Even after declining for nearly eleven months, most investors remain thoroughly complacent toward the possibility that U.S. equities will suffer an additional substantial pullback. Both VXO and VIX, the two most historically reliable gauges of fear, show no more concern today about a significant decline than had existed when the U.S. stock market was close to its seven-year peak in the second half of 2007.
A continued lack of fear in a falling market is the most dangerous scenario of all. The stock market has never completed any major bottom until the majority of investors were frightened enough to sell their stocks and to move their money into the safety of money-market funds and similar safe time deposits.
In confirmation of this outlook, the only insider buying by top executives has occurred in the most undervalued sectors, with continued selling in most industries.
While U.S. Treasuries have rallied to their highest levels since March, the spread between low-grade corporate bonds and U.S. Treasuries is at its highest point since early 2003. Fixed-income traders include very few emotional amateurs or novices, and are therefore generally more knowledgeable than the average equity investor. When the smartest participants have intentionally fled to the safety of U.S. Treasuries and have shown a marked aversion to low-grade corporate debt, this can only mean that the U.S. economy will soon go into a true recession.
You can forget about all those decoupling myths. Whenever the U.S. economy is weak, the rest of the world has proven to be even weaker. Emerging-market equities and commodities have slumped more in percentage terms than U.S. equity indices.
Whenever the U.S. government announces one plan of action or another, the stock market enjoys a sharp one-day rally. Friday's announcement about nationalizing Fannie Mae and Freddie Mac could lead to a sharp move higher for U.S. equities on Monday morning.
But one-day rallies have never been a feature of a healthy market. During the entire bull market from October 10, 2002 through October 11, 2007, there was not a single day when the Dow Jones Industrial Average rose 300 points or more. However, during the bear market from early 2000 through October 10, 2002, there were twelve such days--and six just since November 2007. Sharp one-day rebounds define a market which still has much farther to decline.
The steepest part of any correction almost always occurs in the final weeks, and even in the final days. It's not going to be a pretty picture. The U.S. stock market is going to reach an incredibly deep low in October 2008 that will be accompanied by three-year and even four-year bottoms for most U.S. equity indices.
BUY GOLD MINING SHARES AND FUNDS (September 7, 2008): One sector which has become severely oversold is gold mining shares. On Friday, September 5, 2008, GDX--the most popular fund of gold mining shares--touched a new all-time low of 31.65. [GDX had its debut on May 23, 2006.] This was slightly below its previous bottom of 31.82 from June 13, 2006. If you look at the ratio of gold mining shares to the price of gold, they were only this undervalued on one other occasion--when they completed a historic nadir in November 2000.
As central banks around the world are forced to cut interest rates to respond to a global economic contraction, this will prove to be strongly supportive of precious metals shares even as the U.S. dollar generally continues its rally for another half year or so.
Therefore, I have increased my holding in GDX to 10.5% of my total net worth (see my total asset allocation below), and will continue to gradually accumulate GDX and ASA on all dips over the next several weeks.
I have updated my outlook on gold mining shares, as my target price of 295 for HUI was finally achieved.
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