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Markets hold onto gains, but bonds showing signs of strength

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Traders that continue to monitor some of our key indicators we've been talking about can perhaps see why the markets have stalled out early this morning. We'd encourage traders to look at the 30-year Yield (TYX.X) on a 10-minute chart and then look at the Gold/Silver Index (XAU.X) on a 10-minute chart. Now take a look at some major equity indexes on those time frames. There is still a "cause and affect" between all of this and it has become more evident lately. Use it to your advantage, as it should be helping traders manage their trades for strength and weakness in equities during the trading session. Deviation from trend or Breakout? For younger traders it can be tough to trade when they think a breakout has occurred, only to get stopped out minutes later as the stock or index collapses or trades lower. While there is never a sure way to trade, here's a way to put your trades to the test.

Pharmaceutical Index Chart - 10-minute interval.

Yesterday we were eyeing a potential bullish trade in shares of Forest Labs (FRX) and pulled up a chart of the Pharmaceutical Index (DRG.X) above. For less experience traders, the 10-minute chart above may have said "breakout" on our downward trend. Well, as we see today, that was not the case and this index has traded lower today. One way to have stayed out of trouble was to look for confirmation. We've added two horizontal pink lines at recent higher levels that would have served as action points to actually get bullish. The above chart dictates that of deviation from trend that it did a breakout. Notice today that this index back on trend as it has now pulled right back to that "old" line of resistance. Try using this technique in the future. It can keep you out of some trouble. We'd rather pay a little more in our trade and have some confirmation than try and get a "great price" only to be stopped out for a loss later.

Great questions from readers!

For the past couple of weeks, we've been talking about the relationship between what the Gold/Silver Index (XAU.X) and 30- year Treasury Yield (TYX.X) and just what this relationship has been telling us about investor psychology. While comments we are receiving are very positive regarding the signals this relationship has given, many traders don't understand why "it's working so well." Here's our thought and it is a two staged approach. First, we'll briefly cover "economic theory", then we'll talk about investor "psychology". Before you "tune out" on the economic theory portion, please understand how you can use this in the future to uncover hidden opportunities in the future!

Economic Theory

If we "understand" economic theory (remember it's just theory, but they teach it at most major University's around the world) and use some of the principles of economics we would perhaps believe the following.

Interest rates rise in times of economic GROWTH as demand for capital increases. Here in the U.S., the Fed also has a tightening bias toward interest rates to help try and control economic stimulus and control inflation. Economic theory also tells us that when there is excess demand for something, prices will rise for the product, and the same is true for the interest rate the borrower must pay.

Interest rates fall in times of economic SLOWING as the consumer and corporations aren't as eager to borrow and spend. If the Fed has recently had a tightening bias, the cost of capital may be too high for the benefit received from borrowing. This creates a lack of demand for capital and we know from economic theory what eventually happens when there is a lack of demand. Prices or rates of interest usually fall.

What I took away from economics and Gold is the following. Since the U.S. went off the gold standard years ago, Gold is only perceived as a hedge against inflation and potential currency risk. It is a hard asset that many economists (and this is debatable) feel is a way to hedge against inflation. Economic theory in its simplest form says that gold/silver (precious metals) might see increasing demand in times of inflation or currency weakness. If I feel my dollar might not buy me "tomorrow" what it buys me today, I might turn that dollar into gold, especially if the value of the gold increases in price! Whenever we invest, we usually are looking for the next best alternative for our money to increase our wealth. In short, when inflation is upon us, gold prices should rise (as demand increases) and in times of economic slowing, gold prices should fall (as demand decreases).

We'll follow up later.

OK, that was pretty long for a "market update", but now we have the foundation of economic theory in place regarding interest rates (bond yields) and gold (XAU.X). If we believe that the market is buying/selling the above securities (bonds and gold stocks) can't we then monitor investor psychology? If we can measure (chart) the price activity and study the relationship between economic theory and what is taking place in the markets, we can now build trading scenarios (plans) to fit the model. What we will talk about later we hope you find interesting. What you'll hopefully find is that economic "theory" isn't making a lot of sense right now, but it is working great for measuring investor psychology. If we understand why the market is doing what it's doing, we can plan accordingly. Much like a psychiatrist, we're trying to get inside the mind of the market. If we can do that, we'll have a better understanding just what the heck is going on. Remember that it didn't make a lot of sense that some internet stocks were trading 100 times earnings when they were trading at $50 and 6-months later it didn't make much more economic sense when that same stock was trading at $150 and 500 times earnings. If we didn't participate in some of that move it was because we didn't understand the power of market psychology. Some may say that eventually (today) economic theory won out, but there was great opportunity before and we'd say it will probably take place in the future.

-Staff Analyst

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