Richard Russell on the Markets

GOLD - I'm going to start this Letter with two very important charts. The first is a Point & Figure chart of gold going back to 1999. What I want to point to is this huge "head-and-shoulders" bottom formation. This is not just any old formation; it's a HUGE formation. As I see it, this is a picture of accumulation. It's a picture of patience, of watchful waiting. At what point would this chart turn clearly bullish? It would turn bullish if or when gold breaks out above 330.

When might that happen? Frankly, I don't know nor does anyone else know. But the accumulation is there; the base formation is there. The chart is "telling us" that somewhere ahead gold is going to move up and break out above 330. In the meantime, it's accumulation time for gold and gold shares.

Gold and the S&P - Here's the secret that the anti-gold crowd doesn't want you to know about. It's a monthly chart showing gold divided by the S&P. In September 2000 this ratio turned up in favor of gold. In August 2001 the ratio broke up above its 50-month moving average. The chart is telling us that gold, the metal, has outperformed stocks (the S&P) for the last two years. And as you can see on the chart, this situation is accelerating.

THE PICTURE - Ask the average person what the two greatest forces for profitable investing are, and my guess is that the great majority will not have a clue. Don't believe me? Test it; ask your husband or wife or friend or your kids. The answer to the question is first - the primary trend of the market, and second - compounding.

I try to make it very simple. I want my subscribers to use both of these incredible forces. Everything else aside from these two forces is extraneous. Everything else is a diversion. That's my opinion based on my own experience and my observations and the action of hundreds of investors over the years.

Do you want a simple, basic strategy for building a fortune? Here is the elusive secret that few people understand. When the primary trend of the market is bullish, build a portfolio of leading blue-chip, dividend-paying stocks and stay with those stocks as long as the primary trend remains bullish, always reinvesting the dividends. Then get out at or near the top of the bull market.

Once out, move your money into the safest and highest-yielding fixed income securities. These will usually be bonds, government or otherwise. That's it. Sounds easy? Unfortunately, it isn't. Why isn't it easy? It isn't easy because you need the knowledge to identify the primary trend of the market. Then you need the patience and will to stay with the bull market - and to stay out of the bear market.

Finally, you need the discipline to avoid other distractions, like the desire for the quick kill. You also need the discipline to stick with your strategy, despite the fact that there will always be a hundred distractions. In the end, to follow the strategy outlined above you need knowledge and you need discipline. Few people have either; even fewer people have both. Right now we have a typical test of the strategy. We know that bear markets end with stocks at great values. But stocks are still expensive. Therefore, on the value test this bear market is not completed yet.

You hear about the wonders of "the long term," meaning holding stocks for the long term. But like all simple formulas, this one is for simpletons. The fact is that it all depends when you enter the market, when you buy your stocks. If you buy your stocks when they are overvalued, if you had bought in 1929 or 1946 or 1966 or 1968 or 1971 or 1987 or 1999 or 2000, you may have to wait a decade or a quarter of a century to get even.

But if you bought your stocks at or near a bear market bottom such as 1942 or 1949 or 1974 or 1982 then you can probably hold your stocks forever and never look back. Or at least you can hold your stocks until the next bull market top.

Now I want to talk a bit about the ability of the stock market to look ahead, to discount the future. Many months ago I included in these Letters monthly charts of a number of stock indices.

One chart that fascinates me is the chart of the D-J Utility Average. On this monthly chart we can see that the Utility Average has formed a massive head-and-shoulders top. What is so interesting about this chart was the sheer height of the head. I don't know if I'd ever seen such a bearish chart. Usually, in a head-and-shoulders top the greater the size of the "head," the greater the count to the downside. This head was massive.

Was the market correct or was this a freak structure? What could this huge head portend? What could it be warning us about? Now we know. The staid old conservative Utility Average (bull market high was 416.11) has lost over half of its peak value. And now we hear that the utilities are in their worst shape since the Great Depression.

Who would have thought it? Who would have believed it? I'll tell you who - the market thought it, and the market believed it. The story was in the Utility Average; the story was in that giant formation. When the formation broke down I told my subscribers to bail out of the utilities.

At the time, my favorite utility stock was TXU. Merrill Lynch recommended TXU as their top choice in the Utility Sector. TXU was selling at the time for 48. Where is TXU now? It's selling for 12, down a spectacular 75% from its high. So are charts worth anything? Is technical analysis worth anything? You be the judge.

Next question - what about the current charts? What about the giant head-and-shoulders tops in all the major stock averages? They're not a happy sight. All of these head-and-shoulders formations have broken down, and they have all declined to the point where they are oversold. Meaning they have gone down too far without a correction.

So as I write we're in the corrective phase. The bear is in the process of punishing all those shorts who thought they were going to get rich by selling what they didn't own, and then delivering what they didn't own at lower prices. It worked beautifully for a while, but then the short side got too crowded, and it got too easy. The bear never likes speculators to make too much money "the easy way." He wants to be paid back. That's part of what bear market rallies are all about.

Of course, the bear also doesn't want his reign to end too quickly. It takes time to wipe out a good percentage of the stockholding population. Yeah, it takes time, and one way to extend the bear market is via periodic rallies. Bear market rallies give stockholders hope. It gives them the hope that somehow they'll break even, or maybe even get their money back.

And that's where we are now. Enjoying (unless we're short) a bear market rally, thrilling to the thought that maybe we're going to get our money back, get our 401(k) back to the plus side and get our stocks back to the starting point. But it won't happen. The bear is not that forgiving. He's no more forgiving than the prosecutors who are trying to put poor old Martha Stewart in prison. He's a cruel, insensitive, sadistic bear.