In Search of Knowledge

People are worried. They're worried about the economy, the current state of their country, about how they're going to make ends meet, and about the world their children are going to inherit. My business is a good gauge of the collective peace of mind. When people are feeling good about themselves my services are deemed "unnecessary" but when they are concerned, my services are the security blanket that helps you get through the night. Lately, the demand has gone through the roof. From the increases in the service, portfolio management, and investment fund businesses that I'm involved in, I can tell you that the human race isn't sleeping too well these days. And it's not confined to the U.S. either. There has been a tremendous influx of clients from the Middle East and Europe as well as from the United States. By the Middle East I mean Pakistan, India, Turkey, the Arab nations, and Israel. I am also getting a surprising amount of business from the former Soviet Union, countries whose names I can't even pronounce much less spell. You know the ones, their names all end in "stan".

Why the sudden thirst for knowledge? I think the answer is twofold: first, the information produced by official channels is inaccurate at best and down right misleading in the worse case scenario. Here's an example. On October 29th the U. S. government announced a 5.3% increase in new home sales which was considerably better than expected and some of the markets went gaga. That's sounds great doesn't it? Only if you don't scratch the surface I would reply! A quick look at the details reveals a margin of error of +/- 15%! I contend such a large margin of error makes the figure statistically irrelevant, but that's just me [1]. Then if you look a little deeper you'll see that they revised the previous months of June, July, and August down. The revisions never make it into the newspapers, just the headline numbers. Food for the masses! It reminds me of the difficult times I experienced in Peru back in 1989 when we had shortages of everything, especially bread. One month I remember the Minister of Economics proudly announcing that bread production increased by an amazing 12%. Impressive to say the least, especially since grain imports and production decreased. How did they do it? They mixed saw dust into the flour. If nothing else, governments are creative.

This brings me to the second part of my answer. People instinctively know the system is rigged and they know the system is going to fail at some point in time. They just don't know when and that creates a hell of a lot of anxiety. In their search for the truth, and in an effort to relieve the stress, these people seek out services like mine. Sometimes that's good and sometimes it's not so good. There is an awful lot of stuff floating around out there in cyberspace, and like most things in life, most of it isn't very good. How do you separate the wheat from the chaff? Tough question and I have no good answer. Trial and error I guess. As most of my clients know by now, I read very little of what is published. My reading list is reduced to Richard Russell, Bill Gross, John Embry, Steven Roach, John Mauldin, and a couple of others. Mostly I look at numbers and I try to listen to what they have to say. I spend an average of six hours a day, if not more, just analyzing numbers. Then you have charts, graphs, historical data, and so on. All in an effort to identity and find "value"; easy to say and hard to do.

The problem with a service like mine is that almost no one comes to me at the beginning of their investment experience. The average inquiry starts out like this: "I started with US $10,000 and it went up to US $80,000 and today I'm left with US $6,000. What can I do?" Generally the perspective client wants a "band-aide" solution, and admittedly I'm no good at applying band-aides. I usually start out by telling them that they have to educate themselves and it will require time and effort. I lose a lot of them right then and there. "You mean I have to work at this? No thanks!" Making money in the stock market is no different than practicing law or medicine. There are no shortcuts. As Jesse Livermore said "you can't make a quick buck at brain surgery". I have a number of intelligent clients who are doctors, lawyers, and owners of good-sized companies and yet they are surprisingly naïve about what is required to extract a profit from the stock market. The average client is usually looking for a 100% return right off the bat, then it can go up from there. Nice work if you can get it but most resumes are not quite up to snuff. After all this, the few that are still interested in my service generally head for the door when I tell them that I made a total of twenty-seven trades in 2005 and this year's total won't exceed fifty. "You mean you're not going to buy something today?" they ask me in a panic-stricken voice.

As difficult as I make it sound, I still can't keep up. I currently produce all of my analysis in English, Spanish, and French and am looking to expand into Chinese and Arabic. I receive more than a thousand e-mails a day and after deleting the two hundred or so related to Viagra, it's still a lot more than I can handle. Hire some analysts you might say! Well, so far I've tried out five and none have survived a month. Number six is due to start this week. The office pool is 10 to 1 that he won't make it to Thanksgiving! It seems that I have a "special" way of being not conducive to long relationships in business. I don't mind mistakes as long as they are my own and as long as I don't repeat them. Learn and move on!

