The last bear market was triggered when the credit bubble created by Greenspan’s foolish monetary policy burst. It was exacerbated by Bernanke’s foolish attempt to debase the currency and reflate the bubble. All he succeeded in doing was to inflate oil to $147, which put the finishing touches on an already crumbling economy.

The market gave us a warning when the financials began to diverge from the rest of the market. Considering that the banks were one of the leading sectors during the `02-`07 bull the fact that they couldn’t follow the rest of the market to new highs after the February `07 correction was a big red flag that the bull was on its last legs.

I’ve been saying for more than a year now that the unintended consequences of QE would be to spike inflation, which in turn would poison the global economy. I knew all along that Ben was never going to create any jobs by printing money and of course he hasn’t.

So if inflation is going to sink the economy and kill the stock market we should see warning signs from the sectors most affected by rising inflationary pressures, just like the banks warned us in `07 that the fundamentals were broken.

Sure enough I think we are starting to see those warning signs.

Emerging markets have been the hit hard by food inflation. We are now seeing food riots in many third world countries. Emerging markets just like financials during the last bull were one of the leading sectors. EEM is now starting to diverge from the rest of the global stock markets. It’s now on the verge of breaking back below the November cycle low.

The other sector that is extremely sensitive to inflation is the transports. When energy costs spike shipping companies profit margins are squeezed. The last two days have seen the Dow Transports fold under the pressure of surging oil prices. Keep in mind oil is only on the 17th day of its intermediate cycle. That cycle lasts on average 50-70 days. I think we are going to see $5.00 gasoline by the time the dollar collapses into its three year cycle low later this spring.

If the market can recover from the recent correction and make new highs I don’t expect the transports will be able to follow. That will set up a Dow Theory non-confirmation and most bear markets begin with a Dow Theory non-confirmation.

China is already in a bear market. I think most emerging markets have probably topped and I doubt the rest of the global markets have more than 2 or 3 months left before the next leg down in the secular bear market begins.

I think the brief party created by Bernanke’s printing press is about to come to an end.

Numerous factors and markets are telling us the odds of short-to-intermediate-term reversals are elevated for numerous markets including silver (SLV), gold (GLD), the U.S. dollar (UUP), the euro (FXE), stocks (SPY), and the VIX (VXX). The objective of both fundamental and technical analysis of the financial markets is to help us better understand the risk-reward ratio and relative attractiveness of a wide variety of investments. Since no chart or annual report can help us predict the future, our study of markets deals in probable outcomes.

The possible drivers for market reversals in dollar, euro, gold, silver, and VIX include:

• Concerns about Irish debt
• Uncertainty related to the G20 summit
• High levels of optimism (bullish sentiment/contrarian indicator)
• Near vertical, and correction-less ascents in numerous markets
• Mania-like moves in gold and silver
• Stretched valuations

We at CCM, along with many others, believe the sharp gains in many asset classes off the summer lows were primarily driven by the expectation of money printing and a weaker dollar. As the dollar weakened, many risk assets or inflation-protection assets rose. One example is gold; note the negative correlation between the yellow metal and the U.S. dollar.

These charts can help us from both a bullish and bearish perspective. If the markets reverse near the areas highlighted below, we would be more apt to become risk averse in the short-term, especially in terms of decisions related to cash. If these markets break through areas of potential resistance, then another leg up in risk assets becomes more likely, and we would be more amenable to increasing risk exposure in the short-term.

Just as a declining dollar increased the appetite for risk over the past five months, a countertrend rally in the dollar may open the door to corrective action in stocks and commodities. The Dollar Bear ETF (UDN) was down Tuesday on a 56% increase over average daily volume. As you review the charts below, ask yourself, “Is this market at a logical point for a possible reversal based on the recent action of buyers and sellers?”

The euro may have reached a point where buyers have become less interested. Recent concerns about Irish debt may also give currency traders a reason to cut back their exposure to the euro. Since the euro makes up roughly 60% of the U.S. Dollar Index, a drop in the euro would help propel the dollar higher. The desire to sell the euro ETF (FXE) was not atypical from a volume perspective on Tuesday, which tells us not to assume anything in terms of a reversal. A decline in FXE over the next few days on strong volume would add credence to the trendline. Average daily volume for FXE over the past three months was 1,556,260 shares. A decline over the coming days on more than 1,867,512 would add to our bearish concerns. A break to the upside on more than 1,867,512 would lean toward favorable outcomes for risk (stocks, commodity-dependent currencies, and commodities).

Technical analysis can look complex, but many of the most useful tools are very easy to understand. Trendlines are used to identify areas of past importance in the minds of buyers and sellers. Buyers tend to see value at areas of “support” and sellers tend to see “overvaluation” at areas of resistance.

The VIX, or the “fear index”, has reached what many would term as a level of “complacency”. A rise in the VIX, especially a sharp one, often occurs during periods of risk aversion. The VIX ETF (VXX) was up Tuesday on strong volume.

Silver tends to outperform gold during periods of risk-taking and when the economic outlook skews toward the more favorable end of the spectrum. Silver may have experienced a blow-off rally yesterday (SLV). Markets cannot logically rise in a vertical fashion forever; silver will correct at some point. Another day of high-volume selling would increase the odds that Tuesday’s intraday selloff on extremely high volume was indeed significant from a bearish perspective. As we head into trading on Wednesday, silver gets the benefit of the doubt since the bulls have been firmly in control, but Tuesday was a big yellow flag for the silver bulls.

Gold’s appeal has increased as fiat currencies are being debased around the globe. Gold has not had the high degree of mini-mania seen recently in silver, but the yellow metal has also reached a point where the desire to sell may now exceed the desire to buy. The gold ETF (GLD) was down Tuesday on strong volume.

The S&P 500’s intraday high on November 5th was 1,227.08. A 61.8% Fibonacci retracement of the October 2007 to March 2009 bear market falls near 1,228 on the S&P 500. These levels can be important to traders, so it is helpful to keep them on your radar, especially when you have trouble understanding why a market is stalling with no apparent resistance nearby.

