The Dollar Correlation Myth.

Last Friday, is year-end for many funds. Monday they can "legally" sell.

Monday also begins the first week of November when the three-week bias we mentioned at the beginning of the month culminates. While the market has held up into month-end, fiscal-year end, it hasn't blown off. It’s been choppy and mixed with earnings providing more than the usual Gapism.

Once again, Friday’s early strength was faded but longs came in with a late-day buy program to rescue the session as the S&P was magnetized to the pivotal point of 1184 on the close. Remember 1184 is opposite the time of the late August low and squares the important January high to open the year as it's 90 degrees from that price high of 1150. It's also roughly 90 degrees from the 1220 April high, which is by definition then opposite the end of October.

These squares may be playing out in a six-month top-to-top cycle.

In addition, 1184 is opposite 1115, which is the midpoint of this year’s range.

The March ’09 S&P low at 666 was a 75-point "undercut" of the November 21 low of 741. A 75-point "overthrow" of the midpoint or balance point of the year is 1190. The S&P has been oscillating around 1180 to 1190 all week.

Previous Friday’s close was 1183. Last Friday’s close was 1184.

If gold itself doesn’t start back up strongly by Monday, it suggests it will pullback for another three weeks or so possibly testing the 1230ish level.

The dollar seems to dictate the direction of everything lately. But is this inverse correlation to a declining dollar and rising equity prices overcrowded? Is the notion even true? Does the notion of the dollar devaluation/asset inflation trade always hold true to form?

Let’s look at a weekly chart (above) of the dollar from 2008 versus a weekly chart of the S&P from 2008.

The dollar declined into March/April 2008 in concert with stocks (A).

Notable is the marginal overthrow by the dollar in the first week in March 2009 that marked the precise low tick in stocks. The high tick in the dollar corresponded to the low tick in the S&P (D).

The November 2009 low in the dollar preceded the January high in stocks (E).

Note that the April high in stocks (F) didn't coincide with a top in the dollar. The dollar continued higher to challenge the 2008/2009 highs. The dollar/stocks correlation broke down April to June as the euro got smashed. There were other concerns. "Other" concerns could cause an unwinding again. It is interesting that the decoupling in question this past spring covered the period when the flash crash occurred. Happenstance?

From point E to point F the stocks and dollar advance is positively correlated. Both rose in unison. However, the dollar accelerated strongly in April as stocks topped and declined. Both the dollar and stocks topped in unison (G) in April and declined into the summer.

From the summer into October this year the dollar turned down again while stocks turned decidedly higher: The inverse correlation resumed.

While the market has essentially advanced from March 2009, the dollar has made two round trips.

The tip-off that March 2009 was a low in stocks was the marginal overthrow by the dollar that month over the prior swing high at 88.46 and the outside down week in March 2009.

If there's anything I've learned in my trading career it's that correlations come and correlations go and when they become too popular, they can get unwound violently.

It may be that the inverse correlation resumes here with the dollar staging a rally and stocks going lower, but they could just as easily go their separate ways.

With the election, FOMC, and G-20 in November where leaders will tackle the race to debase their respective currencies, volatility could explode.

Moreover, it's the two-year anniversary of the November 2008 crash low. We got a spring 2009 undercut of the November 2008 spike low. Is it possible we're getting a November spike high to a spring pivot in 2010.

Checking the weekly chart of the S&P and drawing a live angle up from the "true" low of November 2008 and tagging the important July 2009 low shows what may be a bearish backtest. In other words, following the break of this live angle in the summer, the S&P has snapped back to kiss the underbelly of this angle. However, the first "kiss" was rejected in early August while the jury is still out on the second "kiss." Will the second "kiss" get the cheese or the prize?

This may be at the mother of all inflection points. Either the market could extend from here substantially in time and price or it's headed meaningfully lower. And by substantially higher, as you know, I'm not referring to the possibility of a tag and inverse head-and-shoulders projection to 1250 S&P being satisfied going into January. This could play out and still be an overthrow of this live angle. Substantial, in this case, refers to a revisit of the prior all-time highs. This period here in November and then again in January will give us indications as to which way the pendulum will swing.

Money Flowing Into GOLD.