What is the one thing all, or almost all, clients have in common? They want a solution, a panacea if you will, that eliminates the anxiety and allows them to sleep peacefully in the knowledge that there is hope for the future. Right about now you're thinking how absurd! Well, it really isn't as far fetched as it sounds. There are two things all investors can do that will provide peace of mind. The first is to spend a couple of hours a day studying the market; the price movements in particular. The second thing you can do is to invest in gold. Not gold stocks but the actual yellow metal. I usually tell clients to invest 10% of their portfolio in gold, but given the potential for disaster I see on the horizon, that's no longer an adequate recipe. I think the average individual should have no less than 25% of his wealth in gold. His or her purchases should be orderly and consistent with no regard to price or any attempt to "time" the market. You want to sleep peacefully? Well stick a few Krugerrands and U. S. Silver Eagles under your mattress every month and you'll be surprised how well you'll sleep. Don't bother to tell me that there are storage costs, they don't pay any interest, and they're a pain in the rear to transport. I know all of that, but I also know they are the most secure investment in the world. Nothing has stood the test of time like gold and probably nothing ever will. It will most certainly outlast me, my children, and my children's children. After thirty years of studying the markets, my best advise is to buy a little peace of mind. Buy some gold!

MARKET COMMENTARY

Things are heating up. Commodities, bonds, and the Dow are all rising (strange bedfellows if you stop to think about it) while the dollar is declining. I am being kind when I say there are contradictions in the market place. The Dow hit new highs while the Transportation Index acts like its stuck in the mud. The CRB is on the move even though oil can't find a friend. In fact, I find the CRB so interesting that I would like to begin this section with a discussion of the Commodity Research Bureau Index. Let's begin by taking a look at the daily chart of the November Continuous CRB Index (CIX6) futures contract:

We only see part of the sharp decline that began in mid-May and lasted until late September although we do see the lower high that came about in early August. Given what appeared to be a double top and the depth of the decline, many analysts rushed to the conclusion that a major sell signal had been given and it was time to throw in the towel. In my opinion that was a mistake and demonstrates a lack of understanding of the current make-up of the CRB. First of all you must understand that the CRB is nothing more and nothing less than a basket of goods and each good has a weight assigned to it. In 2005, these weights were modified in favor of oil and related items. As it stands now, price movements in oil have a significant impact on the price of the CRB and that has created distortions.

Given this change, it is even more amazing that the CRB has rallied through out the month of October as oil has remained quite weak and copper has been range bound. Basically, the CRB has rallied on the strength of gold, silver, and the grains. I believe that the CRB broke out to the upside with its close above 382.50 in the November futures contract (CIX6). The scenario is particularly bullish when you see the five unfilled gaps left in its wake as we work our way higher. Using the November contract as a guide, good support will be found at 388.88 and 381.88. I feel that the two consecutive closes above 388.88 this last week was of considerable importance, and will now lead to a test of good resistance at 396.04 and eventually 403.93. In short, I am quite bullish commodities and continue to look for a new high above 419.00 before the year is out. Commodities are in a multi-year bull market and still have a long way to go as far as the upside is concerned.

Now I would like to move on to the Grains. As most of my clients know by now, I have been long wheat, corn, and soybeans for close to eight weeks. I have been looking for a rally for months and it finally came about. The question now becomes "is it the real deal or not?" I believe it is and I believe it is long over due. Let's take a look at the weekly chart for the Dow Jones-AIG Grains Spot Index ($DJAGRS):

You can readily see the breakout above the 2005 high and you should also note that we did it with a huge gap to the upside. This is an impressive picture to say the least and quite bullish, but what is even more bullish is the following Point & Figure chart of that same index:

The bullish price objective of this chart is all the way up at 222.0! That doesn't mean we'll get there but when you strip away all the commentary and other garbage, price is saying that we will. I know grains are really overbought, but I also know they can stay over bought a lot longer than you can stay solvent trying to sell them short.

I took an initial long position in wheat, corn, and soybeans about a week after the rally began and thinking that the rally was a bit over done, I lightened up two weeks ago. To be exact, I sold half of everything as it seemed like the right thing to do at the time. Well, it wasn't. Only wheat broke support while corn and beans continued to register higher highs all the way thru Thursday of last week. I won't chase it here and follow up a mistake with a mistake. Instead, I will sit on what I have and wait. Sooner or later there will be a reaction and I will add on. The significant support and resistance numbers for wheat, corn, and beans are as follows:

Wheat was the leader on the way up, peaking well before the other two but has been unable to pull them down along with it. Wheat broke and closed below 488.2 on Tuesday and Wednesday and I really thought that would have triggered selling in the other two, but it didn't happen. A close back above 511.9 would indicate that all three will continue to make new highs over the short run. Over the long run prices will be forced higher do to considerable Asian demand and tight supply, and that is especially true with wheat. I believe the rally in grains is real, there will be reactions, but we are going a lot higher over time.