The chart of the S&P 500 seems to be a little better positioned relative to overhead resistance. If stocks can push higher, a move to 1,234ish to 1,256ish on the S&P 500 seems within reason. The S&P 500 ETF (SPY) was down Tuesday on below average volume, which again highlights the need to pay attention rather than assume reversals are going to take place – no one knows what is going to happen, especially over the short-term. Over the summer, many were convinced the Hindenburg Omen spelled doom for the markets; the S&P 500 is now 16.7% above the Hindenburg Omen lows made in late August 2010, which is just one example of the importance of remaining flexible in terms of market outcomes (bullish and bearish).

Trendlines are broken all the time, which reinforces the probabilistic nature of this analysis. We cannot predict the future, but we can say it makes sense to pay attention over the next week or so. With the information we have in hand now, we believe many market reversals will represent corrections within ongoing trends. We believe gold, silver, and stocks will eventually make higher highs after the next correction, which will come at some point. We recently outlined other concerns about the dollar, and concerns about gold, which still apply to the current market.

If you are a little perplexed by the recent gains in inflation-friendly assets, it may be helpful to scan some of the charts on the lower portion of this Quantitative Easing page. The Fed’s objective of re-inflating asset prices and debasing the dollar will probably lend support to gold, silver, and stocks after the next round of corrective activity. Since there will probably be a QE3, QE4, and QE5 over the next few years, it is worth the time to understand how QE works, what the Fed is trying to accomplish, and the possible impact on your purchasing power and investments.

Since the market topped in April and has since been trading sideways in this rather large range, everyone has small positions at work but waiting for a decisive move before fully committing to one side. There could be a few opportunities in the coming days using bonds, the dollar and the SP500 if all goes well which I explain below.

Lets take a look at the charts…

SP500 – SPY ETF, Daily Chart

There has been a lot of talk about a sharp rally if the SP500 could break the 1130 level or the neckline everyone is talking about. Well this week Obama was on TV and the market rallied into that, then again after. I don’t really thing investors or traders were buying things up as he said the same boring stuff he always says without anything new. I feel there could have been another force at work, which we can discus another time .

Anyways, the market pierced those resistance levels and I’m sure a ton of traders have switch their view on the market from bearish to bullish. While I prefer to trade with the trend I can’t help but feel this market is still range bound, which is why I am still bearish at these shakeout levels. The SP500 did break resistance BUT the following candle did not close above the breakout candles high to confirm the move.

That said, the market is now trading back down at support and the next couple of days I’m sure will shed some like on the direction.

20 Year Bonds – TLT Fund, Daily Chart

We have seen the bond price pullback in a bull flag formation. It touched support before bouncing to break short term resistance as it looks to have started another rally. The chart below overlays both the candlesticks of the bond price and the SP500 which is the white line. You will notice they have an inverse relationship. If bond prices continue to rally then lower SP500 could start to rollover.

US Dollar – UUP Fund, Daily Chart

The dollar has fallen sharply the past 10 trading session and it looks to be oversold for a couple reasons. The past couple days the price has dropped straight down and gapped lower. This recent drop has reached a gap window which will act as support and could provide a tradable bounce in the coming days depending how things unfold.

Mid-Week Market Analysis Conclusion:

In short, the SP500 is flirting with resistance and has yet to confirm the breakout. Bond prices look to be headed higher which will makes me think equities could start to sell off any day now… It’s also important to note that the big banks GS and JPM shares have been under pressure and they tend to lead the broad market. Another point to add is the fact the oil has not rallied even though the dollar dropped like a rock? What happens if the dollar bounces? Could oil finally start its next leg down?

Gold and silver continue their steady grind up. The price action reminds me of the 2009 Nov –Dec move. Once that train de-rails its going to have a sharp correction…

You can get my ETF and Commodity Trading Signals if you become a subscriber of my newsletter. These free reports will continue to come on a weekly basis; however, instead of covering 3-5 investments at a time, I’ll be covering only 1. Newsletter subscribers will be getting more analysis that’s actionable. I’ve also decided to add video analysis as it allows me toe get more into across to you quicker and is more educational, and I’ll be covering more of the market to include currencies, bonds and sectors. Before everyone’s emails were answered personally, but now my focus is on building a strong group of traders and they will receive direct personal responses regarding trade ideas and analysis going forward.

Let the volatility and volume return!

Chris Vermeulen
www.TheGoldAndOilGuy.com

Sunday Sept 20th,
I think it’s safe to say that everyone knows the markets are manipulated… but during options expiry week we tend to see prices move beyond key resistance and support levels during times of light volume which triggers/shakes traders out of their positions.

Trading during low volume sessions Pre/Post holidays for swing traders or between 11:30am – 3:00pm ET for day traders tends have increased volatility and false breakouts. This happens because the market markets for individual stocks can slowly walk the prices up and down beyond short term support and resistance levels simply because there is a lack of participation in the market.

SP500 4 Hour Candlestick Chart

That being said, the chart below of the SPY (SP500 ETF) shows that last Thursday, (the day before Friday options expiry) the put call ratio was showing extreme bullishness. I also mentioned that we should expect a pop of 0.5 -2% in the next 24 hours as big guys will try to shake everyone out of their short positions (put options).

The put/call ratio indicator at the bottom of this chart is a contrarian indicator. When it shows that everyone has jumped to the bullish side, the big money knows its about time to change the direction so they can cash in at premium price levels.

SP500 60 Minute OptionsX Chart of the Week

If you look at the volume at the bottom of the chart you will see there are times where this virtually zero volume trades. The yellow high lighted section shows the overnight price surge which is very easy for the big guys to push higher as everyone sleeps.

Here is what they are doing. The light volume makes it easy to manipulate so they push it higher until key resistance is broken, then everyone who was short and had a protective stop in place will have their order executed. As the price rises, more and more stops get triggered. Also, with the rising number of traders becoming bullish from the previous session have buy orders to go long if key resistance is broken. This causes a virtually automated rally to unfold, but once the orders/buying dries up, the big guys start selling their positions at premium prices, pushing the price all the way back down to where the market closed the previous day.

