attract capital that is seeking the security and liquidity of a currency but with an interest rate yield as well. Put another way, the Australian dollar could be the new carry trade.

3. The Australian economy has, at least for now, remained relatively unscathed by the global economic crisis. In Australia, wages are up, business investments are up, retail sales are increasing, the housing sector is expanding, and the country si running a trade surplus.

In light of the aforementioned, the Australian Dollar seems like a viable long-term alternative to the British pound and the US dollar.

Trading the Australian Dollar

Personally I've been riding the recent short-term rally in AUDJPY (Australian dollar against the Japanese yen), though price action is suggesting this rally may be out of steam in the short-term. Patient traders, though, may wish to keep an eye on AUDUSD and look to enter as momentum turns upwards. The chart below illustrates key price points that can serve as areas where prices may consolidate -- and thus where traders can look to enter or exit positions.

Disclosure: Long Australian dollar.

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Demystifing What Gold is Telling Us

2009-02-19T10:49:00.000-08:00

Well, gold bugs around the world have been having a good chuckle of late, as the market is re-affirming the often eccentric and religious-esque views of gold bugs: gold is up over 11% for the year in US dollars, and up over 4% over just the past five trading days. Which begs the question: why? There are a few possible answers to this question:

1. Deflation. This crisis is global, and everyone is flying to safe stores of wealth. Over the big picture of human history, gold has served as the best store of wealth -- and thus gold is rising. In many ways this is the classic "gold is money" argument, one typically championed by Austrian economists. Robert Blumen has offered an excellent explanation of this argument.
2. Inflation. Gold is typically a hedge against inflation concerns, and as the US federal government continues to aggressively "stimulate" the economy, the rally in gold may be a reflection of increased concerns regarding inflation.

So which one is it?

In my opinion, both. With that said, I view inflation as the larger concern, as I have said many times before. If the environment were truly deflationary, Treasury bonds would be the true recipients of flight to quality, as well as dollar holdings in FDIC insured banks. Instead, 20+ year Treasury bonds have fallen by more than 13% thus far (as measured by TLT). Negative correlation between TLT and precious metals suggests inflation, not deflation. The chart below illustrates.

Deflationists will point to the fact that the US dollar may be strengthening relative to other fiat currencies -- although this is not necessarily a reflection of deflation, as it could simply be interpreted as weakness of all global currencies, all of which are falling against gold. More relevant may be the rise in PPI and energy prices in January of 2009. While one month alone does not provide sufficient evidence for a substantive reversal in macroeconomic trends, it is not consistent with deflation, and may suggest that the Fed's inflationary actions in the second half of 2008 may be kicking in.

Conclusions for Trading

The recent activity in the market has led me to make the following revisions:

1. The forex market is increasingly a trader's environment, perhaps even a daytrader's environment.
2. Gold and silver may retrace, perhaps even by several hundred dollars, though I would view it as an opportunity to buy on dips. The global economy is getting worse and conditions are being aggravated by the actions of central bankers. As a result, the fundamental case for gold and silver will get stronger.
3. Counterparty risk is rising -- this strengthens the argument for increasing the physical delivery portion of one's precious metals portfolio.
4. Because of inflation concerns, my bias is against short positions in all asset classes. If I were a trader of stocks or commodities, I might look into shorting positions relative to a broader index (i.e. short a particular stock while going long the sector ETF, under the rationale that the stock will do worse than the entire sector).
5. Oil's behavior has been quite peculiar; I've yet to find a convincing explanation for why it's moving the way it is. As it escapes my fundamental analysis, and as I find it less appealing than currencies from a technical analysis perspective, I'll stay away from oil.
6. As gold becomes too expensive for many, silver will grow in appeal. And as silver fell more than gold during the second half of 2008, it may be set for a larger rally.

Disclosure: Long gold and silver.

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Copper And Base Metals May Be Good Way to Profit from Inflation

2009-02-04T10:22:00.001-08:00

Copper has become a renewed subject of interest, as some market prognosticators view copper as a leading indicator of the economy as a whole. This results from the fact that copper is used in a wide variety of businesses -- industrial products, semiconductors, infrastructure, etc. -- and thus changes in copper prices can signal big changes in sectors that are copper-dependent. Currently, copper prices are rising, which could be interpreted as businesses showing an interest in buying copper because of an increased willingness to assume risk and invest in certain sectors of the economy.

The chart below illustrates. The transportation and semiconductor sectors tend to be particularly dependent upon copper, and thus included ETFs that track them (XSD for semiconductors and IYT for transportation) in the chart below; we may be able to learn more about which sectors in particular are moving.

While semiconductors have been rallying since mid-November, the transportation sector continues to be devalued. Moreover, the overall demand for copper is declining around the world, as this Bloomberg article notes, and has decreased copper mining efforts.

As platinum, silver, and gold continue to rise while Treasuries continue to fall, copper's rally may signify greater inflation concerns. As metals have rallied while commodities have remained stagnant, the market may be signalling greater concerns about inflation in the midst of a lack of investment opportunities.

Thoughts on Trading

Copper has taken a particularly harsh beating thus far, as the chart above illustrates. As such, the bottom identified in the chart may be a critical level to watch to gauge broader macroeconomic trends; a break of that level could signify the next leg down for equities.

Conversely, copper may be a better play for those looking to profit from reflation of the money supply. As copper has fallen more than many other metals since falling asset prices set in in August of 2008, it may be due for a larger correction.

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A Bull Market in Stocks Could Result from Significant Inflation

2009-02-02T09:55:00.000-08:00

Puru Saxena of Money Matters recently wrote an article entitled "Birth of a New Cyclical Bull?" in which he offers arguments for why we may see 2009 be a bullish year for equities. His basic points:

Inflationary actions by the Fed and declining TED Spread have proven effective in fighting falling asset prices and reducing risk
Treasury bonds need to have higher yields or money will go into equities
Equities have "overshot" to the downside, thus resulting in excessively low valuations

I agree with Saxena's basic premise that the Fed's actions will be successful in creating in inflation in the aggregate; it is only a matter of which asset class will reap the benefits of the inflation, and who will pay for it.

The chart below compares various asset classes against one another for the month of January.

A key question we may wish to begin asking and examining is just how much inflation the Fed has really created for us, something that will become more apparent as lending resumes and money that is "on the sidelines" returns to the game. I'm of the viewpoint that the global economy is currently improperly structured, and needs a complete restructuring, one that will likely require abandonment of the US dollar as world reserve currency, a corresponding decline in US consumption, and a significant restructuring of the FIRE (finance, insurance, real estate) economy in the United States. From that perspective, an equities rally will be unsustainable, unless there is currency debasement to the extent that all markets rise nominally. If that is the case, though, the inflation will result in significant dollar devaluation.

Trading Implications

The fall in Treasuries was the story for January, and will be of importance so long as it continues. If money comes out of Treasuries and into equities and commodities, it increases the likelihood of seeing consumer price inflation. As I've stated before, though, I expect commodities to outperform equities once money comes out of Treasuries and dollar devaluation resumes. And as all currencies around the world are having trouble, gold will continue to rise as fiat currencies continue to struggle.

Disclosure: Long gold.

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Money Coming Out of Treasuries And Into Gold

2009-01-28T09:24:00.001-08:00

To understand how the macroeconomic picture is changing, we can take a look at how various asset classes are changing relative to one another. With that in mind, see the chart below, which shows the ETFs for four asset classes -- Treasuries, gold, commodities, and the S&P 500 -- to see where money is moving.

The chart illustrates the following:

20+ year Treasury bonds were rising, but now appear to be consolidating and possibly turning bearish
S&P is rangebound between 850 and 950
Gold is rallying
Commodities are still in a bear trend

Interpretation

The rise in gold coupled with weakening Treasury bonds, commodities, and S&P suggests the market is still rooting out false forms of wealth -- and that the market is shifting to gold as its preferred method of safety. Inflationists will posit that the rise in gold results from greater inflation concerns, and this may play a part into it as well; money supply indicators and money velocity indicators are both pointing to inflation.

Trade Setups

Two potential trade opportunities come to mind:

1. Betting on a continued exodus from Treasuries into gold, in that the market will continue to favor gold over Treasuries as a safe haven
2. Long commodities relative to S&P; commodities seem grossly underpriced relative to the S&P, doubly so for those expecting a deflation spiral.

Disclosure: Long gold.

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An Inside Look at the Beef Between Mike Shedlock and Peter Schiff

2009-01-28T09:21:00.000-08:00

The Austrian economics blogosphere was rocked to its very core yesterday, when Mike Shedlock, one of the most popular economics bloggers on the web, dropped a serious smackdown on Peter Schiff in a post entitled, "Peter Schiff Was Wrong." In this post we'll analyze the beef between two of the most prolific economists of our time.

Meet the Contestants: Peter Schiff vs. Mike Shedlock

Peter Schiff: Adheres to the Austrian school of economics. President of his own brokerage firm, Euro Pacific Capital. Here's his web site.

Mike Shedlock: Austrian economist. Investment advisor. Prolific blogger -- check it.

Like any great rivalry -- Ali vs. Frazier, Google vs. Microsoft, Batman vs. Joker, etc. -- Schiff vs. Shedlock is not without history; see their previous debate.

Now that we've met the contestants and know the history of this longstanding rivalry, let's take a look at what it's really about.

Schiff vs. Shedlock = Dead Dollar vs. Rangebound Dollar

It's crucial to note that Schiff and Shedlock agree on quite a bit. Such as:

Gold will rally
US stocks will decline
Japanese yen will appreciate

Their primary point of contention is their debate on what will happen to the US dollar. Schiff thinks the dollar is doomed and will lose more than half its value over time; how long is unclear, though Schiff has been anti-dollar for some time (since at least 2002), and is sticking to that as the long-term trend. Shedlock, on the other hand, thinks the dollar will be rangebound and is not expecting to see the dramatic decline Schiff is expecting.

Schiff is referred as an inflationist, while Shedlock is a deflationist. It is crucial to note the terms inflation and deflation refer to money supply, not prices. Thus, a key difference in the analysis of Schiff and Shedlock is that most inflationists will use MZM as a money supply indicator, while Shedlock and other deflationists are more inclined to use something else. As a result, the issue of how best to calculate money supply also plays into the heated rivalry between Schiff and Shedlock.

