Give a man a fire and he’s warm for the day. But set fire to him and he’s warm for the rest of his life. – Terry Pratchett

I may not understand that second quote, but I’m assuming that once you set fire to someone, that’s the end of their life, so yes, that would imply that setting a fire to someone will keep them warm for the rest of their life. – JDH

Good news! I’m not going to teach you how to fish, because I don’t know how to, but I am going to keep you warm by lighting you on fire! I’m going to tell you what’s going to happen on the markets next week.

Month end is August 31, on Tuesday, so even though that’s not the end of the quarter, fund managers still like to have a nice clean month end, so the market will rally on Monday and Tuesday. Here’s the chart (click to enlarge) of what’s happened over the last four months:

As you can see, the market stalls at the 200 day moving average, then drops 800 or 1,000 points, then recovers to over the 200 day moving average for a few days, then it crashes again. Simple. So, all we need to do is extend the chart for a few weeks:

Easy, eh? We have a big rally on Monday and/or Tuesday, and then we are stable for a bit, and then the big crap-out happens, taking us back to the July lows, and perhaps lower.

See how easy it is to predict the market? Download a chart, feed it into your graphics editing program, and boom, one minute later you know what the market will do. It’s that easy.

(Yeah, right).

But don’t take my word for it. Our favorite incarcerated guru, Martin Armstrong, is saying the same thing. In an essay titled World Share Market Outlook and Grand Unified Theory published on August 10, he states, on page 7, that August is a turning point in time, with particular attention to be paid to the weeks of August 2 and August 30. As the previous charts showed, the week of August 2 marked the high point for the month; it will be interesting to see if the week of August 30 is the beginning of a significant correction. On page 8 he summarizes his outlook by saying:

Only a low the last week of August would warn we could flip to the upside. This is NOT going to be a walk in the park. The markets are going to be very volatile and we have to pay close attention to the outcome of the Sept/Oct time period. We are preparing to make a very important directional change.

My opinion, as stated in these electronic pages as recently as last week, where I discussed the Hindenburg Omen and the coming crash, remains the same: it ain’ t going to be pretty. Unemployment remains high, consumer spending has dropped off the table, retailers are offering massive discounts for the back to school crowd, new home sales have crashed, a significant number of U.S. mortgages are under water, and a large number of homes are in foreclosure.

Need I say more?

I don’t think so.

So I will say that we may have two decent up days, and then all bets are off.

Of course, I’m not usually correct, and no one can predict the future, so be careful not to follow this advice, since you may simply set yourself on fire.

Thanks, and see you next week.

Tyler Durden over at zerohedge.com was the first person to make recent reference to the Hindenburg Omen in an article he posted on August 12. Thereafter it went viral, and every Main Stream News outlet in North America picked it up and ran stories about it this week.

Named after the famous Hindenburg disaster from 1937, the Hindenburg Omen was created by Jim Miekka, and here’s how it works: if the following four indicators are tripped, a stock market decline is imminent:

1. The daily number of NYSE new 52 Week Highs and the daily number of new 52 Week Lows are both greater than 2.5 percent of total NYSE issues traded that day (other sources put the number at 2.2%)
2. The NYSE 10 Week moving average is rising.
3. The McClellan Oscillator is negative on the same day.
4. New 52 Week Highs cannot be more than twice the new 52 Week Lows (though new 52 Week Lows may be more than double new Highs).

It would appear that the “Omen” was triggered on August 19, and then again on August 20. Many Hindenburg Omen followers believe that the triggers must occur three times in a row from the triggering of the first event, so whether or not these is a true Omen or not will remain to be seen.

So, does the Hindenburg Omen have merit?

Yes.

And No.

Yes, because every “crash” on the New York Stock Exchange since at least 1985 has been preceded by a Hindenburg Omen.

No, because, as we know, economists have predicted 25 of the last 15 recessions. In other words, it’s not that difficult to back test data to come up with criterion that work in all past cases, but that doesn’t mean it will work in the future.

My thoughts?

I’m not losing any sleep over the Hindenburg Omen. I will not be counting on my fingers 36 days from August 19, expecting to see a crash before the end of September because a series of technical indicators predicted it.

Does that mean I don’t expect a crash before the end of September, 2010?

No, as a matter of fact I would not be at all surprised to see a crash within the next few weeks. I would not be surprised at all, for a number of reasons.

First, as documented here on numerous occasions, the economy sucks. Unemployment in the U.S. is at very high levels (levels that would be much higher if millions of workers had not simply left the workforce, making the statistics look better). The consumer is not spending. Retails sales are dropping, and since the consumer is about three quarters of the economy, there cannot be a recovery without the consumer spending.

And yes, I know, the stock market is doing well, and some corporate earnings are up. That’s true, but earnings are only up because of cost cutting. If you have declines in revenue, and if you can’t cut costs forever, there will be no long term profit growth. That’s bad for the economy long term, and a big negative for the stock market.

Second, the stock market, as shown in this chart of the S&P 500, continues to make a series of lower highs. Sure, we’ve had a big rally, but until the market makes new highs, it’s not a recovery.

Third, along the same theme, as discussed previously, most recently last month in my Fibonacci Says Sell posting, we have not breached the generally accepted Fibonacci Retracement Levels. Specifically:

The S&P 500 peaked at 1,562 on October 12, 2007, and then dropped all the way to 683 on March 6, 2009. A 50% recovery would be back up to 1,123, with a full 61.8% recovery taking us back to 1,226. As we all know, the S&P 500 clawed all the way back to 1,217 on April 23, 2010, but that was it. We got within an amazing nine points of a full retracement, a breach of which would have signaled a possible resumption of the bull market.

But it didn’t get there, and it’s been downhill ever since.

So, regardless of what the Omen’s say, the market is looking lower to me, not higher. And that’s why I’m keeping a large holding in cash, with some gold and silver holdings for downside protection (although I realize that in a crash, everything will drop). I also have a few dollars in puts, just as cheap insurance.

Yes, I have been wrong all the way in the this bear market rally, but even a stopped clock is correct twice a day, and I will be proven correct eventually, perhaps sooner rather than later.

