the dow ~ richard russell comments

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    Given recent discussion on deflation, I thought this was relevant.

    May 17, 2003 -- "No stopping the historic rate dive," says Investor's Business Daily in headlines. Yep, interest rates on US Treasuries have dropped to 45 year lows, and the bond market discounts deflation.

    Further deflation news -- Core inflation has hit a 37-year low. The Consumer Price Index dropped to 0.3% in March. This was the biggest drop in 19 months.

    To make a long story short, deflation is blowin' in the wind. The wind has already blown strongly across Japan, and the Fed is scared silly that the deflation wind is about to waft over the US. The antidote to deflation, of course, is inflation, inflation and well, more inflation. Which is what the Fed has been doing.

    Interest rates have been pulled down and down, the money supply has been blown up and up. But what if the banks can't find borrowers, and what if manufacturers are already producing too much in the way of goods, and what if manufacturers don't want to borrow and what if commercial and industrial loans keep sinking (which they are)?

    Well if all the above materializes (and it is), then money turnover or velocity sinks and it becomes almost impossible to "stimulate" the economy.

    The danger of deflation is that because actual interest rates can't drop below zero, deflation makes negative real interest rates unattainable. And how the devil can Alan Greenspan and crew drop rates if they're already at zero?

    No one yet knows whether the US is heading for actual deflation. But believe me, the Fed is thinking about it, even though they deny the possibility of deflation almost daily.

    The danger of deflation is that consumers put off buying because they think goods will be cheaper tomorrow and the next day.

    Deflation is a problem because in deflation debts become much more difficult to service.

    In deflation, banks loan less and this is a pressure on the money supply. It can shrink during deflation.

    In deflation, corporations cut back on their activities, because they are preparing for slowing business and lower prices.

    Perhaps worst of all, during deflation the mind-set turns to saving, since money becomes worth more, and because pressure is on all prices. As far as manufacturers and stores are concerned, pricing power is nonexistent.

    The world has survived deflation before. But today something new has been added. It's the massive differential between US wages and Asian (Chinese) and Indian wages. This has forced US manufacturers to transfer billions of dollars worth of manufacturing facilities overseas while at the same time firing thousands of US workers. These are not just jobs temporarily shut down, they are jobs that are permanently lost.

    OK, enough. How about the stock market? The stock market is overbought, we know that. And the stock market will correct, we know that. How big a correction? We don't know that. I expect the correction to start any time -- very likely next week.

    Friday the McClellan Oscillator dropped to the 50 level, a level which has found support on four occasions during March and April. If next week the Oscillator drops below 50, I think we will soon see the Oscillator below zero and the correction of the overbought condition will be on.

    The point & figure chart on this site shows the VIX plunging to the "high-complacency" area around 20. This is the area where many corrections have started.

    On top of that we have the very wide spread between bullish advisors and bearish advisors with bullish advisors above 50% and bearish advisors down in the high 20s. This jibes with the VIX situation -- too much bullishness, too much complacency on the part of option-writers.

    Then there is the matter of the price structure. I noted on Friday's site that the D-J Transportation Average has bettered all its preceding peaks going back to August and that it has even bettered its August closing high of 2463.96. But the Industrials have failed to confirm. In fact the Industrial Average shows a long series of declining peaks such as the August 2002 peak of 9053.64, the December peak of 8862.57, and the most recent January peak of 8842.62.

    OK, so we have a situation where the Dow has persistently failed to confirm the recovery high in the Transports.

    Beyond that we have the "rising wedge" pattern in the S&P which you can see on the chart below. A rising wedge is a bear market pattern, although it should also be accompanied by declining volume. As a rule, when the price falls out of the wedge, the rise is over. We'll see if that's the case in the current instance.

    At any rate, the above will give you some idea of the background for the market, at least as I see it.

    For the week ended May 16 the true (common stocks only) advance-decline ratio was as follows: May 12 plus 36; May 13 plus 34; May 14 plus 30; May 15 plus 53; May 16 plus 49.

    As for valuations, the S&P as of last week was selling at an absurdly rich 34.23 times earnings while providing a mini yield of 1.74%.

    Since historically dividends account for roughly two-thirds of total return, you can see what a huge disadvantage today's 1.74% dividend yield represents.

    No matter, since today 70% of the transactions on the NYSE are made by mutual funds, hedge funds, pension funds and other professionals. These people are playing with O.P.M, otherwise known as "other people's money." The pros are playing a comparison game with the S&P, meaning if the S&P drops 20% and their fund drops 16% they're ahead of the game -- but you're not.

    Last week the Confidence Index rose to 72.3 from the previous week's 69.5. Thus, the bond market feels better about the state of debt, and that's a plus for the markets.

    Gold -- Subscribers may be wondering why the gold shares are so reluctant to rally, despite higher gold prices. One reason is that gold is generally sold in dollars and the dollar has been sliding. Where gold workers at the mines are paid in rising currencies, gold is sold in dollars, a falling currency. That works negatively on many mines.

    The other reason, and I've stated this before, is that BIG MONEY buys the metal. Obviously, gold itself is the pure play. The public, when they eventually come into the gold market, will probably buy the stocks, because in many cases they're cheaper than the metal, and the stocks have the leverage.