Secondary Conflicts Over Treasuries and Commodities

Their conflicting views on the US dollar lead to conflicting views on other asset classes -- namely government bonds (i.e. Treasury bonds) and commodities. Commodities are traditionally anti-dollar investments; if you think the US dollar will fall, buying commodities is a way to hedge against this. This was proven to commodities investors who enjoyed the rally from 2002 to mid-2008, which coincided with ongoing dollar devaluation. Likewise, bonds are typically favored when investors "go cold" and look for safety -- but are dreaded by those who view currency devaluation as a great concern.

Sizing Up Schiff

Peter Schiff is an icon of sorts amongst bears, as he has been the most successful in breaking the "bear barrier" and expressing bear ideology to millions via regular appearances on national television. Personally, I agree with Schiff's long-term fundamental analysis, which is bullish for commodities, metals, and Asia, while bearish on the US economy. I think dollar devaluation is baked in, that there is a bubble in Treasuries, and that once this bubble pops, a run on the dollar will ensue (the Argentina and Iceland scenario).

With that said, as Schiff himself admits, it is unclear when the bubble will pop. Bubbles can go on for a few years, and during that time, clinging to your investment thesis can hurt -- and Schiff's overall thesis did not fare well in 2008, as his archnemesis Shedlock is fond of reminding us. For that reason, I think it would be advantageous to couple Schiff's fundamental analysis with momentum following technical analysis. This is essentially my trading strategy, and 2008 was a healthy and profitable year for me -- as it was for anyone who coupled Schiff's views with technical analysis.

Sizing Up Shedlock

There is no denying Shedlock is an excellent economist, and he deserves much credit for being one of the few people who called for a strong rally in the dollar, US Treasury bonds, and a decline in commodities. While most perma-bears and Austrian economists saw the collapse of XLF (financials) and XHB (homebuilders) coming, a more common view was that the bubble would go to commodities, where it would stay and grow. Thus the calls of oil going to $200 (which is something I must confess to having said, but not traded). And we did proceed on this path -- oil got above $140 -- but then came sharply back down, and the bubble was passed to Treasuries.

Ultimately, Shedlock thinks the Treasury market is safe, and is not one of those concerned about a potential collapse in Treasury prices. Shedlock maintains this concern when wealth contraction occurs around the world, thus leaving less investment dollars available for foreigners to buy US Treasury bonds, and also while gold and silver become increasingly popular alternatively stores of wealth, something which Shedlock correctly forecasted. And he maintains the stability of the Treasury bond market when supply is set to increase significantly given Obama's aggressive stimulus mandates and philosophy of "deficit's don't matter."

The Key Factor: To What Extent Is Monetary Policy Fiat?

So who's the winner? Schiff or Shedlock?

Well, as noted previously, I consider both to be outstanding economists, and thus they have already won in the eyes of this judge. In terms of whose investment thesis will prove to be more victorious, however, much of it will boil down to one key question: is monetary policy fiat? Meaning can the Federal Reserve inflate if it wants, and deflate if it wants?

Deflationists will argue that because the Federal Reserve cannot force banks to lend, it cannot affect the portion of the money supply that is created by commercial banks when they lend money into existence, and that credit destruction (declining availability of credit and falling asset prices) will result in a declining money supply. Inflationists will argue deficit spending, interest rate cuts, induction of sell offs by foreign central banks, and coordinated activity with other central banks can always result in inflation, provided there is no restriction on money supply, like a commodity standard that guarantees the value of each note of circulation with respect to a commodity.

In my opinion, the Federal Reserve can inflate if it wants, and that monetary policy in an economy with a central bank a fiat currency is a fiat matter -- if inflation is decided, than that is what shall happen. As Bernanke and friends still view inflation as the solution and view deflation as intolerable, I'm inclined to think inflation/currency devaluation is the greater concern, and that Schiff's long-term thesis is still correct.

Alternatives to Schiff and Shedlock

There are those who may find Schiff and Shedlock to both be unsatisfying in ways, and thus may find the rivalry to be less than compelling. For those folks, I'd recommend Eric Janszen and Stefan Karlsson.

For another take on Schiff vs. Shedlock, see this commentary from David Waring.

Discuss on InformedTrades

If Inflation is Institutionalized, We Need to Learn Short-Term Trading

2009-01-22T08:35:00.000-08:00

Inflation is and has been the monetary policy of choice since the gold standard was fully abolished in 1971. See the long-term money supply chart below.

Consequences of Institutionalized Inflation

The key question for investors and traders: what are the consequences of inflation being institutionalized as monetary policy?

1. It leads to a "pass the bubble" economy. When the Federal Reserve inflates to counter deflation, the excess money supply will be directed into an asset class besides the ones being deflated, thus leading to a new bubble. The bubble in US Treasury bonds is the current example of this.

2. It leads to more of a fiscal-based economy, not a production-based economy. The creation of money and the financial markets, rather than market demands, guide investment and production.

3. As the fiscal economy -- the financial institutions that profit from the creation of bubbles -- becomes the dominant part of an economy, the largest incentives are in speculation and enabling speculation.

4. It's a trader's not an investor's, paradise. A "pass the bubble" economy is, in many ways, a short-term trader's dream come true. When an economy becomes more driven by monetary policy than by market demand, speculation becomes more profitable than production.

5. Consistent with the notion that institutionalized inflation favors traders, analytical tools like technical analysis and short-term money management practices become an increasingly important tool in forecasting price movement.

6. Because legislation and brokerage firms can steer the Federal Reserve's inflation into certain asset classes, sector trading -- trading based on the correlation between sectors -- may become more lucrative. The proliferation of ETFs facilitates this.

Other Key Considerations

It's worth noting that bubbles can last for quite a while. In fact, there are those who argue there is a bubble in Treasury bonds, and that it will last a while -- thus creating a prolonged deflation in the economy. As always we can look for momentum in price charts and potential outlier, "black swan" events to understand when the bubble is being deflated and how monetary policy will try to reflate.

Discuss on InformedTrades

The Aggregator Bank Intervention Trade

2009-01-20T09:50:00.000-08:00

In its simplest form, the financial mess could simply be explained as a bunch of bad loans being made -- loans to home buyers who couldn't really repay the loans, banks taking on too much debt due to the securitization of loans, and government issuing more debt than its tax base can handle.

The government response has been to try to bailout the bad debts through the usage of taxpayer funds and obligations. To this end, the Obama administration is now considering the creation of an "aggregator bank" -- one that will buy up bad loans, under the rationale that this will relieve the banks and cause them to lend.

As market speculators, there are a few things we should consider:

1. Whoever holds the bad loans is holding an asset that needs to fall in value. If the US government creates an aggregator bank specifically to acquire bad loans, the US government will bear the loss. As the US government borrows money, it would mean Treasury holders would bear the loss. Should appetite for Treasuries dry up, the dollar will be devalued, and US dollar holders will bear the loss.

2. As such, bailouts are a way of transferring market losses from financial institutions to taxpayers. An opportunity to trade this would be in going long XLF, an ETF that tracks the financial sector, while going short TLT, an ETF on 20+ year Treasury bonds.

The XLF chart is pictured below; currently, the market is at 9.66, almost 100 points above its 52 week low at 8.67. Government actions may hold up XLF and lead to a rally back up to resistance near 13.20, another key price point to watch.

Discuss on InformedTrades.com

An Introduction to China-US Decoupling and the Potential Trade of the Century

2009-01-19T08:55:00.000-08:00

Some argue that this financial crisis will lead to China "decoupling" from the US economy; meaning it will need to find other buyers of its exports, and will not be able to continue buying US Treasury bonds, which have the affect of propping up the US dollar's value. Instead, the decouplers argue, China will need to invest in increasing its own consumption capabilities. This will have the effect of decreased buying in the Treasury bond market while the supply of Treasuries expands as US government deficit increases -- thus making short selling long-term Treasuries one a very lucrative opportunity, if this is in fact the case.

Can this happen? If so, when?

Skeptics of decoupling argue that the decline of US demand will weaken the Chinese economy along with the US economy, and that the current structure of US consumption driving the global economy will maintain. Decouplers note that the Chinese economy will weaken, but this will force the Chinese government to invest in more infrastructure programs instead of buying Treasury bonds -- at a time when the US is planning to take on more debt and thus increase the supply of Treasury bonds. The result of this will be currency decoupling in that China will become an increasingly powerful buyer relative to the US. And from a geopolitical perspective, China is more economically aligned with Pakistan, Iran, Russia, and Hamas rather than the US/Israel/Britain economy. Thus far, we have seen China direct its buying towards domestic stimulus packages.

With that said, though, Treasury buying could go on for a while; Naked Capitalism notes that China is still buying Treasury bonds. For those who think decoupling is bound to happen, the opportunity to short Treasuries may be the best trade out there when the bubble starts deflating, whenever that may be. TBT is the double inverse ETF for the long-term Treasury bond market.

Three Little Pins and Their Quest for a Treasury Bond Bubble

2009-01-16T09:39:00.000-08:00

As we've discussed previously, there is a bubble in the US Treasury bond market. And as we discussed in Ka-Poom Theory, bubbles always find black swan events -- "pins" to pop them and cause a market panic. As John Mills, a historian of market panics, said, "Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works."

What will be the pin that pops the Treasury bubble, causing a panic that reveals its true value? While it would be futile to try to predict an outlier event, understanding areas where it may be more likely can help us identify potential triggers for what will cause a market panic, so that we can more easily recognize it when it occurs.

There are three pins I think are most likely:

1. Mass monetization announcement. We are seeing appetite for Treasury bonds decline. If the Fed either significantly begins to monetize the debt (i.e. print money to pay it off) or announces it will do so, this could trigger an exit from Treasuries.

2. Military threat. 9/11 was a black swan event that punctured the dot com bubble significantly. As there is still a significant amount of conflict and political tension in the world, a military event triggering a mass exodus out of Treasuries seems possible -- particularly when one considers that some of the largest holders of Treasury bonds are foreign central banks with economic interests that run contrary to those of the United States.

3. "Legislation". The Federal Reserve can modify its charter, Congress can assign more authority to it, and central banks can come into new agreements amongst themselves. For instance, a regional currency which national currencies would be re-valued against is becoming a more commonly voiced idea in many parts of the world. If there is a monetary agreement of sorts, it will likely have the impact of devaluing the US dollar, as a way of compensating foreign US Treasury bond holders.

As a dollar trader, I'll be keeping an eye on potential pins for the Treasury bubble, as well as price charts that can show when momentum has turned. Though when the bubble will pop, as well as how bit it will get before doing so, remain unclear.

