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I feel we are facing significant headwinds moving forward because of the loose monetary policy of the Federal Reserve, the refusal to address the core problems in our financial system and the incredibly opaque derivatives market that has yet to be regulated or even cleared on open exchanges.

The root of the problem

To expand on the first point of loose monetary policy, from my own research I have gathered that the government has put at least $12T, possibly up to $30T worth of guarantees, backstops and other forms of insurance against the prospect of another meltdown. In addition the Federal Reserve has, in my opinion, illegally taken control of AIG through programs they are not authorized to participate in. These actions and other measures have transferred the risk of collapse from the private sector to the US government and to the Federal Reserve.

Interest rates remain below 1% in a range of 0.00% to 0.25%. Combine that with the infusion of US dollars the Federal Reserve has given to other central banks around the world and we have literally created a carry trade scenario. Not only are we repeating the mistakes of Japan, but we are going down a path where should a geopolitical event or other significant negative catalyst occur the repatriation of dollars could create a collapse across nearly every asset class.

Risk grows as stability wanes

This environment that has been created to engender a recovery is not only unsustainable, but it has created more risks than had existed beforehand:

#1 Should another market panic occur where AIG’s credit default swaps are due, the US Treasury and Federal Reserve must cough up the difference. This would lead to another series of bailouts and funneling cash to foreign and domestic banks at the tax payer’s expense on bets that never should have been made and were downright idiotic.

#2 Big banks are BIGGER now than before: JPM, BAC, WFC, USB and others are now larger and present a much more significant risk to the system should, say for example, one of their mark to make believe off balance sheet assets implode — potentially bringing down the entire world financial system, again.

#3 The stress tests were fraudulent and did not expose the off balance sheet asset liquidity vacuum these banks are suffering from. Papering over fraud never leads to a sustainable rebound.

#4 Tax receipts are down across the board – how can counties, cities, states and the Federal government hope to control deficit spending if they are not collecting as much in taxes? They can’t sell bonds forever, bringing me to my next point.

#5 Commercial real estate and corporate bonds are headed towards a potential implosion in the next few years, with major mall holders filing bankruptcy and many occupants of office and retail space vacating as they downsize. Corporations also must refinance their debtload which is ever growing while the global appetite for these bonds is diminishing.

#6 We in the United States are very seriously facing the risk of a sovereign debt default in the future. This prospect is made even more serious by continued bail outs, war spending, entitlements and other programs that are completely unsustainable with our country’s $14T debt burden.

#7 Such a sovereign debt default would lead to a currency collapse and that could engender either an environment of hyperinflation or heavy deflation — all depending on where the chips fall at the end of the day.

Inflation or deflation?

While speculators are now hedging for inflation and shorting the dollar in any way possible, there is another market we must pay close attention to. A market that significantly dwarfs the size of the commodities markets as a whole. That is the US Treasury Bond Market. Last I checked it was $33.5 trillion dollars. I find it interesting that gold is touching $1111.00 an ounce while 10 year bonds are at only 3.625% — who is wrong in this gigantic game of chicken?

Either the folks buying gold are insane to believe inflation is the bogeyman to fear or the much larger, much more influential and liquid bond market is crazy because they obviously fear deflation. Why else would a rational human being buy a bond at 3.625% that they must hold for 10 years? Such an instrument would be less than worthless in an inflationary environment.

First the principle value of the bond erodes as interest rates rise, and secondly the yield would not make up for the rate of inflation. So we are experiencing a financial conundrum right now. Either we are on the verge of a deflationary collapse or a hyperinflationary currency crisis. Which way we’re going to go has not yet been made clear to me because I feel the markets are being propped up, even manipulated.

The most dangerous bubble

Why would I pose such an idea? Let’s start with the P/E of the S&P 500 which is now well over 25 (and was at one point over 100). How can anyone feel that these stocks are reasonably valued with such an absurd P/E? Most of the decrease in P/E from over 100 to over 25 has been from companies downsizing, firing employees, hiding bad assets and not organic growth. In the current global macroeconomic environment there’s no feasible way earnings can catch up, so in my opinion we’re already in a bubble.