So I sit, and I wait. Don’t believe the Hindenburg Omen, because it has predicted crashes that haven’t happened, but expect a crash regardless.

Thanks for reading; see you next week.

The answer is: yes.

The “hyper inflation is coming” people will tell you that the massive stimulus spending by the government is very inflationary, so a hyper inflation is inevitable.

The “deflation people” will tell you that, if we haven’t seen a hint of inflation after a few trillion dollars in government spending, it’s unlikely we ever will.

So who is correct? Before I give you my thoughts, let’s talk about what inflation means.

To the average person on the street, inflation means “prices are going up”. That may be the manifestation of inflation, but that’s not necessarily inflation. If I design a really cool new gadget, version 5.0, and I can charge more for it that the old 4.0 version, is that inflation? No, it’s just the price of something going up.

I define inflation as an increase in the money supply. Here’s a very simple example.

In the entire economy there are only ten pencils. In the entire economy there is only $10 in money in circulation. Since the only thing you can buy in this economy are pencils, the price of a pencil is $1.

Then, one day, the government decides to “stimulate” the economy by printing more money. The print $90 more dollars, and give those dollars to the citizens of this economy. There is now $100 of money in circulation. Of course printing money doesn’t actually create any products, or wealth, so the only thing you can still buy in this economy are pencils. Now there is $100 of money chasing ten pencils, so the value of a pencil rises to $10 each.

It would therefore appear that pencils have experienced price inflation, since their price has inflated from $1 to $10. However, the true value of each pencil has not changed; each pencil remains one tenth of the economy. What has changed is that the money supply has increased, and that’s what has caused inflation.

To summarize: inflation occurs when the money supply increases.

Based on that example, it would appear obvious that we are in a period of significant money supply inflation. There are now a lot more dollars chasing the same number of goods. So why are we not seeing inflation?

Good question.

Milton Friedman’s is known for his quote that “inflation is always and everywhere a monetary phenomenon”. I’m not as smart as Professor Friedman, so I will assume he’s correct: past inflations were caused, in large measure, by increases in monetary policy (or increases in the money supply). However, that doesn’t mean that an increase in the money supply automatically leads to inflation. How do I know that? Because we have had massive increases in the money supply in the last two years, but we have had no inflation. One obviously does not lead immediately to the other.

But again, why, with massive government spending, are we not seeing inflation? There are a number of reasons:

The main reason is that no-one has any money.

The government gives a billion dollars in bail out money to a bank. The bank uses that money to “shore up it’s balance sheet”, or to cover it’s loan losses. No new money is lent, so actual consumers, that make up three quarters of GDP, have no additional money to spend. No-one has any money because:

• consumer’s can’t borrow, because banks are not lending;
• household income is falling (due to the recession, high unemployment, and declining real wages); and
• people have no savings (we owe more than we have saved), which means, simply put, we have no real money. If we have no money, we have nothing to spend.

And that’s the point. We have no money; we have nothing to spend, so prices are not being “bid up.” Here’s our story, again:

In the entire economy there are only ten pencils. In the entire economy there is only $10 in money in circulation. Since the only thing you can buy in this economy are pencils, the price of a pencil is $1.

Then, one day, the government decides to “stimulate” the economy by printing more money. The print $90 more dollars, and give those dollars to the banks. There is now $100 of money in the economy, but there remains only $10 of money in circulation, so the actual price paid for a pencil doesn’t change.

As you can see from this example, a massive increase in the money supply does not automatically lead to price inflation; for prices of consumer goods to increase, there has to be demand.

Today, there is no demand. Unemployment is high, and despite all of the government happy talk, the man on the street knows the economy is still suffering. He knows that he could be unemployed at any time, or he is already out of a job. So how does he react? He starts to cut his expenses. He pays off debt. He tries to save money. Not surprisingly, if we are saving instead of spending, prices are not going up. If retailers can sell stuff to us, they have no choice but to lower prices to get us to buy.

Prices going down is not a sign of inflation.

Yes, it’s possible that the price we pay at the gas pump may go up. It’s also possible that the cost of imported food will also increase. But that doesn’t mean we have inflation. It means we may be spending more on gas and food, so we will have to cut back in other areas, since our resources are limited, and it’s no longer easy, or prudent, to borrow to consume.

So, for now, we are in a deflationary period. We may still get hyper inflation in the future, but for now, expect deflation, not inflation.

Investment Implications of Deflation

Reduced consumer spending is NOT a formula for stock market increases. In simple terms, stock prices increases when company profits are increasing. Company profits only increase if consumers are actually spending money. Since consumers are not spending money, companies will not increase profits, so stock prices will not increase.

But wait, you say, the stock market has increased! No, it is actually down year to date, but yes, I see your point; since the bottom of the crash the markets are higher. How can that be? There are two explanations:

First, the markets are wrong. Investors are assuming the recession is over, and they are pricing stocks based on the assumption of future profit growth.

Second, company profits have increased since the bottom. That’s true, but in most cases they have increased due to a reduction in expenses, not an increase in revenue. If Company ABC’s revenue remains flat, but they lay off 10% of their workforce, and cut 10% of their expenses, their profit will increase by 10%. The earnings per share goes up, so the stock price goes up.

Great! So if companies continue to cut their workforce by 10% per year, we will all be millionaires! Except for the fact, of course, that no-one will have a job, and if no-one is working, no-one is spending or consuming, and the depression gets worse. Again, that’s exactly where we are today. Official unemployment in the U.S. remains stubbornly in the 10% range, but the true unemployment number, when you add back discouraged and under-employed workers, is a lot closer to the the 25% levels that were reached during the last Great Depression in the 1930′s. That’s deflationary, and that’s not good for stocks.

Which is why I am largely in cash at the moment.

The Implications for Gold

If the stock market is poised for a drop, does that mean gold and gold stocks will also drop? That’s two separate questions. Yes, when the tide goes out, all boats fall, so if we have a significant stock market correction, all stocks, including gold stocks, will suffer.

However, gold is a store of value. We humans tend to think of gold in terms of “dollars per ounce”, which is the wrong way to think of gold. We should think of gold in terms of other products. Today, an ounce of gold, at $1,200, will buy you a good man’s suit. Back in the 1930′s, when gold was $35 per ounce, an ounce of gold would buy you a good man’s suit. The price of gold in dollars may change, but an ounce of gold, yesterday, today or tomorrow, will still buy you a good man’s suit.