Since the financial crisis in 2008, it's undeniable that precious metals have been the best performer. One would assume that market participants have been piling into precious metals. Certainly some money has moved into the sector, smartly anticipating the continuance of a major bull market and looming severe inflation in the next several years. Yet, most funds have moved into fixed income.

Corporate bonds have been an even better performer than treasuries and rightly so. Not now, but a year or two years ago one could find great yield with the bonds of blue-chip companies, which will be in business for the years to come. Meanwhile, Uncle Sam has taken on the losses of the private sector amid a worsening economy. To begin with, Uncle Sam's balance sheet was a mess.

How does this all relate to gold? Another way to track fund flows is to compare markets via intermarket analysis. Gold has performed very well but most money has moved into fixed income. Gold will begin to accelerate when money starts moving out of bonds and into gold. The chart above shows gold versus the total return of corporate bonds.

This ratio just broke out from a 31-month base! Since the crisis, gold and corporate bonds were performing about equally. Now gold has gained the upper hand. This breakout could be the start of a new trend in fund flows over the next several years. Look for money to favor gold and other commodities, as inflation becomes a major concern. Ignore those who are promoting stocks as a way of beating inflation. Their interests aren't aligned with yours.

How does this affect gold right now? Gold is in a correction. I have upside targets of $1450-$1500 with a downside target of $1280-$1290. No one can predict the future but we can assess probabilities and manage risk. If this breakout holds then it means money in fixed income is starting to worry about inflation. After all, the above chart is providing an early indication. Ship'it out shagg !

The Recent Surge In Indonesia And Malaysia ETFs.

The Market Vectors Indonesia ETF is up 40% year to date while the iShares MSCI Malaysia Index Fund is up 30% over the same time frame.

For anyone that follows emerging markets ETFs, this won't come as a surprise, but inflows to funds tracking Indonesia and Malaysia have surged this year.

BlackRock, parent company of iShares, the largest ETF issuer in the world, said inflows to Indonesia ETFs have more than doubled to $469.2 million through the first nine months of this year compared to $167.5 million for all of 2009.

Malaysian ETFs have garnered $346.1 million in new investments, compared with $71.1 million in 2009.

Specifically, IDX has attracted $340 million in new cash this year and the iShares MSCI Indonesia Investable Market Index Fund (EIDO) has landed more than $200 million assets and that fund made its debut less than six months ago.

EWM has landed $268 million in new cash through the first nine months of 2010.

The inflows may not be stopping, either.

Indonesia's stock market is forecast to see annual earnings growth of 18.5% in 2010 rising to 21.5% next year, according to Citigroup, while Malaysian earnings are projected to increase 24.9% this year before slowing to 12.9% in 2011, according to the Financial Times.

Wat Ben Said, and Wat It All Means For The Markets.

Ben: "The near-term pace of recovery to be 'fairly modest'."
Translation: Despite the first trillion dollars, the disconnect between the stock market and the economy persists.

Ben: "2011 growth is unlikely to be much above long-term trend."
Translation: Even with historic stimuli, we'll be lucky to get back to what was previously considered a normal recovery.

Ben: "Measures of underlying inflation are 'trending downward'."
Translation: We don't wanna say "deflation" -- it’s an admission of defeat -- so we'll dance around the topic and vaguely allude to it.

Ben: "Fed is ready to provide more accommodation if needed."
Translation: Engine room, more steam! We'll print moew money.

Ben: "Bulk of increase in unemployment is due to contraction."
Translation: Hey, it wasn't me!

Ben: "Inflation trends will be subdued for some time."
Translation: It's gonna be a long hard road.

Ben: "Pace of growth is less vigorous than we would like."
Translation: What’s the definition of hyper-inflation? Spend one trillion dollars while running to stand still.

Ben: "Labor market recovery is 'painfully slow'."
Translation: The velocity of money was critically damaged with the collapse of Fannie Mae and Freddie Mac.We are screwed!

Ben: "Risk of deflation is higher than desirable."
Translation: DAMN! Who let that word slip through the censors?

Ben: "Fed has less experience on the impact of asset purchases."
Translation: Your guess is as good as ours!