Let's move on to oil. Ever since oil topped out in July, it couldn't buy a friend with a fist full of one hundred dollar bills. No one likes it right now and a lot of people are predicting a test of support at 45.00. I don't happen to agree with the conventional wisdom. I can't remember what I had for breakfast today, but I do remember that just about everyone and their brother said oil had put in a double top at 70.00 back in February, and the bull market was dead and buried. The cadaver then proceeded to march all the way up to 80.00. As you can clearly see in the weekly chart of oil, we appear to be consolidating (or distributing, depending on your perspective) in the same area as we did a year ago. You can also see that oil is quite oversold as both RSI and MACD are as negative as they have been in a very long time.

We are now in a range of support, 55.90 and 58.68, that should hold. The latter is an important Fibonacci number while the former is an old low and is significant. Furthermore, nothing has changed with oil. Supply is finite and dwindling while demand is increasing do to substantial Asian growth. As a result I do not see $45.00 oil in our immediate future, and maybe never. I do see US $100.00 oil sometime next year. Nothing has changed in the Middle East. The Arabs and the Jews are not about to become best buddies anytime soon and there is still a fellow by the name of bin Laden at large in the world. Sooner or later, we'll hear from him. I am bullish oil and see absolutely no reason to change.

Then there is gold and silver. Tulips and the NASDAQ have come and gone but gold always was, is, and probably will always be. Every culture that I am familiar with puts a value on gold. It's only real detractors are the producers of fiat money, i.e., the central banks. They are the modern day alchemists, trying to change nothing into something, and like their predecessors they will fail. Paper money is nothing more than legalized fraud. Gold on the other hand is a true store of wealth! Currently the yellow metal is picking up a head of steam and depending on who you ask, silver is either just ahead or just behind it. Let's start out with a weekly chart of Gold ($GOLD):

The 730.40 top is easy to see as is the sharp sell-off that followed. I was able to identify the bottom in June and so far the market has not made a liar out of me although there have been a few tense moments along the way. Back in September we made a higher low and have since broken out to the upside. Just last week, we managed to close above key resistance at 616.6 and 624.6. These now become support and we will face significant resistance at 644.5, 664.2, and 686.2. These are the important numbers and the only one's you need to remember. There will be volatility and plenty of it.

Just about the same can be said for both silver and the HUI. Like gold, both have broken out to the upside and it now appears to me that the HUI is trying to lead the way. It also seems that silver is acting a bit better than gold, not that gold has any problems because it doesn't. Take a look at the weekly chart of Silver ($SILVER):

The key numbers for silver are support at 1196.0 and 1234.2 and resistance at 1332.5. Neither gold nor silver are anywhere close to being overbought. In fact, they are just now beginning to get some wind in their sails. At the very least I expect gold and silver to breach 686.2 and1332.5 respectively by the end of this month.

With respect to gold and silver stocks, I have not budged one bit. I remain long BVN, CDE, GG, GLG, NEM, RGLD, and SLW and will stay long these stocks for quite some time. In order to do what I do (sit tight), you must understand two things about gold stocks:

• There will be a tremendous consolidation in the industry as ore-strapped large companies buy up anything and everything that has decent reserves. To get a new mine going takes five to seven years and the Newmont's of the world aren't going to wait seven years.
  
• As these companies become more and more profitable, they will become the targets for cash strapped governments who will look upon them as their private piggy banks.
  

The large blue chip companies will be in a position to deal with these two issues and that is why I focus all of my attention, and capital, on these particular entities.

Copper is my first foray into the non-precious metals and it attracted my attention do to its ability to resist any real or significant reaction to the downside. Currently, copper is range bound, floating between 323.25 on the low side and 370.00 on the high side. A lot of people think copper is distributing here but I beg to differ. I think copper is being accumulated by those who know that supply continues to be tight. Last week we tested support at 323.25 and rebounded that same day. The December futures contract (HGZ6) closed on Friday at 332.25 and should now test decent resistance at 351.62. I am very bullish copper and I believe we'll break out above the old 380.00 high before the end of the year.

To my way of thinking, the foreign exchange market is the most fascinating market at this point in time. Absolutely every major central bank in the world is loaded to the gills with dollars and yet the U.S. keeps on churning them out like there is no tomorrow. It is becoming obvious that the central banks don't want any more dollars and would actually like to get rid of the ones they have. It's a real dilemma; in fact, I think it's the biggest dilemma the world has faced in the last five hundred years. Maybe the plagues were comparable but it's hard to say. My clients are sick of looking at this but feast your eyes on the weekly chart of the U. S. Dollar Index ($USD) below:

This chart is just so bearish that it's hard to know where to begin. There is an ominous head-and-shoulders formation that will show up in textbooks fifty years from now. Also you have the 50-wma trading well below the 200-wma and both heading down like a rabbit in search of a hole. Finally, you have the series of three lower highs put in after the November 2005 top. There is a line in the sand and that is important Fibonacci support at 84.87. Two consecutive closes below it and I believe we'll set up for a test of the 80.50 low put in almost two years ago.

