THE FED'S ADMISSION OF GUILT

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"There is a boundary to men's passions when they act from feelings; but none when they are under the influence of imagination."

Edmund Burke

Before I go off on one of my rants, I want to comment on something. On Friday the Brazilian petroleum company, Petrobras, completed the largest stock offering in history.

It sold seventy-eight billion dollars worth of stock to unsuspecting suckers, widows and orphans! I know it's just paper, but I truly think the world has gone mad. I know they're supposed to have the largest oil reserves in the world, but the line between what's "proven" reserves and what's "probable" reserves often becomes blurred and that is especially true in Latin countries. Investors in Royal Dutch learned that lesson the hard way some years ago when it was learned that they only had a fraction of the proven reserves that had been previously claimed. The people buying Petrobras stock today will get a refresher course in what's real and what isn't. Now on to bigger and even more dangerous themes

Every so often we have a watershed event, and since we are all tied up in the moment we often miss it altogether. Months or years later someone writes about it and you have to wonder how you slept through it. I believe that we had such an event this week in the form of a Fed statement that acknowledges the need for more quantitative easing… Fed speak for another stimulus package en route. In every great struggle there are defining moments and in the fight to the death between the great bull market in stocks that ran from 1982 to 2007, and the ensuing bear market, there are two such defining moments. The first came in October 2007 when the Fed failed to act, preferring to let the Bush administration apply a series of worthless band aids, and pretended that nothing of importance was taking place. The second defining moment occurred on September 21st when the Fed announced that it stood ready to inject more liquidity into the system at a moment's notice. It is significant because it is an admission of failure.

I have maintained for two years that the Fed was too slow to act from the beginning, fell so far behind the curve that it couldn't even see the curve, and therefore let deflation get a death grip on the American economy. Tuesday's implicit admission that further motivation would be needed was nothing more and nothing less than the white flag of failure. The distinguished professor and renowned expert on the Great Depression, Ben Shalom Bernanke, fell asleep at the switch and allowed the worse of all evils, deflation, to gain a toehold in the economy. They'll chisel that on his tombstone someday! To make matters worse the poor dumb fellow doesn't have the slightest clue as to the damage he's done. That's what happens when you spend your life in an Ivory Tower. How sad is that? A case can be made that he inherited the mess from Sir Alan Greenspan but my response would be that he did nothing to improve the situation. In fact he made things worse; the final nail in the economic coffin.

Now the pressure increases as both the Congressional Office of Management and the Treasury list a total shortfall of $4.5 trillion coming due during the next 12 months. Obama is clueless as another member of his economic team, Larry Summers, abandoned ship this week and qualified replacements don't seem to be answering the phone. We have a mid-term election coming and no political will to do anything what so ever, other than criticize. As I mentioned earlier the Fed issued a statement on Tuesday where they said that "the pace of recovery in output and employment has slowed in recent months." They went on to say that "the committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period. The committee also will maintain its existing policy of reinvesting principal payments from its security holdings."

In very simple terms the Fed is saying it will keep rates at zero for "an extended period of time." Furthermore the Fed will continue its "existing policy" of quantitative easing, meaning it will print until the cows come home. The Fed is openly and unashamedly announcing that it will adhere to a policy of inflating and destroying the dollar. Now here is the most important point of all: the Fed is admitting it failed! That admission is now having repercussions in the market place in general and with the US dollar specifically. Since the Fed made their little announcement on Tuesday at 2:15 pm EST the US dollar has done nothing but lose ground. The spot US Dollar Index closed out Friday's session at 79.39, well below what should have been strong support at 80.16. In all honesty it went through the support like it was a walk in the park and that is somewhat disconcerting. The sell off comes at a time when the Administration is trying to pressure China to devalue the Yuan and Congress, in an effort to win elections, looks like it's ready to start a trade war.

The fact that the dollar is giving up the ghost shouldn't come as a big

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surprise to anyone given the fact that it failed four times to move through strong resistance at 89.97. Also, the fourth attempt was part of the large head-and-shoulders formation you see above, and now we've broken down through the neckline. Along the way we've seen an almost gradual deterioration in RSI and the MACD as the 50-dma falls closer and closer toward the 200-dma.

The promise of an almost infinite supply of dollars coming out of Washington, along with a complete lack of fiscal responsibility, will do three things:

  • It will drive the greenback down to a new all-time low by early spring of 2011,
  • It will drive the price of gold much higher, and
  • It will drive all other currencies generally higher but one currency will benefit more than others, the Swiss Franc.

Does it seem strange to anyone that the Swiss Franc is the only the only fiat currency to make a new multi-decade high:

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On Friday the Franc traded as high as 1.0234, a new intraday high, before intervention left it unchanged at 1.0155 and well above par. As you can see below, neither the Euro:

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nor the Yen can make that claim:

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and neither can the Canadian dollar nor the British Pound although their charts aren't shown here.

Now here's the interesting question: why is the Swiss Franc the only currency to break out to a new multi-decade high? It isn't because the demand for chocolate has skyrocketed or that the Franc is a reserve currency, because neither is the case. Years ago I told my clients that I accumulated Swiss Francs for one simple reason, and that has to do with the fact that it's an insurance policy. When things go wrong in the world, the smart money makes a bee-line straight for the Franc! They know that the Swiss aren't going to nuke anyone, and no one will nuke them (even the bad guys keep their money there). Switzerland's main business is money so over the long run they will always do what is in the best interest of the Swiss Franc. By the way that is the opposite mentality of the Fed's approach to the US dollar. The dollar is the reserve currency of the world and yet the Fed is dedicated to destroying it! When you stop to think about it, that's quite a contradiction.