Bubbles of the past were not as dangerous because the US government never had such a large stake in the market. Now we’re talking about a situation where if the credit, bond, currency and/or stock markets implode, so does our sovereign debt and currency potentially.

Investing is now speculation

Investing in this environment is difficult at best. During the March panic I was a buyer in the high S&P 600s of just about any material, technology, financial and energy stock I could find, but once we got to the 900s and I saw P/Es jump beyond levels I felt were fair valuations I became a seller of my holdings. I also invested some in to silver, foreign currencies and other commodities during the March lows, but also have since taken a lot of those profits off the table.

We are in a very risky area for people to be entering the market. I don’t feel these lofty levels are sustainable nor do I think the valuations are rational. I don’t know when the rally will end, but I do know that any parabolic move usually ends very badly and any time there has been a carry trade in the history of money it has ended painfully for all the speculators who did not exit in time.

Another collapse coming?

In closing I will say that before Rome’s collapse the government was shaving gold and silver coins down to create more currency. They also had a severe debt crisis. The shaving and continued spending led to awful inflation that eventually catalyzed the empire’s downfall.

History is being made every day and the decisions are going to shape the face of America’s future. It is imperative that we start to take our medicine (meaning we must face the financial problems instead of ignoring them) and deal with the overwhelming burden of debt before it swallows up everything left.

At this point there is some distortion between energy and metals which have a direct relationship as energy must be expended to mine the metals. usually the ratio is 10x the price of a barrel of oil for an ounce of gold, but now it’s been in a range of 12.5x-15x.

Either oil is very undervalued (which is unlikely) or gold is overbought at these levels.

Today’s close of the stock markets and oil seems to indicative of a risk repricing that began last week.

960 (around the 50 day moving average) on the S&P 500 and $65 a barrel on light sweet crude are my downside targets short term, but if either breaks we could trade to much lower support levels.

In addition, when examining the huge sell off in natural gas prices, it’s near certain that energy has more negative catalysts than positive because industrial utilization continues to lag despite the green shoots propaganda that we keep hearing.

Finally, there are a growing number of bears calling for a shake out of March’s lows coming this fall because of a new leg down in commercial real estate that will bleed liquidity out of the equity markets and REITs.

We may be seeing an interim top on the US dollar index, which is no doubt expected to see pressure from the stimulus plan and the Obama administration’s bank bailout 2.0 that is expected to be revealed in the weeks to come.  The US dollar index appears to be making a descending series of highs.  If the pattern continues this could signal the next wave down.

Watch the foreign exchange markets, as the US dollar could be bound for a correction soon.  Possible trades include going long Canadian dollars, Australian dollars, Swiss francs, Gold, Silver and hedging by shorting the GBP Sterling.

The action in precious metals lately has been impressive.  Silver and gold caught a bid amidst the chaos in currency markets and bank balance sheets.  The nervousness has created an atmosphere of fleeing away from equity in to safer havens.  With gold seemingly gaining steam to make another move to the upside, is $1000 within sight?

Looking ahead

Markets tend to discount the here and now and focus on the future.  Has gold already priced in potential inflation or is that a variable being gauged on a daily basis?  Options traders in GLD would suggest that $95 to $100 (or around 950-1000/oz) are reasonable price targets given their usually large call positions.

Charting the course

Right now $1000 is resistance long term, without some extraordinary volatility to the upside.  Below is a three year, weekly chart of GLD.  The bollinger bands are a great indication of potential support and resistance in price moves.  We’re using a longer term chart to get a very broad view of GLD’s price action over the last 150 weeks.

Past performance

While past performance is no indication of future gains, GLD has outperformed the SPY (S&P 500) consistently for quite some time.  Gold has always provided a safe haven for value.  For thousands of years, gold has had the same purchasing power.

It is wise for investors with long term objectives to have some precious metals exposure in any portfolio as a hedge against inflation, which is expected to increase significantly in time.  Traders may want to be more aggressive playing the rally depending on your strategy.