Discuss on InformedTrades

Ka-Poom Theory: Understanding and Predicting Black Swan Events

2009-01-14T10:35:00.000-08:00

In this post, we'll take a look at the Ka-Poom Theory, a framework for investing in "bubble" economies -- economies driven by the creation of asset bubbles.

Ka-Poom Theory: What It Is

Ka-Poom Theory is a theory that postulates how the asset bubble cycle works -- meaning how bubbles are created, destroyed, and reborn. It was developed by Eric Janszen, former venture capitalist who now writes commentary at iTulip.com.

Ka-Poom Theory offers the following framework for understanding bubble cycles:

1. The Bubble is created. Ka-Poom Theory posits that the creation of the bubble is a result of interest rates being kept too low by the central bank. This is the same conclusion reached by the Austrian Business Cycle Theory.

2. Also like Austrian Business Cycle Theory, Ka-Poom Theory expects the bubble to begin deflating at some point. In addition, though, Ka-Poom Theory expects a "black swan event" -- an unpredictable, external, outlier event that has a monumental impact and, in the context of Ka-Poom Theory, a deflationary effect. It does not, however, cause a deflationary spiral. Thus, Ka-Poom Theory refers to this state as disinflation.

3. The central bank will respond to disinflation with inflationary policies that will take approximately 12 months to impact the markets. The period of disinflation will be erratic.

4. The black swan event is the "ka" of the Ka-Poom Theory. The "Poom" is the subsequent re-inflation of the money supply. Deficit spending and inflationary policies initiated by the Fed dictate to what sector the re-inflation of the central bank will go.

Ka-Poom Theory posits this is what has been happening in the US economy since the dot com bubble, and thus is the current framework for understanding thus US economy.

Assumptions of Ka-Poom Theory

The most critical assumption the Ka-Poom Theory makes is that the central bank has the power to inflate the market at will, invariably. In other words, Ka-Poom Theory is based on the premise that if the Federal Reserve wants to inflate and create higher prices, it can -- by printing money, buying up assets, working through the credit market, or inducing foreigners to sell Treasury bonds and dollar holdings. It also assumes that the results of the central bank's actions are not instantaneous; the gap between their policy enactment and the corresponding re-inflation of asset prices is a period referred to as disinflation.

Because of this assumption, Ka-Poom Theory is essentially a framework for understanding how a planned economy works.

Implications of Ka-Poom Theory for Traders and Investors

To the extent that Ka-Poom Theory is valid, a few deductions can be made for traders and investors:

1. The period of disinflation -- what Ka-Poom Theory argues we are in now, which is characterized as the period between the Federal Reserve's policy enactment and the corresponding effects -- is deemed to be erratic. Janszen prefers to stay out of the market during these times.

2. In a debt-based bubble, the long-term bond market will likely be where the arbitrage opportunity is, in the sense that bond prices will fall as the market begins to re-inflate.

3. In order to understand what sectors will be set to inflate -- where the next bubble will be found -- Ka-Poom Theory looks at government spending to lead the way.

Discuss on InformedTrades

Bears Reported to Have Begun Munching on Bulls Who Have Fallen Into Bear Trap

2009-01-13T10:25:00.000-08:00

I'm sorry it has to be this way, folks, I really am. But it looks like the bears have set the trap. The bulls have wandered in. And now, there's only one thing left: for the bears to have their lunch, and for the bulls to meet their fate.

Fundamentally we know the story: unemployment and low retail sales in the US economy are all the talk. And while the January effect coupled with inflationary stimulus packages may have helped the market engineer a bit of a rally, the economic woes are still clearly in place, and it looks as though the primary trends are preparing to resume themselves. For instance, at the time of this writing, S&P 500 futures are pointing to a fifth loss in a row.

Technically we see a nice potential trade lining up on SPY, particularly if SPY can break support at 85.43. The market is now trading below the 5, 10, 20, and 50 simple moving averages, all of which are converging -- another indication the bear market rally may be concluding. A break below 85.43 could pave the way for a retest of previous lows at 75.

Check the chart below.

A lower S&P 500 is also generally correlated to a stronger yen. We have seen the yen begin to rally again, as the USDJPY exchange rate has broken below 90. The chart below plots the USJPY (blue and gray candles) against the SPY (red and green candles). In sum, a resumption of the bear trend in the S&P would be a bearish sign for USDJPY, which stock market traders can take advantage of via the FXY ETF.

Disclosure: Short USDJPY.

Discuss this article with me and others on InformedTrades.

Analyzing The Arbitrage Opportunities in Commodities

2009-01-12T09:21:00.000-08:00

Regardless of what side of the inflation/deflation debate you're on, one thing is certain: false forms of value are being destroyed, and there is a "flight to safety" -- safe ways of preserving purchasing power. In our current environment, this has caused the US dollar to strengthen in the second half of 2008, and US government treasury bonds to rally as well.

So what's this mean for other asset classes, like commodities? To answer this question, we will need to understand the origins of money.

The Origins of Money

Long, long ago, before the advent of paper money, people bartered goods. In other words, if you made shoes and I made pants, we might be able to work out a trade in which you would make a pair of shoes for me and I would make a pair of pants for you. In this way we would both be able to increase our wealth.

Of course, what if I wanted shoes but you did not need pants? We might then be able to have difficulty in making a trade. Unless, of course, you were able to accept my pants and trade them with someone else who wanted pants. And that is precisely what began to happen as economies developed. In such an environment, what became money was simply the most easily traded commodity. Such commodities typically had a few attributes:

durability -- did not deterioriate over time, thus allowing wealth to be accumulated and an economy to be built on savings
divisibility -- easily divided, thus enabling transactions of all sizes
recognizability -- so that people could accept it as money with confidence
portability -- so that people could take their money with them
scarcity -- because too much of it would encourage speculation and making savings difficult

Many commodities were tried as money, though in the end, two stood out as clear winners: gold and silver. Thus you will sometimes find passionate gold and silver investors who say "gold is money."

What This Means If You Believe Deflation is a Concern

If you view the crisis as deflationary in nature, the asset classes most appealing to you will be as follows (listed in order):

real cash -- i.e. US dollars, euros, etc
government issued bonds
precious metals
commodities
consumer goods
real estate
financial goods (stocks, bonds, derivatives)

Deflationists argue the supply of paper, government-issued money in the economy is contracting, and thus it is not in danger of being devalued by excessive supply -- and so its purchasing value will increase as the market moves to find real stores of value.

What This Means If You Believe Inflation is a Concern

If you believe inflation is a concern -- meaning that the government has excessively expanded the supply of paper money in the economy -- then the asset classes of choice will be as follows:

precious metals
commodities
consumer goods
real estate
financial goods
real cash
government bonds

Of course, this would depend on how much inflation there is -- cash would higher on the list in the event if there is not much inflation. And with respect to financial goods, those correlated to healthy companies will be higher on the list.

How to Trade This

The easiest way of trading this is to trade asset classes against each other; for instance, if you're a deflationist, going long cash while shorting financials (which simply amounts to selling stocks and holding your money in a bank account). Conversely, you can look for potential arbitrage opportunities in which the market is not behaving as macroeconomics would posit that it does. In our current times, for instance, commodities have fallen more than financial assets; the chart below shows the SPY against DBC (an ETF tracking an index of commodities). Commodities, represented by the blue and gray candles beneath the red and green candles, have fallen 16% more than the S&P over the past 200 trading days. For this reason, many investment advisors are quite bullish on commodities, citing it as some of the best buying opportunities.

Of course, as the old saying goes, the market can stay irrational longer than you can stay solvent, so such strategies looking to take advantage of economic inconsistencies may benefit most if coupled with trend-following technical analysis.

Disclosure: Long gold and silver.

Click here for a review of products and services I use to profitably trade.

Discuss on InformedTrades

Analyzing What the Conflict in Israel and Gaza Means for the Financial Markets

2009-01-08T10:18:00.000-08:00

The combat currently going on in Gaza involving Israel and Hamas could have profound effects on the financial markets. Let's take a look at the situation.

Where We Currently Stand

Egypt and France are leading the way to broker a truce between Israel and Hamas. Egypt's ambassador to the UN, Mr. Maged Abdelaziz said peace talks could begin in Cairo today (January 8, 2009). French President Nicolas Sarkozy has said Israel has accepted the ceasefire plan. And in what could be a step towards a peace agreement of sorts, Israel halted its military operations for three hours yesterday to allow for civilian aid; Hamas is reported to hold fire during those hours as well. The Scotsman has a more detailed report.

Still, though, the conflict has widened, as rockets from Lebanon have struck northern Israel today. Bloomberg has the full story.

Ultimately, the geopolitical scenario remains tense. If the conflict continues and widens, it sets the stage for a larger war to emerge, with US, India, and Israel on one side, and Pakistan, China, and Iran on the other. Economic interdependencies can help expand the war as well, and may have the impact of pulling in seemingly uninvolved countries, like Russia and Venezuela.

Impact on the Financial Markets

Four key observations:

1. As bad news and uncertainty in general tends to be bullish for gold, this could stimulate demand for gold. We have already seen a bit of this.

2. Given the economic aid US provides to Israel, the threat of economic warfare against the United States becomes more likely as a way of weakening Israel. Economic warfare would come in the form of selling US dollars and US Treasury bonds. A key turning point to watch for is if China is pulled into this conflict, as China is a large holder of US Treasury bonds and thus more capable of waging economic warfare by dumping Treasury bonds. Thus far, China has urged for a ceasefire, though China has been reported to have provided arms to Hamas, and has cooperative relationships with Pakistan as well. Economic warfare would be bearish for US dollars and US Treasury bonds.

3. While neither Hamas nor Israel is directly in the business of oil, conflict in the Middle East tends to increase the likelihood of supply lines being attacked, intentionally or not. Moreover, whether or not actual supply is affected, the psychology of traders is, as evidenced by a spike in oil prices at the onset of the conflict. 24/7 Wall St notes that Iran benefits from higher oil prices, and as a source of funding for Hamas, and thus there are economic incentives that play into prolonging/exacerbating the conflict as well.

4. US Defense ETFs naturally benefit from the greater likelihood of war, particularly if it becomes seems more likely that the United States will get involved. In particular, PoweShares Aerospace & Defense ETF (PPA) may be an interesting play from a technical perspective; the market is making a double top formation and is testing its November 4 high of 14.69. This could be a nice "break or bounce" play, in that a break above 14.69 coupled with momentum indicators and expansion of war could be a buying opportunity, while a bounce off this level coupled with successful peace talks could represent a short selling opportunity. The chart below illustrates.

Disclosure: Long gold.