That same ounce of gold will also buy other products. 20 ounces of gold will buy an inexpensive car, 200 ounces of gold will buy a nice house, and so on. As prices deflate, do I want to store my wealth in a product that is also deflating, or do I want my wealth in something that will hold it’s value?

Obviously I want to store my wealth in something that will hold it’s value. Gold is good for that. So, I will continue to hold gold, because I know that even in the future I will be able to trade in my one ounce gold coin for a nice man’s suit, or other commodities I need. The same can’t be said for fiat currency.

Of course I could also store my wealth in other commodities, like a good shovel for use in my garden, or a bicycle I can use for transportation, or some solar panels for my house. (I have yet to convince my wife to let me put solar panels on the house, since they are not yet cost effective, but I do have good garden tools, and two good bikes).

So to summarize: I expect stock markets to fall, but I plan to continue to hold gold, since in both periods of inflation and deflation, gold will hold it’s value.

As for the muddling markets, that was a nice little drop on Wednesday, if you think a 3% drop on the Nasdaq, and an almost 3% drop on the S&P 500 is a “nice little drop.” It allowed me to close out my September S&P 1020 puts, at a nice profit. I then took the money I originally invested (taking my profits off the table), and immediately bought some September S&P puts with a 990 strike price. Silly gamble? Probably, but most of my money is in cash, and I find if I play with a few dollars it keeps me interested, and prevents me from being silly with larger amounts of money.

The S&P 500 closed the week at 1,079, stuck right in the middle of it’s 1,000 to 1,200 trading range. Which way will it break? If I had to guess, I’d be betting on the lower end of the range, obviously. Of course I have no idea when it will break, so for now, I continue to ponder the impact of near term deflation, I continue to hold cash, and I sit, and I wait.

Until next week, thanks for reading.

(For those of you who have never heard of Dines or Casey, you can read my post on Doug Casey, and Casey Research: A Comparison to The Dines Letter, and my detailed comments on The Dines Letter 2010 Annual Forecast Issue for more background).

Mr. Dines is a master of self-promotion. He has labeled himself “The Original Gold Bug”, and the “Original Internet Bug” (well, not anymore), and his latest, “The Original Rare Earth Bug”. In his most recent issue of The Dines Letter, published on July 23, 2010, under the headline TDL’S LATEST FROM “THE
ORIGINAL RARE EARTH BUG”, Mr. Dines comments that:

The big news reported in our latest flurry of Interim Warning
Bulletins (IWBs) is that China has slashed its export quotas by
around 70%, so deeply that even America and Europe are
beginning to notice that they are at the mercy of China’s
supply of nearly 96% of the world’s estimated Rare Earth
production – with 60% of that total reserved for China’s own
use! This is not some Old World commodity, such as OPEC’s
petroleum cartel, but the future of many vital new technologies
including windmills, electric cars, cell phones, high-tech magnets,
lasers, superconductors and military weaponry. We predict that
China’s Rare Earths will emerge as a new monopoly the likes of
which the world has never seen before, believe the unbelievable or
not.  (Bolding and italics reproduced from the original – JDH).

Cool. Perhaps I should use bold type and italics more when I write as well.

Mr. Dines has a portfolio of eight rare earth element stocks, and he recommends placing an equal amount of capital into each. I’m not going to tell you the names of the stocks; you can buy a subscription if you want to their names. Not surprisingly, the results have been mixed. Here are the returns:

As you can see, one stock made a 904% return; obviously without that stock in the portfolio, the portfolio would have been slightly above break even. However, you can’t argue with the fact that, if you had put an equal amount into each stock, you would have more than doubled your money in Mr. Dines’ rare earth element stock picks.

For those of you who would like me to play Devil’s Advocate, Stock #5 in the list above was first recommended on July 7, 2009 at around 30 cents. It exploded to over $3.70 in the next two and a half months, and then peaked again in April of this year at over $4. By the end of last month it had dropped back to $2, before recovering to around $3 today. In other words, this is a very volatile stock, and your returns will change dramatically depending on the day you check your portfolio.

Equally interesting is that this stock has an average volume of approximately $250,000 worth of trades. That’s a very thinly traded stock. An order for $10,000 in shares can have a material impact on the price.

Dines’ disciples will tell you that he is very good at uncovering a new bull market before the rest of the investment world catches on. There is an element of truth to that statement. He was an early proponent of gold, and internet stocks, and uranium stocks. He was not the first; but he was early in the process.

His detractors will tell you that if you have a newsletter read by 25,000 people (and I just made that number up; I have no idea what The Dines Letter‘s circulation is), and each of those readers invests $1,000 in a stock, you instantly have orders for 100 times the normal daily volume of the stock. It’s therefore not that hard to create a self-fulfilling prophecy: he tells his followers to buy, and up goes the stock, which makes him look very smart indeed.

Frankly, it’s a great business model. He picks a thinly traded stock, and tells everyone to buy, and his personal holdings go way up. Obviously that strategy is not as successful with large cap blue chip stocks, since it takes a few million in orders to budge the price in any direction.

Dines and Casey

So, what does all of this have to do with Dines and Casey? Every day the Casey Research organization publishes Casey’s Daily Dispatch, a free publication. On August 5, 2010 the headline was Talk vs. Action on Rare Earths, and the they commented on, you guessed it, Rare Earth Elements. Here’s a snippet, with emphasis added by me:

A number of subscribers have written to ask why we haven’t taken the plunge on the rare earth element (REE) plays that have been making so much news lately.

Actually, we did, in our Casey’s Investment Alert service, well before the REE bubble inflated last year, and having made a bunch of money and taken profits, we still have some risk-free chips placed on our favorite REE play. This was a very high-risk move, made because the company in question also had a strong gold story. If the market hadn’t gone gaga over REEs when it did – for no reasons anyone could have predicted with any high degree of confidence – we’d have likely taken a loss on that bet.