Ben: "FOMC will be able to tighten policy 'when warranted'."
Translation: Sorta like a slow pick-off toss to first base; you won't catch the runner, you just wanna keep him honest.

Ben: "See a case for 'further action' with too low inflation."
Translation: Don't push me 'cause I'm close to the... button.

Ben: "Fed could buy assets."
Translation: A classic case of post-rationalization but now I said it, so there!

The Light At The End Of The Tunnel, Is An Oncoming Train!

Peak Oil, sovereign insolvency, and currency debasement will permanently transform the economic landscape.

The US isn't yet on the final path to recovery, and there are one or more financial "breaks" coming. Underlying structural weaknesses haven't been resolved, and the kick-the-can-down-the-road plan is going to encounter a hard wall in the not-too-distant future. When the next moment of discontinuity finally arrives, events will unfold much more rapidly than most people expect.

I am figuring out which macro trends are in play and then helping people adjust accordingly. Based on trends in fiscal and monetary policy, I favoured accumulation of gold and silver in 2007. These weren't "great" calls; they were simply spotting trends in play, one beginning and one certain to end, and then taking appropriate actions based on those trends.

We happen to live in a non-linear world, a core concept of the Crash Course. But far too many people expect events to unfold in a more or less orderly manner, with plenty of time to adjust along the way. In other words, linearly. The world doesn't always cooperate, and my concern rests on the observation that the world economy still face the convergence of multiple trends, each of which alone has the power to permanently transform our economic landscape and standards of living.

Three such trends (out of the many I track) that will shape our immediate future are:

-Peak Oil
-Sovereign Insolvency
-Currency Debasement

Individually, these worry me quite a bit; collectively, they have my full attention.

History suggests that instead of a nice smooth line heading either up or down, markets have a pronounced habit of jolting rather suddenly into a new orbit, either higher or lower. Social moods are steady for long periods, and then they shift. This is what we should train ourselves to expect.

No smooth lines between points A and B; instead, long periods of quiet, followed by short bursts of reformation and volatility. Periods of market equilibrium, followed by Minsky moments. In the language of the evolutionary biologist Stephen Jay Gould, we live in a system governed by the rules of "punctuated equilibrium."

Accepting "What Is"

The most important part of this story is getting our minds to accept reality without our passionate beliefs interfering. By "beliefs" I mean statements like these:

“Things always get better and are never as bad as they seem.”

“If Peak Oil were ‘real,’ I'd be hearing about it from my trusted sources.”

“Dwelling on the negative is self-fulfilling.”

Peak Oil

Peak Oil is now a matter of open inquiry and debate at the highest levels of industry and government. Recent reports by Lloyd's of London, the US Department of Defense, the UK industry taskforce on Peak Oil, Honda (HMC), and the German military are evidence of this. But when I say “debate,” I'm not referring to disagreement over whether or not Peak Oil is real, only when it will finally arrive. The emerging consensus is that oil demand will outstrip supplies “soon,” within the next five years and maybe as soon as two. So the correct questions are no longer, "Is Peak Oil real?" and "Are governments aware?” but instead, "When will demand outstrip supply?" and “What implications does this have for me?”

It doesn't really matter when the actual peak arrives; we can leave that to the ivory-tower types and those with a bent for analytical precision. What matters is when we hit “peak exports.” My expectation is that once it becomes fashionable among nation-states to finally admit that Peak Oil is real and here to stay, one or more exporters will withhold some or all of their product "for future generations" or some other rationale (such as, "get a higher price"), which will rather suddenly create a price spiral the likes of which we haven't yet seen.

What matters is an equal mixture of actual oil availability and market perception. As soon as the scarcity meme gets going, things will change very rapidly.

In short, it's time to accept that Peak Oil is real -- and plan accordingly.

Sovereign Insolvency

Once we accept the imminent arrival of Peak Oil, then the issue of sovereign insolvency jumps into the limelight. Why? Because the hopes and dreams of the architects of the financial rescue entirely rest upon the assumption that economic growth will resume. Without additional supplies of oil, such growth won't be possible; in fact, we’ll be doing really, really well if we can prevent the economy from backsliding.

