The set-up for 2002 in Stocks/Oil/Gold

November 28, 2001

In recent weeks we have commented on the likely scenario in the equities market as we round out 2001 and head into a new year. We noted, too, that this year shares many remarkable similarities with late 1998, including successive Fed interest rate cuts and a huge V-bottom reversal in the Dow. The only difference is that the recovery of '98 occurred within the context of a major bull market and this year's recovery (of sorts) has taken place within a major long-term bear market. The beginnings to both rallies were nearly identical, but the outcomes will be very much different. The present rally has enough volume momentum to last into the initial weeks of 2002 before fizzling.

Early 2002 is when numerous cycles have their peak, which should lead to a substantial decline throughout a good part of next year. There will be added downside force from the declining 2-year cycle, and the all-important 12-year cycle, both of which bottom in late 2002. These two factors alone will combine to ensure that next year is a particularly nasty one for equities.

The vigorous nature of the current rally should not be surprising since it represents pent-up demand from stock traders since last year. There is still much latent bullish sentiment among today's traders and investors and this buying urge must be served before the decline can resume full force. Harry Schultz, in his book "Bear Markets: How to Survive and Make Money in Them" writes, "In bear markets, stockholders are anxiously awaiting the return of the bull tide; they are eager to seize upon any rally as the 'turn.'" Since the current rally began at oversold levels on extremely high volume, we must expect more time before the volume and momentum are completely exhausted and the trend turns down again.

Many traders believe that this rally represents a resumption of the bull Market, but this is not the case. This is true because even the bulls themselves will help to facilitate the reversal, once prices reach a point to where traders who lost money in the last down leg can recover a substantial portion of their losses, and where buyers want to take a profit. Schultz describes the psychology of bear market rallies this way: "As prices rise to retrace about half the fall, traders will begin short selling again, and those who bought at the recent bottom will see nice profits which they will begin to take, and those who have done nothing since the bear market started will see prices returning close to their cost price, so some begin to sell, willing to take a small loss in many cases. Since the public confidence was shaken by the prior down-move, there will be few who will wait to see how far prices go; they will take a relatively reasonable price for their stock while they still can."

A word about the gold market is in order. A concerned subscriber writes: "I have accumulated physical gold twice this year. The recent drop in gold price is pretty rapid and is having me worried. Was it a bad practice to accumulate physical gold? Should I have traded gold stock instead? With the latest situation in Afghanistan, stock market, gold market, it seems like, and feels like people are expecting at least a not-so-bad year in 2002. I am very baffled and puzzled. I have been thinking that the debt system should implode. Now it feels like 'Don't fight the Fed.' Could you please give me some advice on this? Should I hold on to my physical gold? What would 2002 be like?"

Good questions all of them and ones that we must address individually. Was it a poor investment choice to accumulate gold bullion or bullion coins? No, because the long-term and intermediate-term outlook for the yellow metal has never been brighter, as we have pointed out several times in the past year. What about gold stocks-should they be bought in lieu of physical gold? It all depends on your investment needs. There is certainly nothing wrong with accumulating physical gold-a liquid commodity if ever there was one-when the overall outlook is bullish. Gold stocks can always be expected to track the overall price trajectory for gold itself. So to say that gold stocks are any better or any worse that gold would be fallacious. True, certain gold stocks, due to their leverage, will enhance returns and offer higher percentage returns over a short period of time than gold itself, but in the main gold stocks must be expected to follow the path laid down by the physical commodity they represent.

Will Year 2002 be a good one or a bad one for stocks? We feel we have sufficiently answered this question in the foregoing paragraphs, and certainly the cycles point to a ferociously bearish year in 2002. Even though many economists/financial analysts are forecasting a recovery next year, the market has other plans as evidenced by the cycle channels already laid out. In fact, from a contrarian perspective, we might expect the majority of traders and investors to expect a bullish year since the market delights in proving the majority wrong. True, there is an old saying on Wall Street that one should never "fight the Fed." But this saying was made popular and proven to be largely true in the secular bull market between roughly 1950 and 2000. That bull market is now over and the rules that held true then will not all hold true now. A new set of rules will likely be written for the new long-term bear market now underway. And if history is any guide, central bank machinations will prove largely ineffective in turning the tide of the market.

But the short-term outlook for gold and gold stocks will likely be trying for most investors. The XAU will likely test $44-$45 in the next couple of days, and a break below this benchmark area would be enough to scare many traders into giving up on gold (at least enough for the big-money insiders to shake things up a bit and accumulate more shares on the slide). We have stated this innumerable times in the past two years, but gold has absolutely bottomed above $250 and this level is absolute. And as we forecast a couple of weeks ago, $270 is likely to hold as a near-term gold market support. The current weakness is but a reflection of the short-term strength in the financial markets, but this will pass. The overall trend for gold has turned up and this is nothing more than a "wave 2" correction. Those of you familiar with Elliott Wave Theory will no doubt recognize that in early bull markets, wave 2 declines are often viewed by most observers as the resumption of the previous bear market trend when in reality the bear has ended. Bearish sentiment is never higher than during wave 2 declines since the last of the long-term hangers-on finally "throw in the towel." But now is not the time to throw in the towel. The insiders will be accumulating heavily during this time and so should you be.

An open letter from the Central Bank Oversight & Monitor Committee (CBOMC) to central bankers, secretariats, and governors last week addressed the inherent weaknesses in one of the leading money center banking stocks, J.P. Morgan, and the potential vulnerabilities it presents to the U.S. financial system. The CBOMC letter stated, "What we could be seeing right now are the early tremors going through their common stock, reflecting in part a plunging U.S. bond market, and massive debt repudiation by Enron and Dynegy."

The committee went on to make the shocking assertion that "The entire derivative pyramid will come down around this institution [JPM] and other players having extreme risk exposure. The Federal Reserve will be powerless to prevent this unraveling. To attempt a remedy would be to threaten the recovery of the entire world economy, and the political institutions of same." The committee's in-house market technicians pointed out not only the fundamental weakness of J.P. Morgan but the technical shortcomings as well. Relative Strength and MACD indicators are "sounding the alarm bells" for a collapse in J.P. Morgan's stock, as the committee rightfully pointed out. Our own analysis of JPM shows overhead resistance already being encountered between $40 and $43 and a series of falling cycle channels slightly above these levels. This means JPM is likely to meet with concentrated selling in the weeks immediately ahead. This situation merits close attention so we'll follow JPM on an ongoing basis and update you of any significant moves in development.

Although the oil and gas stock outlook is extremely weak at the present time, by mid-2002 this outlook will begin to change as the oils come into their own and launch counter-cyclical bull markets of their own to join the golds. Current weakness in petroleum prices is a function of the market foreseeing considerable increases in oil output related to the effort to bring Caspian Sea oil to the market. This is what, in large part, the war in Afghanistan is all about. Remember, the forces governing prices operate at least 6-9 months ahead of actual supply and demand. Since the oil and gas sector is close to hitting the extreme bottom of its dominant cycle channels (which should occur early next year), after a time of consolidation and recovery a strong bull market should be underway later next year which will see energy prices and oil/gas stocks soar in value.

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy.  The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment.  He is also the author of numerous books, including most recently “2014: America’s Date With Destiny.” For more information visit www.clifdroke.com.

Small amounts of natural gold were found in Spanish caves used by the Paleolithic Man about 40,000 B.C.