The critical point here is that the market for REE juniors took off because a writer made a big splash publicizing the REE market, not because of some sudden and real change in the underlying supply and demand in that market. Many companies in the sector shot up two, three, even five times, without anything changing in their fundamentals.

That worked out great for those of us already invested, but once a “flavor of the day” inflates a bubble, it’s time to take profits, not buy.

That said, there has now been a seismic shift in the REE market, in the form of the Chinese, source of over 90% of the world’s REEs, cutting their exports by 72% recently. Here’s a link to a story on this.

So, with the REE plays having sold off since the bubble peaked last year, is now finally time to buy?

Maybe. Or maybe not.

First, note that in spite of the major shift in the market the Chinese have created, popular REE stocks, like RES, AVL, and CCE, have not gone through the roof.

Second, the highest-profile REE play out there at the moment is the new IPO of Molycorp (NYSE.MCP), which has the past-producing Mountain Pass project in California. And yet, the company had to reprice the IPO at a lower level, and the shares have not taken off, as of this writing.

These are clear signs that REE plays really were in a flavor-of-the-day bubble, but more importantly regarding the junior explorers, as far as I can tell, none of them can say yet how much it will actually cost them to produce a pound or kilo of the metals they propose to produce. If this were off-the-shelf technology we were talking about, we might go with reasonable estimates from similar projects, but it’s not. Ranging from technical factors such as crystal size to the specific mix of metals in each deposit, these minerals are each unique, meaning there is no simple, economic production process. Until these guys can say what it will cost them to produce what they have, we cannot say that what they have has any value at all.

That doesn’t mean that they will all fail to figure out their processes, just that until they do, we’re likely to remain on the sidelines.

To repeat: Rare Earth Element stocks went up because “a writer made a big splash publicizing the REE market.” I did a Google search for Rare Earth Elements, and I couldn’t find any particular writer attempting to make their name publicizing this type of investment. So what do I conclude?

I conclude that Casey Research is referring to “the Original Rare Earth Bug” himself, Mr. Dines. No reading between the lines is required to conclude that the Casey Organization are not big fans of Mr. Dines. Why? Two reasons, I assume:

First, they are competitors. They both write newsletters, and they want investors to subscribe to their newsletter, so it behooves them to cast their own product in the best light possible. (Note to self: I’ve never heard either Casey or Dines use the word “behooves” before). They both recommend precious metals stocks. In fact, they both recommend many of the same precious metals stocks. They also follow uranium stocks, so it’s not surprising that there is some overlap in their subscriber base, and it’s logical to assume that they know they are being compared to each other, and they want to win that competition.

Second, Casey presents their analysis in a more analytical fashion than Dines. It is very common for a Dines Letter to include a note “Stock ABC added to Supervised List #3, no stop yet”, and that’s it. No explanation, just “buy”. Conversely, all Casey recommendations contain the Eight P’s (people, price, push, etc.) to explain why the stock is being recommended. Generally a recommended price is also given; in many cases Casey’s advice is “don’t buy yet; wait until the price drops to $X”.

Does that mean Casey is good, and Dines is bad? No. It simply means they have different approaches. Dines devotes a great deal of time to the big picture; he explains why he believes, for example, that gold, or uraniums, or Rare Earths are in a bull market. He then picks the best stocks in that market and recommends them. Casey also discusses the big picture, and then provides detailed analysis on each stock he recommends.

Of course it is entirely possible that both Casey and Dines “front run” the stocks they recommend, taking positions in advance of their formal recommendations. Dines admits as much in his disclosure policy, and Casey publishes paid advertising from companies he recommends, so neither of them are “pure as the driven snow.”

(For the record, no-one pays me to say anything, but if any readers want to pay me, feel free to send money………).

So what’s my conclusion?

Caveat Emptor. Buy beware.

Over the years I have both made and lost money following the recommendations of Dines, Casey, and many other market commentators. Ultimately you have to make your own decisions. I advise everyone to think for themselves.

Read what each commentator has to say, and decide for yourself if you agree with their reasoning and thought process. If you do, follow their advice, or tailor it for your own purposes. If you don’t agree with their reasoning, don’t follow their advice. Simple.

All gurus have their pet projects. Both Dines and Casey are fans of precious metals. When gold and silver are up, their stocks do well, and vice versa. In many instances their skill is being in the right place at the right time, which is why if you review their returns over the last few years you will see they have good years, and bad years, just like the rest of us.

Gurus are a resource, but not a substitute for your own thinking.

So think.

That’s it for today. The economy is in terrible shape with rising unemployment and declining consumer spending (which is 70% of GDP), but the market is oblivious; all is good, so the market continues to rise. That can’t continue forever, but as we all know the market can be illogical for a lot longer than we can remain solvent, betting against it, so for now we bide our time, remain with lots of cash, buy the odd put for downside protection, and sit and wait.

Thanks for reading’ see you next week.

Nothing.

The market’s are still in a bubble like state of euphoria, pumped up by massive stimulus spending.

It’s possible that we will look back on the 10,600 level on the Dow as a near term top. On June 21 the Dow peaked, intra day, at 10,627 (and closed the day about 200 points lower). The Dow then spiked up to 10,632, intra day, on July 27, and then spiked again to 10,609 on July 29. Will we see 10,600 again? Perhaps. But the Dow is at 10,465 now, and there’s lots of resistance between here and 11,200, so this cannot be called a bull market, by any stretch of the imagination.

I know I sound like a broken record, but I still be believe we are headed for a fall. (For those of you under the age of 30, a record is a plastic disk used to play music; a needle traced grooves in the record to amplify the sound. If a groove was damaged the record would continue to play the same sound over and over again. Like me. But I digress).

You can get away with something for a while, but not for forever. You can drive faster than the speed limit for day, months, even years and never get caught. But then, one day, you get nabbed. That’s how it is.

I’ve been wrong about market strength. I under-estimated the power of unlimited government spending. However, there are lots of signs of weakness, if you care to look.

GDP growth may look good, but it isn’t. At this stage in a recovery we should be at 5% growth or more, not 2.4%. Take out the tax credits and other stimulus, and we are in a deflationary environment.

Consumers are cutting back, and actually saving money, which doesn’t stimulate demand.

The record player might be broken, but so be it; I’ll keep playing it.

