Kitco
 

A Necessary Correction

 

By Gary Savage

Sep 3 2008 3:56PM
www.garyscommonsense.blogspot.com

   

I’m going to look at the current dollar rally from a very long term perspective. In the first chart I’ve noted the monthly Stochastic levels. I’m pointing this out not so much as a tool to trade the dollar rally although one probably could develop a successful strategy by watching the monthly Stochastics. What I really want to look at is human emotions.

One thing that we can always depend on as investors is the fact that human emotions never change. One thing that never changes is the swing from one extreme to another. There is no half way when it comes to human behavior. This is illustrated nicely by the monthly Stochastics on the dollar chart. During the first leg down in the dollar Stochastics got oversold and stayed oversold for 3 years. At the point where this negativity became too extreme to be maintained any longer, we got a counter trend rally. That rally didn’t just bounce back up to a median level and then roll over again. No this bounce continued for almost a year and didn’t rollover until it pushed the monthly Stochastics into overbought levels. Those overbought levels are a very good representation of human emotion. Investor sentiment had to move to an extreme bullish level again before the dollar rally could finally roll over.

Now realistically did anything change fundamentally about the dollar? Hardly! The Fed was still on a liquidity campaign. The fundamental story was still the same. All that happened was that human emotions needed to move back to a bullish extreme before the dollar could continue its secular decline. Once that was accomplished the dollar turned tail and followed the fundamentals back down to new lows.

Now the dollar is in the same situation again. Bearish sentiment has become too extreme to be maintained any longer. The dollar needs to rally to work off that bearishness. Don’t expect this to end until sentiment again becomes too bullish. While this unfolds commodities are going to be under pressure.

The next chart is the weekly chart of the dollar. One could rationalize that since the weekly oscillators have now become overbought the dollar should be ready to roll over and continue down. However take a look at the period between 99-02. The dollar was still in a secular bull market at this point. Notice that in a bull market the oscillators can become overbought and stay overbought. That’s how bull markets work. Again it all comes back to emotions. Once investors become optimistic it takes awhile for that optimism to turn. So just because the dollar is now overbought I don’t think I would automatically assume that a major correction is imminent.

Now I want to relate this to the precious metals market.

I think its safe to say that bullish sentiment towards gold and especially oil became obsessive recently as gold rose above $1000 an oz. and oil traded up to $147 a barrel. In my opinion the longer this continued the less chance we would have had of seeing this secular bull market continue. All bull markets need to go through major corrections from time to time, to reset the bar so to speak.

Without 1987, 1990, 1994 and 1998 I seriously doubt the bull market in stocks would have lasted anywhere near as long as it did. It certainly wouldn’t have developed into the massive bubble that peaked in 2000. These corrections while certainly scary and probably costly for many investors did what they needed to do. By that I mean they wiped out the bullish sentiment allowing the stock market to reset and build a foundation for the next leg up.

Take a look at the oil market in 06. That massive decline was absolutely critical to set the stage for the recent parabolic spike we just saw in oil. Without that correction I dare say there is no way oil would have come close to $147.

We saw a correction in gold during that same time only it was no where near as severe. I’m going to suggest that we absolutely must see the precious metals correct and correct hard, not only price wise but time wise. The only way we are going to see a Dow:Gold ratio of 1:1 in the future is if everyone gets shaken off the bull from time to time. Sentiment needs to turn black and hope must be crushed before this secular bull market will have any chance of continuing.

My current estimate is that it will take at least a year to work off 7 years of built up optimism. Actually the three year cycle in the CRB isn’t due to bottom until late 2009 or 2010. If one understands how emotions work we can be prepared for this correction and actually welcome it for two reasons. First: We’ll understand that a massive correction is essential for the next phase of the bull to have any chance of developing. Second: This correction is going to give us the opportunity to buy in at prices none of us thought we would ever see again.

As long as investors know what to expect they will be much better prepared to take advantage of the opportunity that’s coming. Hopefully they won’t get caught on the slope of hope as the precious metals work their way through this correction.

Gary Savage
The Smart Money Tracker

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Gary Savage is currently retired and lives in Las Vegas. He is the author of the Smart Money Tracker, a financial blog with special emphasis on the gold secular bull market.