What Now?

Every once in a while you come to a fork in the road, and if Lady Luck really likes you that particular day, you're able to recognize the fork when you come to it. This can be said of the May 10th high of 11,670.19 registered in the cash DJIA, and the same can be said for what is supposed to be the June 22nd low. Or will it be a lower high? In a recent article entitled "One Possible Road Map" I happened to mention, in a footnote no less, that June 22nd could produce a stock market crash if the moon is right (sarcasm here). I originally intended to leave the comment out altogether as it seemed so remote that it wasn't really worth mentioning, and it wasn't the purpose of the article. Finally, I decided to put it in a footnote precisely because I felt it should be mentioned but in a footnote I could do it without drawing a lot of attention. Who reads footnotes, right? Apparently a lot more people than I ever thought possible. After answering hundreds of e-mails asking what an inversion is, what's a time cycle, and why it would be significant, I have come to see the error of my ways. Never again will I try to hide my inner most fears at the bottom of a page. Instead I will leave it scribbled on the margin of my trusty legal pad where it belongs. But now that the possibility of a crash it out of the bag, I would like to try to put things back in perspective if at all possible.

I began to write about the DJIA, and its May 10th top, the day it happened and that is the real story, not a possible crash scenario. One should realize that we were never in a new bull market as so many CNN gurus would like you to believe. Rather we were simply in a liquidity distorted bear market rally that had the bad taste to last almost four years. Quite probably the longest bear market rally ever recorded anywhere, but a bear market rally none the less. How do I know? I a word, value! Bull markets begin with good value and end with a lack of value. The bear market rally began with a PER of 17, ended with a PER of 20, and at no time did the average dividend surpass 2.5%. No value there folks, just an appeal to the greater fool and that is a club where membership is expensive and, at the same, undesirable. The secondary upward reaction in the DJIA has come to an end and that is the real story, not the how but the when. If we crash here or make a 'managed' orderly decline, like the dollar, it's really irrelevant. What matters is that we are heading down. The crash will come and value will rise to the top like cream. The date will be important only to historians. Speculators like myself see the change in trend, take a position, and try to hold on for dear life. The duration of this new leg down in the bear market is not as important as when you take your initial position, although I do think this leg down will last for quite some time and turn out to be brutal, crash or no crash. As old man Rothschild would have said "blood will run on the streets" before all is said and done.

As high as the DJIA rallied, it wasn't high enough. We missed a new all-time high by just one hundred measly points, and it just goes to show you that the difference between obscene valuations and real value is razor thin. In the end, those elusive one hundred points just might turn out to be the most expensive one hundred points in history. The DJIA recently traded as low as 10,698.85, more than one thousand points from our recent high, and yet the complacency was so thick you could have cut it with a knife. People just don't believe the DJIA can decline and I can't understand it. If I didn't know better, I would swear everybody is smoking something and it's not

tobacco! I can't begin to tell you just how dangerous this attitude is. I try to study the history of the market as much as I can and, although it is quite subjective, and I am hard pressed to find a similar situation. Not in 1929, and not even in 1907. The level of complacency is clearly in uncharted waters! The "this time it's different" crowd has really done a job.

Assuming I'm right and the bear market rally is dead and gone, then what can we expect from here on out? Well, the first thing you need to recognize is that a declining DJIA is in reality a deflationary force of significant proportion. The first leg down in this bear market wiped out an estimate two trillion dollars in market cap and the second leg down has the potential to be at least as damaging, if not more so. What's more, we don't have to crash to do it. All we need is a 'grind em up and spit em out' type of decline; a decline that is so gradual that the bulls hesitate to exit because they always have the impression that the next rally is right around the corner, but the corner never comes. This type of decline affects everything from a company's ability to obtain credit to your IRA account. Almost nothing is left untouched! Unemployment and earnings drop and the latter is where the rub comes in. Earnings drop almost as fast as share price, and in some instances, faster. As a result, the PER that everyone follows so closely seems take forever to fall to acceptable levels, i.e., single figures.

