Zeev's Turnips Patch-No Politics (ZEEV)

[basserdan]

*** Richard Russell commentary ***

A bit tardy, but, imo, better late than never. <g>

Sage Russell Market Opinion

May 9, 2003 -- Is the "impossible" about to become possible? What's the impossible? Heaven forgive me for using this word -- it's DEFLATION. The situation has become so dicey that both the New York Times and the Wall Street Journal mentioned the deflation issue today.

From the Times headline, "Fed Is Starting to Fret Over Falling Prices." Russell Comment -- "Fret," baloney, the Fed is panicking over the possibility of deflation.

From the little squib on the second page of today's WSJ, "Deflation Worried the Fed As Early As March." Russell comment, congratulations to the cheerleading Journal for even mentioning such a frightening subject.

The long article in the after-section of today's site explains why in the Federal Reserve debt system, deflation is the economic equivalent of death. The dollar is a currency based on debt. In deflation consumers hold off buying since they believe prices will be lower a month, six months, a year from now. When consumers hold off buying, they cut back on debt, and when debt contracts the money supply contracts. This chain of events would be a disaster to the fractional-reserve system that we all live under. The US would become a larger version of Japan. Except that the Japanese people are savers while US consumers are spenders and debt accumulators.

But wait -- the Fed is not unaware of the dreaded possibility of deflation. So besides driving the price of long bonds down, the Fed is pumping up the liquidity.

You don't believe it? Check this out -- for the latest week of April 28, M-3, the broad money supply, rocketed up $55.4 billion. It looks like the Fed is aiming for maybe a $2 trillion increase in M-3 over the coming 12 months.

This picture is not lost on gold, which, despite continued central bank sales, is now in a pronounced uptrend. HUI, the unhedged gold stock average, has been climbing and is now well above both its 50-day and 200-day moving averages. The 50-day MA at 124.21 is still below the 200-day MA, at 126.26, but if and when the 50-day MA climbs over the 200-day the gold stock average will be in its full bullish mode.

Despite the surge in Fed-inspired liquidity, the bond market continues to send an ominous, potentially deflationary signal. The signal comes from the inflation-adjusted Treasury note, the TIPS or Treasury Inflation-Protected Securities. The TIPS have fallen to their lowest level since January, extending a slump that began last February.

Since March the TIPS note has lost 1.3%. The TIPS maturing in July 2012 yields 1.94%, about 1.69% below the Treasury. So far in 2003, the TIPS have been a bum investment. Why? Because the bond market has discounted declining inflation. Meanwhile, the 30-year bond has advanced to an all-time high with yields below in the 4.7% area.

The Fed is praying that the long bond doesn't slip below 4.5%. Below 4% and the Russell guess is that deflation is just around the corner.

There's one phenomenon that the Fed can't control. And it's the mass transfer of US jobs to China, India and other Asian nations. This constitutes an attack on the whole manufacturing base and service base of the US. And it's something that neither US liquidity not inflation can cure.

China has become manufacturer to the world. Thus, China is exporting deflation to the US. Can Fed-created inflation counter-act Asian exported deflation? We'll find out in coming months as the battle to reinflate the US economy continues.

None of this seems to have rubbed off on the stock market, which has marched irregularly ahead ever since the Dow low of 7286.27 struck on October 9, 2002.

However, the stock market is at an interesting juncture now, and I'll list some of the salient points or at least the various items that I see.

The VIX today sank below the 23 area. This suggests that option-writers don't see any real danger on the downside. In fact, the VIX has remained in the 23 area of over a week. This is the option-writer's forecast of low volatility. The contrary interpretation is that option-writers are too complacent here.

My 13 week moving average of the Dow is just about to cross below the 26-week MA of the Dow. This means that the Dow's momentum is about to turn down.

The stochastics for the Dow have turned negative.

On-balance-volume for the Dow has turned down.

The 200-day MA for the Dow now stands at 8321. The 50-day MA for the Dow is still below the 200-day MA; the 50-day MA of the Dow stands at 8202. The Dow will not in its full bullish mode unless or until the 50-day MA rises above the 200-day MA. This has not happened yet. The 50-day MA as of today was 119 points below its 200-day MA.

On the larger picture, the monthly Dow has formed a huge "head-and-shoulders" top formation, and I'll show this again on my regular Dow Theory Letter. The support for this formation comes in at Dow 7286. The "right shoulder" of the formation began to form in October 2002 and recorded its high of 8931 on November 27, 2002.

If the Dow was to close about 8931, that would be very impressive, since that would take the Dow above the "right shoulder" of the giant "head-and-shoulders" formation.

Now I want to apply the 50% Principle to the Dow. The 50% Principle should only applied to an average, and only to major, extended moves in an average.

From the bull market peak of 11722, the Dow sank to a bear market low of 7286. That represent a Dow decline of 4436 points. The halfway level of that 4436 decline is 9504.

The 50% Principle is saying that as long as the Dow trades below 9504, the odds are that in due time the Dow will decline to test, and probably break below, its bear market low of 7286.

However, if the Dow can close decisively above the halfway level of 9504, then there is a good chance that the Dow will approach and possibly even advance above its bull market high of 11722.

With liquidity flooding the markets and with the bonds at new highs, the large list of bond funds and preferreds on the NYSE are giving a lot of upside power to the advance-decline statistics and the high-low statistics. Since the McClellan Oscillator and many other indices are based on market breadth and the breadth figures are skewed to the upside, it's going to be more difficult for these various indices to decline to oversold levels.

There is a lot of talk today about "maybe we're on the edge of a new bull market." I'm afraid this is misguided optimism. The stock market and ALL the markets are now floating on an ocean of massive liquidity, liquidity created by the frantic efforts of the Fed to ward off what the Fed terms "falling inflation" but what I call "hints of deflation."

However, we're still in a bear market that has a long way to go. This bear market won't expire as a result of Fed-created liquidity. This bear market will, like all other great bear markets, die amid sellers' exhaustion -- and it will die only when the market has fully discounted the worst that lies ahead. The bottom of this bear market will be characterized by great values in stocks, with blue-chip stock yields of 5% and above. The bear market lows will see the big averages selling at 5 to 8 times earnings, not the 25 to 30 times earnings which we see today.

Question -- "Russell, the US in now in an all-out inflation mode? What's the potential danger in this process?"

Answer -- The danger is to the dollar. Remember, unlike Japan the US is a debtor nation. On top of our inflation mode, we're running huge domestic budget deficits. Beyond that we're actually talking about cutting taxes, which will run up the deficits even further. The dollar has been diving against the euro. And the question is, how much lower will the dollar go? Let me put it another way, from the standpoint of our foreign friends, what possible reason do they have for buying or even holding securities denominated in dollars?

Richard Russell
Editor-in-chief - DOW THEORY LETTERS
http://www.dowtheoryletters.com/dtlol.nsf

May 10, 2003

http://www.gold-eagle.com/gold_digest_03/russell051003.html

Dan