I have spent some time during recent days in remorse. "How did I not see all of this coming and get into cash?", I ask myself. But I am being unfair to myself, because I did see all of this coming, but could not bring myself to believe that it would actually happen or pull the trigger to sell out and get 100% into cash.

I looked to see what I was saying in January 2004, and low and behold, I thought all of this was a possibility, though in early 2004 I did not yet fully appreciate how much the real estate bubble would affect the future. By the end of 2005, I understood that was the true danger. But if our financial system was not so inherently weak prior to that bubble, it would not have brought the system down. Looking back on this advice, it sounds as relevant today, as it did almost five years ago.

Here is what I said in my annual letter, January 2004:

REAL ASSETS

This category was not mentioned in previous reports, but is an area of great interest. The base materials (natural resources) markets have outperformed many equities and all bonds in 2003. Gold, like oil and other natural resources, has reversed a 25 year downtrend. This is very significant. It was only two years ago that many central banks decided to liquidate gold reserves, pressuring prices with the anticipation of increased supplies. Now, gold has gone from $250, to well over $400/oz. in 18 months. What does this mean? Is it a portent of things to come? Gold has been the “Anti-dollar” since 1971, when the USA (and by extension, any central bank with currency linked to the dollar) went off the gold standard and onto a paper based standard (the USD). Gold prices went from $35 in 1971 and eventually to $850 in 1980, during the height of inflation. Then as now, gold strengthens when the dollar (and other paper currency) weakens, as gold is the alternate form of world financial exchange.

Gold and other commodity prices are considered by many economists to be predictors of future inflation. Inflation is created by excess debt leading to declining currency valuation. If government and consumer debt and money supply is again in excess, then inflation and declining purchase power of the USD is on the way (Boy, sure got this one right!!). The deficit spending of the past 3 years rivals the late 60s, during Johnson’s “Guns and Butter” program, as a percent of GNP. But the story is really worse this time. Unlike the 60s, when the USA was still the world’s creditor nation coming out of World War 2, with positive balance of trade, now, the USA has severely negative balance of trade. Continued build up of national and personal debt is doubly troublesome. Unlike the 1970s, now have nothing to offset our debt, except more paper.

Potential “Doomsday” scenarios come out of this ominous situation. At best, as hoped for by me, the large national debt will result in a price inflation, a stagnant economy, flat stock market, and declining bond prices in concert with increasing interest rates. See the 1970s for an example. I believe this is what the Fed is now trying to engineer: dollar devaluation and price inflation. The dollar devaluation makes exports more attractive and imports less attractive, helping our trade balance. Price inflation reduces the impact of long-term debt for both government and consumer at the expense of the creditors: mortgage holders in the case of consumer debt and foreigners in the case of government Treasury bonds.

In the worst case scenario, the dollar’s value will disintegrate taking the USA and many other dollar-denominated economies with, leading to a global financial crisis and depression that could last for 10 or more years. From this depression will emerge a new global financial power, China, which would de-link its currency from the USD, and make the China Yuan as the new global currency standard. As the new creditor power, replacing the USA role from the 50s and 60s, China will dictate world policy.

The end result of these concerns is the need to own either commodities in the form of mining, energy or other natural resource companies, and rare metals: gold, silver, platinum, etc, in certificate or in fact.

Energy stocks are another commodity that would do well in an international financial crisis. Asia (China) continues to increase consumption of energy products, like oil and coal. Supply is limited and requires years of effort to expand. Commodities will also do well during a period of global inflation, or deflation, as during the 30s. Raw material values may not increase in absolute terms during periods of deflation, but they do not decrease much, either. So, if currencies increase in value, as they do during a period of deflation, then commodities appreciate in relative terms.

This is just my speculation, but I wonder if this chaos is being initiated by Islamic extremists. There is enough money from oil sales in the hands of Iran or other anti-American oil nations to precipitate this crash.

Think about it: the entire goal of hitting the WTC on 9/11 was to collapse the Western world's financial system. Knocking down buildings didn't work, so I am sure Al Queda and other extremists went to work on a new plan to do the same.

