What is the Story These Charts are Telling us?

October 29, 2002

In short, the economy seems unlikely to grow strongly from this point.

OK, but there is still the issue of P/E ratios hovering around 30X. What will happen if investors start to focus on the high probability that the growth that has been factored into current share prices will not materialise?

If the market as a whole turns down, will this lead to a break down of the S&P500 below its October low of 782?

If the S&P500 penetrates the 782 level on the downside, it will almost certainly lead (in my opinion) to a panic style market crash. Why? Because with such an occurrence, understanding will "finally" dawn in the minds of the majority of investors that underlying economic activity is not sufficiently robust to justify the unrealistically high P/E ratios.

In a previous article I demonstrated that the "immediate" down-move target following such a penetration is likely to be of the order of magnitude of 35% (Thirty Five percent) from then current levels.

The above weekly chart shows that there is a "faint hope" that the market as whole will not penetrate the 782 level on the downside because although the price chart and the OBV chart have been "in sync" (both show lower lows), the MACD shows that the recent bounce was from a higher low than in July/August.

Unfortunately, the most rational conclusion that can be drawn is that the "jury is still out" regarding whether the 782 support level will hold.

My own gut feel is that this level WILL be penetrated on the downside, but I have to stress that this is only an intuitive feeling. I have no hard evidence to support it.

Now, if the S&P DOES penetrate on the downside, what will be the likely behaviour of the gold price?

The above weekly chart shows that the gold price is clearly in a rising long term trend, and is trading above both its 50 week Moving Average and its 200-week Moving Average.

The level of 325 - $335 seems to me to offer the ultimate resistance to an "explosive" up-move in gold. Why explosive?

If one looks at a longer period weekly chart of gold (courtesy DecisionPoint.com), what we see is the emergence of a classic "saucer" or "bowl" formation which began to form in Q1 of 2001 and has been slowly evolving since that time. The pullback from the rim of the saucer that we have seen recently represents typical market behaviour but, theoretically, could just as easily represent a "double top" - which could have bearish connotations.

It is this lack of resolution - saucer formation? (bullish) vs double top? (bearish) which has led to the indecision that we have been witnessing in the gold price over the past few months. In essence, weak (hopeful) holders have been squeezed out.

If/when this situation is resolved on the upside, the chart shows that the next significant resistance level will likely be at $400/oz and this level is likely to be achieved very quickly once the indecision finally resolves itself.

Of course, it's possible that the situation will not definitively resolve itself for some time. What might happen is that the gold price could tic-tack back and forth between $275 and $325/oz, whilst the S&P500 tic-tac's back and forth between 780 and 900.

The main "clues" seems to be:

  • A saucer formation usually resolves itself with a breakout to the upside.
  • P/E ratios of 30X cannot be justified except (by drawing a LOOONG bow of reasoning) if underlying profitability is to grow at a rate in excess of 15% p.a. over the next five years.Then "normal" P.E ratios can once again begin to manifest within five years if prices remain constant at current levels

This begs the question: What's the probability of underlying earnings growing at 15% p.a. compound?

Well, if you believe the charts of the leading retailers, home mortgage lenders and motor car manufacturers, there is NO chance! It just ain't gonna happen. The relevant charts are providing evidence that even the market itself does not believe this. This is quite apart from the historical fact that profits don't physically tend to grow at this compound level for very long.

Overall Conclusion

When all is said and done, the logical probabilities favour a downside penetration of the 782 level in the S&P500 - followed by a "crash" in equity prices to a level of around 30% below current. If a crash were to unfold, a significant atmosphere of fear is likely to pervade the investment community, and the gold price is likely to penetrate the $325 - $330 level on the upside, and move quickly to (at least) the $400/oz level.

Despite this logic, there is some technical evidence to support the contra-intuitive view that both the S&P and the Gold markets could continue to "churn" for some time, and it is therefore not possible to be definitive.

Overall, if one proceeds from the base assumption that wealth is accumulated by those people who "buy low and sell high", it is much more sensible to be invested in gold and disinvested from equities.

Caveat

There is an important caveat: It is a matter of indisputable fact that Gold can never again become the currency of last resort throughout the financial world as a whole because there is simply not enough of it to go around. By analogy, it would be like trying to paint an entire apartment building when you only have five litres of paint available to you. It does not matter what the price of gold rises to, there is simply not enough gold to go around for gold to become generally accepted as a currency of exchange.

It follows that the most logical role for gold to play going forward will be as a foundational base within a centrally controlled fractional reserve monetary system. For this reason, we cannot allow the world's financial infrastructure to disintegrate - as it might very well do if organizations such as JP Morgan and Citibank and Rothschilds were allowed to go belly up.

We therefore need to be extremely careful not to throw out the baby with the bath water. The world's economy needs a financial infrastructure, and the main pillars of that infrastructure need to be preserved - whether we like it or not, and whether the individuals behind these pillars deserve to be protected or not.

This is not the time or place to discuss the subject, but if we are to face the future with confidence, it will be necessary to remove from the offices of power those leaders who secured their positions by ambitious force of will rather than because they were qualified or suited to lead. Men like Bill Clinton and George W Bush are not suited to lead because they have insufficient humility. There is no place for testosterone in today's complex world.

The Federal Reserve Bank of New York holds the world's largest accumulation of monetary gold.

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