What Does a Trillion Dollar Deficit Mean for the Financial Markets?

2009-01-07T09:38:00.001-08:00

The New York Times has an article this week reporting on US President-elect Barack Obama's warning that there will be trillion-dollar deficits for years to come." What's that mean for the markets?

The first line of recourse will be the issuance of Treasury bonds; in other words, the US government will look to borrow money, offering to pay it back with interest. The key question, though, is to what extent buyers of Treasuries will be easily found. As we have discussed previously, the very low yield on bonds coupled with the fact that the economic pains are being felt all around the world suggest one of two possibilities: bond rates will have to go up or the Federal Reserve will have to "monetize the debt" -- meaning it will simply have to print more money.

I have stated and continue to believe that the result of increased deficit spending, due largely to government bailouts, in this environment will be debt monetization (even if there is a rate hike, that will only increase the future debt, and thus will only delay and exacerbate debt monetization). I believe this will prove to be inflationary, that it will devalue the US dollar, and that this is the real way the bailouts will be paid for; not via a direct tax, but rather a tax through inflation. Economist Mike Shedlock, however, offers a counter viewpoint:

The Fed at some point will resort to out and out monetization, and that will have the inflationists screaming at the top of their lungs. However, banks will still be reluctant to lend, and consumers and businesses will be reluctant to borrow. In addition, I expect the velocity of money printed to be close to zero and for the savings rate to rise. In aggregate, these are not hyperinflationary things. Heck, they are not even inflationary things.

Admittedly, I am one of those inflationists who will be screaming at the top of my lungs.

There are two reasons I believe debt monetization will be inflationary:

1. I disagree with the notion that banks won't lend and consumers won't borrow. As I recently noted, we are seeing a declining TED spread as well as an increase in many money supply metrics (M1, M2, MZM). And even in this environment, we have seen companies like Verizon be able to secure a massive $17 billion loan.

2. Even if lending is reduced due to the economic climate, debt monetization increases the likelihood that foreigners will not only stop buying Treasuries, but that they will sell the ones they have, and will dump US dollar holdings out of a concern of dollar devaluation by the part of the Federal Reserve. This suggests there will be a "run on the currency," similar to what was seen in Argentina. See our previous article on the similiarities between the US economic crisis and the Argentinian crisis of 2001 for more on this subject.

How to Trade This Scenario

Timing is the key issue for trading this; we are currently seeing a rally in the market, though I expect that at some point in the second half of 2009 we will see the concerns about the Treasury market begin to manifest. As a trend-following trader I look for momentum that corresponds to my fundamental viewpoint, with the exception of precious metals, which I treat as buy and hold type investments.

With that in mind, here are the conclusions I am making based on the trillion dollar deficit scenario:

1. US dollar will fall in value. For stock market traders, UDN is an ETF to watch.
2. Dollar hedges like gold and silver will rise. GLD and SLV are corresponding ETFs.
3. Both monetization of debt as well as a hike in interest rates will send bond prices falling, as a rate hike devalues all bonds previously issued at a lower rate while monetization of debt introduces inflation concerns and the possiblity of the bond being paid back with a currency that is worth less.
4. A rate hike, which I think is increasingly unlikely given the Fed's behavior though still possible, will be bearish for US stocks. DOG and SH are inverse ETFs worth considering in such a scenario.

Disclosure: Long gold and silver; currently short US dollar against Australian dollar.

Analysis of GEX and Alternative Energy Investment Opportunities

2009-01-06T11:39:00.000-08:00

The alternative energy sector has been heralded by many as an investment opportunity in the US over the next four years. The rationale:

1. Fossil fuels are declining in supply and are environmentally destructive. While there are those who dispute this, there seems to be enough of a "green movement" that demands alternative energy.
2. Because fossil fuels are declining in supply, they will rise in costs,thus fueling an economic need for alternative energy solutions. This seems to be questionable of late, as gas prices have fallen sharply in the US.
3. US President-elect has made government investment in alternative energies a priority.

While there are scientific arguments for and against alternative energies, the "green movement" seems to be quite strong, suggesting strong consumer demand, and Barack Obama's stimulus plan suggest this the US government will look to feed this demand.

How can investors profit from this?

GEX: The Alternative Energy ETF of Choice

While there are a number of alternative energy ETFs, Market Vectors-Global Alternative Energy (GEX) seems to be the best one over the long-term. The primary reason I hold this view is that GEX is internationally diversified; European companies constitute 47.1% of the fund, China/Japan 11.1% and U.S. 41.8%. In light of the uncertainty in global economy, I view international diversification as something that is of paramount importance from a long-term risk management perspective. GEX meets this requirement better than many of the other alternative energy ETFs.

From a long-term perspective I remain bearish on all aspects of the US economy -- stocks, bonds, and the US dollar. While an internationally diversified ETF can help significantly in hedging against this risk, investors may wish to take a market-neutral stance by coupling any long position in GEX with a short position in a market index. Inverse ETFs like DOG and SH can help in this regard.

The Short-Term Outlook for GEX

For those looking at the market from a short-term perspective, the daily chart of GEX may be of interest.

Momentum traders could find a short-term buying opportunity on a break above 25.56, with a target of 28.17, the recent high reached on November 4, 2008 (the day of the US Presidential elections). Traders who enter on a break of 25.56 may want to see RSI break its recent high as well to ensure that the momentum is real and that the breakout is not false.

January Effect: What It Is And How to Trade It

2009-01-05T11:00:00.001-08:00

As US equities market have rallied since the beginning of 2009 -- the S&P is up 3.03% at the time of this writing since the start of the year -- many traders and investors have begun to ask a key question: is this rally a sign of the January Effect?

What is the January Effect?

The January effect is a term given to the tendency of for the US stock market to rise in the month of January. In particular, small cap stocks -- generally those with a market capitalization of less than 2 billion USD -- will rise more than mid cap and larger cap stocks. The rationale for the January effect is that investors often sell positions in December with the intent of creating tax losses that can be written off, and then buy them back in January. There is some evidence for that, as the January effect does not seem to be in place prior to 1913, the year the income tax was introduced.

Is the January Effect Real?

There is much debate as to whether or not the January Effect is real. Meaning do stocks actually rise in January? The chart below, courtesy of World Beta, suggests they do. The chart shows the results of trading the January effect over the past 80 years. The red line represents buying and holding the bottom 20% of the US stock market during January of each year; the blue line represents investing in the S&P 500 during January of each year. Both strategies prove to be consistently profitable.

Chart by World Beta

However, as the chart above illustrates, though, returns over the past three years have not been as great as the January effect's heyday back in the '80s. This has caused some to suspect that the market has begun pricing in the January effect, and that it is thus no longer a viable investment strategy. 2008 in particular was a negative year for the January effect. Conversely, those who remain advocates of the January effect will note that it works particularly well in years where the stock market declined in the previous year. This is consistent with the notion that positions will be closed and losses will be recorded for tax reasons, but then re-opened in January to resume the trade.

How Can You Utilize the January Effect In Your Trading Strategy?

Personally, I wouldn't use the January effect; it doesn't fit into my style of trading, and I'm not particularly comfortable with it, especially when I already have my own analysis of the market based on economics and technicals. However, if you're looking to trade the January effect, here are some ideas:

Go long the whole market, small caps and large caps, skewing your position to small caps as they tend to do better than large caps during January.
Go long small caps and short large caps; this allows individuals to be market neutral while still profiting from the January effect. If I were to trade the January effect now, I would favor this strategy, as I would not want to be long US stocks.
ETFs are a great tool for trading the January effect; in particular, PZI, FDM, and IWC are great for playing small caps, while SPY and VTI are great for the larger caps. Inverse ETFs like SH and DOG are also worthwhile if you're looking to short large caps as part of your January effect strategy.

Links to Help You Learn More About the January Effect

World Beta - Engineering Targeted Returns and Risk: The January Effect After Really Bad Years In Stocks
CBOE - The January Effect and Portfolio Management Tools
The January Effect | Investment U

Australian Dollar Consolidating Now

2008-12-30T09:48:00.000-08:00

Through the end of 2012, I am one of those expecting a shift in economic power from Western economies (namely the US) to Eastern economies (China, Japan, etc). In particular, Australia, as a producer and exporter of precious metals -- which stand to rise when fiat currencies are troubled -- and commodities as well, may find its currency in greater demand.

So is it time to buy the Australian dollar? Let's take a look at the price chart to get an idea if now is the time.

After being in a strong bear market since August 2008, the Australian dollar is now rallying. It is currently forming an ascending triangle/rising wedge pattern, as the chart above illustrates. The hourly and weekly chart also show consolidation, suggesting the market may be ready for a breakout.

For US stock market traders, FXA is an ETF that tracks the Australian dollar.

Disclosure: Long Australian Dollar.

Banks Are Lending And Money is Abundant Again

2008-12-28T08:41:00.000-08:00

Monitoring the money supply can be a useful tool in understanding "the big picture" of what is going on in the economy. Towards the end of the summer/early fall of 2008, we saw money supply indicators, like MZM, contract. This was the result of deleveraging; in our debt-based economy, in which all money originates out of debt, paying off debts reduces the money supply -- while the issuance of debts increases money supply. Thus, the combination of deleveraging (paying off debts) with a decrease in bank loans resulted in the money supply contracting, the dollar strengthening, and asset prices falling -- all characteristics of deflation.

These trends seem to be reversing. The chart below tracks MZM; note the recent spike upwards.

Likewise, the TED spread -- an indication of fear and risk in the market, and whether or not banks are lending -- has been declining. A lower TED spread means less fear and more lending. The increase in money supply makes sense with a lower TED spread. Both run contrary to reports from much of the media that banks are still unwilling to lend.

The chart below illustrates the TED spread; note it has declined significantly from its peak in October, when the psychology of fear was at its peak.

In terms of financial markets, we've seen the dollar weaken of late, while gold has been rising. This is consistent with the behavior of MZM and the TED spread.

Disclosure: Long gold.

Taking A Look at the Reversal in the Japanese Yen

2008-12-27T13:07:00.000-08:00

The Japanese Yen has been strengthening against the world's other currencies for the past few months. For the time being, however, this trend seems to have reversed. The charts below tell the story.

CHFJPY - Note the recent strong uptrend.

EURJPY - Ascending triangle formation in the works.

USDJPY - Moving averages turning upwards, and price trading above moving averages.

Personally I've been in and out of short USDJPY since 101.30; I just closed my most recent USDJPY short position, as I think a short-term reversal of sorts may emerge. Still, though, I think the long-term trend of yen strength will continue. Accordingly, I'll look to re-enter on a break below 88.00, or possibly 85.00.

