Market's Grand Sweep

Once in a while it becomes necessary to take a step back and do a "reality check" on the overall state of the markets.

We are living in an era of the Internet, where virtually infinite information is available, virtually instantaneously, to virtually everyone; where 'get rich quick' technical trading systems on the markets are a dime a dozen; and where Generally Accepted Accounting Principles (GAAP) allow for (sometimes insist on) accounting today for what will likely happen tomorrow. In this latter regard, and because of quarterly reporting, it has become an unfortunate fact of life that future earnings are accrued with greater zeal than future expenditure.

Lately I have formed the view that, because of all of the above, short term technical indicators have lost their credibility. Microscopic assessment of every nuance of the market's behaviour has become a nonsense. With the advent of sophisticated derivative instruments it has become too easy for "vested interests" to play games or, - to use an expression which seems particularly appropriate - to apply lipstick to the market pig.

At times like this, a view of the monthly charts has the effect of bringing a dose of reality to a surreal world. The chart below (source:www.decisionpoint.com/prime/dailycharts/SPPE.html ) seems a good starting point.

If we focus on price relative to the blue "Fair Value" line, we note that in three periods since 1925, prices have tracked below this blue line. Very roughly, these were:

• 1940-1945 (WWII)
• 1947 - 1957 (Post World War Reconstruction)
• 1973 - 1986 (Post Vietnam psychological adjustment and coinciding with the Cold War)

Conversely, the periods that the market tracked above the blue line were:

• 1960 -1973 (A period characterised by price inflation)
• 1990 - 2005 (A period characterised by banking excesses following the euphoria associated with the Berlin War coming down in 1989)

Of significance is the sharp angle of incline of all three of the blue, green and red lines since 2002 - which was a period of particularly easy money and credit.

This steepness in the angle of incline has only manifested twice before:

• 1946 - 1951 (Post War reconstruction)
• 1992 - 2000 (Euphoria associated with IT revolution preceding Y2K)

In context of all of the above it is important to note that the price line is now tracking below the Red "Overvalued" line for the first time since 1997. It is probably also important to emphasise that only once before - in 1938 - did P/E ratios dip sharply following a previous dip (1929 -1933).

The conclusion to be drawn is that, barring a catastrophe of the dimensions of WWII, it seems more likely that P/E ratios will trend sideways from this point than fall precipitously. However, in terms of "Value", there is no objectively defensible argument to negate the fact that the market is still above "Fair Value". P/E ratios seem unlikely to rise from this point and, indeed, it seems unlikely that the "E" element of the equation is going to rise significantly from this point either.

It follows that a "best case" scenario is a sideways trending of the market for some years to come.

If we now turn to Dow Theory - which requires that the major sectors of the markets should be confirming one another's Primary Direction, we see a major "non confirmation" in that the Transports and Utilities rose to new heights, which moves were not confirmed by the Industrials.

One reason for the Utilities and Transports strong moves was - paradoxically - the explosion in the oil price. Suppliers passed on the percentage rise in cost by raising their prices by a similar percentage, giving rise to bonanza profits and a speculative frenzy.

The charts below (Source http://www.decisionpoint.com/prime/dailycharts/trend_crudeoil.html ) seem to be indicating that this particular party may be over

The Crudollar Index is showing a bearish rising wedge, and the Oil Fund Chart is showing what optimists might argue is a bullish ascending triangle, but pessimists might argue is a bearish "quadruple top" - which failed to penetrate to the upside notwithstanding the Israeli retaliatory attack on the Hezbollah in Lebanon.

What possible reason could there have been to explain this failure?

Personally, I can only think of one "sensible" explanation:
The velocity of money within the USA is slowing.

Diligent readers may wish to research a previous article that I published on Gold Eagle which demonstrated the fact that, when the oil price was trading at $45 a barrel, oil and its immediately derivative industries accounted for 10% of world GDP. Clearly, if the oil price rises to $70, something else has to give. The pie doesn't get proportionately bigger. World GDP still only grows - at best - at its previous rate. Therefore, if World GDP is to remain growing at its previous rate, income from other slices of the pie must lose proportionate market share. The rate of their growth will slow. Ergo, the pace of business that is not oil related can be expected to slow. The only other alternative is that we will experience price inflation across the board.

Why won't this happen?

The reader's attention is drawn to the inverse relationship between the oil fund index and the US Dollar - regarding which everyone agrees is going to fall out of bed. But, if the inverse relationship remains intact, and if the oil price does not break to new highs because of a slowing in the velocity of money, then the US Dollar will not break below 80. Technically, the bearish rising wedge in the Crudollar index is validating this conclusion. Technically, the recent bursting of the speculative bubble in the Transport Index is also validating this conclusion.

Of course, the assumption that the inverse relationship with the dollar will continue must remain true.

So let's look at the gold price to see what it may be telling us about the dollar:

Note the position of the PMO on the monthly chart. For gold to rise further from these levels implies that the PMO must rise even higher than its currently stratospheric levels.

Further, the ratio of gold:dollar must also rise above its current 20 year high.

Of course, anything is possible, but one unarguable "fact" needs to emerge for this to hold true: The World's Central Banks will need to lose control - totally - of the World Economy.

What investors have to ask themselves is this: "What is the probability that the now Globalised Economy is going to spiral out of control of the Cental Bankers?"

If you conclude that this probability is high, then your appropriate behaviour will be to invest your capital in canned beans and bottled water - because you are going to need to survive a long, cold, Economic Glaciation period.

If, on the other hand, you conclude that the SPX is likely to trend sideways for some years to come, then it follows that the US Dollar will not collapse, and gold will probably also trend sideways for some years to come - until its nascent industrial uses start to manifest.

Overall Conclusion

The Investment Party is probably over, but rumours of the Global Economy's death are probably greatly exaggerated. (Apologies to Mr Twain). I'm holding onto my gold and silver investments, but for reasons related to emerging technologies as opposed to currencies.