Just when a collective sigh of relief was breathed about 2008 ending and a fresh year beginning, 2009 was ushered in by the worst ever index performance in the S&P 500 and Dow Jones 30 for a January.  This was certainly not encouraging for those that believe in the adage, “So goes January, so goes the year”.

Outlook not so good

2009 promises investors and traders one thing.  Uncertainty.  While the market has declined nearly 50% peak to trough, the deleveraging process has not been completed.  Banks still have far too much common stock equity vs. assets on book.   Usually recoveries in any stock market are led by financials, so this turn around prospect seems bleak until the equity to assets ratio improves.

Inflation prospects seem to be rearing their ugly head again, as precious metals are catching a strong bid.  Oil seems to have bottomed.  Gas prices are on the rise again for consumers.  Treasury bonds are selling off.  The baltic dryships index has been recovering based on Asian demand for raw materials.  Certainly ZIRP (zero interest rate policy) has created the possibility of a new carry trade.

Recovery, what recovery?

Most predict that the US markets will tread through a slow, “L-shaped” recovery because of the serious damage to credit and stock markets, and most importantly, confidence.  Nearly $9 trillion is sitting on the sidelines in virtually zero yield short term treasuries and money markets.  That cash has yet to be deployed, and was originally retracted from equities, because of a flight to safety from confidence being lost.

The smart money is watching China and Taiwan, as the markets there have enjoyed a significant recovery from their lows and forming a bottoming pattern.  With the US dollar nearly free to borrow for currency traders, the possibility of the dollar becoming a carry trade currency is quite real.  Long term prospects for the dollar are weak so traders would not feel as though their principle loan is going to increase from dollar strength.

History in the making or repeating itself?

The possibility is striking because when Japan suffered a similar crisis in the early 90s, their currency suffered this very fate.  The carry trade in Japan caused most financial institutions to move money outside of Japan rather than invest in the country and assist its recovery.  Infact, Japanese equity markets have never recovered and still thrash around making significant lower highs and lower lows in recent months.

In my opinion, this is indicative of a significant risk to recovery in the US markets.  Already gold is more valuable per ounce than the S&P index.  Other stock markets are outperforming the US market on their recoveries.  Will the trend continue?

So, Fannie smells like its namesake and Freddie is more like Frauddie.

What has inspired this recent massive confidence boost?  Wait, who said it was confidence?

The SEC says, “Thou shalt not short”, and the blood that flowed in the streets retreated back in to the respective institutions in which it had spouted from.

The Treasury says, “We will buy the risk on the taxpayer’s dollar”, and somehow gold and silver decrease in value and the dollar holds its ground against other currencies.

The Fed says, “We have to raise rates” out of one side of it’s mouth while also saying, “The risks have markedly increased” from the other.  And yet the markets accelerate up in leaps and bounds.

What really happened?  Why are financial stocks rallying?  Because you can’t short them as easily if you’re a market maker or institution.  Any short positions that don’t have shares borrowed must be unwound.  Is this a magical cure-all for the financial markets?

Is Paulson’s plan for a blank check of nearly $1 trillion dollars to Mac and Mae a way to say, “Everything is OK”?

We have to examine the core underlying message here carefully to paint a more accurate picture of what’s going on behind the scenes.

Paulson needs lots of cheap money and fast to bail out a cataclysmic decline in Fannie and Freddie’s paper.  Meanwhile, Fannie and Freddie already out diluting their share holders with new issuances.  Why is that good for share holders?  They’re effectively seeing their shares watered down.  Oh wait, it’s harder to short during the next 27 days because of the SEC, so these stocks aren’t really rallying, they’re just floating on ether.  Ultimately the Fannie and Freddie share holders will see the equities go to 0.  Only the debt holders, particularly Japan, China, Russia and other governments, will come out with any cash.