There was evidence of short selling by Islamists against the American market on the days leading up to 9/11. They know how to use that tool. To make the case more compelling was the attack on the US Embassy in Yemen yesterday. Al Queda likes to conduct attacks on multiple fronts to undermine confidence in the Western economic system.

Today, I just heard that there is a short selling campaign against State Street Bank, which is a major clearing house for Wall Street, based in Boston.
If this is the case, it can be stopped by a concerted effort of the Central Banks and regulators. The terrorists know that we are very reluctant in a free economy to employ controls. They are counting on us allowing our free markets to solve the problem. But they are manipulating short selling against major banks, one at a time, first the weak, and then the strong. We should be suspending all short sales, period, against money center banks and major financial institutions. That will freeze the market, but at least it will get rid of the speculation.

Then, there should be an intense effort to trace every significant short sale against banks on record to trace back the transaction to its source. If those sources are foreign, the accounts that transacted the business should be frozen. If we find it is terrorists, we should do everything possible to eliminate those people. If the transactions are domestic, the FBI should be sent to question the transactors to find out their intentions. If the intentions are found to be manipulative rather than speculation, the transactors should be prosecuted on federal racketeering charges.

This is what I hope is happening today behind the scenes.

On Friday, at the market close, and less than 6 hours after the Financial stocks tanked on the bad employment data from August, Treasury Chairman Hank Paulsen let leak that the Feds would be taking over Fannie and Freddie on Sunday.

My reaction was: DARN! or something close to that. I had been waiting for this to happen and knew it would create a trading opportunity on the financial indexes that I have been trading. But unlike the Bear Stearns bailout in March, where the rumor was on the net a couple days before the event, this one was very well guarded. Some people must have known as after the financials tanked Friday, they worked their way higher all day from about 10am on. Then, at the close, when the press release about the meeting on Sunday was announced, the UYG popped by 10% and I knew my goose was cooked, at least for a few days.

I would have loved to have been on the right side of this trade, but the financials had not dropped enough for me to cover my short position (SKF) and take a new long position (UYG). I was close, but about 5% away from pulling the trigger. And, as I have a day job, I did not have a chance to watch the financials move higher all day long into the close and the Fed press release. Had I been a full time trader, I would have looked into that counter trend movement (against the backdrop of the bad employment data in the morning) and might have found enough information to get me to switch direction.

But all is not lost! This is NOT the proverbial "other shoe dropping" signaling a change in direction for the financials, the stock market and the economy. In fact, I was stunned that the market reaction was so dramatic this morning. The fact that the Fed would have to intervene in Fannie and Freddie has been known for many weeks, really since the July 15 bottom when Paulson asked for and received authority to make this move. Most market followers expected this move sooner than this, so there should have been no "surprise factor" here.

In fact, the deal went down just about as expected. Fannie and Freddie common share is basically wiped out. This was necessary to eliminate concern of "moral hazard" where investors get taken off the hook by taxpayers. But Paulsen did not stop at common shares, he also took out the preferred shareholders. He did not actually bankrupt the company, but by giving warrants to the US government / taxpayers that give 80% of the equity to the government, with no dividends until Fannie and Freddie get profitable, for practical purposes, the stock is worth very near zero.

Worse for the financial market, many banks hold Fannie and Freddie preferreds as part of their capital structure. This was an arrangement with the bank regulators where FNM and FRE stock was considered as safe as cash, so avaiable as collateral for capital. But, it was not so safe and has now been written down to nothing. In fact, the preferred was not convertible to common, so its only value is for the dividend, which has now been eliminated for the forseeable future.

This is a material surprise. And it has a materially negative impact on many banks. That information will get back into the stock price in the next few days. I still think the Financials will continue to go down, with bounces along the way. I would use this opportunity to get short on Financials, which I am doing by selling more puts on SKF.

Jeff asked me yesterday to keep an eye on a few key charts for signals to buy or sell within that sector, or the sector itself. So, I will monitor the S&P; 10 sectors plus a few other specialty sectors like Materials and Mining. I will post them here regularly, as there are changes to report.