In short, the big guys shook the majority of traders out of their positions Thursday night and pocketed a ridiculous amount of money. Crazy part is 99% of the public don’t even know this type of thing is happening while they sleep.

SP500 OptionsX Intraday Price Action

I thought I would show this chart as it shows the selling pressure in the market. What I find interesting about this chart is the fact there was more selling volume during options expiry week, but the prices continued to move higher.

From watching the market internals I saw the majority of traders go from bearish to bullish by the end of the week, and this really gave the big guys a huge advantage in my opinion. Each session selling volume took control with the big guys unloading bu the low volume afternoons naturally brought prices up again as more and more traders became bullish each session. This happened all week and Thursday night it looks as though they let the price rise allowing the key resistance level to be broken which caused a surge of buying which they could selling into. So what’s next…

SP500 / Broad Market Trading Conclusion:

In short, the market looks toppy and if all goes well, last weeks overnight shakeout just may have been a top. This week will start off slow and most likely with light volume until Wednesday. During light volume times, keep trading positions smaller than normal and remember there is a neutral/upward bias associated with light volume.

You can get my ETF and Commodity Trading Signals if you become a subscriber of my newsletter. These free reports will continue to come on a weekly basis; however, instead of covering 2-4 investments at a time, I’ll only be covering only one. Newsletter subscribers will be getting more analysis that’s actionable. I’ve also decided to add video analysis per customer’s request, and I’ll be covering more of the market to include currencies, bonds and sectors. Before everyone’s emails were answered personally, but now my focus is on building a strong group of newsletter traders and they will receive direct personal responses regarding trade ideas and analysis going forward.
Let the volatility and volume return!

Chris Vermeulen
www.TheGoldAndOilGuy.com

Wednesday was a big session with better than expected manufacturing surging the market 3%. In this article I will do a quick technical take on the current situation for the SP500 and gold as they are both trading at a key resistance level. also its important to know what type of price action we will get in the next 1-2 days so you can have your profit targets or protective stops in place depending on which side of the market you are currently playing.

SPY – SP500 Exchange Traded Fund – 60 Minute Chart

The market is currently in a down trend which means bounces get sold. But if you take a look at the buying volume ratio at the bottom of the chart you will notice that in an uptrend buying surges are the beginning of a rally, and during a downtrend buying surges are the end of a rally. I also want to mention that a lot of volume traded at this current level which you can see on the volume by price bars on the chart. This means there will be a lot of sellers to overcome before breaking to the upside.

The situation the market is at now makes things difficult to tell if this bounce will get sold, or if its just the starting of a rally. There are several arguments for each side but the one which I think has the most influence is the buying volume. It was very strong on this current bounce. It feels more like a rally but we will not know for sure for a couple days…

That being said, if the SP500 moves up Thursday then I would consider the market to be in an uptrend and exiting any short positions is a smart play. But if this bounce is sold and the market drops, then the 3% rally on Wednesday could all be given back and then some.

GLD Gold Exchange Traded Fund – 60 Minute Chart

Gold has continued to grind its way up to the previous top. Problem is the volume has been very light and that tells me there is not much demand for gold at these elevated prices. While we are still long gold it is crucial to have your protective stop in place so we lock in as much profit as possible for when the sharp selling spike happens.

Mid-Week Technical Take:

In short, the market feels like its trying to reverse back up but at this time its still in a down trend and trading under a key resistance level. This means trading with the trend and selling the bounces is still the play. That being said today’s strong volume makes this bounce suspect. Keeping positions small and setting a protective stop should be done as a safety precaution. The next couple days will shed some light for sure…

As for gold, I am still bullish but expecting our protective stops to be triggered any day now, which means we get paid and can mark another successful trade down on the scoreboard.

I’d like you to have my ETF Trade Alerts for Low Risk Setups! Get them here: http://www.thegoldandoilguy.com/specialoffer/signup.html

Chris Vermeulen

Early September is very important for the financial markets; especially for the bulls. Numerous elements are in place for a rally to take hold now. The markets have been weak and the bears have been in control. If the bulls cannot make a stand soon, it will be a bad sign for risk assets. The good news for the bulls is several factors, across numerous markets and asset classes, are pointing to a possible rally in risk assets:

• Bearish sentiment is high at the moment. Sentiment, especially as it approaches extremes, can serve as a contrary indicator.
• The Fed has signaled they are willing to print more money if needed. Right, wrong, or indifferent, the markets are anticipating more quantitative easing from the Fed. The Fed’s next meeting is only three weeks away. Markets look forward. A rally in risk assets for a few weeks is not out of the question.
• Currency and interest rate markets are acknowledging the possibility of the Fed cranking up the printing presses. In recent weeks, the U.S. dollar and the 10-Year Treasury have been firmly in the bears’ camp, but they are sitting near logical points of reversal. Recent rallies in the 10-Year Treasury have been showing signs of fatigue, which also points to a possible reversal in interest rates.
• Better than expected manufacturing data from China and better than expected growth in Australia have been reflected in the copper market. Emerging market stocks closed yesterday at a logical point of reversal; this morning’s news from China and Australia could spark a rally.
• Despite weeks of disappointing news on economic progress in the United States, the S&P 500 and Dow have yet to revisit their June lows, which is hard to believe given the recent lack of interest from buyers. When markets do something you do not expect, it is time to pay attention.
• Monday’s sell-off appeared to be a win for the bears, but unlike recent down days for stocks, total market volume contracted relative to the volume during Friday’s Fed-induced and broad-based rally. The S&P 500 and Dow have both held at logical reversal points.

Since a picture is worth a thousand words, we can show most of these concepts on the charts below. When you examine the charts, ask yourself, “Based on the actions in the past from market participants, is it logical for this market to reverse near current levels?” If the answer is yes, then the next thing to look for is some confirmation from the markets, which can come in the form of market breadth (advancing issues vs. declining issues), volume, and whether or not a broad cross section of markets are moving in the same direction (stocks, commodities, interest rates, currencies, etc). This analysis was completed after Tuesday’s close (8/31); so none of Wednesday’s (9/1) gains are reflected.

Below is an “after” and “before” chart showing an area of a possible reversal for the S&P 500.