Yen traders may also find the recent comments of Akio Mikuni, president of credit ratings agency Mikuni & Co., to be of interest. Mikuni said:

Japan’s economic model has been dependent on external demand since the Meiji Period that began in 1868. The model where the U.S. relies on overseas borrowing to fuel its property market is over. A strong yen will spur Japanese domestic spending and reduce import prices, thereby increasing purchasing power.

Mikuni said the USDJPY could fall to 50 or 60 from its current price of just aboe 90 unless Japan takes "drastic measures" to help bail out the US economy.

Disclosure: No position.

Analyzing The Housing Sector and Opportunities to Short XHB

2008-12-12T08:16:00.000-08:00

Let's take a look at the housing market, and potential trading opportunities it presents.

Fundamental outlook: Fundamentally, the housing market is still very much in a bear market. According to Austrian business cycle theory, the housing market represents a good short opportunity, as the housing bubble fueled by credit expansion is now being deflated as credit has become more scarce. Economist Mike Shedlock recently had a great post analyzing the housing market, in which he called for a bottom to be 3-5 years away, as we recently discussed.

The excess number of houses already created in the US as a result of the housing bubble, coupled with increasing job losses and tightening credit, makes shorting homebuilders an interesting proposition. US stock market traders can look to short XHB, an ETF tracking homebuilders, to capitalize on this opportunity.

Technical outlook: Technically, there has been some talk of a market reversal getting ready to happen, like we recently discussed. At the time of this writing I'd still prefer to see additional confirmation that a reversal is indeed forming -- preferably gold sustaining a break above 850 -- but if indeed we see a reversal of the trends we've seen for the past few months and the US stock market does rally, it could translate into an opportunity for traders to get short XHB at a higher price.

Below is a chart of XHB that offers some insight into key price levels traders looking to get short may want to watch.

Click to see enlarged image.

Disclosure: No position in XHB or any housing investment.

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Is a Reversal Shaping Up in the Markets?

2008-12-11T08:56:00.000-08:00

There's been an increasing amount of talk lately that the US stock market market is gearing up for a rally, and that we're set to see a reversal of the market trends that have dominated the last few months of trading. Let's take a look at key signs of a reversal and corresponding trading opportunities.

1. Gold is rallying and is currently at an eight week high. GLD, an ETF that tracks gold, also appears to be rallying, as it is making higher highs and is testing key resistance at 81.72. A break above this level could provide momentum traders with the confirmation they are looking for.

2. Likewise in the forex market, we see EURUSD reaching breaking past key resistance at 1.3250, and USDJPY breaking below 92.00. A break below 91.00 may be a great opportunity for USDJPY traders looking to trade the longer-term trend to 85.00. For stock market traders, the FXY ETF may be of interest in capitalizing on this.

The Bigger Picture

If the rally is sustained, I would view it as a resumption of longer-term trends in the dollar and gold (weak dollar, rising gold), but a counter-trend correction in the US stock market (whose longer term trends is bearish in my opinion). In terms of gauging the overall health of the US economy, I would look to measure any gains in the US stock market in comparison to losses against the US dollar; if the stock market is rising but the dollar is falling, it may suggest an increase in nominal, but not in real value.

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A Beginner's Guide to Understanding Currency Valuation

2008-12-08T10:47:00.001-08:00

The market value of asset is largely a reflection of supply and demand for that asset. And thus, if we are looking to assess the value of a currency, we should try to gauge the supply of and demand for that particular currency.

Understanding Supply

To understand money supply, it is crucial to note that in under current monetary policy, money is created out of debt. This happens in two ways:

1. Money is created when governments need to borrow, and central banks then print money and buy treasury bonds
2. The money supply is then expanded again when banks loan money; banks are allowed to loan out 10X the money they have in deposits, and thus expand the money supply when they loan.

Because money comes out of debt, we can extrapolate two further points:

1. If there is no more debt -- meaning if lenders are not willing to lend and borrowers are not willing to take on more debt -- the money supply will have difficulty expanding.
2. Paying off debts results in decreasing the money supply. Ironically, if all debts were repaid, there would be no money.

There are a number of ways to calculate the money supply; see our previous post on this subject. The Mises Institute also offers a free tool to let you compare various money supply indicators.

Understanding Demand

The following can help you gauge demand for a currency:

Trade flows
Capital flows
Reserve currency status -- do other central banks hold the currency in question as part of their reserves? Are they changing their reserves?
Commodity prices -- If commodity prices are rising, the currency is likely weakening

Gauging how supply and demand is changing can help you develop a longer-term outlook on how currency prices will fare.

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Comparing the Crisis in the Icelandic Krona to the Crisis in the US Dollar

2008-12-05T09:17:00.000-08:00

We recently compared the crisis with the Argentinian peso in 2001/2002 with the current situation surrounding the US dollar, and postulated that the US would follow down the Argentinian path.

The current situation in Iceland also fits the bill of a currency crisis (also referred to as an inflationary depression). To illustrate this point, let's compare the factors leading up to the crisis in the Icelandic krona with the conditions of the US macroeconomy:

1. Like the US, Iceland de-regulated much of its banking sector in the '90s.
2. Like the US, Iceland then proceeded to target low interest rates. This resulted in a large amount of borrowing and spending, which resulted in a credit-based boom.
3. In both countries, de-regulation allowed for greater securitization -- meaning the loans that enabled this credit-based boom were re-packaged and sold to debt buyers all over the world. This resulted in a scenario where much of Iceland's wealth was owned by foreigners.
3. Like the US, Iceland also experienced the contraction forecasted by the Austrian business cycle theory, which we recently discussed.
4. In both countries, this resulted in a deflationary spiral: significant declines in equities markets, bank failures, and contracting GDP.

To learn more about the factors leading up to the Icelandic currency crisis, I recommend this article from CNN.

Now in Iceland, like in Argentina, the true breaking point came when its central bank became insolvent. The result was a complete lack of confidence in Iceland's ability to repay; essentially, Iceland had defaulted. The result has been a run on the Icelandic krona, which has lost half its value in just a few months time.

Government Response

Or should I say, there has been a partial run on the Icelandic krona -- for the government has put currency controls in place, after raising interest rates. Citizens of Iceland will find it difficult to legally exchange their krona for a foreign currency unless they are travelling.

Proposed solutions include integrating Iceland into the Eurozone, which would help stabilize Iceland, continue international trade, and help ensure that lenders are repaid, argue its proponents.

Social Response

Icelanders have united in protest against the government, in much the same way Argentinians did after their currency crisis. Thus far in the United States, criticism and dissatisfaction with the government handling of this crisis have risen significantly, though street protests remain at relatively low levels.

Market Response

The collapse of the Icelandic krona is the biggest event, as it devalues all assets denominated in the krona, as was the case in Argentina. A key difference between the US dollar and all other currencies, though, is that the US dollar is the world reserve currency. It will be interesting to see if Iceland enters the Eurozone as a solution to this crisis; if so, it paves the way for the creation of a world currency to be proposed as the solution to a crisis in the US dollar.

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Using Austrian Business Cycle Theory to Invest in the Current Depression

2008-12-03T18:38:00.000-08:00

I know I've talked about Austrian business cycle quite a bit in my blog posts, but I wanted to make a post that provides a clearer introduction to it and its logic. So here goes.

Austrian economics and Austrian business cycle theory have regained a bit of popularity of late, given the recent turmoil in the financial markets. Understanding Austrian business cycle theory can help us understand where things are headed, so that we can invest accordingly.

What it is: Austrian business cycle theory basically posits that bubbles and busts result primarily from an overexpansion of credit. Credit is too cheap and too easy. Entrepreneurs are trained in finding market opportunities and inefficiencies in the market; and thus, the Austrian business cycle posits, entrepreneurs as a whole can only be collectively mislead for a sustained period if credit is excessively expanded. This will cause entrepreneurs to excessively invest in capital-intensive projects, like building houses.

The result: The result of this excessive expansion is that the market will eventually try to deflate and purge the misguided investments out of the market. This will result in deflation.

What government policy should be: According to Austrian business cycle theory, deflation is good, and government policy should be to embrace it -- not avoid it. Deflation will encourage "hoarding of cash," which is perhaps more accurately referred to as savings. These savings will then form the basis for the economy to heal itself and become strong again.

What happens if government intervenes: If government intervenes to prevent deflation, one of two things will happen: deflation will be prolonged and deepened, as we see in Japan; alternatively, if government goes into greater debt while its tax base diminishes, it runs the risk of being unable to find borrowers, at which point faith in the currency is lost and a run on the currency begins -- meaning everyone looks to sell the currency, causing its value to fall and prices to rise, as we saw in Argentina in 2001 and 2002.

Which brings us to where we are today.

So the key question: how much deflation? To answer that question, consider the chart below:

Note the uptrend that begins in 1995; this is the beginning of the tech bubble, which was brought about by excessive credit expansion under Greenspan's Fed. The market tried to deflate -- this was the "dot com apocalypse" from 2001-2003 -- but the Fed lowered rates again, preventing a full deflation, and instead pushing the bubble into the housing market. A full deflation would then push S&P back to the 1995 level of around 400. Alternatively, a run on the US dollar may cause the nominal price of stocks to rise, but it will fall respective to other currencies. A way to gauge whether the stock market is truly rising in value or if it is just a nominal gain resulting from currency weakness is to compare percentage gains in stocks to gains in gold. If stocks are rising faster than gold, it could be a sign of real growth.

According to Austrian business cycle theory, if money supply was not excesively expanded but was kept at appropriate levels, there would be no real bubbles or busts. This may make the stock market less fun. Conversely, it would lead to greater focus on profitability rather than financial ratios, and a corresponding focus on dividends rather than valuations.

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Next Stop for the US Dollar: Argentina

2008-12-02T16:02:00.000-08:00

Something I've touched on before but have not elaborated too much on is the similarities between Argentina in 2001 and 2002 and the US now. Here is a fantastic analysis of this subject. Below is a breakdown of the key events:

1. In 1997, Argentina experienced a recession. The government response was to ease credit -- i.e. lower interest rates -- and increase government spending, which for Argentina, would mean increasing deficit spending (i.e. borrowing and spending rather than taxing and spending). The US followed the same path in the semi-bursting of the 2002 and 2003 NASDAQ bubble.

2. The excessive easing of credit leads to inflation. For Argentina this occurred in 1998 and 1999; in the US, this peaked in the summer of 2008. During these episodes of inflation, both countries receive warnings from the IMF that their monetary policies are unstable.

