Some would argue that a parabolic move in a sector is indicative of massive demand for the same. I would suggest that parabolics (see the chart of the week) from a sector perspective, tend to mark exhaustive buying sprees and subsequently mark the end of a significant sector move. Like anything in the world of physics, assuming normal gravity, we know that it takes an enormous amount of energy to keep an object moving higher once it has achieved maximum acceleration. Think of a powerful fighter jet that can get off the ground very quickly and shoot vertically higher for a short while but will eventually stall and give way to the greater pull of the earth. When I look at current charts of Gold, Japan, Emerging Markets, even Energy to a degree, I see the potential for the same series of events unfolding in the short term. Earth and gravity, in our example, are equivalent to the 200 day moving average applied to any chart and the premise in the world of finance is that everything eventually reverts to the average. We can look at practically any index or sector and see that in up trends and down trends prices seem to bounce along the average until we see a definitive trend change. To find extremely overbought conditions, one simply needs to measure the distance between current price and the long term averages and look for extremes like those we see today. Let’s take a look at some stats.

First gold. Today the XAU index which represents the shares of most mining stocks is now sitting 31% above the 200 day moving average. I looked back to 1989 and found only 3 instances where the price of the index had moved more than 30% above the 200 day moving average. Of course this period does not capture the really crazy days of gold in the late 70’s so we’re talking about recent history here. In all previous instances the almost immediate decline in the index was a minimum of 26% and in one case (1995) marked the final peak in gold resulting in a 72% decline over the next 5 years. Personally, I do not believe this is the final peak in gold but the odds of a further advance in gold without a steep correction in the short term, is simply without precedent. I sold the last of our gold positions at the end of last week and will look to put our positions back on the table once prices return closer to the mean. I know that the gold guys out there will say only a fool would sell gold at this point. In our shop we manage risk and I know that I have no tolerance for 26% declines. Fundamentally, I still like gold as long as the inflationary scare, war and deficits are still in play. However, I just don’t like the risk profile in the short term and will look to buy it back at a better price. I’m never sad about taking 30%+ gains off the table on any trade. Interestingly, the US dollar has retraced all the way back to the 200 day moving average and today is having a strong move up off that level. Gold and the US dollar are inversely related and I’d rather bet on strength in the US dollar than a lot more gain in the price of gold in the short term. Remember, everything in the financial world (and life) eventually reverts to the mean.

Emerging markets are another “Rocket Man” sector showing a near vertical rise in the last 2-3 months. We don’t have as much data to work with but again, the current price of most emerging market’s indexes is now 23% above the 200 day moving average. History suggests that in strong cycles the index don’t always get all the way back to the long term moving average before resuming the uptrend but declines in the neighborhood of 12-17% are pretty normal from this overbought level. Fundamentally, I too like emerging markets for their growth rates and recent inclusion in the global economy as a low cost provider of goods and services. However, again, I’m not interested in losses of that magnitude and so we’ll wait for a better time to put our hard earned capital to work when the indexes are closer to the long or even intermediate term averages. Remember a rising US dollar is also bad for foreign investments and I have to say the chart patterns favor a stronger US dollar starting now.

Like emerging markets, Japan has also experienced a parabolic price increase starting back in May of 2005. We put on a big position in Japan mutual funds in the October/ November period and have made some very strong gains. Last week, I sold our 12.5% leveraged position (Profunds Ultra Japan fund) down to 8%. The Japanese Nikkei index lost 4.1% in the last two days and I don’t think the correction is over yet. The Nikkei average now sits 22% off the 200 day moving average and I don’t like the current risk profile. Not to sound repetitive but I still like Japan a lot as a long term fundamental position as they emerge from 14 years of recession. And because the prospects are so encouraging, I am willing to carry a small position through this correction. But Japan simply got ahead of itself and needs to take a rest so we cut our allocation and I’ll wait for a better level to bring our exposure back to a full position.

Today, if the major averages close where they are now (Dow down 70, NASDAQ down 17), a number of our short term indicators will give sell signals. Breadth was pretty weak last week and the emotional strain of the Dow not holding above the 11,000 mark after making the headlines of every publication could be all it takes to kill this rally. One of my personal trading rules regarding performance management is that gains made before March should be coveted because the odds of losing them between March and August are generally pretty good. So I don’t know if this is the end of the current stock market advance but it does look likely that our first good correction off the December lows is now in force and we’ll want to pay special attention to the underlying selling pressure in the next couple days. Holding and hoping is not something we do here and as I said in the year end report, understanding market risk, staying flexible and avoiding losses are secrets to investment success. We will make adjustments daily, weekly or monthly to find low risk opportunity and avoid high risk markets. This is a time to set reasonable stops on any and all positions and live by them. Please feel free to call me anytime if you want to discuss outside assets of concern. Have a great week.

Sam Jones