When markets across different time frames support the possibility of a reversal, the odds of the reversal taking place increase. The charts above cover 2009 and 2010. The chart below goes all the way back to 1992.

Another look at the S&P 500 supports the possibility of a sustainable rally in risk assets

The Dow contains dividend-paying stocks; an area of interest for many investors in the current low-rate, low-growth environment. We, too, are interested in adding some dividend payers to our playbook should risk assets be able to hold near current levels. Industrial stocks appear to have found buyers near an area where three pink lines intersect. Two of the lines are trendlines and the third is a line of possible support. Three is better than one in terms of the probability the lines will be meaningful in the current day.

We hear lots of talk of a bond bubble. Bubbles can last much longer than many expect. Therefore, calling an end to a rally in bonds may be premature relative to long-term time horizons. However, a short-to-intermediate term reversal in bonds seems logical given the extreme bullish sentiment toward bonds and recent activity in the 10-Year Treasury. The yield on the 10-Year Treasury (shown below) has reached a point where reversals have occurred in the past (buyers became less interested). If you examine the daily chart of the 10-Year yield, numerous technical indicators are showing a weakening downtrend for interest rates, which again supports a possible reversal in rates and more conservative bonds.

We mentioned the good economic news from China and Australia that was released this morning. Emerging market stocks appear to be at an advantageous position on the charts to capitalize on the fundamental support. We will look for confirmation from market action over the next few days. No need to guess.

The U.S. dollar continues to perform the ironic role of a “safe haven” currency. As a general rule, when risk is out of favor, the dollar is strong. When risk is in favor, the dollar reverses. The dollar’s position as of Tuesday’s close also supports a good starting point for a sustainable rally(a few weeks or more) in all risk-related asset markets.

Another timeframe on the dollar (weekly chart going back to late 2007) also shows a market in the neighborhood of resistance.

The euro could be eyeing a possible move toward 140; especially if it can find a way above 133.34.

Despite months of worse than expected economic news from around the globe, copper is closer to its 2010 high than its 2010 low. The next few days are important for copper. Like the market for Treasuries, copper’s recent gains have shown signs of fatigue. If copper cannot hold above 337, a move back toward 320 to 325 could be in the cards (or worse). Copper may be an excellent way to monitor all markets for the next few days and weeks. If copper can break to the upside (above 346), the move would lend credibility to any rally attempt in risk assets. If copper fails near 346, especially in a decisive manner, then we would become more skeptical of any bullish move in the risk markets.

Our primary bull/bear model also shows the current market profile aligns well with past markets that more often than not were able to rally from very weak conditions.

The fact that conditions are ripe for the bulls to stage a rally does not mean they will necessarily seize the moment. Our job is to be prepared should more fundamental and technical data surface in support of the “rally in risk” scenario. Friday’s rally was a good first step for possible bullish outcomes over the next few weeks. Another strong day of gains would serve as further confirmation of a possible bullish turn in the short-to-intermediate term. Even if a rally can take hold, incoming data and actions from the Fed (or lack thereof) will most like dictate longer-term outcomes in what continues to be a “prove it to me” market.

After Friday’s impressive gains, we conducted some research looking for possible “rally assets”. Our findings are shown in Monday’s post, Markets Looking for Follow Through to Friday’s Rally.

Chris Ciovacco
Ciovacco Capital Management

Terms of Use. The charts and comments are only the author�s view of market activity and are not recommendations to buy or sell any security. Market sectors and related ETFs are selected based on his opinion as to their importance in providing the viewer a comprehensive summary of market conditions for the featured period. Chart annotations are not predictive of any future market action rather they only demonstrate the author�s opinion as to a range of possibilities going forward. All material presented herein is believed to be reliable but we cannot attest to its accuracy. The information contained herein (including historical prices or values) has been obtained from sources that Ciovacco Capital Management (CCM) considers to be reliable; however, CCM makes no representation as to, or accepts any responsibility or liability for, the accuracy or completeness of the information contained herein or any decision made or action taken by you or any third party in reliance upon the data. Some results are derived using historical estimations from available data. Investment recommendations may change and readers are urged to check with tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.

Mike Burnick, Director of Research and Client Communications — Weiss Capital Management

Since Bryan is on vacation this week, Martin asked me to pinch-hit as a guest editor today. And it couldn’t come at a better time, because at present, the Weiss Capital Management^† investment team is on high alert for a potential market sell-off.

We’ve had a nearly uninterrupted market rally over the past 12 months, but now we believe it’s time to play good defense … and take steps to help protect your gains. Let me explain why …

Naturally, the bulls are quick to point out the 70 percent surge in stocks since the March 2009 lows … they’ll tell you this is a sure sign the economy is recovering … and that we’re back to business as usual.

But don’t believe it! If anything, this rally should give you even more reason to be vigilant right now.

After all, stocks certainly can’t be considered bargains anymore. Based on measures of long-term price-to-earnings ratios, the S&P 500 is as much as 25 percent overvalued now.¹ [Editor's note: To learn more about a Weiss Capital Management strategy that's designed for both bull and bear markets, go here.]

Stocks have gone nowhere but up for over a year, and now they’re trading at expensive valuations, just like in 2007 … and, needless to say, you know what happened next …

Nevertheless, true believers in the recovery continue to ignore valuation while driving share prices even higher. In our view, the rally could come to a crashing end at any time.

What Happens When the Bailout Recovery Ends?

Our biggest concern is that this is not a “normal” recovery at all and our economy remains highly susceptible to a relapse at any time.

The so-called recovery, along with the rally in financial markets, has been largely bought-and-paid-for with taxpayer dollars … with TRILLIONS doled out by Washington for various stimulus and bailout efforts.

• In fact, federal government spending and transfer payments now account for nearlyONE FOURTH of our entire economy! ²
• To put this in perspective, even during the Great Depression — with FDR’s massive New Deal costs — government spending to GDP peaked at just over 10 percent.
• That’s less than HALF of where we are now — with federal spending today closer to 25 percent of GDP! ³

This deficit spending is simply unprecedented and it carries dangerous unintended consequences. Once this government stimulus is withdrawn … what then?