I’m off to enjoy the good weather; let’s see what tune I’m singing next week.

I decided that walking through the water made no sense, so I put my car in gear, and made the fateful decision. I would floor it, in the hopes that my forward momentum would get me through the water before my car stalled.

Wrong decision.

I gunned it, but as I drove the forty feet to my destination my car started to lose power in the water, and as I hit a submerged speed bump, my car stalled.

Great.

I waited a minute, and I was able to restart the car, but the transmission wouldn’t shift into drive.

I was stuck.

I considered my options again, and realize I was stuck until the water receded, I opened my car door. The water was up to the bottom of my door.

Great.

Realizing it would probably take an hour or two for the water to recede, I took off my shoes, took off my socks, rolled up my pants, grabbed my briefcase, and walked the ten feet through the water to my office door. I own the company, so I’m sure the thirty employees in the office that day had a good laugh watching the boss get his car stuck in the water, and then walk in to the office barefoot.

Apparently the rain fell so quickly that the sewers were backed up, and the water was coming up from the storm sewers, and hence the flood. Had I been more observant, I wouldn’t have attempted the river crossing. Two hours later the water had receded, and I was able to start my car and drive it to higher ground. Unfortunately by then the damage was done. The engine made a grinding noise, and even though I’m no mechanic, I knew that was not good.

I had the car towed to the local dealership, and two hours later they called me with the bad news: Water damage in the engine, and the simple answer was that the engine needs to be replaced.

Great.

Later that evening, after my wife, who clearly has more knowledge of these matters than I do, informed me that the proper technique for driving through water is to drive slowly, which of course is the exact opposite of what I did.

I thought that driving fast would give me the momentum to make it through the water. Instead, driving fast only served to drive the water deeper into the engine, which is what caused all of the damage.

So, today’s advice: drive slowly through the water, or avoid it entirely.

That’s probably good advice on the markets as well.

If you listen to the happy talk on TV, there are no puddles at the moment. Everything is great. Over the last month the markets are up. As the chart shows (click on it for a larger view), from the bottom on July 1 the market is in a beautiful uptrend, pausing down to the uptrend line on July 20 before breaking out to new monthly highs on Friday. On Friday the S&P 500 bounced over it’s 50 day moving average, and is now less than 11 points below the 200 day moving average.

So why is everyone so happy? Lots of reasons:

• Bernanke wants to the Bush tax cuts extended, which would provide further economic stimulus;
• Obama’s approval rating continues to fall, which increases the chances that a more pro-business Republican slate could regain control of the House and Senate in November (this of course ignores the fact that both Republicans and Democrats spend like drunken sailors, but I’m talking perception here, not reality);
• The Baltic Dry Index may have finally made a bottom (probably not, but maybe);
• The BP Gulf Oil Spill appears to be under control at the moment (of course this could also mean that with the well capped the pressure is simply building under the sea bed, which could cause violent ruptures at some point in the future, but for now, all is quiet);
• Mortgage delinquencies in major U.S. cities are declining (which could mean that no-one has a house anymore, so no-one is left to default);
• Decent earnings reports (for example Microsoft beat earnings estimates);
• And, finally, the S&P 500 closed at 1,102 on Friday, which is the first time this month the S&P 500 has eclipsed the 1,100 level (it tried on July 13, 14 and 15 to get over 1,100 and couldn’t), so getting over 1,100 is both technically and psychologically important.

Of course, cynic that I am, I take the alternate view.

When one reviews the six month chart, it is clear that Friday’s 1,102 close stopped the bleeding; it was a higher high. But, clearly, there is still lots of overhead resistance, as indicated by the blue lines, including highs of:

• 1,117 on June 18;
• 1,171 on May 12;
• 1,217 on April 23.

We still also have the matter of the “lower lows”, the red lines, including the July 1 intra-day low of 1,014, which easily broke the previous low on the year of 1,056 on February 8.

The chart also shows that volume is not picking up, so this continues to appear to me to be a thinly traded market; the Big Boys are propping it up with little effort, and the rest of us are along for the ride. All it will take is some jolt of bad news to pop the bubble.

I am still holding my puts, and obviously that was a foolish decision on my part. (Almost as foolish as driving fast through water). So, this week, I will watch the key levels:

• The 200 day moving average is at 1,113;
• The next resistance level is at 1,117 (the June 18 high);
• The market started the year at 1,115, so that’s the level needed to get back to positive returns for the year.

If these levels are taken out, we could easily see the market run up to the 1,200 level or higher. A move above 1,200 quite obviously breaks the down trend line, and at that point, who knows.

However, until we get above 1,115 the S&P 500 is still down over 1% on the year, which is obviously not a characteristic of a bull market.

I still worry about:

• very high unemployment;
• slow GDP growth;
• negative earnings surprises;
• a really screwed up housing market, despite some small signs of good news.

So, this week I will do two things:

First, I’ll watch the market early in the week, and if it looks like the bounce up will continue, I will close out my August S&P puts at a substantial loss.

Second, if, when my car gets out of the shop later this week with it’s new engine, I encounter any large puddles, I will drive slowly.

See you next week.

• No jobs;
• The Baltic Dry Index is tanking;
• Government deficits continue to increase;
• Oil continues to explode into the Gulf;
• Real estate prices are plummeting;
• An Israel-Iran war looks inevitable, perhaps around the July 11 time period; and
• Gold continues to make new highs, revealing investor’s flight to quality.

On that basis, I lightened up the stocks in my portfolio, and moved more into cash. This week, let’s look at the charts, because the charts don’t lie either. To quote the immortal philosopher Yogi Berra, “You can see a lot by looking.” So let’s try looking, shall we? Here’s a chart of the Dow over the last two years:

As you can see, from the bottom in March 2009 until the top in May, 2010 the Dow made a series of higher lows, and higher highs (as indicated by the blue lines; click on the chart to enlarge). It doesn’t take a genius to understand that the markets are going up when lows are higher, and highs are higher.

(As an aside, I’ve been expecting the market to correct for over a year now, so why I couldn’t see this simple pattern obviously proves that I’m not a genius, but I digress).

From the top in May to now, the markets have made a series of lower highs, and lower lows, as indicated by the red lines. That clearly indicates that the market is dropping.