Virtually every single OECD country, due to outlandish pension and entitlement programs, has total debt and liability loads that Arnaud Mares (of Morgan Stanley) pointed out have resulted in a negative net worth for the governments of Germany, France, Portugal, the US, the UK, Spain, Ireland, and Greece. And not by just a little bit, but exceptionally so, ranging from more than 450% of GDP in the case of Germany on the "low" end to well over 1,500% of GDP for Greece.

Such shortfalls can't possibly be funded out of anything other than a very, very bright economic future. Something on the order of Industrial Age 2.0, fueled by some amazing new source of wealth. Logically, how likely is that? Even if we could magically remove the overhang of debt, what new technologies are on the horizon that could offer the prospect of a brand new economic revival of this magnitude? None that I'm aware of.

In the US, the largest capital market and borrower, even the most optimistic budget estimates foresee another decade of crushing deficits that will grow the official deficit by some $9 trillion and the real (i.e., “accrual” or “unofficial”) deficit by perhaps another $20 trillion to $30 trillion, once we account for growth in liabilities. This is, without question, an unsustainable trend.

It’s time to admit the obvious: Debts of these sorts can't be serviced, now or in the future. Expanding them further with fingers firmly crossed in hopes of an enormous economic boom that will bail out the system is a fool’s game. It's little different than doubling down after receiving a bad hand in poker.

The unpleasant implication of various governments going deeper into debt is that a string of sovereign defaults lies in the future. Due to their interconnected borrowings and lendings, one may topple the next like dominoes.

Currency Wars

The currency wars have begun, and the implications to world stability and wealth could not be more profound.

When pressed, the most predictable decision in all of history is to print, print, print. So I can't take credit for a "prediction" that was just slightly bolder than "predicting" which way a dropped anvil will travel; down or up?

The only problem is, widespread currency debasements will further destabilize an already rickety global financial system where tens of trillions of fiat dollars flow daily on the currency exchanges.

You can be nearly certain that every single country is seeking a path to a weaker relative currency. The problem is obvious: Everybody can't simultaneously have a weaker currency. Nor can everybody have a positive trade balance.

If a country or government can't grow its way out from under its obligations, then printing (a.k.a. currency debasement) takes on additional allure. It's the "easy way out" and has lots of political support in the home country. Besides the fact that it's already started, we should consider a global program of currency debasement to be a guaranteed feature of the US economic future.

Conclusion

Three unsustainable trends or events have been identified here. They aren't independent, but they're interlocked to a very high degree. At present I can find no support for the idea that the economy can expand like it has in the past without increasing energy flows, especially oil. All of the indications point to Peak Oil, or at least "peak exports," happening within five years.

At that point it will become widely recognized that most sovereign debts and liabilities won't be able to be serviced by the miracle of economic growth. Pressures to ease the pain of the resulting financial turmoil and economic stagnation will grow, and currency debasement will prove to be the preferred policy tool of choice.

Instead of unfolding in a nice, linear, straightforward manner, these colliding events will happen quite rapidly and chaotically.

By mentally accepting that this proposition isn't only possible, but probable, we're free to make different choices and take actions that can preserve and protect our wealth and mitigate our risks.

What changes in our actions and investment stances are prudent if we assume that Peak Oil, sovereign insolvency, and currency debasement are "locks" for the future?

When it comes to markets riding on a flawed fundamental premise, perception is everything.

Consider that in December of 2007, the world had plenty of food, but by February of 2008, we saw food riots and the international perception of food scarcity. Almost nothing had changed with respect to the fundamental quantities of food stocks between December and February, and that's the point.

Or consider that one month Iceland was in fine shape and the next month desperately broke. Ditto for Greece. Again, there was nothing that had fundamentally changed from one month to the next, in terms of cash flows or debt levels, that would justify the size of the adjustments, but they happened nonetheless, and they happened quickly.
However, it's when we consider the impact of the widespread realization of Peak Oil on the story of growth that the whole idea of sovereign insolvency really assumes a much higher level of probability. More on that later.

For now we should accept that there's almost no chance of growing out from under these mountains of debts and other obligations. We must move our attention to the shape, timing, and the severity of the aftermath of the economic wreckage that will result from a series of sovereign defaults.