Can the economy — and especially the weak financial sector — sustain a rhythm of growth, without even more massive bailouts? Or, will it be right back to the emergency room for life support?

Only time will tell. But since the government is already winding down support, we may not need to wait much longer to find out what’s next.

Three Key Indicators Forewarn Potential Market Sell-off

Warning Flag #1: Leading Indicators Are Lagging Again: The first cause for concern is a sharp divergence in the indicators that predict the direction of the economy.

Take a look at the index of leading economic indicators, which appears to be clearly rolling over, a sign our economy may be contracting again.

This gauge tends to foreshadow broader moves in the economy.

• It correctly forecast the beginning of the Great Recession in mid-2007 — several months ahead of time.
• This indicator bottomed in late 2008, correctly signaling the bounce back we witnessed last year.
• Now, as the chart above clearly illustrates, the growth rate in the leading indicators has been falling for 10 weeks in a row! ⁴

This tells me that the recovery may be slowing substantially. Could it be foretelling a double-dip market decline ahead?

To answer that, you need to look closely at stock statistics.

Warning Flag #2: Risky Stocks Leading Rally

Watch which types of stocks are performing best. Indeed since last month’s low, trash has been making investors the most cash lately!

Translation: The riskier, lower-quality stocks seem to be back in favor in recent weeks, leading the market advance.

Market researchers at Bespoke Investment Group rank the quality of stocks in the S&P 500 based on their market size, valuation and credit ratings. ⁵

They found that since the recent market lows in early February, investors are walking on the wild side again … favoring poor-quality stocks over more defensive, dividend-paying blue chips.

In many cases, these poor-quality stocks are the same “junk stocks” that led the big market rally in 2009. Small-cap shares — often considered more speculative — are also favored more than blue chips.

• The Russell 2000, a benchmark for small-cap U.S. stocks, is up 15 percent since early February …
• Meanwhile the Dow Industrials, the blue chip index, gained less than HALF as much, or just 7 percent ⁶…
• Plus, the Russell 2000 is trading at over 50-times trailing earnings now … more thanTWICE as expensive as the S&P 500. ⁷

Of course, there may be perfectly rational reasons why investors prefer small caps over blue chips. For one thing, some analysts believe small caps have stronger profit growth potential.

On the other hand, junk stocks are the same stocks that could prove most vulnerable should the economy relapse into a double-dip recession later this year or next.

Warning Flag #3: Cycle Research Suggests Trouble Ahead

We’re also in the midst of two ominous historical market cycles.

Two of the more popular historic market cycles are the decennial (10-year) market cycle and the quadrennial — or presidential election cycle. This year, we have a convergence of the two, which suggests 2010 may not turn out to be a smooth ride for investors. Consider this …

The decennial cycle indicates that years ending in zero tend to be the absolute worst stock market performers of the decade, at least historically. In fact, from the 1880s through the year 2000, the tenth year of the decade has produced an average LOSS of 7.2 percent annually. ⁸

At the same time, 2010 is a midterm election year, and according to the presidential cycle, midterm years have posted the second worst performance of the four-year cycle and they have also been turbulent years.

Considering the partisan squabbling coming out of Washington these days, I’m convinced the 2010 midterm election could be especially contentious, adding more uncertainty to the mix as the year goes on.

Since 1930, stock market corrections have averaged nearly 21 percent at some point during midterm years! That’s a sizeable decline … especially when you consider that market declines have so far been relatively mild during the current rally … such as the 8 percent pull back in January and early February. ⁹

What do these cycles mean? They could indicate a double whammy for markets this year, especially if history repeats itself.

Three Key Steps You Need to Defend Your Portfolio

So, what’s the best way to prepare for potential market volatility ahead?

First, consider paring down your most vulnerable securities holdings — especially if you have profits from this rally. In other words, look at your smallest, most vulnerable stocks carefully. Jettison the riskiest.

Second, consider adding hedges, perhaps using inverse mutual funds or ETFs that short the S&P 500 or the Russell, but stick with single-beta inverse funds only!

That’s because some ETFs should be handled with extreme care, especially the leveraged or inverse funds. These funds don’t always track their index as advertised, and should be monitored carefully. [Editor's note: For more details, see this recent Weiss Advice^† article.]

Third, contact your financial advisor to seek professional guidance in turbulent markets.

At Weiss Capital Management, our goal is to grow and protect our clients’ wealth in strong markets and turbulent ones. As a result, these recent trends have us on alert. We have been reducing positions in higher risk investments and raising extra cash in our managed strategies.

Many of our strategies, including the Weiss All Weather Managed Account, have the ability to proactively hedge against a sell-off in either stocks or bonds, using inverse index funds and ETFs.

This strategy is one of several we offer that gives us maximum flexibility in all market conditions … both good and bad. To learn more about this innovative strategy, we’ve put together a special report for you with more details. You can get a free copy here.

Remember: A sudden market plunge of 20 percent or more this summer or sometime this fall would not surprise us at all, but it could prove to be a jarring wake-up call for unsuspecting investors.

Taking proactive risk control measures now within your portfolio may prove valuable in helping protect your wealth during a cycle of more pronounced market turmoil ahead.

Good investing,

Mike Burnick

Director of Research & Client Communications

Weiss Capital Management

^†Weiss Capital Management (an SEC-Registered Investment Adviser) is a separate but affiliated entity of Weiss Research, the publisher of Money and Markets. Both entities are owned by Weiss Group, LLC. Weiss Advice is a publication of Weiss Capital Management.

¹ Wall Street Journal: Worries Rebound on Bull’s Birthday, 3/10/09

² Gluskin Sheff Economic Commentary, 3/1/10

³ Ibid.

⁴ Gluskin Sheff Economic Commentary, 3/1/10

⁵ Wall Street Journal: Rally Is a Tale of Wounded Stocks, 3/15/10

⁶ Ibid.

⁷ Ibid.

⁸ Hirsch; Stock Trader’s Almanac, John Wiley & Sons, Inc. 2005

⁹ Merrill Lynch Market Analysis Comment, 1/5/10

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Moving forward, investors need to focus on quality, take the time to understand what’s really happening in Washington, and turn to such once-unconventional investments as oil, commodities and China stocks, says Money Morning Chief Investment Strategist Keith Fitz-Gerald.

