Overextended – You Bet!

I was looking through the archives and noted that we’ve been bullish on gold, and silver for many, many months. Our conviction has led you to make enormous profits had you followed through on our advice. Today, however, I must sound a note of caution for the near term.

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The markets, all of them, including the metals are in an overly exuberant stage.  Valuations from nearly every measure from historical price to earnings to the Volatility Index (VIX) are at dangerous levels.

Early last week the rating agency S&P downgraded US Sovereign Debt from AAA stable to AAA negative. This was hardly unexpected, but of all the nations with an AAA rating, the US sports the lowest one today. The US dollar suffered as a result, falling more against currencies like the lowly Euro which has two countries within the compact that are paying double digit interest on their Sovereign debt (Portugal at 10% and Greece at 20%).

While the S&P downgrade is serious, it is not a critical downgrade as much as it is a needed call to action to do something about the out of control obligations that the country is piling on. The markets took the opportunity to sell off…only to recover on the heels of good earnings reports. This might be interpreted as a bullish sign, and it is…for the longer term.

However, in the short term, the news coming out of the “main street” economy is still not encouraging. Jobless claims, while falling, are still stubbornly higher than they should be at this point in a recovery. A recovery without jobs is not a recovery that can last. Housing prices continue to drop, albeit at a slower pace. Yet, until we see the situation turn around, the recovery in progress will continue to soften.

The current rally is missing one component to validate it in my opinion. That component is the financial sector. It has underperformed so far this year, losing ground while the S&P has gained ground. If you recall, it was this sector that led the market recovery last year. The news coming out of the sector this quarter looks good on the surface, but not so good below it. Banks are reporting profits, but they are not reporting gains in revenue. Instead, the profits are coming from accounting manipulation. To bolster earnings numbers, banks are lowering their bad debt reserves. Now, the lowering of reserves or in this case the clawing back of losses taken in prior quarters may signal improving credit quality, but it doesn’t signal growth in lending, something that has to happen for the economy to prosper.

Resources and technology are leading the rally we are seeing today. These are two of the most volatile and fickle sectors of the market. Technology is overstretched with a new bubble forming in the areas of cloud computing and smart technology. The leadership is narrow and many of the large cap technology stocks are not even close to trading near their historic highs. The resource sector could prove to be the most troubling.

The metals are soaring in value, as is oil. Yet, this past week, Saudi Arabia announced production cuts, as it believes
that there is an oversupply of oil in the market. These cuts are being made in spite of the Libyan crisis and a potential crisis in Nigeria, two major producers. Gold and silver are also rallying as the greenback plunges and the perception of a deepening worldwide currency crisis gains strength. Yet, if the politicians in the US begin to discuss cutting debt seriously, whether now or ten years from now, the precious metals sector could plunge overnight. Remember, markets are not driven only by current events but also by perception of what will happen in the future.

The market in general as measured by the Volatility Index or VIX is in a state approaching euphoria. I don’t know about you, but I am not feeling euphoric right now. It makes sense, that after a strong run-up for two years, we may be due for a significant pullback. This may not be the time to sell everything and head for cover, but prudence dictates that taking some profits off the table during a time of market euphoria is the right thing to do.

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