August 13, 2008 — We’ve recently seen the greatest expansion of credit in history. It was a product of Asian and Mid-Eastern countries holding down the value of their currency by creating more of their own money and buying dollars. The Fed got into the act in 2003 when it held down Fed Funds to 1% for month after month. It was a wild expansion of money and credit. Now the party is over.

The US and the economies of the free world run on credit. In the US it now takes six dollars in credit to produce one dollar in Gross National Product. Maybe the biggest problem today is that the banking system has become so traumatized that it is restricting credit. Today “nobody can get a loan,” the complete opposite of the situation which existed prior to the housing bust. The danger — constricting credit will impact heavily on the nation’s GDP. If that happens, say hello to a blistering recession.

With credit being restricted, a second and very serious danger surfaces. That danger is asset deflation. The very thought of asset deflation sends chills of fear up Fed chief Ben Bernanke’s spine. Credit contraction, asset deflation — shades of the great Depression.

What’s the antidote to deflation? It’s print, print, print. What would gold’s reaction be to “print, print, print”? Gold’s reaction would be — rise, rise, rise.
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Following up on yesterday’s XAU chart, below we see a daily chart of Gold going back to the year 2000. First gold established that long shallow rising trendline that you see. Then around 2005 gold established a much steeper trendline. During 2008 gold moved up and away from its steeper trendline, hitting a high of 1037 in May.

But by that time gold had gone up too far and too fast. Ads in the newspapers appeared telling you that gold was going to the moon. Gold had become “a hot item.” Next, gold slumped in to what we might call “the big correction.” Which is where we are now.

But gold is also severely oversold. Referring to the chart, look at RSI, look at MACD, look at the bottom panel which is momentum or the 144-day rate-of-change. So no, I don’t think it’s the end of the great gold bull market. I guess you could call this “the correction that makes the true-believers doubt their beliefs.”

It may take an extended period of time to repair the technical damage to gold. But as the girl who was eating peas one at a time said, “What’s the hurry?”

But gold isn’t the only item that is oversold. Just for the fun of it, I ran the Dow with the same technical coordinates. First, we see the Dow breaking below a long rising trendline — and then plunging.

Up to now, all the market’s shenanigans have occurred with the Dow holding above the 50% level of the entire 2002 to 2007 Dow advance. That’s the good news. The bad news is that the decline is clearly not over. What level will the Dow be at when it finally hits bottom, that’s what is so important. Will the Dow establish its final low above 10725 or below it? That’s the trillion dollar question.

Question — The stock market is in an extended decline, and with Lowry’s Selling Pressure at its high, nobody knows when or where this decline will end. Could the stock market become so chaotic, so scary, that people will buy gold as “the only item that can’t go bankrupt?” Will they buy gold because they don’t trust anything else, and gold represents pure wealth?”

Answer — That’s a possibility, a distant one to be sure, but it is one rationale for holding bullion (coins). When all else is suspect, gold will represent wealth with no counter-party — the eternal standard against which everything else is priced.

Question — Russell, we’ve be hearing the bad news month after month. It never seems to end. How bad do you really think the US economy might become, at its worst?

Answer — I honestly have no idea. I’m more interested in this question — “at what point will the stock market have discounted the worst that can be seen ahead?” For at least a hint of now bad the situation might become, read the piece below about Meredith Whitney.

I just received the latest issue (Aug. 18) of Fortune magazine. On the cover is a picture of Meredith Whitney, currently the hottest analyst in the nation (she called the credit meltdown a year ago before anyone else knew what was going on). So what’s her verdict now? Here it is, fresh out of Fortune —

“Whereas her peers keep searching for some sort of light at the end of the tunnel, Whitney thinks the tunnel is about to collapse. Bank stock investors will get crushed if they jump back in now, she contends because the banks are facing much bigger credit losses than what they’ve reported so far. Moreover, Whitney is convinced that the economy is about to sink into an “early 1980s-style” recession that will devastate the 10% of the population that became over-extended during the housing boom. “It feels like I’m at the epicenter of the biggest financial crisis in history,” says Whitney.

Russell comment — If the sage Meredith Whitney is correct, the market is probably fated to fall apart. That is, if the stock market has not yet discounted all the bad news she’s talking about. But there’s always that nagging question — how much of the bad news has the stock market already discounted?
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Discouraging development from Lowry’s — At yesterday’s close Lowry’s Selling Pressure Index was at exactly its multi-year high. Major stock market lows have never in the 75-year history of Lowry’s occurred within a month of a new high in the Selling Pressure Index.

The best hope for the bulls is that this market will record a final bottom in the October-November period of 2008. The further best hope is that the Dow will be able to register its final low this side of Dow 10725.