“I expect the markets to remain very fragmented. Volatility will almost certainly increase, leaving investors both psychologically scarred and totally confused,” Fitz-Gerald said, underscoring the need for investors to embrace a truly global view. “Fully 75% of the economic activity on the planet now takes place outside U.S. borders. So it only makes sense that investors embrace new ways of thinking in order to avoid getting left behind. At the same time, energy and commodities still have a long way to run – meaning there’s substantial profit potential available.”

In a wide-ranging interview, the former professional trade advisor, best-selling author and noted Asia-investing expert:

• Predicted that oil and commodity prices are headed higher, making them “must-invest” asset classes for investors who don’t want to be left behind.
• Stated that ongoing miscues in Washington coupled with higher growth abroad make it imperative that U.S. investors embrace a truly global view when planning their investing strategies.
• And predicted that many blue-chip U.S. companies will go for dual-listings, listing their shares on China’s Shanghai Stock Exchange (SSE), providing those U.S.-based firms with access to the plentiful capital and robust growth available in that Asian giant’s marketplace.

William Patalon III (Q): Now that we’re one year removed from the March 9, 2009 market bottom, a lot has been made of how well U.S. stocks performed during that stretch. You correctly called the short-term correction and recovery that we saw just after the New Year. But as you’ve pointed out, the real question is where the market – as well as the U.S. recovery – goes from here.

Keith Fitz-Gerald: Thanks for noting that market call, Bill. Obviously, the big question is whether or not things can continue from here. On one hand, the U.S. Federal Reserve’s low-interest-rate policies are designed to encourage us to remain “long” and to reinflate the stock markets. So, generally speaking, investors have one heck of an incentive to stay “long”…. until the bill comes due. On the other hand, travelling around the world as much as I do, I have the distinct impression that global traders are losing patience, so investors clearly need to keep their “stop losses” tight, and remain conservatively invested.

(Q): Keith, what do you see going out six months, nine months and a year from now – not necessarily in terms of predicted performance, but perhaps the opportunities and threats you see to a continuation of this bull-market move into Year Two?

Fitz-Gerald: In the stock market right now, one characteristic separates the winners from losers – quality. Investors who want to maximize profits and minimize risk need to buy the best-quality stocks – and best-quality companies – they can find. No exceptions.

The best choices are going to be investments that not only tap into the tremendous growth taking place overseas, but that also have higher-than-average free cash flow (FCF), strong balance sheets and seasoned management that can compensate for the hopelessly inept central bankers toiling away around the world. Infrastructure, water, power and diversified-equipment makers are good examples of the categories of companies investors should be looking at right now. Energy, metals and inflation hedges also figure to be solidly opportunistic profit plays during the next 24 months .

On the other hand, I don’t see consumers gathering strength anytime soon, meaning that luxury brands and cyclical consumer goods are off the table – with one exception: China. Retail-spending growth in China is expected to top the growth in retail spending in the United States, Japan and Eurozone combined.

(Q): What should investors be doing to capitalize on those opportunities, while also protecting themselves against the risks you’ve outlined?

Fitz-Gerald: For investors right now, the first order of business is to replumb their minds and focus on cleaning up their investment house, so to speak. Wall Street won’t and Washington can’t. So more than any other time in history, the average investor must take responsibility for his or her own future. The objective is to position yourself for a solid upside, while at the same time cutting risk to razor-thin levels. To do this, rely on such tools as the 50-40-10 portfolio-allocation strategy that we espouse. Of course, trailing stops are a big part of this, too, and that’s something we talk about all the time.

(Q): It goes without saying that there’s tremendous uncertainty surrounding the U.S. economy. Many of the concerns that you outlined to Money Morning readers as far back as 2008 proved to be the undoing of the record bull market in U.S. stocks, as well as the surging U.S. economy. In terms of the U.S. economy, what are you concerned about now? Perhaps you could provide a couple of possible scenarios that you see playing out over the next six months to a year.

Fitz-Gerald: The single-biggest challenge to our recovery is our political leadership. Time and again, when given the chance, political leaders make decisions, pass laws or reach conclusions that are ill advised, flat-out wrong or badly mistimed. I can point to two great examples in Washington right now. The first is the growing protectionist sentiment against China … while the second is the $14 trillion fiscal hangover Washington created because or leaders insisted that we bail out Wall Street. The first example is completely misguided – not to mention about as poorly timed as humanly possible – while the second demonstrates that we can’t get our own house in order.

With regard to scenarios, I see a “slow growth/no growth” outlook in the United States almost certainly for the next few years. Most of the issues that caused this mess have not been solidly addressed and the banking industry remains held together with wallpaper paste and bailing twine.

I expect the markets to remain very fragmented. Volatility will almost certainly increase, leaving investors both psychologically scarred and totally confused.

Fully 75% of the economic activity on the planet now takes place outside U.S. borders. So it only makes sense that investors embrace new ways of thinking in order to avoid getting left behind. At the same time, energy and commodities still have a long way to run – meaning there’s substantial profit potential available. That’s as much a function of demand growth in the emerging economies as it is the weak-dollar policies of our own government – and now the Eurozone, in terms of the impact that the escalating debt problems of Greece and other EU nations will have on the European euro.

(Q): You’ve talked at length about how the “rules of the game” have changed. Could you explain the difference, and perhaps give an example or two? One statement that I’ve heard you make, for instance (that might surprise investors who aren’t regular readers) is that “buy-and-hold” investing is dead.

Fitz-Gerald: Time and again throughout history we’ve seen how any kind of a major change … including a massive financial crisis … leaves the resultant landscape permanently altered. Understandably, most investors find that fact to be disconcerting – if not downright scary. But there are actually some very good reasons to be optimistic, because history also shows us that huge sums of money are made in the transition period that immediately follows any great calamity. You can see that clearly in the days following the English Empire’s expansion, after the Industrial Revolution, and after the computing revolution, to name just a few.