At some point everyone who holds dollars will begin to head for the door at the same time. It will be like trying to pass a kidney stone the size of a Chevrolet. It isn't going to happen! I believe that point is at 80.50 and I'm not so sure the Asians will come out to defend it this time around. Why? Two reasons really:

• Through a series of international miscues, the current administration doesn't have many friends anymore. When you're the bully on the block, you'd better not stumble because no one will be there to catch you, and
  
• The Asians are starting to get the idea that they actually have internal demand for their own products, and if that's the case, they'll think twice before they finance anymore of our escapades.
  

Good support for the dollar is at 84.87 and 83.98 while resistance is at 85.79 and 86.64. Although stranger things have happened, I would be really surprised to see a close above 86.64. As most of you know, I have been bearish the dollar since March of this year and I see absolutely no reason to change my stance.

Finally, we arrive at the Dow Jones industrial Average. A mystery wrapped in an enigma. Houdini would be proud! Oblivious to everything and everybody as we climb a wall of worry. Value be damned, full steam ahead! The Dow is now sporting a PER in access of 24 and an average dividend of 1.6% and yet people still line up to buy. To say the least, I am impressed. Here's a daily chart of the Dow Jones ($INDU):

What we have here is a day in, day out grind to the upside, but what we are lacking is the blow-off to the upside where the price goes close to vertical. That will tell me that the end is near. I was looking for the blow-off to coincide with the 90-day cycle date of October 17th, and although we paused there for several days, we didn't bet a blow-off and it didn't hold.

As most investors are aware of, the Dow recently made a new all-time high on the 26th of October. What most people aren't aware of is that it is virtually alone in that distinction. The other three major indexes, the NASDAQ, S & P, and the Transports, are all somewhat below their all-time highs reached back in the year 2000. Take a look at the historical chart for the S & P 500 Index ($SPX) below:

This index closed at 1,368.50 on Friday, well below the 1,575.00 all-time high. For a very interesting take on why this is happening, you should read an article entitled "That Stubborn Yield Curve" by John Maudlin (www.frontlinethoughts.com). I don't want to steal his fire but what he is saying is it has to do with how the Dow is calculated. The Dow is price weighted while just about every other major index is market cap weighted. That's why the Dow can rally to a new high with only ten of the thirty Dow stocks above their January 200 highs. "Fifteen of the remaining twenty are down 25% or more. The biggest reason for the surging of the Dow has been just four of its stocks, which not coincidentally are its highest priced components. And as Barry Ritholtz noted, not a one of the thirty Dow stocks was at an all-time high as the Dow was making its new index highs." Now here is where it gets interesting:

• "What if the Dow had been capitalization weighted? Your total return (including dividends!) would have been only 1.13%. Taking away the dividends, the Dow 30 would still be under its high-water mark by about 13%!"
  

I'm not saying it's wrong to calculate the Dow in this fashion. I'm just saying that you have to understand what the numbers are really saying, i.e., there is no great investment here.

In my opinion, we are leading up to a top and it is just a question of when not if. What is important is not the top, or even the initial reaction. What is important will be the strength (or lack of it) of the rally that follows the initial reaction. Could the recent decline which ended on Friday with six days down have marked the top? If it did, then this rally should produce a lower high but I don't believe that will be the case. If we do produce a lower high, then the next reaction will be significant. We'll just have to wait and see.

I would now like to conclude this article with a word or two on bonds. The long term trend sin bonds tend to be counted in decades rather than years. Take a look at the historical chart for bonds:

You'll see that bonds spent more than a decade rallying to their 1998 top. Since then we have put in two lower lows and spent a great deal of time distributing within a range of 101.00 to 120.00 and most of that was spent between 107.00 and 114.00. I do not live in a cave and I do know the economy is slowing. I also know that just about everybody and their second cousin is calling for lower rates (higher bond prices), but I opine that everybody is wrong. The Fed is going to try and talk rates down, but that is the extent of it. Just talk! Prices are on the rise and the Fed will have to raise rates sooner or later.

Then we have the issue of debt. Hundreds of billions of dollars of trade and budget deficits will need higher interest rates if you want investors to accept the risk that goes along with it. I sold bonds short on Friday at 112.03 and will be interested to see how the price moves this week. I may be a bit off on my entry point but I do firmly believe that bonds have to head down over time.

Reference

[1] Imagine if I sent out a statement to a client saying he made 5.3% in the month of October but there was a 15% margin for error. How long do you think I would stay in business?

Enrico Orlandini

Dow Theory Analysis

Ignacio Merino 636, Santa Cruz, Miaflores, Peru
Phone: 001-51-56-973-5599 - Fax  :  001-51-19-280-8796
Email: ebo@dowtheoryanalysis.com
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