Here’s a chart of the last six months:

It’s quite obvious that we are in a pattern of lower highs and lows. It will also be obvious when we break out of this pattern. We had a great week, until Friday, and many were ready to proclaim the start of a new bull market. Obviously that was not the case, and Friday’s action proved that it’s a lot easy to go down than up. Friday’s drop of almost 3% was easily enough to wipe out a week’s worth of gains.

The Dow is not particularly representative, so let’s cast our gaze instead on the S&P 500 index. You will all recall the Fibonacci retracement chart I posted when back on March 27 I wrote about Gold Heading Higher, Market Heading Lower?, and I showed this chart:

The S&P 500 had peaked at around 1,561, and then dropped to around 683. A bounce back by 61.8%, which is a key Fibonacci level, would bring the market back to somewhere in the range of 1,225 to 1,230, depending on the exact data points you use. My point then was that to confirm the rally and demonstrate more conclusively that the new bull market had begun we needed a close on the S&P of around 1,230 We got close, but then that was it.

Let’s update the chart, shall we?

You can clearly see where the market got close to the key Fibonacci level, but pulled back, and hasn’t gotten close since. This ain’t no bull market, my friends.

Want a different perspective? Here’s the S&P 500, but let’s look at it in reverse.

The rise from 683 on March 6, 2009 to 1,218 on April 23, 2010 is the 0% to 100% gain. A pullback of 61.8%, a key Fibonacci retracement level, would pull us back to the 887 level. It may just be coincidence, but on July 10, 2009, a mere 53 weeks ago, the index closed at 879.

And yes, you can do an even shorter term chart, and get similar results:

So, to summarize:

We are not in a bull market. Not even close.

The market blew through the 1,092 on Friday, confirming the down trend.

If the market can’t hold in the range of 879 to 887, we’ve got really big problems; that will be a big break to newer lows.

It would appear that the next level to watch for on the S&P 500 is the support level of 1,014 established intra day on July 1, 2010. That’s only 50 points away from the close on Friday, and since Friday was a day when the market fell almost 32 points, it may be this week when we find out if that level will hold.

I have lost money on the SP 500 Index puts that I bought over a week ago, but that’s fine. I’m not playing with big dollars, so at this juncture I am peace holding cash, and some puts, and a small selection of precious metals stocks. I can sleep well at night, provided I don’t think too much about these charts.

More down than up is in our futures, I fear.

Thanks for ready, hold cash, and see you next week.

• No jobs;
• The Baltic Dry Index is tanking;
• Government deficits continue to increase;
• Oil continues to explode into the Gulf;
• Real estate prices are plummeting;
• An Israel-Iran war looks inevitable, perhaps around the July 11 time period; and
• Gold continues to make new highs, revealing investor’s flight to quality.

On that basis, I lightened up the stocks in my portfolio, moved more into cash, and bought some August put options as insurance.

So, against that backdrop, as I was not happy to read the headline in the Wall Street Journal: US Stocks Rise, Capping Best Week Since July 2009. Yes, it’s true. The Dow was up5.28% this week, for its biggest weekly gain since the week ended July 17, 2009.

What gives? Well, obviously, the 9,500 level provided support, and the Dow bounced off it. But, as you can clearly see from the chart (and if it isn’t clear, click to enlarge it), since the high in April we have had a series of lower lows, and the Dow is still clearly in a down trend. The Big Boys can put on a short squeeze and drive the market up, as they have obviously done, but that doesn’t mean all is right with the world. It just means they squeezed the shorts this week.

Fine. We had a technical bounce from oversold conditions. This is not a new bull market. Not even close. Big moves by program traders in the last half hour of trading are not indicative of the retail investor returning to the market.

Canadian Unemployment Numbers

Now, a word to my fellow Canadians.

On Friday we got to read the good news that Canada churns out 93,000 new jobs; great! That’s over 300,000 net new jobs so far this year, so it would appear that the recession is over in Canada, which is more than you can say for the U.S., since the USA is losing jobs.

I take these numbers with a grain of salt, for two reasons:

First, average hourly earnings fell by 0.6% this month, and average hourly pay is now at it’s lowest level in nine months. So, while there are more jobs, they are lower paying jobs, which isn’t great fuel for an economic recovery.

Second, on July 1 Ontario and British Columbia, two very large provinces, combined their provincial Retail Sales Tax and the Federal Goods & Services Tax into one new combined tax, the Harmonized Sales Tax. In Ontario the 8% provincial sales tax and the 5% federal GST are now the 13% HST. This may not seem like a big deal, since on most items the combined tax remains at 13%.

However, there are many services that were previously exempt from the PST, but now include the HST. Everything from haircuts to landscaping and home renovations have increased in cost to the end consumer. As a result, to beat the HST, many residents of Ontario and British Columbia built new decks, had their driveways paved, did some landscaping, or renovated their basement in the months prior to July 1. That may be a significant contributing factor to the higher employment numbers. I suspect that now that the higher taxes are here, many of those jobs will be lost, and the employment picture will dim.

So, I plan to stay the course, stay in cash, and hold my puts.

Thanks for reading, and have a good week.

But first, it’s time for an update on our 2010 Predictions, made last December. I am pleased to report that my prediction for the Dow, on June 30, 2010, was 10,000, and it actually closed at 9,774, so I get the “closest to the pin” award. As for the gold price prediction, I predicted $1,350, and it actually closed at $1,243, so I was close, but the “closest to the pin” award goes to our perennial winner, Davidslane, who predicted a gold price of $1,180, only $62 off the actual closing price. Congratulations.

Now, back to our regularly scheduled programming.

As I have repeated for many weeks in this space, I don’t think the summer will be pretty. This week was a preview of our summer of discontent. In summary:

1 There ain’t no jobs. This is a “jobless recovery”, which of course is an oxymoron; you can’t have a recovery without jobs. On Friday the U.S. Department of Labor released the June Labor Report, and it was not pretty. Here’s the quote:

Total nonfarm payroll employment declined by 125,000 in June, and the
unemployment rate edged down to 9.5 percent, the U.S. Bureau of Labor
Statistics reported today. The decline in payroll employment reflected
a decrease (-225,000) in the number of temporary employees working on
Census 2010. Private-sector payroll employment edged up by 83,000.