Is there any better protection than the Swiss Franc? The answer to that question is a resounding yes and the object of my affection is gold and its humble cousin silver. Gold is well on its way toward a tenth straight year of gains, more than any other index, currency, commodity, or bond in the world and yet almost no one knows about it. Why do you think that is? The reason is simple: gold is the mirror into the soul of the Federal Reserve. If gold is grinding higher month after month and year after year, it's because the Fed is doing a poor job. Since the Fed doesn't want you to know what a lousy job it does, it prohibits audits of its balance sheet and the nation's gold supply, it suppresses the price of gold, and it stifles any positive comments on the yellow metal. It's kind of like sweeping dirt under the rug, you have the illusion of cleanliness but it's just an illusion. The Fed does that because it has no assets, other than a printing press, and every time it prints a dollar it is really creating more debt.  That is a wonderful environment for gold if

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you take the time to stop and think about it. Gold can't be created out of thin air, it's a store of wealth, and it's known around the world. No politician or central banker can push a button on a keypad and create a bar of gold. It must be dug out of the earth at great expense.

This week we saw gold make consecutive all-time closing highs as it went out on Friday at 1,297.00 after trading as high as 1,300.00 on two occasions. This is significant because it spent time above the critical 1,298.10 resistance level in what was the first ever test of that level. I'm going to let you in on a little secret; it won't be the last test!  With

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that in mind take a look at the daily chart for gold. With RSI at 78.00 gold is extremely overbought and due for a reaction. Look at the run-up since the July low; no more than a three day reaction along the way. I am looking for a nine to eleven day reaction that could take gold back down to the 1,236.00 level and scare away the Johnnie-come-lately's. Of course that will bring out all the top callers and as usual they'll be wrong. As far as timing is concerned, I wouldn't be surprised to see the reaction begin as early as this week. Then it's off to test the next level of resistance at 1,372.80 which happens to be my projected top for this leg up.

As good as gold looks, silver looks even better and that's been the case

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for more than a month. Spot silver closed at 21.45 on Friday and well above what was critical resistance at 20.98 for the second consecutive session. Like gold silver is also extremely overbought and due for a reaction, but that doesn't mean we'll get one, it just means we're due for one. Both gold and silver have astronomically high price targets in their Point & Figure charts, at 1,560.00 and 29.00 respectively, and they just might get there. Time wise I don't think this move higher will run its course until the end of December or the beginning of January, and if the Fed really screws up, the Point & Figure price targets could come up well short of where the unraveling dollar eventually takes us. It's worth remembering that the general public has yet to enter this market, and fear of a collapsing dollar could be the catalyst that forces them to act.

Perhaps the most fascinating market of all today is the stock market. We have real drama as the Fed is trying to move mountains in an effort to genetically alter a bear, turning it into a bull. The drug of choice is fiat currency and the weapon of choice is the printing press. On Friday the Dow had what appeared to be a stunning rally as it surged 197 points to end the week at 10,860 and well above the August closing highs for the third time in a week. Under the surface we see a slightly different story as volume was quite light, advances led declines by slightly more than 4:1 which is light considering the big up day, it was not a 90% up day, and most importantly the Transports failed to confirm for the third time in a week and by less than one point. Yes, the Dow made higher closing highs but the Transports failed to confirm not once but three times. The longer it takes the Transports to confirm, assuming they eventually do confirm (I don't make that assumption), the less meaningful the confirmation.

Right now we are bearing witness to one of the greatest battles of all time, the lie versus the reality, and it's "live on CNN". I think reality will take the day but I am the first to admit that I am extremely biased. Aside from all the obvious shortcomings I already mentioned above, it

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is also about to enter extremely overbought territory and stocks are sporting a PER of 21 as well as an average dividend yield of 2.25%. Both are indications of bull market highs and not bear market lows. So where to from here? The majority would say stock prices are headed higher, but I couldn't disagree more.

Aside from the failure of the Transportation Index to confirm the Dow, I also see increased weakness in the Baltic Dry Index as you can see below:

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The BDI has broken down after failing to penetrate the 200-dma. Now it looks like it wants to cross below the 50-dma which is already well below the 200-dma, and that would be yet another bearish indicator that worldwide demand is on the wane. Finally, while the Dow rallies the Shanghai Stock Exchange has gone nowhere and late last week fell below its 50-dma that in turn is below the 200-dma. If China can't rally the troops with almost US $3 trillion in assets, what chance does the Fed have with US $67 trillion in debt? The answer is none, at least over the medium and long run.

Right now it's a battle between the Fed's printing press and the primary trend of the market which happens to be bearish. Like the bond market the Fed is slowly becoming the buyer of last resort for stocks. Government has spread its tentacles to the banking, mortgage, healthcare and auto industries, and now it wants to be market markers for stocks and bonds. It seems that the Obama administration is trying to expand Big Brother's sphere of influence exponentially, and since this expansion needs to be financed, that means more debt. Meanwhile back at the ranch unemployment is on the rise while commercial and residential defaults are climbing. We're heading toward mid-term elections and no one has any real concrete proposals. The Republican's want to cut taxes but fail to mention how they'll deal with the debt problem. I'm sure that was just an oversight on their part and they have it all worked out. Campaigning is big business, as well as business as usual, as both sides try to tell the people what they want to hear. My hope is that the American electorate will finally break the mold and look for quality instead of quantity, but I am skeptical. I've seen the Perot's, the Mondale's, the Jesse Jackson's, and even the Kennedy's come and go and it always falls back to the good old boys and business as usual.

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September 26, 2010