3. Both countries than revert back into a recession. This time, however, they are both saddled with greater debt.

4. The recession, coupled with the increased debt burden, leads to a credit crunch, defaults on borrowed funds, and bank failures. For both countries, this results in a decrease in the money supply.

This is where the similiarities end, as we don't know how the US will get out of this situation. Will it continue to follow Argentina? Let's see:

1. During its debt ridden recession of 2000, Argentina responded by continuing deficit spending. Likewise, Barack Obama has already stated that deficit spending is not a concern, and that deficits to stimulate the economy is needed.

2. Eventually, Argentina was having trouble finding borrowers to lend it money. To make its debt more attractive, it increased its yield -- what it was willing to pay to borrow money. In the United States, we are seeing bond prices rally, and many are pointing out similiarities to other bubbles. If this is a bubble, and if it starts deflating, interest rates will need to rise to make the bonds appealing (see our previous article on this subject). Interestingly, Paul Volcker, the Federal Reserve Chairman who raised rates in the '70s to help curb inflation and tighten the money supply, has been brought on to head a new economic advisory board. Are they looking to Volcker for assistance in raising rates?

3. For Argentina, the rate hikes were not sufficient. Eventually, the diminishing tax base, bank failures, and higher interest rates made Argentina unable to make debt repayments. The result was a run on the currency. If the US cannot find buyers for its debt, the same scenario would play out here, which would result in currency devaluation.

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What Will Be the Hottest ETFs in 2009?

2008-12-02T08:44:00.000-08:00

As we enter the final month of 2008, it's time to start thinking about what will be hot in 2009. To start that off, I want to revisit this post I made in late September of 2008 -- a little more than two months ago -- regarding preserving your wealth in our current economic downturn. Here's a reassessment of that view:

1. My macroeconomic view remains unchanged; I still view what we're in as an inflationary depression. I grossly underestimated, though, the size of the deflationary forces, which currently are reigning supreme. Accordingly, I think we'll see deflation continue through much of next year. However, I do expect inflation to resume, perhaps some time in the second half of 2009, and I expect it to come back fairly sharply when it does.

2. I previously recommended foreign bond ETFs, particularly Asian bond ETFs like FAX, and still think they are a good buy and hold, and will do well once inflationary trends resume. However, for as long as we are seeing dollar strengthening, it will not do well -- and thus it has not done well for the latter part of 2008, and I would expect the bear trend to continue into the first half of 2009. If you're a trend follower -- which I am for everything aside from precious metals -- then you'll want to wait until the trend resumes. If you're a buy and hold type of person, now might be a time to do some bargain shopping.

3. I also recommended VEU, an ETF of foreign stocks designed to diversify against systemic US risk. I think this was an error on my part; while VEU could do well, I'm not particularly confident in it. Previously, I underestimated the size of deflationary forces not only in the US, but also in the rest of the world. I should note, though, that those who are interested in comprehensive risk diversification may still find some value in VEU.

4. My worst call was FXE, an ETF tracking the Euro. While I knew the Eurozone had problems, I underestimated the size of those problems, and I thought the Euro could replace the US dollar as the world reserve currency. While I expect the US dollar to lose its world reserve status, I no longer think the Euro stands much of a chance to replace it. I think things will just become more free-floating. A by-product of this will be that forex will become a more important market. With that in mind, I'm not interested in FXE, though as a currency trader with experience in trading EURUSD, I will probably trade EURUSD once I see signs of an uptrend resuming.

5. All forms of gold I am still bullish on -- very bullish, even more so than before. In terms of ETFs, that means GLD and GDX, the latter of which tracks gold mining stocks. As I noted, I always favor trend-following trading as a safer form of money management, but for gold, I make an exception. It's too volatile to predict and I'm extremely bullish on it, and so I am a buyer and a holder. All of that could change if gold starts to trade on COMEX below 650 US dollars, though gold has been holding up quite well against the US dollar during our current episode of deflation, so I would be a bit surprised if a break below that level is sustained.

6. The same holds true for silver, the ETF for which is SLV. I'm very bullish and still a buyer at these prices. At this point, I expect to hold gold and silver until at least 2013.

7. I previously was very bullish on oil, the ETF equivalent being USO. I view oil and the US dollar as inversely correlated in our current times, and thus I am still bullish on USO -- though it's in the same boat as my other dollar-hedge ideas, in that it is a buy and hold, and thus will require some patience until we see inflationary trends resume in 2009 or 2010.

8. I am still bullish on commodities, and thus think DBC is a good buy and hold for stock market investors. Commodities do not, however, do well during dollar strengthening, though when inflation resumes, I expect commodities to lead the way and outperform most others, save currencies and metals.

Some ETFs for the Deflationists in All of Us

I previously commented on what I think will do well in deflation, and as I expect deflation to continue into at least the first half of 2009, I still like inverse ETFs that let you short sectors and indices. SKF and SDS I am particularly fond of, and given Mike Shedlock's recent comments and what we've seen thus far, I'd add SRS to that list.

The Japanese Yen: Transcending the Inflation vs. Deflation Paradigm

Since we entered the sharp deflationary trends in September, all I've traded on a short-term basis is the yen (I've been accumulating gold and silver during this time as well, but for the long-term). This has worked out very well for me, and the Japanese Yen is a currency I expect to continue to do well, and thus look for trend-following opportunities to trade Yen strength -- particularly against the US dollar.

Money Management in 2009 and Beyond

One of the most dominant trends we've seen since September of 2008 -- which, for me, marks the beginning of the psychological shift in the marketplace, to where bearishness became the dominant mindset -- is greater volatility. Greater volatility makes money management and short-term trading even more appealing. I expect these trends to continue and be with us for quite some time.

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How the Mumbai Militants Will Affect Financial Markets

2008-12-01T08:54:00.000-08:00

As has been widely reported by the international media, there were recently attacks by militants in Mumbai. Here are some thoughts on how this will affect financial markets:

1. Gold. The proliferation of militant networks around the world has coincided with the emergence of a bull market in gold. The more unexpected attacks by organizations that are not nation-states we see, the more we can see a rise in gold -- and likely silver as well.

2. Defense ETFs. US President-elect Barack Obama has already declared Pakistan a threat and has suggested he may order troops into Pakistan. Moreover, in light of these recent attacks, India has already requested Pakistan take action. In the event of US entry into Pakistan, this would be a bullish sign for US defense ETFs, like ITA and PPA. It is crucial to note, however, that we are in a bear market in US equities; personally, I don't see this bear market ending soon, and thus would be reluctant to go buy ETFs and stocks that are dependent on the US macroeconomy.

3. India ETFs. ETFs that track the Indian economy on US exchanges -- namely EPI and PIN -- may see additional downward movements. These markets were already in a bear trend prior to the attacks, similar to how US markets were already in a bear trend prior to 9/11. This would be an additional bearish argument for India ETFs.

Disclosure: Long gold and silver. No positions in Defense or India ETFs.

Five Rules of Survival for Private US Companies in the Global Downturn

2008-11-27T13:50:00.000-08:00

By now the idea that this economic breakdown is not going to be solved in a week or two, and that it represents a restructuring of the global economy, is starting to become more apparent. With that in mind, here's guideline for private companies in the United States looking to safely grow over the next four years:

1. The big picture is the US dollar. As I've stated many times before, the US dollar, its value, and its role as the world reserve currency are at the heart of the current economic crisis. In my opinion, the end result of all these bailouts and collapse of the US financial markets will be currency devaluation, and thus I recommend businesses prepare accordingly.

2. While the US dollar is strong, shop till you drop. The US dollar has been strengthening for much of 2008; while this scenario continues, American private businesses should be looking to acquire. As the currency gets devalued over the next four years, prices will rise and purchasing power will decline. This makes now a great time to go shopping and buy assets that will be needed over the long-term.

3. Consider getting fixed rate credit. Right now, interest rates in the US are very low; they are approaching zero. This, coupled with the expectation of significant currency devaluation going forward, makes borrowing to buy now and pay back later (when the currency is worth less) a compelling strategy. This must be done carefully; only companies that can reasonably manage debt should consider this option. Also, as we have discussed previously, the Federal Reserve may need to raise interest rates to make the debt it continues to issue more attractive.

4. Don't forget to raise prices. Ask anyone who lived through the currency crises in South America: the biggest mistake companies make is failing to raise prices quick enough. Keep an eye on dollar prices and the rate of fluctuation in its value, and move your prices accordingly. Alternatively, if possible, consider pricing in other currencies -- particularly gold or silver. Last but not least, bear in mind that Asian currencies may appreciate while the US dollar declines, particularly if they stop purchasing US Treasuries but direct that wealth instead to domestic production, which China recently took a step towards doing via its stimulus package. As a result, opportunities for American businesses to export to Asia may be a sector to look into.

5. Everyone's a central banker now. Central banks maintain a reserve that is diversified across a number of currencies and precious metals. In a globally volatile economy, businesses must do the same to effectively hedge risk and preserve wealth. Precious metals and foreign currencies are more important than ever.

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EURUSD: The Comeback Kid of the Forex Market?

2008-11-26T14:52:00.000-08:00

Last week EURUSD was testing the bottom of a descending trendline, and while I don't trade dollar strength because I don't trade against what I perceive to be the long-term trend, I expected it to fall.

Looks like I was wrong. EURUSD did shoot out of the descending triangle quickly -- but it did to the upside. So is EURUSD ready to start an uptrend again? Let's see what the charts tell us:

1. The four hour chart shows the moving averages bullishly aligned, Moreover, the three consecutive bullish candles, each with higher lows, and coming following a downtrend, suggests a three white soldiers pattern, which would be a bullish sign.

2. Meanwhile, on the daily chart, we also see the three white soldiers pattern, as well as the moving averages having turned bullish.

3. Lastly, on the weekly chart, we see that the market has been trading in a range for the past few weeks, consolidating its previous sharp moves. Now, though, we see a bullish breakout, as well as a change in direction on the 5 EMA.

Key Levels

If you're looking to go long EURUSD, I'd look for resistance at around 1.3250, with support at 1.2950. A break above the 50 EMA, which is currently at around 1.3250, may suggest a larger reversal of trend is forming.

Fundamental Factors Confirm

We're seeing dollar weakness show up in other markets as well; USDJPY broke south of its descending triangle, and gold has broken above resistance at both $748 and $800. US stock market traders will want to be particularly wary of bull markets at this time; is it really a bull market if it were priced in another currency, like gold?