These deflationary affects spill over into everything: banking, housing, consumption, nothing will escape unscathed. To make matters worse, it feeds on itself in a self-stoking sort of way. The

US is a country that depends on consumption ¹, and as consumption declines, businesses and all the rest suffer. That in turn leads to more unemployment, defaults on mortgages, and so on. By now you should get the idea. A quick look at the weekly chart of the Consumer Index ($CMR) above shows what some would classify as a "double-top" followed by a decline down to test the 50-wma. Below you'll see a weekly chart of the Banking Index ($BGX) and although you don't have all the

comparisons, it is the last of the major indexes to give up the ghost. No double top here, just a new high at 113.73, and then a decline to test the 50-wma. I suspect it will continue down from here but we'll just have to watch.

In conclusion, I don't know if the June 21st high was the lower high or not, and I don't know that a crash will follow. I suspect not. I suspect that the initial decline of 1,022 points was sufficient enough to introduce an element of bearishness. It was also large enough (probably) in points so that it would be difficult to follow it up with a crash. To have a reasonable crash scenario, I would have liked to see the high fall on the 22nd reaching 11,251 as minimum and 11,371 would have been even better. That didn't happen. On the other hand, the fact that the bonds broke critical resistance on the 22nd is ominous if you ask me. The price action Monday and Tuesday will be critical in defining the current trend. If we continue up, then we were testing resistance and we'll rally some more, to 11,371 at the very least. If we turn down from here, then the lower high is in and we'll grind it out to the downside. We'll just have to watch.

Market Commentary

Bonds - The September Bond futures contract closed out the week at 105.22 and below excellent support at 105.27. This is the second time, the first being back in mid-May when we made one close below 105.27 and then proceeded to rally until mid-June. The top of the rally was 108.14. Since then we've given back almost all the gains in less than half the time it took to accumulate them. That is a troublesome sign of weakness. As most of my clients know, I have been anticipating a break of 105.27 for quite some time and here we are for the second time. Two consecutive closes below the above mentioned support level will almost guarantee a trip down to the next level of critical support at 101.27. The following weekly chart of the US Treasury bond paints a rather bear

picture with the price trading well below the 50-wma and 200-wma. Also note that the 50-wma has turned down and appears ready to cross below the 200-wma and that would be extremely bearish. On the other hand, a look at the RSI and MACD shows that the bond is quite oversold.

What is not shown is the fact that the bond has probably priced in a 6% interest rate and a trip down to 101.27 would seem to indicate that interest rates will hit 7.5% at the very least. Any idea what that will do to the housing market, or credit card debt for that matter? Let's just say it will not be a positive influence. There will be some minor support levels along the way, at 104.00 and 102.22 to be precise. And 105.27 should become reasonable resistance. Bonds just happened to break support on June 22nd and I don't think that is a coincidence. If we have a confirmation Monday, i.e., a second consecutive close below 105.27, we should see lower prices and higher rates. In a deflating economy, that will make debt service difficult at best.

US$ - The decline in the dollar stalled at 83.27 basis the September US Dollar futures contract and since then we have seen a reaction to the upside. There have been a number of articles published calling for a rally in the Index up to 96.00 and maybe even higher before we turn down and make new lows. While anything is possible in our distorted world, I seriously doubt that such a secondary rally could occur. Why? Simply put, there are just too many dollars floating around out there and there are more, a lot more, being printed every day ². For such a rally to occur, it would be necessary for the Chinese and Japanese to have a willingness to increase considerably their exposure to the dollar. I believe the opposite is the case. Our banks, because that's the role China and Japan really play, would love nothing better than to exit their dollar positions. Ideally they want to do this in an orderly fashion, but I believe that is next to impossible. Let's take a quick look at the weekly chart of the US Dollar Index below and I'll make a few observations:

First of all, is that a classic head-and-shoulders formation or what? And the fact that it took slightly more than a year to complete is even more impressive. Since the November 2005 high, we've posted two lower lows and we are now going to make a second lower high. The current reaction in the dollar will, in my opinion, stop somewhere around the 87.33 level bases the September futures contract. That would be a 50% retracement from the May 83.27 low, back up to the November 2005 high of 91.40.

