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If you had told me late last year that we would soon see both the dollar and gold rally, I would have dismissed you as nuts. But this is exactly what happened after the dollar made a short-term bottom in mid-December. In early December, I suggested that the dollar had formed a double-top making it likely the dollar was headed lower. The dollar did sell-off, but it quickly rallied right back to the resistance formed by the double-top.
At the same time, gold has finally broken out of the pattern of lower lows and higher highs. It is now up almost 10% for the year. Last year, I said that gold would be my favorite place to be in 2009. So far, so good.
While gold was working off late 2008's downtrend, I was fascinated by skeptics who observed that gold had "every reason to blast higher" given the world's economic chaos and yet had done nothing. From a short-term trading perspective, such contrast certainly takes the gold trade off the table. But from the perspective of longer-term capital preservation on a planet where currencies are growing (or will be growing) on trees, the disconnect simply meant there were more immediate things on the collective minds of investors.
The fear of deflation and other assorted global economic calamities had everyone focused on taking shelter in U.S. Treasuries and the dollar. But as those fears slowly (very, very slowly) subside, more and more attention has turned to gold. But we are only just getting started. It is nearly impossible to say when inflation will become a problem only that it will likely be a problem once credit finally gets converted into investment and purchases again to take advantage of all the liquidity facilities being provided by the Federal Reserve. Some point out that Japan is an example where massive liquidity accomplished very little, and the same fate awaits the U.S. But from what I understand about the yen carry trade that took advantage of the low borrowing costs in Japan, Japan in a sense "exported" inflation to the rest of the globe. Investors took advantage of Japan's cheap money to inflate assets all over the world where there was appetite to borrow, consume, and repeat. (Please correct me if I am wrong! PlanetMoney from National Public Radio has an interesting podcast on the lessons from Japan's lost decade. You can skip to the 4-minute mark). I am not yet clear how the U.S can export its inflation away when more and more central banks are dropping rates to rock bottom levels. In this scenario the supply of gold relative to paper money is rapidly decreasing. Moreover, America has been a global pioneer in financial engineering. I have full confidence that smart bankers are already mapping out long-term strategies for generating profits that will help drive future reflation.
Even if the velocity of money takes forever and a day to build up to inflationary speeds, I strongly suspect that the Federal government will attempt to inflate its way out of its massive debt. When the bills come home for all the financial repair work being done in this country, there will be little appetite for increasing taxes enough to pay down this debt in any significant way. The economic multiplier from stimulus programs will also not provide sufficient tax revenues. America's biggest and most cooperative foreign creditor, China, has probably just served us notice that they will not help us more than they already are helping. China currently holds 12% of the $5.75 trillion in U.S. marketable debt. Inflation will be the indirect tax that will confront lower legislative hurdles.
I am focused now on just two other commodity plays for core positions: silver (SLV) and copper (FCX as an approximate proxy). SLV is up 20% this year while Freeport McMoran (FCX) has chopped around in a trading range. Late last year, I was premature in making bets in the falling knives of commodities like copper and steel. I ended up with a lot of profit in puts, but not quite enough to eliminate the pains in the related stocks. I plan to pick my spots for steel very selectively and for shorter-term moves. So far this year, I have liked playing Cliffs National Resources (CLF) and Nucor (NUE) after sell-offs. I thought I would include U.S. Steel (X) on this list, but it has been stuck drifting in a downtrend all year. My thinking is that I will not be smart enough or fast enough to time the switch from deflation to inflation; I just know I want to have at least a small core position ready for whenever that time comes. Outside of that, I am mainly biased short for now.
I will end with a quick look at the S&P 500. Since I still believe fresh 52-week lows are coming in the near future - news and rumors of government economic plans notwithstanding - I tread very carefully and selectively with any longs. In the past month, we have had three separate high-volume selling events that have attempted to break the support that still holds from the "the December wash." Each bounce from support seems to produce more hope that we are building a base for a sustainable bottom. There are also a good number of stocks that have hit fresh highs for the year just in the past week. But once it is clear that a modest recovery in the 2nd half of the year will not make its annually scheduled appearance, the major indices will be sold to fresh lows (I may have to make an exception for the NASDAQ which has proven particularly resilient so far in 2009). In the meantime, the stock market will continue to predict this imminent (soon to be elusive) recovery over and over and over again.
Be careful out there!
Full disclosure: long FCX, SLV, GLD, TIP, and the S&P 500 in an index mutual fund. For other disclaimers click here.