Now what is the plan......and what is working?

Market has been doing quite a few fakeouts over past few weeks. I remain bearish although I am near throwing in the towel on gold. I have also come up with a potential bearish thesis on gold that my explain some of my pain and the future pain of many others. (Important note: I am still long a small position in Newmont Mines and remain long-term bullish - but I am questioning the probability of a quick rise above $500 level over next 3 months). It will help to get to this idea by first laying out the bullish case again. Gold should excel under any of the following scenarios:

1) Weakening dollar
2) Rising inflation
3) Lower interest rates

The funny thing though - is that all of the above are closely interrelated and affect each other. I think one of the biggest factors at work affecting all of the above is the Fed. The Fed has made a credible commitment to the public and the markets that they are A) aware there is inflation out there and B) are going to be closely monitoring it and removing accomodative monetary policy. This means that they are going to continue to jawbone the market and raise the short term interest rate to back their credibility.

It is very possible with the economy still showing signs of strength that the tightening cycle could continue far into next spring with even 5.5% or 6% being the ceiling. I have also heard calls that we might see 50 basis point hikes in November and December - although I consider that highly unlikely.

The main bearish case for Gold is quite simple actually - Gold excels in an environment where inflation is running faster than the growth of the economy. In other words - where the majority of the growth in the economy is that of paper money and price increases as opposed to real economic growth of output and productivity gains.

We certainly had plenty of this over past 3 years as tons of money were pumped into system by the Fed, however now we have the reverse. Gold recognized this and benefitted from it - rallying from $250 an ounce to $480 an ounce over 5 years - a 100% increase (20% annualized) - that is certainly nothing to scoff it - especially as relative to the stock market.

Now we have a situation however, where the Fed has progressively over the past 12 months - begun to change its stance from an accomodative policy to a restrictive policy - trying to remove liquidity and money from the system and slow the economy, commodity prices, and inflation.

In effect the huge inflation numbers that we are seeing coming out (re: PPI and CPI) may already be priced into the gold market and are currently in the process of being priced into the stock market. As the Fed raises rates we can anticipate that the economy and inflation should slow over the coming 12 months. If market (including gold market) is a forward pricing mechanism - I would expect gold to continue to decline in anticipation of this (note: I do not expect it to fall below $400 an ounce again - but I do think low $400s is possible over next 12 months).

Finally, what the gold market and gold bulls may really be waiting for - is the economic collapse that may follow here. The huge bubble of debt which is the American economy (extremely finance based economy) - should struggle mightily even under moderately higher interest rates - re: 6-8% range as opposed to 3-5%. As the costs of so many borrowers increase, just as their ability to service their debt also decreases - they may lose their job in a finance related area of the economy (take your pick -real estate, lending, stock market, etc.)

To clarify - gold bulls are not waiting for the "economic collapse" per se - they are waiting for the government's regulatory response which will certainly not be immediate, just as they have been slow to recognize that inflation is in fact - out there. If this Fed rate hike cycle kills the stock market and now (property markets) as the cycle in 2000 did - the Fed might once again be quick to pump liquidity back into the system to try and prop things up. At that point - I think our economy would be at its weakest stage - but we would probably finally see the following: 1) collapse of the dollar, 2) inflation begin to rise quickly again, and 3) rising gold prices.

That is one of the reasons, I am not rushing to buy Gold again - although I may have just been faked out by last weeks shellacking and I am waiting to get my mojo back.

Now regarding the XLF short - which I believe we will see working here again soon. Just as inflation numbers are popping out of control, and the Fed is publicly stating repeatedly - that they know it is out there and plan to kill it - longer term interest rates are in great flux. Here is the yield curve chart courtesy of Yahoo:

We see two main things - 1) rising longer term interest rates which are causing increasing mortgage lending rates and changes in underwriting standards (both are important) and 2) a narrowing of the spread between shorter term and longer term interest rates (now less than 100 basis points - at 93!!!!!).

Banks and other financial institutions rely on this spread to make their money. When it is flat or even negative investors become quite negative on the financial sector in general. We would also expect to see less lending volume to consumers at the higher rates. Additionally and maybe most important, as the variable rate mortgages adjust and consumers begin to default on loans - Banks will probably move quickly to shore up their quickly declining capital ratios v. loans outstanding.

Perhaps most at risk here are the portfolio lenders - those financial institutions that did not resell their mortgages in the secondary market to Fannie Mae or Freddie Mac, and instead are counting on profiting from the numerous lower interest rate mortgages that they originated over the past 3 year. They may also be surprised to find that the derivatives they purchased to hedge the interest rate risk - do not work quite in the manner they predicted. It would also seem logical that the mortgage insurers (re: PMI and Radian) would take a hit here.

Instead we see the homebuilders taking it on the chin FIRST!!! I would think that all of the above has quite a close correlation. We should not have a decline in the demand for housing and a rise in supply of it at same time without also questioning the potential price impact on collateral values (re: homes) and also the quality of the loans that are outstanding on the existing homes.

I expect sometime over the next 6 months that the Financials as a sector are going to have a "come to jesus meeting" with Uncle Al. This is not going to be pretty.....

What is the counterpoint - banks are still reporting excellent trailing earnings and pay healthy dividend yields to investors. Wall street analysts also continue to make bullish forecasts for the financial sector. I have also read recommendations to go long financials such as Fannie Mae, Commerce Bancorp, and CitiBank - even into the beginning of the down cycle (all IMHO of course).

Anyways that is why I decided to remain short the XLF and we will just have to see how this plays out. ;) It will be important to watch the language of the next Fed meeting in November. Hopefully the PPI report scared the bejeesus out of them.

Regards,

BG