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May 19, 2008

Profiting from the Fed's Disastrous Mistake
by David Nichols

Although there is much fear and uncertainty about the economy and financial markets right now, there is actually a very clear and simple way to interpret the current situation, using the monthly charts of equities, bonds, and gold.

In my daily reports I often discuss the 1440 level on the S&P 500 Index (SPX), as this has been -- and still is -- the clear line of demarcation for the big pattern in equity markets.

The first two shockwaves from the credit crisis caused two hard tests of this critical 1440 energy level, back in August and November of last year. But it was only when the Fed delivered that hapless and disastrous quarter-point rate cut at the December meeting that the situation escalated into a full-blown crisis, causing the 1440 level to give way.

It's rare to be able to track a market crisis back so clearly to one particular event, but all of the ensuing carnage in equity markets that followed in January 2008 was a direct result of the Fed's ridiculous quarter-point cut at the Dec.11 FOMC meeting, where they dropped the target rate from 4.50% to 4.25%.

Only six weeks later, at the end of January, the target rate had been slashed to 3.00%, on the way to the current 2.00%.

Now that the Fed has been sufficiently slapped around by the markets, the SPX has been able to scratch and claw its way back up to just under the still-critical 1440 level. Equity markets are once again at the critical balance point, and are now in position to put this very difficult period in the rear-view mirror.

Bonds have also worked their way back to a similar critical balance point, at 115.

And gold has moved back to its critical level at $850.

I generally don't advocate putting too much faith in inter-market relationships, as they have this annoying tendency to break down right when you are relying on them to hold up.

Yet gold bulls need to be aware of the possibility that a massive rally in the SPX could wipe out all of the gains in gold since August 2007. Gold will be in a very precarious position if it sinks below $850.

I'm not actually expecting such a breakdown in gold, at least not in the foreseeable future, as instead gold looks ready to head back up towards the highs, as part of its long consolidation pattern that should last well into 2009. There is definitely a chance that gold can now extend up as high as $975 during the next leg up in this consolidation, which we'll continue to track on a daily basis in the Fractal Gold Report.

Getting back to the SPX, there is a very interesting historical analog from 1990/1991 that is worthy of close attention, as this is a great example of what can happen in a market when "the herd" is gripped by fear, but then suddenly discovers the fear was overblown.

Back in 1990 there was a straight down move, followed by a grinding reversal pattern, and then a straight up rally. It's a very similar pattern to what we're seeing now -- but crucially, we haven't yet seen the straight-up part.

But it's coming.

The key insight from this analog is just how quickly a market can change its mind in this type of situation. That is, if market participants now sense that the "greatest financial crisis in 70 years" isn't actually much of a crisis at all, prices will be re-rated upwards at an astonishing pace.

Back in early 1991, the SPX moved up 20% in only 22 trading days.

A similar move now -- launching from, say, 1385 -- would take the SPX up to new all-time highs around 1660, in only 4 or 5 weeks.

There is a very good chance that we're only a weeks away from a similar "life-changing" move, as a 20% upwards re-assessment of equity prices can translate into massive gains if you're positioned correctly ahead of time in options or other leveraged instruments. Of course there's no guarantee this launch is going to happen, but if it does, we're going to be all over this set-up, and playing it for all it's worth.

Before the SPX is ready for such a launch, there is likely to be one tricky move down off 1440 to create the right sentiment mix for the rally.

This type of sudden decline is actually an essential part of a developing uptrend. The SPX needs to convince the majority that it's about to go into a free-fall, right before it turns around and rallies to new all-time highs.

There are a few specific ways that I'm looking for this pattern to develop, to know that the "pre-launch" phase is still on track. As always, I'll continue to update subscribers on a daily basis on the developing pattern.

Such a blistering move up in equities will also have a dramatic impact on gold, and it remains to be seen how the gold/equity relationship will behave during this period. A subscription to the Fractal Gold Report also includes a subscription to the Fractal Market Report -- a daily update on the S&P 500 index -- and if you opt for the annual or 2-year subscription plans you will also receive fractal analysis of silver and platinum.

David Nichols
email: editorial@fractalgoldreport.com
Fractal Gold Report

David Nichols publishes the Fractal Gold Report, a daily report covering the gold market using proprietary techniques that go beyond technical and fundamental analysis. The Fractal Gold Report is available by subscription here. Fractal Gold Report Disclosure.

David Nichols is a graduate of Yale University and a leader in the emerging field of fractal market analysis. This pioneering analytical approach studies the markets as chaotic, non-linear systems, addressing the predictability in financial markets. Fractal market analysis discovers the order hidden within the seemingly random chaos of the markets.

David is the editor of the Fractal Market Report and the Fractal Gold Report, daily subscription newsletters written in an easy-to-understand style that cover the markets using his proprietary techniques that go beyond technical and fundamental analysis.

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