Bubble Trouble

A crack in the 'bubble wall'?

In our July-25 commentary at www.speculative-investor.com we described a number of early warning signs that the giant US credit bubble had entered its terminal stage. Amongst these 'things to lookout for' was a breakdown in the stock prices of the Government Sponsored Enterprises (GSEs).

The GSEs have played an important role in perpetuating the credit bubble by making a virtually unlimited supply of credit available for the purchase of homes and the re-financing of existing mortgages. After all, the GSEs are not hamstrung, as the banks are, by the need to maintain a certain level of reserves relative to their liabilities. The ready availability of credit for anyone wishing to take out a mortgage or re-finance a mortgage has helped push property prices higher even as economic growth has ground to a halt. Higher property prices and the ability of home-owners to monetise the equity in their homes have, in turn, boosted consumer spending and led to a build-up of money in money-market funds. The money that is currently sitting in money-market funds earning 3% per year will, of course, eventually find its way into the economy, thus pushing other prices higher.

The largest of the GSEs is Federal National Mortgage (NYSE: FNM), affectionately known as Fannie Mae. The Fannie Mae stock price surged during the final 5 months of last year in anticipation of the coming Fed rate reductions and the mortgage re-financing boom, peaked immediately prior to the first Fed rate cut, and has been in a flat consolidation for most of this year (see chart below). It is now starting to break down, having just fallen below its medium-term up-trend and its 200-day moving-average.

Friday's break below the 200-day moving-average is perhaps even more significant because it happened on strong volume and on a day during which the Dow gained 200 points. Major support is around $72 - a break below $72 would be a signal that the credit bubble is on its deathbed.

The other early warning signs that the Bubble was in trouble were identified as being:
a) A substantial and prolonged fall in the US$. For an extended period leading up to the bursting of previous major credit bubbles (eg, Japan in 1990 and the US in 1987), the currency of the bubble economy has trended lower. As such, we expect the final phase of the current US credit bubble to be characterised by a downward-trending Dollar. The Dollar began its decline in either October of last year or July of this year depending on whether we use, as the starting point, the peak in the Dollar's value relative to the euro and the SF or the peak in the Dollar Index. Either way, the downtrend has a long way to go.
b) Major rallies in gold and gold stocks. So far we have only seen a few hints of what is to come in the gold market.
c) A large fall in bond prices. Bonds are still in the process of topping, but we expect much lower bond prices (much higher long-term interest rates) once the effects of the massive inflation of the past 10 months work their way through the US economy.

The ducks remain in line

In our recent article "Manipulation Versus Natural Market Forces" we made the argument that market forces were gradually getting the upper hand over the on-going attempts of governments and bullion banks to manipulate the gold price lower. In the article we described what we consider to be the three most important natural influences on the gold price - the US Dollar's exchange rate versus the European currencies, the yield spread, and the inflation-adjusted (real) interest rate. The trend in each of these influencing factors turned positive for gold during the final quarter of last year and remains so to this day.

Note that we did not include changes in the supply of newly-mined gold or the fabrication demand for gold as important influences on the gold price. This is because the gold price is primarily determined by investment demand (investment demand is the main driver of the gold price whereas fabrication demand is driven by the gold price). The investment demand for gold is, in turn, determined by such things as the level of confidence in the Dollar, perceptions regarding inflation and the real rate of return on US$-denominated securities. 

From time to time over the past several years different factors have come into play to make a gold rally appear likely. However, the last time that all the important ducks were lined up the way they have been since November of last year was during the first half of 1993. For those with short memories, the first half of 1993 was a very good time to be invested in gold stocks. 

Other ingredients, such as dangerously-high leverage within the financial system and a massive short position in physical gold, have been added to today's gold market mix. These other ingredients are usually portrayed as being positives for the gold price, which is partly true since they could potentially result in an explosive rally of $100 or more. However, because the total short position is too large to be covered without causing an enormous rally and, therefore, without causing the players involved serious financial damage, there is a powerful incentive to step-up the selling pressure whenever the gold price begins to edge higher. This effectively eliminates the possibility of a prolonged steady rise in the gold price. Instead, if the underlying trends in the financial markets remain positive for gold then the pressure will just continue to build until there is a price explosion.

As long as the financial market trends remain positive for gold we will continue to emphasise gold-related investments, particularly when price-action is also constructive as it has been for gold stocks since November of last year and for gold since April of this year.

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