And that’s where we are now…on the doorstep of what could easily be a Golden Age of investing for those savvy enough to recognize it. This time around, instead of a change in industrial tooling or a new age of exploration, we’re seeing that the very rules of money are being rewritten – particularly as they pertain to the use of such instruments as credit default swaps.

To put it another way, the West is trying to engineer its way out of trouble with “pretend money” – the swaps – while much of the world led by China is concentrating on the management of real growth. Whether or not the data is manipulated is irrelevant…the growth is real so it makes sense to concentrate on the creation of real wealth rather than the preservation of an illusion.

(Q): Everyone’s familiar with the stunning market call you made in the crude oil market several years back – calling for an escalation well into the triple digits when crude prices were sedentary and trading in the mid-$80 range. Within months, oil was trading at record highs near $150 a share. In conversations we’ve had, you’re now warning that energy prices are headed higher. What do you see and how should investors position themselves for this eventuality?

Fitz-Gerald: Again thanks for noting that, Bill. I believe that two things are right now driving the ship, so to speak.

First, growing global demand is not only going to outrun existing supply – it’s even going to outrun the development of new supply. People often point to alternative energy as a means of slowing demand growth and they’re right – in the Western world, where demand has arguably dropped. But that scenario ignores such markets as China – which all by itself accounted for fully one-third of total demand growth over the last 12 months. At the current pace China is expanding its usage, that country will be using as much oil as the United States by 2018. That alone means the pricing dynamics we now take for granted are going to have to change. And there’s also India, Africa and Latin America, which investors will need to factor in.

The second point to note is that while the central seemed hell bent on maintaining a weak-dollar policy, governments around the world were actively diversifying their reserves into hard assets such as oil. What they are doing is not so much a consideration of higher prices as it is a desire to safely store the “value” of their investment holdings. In effect, they are using oil as a currency, even though it’s not thought about that way by most people. This, too, will create upward pressure on oil prices – as well as on other important commodities. This makes commodities, in general, an investment that investors must consider for the long haul.

(Q): China has recently become the focus of much concern. There are worries about the Asian giant’s debt, about bad loans – especially at the local level – and about housing, to list just a few of the concerns. You live part of each year in Asia, and make several research trips to China each year. Those facts, as well as the fact that you’re the editor of The New China Trader advisory service, means you’re better-versed on China than any of the pundits right now trying to write that country’s epitaph. I know you still believe the long-term story is sound. What do you see in the near- and intermediate terms, and what (good or bad) impact could that have on the world economy? In the final analysis, what do you advise investors to do?

Fitz-Gerald: Double their exposure to China. What the China bashers don’t understand is that China is taking pre-emotive action to tap on the brakes. Our government, beset by a $14 trillion fiscal hangover, is staggering around after the party trying to tell people to drink less. The Chinese are taking away the punch bowl.

Let’s tackle housing as an example. There are three key points to understand.

First, there will be more than 500 million people moving into China’s cities by 2020, so it’s only natural that housing prices are going to go up – particularly in the high-demand areas of Beijing and Shanghai that are clearly central to China’s future.

Second, even as this migration accelerates, you can’t buy a house without a 30% down payment. Second homes require 50% down. So the only people buying homes are those who can afford it.

Finally, housing costs – as a function of per-capita income – are still declining, which means that incomes are rising at a faster rate than housing prices.

Obviously, there are pockets of overheating – just as there are in other major markets around the world. To write off China purely on the basis of what’s happening with real estate prices is a major mistake and represents some very-short-sighted thinking.

(Q): Japan’s another market that you’re probably as close to as any investor in the marketplace today. Many are calling for a rebirth there, reasoning that after being down for the count for so long, and having finally made some of the needed moves, that a turnabout is in the offing. But I know you’ve cautioned investors about being overly optimistic about Japan. Could you share some insights?

Fitz-Gerald: As you know, I’m very close to this issue, having spent the better part of 20 years traveling about in Asia and having a home in Kyoto. Japan will never regain the mantle of leadership in the Pacific region that it enjoyed from the 1950s to 1990. That’s not to say that there aren’t spectacular opportunities there, because there are. But the thing most people don’t understand is that Japan has a declining population, so the companies that will clean up are those that have shifted their efforts away from America and the EU and toward China. Don’t fall for the illusion of domestic Japanese growth because it simply doesn’t exist.

(Q): What other issues … or potential situations … are you studying right now? What other concerns do you have?

Fitz-Gerald: I remain concerned that our leadership will fall prey to populist agendas. The biggest single factor that could derail a recovery is our own government doing something really stupid – like beating up China over the yuan or plopping another $11 trillion of debt on top of what we’re already carrying.

The first miscue will virtually double the cost of anything coming from China, furthering the U.S. consumer’s perception that China is a villain when the reality is that this Asian giant is the relief valve for U.S. inflationary pressures.

The second misstep is simply just additional denial that fiscal responsibility really does apply to our government the way it applies to households and individuals. You can’t rob Peter to pay Paul forever…sooner or later Peter’s going to leave – and that’s happening already on both a corporate and personal level. Washington is treading on very thin ice.

(Q): And, lastly, knowing that you’re a man who’s never been afraid to make a prediction, what are the one or two prognostications that you’re making right now that would most surprise investors?

Fitz-Gerald: There are two things that come to mind.

First, faced with an increasingly distrustful and skeptical public, the U.S. government will make a land grab at the $14 trillion in retirement assets it presently can’t touch. But don’t expect a backlash. This will be sold to a “thankful” public as a way for a benevolent government to protect our personal financial futures. In reality, it is nothing more than a way of forcing us to buy U.S. government bonds – financing the mess that Washington created.

And, second, watch for American Pie stalwarts such as – I’m merely using these as examples – General Electric Co. (NYSE: GE), The Coca-Cola Co. (NYSE: KO) and others to list their shares on the Shanghai Stock Exchange within the next five years – at most.

This will be the ultimate wakeup call for those who don’t believe that Asia is the key to our economic future. The truth is, the companies that make this move the earliest are worth watching, for this will prove to be quite a shrewd move. These “reverse ADRs,” for lack of a better term, give these companies access to the world’s biggest potential capital markets at a time when ours are tapped out. And because they will establish foreign subsidiaries to handle this, they will build a much-closer relationship with their new-and-growing customer bases in the highly promising China market.

