Ready for Launch?

By: Greg Silberman | Sun, Dec 10, 2006
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Article originally submitted to subscribers on 3rd December 2006...

The Big News:

In case you haven't heard, the US Dollar broke significant support 2 weeks ago and is poised to test the all important 80 level.

Actually it's a lot worse than that!

Chart 1 - US Dollar Monthly

The break below 85 completed a Cup and Handle formation (blue arrow) with a target of 78.

A sustained move under 80 would be catastrophic for the Dollar in that it would complete a larger Head and Shoulders pattern (blue line at 80 = neckline) with a target below 60! This would be tantamount to wholesale DUMPING of the US$ and in all likelihood an end to its Reserve Currency status.

In the face of what's shaping up to be a Dollar crisis what do you expect the Stock and Bond markets to be doing?


Try again.

The Dow continues to hover around all-time highs. The Bond market continues to move higher and the Utilities Index is making fresh all-time Highs.

Hardly the reaction you'd expect right?

Add to the mix a decidedly Bearish news flow - manufacturing weak, housing sales falling, Walmart sales dropping and unemployment benefits up substantially - and you've really got to be scratching your head wondering if the markets have gone MAD?

No, the markets are doing exactly what they should be doing. It's our perspective that is skewed.

The brilliant John Murphy of Inter-market Analysis fame puts it; there is a time lag between a falling Dollar and a falling Stock and Bond market (paper asset markets).

In Inter-market analysis the link between the Dollar and paper asset markets can at times be very unconvincing. The key to unravelling the mystery is the commodity and, more importantly, the Gold market.

A declining Dollar is most definitely inflationary as the cost of imports rise. The timing of a drop in other paper asset markets is after Commodities have responded to the inflationary infusion. That is, the inflation must first filter through the commodity market before there is a knock-on affect on the Bond and Stock markets.

Commodities must be screaming inflation before other paper asset markets respond.

Now in the case of Gold, there are 2 necessary ingredients to create a sustained move:

  1. A slowing economy and
  2. An increase in inflation expectations

A proxy for slowing growth is Gold outperforming economic sensitive materials e.g. industrial metals. The Australian Dollar is a good proxy for industrial metals:

Chart 2 - Gold in Aussie $ - growth slowing but more required to sustain upward trend

What we see here is that Gold has been outperforming the Aussie Dollar since October but has not broken any new ground (blue line) - more evidence of a slowdown is required.

Inflationary expectations

One way to gauge inflationary expectations is to view the spread between Treasury Inflation Protected Bonds (TIPS) and unprotected Bonds of the same maturity. The theory being that when investors perceive a greater inflationary risk they would prefer TIPS versus unprotected Bonds and hence TIPS should outperform.

Chart 3 - 7-10yr Bond Fund vs. Inflation Protected Bonds

Based on the above chart, inflation expectations remain very low amongst investors. The unprotected bonds have been outperforming the inflation protected bonds since early 2005. The current structure however looks unsustainable as price has gone parabolic (blue line) but the MACD internals (bottom blue line) have not confirmed.

In summary: inflation expectations are beginning to pick up but we're not there yet.

We are now in a position to understand why other paper asset markets haven't fallen apart in the wake of a falling Dollar:

Growth is moderating and inflation expectations are beginning to rise, but there is just not enough evidence to conclude that a sustainable Gold rally is upon us.

As the Dollar continues to fall, the ingredients for a major Gold rally should slot into place. We will have our Perfect Storm yet but for now the markets are saying, "Needs more time ..."

More commentary and stock picks follow for subscribers...



Author: Greg Silberman

Greg Silberman CA(SA), CFA

Greg Silberman

Profession: Research Analyst and Newsletter Editor
Company: Ritterband Investment Management LLC

Career Brief: Greg qualified as the youngest Chartered Accountant and Chartered Financial Analyst (CFA) in South Africa in 1998 at 25 years old. After completing his traineeship with Grant Thornton he moved to London where he worked for JP Morgan Chase in their Fixed Income Swaps Division. Sick of the grey skies and cold weather Greg relocated to Atlanta, Georgia where he spent the next 4 years freelancing as a management consultant. His targeted clients were fast growing mid size US based companies and he worked across many industries including credit cards, health insurance and energy trading. Greg has recently returned from Sydney Australia where he spent the last 2½ years working in Equity Derivative Structuring for Perpetual investments a major Australian Asset Management Company.

Greg has a passion for the markets and has been writing Greg's market newsletter for 2-years. A newsletter focused on metal and energy stocks and recently non-resource small caps listed in the US and Internationally.

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.

Copyright © 2006-2008 Greg Silberman

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