Technically speaking, the dollar is not oversold (contrary to a daily chart where the dollar is over bought). Both the RSI as well as the MACD are in neutral territory. On the other hand, it is obvious the dollar is in a bear market as the 50-wma is trading below the 200-wma and the actual price is below the 50-wma. We have now entered an area of considerable resistance and it is possible that the dollar just may have topped on Friday. We'll have to wait and see. In any event, you can rest assured that the dollar will not enter a bull market any time soon, at least not the dollar as we know it today.

Oil - The crude oil has been trending for weeks now, since the beginning of April to be precise. April's top was followed by a weak move down and that should have been followed by a test of the new high. That didn't happen and we began to trend sideways. For a better illustration, take a look at the weekly chart for crude oil below and two things become apparent. First, we have used and continue to use the 50-w.m.a. as support and most significant declines bounce off of this support. This "correction" has yet to touch it. Secondly, we appear to be consolidating while, at the same time, working off an over bought condition. If we are still in fact in an inflationary world, and I believe we have been for quite some time, oil will continue to consolidate and then move to a higher high. A test of 81.00 would be the order of the day in my opinion. The rub comes if deflation

is raising its ugly head. If that's the case, this will turn out to be distribution and we'll turn down and break support at the 50-w.m.a. eventually testing the 200-w.m.a. I would not advise clients to jump the gun here and dump oil and related stocks just yet as oil has done nothing wrong. Looking at this chart, and noting that the current consolidation is above the last two highs of 70.85 and 69.20, I have to assume the next move will be up. Never fight the trend, and the trend is up until the price tells us otherwise!

Oil, along with copper, will be the ultimate gauges of inflation. As most of my clients know, I preached the deflation scenario for the better part of five years and only recently became a stagflation ³ convert. I really had no choice given the advances in the CRB; after all it's hard to argue with a 100% increase in price. In all honesty, it's a position that I am not comfortable with and I suspect the deflation boogieman is hiding under the bed and will end up rattling the furniture before it is all said and done! I believe the next move in oil and copper will give us the answer; we'll just have to be patient and wait.

Gold - It has inspired more dreams and, at the same time, dashed more hopes than any other substance the world has ever known. This time around, it won't be any different. The bearishness that existed last week reached a level that I have never experienced before, and I've been in this business for a couple of decades. I was informed that the bull market was over and we'd entered a new bear market by numerous clients who were old enough, and educated enough, to know better. The yellow metal would be back at US $400.00 an ounce before you knew it and, if I was smart, I'd better take the short side while I had some money left to bet with. So what did I do faced with the new reality? I went out and bought gold, that's what I did! When ever people are willing to throw there gold away, you can bet your last shekel I'll be there to fish it out of the trash can.

That's the psychological part of gold; what about the technical aspects of the precious metal. As you can see in the daily chart of gold below, we can see that by mid-June gold had reached an extremely oversold condition as it traded all the way down to its 200-dma. To put this secondary reaction in perspective, before the rally began gold had traded in a range for $534.00 to $571.00 for

what seemed like an eternity. What the reaction succeeded in doing is simply return to the level we broke out from. No more and no less. On a closing basis, we held strong support at $553.00 bases the August Gold futures contract and that just happened to be my original projection for a bottom. ⁴ That decline amounts to a 25% correction, the largest such reaction to date.

