Almost End of Summer Thoughts

by JDH on August 18, 2012

Let’s take a step back and review where we are at, shall we?

The Dow is up over 2,000 points, or 18%, in the last twelve months. If that was the only data point that existed, you would assume that all is great in the world. The recession is obviously over, and good times are here. All is good.

In fact, that may be the answer. Everything may be fine.  Perhaps we humans fall into the trap of “over thinking” what’s happening in the world.  The market is up, so let’s all pile on board and enjoy it.  There are two obvious reasons for optimism:

First, interest rates are low, and are likely to remain low for the foreseeable future. As reported this week, inflation in Canada is low, so interest rates will likely remain low. The U.S., and the rest of the world, is in the same low inflation boat.

Second, as a result of cheap money, corporations are sitting in huge piles of cash, and they are making huge profits, which is one of the reasons the markets are doing so well.  As long as that trend continues, everything looks good for the future.

Third, market volatility as measured by the VIX is at a five year low.  Hard to have a panic with no volatility, right?

Finally, it’s an election year in the U.S., and it’s logical to assume that the party in power will do everything in it’s power to keep the party going until at least the elections in November.  Interest rates will remain low, and money will continue to be printed.  It’s all good.

So, logically, the correct strategy would appear to be to simply ride the trend, stay long, and go with the flow.

The Alternate Viewpoint

Of course there is an alternate perspective:

We’re doomed.

Yes, the markets are doing well, but that’s only because the Fed is printing money like crazy.  M1 is up almost 15% over the last 12 months.  That money must be going somewhere, and some of that somewhere must be the markets.  Fake money makes the fake markets go up, but it’s an illusion, it’s not real.

I don’t have the numbers on my fingertips to prove it, but I assume the vast majority of market action today is program trading, computers trading with computers.  The retail investor “left the building” in 2008, and hasn’t returned.  That does not bode well for the long term health of the market.

The problems in Europe are worrisome, to say the least.  In fact, it could be hypothesized that all of the Fed money printing is simply to prime the pumps with cash to bail out Europe.

If you want more to worry about, consider that Iranian President Mahmoud Ahmadinejad continues to advocate the destruction of Israel.  We know that he’s crazy, and we know that he’s “preaching to the choir”, but if he has big guns and wants to use them, we could have a heap of trouble in the near future.

And if you want more mundane things to worry about, consider that the Baltic Dry Index, a measure of shipping traffic, is down 35% year to date.  How can that be good news?  How can a 35% decline in shipping lead to new highs in the market?

The short answer is: I don’t know.  I don’t know if we are on the road to ruin, or if we have already turned the corner and the bottom is well behind us.

All I can do is look at the charts, like this one, of SLW.TO – Silver Wheaton Corp..  April 2011 was the double top peak, and the stock has travelled a down channel ever since, even breaking below the bottom of the down channel in May of this year.

But, since then, the stock has consolidated, and has even broken above the $30 resistance level that existed throughout the summer.

Given that the RSI is sitting at 73, I would assume a pullback below $30, and even $25, is quite possible, but I would not be surprised if the May bottom holds for the long term.

Gold stocks are showing a similar pattern.

For example, here is the same time period for AEM.TO – Agnico-Eagle Mines Ltd.

We are obviously no where near the highs, but a significant base appears to be building, and I can easily see this stock much higher in the medium to long term.

So how do you play it?

You’ve got three choices:

First, stay on the sidelines until November.  If the world does crash, you will be happy to be able to deploy your cash on some great bargains.

Second, you could assume that the bottom is in, and go all in at these levels.  There is little doubt the precious metals stocks will be higher next year, and the year after, so there’s not much risk at these levels.  They may correct further, but if the long term trend is up, get it now.

The third option is a combination of both strategies.  Continue to hold some cash to deploy in the event of a crash, but continue to buy precious metals stocks on days of weakness.

Personally, I like option #3.

And, for greater leverage, after a few days of strength, do some covered writing.  Sell some out of the money calls against stocks you own.  I did it with Agnico-Eagle this month and pocketed a few dollars.

I don’t see our economic salvation on the horizon, so keeping some cash and deploying the rest is my plan going forward.

Thanks for reading; see you next week.