[Editor's Note: As this package of predictions so clearly demonstrates, Money Morning's Keith Fitz-Gerald has a gift. A veteran trader, skilled analyst and noted market tactician, Fitz-Gerald is able to see through the confusing haze of today's quickly changing markets to visualize and understand what the market really holds. This ability to see into the future, predicting looming changes - while also divining the profit opportunities those changes will create - is one of Fitz-Gerald's greatest strengths. It's a big reason that he's a perfect 22 for 22 with his Geiger Index advisory service. If you would like more information about the Geiger Index, please click here.

Also, watch Money Morning for a new interview with Keith Fitz-Gerald. During the lengthy question-and-answer session, the market strategist and best-selling author will detail his expectations for U.S. stocks, the U.S. economy, and for other key markets around the world. He will outline opportunities investors should capitalize on, and highlight areas of caution.]

Why have commodity prices been weak as of late? Paradoxically, the answer can be found in Chinese inflation.

You may have noticed something strange lately. Though the bulls have been stampeding, commodities just haven’t been getting the job done.

All the old relationships seem to be out of whack. For example, less than two weeks ago I wrote to you about “the great decoupling,” i.e. the growing disconnect between crude oil and stocks. As I write, stocks are modestly higher, yet oil is cratering.

You can see the disconnect of stocks and crude oil stocks in the chart below of the Reuters/Jefferies CRB index:

The CRB index tracks a basket of major commodities. Right now, the price action in CRB is middling at best. The 50-day exponential moving average is close to flat. What’s worse, prices are headed in the wrong direction, having failed twice to retake the average or break previous resistance.

The weak price action in commodities comes against a backdrop of renewed equity strength. Financials, banks, homebuilders – all have ripped higher in recent days.

Theoretically at least, renewed optimism for the U.S. economy should be inflationary. If things are getting better for consumers and the banks, then monetary velocity should be picking up. Stagnant pools of lending dollars should be flowing again. All this should be bullish for commodities (and prices in general).

Why isn’t it?

One potential reason is Chinese inflation.

Slamming on the Fiscal Brakes

China’s economy is showing signs of overheating. This, in turn, has led to concern over what the PBoC (People’s Bank of China) may do in response to keep inflation in check.

If China taps on the brakes too hard, as the CEO of Caterpillar so memorably put it, the result could “send everyone through the windshield.”

Chinese authorities have stated with confidence that things are still under control. But this isn’t really news, because what else would they be expected to say? Evidence on the ground suggests otherwise.

“China’s accelerating inflation has started to erode household savings,” Bloomberg reports, “threatening to spur purchases of property and stocks and fuel asset-price pressures.”

Chinese consumer prices rose the most in 16 months in February. Food prices saw some of the biggest gains. “A potentially troublesome sign for Beijing,” The New York Times notes, “given that the Chinese on average spend a third of their income on food.”

“Inflation may top the 3 percent policy target by April, which is bound to trigger further monetary tightening,” says Dariusz Kowalczyk in Hong Kong.

Inflationary Boom Psychology

The open questions here are 1) whether China will wind up doing “too little, too late” in its inflation fighting efforts, and 2) whether China will have to recreate the Volcker experience to get a handle on things.

Once the ball of inflationary expectations gets rolling, it can be very hard to stop. On every continent save Antarctica, the phenomenon has played itself out over and over again.

In China it might look something like this:

• Mrs. Wen notices that food prices are rising faster than her annual rate of deposit.
• In a bid to avoid the erosion of purchasing power, Mrs. Wen looks to either borrow or invest.
• If she borrows, she does so with the conviction that prices will be higher tomorrow than today.
• If she invests, she is hoping to outpace inflation by capturing a higher rate of return on her assets.
• This borrowing and investing activity feeds the accelerating inflationary boom.

This is the pattern that existed in the late 1970s. Consumers were borrowing like crazy, knowing the thing to do was leverage up and buy now, paying back the debt in cheaper dollars tomorrow. Investors were also going crazy with inflation-linked asset plays, plunging headlong into oil and gas partnerships and the like.

Volcker On Steroids?

The U.S. inflation and stagflation of the 1970s led to huge profits for some. But it was bad news for America’s economy on the whole. Fed Chairman Paul Volcker finally stepped in and “broke the back of inflation” by raising interest rates sky high over a multi-year period.

The economy experienced painful recession under Volcker. But it was widely agreed that something had to be done.

In seeking to rein in inflation, Chinese authorities may have an easier time of it than Volcker did. This is because they have more control. Whereas Volcker could not give direct orders to the major banks, Beijing can do just that.

Any move on China’s part to “break the back of inflation” could still be painful, though. Slowing down a runaway economy is no easy task. It is less like conducting an operation with precise surgical tools, and more like hitting a mule over the head with a sledgehammer. In order to slow the mule down, you have to swing hard enough to make an impact on his thick skull. But if you swing too hard, of course, you risk knocking the mule out cold.

The evidence suggests Beijing may be forced to move sooner rather than later. This fear of China’s next actions – how hard they come down on inflation pressures – could be the main thing holding commodities back. A slam on the fiscal brakes for the world’s No. 1 growth story would lessen the attraction for hard assets, at least in the near to intermediate term.

The rally out of the `06 bottom to the February `07 mini crash is a classic example of a runaway move (chart below). Note the brief measured corrections. Needless to say, if something like this develops soon, one doesn’t want to get caught on the bearish side of the tracks.

Not only is it getting late in the cycle but multiple other signs are springing up suggesting this rally is starting to run on fumes. Sentiment is starting to skew extremely bullish (contrary indicator), there are signs that institutions are starting to take chips off the table, and breadth is deteriorating.

It’s also not possible to rack up trillions and trillions of dollars of compounding debt and have a strong currency. Hey let’s face it, we don’t live in never, never land. Magic just doesn’t work in the real world.

I think the dollar is probably about to get smacked in the face by reality again.