Long-term I am very bearish on the US dollar, so now seems like there may be an opportunity for dollar bears in the EURUSD market.

Disclosure: No position in EURUSD. Short USDJPY.

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S&P 500 Heading to 500?

2008-11-26T14:31:00.000-08:00

In David's wrapup yesterday, he posted this monthly chart of the S&P 500, going back to 1982.

As the chart illustrates, the S&P is approaching a trendline that has been in the making since 1982.

The market may bounce off this trendline, or trade in a range for some time. But consistent with the fundamentally bearish view I have over the long-term, I think this trendline is going to break, and I don't think it will take too long -- within six months, if I had to guess (but of course, traders will let the technicals tell them when to enter).

The viewpoint from the perspective of Austrian economics is that the stock market bubbles created under Greenspan's Federal Reserve are now being deflated. The big run up from 1995 to 2001, as visualized in the chart above, was largely the result of the Fed's lax monetary policy in the early 90s; now, as debts are being eradicated, the stock market is naturally correcting itself and removing the malinvestments and excessively high prices that resulted from such an artificially lax monetary policy. Note the significant downturn in the chart above in 2002 and 2003; this was the market trying to deflate itself, though the Fed intervened again by forcing rates too low and thus resulting in an expansion of the money supply and a reinflation of assets. Now, the Fed is once again trying to to cut rates and re-inflate the market -- but it seems as though no one is buying the debt (at least for now).

A full correction of the Greenspan bubbles would result in the S&P going to at least 500, probably further, in my opinion.

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The US Dollar's Five Vital Signs

2008-11-26T14:23:00.000-08:00

As many economists and analysts have noted, the stability of the US dollar is a key issue in our current times of economic turbulence. To keep an eye on the stability of the dollar, its value, and how this will affect other markets, there are a few key factors to watch:

1. CDS Prices. Credit default swaps (CDS) can be thought of as default insurance; the buyer makes regular payments, and the seller makes a payoff if the credit instrument in question goes into default. When CDS prices rise, that is an indication that the market is pricing in an increase in the likelihood of default risk. The CDS price for 10 year US Treasury bonds has increased by 2500% over the past year. If the market believes the US government will not be able to pay off its debt, or will have difficulty doing so, it introduces concerns about the stability of the dollar, as it increases the likelihood of the Federal Reserve creating more money to pay off US government obligations.

2. US Government Debt and Deficit Spending. The more deficit spending -- meaning spending that is greater than the revenue the government takes in via taxation -- the more treasury bonds the US government will need to issue to raise capital to finance deficit spending. More deficit spending leads to a greater need for debt, which leads to more Treasury bonds being issued; this could lead to an expansion of the money supply and higher CDS prices, particularly if the Fed continues to seek a low interest rate. Currently US government debt is rising rapidly.

3. Fed Funds Rates. To counter the effect of rising CDS prices, the Federal Reserve may seek a higher Fed Funds target rate to make US debt more appealing, and to counter concerns about a weakening dollar. At this point, however, we still see the Federal Reserve moving in the opposite direction -- towards zero percent interest rates.

4. Money Supply Indicators. Monitoring money supply can also give an indication as to how inflationary forces -- attempts at expanding the money supply, which can potentially weaken the US dollar -- vs deflationary forces (money supply contractions resulting from credit destruction) can give us an idea of stability issues related to the US dollar. At this time, one money supply indicator that recently turned downward is MZM. Declines in the money supply often correlate to a strengthening of the currency, though demand for money is also a key issue.

5. TED Spread. The TED Spread measures the difference between the rate on three month US Treasury bonds and the the rate at which banks will lend to each other. A higher TED Spread indicates banks are trying to pull credit out of the market. High TED spreads also result in the market countering the inflationary actions of the Federal Reserve. TED spreads have been volatile this year; they are currently declining, which suggests banks are starting to lend again, which is a factor that can lead to money supply expansion and corresponding potential currency instability.

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Four Investment Opportunities in a Deflationary Market

2008-11-26T14:18:00.000-08:00

Though I remain firmly in the inflationist camp in terms of how this economic crisis will unfold -- meaning I expect rising consumer prices, rather than falling asset prices, to be the primary source of the economic crisis, as I recently noted -- there is no denying we are seeing all the signs of deflation at the moment: MZM is contracting, equities markets are collapsing, the dollar is strengthening, and demand for US government treasuries is very high.

So what's an optimal portfolio for this bout of deflation look like?

1. Inverse ETFs. For those who love exchange traded funds (ETFs), now is an opportunity for inverse ETFs to shine. Broad indices are set to fall, and hence inverse ETFs -- meaning ETFs that go up when the underlying assets in the ETF go short -- are great for deflation. Ones that have done exceptionally well this year:

MZZ -- Twice the inverse of the S&P MidCap 400 Index. Up 105.75% this year.
SMN -- Twice the inverse of the daily performance of the Dow Jones U.S. Basic Materials index. Up 124.13% this year.
SKF -- Twice the inverse of the Dow Jones Financial Index. This is one of my favorites from a fundamental analysis perspective, and is up 52.44%.
SDS -- Twice the inverse of the S&P 500 Index. Up 85.68% this year.
DXD -- Twice the inverse of the Dow Jones Industrial Average. Up 70.37% for the year.I like all those ETFs, although I personally would feel most comfortable with SKF, as that makes the most economic sense to me.

2. US Dollar. I'm always reluctant to say dollar strength, in light of the terrible fundamentals on the US dollar and my inflationary outlook, though while MZM (money to zero maturity, a money supply indicator) is contracting -- which it currently is -- I think we'll see the dollar strengthen. UUP, the ETF for dollar bulls, is up 10.55% for the year.

3. US Treasuries. I'm still wary of the entire US bond market, and thus would not recommend US treasuries. With that said, it has become apparent traders/investors as a whole are favoring short-term treasuries as a safe-haven. To the extent the market continues to behave this way, treasuries will do well in deflation. I'd urge investors to consider arguments for why the bond market is due for a collapse. As a person who views inflation as a larger concern than deflation, the well-being of the bond market is of particular concern to me, as it could lead to a run on the US dollar.

4. Japanese Yen. My personal favorite, as it is the only thing I've found that can satisfy both inflationists and deflationists. The yen has been rallying along with the US dollar, and has even been rallying faster than the US dollar. FXY, the ETF monitoring the Japanese Yen, is up 14.69% for the year. I expect Yen bullishness to continue, and favor a portfolio diversified across Asian currencies.

What do you think? What's in your ultimate deflation portfolio? Discuss with us at InformedTrades.

Disclosure: I am long Japanese Yen.

Milton Friedman, John Keynes, and Other Foes of Sound Money

2008-11-26T13:34:00.000-08:00

Given that debates on how to fix the financial crisis have become the conversation du jour, now seems like an appropriate time to re-visit various monetary theories to see what works. So here goes:

Keynesian. John Maynard Keynes is the father of contemporary macroeconomics. I would consider this to be a rather negative claim, given that Keynesian policies are at the heart of our current crisis. According to Keynes, deficit spending is not a problem, and the government should use it when necessary to stimulate the economy. Traditional Keynesian economists are not concerned with price inflation, because they argue that prices will not rise above aggregate demand (i.e. prices will not rise above what people are willing to pay for them). Stagflation is precisely the term for the scenario in which prices begin to rise beyond aggregate demand; witness Zimbabwe, and to a lesser extent, the United States in the late '70s and in 2007.

Regrettably, we still see Keynesian solutions being offered to Keynesian problems. US President-elect Barack Obama has stated that deficit spending should not be feared, and needs to be embraced in the short-term to boost the economy.

Friedmanites. Milton Friedman is not too different from Keynes; the only real difference the most significant difference is that Friedman advocates legislative bodies like Congress regulate the money supply via an agreed upon formula, rather than an independent central bank unbound by formulas. The assumption implicit in this school of economics, though, is that a proper formula can be devised, and that a political body can manage it appropriately without the threat of overwhelming corruption.

Supply-siders. Led by Arthur Laffer and Charles Kadlec, supply-siders argue for watching commodity prices, and then tinkering with the money supply to keep commodity prices stable. In a way, this is similar to the policies championed by Paul Volcker, Federal Reserve chairman during the late '70s. Gold prices were rising dramatically, and Volcker raised interest rates to effectively contract the money supply, strengthen the US dollar, and bring gold prices back down.

Austrians. The Austrian school of economics calls for commodity-backed money. This means that government's job is simply to ensure that each currency certificate can be redeemed for a specific commodity -- typically a precious metal like gold or silver -- and that it is government's role to define the terms of convertibility. The money supply is thus determined by the availability of a commodity. Should the market need to expand the money supply, demand for commodity production will grow. Thus the money supply is regulated by market forces.

What Type of Monetary Policy Can We Expect -- And How to Trade It

I am a strong proponent of the Austrian school of economics, and believe it will result in the most sound monetary system, upon which free market capitalism can best survive and flourish. Though the Fed is pushing interest rates to zero, should the US dollar give back the gains it made in 2008 and should the US government have difficulty finding buyers of its debt at such low rates in a globally weak economy, the result may be the need to raise interest rates sharply, thus bringing about a return to supply-side ideas and Volcker's policies in the '70s (we talked about this previously in our article on bond prices). This would be a bearish argument for gold -- just as we saw gold fall in price after Volcker's Fed raised rates.

Ultimately, though, I think Keynesianism is still the dominant ideology. The ideal result of this would be prolonged deflation, as seen in Japan, though as I've stated before, my larger concern is that this will result in sharp currency devaluation, as seen in Argentina.

Trade accordingly!

Inflation, Deflation, and the Depression

2008-11-26T12:58:00.000-08:00

The key to my fundamental analysis of the markets is money supply: is money supply going up (inflation) or down (deflation)? As I've blogged about previously, I'm very much in the inflation camp.

While I am still an inflationist, it is clear we are in a deflationary environment, which I was not expecting; I was simply expecting the ongoing expansion of money supply to find is way into an asset class (stocks, commodities, housing, etc) and push prices up in that asset class, as is normally the case. Instead, the market's attempts at deflation -- at purging the overinvestments and malinvestments that have been created through excessive expansion of the money supply, thus returning money supply to the level that the market demands, have proven to be dominant. This results in falling prices, a rising currency, and deflation. The Federal Reserve has tried to inflate the markets with all its might, as recent money supply calculations suggest, but banks have been refusing to lend that money, and thus the deflationary forces have been winning.