As you may recall, I wrote an article back in February where I talked about the significance of $569.70 (spot price) and the 50% principal. The $569.70 price just happens to be a 50% retracement from the 1999 bear market low back up to the 1980 bull market high. Once we managed two consecutive closes above that target, you could rest assured that, sooner or later, we would test the 887.50 all-time high. We saw the two consecutive closes above the target and then gold really took off. It's no coincidence that the recent negative reaction came back down to that target, with two marginal closes below it, and then proceeded to rally back up to the $580.00 area. I now believe that gold should consolidate in a trading range that will extend from $553.00 on the low side on up to $588.60 on the high side. This consolidation period should last a period of weeks followed by an attack of good resistance at $644.70 and then a test of the $728.60 resistance that stopped the last rally. I expect this process to take the remainder of the year and a break of 728.60 should occur by Christmas, assuming there is no external crisis that could affect the price one way or the other.

Silver - There really isn't much to say here except silver will bottom when gold does and not one minute before. In a perfect world it wouldn't be that way, but we do not live in a perfect world and less so in the precious metals. Manipulation is a force to be reckoned with and the boys' won't take their knee off the neck of silver until they have no other choice. Once we can confirm gold's bottom, silver may very well lead gold up just like it did the last time around.

Gold Stocks - I have been long Buenaventura, Coeur D'Alene, Gold Corp., Glamis, Newmont, Royal Gold, and Silver Wheaton for a long time and I will stay long these stocks without exception. I'm the first to admit that there is nothing flashy in this portfolio. I liken it to 'meat and potatoes', but it certainly gets the job done. The latest reaction was the first time where I did not add on to my holdings when I saw a bottom. Why? We have an extenuating circumstance, and it's nothing less than the DJIA! Take a look at the daily chart for the HUI below:

The HUI topped at 401.69 in early May right along with the DJIA and gold, and then turned down. The decline continued for slightly more than a month until it bounced off good support at 274.10 earlier this month. So far we have rallied and closed above what was good resistance at 303.32. The next line of resistance is at 320.50 and I suspect it will take some work to close above it. Should the DJIA have topped on the 21st, it will be quite difficult for the HUI to work its way up. Knowing how rough a three or four month decline in the Dow could be for gold stocks, I have decided to sit through it. I've sat through everything else over the last six years, what's another couple of months.

CRB - Since I've already covered oil, gold, and silver already, I won't spend a lot of time here. Suffice it to say that we are at a critical juncture in the CRB Index. Take a look at the weekly chart for the CRB Index below and you'll see what a bull market looks like. If I were to put a historical

chart in its place, you would see a situation very similar to gold, i.e., an almost uninterrupted rally from the year 2001. In the above chart you can clearly see that the price has used the 50-wma as support and the only violations have been marginal at best. The RSI is in neutral territory as is the MACD. The histograms are actually negative at the moment.

This is important so pay attention. If in fact the inflation we have experienced over the last four years or so is to continue, the CRB must hold the 50-wma. That's my opinion of course and I'm sure that you can find a bevy of analysts who would disagree with me. As I have mentioned a number of times in this article, my concern is that deflation is already applying pressure to the US economy and, if I am correct, the CRB will demonstrate that with a prolonged decline. Maybe even a new bear market. A lot depends on whether China and India have developed an internal market with sufficient demand to offset the decline in the US economy. I don't have the answer to that question, but the CRB will tell us shortly.

Conclusion

We are at an important juncture. Is the DJIA's low high on the 21st a valid top? Is it just a coincidence that bonds broke down on the 22nd, taking out what was strong support at 105.27? The CRB, oil, and copper are hanging on by a thread and if they roll over and head down, what could be a more deflationary scenario? Commodities, stocks, and bonds all heading south at the same time! It probably won't happen, but what if it did? The only thing left for the Fed to do is fire up the helicopters. I'll let you in on a little secret, it won't make any difference.

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
Website: www.dowtheoryanalysis.com

For those of you interested in receiving information on the Funds we manage, please feel free to e-mail us at ebo@dowtheoryanalysis.com and we will respond as soon as possible.