Markets about to turn the screws on the Fed?

Below is an extract from a commentary originally posted at www.speculative-investor.com on 25th October 2006.

A massive credit expansion facilitated by the Fed's monetary largesse fueled one of the world's greatest ever stock market bubbles, and when this bubble eventually went 'pop' in 2000 the Fed facilitated an even greater credit expansion in an effort to mitigate the economy-wide effects of the bursting stock market bubble. At that point the credit expansion began to influence other markets to a much greater extent than the stock market, causing a juvenile real estate boom to develop into the 'bid daddy' variety and setting in motion major upward trends in commodity prices.

Last week gold stocks broke out of their downtrend resistance channel as the XAU popped above the 130 level. The market tipped us off that a bullish move was in making, because gold stocks outperformed the metal last Monday and Tuesday before breaking out. In fact gold fell over 20 points on Monday and Tuesday while gold stocks went up. It's easy to forget that this happened since it was a week ago, but it was a key event in the development of this new gold stock uptrend. Remember gold stocks tend to lead the metal so if they trade up while the metal drops its a very bullish sign. As I've written before, I believe we are on track to see the XAU go up to the 145-150 area by Thanksgiving.

Shares of TheStreet.Com crashed yesterday as the stock failed to meet analyst projections. This is what happens with growth stocks when the growth stops and is an example of the momentum mania going on in the stock market today. Fund managers buy buy buy, because of a story and panic when they see a dark cloud.

It seems that the Mad Money effect peaked months ago. TheStreet.com's subscription revenue fell 1% sequentially in Q3 (excluding its acquisition of Weiss Ratings), versus growth of 10% in Q2 and 17% in Q1. Take a look at the number of times that Cramer's name has been typed in Google and how it has shrank over the past few months:

I want you to remember yesterday. I want you to remember the headline sitting on CNNFN.COM before the market opened titled "Days of Big Oil Are Over." Well, right after CNNFN.COM posted that oil traded up $1.50 and by the end of the day had broken out of its downtrend to turn up:

And of course gold stocks broke out of their reverse head-and-shoulders bottom formation and are trending up too! The XAU and HUI are on track for a 10% gain over the next few weeks.

It's amazing how nothing changes. The masses are always wrong at the key turning points, and so is Wall Street. Sentiment for commodities has been awful the past few weeks. When I went to the Toronoto Gold Conference just a few weeks ago no one was really interested in buying new stocks. And CNBC has been calling for a new bear market in oil for weeks too. The CNNFN.COM was just the most blatant negative headline, and it came at the silliest time to call for an end to commodities.

Every morning I spend 30-45 minutes going over the news stories. I check out the leading financial websites and some commentators that I follow too.

On CNNFN there is a headline that says "Days of Big Oil Are Over." When I click and read the story it notes that oil is trading up this morning. It seems that no one has anything good to say about oil or commodities anymore.

Well, no one except gold bugs who have been in gold for some time and understand what is going on. Hedge fund manager William Fleckenstein wrote this:

"As to what that might be, a knowledgeable reader (who essentially does nothing but trade gold shares -- and rather successfully) pointed out that it wasn't just NEM and PAAS yesterday but the whole gold-stock group that's been giving off bullish signals for a little while now. He noted that when gold-share prices dig in despite an extremely weak gold price, and it's after a major correction, it's one of the best signals that a turn is at hand. (Certainly, if you looked at a gold chart this morning, you could see how it might illustrate the right shoulder of an inverse head-and-shoulders bottom, which is a development I've been thinking might occur.)"

I use TC2007 to discover new stocks and sectors to buy and to keep track of what I own. Over the weekend I did a scan of all of the exchange traded funds to try to find at least one that looked like it was going to make a big leg up. Using this software it only takes a few minutes to flip through hundreds of charts. The ETF that stuck out the most was ILF - The S&P 500 Latin America 40 Index Fund, comprised of 40 ADR's from countries below Mexico. With a little more research I found that all of these countries have been going through huge bull markets over the past few years and have sported high rates of GDP growth.

In yesterday's WSW Power Investor Pre-Market Bulletin I made note of the fact that the stock market appears increasingly vulnerable. Weekly indicators are signalling that it is totally overbought and according to Investors Intelligence there are now as many newsletter writers proclaiming themselves stock market bulls as there were back in April, right before the market's last big correction. Jim Cramer is now telling people to jump into tech stocks while CNBC talking heads are saying that energy is in a bear market.

There has been a strong correlation in the past few years of the DOW rising when oil falls and the DOW falling when oil goes up. Well oil is now oversold on a weekly chart just as the DOW and Nasdaq are overbought. All signs point to a rally in commodities. If the pattern of the last few years holds then you can expect the broad market to weaken as commodities go up.

Oil is on the move. As I noted yesterday it had fallen so much over the past two months that it became more technically oversold then it had been at any point in the past six years. This month oil stabilized and went sideways as it put in a bottom and based out. Yesterday it broke out of its two month long downtrend resistance line. The trend for oil is now up.

And it's not just the charts saying this. It's logic too. OPEC is meeting on Thursday to discuss production cuts. And don't forget we are now entering winter heating season, which historically has been a bullish period for energy stocks. Oil should now trend up through the end of the year. This correction has provided an excellent entry point for people wanting to position themselves in energy, just as the recent correction has done the same for gold.

On Friday, the XAU closed above its 20-day moving average while breaking the downtrend line connecting its two September peaks. This serves as confirmation that the XAU and gold stocks did indeed bottom. The trend is now up.

Short-term resistance on the XAU is now at 131 and then 135. The 1/3 retracement level of the September-October bottom at 131 is also the point of the XAU's upper daily bollinger band. I think we're likely to see the XAU go up to this level and then pull back down into the 124-128 area and then proceed higher.

The XAU is on the verge of giving an intermediate-term buy signal. It currently has resistance at the 125 level. This is the high of the past week, the mark of its downtrend resistance line connecting the September and October highs, and is also the point of the 20-day moving average. That's important because if you go back over the past 15 years every time the XAU had a correction, bottomed, and then closed above its 20-day moving average it rallied for at least a month. What is more if the gold stocks rally and outperform the metal today then the XAU/gld and HUI/gld downtrend resistance lines will be broken too. All the XAU needs to do is close above 125.79 to break all of these technical levels.