Of course these numbers are “cooked”. It’s mathematically impossible to lose 125,000 jobs (including 225,000 jobs lost now that the temporary Census workers are no longer taking the census), and yet have the unemployment rate “edge” down to 9.5 percent. Well, it’s not mathematically impossible if, for some reason, in the month of June, 652,000 Americans left the Civilian Labor Force (you can find that number on Table A). So there you go. A lot of jobs were lost, but even more people decided to simply stop working, so the unemployment rate improved.

Fortunately, some members of the Main Stream Media actually figured this out. The Los Angeles Times reported that Unemployment rate dips as more workers leave labor force, which is a perfect summary of the “good news” about the unemployment rate “edging” down. In other words, it’s not good news at all.

2 The Baltic Dry Index, which is a generally reliable measure of shipping activity, is tanking, and looks ready to approach the lows in the depths of the recession from November, 2008.

3 Government deficits around the world are really, really big. That’s not good. Even worse, all of the massive stimulus spending of the last two years, has, quite predictably, done no good. You can’t simply print money and expect paper to increase wealth, just as an individual can’t go on a credit card spending spree and increase their wealth. Governments are power hungry, which makes them stupid, which is the cause of our current mess. (See items 1 and 2 above). And for a real laugh, check out some lady named Nancy Pelosi who thinks that the solution to all of our problems is to send out more unemployment insurance checks, because that will create jobs. What a nut.

4 The oil spill in the Gulf continues to spill away, with no end in sight. It is now obvious that BP and the government have no idea how to stop it, so we can assume it will continue to flow for many months to come, increasing the disaster, and increasing the economic repercussions. Real estate prices in the area will plummet, which isn’t good for the economy.

5 Real estate prices are plummeting. In Florida, 81% of homes are “underwater”, meaning the property is worth less than the outstanding balance on the mortgage. That’s a disaster.

6 An Israel-Iran war now appears inevitable. This is not a political blog, so I won’t elaborate on the reasons, but it appears that military action will start within the next two weeks, with July 11 looking like the likely date. Let’s hope I’m completely wrong on this one.

7 Gold continues to make new highs. Yes, I know, there was that little hiccup on July 1 where gold crashed $44, or 3.5% in one day. Gold was treading water right up to 10:00 am on Thursday, and then the Big Boys (JP Morgan) overwhelmed the market with sell orders, presumably to do some short selling. That’s fine; made for a good buying opportunity. All of their suppression efforts have kept the price low, but it hasn’t lead to a correction, so that’s good news for gold investors, but very bad news for governments that want to hide the fact that they are printing money. (Investors realize that printing money diminishes the value of the currency, forcing investors to flee to gold as a “safe haven”).

So, the summer won’t be pretty. It might get very ugly. So how am I playing it? With a relatively simple approach.

First, I am holding more cash than normal. In a deflationary environment, cash is king.

Second, while I have no doubt that gold will rise substantially in the medium to long term, the outlook for the traditionally weak summer period is less rosy. So, I am holding my gold and silver stocks, but to reduce my risk I am using a covered writing strategy, where I sell call options against shares I own.

As I reported last week (Gold and the Markets: Exactly as Expected) on June 25 I sold options covered by stocks I own. I sold July call options, around $1 out of the money, on:

• AEM.TO – Agnico-Eagle Mines Ltd.
• G.TO – Goldcorp Inc.
• K.TO – Kinross Gold Corp.
• PAA.TO – Pan American Silver Corp.
• SLW.TO – Silver Wheaton Corp.

With the collapse in the gold price on Thursday, my gold stocks took a beating. That’s fine, that’s just a temporary hiccup, but it made the options strategy work beautifully. Here’s the summary:

• I sold the AEM.TO – Agnico-Eagle Mines Ltd. July $66 calls for $1.30 on June 25, and bought them back on July 2 for 49 cents.
• I sold the G.TO – Goldcorp Inc. July $48 calls for 91 cents on June 25, and bought them back on July 2 for 28 cents.
• I sold the K.TO – Kinross Gold Corp. July $19 calls for 60 cents on June 25, and bought them back on July 2 for 13 cents.
• I sold the PAA.TO – Pan American Silver Corp. July $29 calls for 50 cents on June 25, and bought them back on July 2 for 15 cents.
• I sold the SLW.TO – Silver Wheaton Corp. July $22 for 60 cents on June 25, and bought them back on July 2 for 15 cents.

What does this mean in real money? Here’s an example, with dollar values:

Each options contract represents an option to buy a lot of 100 shares. So, one contract of the Agnico-Eagle July 66 call sold for $1.30 would net $1.30 x 100 = $130. If you own a block of 1,000 shares, you can “cover” those 1,000 shares with 10 contracts, so your net proceeds before commissions would be $1,300. Each brokerage account will be different, but let’s assume the commissions on the sale were $22.49, so that leaves net proceeds to me of $1,277.51. So, on June 25, I owned my shares in AEM.TO – Agnico-Eagle Mines Ltd., which was selling for around $65, and I had sold the option on those shares to someone who could buy them from me for $66 anytime up to options expiry on July 17.

Then, on July 2, I re-purchased those options for 49 cents. So, it cost .49 x 10 contracts x 100 shares per contract, or $490 to re-purchase them, plus the $22.49 commission, for a total cost of $512.49.

That puts my net profit at $1,277.51 – $512.49 = $765.02

Of course the only reason I could repurchase the options for less than I sold them for was because AEM.TO – Agnico-Eagle Mines Ltd. fell from around $65 to around $62, so you could argue that the correct course of action would have been to sell the shares on June 25 and avoid the $3 per share loss. However, I can’t pick the exact tops and bottoms, and long term I plan to own the stock. I assume it will recover, so I’m satisfied to have reduced my cost of ownership by $765.02 / 1,000 shares, or 76.5 cents per share.

The results on the other shares are similar.