    In the end, a bull market floats everything higher. Which is what I expect in gold and gold shares. New subscribers ask which gold shares to buy. At this point we're all just guessing. As a start, buy NEM, ABX, GG, GLG, RGLD.

    Back in 1949 George Schaefer wanted to demonstrate how a bull market works. He started two actual funds with $50,000 in each. One fund held only blue-chip stocks, the other only low-priced stocks and "cats-and-dogs." He predicted that the blue-chip fund would beat the low-priced fund during the first phase and the second phase of the bull market.

    But during the third phase he predicted that the low-priced stock fund would climb above the blue-chip fund. He was right, and that's exactly what happened. I believe the same thing will happen with the gold shares. So at this point I'd advise buying the quality gold stocks.

    And that does it for Sa*urday. I'll catch you all on Monday, and as I said, next week should be very interesting.

    Over and out,



    U.S. bankruptcy filings rose to a record high in the
    12 -month period ending March 31, U.S. court officials
    said on Thursday, as the weak economy hurt personal
    finances. Bankruptcies rose to 1.61 million from 1.5
    million in the 12-month period ended March 2002,
    the Administrative Office for the U.S. Courts said in a
    release. The number of bankruptcies in the first
    quarter rose to 412,968, up 4.5 percent from the
    previous quarter, the court office said. ``The number
    of filings continues to break records,'' it added. The
    quarterly figure is the highest in the last nine years. A
    spokeswoman for the courts said she believes the
    number is the highest since the courts have been
    collecting the data - CNBC

    michael k. mattheiss
    when the student is ready the teacher will appear

    Russell Comment -- If deflation hits, you'll see a rising total of bankruptcies you won't believe.

    Dear Richard,
    You often caution your subscribers to never take the BIG LOSS. I came across a good example of why that is important. The following is from the prospectus for the ING Russia Fund.

    Year by Year Total Return Value of $100.00 investm

    1/1/97 $100.00

    1997. Plus 67.50 % 1/1/98 $167.50
    1998. Minus 82.99 % 1/1/99 28.49
    1999. Plus 159.76 % 1/1/00 74.01
    2000. Minus 17.80 % 1/1/01 60.84
    2001. Plus 80.32 % 1/1/02 109.71
    2002. Plus 24.72 % 1/1/03 136.82

    The fund was able to show a gain of 36.82 % over the six-year period. But look what spectacular gains were required to offset the 82.99 % loss in 1998. It should be noted that the $136.82 value at the end of the period can be calculated from the equation:
    136.82 = 100.00 x 1.675 x .1701 x 2.5976 x .822 x 1.8032 x 1.2472

    Since the order of multiplication is not important, It follows that when the big hit is taken is not important. Whether the big hit comes early or late does not matter.

    Hoyle Julian

    Russell Comment -- To me, the important thing to note here is the huge percentage declines in 1998 and 2000. Who has the stomach to sit through those declines? Odds are that if you bought in 1997 at $100, you'd have dumped in 1998.

    That's the fallacy of "holding for the long term." Sure, stocks have risen in the long term and may continue to do so. But when, for instance, the Nasdaq 100 declines by 80%, who in his right mind will hold the Nasdaq stocks through that kind of decline?

    Famed professor Jeremy Siegal says "hold stocks for the long term." Yeah, right. Jeremy, did you hold your Nasdaq stocks through the bear market?

    And that's why professors don't run money. Theories are great, but stomachs are weak and nerves are fragile and fear is one hell of a powerful emotion.


    Hi Richard,
    A good friend of mine, and a real futures market pro, said the other day
    "What's Russell talking about with this deflation stuff? Just look at
    the CRB - it's been screaming upward for months." Well, he's right.
    But the lower prices ARE there, they're just more in the manufactured
    area, as this very real tale shows.

    I needed to buy a new sander for my surfboard work. Checked out Sears
    and Home Depot. They have Milwaukees (made in the US?) at $199, and
    Hitachis (made in Japan?) at $169. A lot of money for a damn sander!
    So I went to Harbor Freight Tools yesterday, which advertised the
    Hitachi for $149. They were all out, but I noticed a Chicago brand
    sander - at $49. That's forty-nine dollars!!! Guess where that sucker
    was made? Bought it, and a two-year extended warranty for $64, out the
    door including tax. I sanded my new board last night and can tell you
    that the quality's not quite up to Hitachi or Milwaukee, but it's not
    bad. And at 1/4 to 1/3 the price? - MORE than worth the money. So how
    can American (or Japanese, or Mexican) companies stand up to that kind
    of brutal price undercutting? Of course, they can't. And I suppose
    that essentially the same thing has been happening in EVERY industry.

    What we're seeing is basically the opposite of the negative terms of
    trade that we always talk about LDCs having. They, producing primary
    products and buying manufactured goods, traditionally have been getting
    killed by the (relatively) lower prices they get for their raw
    materials, compared to what they have to pay for manufactured items.
    Kinda looks the other way around right now (which is not to say that the
    LDCs are exactly sitting fat, either). Commodity prices holding their
    own, or going up, while manufactured goods keep dropping. Led by the
    Chinese. May we, as they say, live in interesting times.....

    Enjoy the weekend.

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