Don't Bait the Bear

07/01/2010 1:27 pm EST

Focus: MARKETS

Curtis Hesler

Editor, Professional Timing Service

Curtis Hesler, editor of Professional Timing Service, predicts more pain for stocks as investors shift money to bonds, gold, and crude.

Volatility agitates retail investors. They like calm and generally rising markets that give them confidence in the future. Extreme volatility as we have been experiencing destroys confidence; and, like it or not, the whole financial game is based on confidence. Liquidity is nothing more than confidence. Once confidence vanishes, liquidity dries up and bad things happen.

I think the retail investor has had enough of the stock market. Investors will shift some money into bonds thinking they are safe; but once interest rates begin to rise, confidence will be shattered in the bond market as well. Mutual funds, hedge funds, and managed accounts will all see their clientele make a mass exodus. This is what bear markets are all about.

I have a theory about bear markets. The public invests during the good times, but then inevitably something happens and they lose money. Once burned, they leave the market and never return. The bear will then run its course until prices get ridiculously cheap and until a new generation of investors comes along. This new generation will mature economically to the point of having available investment funds, but they will not have any experience, good or bad, in the markets. They will begin investing—and buying low, they find success. As more neophytes join the party and prices rise, more investors are attracted to the game, and a new bull emerges. Eventually, this group gets burned like their predecessors, and a new bear market takes over. The cycle takes about 20 years.

As the current group of investors bails out, where will their money go? Some of their money will evaporate as losses. The answer to this conundrum is not easy to find. The public is not rational—they invest emotionally and they rarely have a plan. Real estate is a dead issue, so don’t look for any investment trends to begin there. Real estate is a separate bear market. We will have to wait for a new generation of individual real estate speculators and some serious inventory adjustments before the next real estate bull market. Yes, there will continue to be a real estate market, but its investment appeal will not resurface for many years.

I think money will gravitate into Treasuries; and as time progresses and interest rates begin to rise, the short end of the yield curve will become increasingly popular. There will also be a move into commodities, where the profits are.

Gold, after all, has appreciated from $250 to $1,200 an ounce, while the S&P 500 has lost 30% from its highs, even after the wonderful rally over the last year. This is not lost on the public investor, and he loves to put his money into what has been performing the best. Commodities—including crude oil and gold—will gain momentum over the next few years. In fact, we are currently deeply ensconced in the investment stage of this commodity market—the commodity bull market’s second stage.

As a refresher, bull markets evolve in three stages. First is the value stage. This occurs once a bear market has run its course and prices have fallen to ridiculously low levels. Before the current bear in the stock market is over, stock prices will fall to single-digit price/earnings multiples. The Dow Industrials will sell for less than ten times earnings, and will yield 6%. Volume will dry up, and many mutual funds and hedge funds will close due to lack of interest. Most important, the Dow/gold ratio will fall under 5.0 and, most likely, it will fall to 2.0. The last value stage for the commodity market was in the late 1990’s when commodities were selling for less than it cost to produce them.

The second bull market stage is the investment stage. This is when prices rise and the asset class is once again viewed as a viable investment. We are in the commodity bull market’s investment stage. In fact, commodities have become a mainstream investment. A classic example of this is the popularity of the SPDR Gold Trust ETF (NYSE: GLD). There are now multiple commodity ETF’s and mutual funds offering tangible asset investments. The worrisome side of this is that there is a great deal of money concentrated in these vehicles and, to some extent, prices are being moved by investment demand as well as physical demand.

As stocks and bonds become more disappointing, investors will flock to where the money is being made. That will be commodities—gold and crude oil in particular. As the public increasingly gravitates into tangibles (like they did in the 1970’s), the final velocity stage will unfold. The shift from the investment stage to the velocity stage is based on momentum, but enthusiasm born in the investment stage will overextend itself. Investment demand will become just as maniacal in the commodity market as it became in the dot-com craze in the late 1990’s. All shreds of reason will be left behind. The key leader in this acceleration will be from the archetypal tangible asset—gold.

It is best to concentrate on the gold market from a technical standpoint and let the so-called fundamentals fall where they may. The only fundamentals that are important are the fact that global gold production is falling, and every day we see government policies being enacted that are bullish for gold and bearish for paper currencies. I see gold much higher by the end of the year.

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