Plosser of the Fed says, “We must raise rates sooner than later”, yet the financial system is still in peril.  Raising rates would boost the dollar slightly, but the fundamentals are weak because of a spiraling out-of-control current account deficit that may rise to $12T by 2010.  That would be a near treble from 2000’s level, which suggests the fundamental value of the dollar is being cut down by 66% (or a by two thirds) to 33% of its original value in 2000.  Wait, WHAT?  That’s correct, we aren’t even near the end of this fun ride yet.

In fact, it’s likely about to become much worse as savvy hedge funds and institutions find other ways to short weak companies, using options, derivatives and shares listed in other countries with more lax regulations.

At the same time the US government fancies itself the regulator of all markets now.  They’d like to tell speculators how many crude contracts they’re allowed to hold, after being told by the Federal Reserve, CFTC, independant researchers and many brokers that this will simply create more problems.  If there are less speculators, the markets will become less liquid, volatility will increase and the fundamental supply demand story isn’t over.  We may or may not be at peak oil, but one thing is certain, oil’s uptrend since $1 a barrel in the 1900s is far from over and Boone Pickins’ prediction of $300 oil by 2012 seems more than reasonable.

Where does that leave us?  We are in an area of extreme uncertainty.  Every rally is questionable.  Every dollar we hold in our bank accounts, retirement accounts and wallets are declining in value significantly.  Stagflationary pressures are now globalizing and the world economy seems poised for a marked slowdown.  We can hope and pray that this will pass and everything will be just fine, but after the second biggest bank failure in FDIC history (and more to come), we are nowhere near out of the woods, yet.

  Gold is outperforming the market by a large gap now. This is expected to keep up until gold potentially reaches $800/oz levels based on increasing US dollar weakness, fear driving traders in to safe assets (gold, bonds, etc) and away from stocks.

With the housing recession potentially spreading to other sensitive sectors, we see the potential for an economic slowdown being exacerbated by the ever weakening US dollar. Gold, which is a traditional safe haven in times of crisis and fear, is gaining strength. December 2007 futures are trading over $710/oz up from a low of $655/oz only several weeks ago. Traders that were short gold futures have covered or reversed positions and investors have been buying gold in large volume.

I would recommend buying gold on any weakness going in to the end of the year. We’ll see the dollar continue to weaken further, especially if the Federal Reserve cuts interest rates. This will cause traders to reprice gold higher accordingly.

Good luck trading!

Home builders have had a very rough run lately. It’s probably not over by a long shot either. Those engaged in the industry generally understood that residential real estate was overbought and inventories would eventually grow very large if building kept on pace. These same builders kept building at the same pace, all the while creating an astronomical number of unsold developed properties in their portfolio.

With the credit crisis stifling mortgages and home sales, these builders are in a very risky position with portfolio’s full of unsold homes that are now depreciating in value by the day. Without substantial rate cuts, the housing market will likely not rebound for a few years. This will force many home builders to sell their inventory at a discount and others to declare bankruptcy. It may be a good time to watch ITB (see below chart vs. CFC) and consider shorting it.

I’ve charted ITB against CFC because I believe they follow a very similar downward trend without support. CFC is guiding even lower and ITB is likely to follow as the situation worsens throughout 2007. Traders may want to short ITB and go long gold, US treasury bonds or Euros for a potential recession hedge. Good luck!

Today, as the dollar weakened, gold rallied in response by 2%. Traders also speculate that this rally in gold is in response to the anticipated US Federal Reserve rate cut on September 18th. AUY along with other gold miners also rallied in response.

This morning, with tremendous support from the US futures, European markets and gold, the world optimistically awaits the Federal Reserve’s speech during the conference on housing and monetary policy in Jackson Hole, Wyo. at 10 a.m. EDT.

Currently S&P futures are up about 1%, gold is up about 1.5% and the German DAX is up 1% all in anticipation of good news.

Why is the world optimistic about this? Let me present a few views:

1) President Bush has stated he will expand the government’s role to deal with the subprime mortgage credit crisis.

2) Ben Bernanke is expected to at least give traders and investors clarity about his views on the economy. There is also (somewhat irrational) speculation that Dr. Bernanke will give indications on his Federal funds rate policy decision at this speech.

