06/26/06 - TraderMike: The Misplaced Fed Obsession
The Tuesday Federal Reserve meeting is going to dominate the action thisweek. There has been a lot of talk about the Fed in the financial media.I'll have more to say about that in a minute. But most of the time whenthe markets trade into the Fed, volume and volatility shrink the daybefore the meeting and then the markets make a move in the daysafterwards.
There are worries that the Federal Reserve is going to raise interestrates by half a basis point, instead of just a quarter, which is alreadywell priced into the market. I seriously doubt that is going to happen.So, if the Fed raises rates by a quarter we should get a decent reliefrally in the markets. This should give us a strong finish in theDOW, Nasdaq, and gold by the end of the week. All of these markets justmade bottoming formations over the past few weeks and are poised to gohigher. All they need is an excuse.
That's the funny thing about news and the markets. During this lastcorrection, the financial media obsessed over the Federal Reserve andstatements by various Fed officials about inflation. As the marketdropped financial commentators blamed the drop on the Fed. Some called anend to the bull market in commodities and gold. Now, if we start to go up(which I think we will) they'll claim that these worries were overdoneand that everything is back to normal.
The truth is that the DOW, Nasdaq, energy, and gold markets were allpoised to drop. All had become overbought. As I warned right before thecorrection began, gold stocks had become extremely overbought and goldstocks were lagging the rally. It was the type of action you see before agold stock correction and that is exactly what we got. It was violentbecause of the extreme overbought reading. Too many people got in thesegold stocks, some of which were trading nuts who love to make big bets.They used margin and didn't know what they were buying. People werebuying things like Krystallex based solely on Jim Cramer'srecommendation, not knowing that the company is so unsavory. They boughtbecause gold was hot.
This was a typical gold stock correction. And it is a big positive thatthe bottom came around the March low. This puts the odds in favor of aneventual move above the current highs, which would start another giantbull run before the year is over.
Resistance on the XAU is now in the 145-52 area. We should see goldstocks read this level by the end of July at the latest. They'll thenconsolidate for a weeks and if the XAU/gld and HUI/gld ratios continue totrend up we'll be set up for a huge breakout and rally by theAugust-September time frame. It will make the previous stock run looklike peanuts.
The broad market correction has been a little different than the drop ingold stocks. Gold stocks corrected after they made new highs in a bullmarket. The Nasdaq wasn't making new highs when it started to correct.The broad market has been showing signs of technical deterioration forthe past year. Money has been rotating out of technology stocks and intodefensive stocks, energy, and gold. These aren't the type of sectors thatmake new bull markets.
The sectors and stocks that led the market since 2003 all began to fallapart toward the end of last year and have been falling ever since. Thisaction has been masked by the seemingly strong DOW-30 and the celebrationof its move back above 11,000 by the press earlier this year. But theaction inside of the market is sickly.
That's why the market was also due to drop. The Federal Reserve has beenraising interest rates for over a year now. It wasn't the fear of one ortwo more Fed meetings that smashed the market. That's silly. It was thetechnical condition of all of these markets going into May. The Fed newswas just an excuse to sell. And that's why all of these markets fell atthe same time.
For gold we got an overdue correction within a bull market. But for theDOW and Nasdaq we saw a correction near the tail end of a cyclical bullmarket. We got what looks like a key market turning point.
The correction took me by surprise because we saw extreme selling in themarket. Over the past week we've seen back to back days in which theput/call ratio (which measures fear in the options market) traded aboveone. We saw multiple days in which the ratio of down to up volume on theNYSE and the number decliners beat advancers were both greater than nineto one.
That's extreme selling. And the interesting thing is, over the past threeyears every time these ratios got above nine it marked the bottom of ashort-term correction. But this time it happened several times withoutthe market correcting. That's how extreme the selling was this time. Ofcourse, you can get a hint of this on a chart of the Nasdaq by looking atthe big increase in volume to the downside and the collapse of the onbalance volume indicator.
When indicators start to act differently it is time to pay attention,because it means the market is changing. We noticed last year how thegold commitment of traders report stopped working at spotting tops andbottoms like it had successfully done the previous four years. We took itas a sign that the gold bull market was maturing from stage one to stagetwo.
Now for the broad market this change means that the cyclical bull marketthat started in 2003 is over. "We are in a bear market," PaulDesmond, president of Lowry's Reports, told Barrons. Lowry's tracksinvestor demand by measuring buying power and selling pressure in themarket. According to their indicators, buying power has been dropping allyear while selling pressure has been rising.
You've got to watch the technical action of the market or you'll gettricked. There is a high probability that the markets will bounce fromhere. I'd expect a bounce through July and August and then another dropgoing into the Fall. If we get a rally though, you'll hear boldpredictions about the market.
Those people who have been saying the market is falling because ofinflation fears will start to say that another bull market is around thecorner if we get a bounce. They'll claim that the market is rallyingbecause the Fed is almost done raising interest rates and, when theyfinish, everything will take off. This is the same story CNBC spun in thesummer of 2000 that sucked so many people into losing their shirts in thebig stock market bust.
When the market drops people like to blame events or news for the dropand when it goes up they'll twist the same news stories around to makebull market predictions. But you don't need to use excuses to explainevery wiggle in the market. You just need to figure out where the marketis going by listening to it.
The next bounce, when it comes, will be a Fed bounce near the end of therally. You'll see so much celebration on TV that if you don't keep yourwits about you you'll lose your head. Don't do it! If the market bounces,it will be nothing but a bounce. And the market will fade the rest of theyear as the stock market starts to factor in a slowing economy.
The dollar index has resistance in the 88-89 area. It will probably takea month for it to get there, go sideways, and start to go back downagain. Gold is already starting to go up on days when the dollar is up soit has already factored in a dollar bounce. The gold market doesn'tbelieve the dollar is entering a new bull market. Gold is treating thisas nothing but a bounce. A weakening economy would crush thedollar.
This is another reason I remain bullish on gold despite the recentcorrection. We may see gold and the DOW appear to go up together over thenext couple of weeks. But by August, any linkage between the twoshould become broken. This relationship is already starting to weakenalready.
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