If we have another run up in gold early in the week, I may cover my shares again, with more July calls. Obviously the premiums won’t be as high, since a week’s worth of time premium will have eroded, but it’s possible that there will be more gains to be had. Even if it can’t be done again, do the math:

If the share price were to remain unchanged at $65, and if you could generate 76.5 cents per month writing calls against the stock, that would be an annualized return of 14%. That’s not bad at all. Of course if the share price remained unchanged the option premiums would be lower, so these profits would not be possible, and of course the share price won’t remain unchanged. However, if you cover after three solid up days, and then “Buy to Close” after the inevitable corrections like we experienced on Thursday, you can certainly mitigate some risk, and feather your nest at the same time.

Finally, back to the market. I continue to believe that the market is headed down, and this week’s action didn’t change my mind. The long term support level of around 1,040 on the S&P 500 going back to last September was broken this week, and that’s not good news if you are a bull. With the RSI at 30 a short term bounce early in the week is quite possible, but I’m betting on 900 before we will see 1,200.

I continue to hold a few shares of the RSW – Rydex Inverse 2X S&P ETF, an ETF that goes up when the market goes down. I don’t have a large holding, but it’s there as short term insurance.

Second, with play money, I am also buying puts. On June 24 I bought some August 1000 SPX puts; I paid $22 for them, and then sold them the next day for $24. I put a buy order in again on Monday at $19, and didn’t get filled, which was a tragedy, since the market had a big correction on Tuesday. I would have come close to doubling my money. Oh well, can’t win ‘em all.

On Tuesday I bought more August 1000 SPX puts for $31, and then sold them on July 1 for $38. A nice profit, but not what it could have been.

In an effort to reduce my exposure, on Thursday I dropped down a notch on bought the August 900 SPX puts for $15; at the close on Friday they were worth around $12, so I’m down on this trade so far, but there’s still time, so I’m holding.

Again, let me emphasize that doing covered writes by selling options against stocks you own is a relatively conservative strategy. Buying short term options is essentially gambling, so you would be a fool to do it with anything more than a few dollars that you won’t miss when you inevitably lose the whole bundle.

We shall see how July progresses; I suspect we will look back thirty days from now and marvel at how much worse things got.

I hope I’m wrong. If I am, no problem, I’m holding cash, so I’m not concerned.

A belated Happy Canada Day to my fellow Canadians, and a Happy Fourth of July to my American readers. See you next week.

I’ve covered all of this before, and today I will give you more of the same.

First, I have been worried about the markets for quite some time now, and with each passing day, I get more worried. Onlooker had a good comment on Black Swans over on the Buy High Sell Higher Forum on this very topic. The Great Depression was a series of setbacks; here in 2010 we had our first setback (back in 2008), and I continue to wait for the next one, whatever it may be.

As this chart of the Dow shows, there is obvious support in the 9,750 area, and it would appear that the market is poised to test that level again. If it holds, we get a bounce. If it doesn’t, we are screwed. Hello, 8,000.

So, this week, I put my money where my mouth is. On Thursday morning, the market was looking weak, so I bought some August SPX 1,000 puts (puts on the S&P 500 index). I paid between $18 and $20 for each contract. On Friday, seeing that the weekend’s weather was looking nice and I didn’t want to think about it over the weekend, I sold the puts, for $24. My profit was between 20% and 30%, which is fine for two days work.

Of course I wasn’t playing with any serious money; just a few dollars; this is not a “bet the farm” “investment”, this is pure gambling. However, if you think the direction of the market is down, then gambling to the down side makes sense.

If we see a small bounce early in the week, I’ll do it all over again. I’ll buy some puts, and hope for a nice gain over a short period. If I’m wrong, I lose a few dollars, but I’m not playing with significant sums of money, so I’m not concerned.

Gold

Of greater interest is where I have my real money: gold.

As I explained last week, with only one or two exceptions, all I have in my portfolio are gold and silver stocks. My biggest “blue chip” holdings include:

• AEM.TO – Agnico-Eagle Mines Ltd.
• G.TO – Goldcorp Inc.
• K.TO – Kinross Gold Corp.
• PAA.TO – Pan American Silver Corp.
• SLW.TO – Silver Wheaton Corp.
• CEF.A.TO – Central Fund of Canada

As I have explained over the last two weeks, in How to Juice Your Returns on a Stock you are Selling, and last week in Gold: How I Played it, and What’s Next, I assume gold and gold stocks will continue to increase in value, but they will not go up in a straight line. June is a traditionally weak month for gold, and July isn’t great either, so recent strength is a good opportunity to lock in profits.

So, on Friday, I did it again. I sold options covered by stocks I own. I sold July call options, around $1 out of the money, on:

• AEM.TO – Agnico-Eagle Mines Ltd.
• G.TO – Goldcorp Inc.
• K.TO – Kinross Gold Corp.
• PAA.TO – Pan American Silver Corp.
• SLW.TO – Silver Wheaton Corp.

For example, I sold the Agnico-Eagle July 66 call for $1.30. At the time AEM.TO – Agnico-Eagle Mines Ltd. was selling for around $65, so I was paid $1.30 for something that was worth negative $1 (ie. it was $1 out of the money). If AEM is trading for $66 or less at the end of the day on July 17, about three weeks from now, I keep the $1.30. For me to lose on this deal AEM will need to increase in value by more than $2.30. If it does, I lose some of the potential profit.

However, $2.30 on $65 is 3.5%, which again is not a bad return for three weeks work, with very little risk.

So I will sit and wait.

It’s not sexy and exciting picking up 2% here and 3% there over a two or three week period, but over many months it will turn into real money, with little risk.

By the time we get to the Fall, and all hell is breaking loose in the world, and the markets, I will stop covering, and let my profits run. For now, prudence makes sense.

Why am I being cautious? First, the summer traditionally is not great for gold stocks.

Second, there is the obvious concern that general market weakness will drag down all stocks, good and bad, as happened in 2008 when traders were forced to liquidate everything, good and bad, to meet their margin calls. There’s a great article on Will Gold Miners Act Like Stocks or Gold During the Crash? that correctly concludes that gold stocks will fare better than the general market in a correction, but caution is still warranted.

So, caution it is.

I am gradually increasing my cash, and I expect that this conservative approach will leave me well positioned to pick up any available bargains.

Time will tell; see you next week.