Analyzing Where We're Headed

So how much longer will deflation lasts? Depends on what happens:

1. If the Fed resists the temptation to increase the money supply, it will likely be very sharp but relatively short. The dollar bubble is a 37 year bubble, which started once the dollar fully abandoned the gold standard in 1971. Here in my opinion is an excellent article on the implications of that.

2. If the Fed continues to intervene but deflationary forces prove to be stronger, it will likely be steady deflation for a long time. This is similar to what happened in Japan when the Bank of Japan tried to resist deflation. However, Mike Shedlock chimes in with some key differences if America goes deflationary.

3. If the Fed is able to successfully inflate, it will need to find a market to put a bubble into. Given that the US has terrible economic fundamentals -- GDP is faltering, high private and government debt -- it is hard to foresee a bubble in US markets. Perhaps international markets, like commodities, precious metals, foreign stocks, foreign currencies, etc -- will get an influx of US dollars, thus creating bubbles in those markets. This will result in significant dollar devaluation, as those newly created dollars will just be sold and put into non-US markets. This will push the price of US imports up, and thus will result in lots of price inflation for consumers. It could create an opportunity for US export-based businesses.

4. If the Fed inflates but the market realizes the Fed is just printing with no signs of self-constraint, we'll see hyperinflation. In other words, the Fed will have tried to purge the toxic debt by creating junk money, which devalues everything. Just as banks don't want the toxic debt and are not trading with each other because of it, no one will want "the toxic dollar." In other words, there will be a massive run on the dollar in this scenario, which will send dollar-denominated prices through the roof. This is the Argentina scenario.

My Opinions

I think there's going to be a combination of #3 and #4. It is critical to note, though, that foreign markets are experiencing a similar problem, and they are taking the central banking solution of trying to inflate the solution away. We are seeing bubble-type activities in certain markets, such as the Japanese Yen, evidenced particularly by big moves in EURJPY. Dennis Gartman has stated he views EURJPY as a great indicator of the global economy, which I found to be a compelling insight. EURJPY volatility has been huge of late.

In the US, deflationary forces are winning, as evidenced by the rallying dollar, falling commodity prices, and MZM as a money supply indicator, which economist Stefan Karlsson commented on. Meanwhile, reports of shortages and price suppresion in precious metals markets, and attempts on the part of government to force banks to lend to each other, which Mike Shedlock has commented on, are, on the other hand, inflationary arguments.

I do not expect deflation to be reigning for much longer. Government's desire to inflate markets, which is essentially a way of taxing those who hold the currency of the respective economy and transferring wealth to the recipients of the newly created money, is why I'm generally very biased towards viewing inflation as the primary concern. Bernanke has admitted deflation is not really possible, which suggests he will do whatever it takes to inflate the market. Bernanke has also acknowledged inflation is a tax, so he seems to favor this viewpoint with the knowledge that he is taxing the public. Meanwhile, members of Congress have reported that they were threatened with martial law if they did not pass the Paulson Plan, which was eventually passed. Furthermore, we do not see government spending being cut. So, the diminishing tax base is coming as government spending is increasing, which will either require further inflation of the money supply or the sale of additional US debt. As debt is now largely held by foreign countries with tenuous geo-political relationships with the United States -- namely China and Iran -- there is the possibility of economic warfare; foreign debtholders can refuse to continue buying debt, which would also fuel inflation, as the debt would be paid for through further expansion of the money supply.

The always insightful Agora Financial has stated that they expect oil to go to $50 and then $200 within 36 months. I like that assessment quite a bit.

Thoughts on Trading This Environment

My primary concern is wealth preservation. With that in mind, I'm primarily looking to protect against dollar devaluation. As a result, here's what I'm doing:

1. I'm viewing deflation as a great opportunity to accumulate precious metals. Gold and silver are great hedges against inflation, and even in deflationary environments, they fall less than other asset classes, and thus still offer opportunities for those who own gold and silver to gain purchasing power (i.e. gold and silver may be falling in price, but everything else is falling faster). I don't trade precious metals, but I "invest" in them -- meaning I accumulate them and don't plan on selling until at least a few years out.

2. I'm particularly concerned with dollar devaluation, and thus look for markets in which excess US dollars would find their way into. For a while, EURUSD was great for this. Now the Eurozone clearly has their own problems, though I think Asian currencies are going to pick up some dollars, and thus I've been trading the Yen, and am in a Yen trade now.

In deflationary environments, I'll be trading less, and will largely be out of the market, instead looking for opportunities to accumulate precious metals and cash. If you're into trading deflation, markets where the money supply is being pulled from may prove to be great short opportunities. As money supply contractions have a natural tendency to come from bubble markets, financial instruments and the US housing sector are natural opportunities. For those who believe the US recession of 2002/2003 was not complete -- meaning the NASDAQ bubble was not fully deflated -- US tech stocks may have some room to go down.

As an inflationist, I'll be in foreign currencies and precious metals. I'll buy and hold metals, and will enter currencies when they look bearish for the US dollar, my home currency. I also previously noted some ETFs on the US stock markets that I thought would be worth considering in an inflationary environment.

The Four Corners of Safely Managing Money in a Volatile Economy

2008-11-26T12:53:00.000-08:00

It seems like all around the world, we're having some economic problems.

2008 is a year where we saw price inflation on a global basis. We're also seeing a global housing crisis. A global food shortage. And an increase in oil prices around the world.

What is going on here?

While there are many ideas as to what is causing all these problems, one thing is for certain: shortages and price shocks on a global basis require a different approach to wealth management. As one crisis can easily lead to another -- for instance, a rise in global oil prices will increase transportation costs, which in turn will increase prices for everyday goods and services -- there is a serious danger of a "domino effect" of sorts that creates greater economic chaos than most of us have seen in quite some time -- possibly in our life times.

With that in mind, there are four guiding principles individuals should bear in mind when looking to preserve their wealth in a turbulent global economy:

1. Liquidity is Key. Liquidity -- the ease with which you can get in and out of your investments -- is of greater value than ever before. As underlying economic ecosystems are vulnerable, investors should pay extra attention to ensure that they can get in and out of investments as easily as possible. As an example, houses tend to be a bit illiquid; it takes time to buy one, and to sell one. In a deepening housing crisis where the market is overwhelmed with sellers relative to buyers, sellers may be in a particularly dangerous situation; it's a buyers market, and as prices continue to fall, the relatively illiquidity of housing as an investment becomes more apparent and detrimental to one's overall investment portfolio.

2. Short Term Strategies. Related to the idea of liquidity is the notion of short-term investing. For the past few decades, many people, particularly Americans, have grown accustomed to thinking of long-term investing as a safer bet -- i.e. retirement funds, buy and hold strategies with solid companies, etc. In times of economic turbulence, longer term outlooks become harder to forecast. Instead, individuals should look to manage their wealth on a more short-term basis, where one can obtain a more reliable data set upon which to make investment decisions.

3. Technical Analysis. A natural extension of short-term investing is technical analysis -- the decision to base investing decisions based more so on price patterns rather than fundamentals. For instance, a longer term strategy may be to buy stocks of company XYZ, because company XYZ makes a great product and has an experienced and intelligent management staff. Such a strategy may have yielded great results in a more stable economic environment, but in today's more volatile markets, it becomes more important to look at buying and selling activity, and make decisions based on what assets appear to be overbought, oversold, or ready to make a big price increase. Technical analysis may seem like a foreign concept to many, but it is increasingly becoming the primary way professional speculators -- like hedge funds -- participate in the market. The good news is that with the advent of the Internet, an abundance of information, and online trading, learning and successfully applying technical analysis is easier than ever.

4. Diversify on a Macroeconomic Basis. As we noted earlier in this article, one potential cause of concern is for there to be a "domino effect" of crises -- this is why liquidity, short-term strategies, and technical analysis are important. Likewise, so too is the importance of diversifying on an international basis. In other words, as the economy becomes increasingly internationalized, true diversification will mean diversifying across economic ecosystems. One example is currency trading; this allows traders to diversify against currency crises. Another example is investing in commodities -- oil, agricultural products, precious metals, etc -- as these products have a global demand, as opposed to being dependent upon a single ecosystem, as individual stocks and mutual funds generally are. In sum, by embracing these four principles, individuals can find ways to preserve and even enhance their wealth during times of global economic turbulence.

EURUSD Trade Placed on September 5

2008-11-26T12:34:00.000-08:00

I wanted to post the charts that led to me to place my EURUSD trade on September 5.

Below is a weekly chart I used to help identify a strong support level. The area highlighted is a 38.2 Fibonacci level.

I look to the daily chart to confirm that support level, and to wait for the moving averages to align downward as confirmation that the market is trending downward.

I enter on a break of support at 4321. One thing I forgot to include in the chart is the RSI indicator, which I used to check if there was RSI divergence on the break of support. There was no divergence, so I entered.

I'll exit portions of the position once the market begins to retrace and the moving averages begin to reverse.

A Simple Explanation of the Fannie and Freddie Bailout

2008-11-26T12:30:00.000-08:00

The bailout of Fannie Mae and Freddie Mac has been all the talk of late in the economics and finance communities, and rightly so. The bailout will have massive economic consequences.

What I feel this means for traders:

1. The US government simply cannot afford the bailout that it has agreed to make. This will mean that the US government via the Federal Reserve will likely have to print more money, which will result in dollar devaluation.

2. While markets did react positively to this news in the short-term, the underlying economics have not changed. There is still too much bad debt going around. As such, I would expect paper assets -- i.e. financial instruments -- to continue falling.

3. With financial assets falling and the US dollar falling, smart money will increasingly go to hard assets and commodities.

As such, I would expect more of the same. Meaning:

1. Dollar devaluation, which will result in price inflation

2. A bullish market for commodities

3. A bearish market for US stocks

These are long-term outlooks -- think years. Recently, we've seen the dollar strengthen a good bit, and we've seen gold prices and oil prices fall; I would view these as momentary corrections in what I feel can only be described as a massive economic downturn. Short-term traders should of course base decisions based on price action and other technical factors, though I personally prefer to know whether I am trading with or against the long-term trend. Below are links to commentary I found to be accurate and insightful regarding the Fannie Mae and Freddie Mac bailout. Given the magnitude of this issue, I recommend traders gather a wide variety of opinions so as to be capable of making their own informed decision.

The Smart Money Tracker: The end of the bear?

Death of Fannie, Freddie Only the Beginning

Gov Bailout of Fannie and Freddie Would Destroy the Dollar

Fannie & Freddie Discussed on InformedTrades