3) Bond rates indicate traders expect a rate cut in the short term.

4) A lack of volume because of the upcoming holiday makes the US market very volatile.

5) The weakness of the Yen has lent strength to US markets as the carry trade may be winding up again.

All of this is important to consider today. What does it mean?

If the Fed speech gives no clear indication of policy or interest rates we may see market weakness. That market weakness may be exaggerated to the downside because of the low volume. This weakness may be temporary, as President Bush will be speaking around 11AM EDT regarding the subprime mortgage credit crisis. It will be very important to watch bond yields and the Yen today for signals.

Alternatively, if Mr. Bernanke gives the market a high degree of transparency in his speech, and it gives markets the indications it wants to hear about a rate cut, we will absolutely see an unprecedented rally.

My advice? Watch and wait. If you are an experienced trader you may want to trade the speech.

We saw gold drop $14 this week, gold stocks were punished and the market showed a lot of fear and trepidation. With such volatility, you might ask, why do I think gold is good? It’s simple.

That’s right, simplicity. That makes an asset attractive. For the past two years gold has outperformed the S&P 500, Dow Jones and NASDAQ.

If this isn’t enough for you, however, you should note a few very significant facts:

1. Gold trades in US dollars. That means when the dollar is weak, gold is strong. The dollar has strengthened recently because of a “lack of liquidity”. Liquidity usually refers to US dollars flowing in and out of different equities and other asset classes. When it dries up, that means there are less “dollars” (whether in hard or soft form) in the system. This creates a temporary boost in the value of the dollar and temporary weakness in gold.
2. India and China are now the world’s largest consumers of gold and their appetites are likely to keep expanding. This creates more demand and pressures the supply, thusly raising prices.
3. Gold is the world’s oldest asset and is only gaining in popularity and probably the world’s most liquid asset.
4. Hedge funds bought gold as an appreciable asset, not fully understanding the implicit lack of hedging this creates when other funds mimic the same behavior.  Gold was oversold this week because of investors having to cover their losses in other assets by selling their profitable investments.

Gold is now ready to rebound and it closed today bullishly up $9.70 in to the weekend, indicating investors are willing to stay in their positions. Gold stocks rebounded positively as did the precious metals indices. The overselling that occurred mostly to cover losses is over and the bargain buying has already begun.

The next step is for the Federal Reserve to cut interest rates in September (or sooner). Once this happens, the dollar will further weaken because of the increased availability of credit (which is essentially virtual money flooding the system). This weakening dollar and increased availability of credit encourages investors to flock back towards gold, stocks and other oversold assets.

It may just be time to buy some gold ETFs (IAU, GLD), futures or stocks (AUY). Have a Mooriffic weekend!

Another interesting chart demonstrating how the carry trade unraveling affects all asset classes, including gold. In the chart below I have JPY (vs US dollar) compared with gold (rather than the reverse in my previous entry). As you can see, JPY and gold have a direct correlation, much more than I expected.

Good luck trading!

Gold trades myopically based on fear and greed, generally not taking the larger picture in to consideration (long term: weakening dollar, US economy slowing, inflation growing). As such, opportunities arise to exploit fear and greed to yield a high profit.

As you can see in the image below, gold oversold based on fear this morning that the market would collapse based on credit concerns. I bought here $675.00 because I felt gold, being down about $20 from the day before, was oversold.

As you can see, it quickly rallied to $686.00, where I sold, because I felt the rally was overdone by traders relieved by the Federal Reserve injecting $19B in liquidity to banks suffering from a lack thereof.

That’s basically how the fear/greed trade works. This is a single trade that can span minutes, hours, days, weeks, even months and years depending on your strategy and outlook.

The US Dollar slid vs. the Euro amid expectations of lower economic growth in the US, pushing gold higher. US Markets are poised to open higher as better than expected earnings from General Motors, Waste Management and Sun Microsystems beat Wall Street expectations.

UPDATE: The dollar’s strength was increased by news of slower domestic inflation. This caused a sharp turn-around against the Euro and as a result pushed gold futures lower.