We talked about Technology. After hearing the Cisco news yesterday, it seems like Tech might be taking a little turn for the better. Tech is a good sector to buy as a sector since there are a lot of casualties in that sector. The chart for the S&P; Tech is XLK. It does show a recent breakout where the third green arrow was made two days ago, so now is a time to buy the sector, or good stocks within the sector. I hope this change in trend helps out Microsoft, which I have in a big way:

Another sector to monitor is the Energy sector. We recently looked at the OIH (yesterday it was in a report I sent out). Jeff was concerned about the prospects of equipment builder RIG, which has been declining steadily along with the entire sector. You can make the comparison yourself, but both charts are down about 25% from their high and are trending lower.

RIG is getting very cheap by all measures (P/E, P/CF, Book Value, PEG, etc). But what about the overall Energy Sector, XLE? It is in a downturn and should be watched for a break to the upside. But there is no rush. When a chart is in steep decline as this one is, it can continue quite a bit lower. Don't try to catch the falling knife, is the saying. A cheap Value guy like me, has been stabbed numerous times by not heeding this advice. The 12 month low in XLE is 10 points lower than where it is today (62.50). Don't fight the tape is another of the oldest sayings in investing. We should wait till we get three Green arrows, before we commit new money to Energy stocks.

Just picked this up off the E-Trade News. The article from this PM confirms the points I have made recently regarding a rotation from the commodities to the financial equities. It sure is nice to see someone independently come up with the same technical indicators that I have identified ;o) The rotation may not be long term in nature, but it sure looks tradeable over the next few months (today's action notwithstanding).

The chart below compares the Financials index, XLF with the oil index, OIL. The relationship between the two is almost perfectly inverse the past month. So, as oil and commodities decline, financials and other related equities will increase. This makes sense because oil / commodities are a reflection of inflation denominated in the home currency. Higher inflation must mean higher interest rates, which must damage financial equities.

"Goodbye commodities, hello financials" 1:01 PM ET 7/24/08 Marketwatch

NEW YORK (MPTrader) -- It seemed as though there was no place to hide when Apple and the technology sector, along with Bank of America and the financials, got clobbered with the rest of the market at Tuesday's open. Though by mid-day, the market did recover in a big way and left behind another significant low within a "rolling bottoming process."

Tuesday's action in the Standard & Poor's 500 Index (SPX) established a low of 1248 and high of 1277. That dwarfed Monday's daily range, closing well above Monday's close and high, so from a strict technical prospective the blue chip index had a key upside reversal.

In addition, unlike the rally off of last week's July 15 low, Tuesday's rally did not have the feel of a temporary oversold rally. The morning sell-off wasn't as dramatic, with the S&P; 500 only down 11.5 points from its previous close as opposed to nearly 28 points on July 15. So it was a higher, secondary low -- more corrective looking than that of the previous week, and less susceptible to a mere reactive bounce.

Driving the S&P; 500, which has now recovered 6.8% from its July 15 low (through Wednesday's close at 1282), are the financials, which have room to go higher. Over the last several months the percentage that the financials make up of the S&P; 500 has diminished just by virtue of the price deterioration, while the energy sector percentage of the index has increased. But institutions in the last week, in particular, appear to have begun to shift their money out of the once high-flying energy sector into equities.

One way to play this trend is through the Financial Select SPDR (XLF) or its sister ETF, the Ultra Financials ProShares (UYG), which moves two times that of the XLF. Since its low of 14.08 on July 15, the UYG is up 68% through Wednesday's close at 23.67.

Traders should look this week for a break of 26.40. That's where the major resistance trendline from Sept. 30 of last year cuts across the price axis, a break of which would be the first major signal of damage to the downtrend that's transpired since the fourth quarter of last year. Beyond that, if the UYG can sustain above 33.75, it would indicate the end of the bear market in financials.

Likewise, the Ultra Short Oil & Gas ProShares (DUG) provides an opportunity to play the downside move in energy shares. The DUG has put in a rounded bottom at around 25.30, closing Wednesday at 36.16, up 42% from its low, as oil prices have declined 15% from their $148 high. Its chart points to 39.50-41.00 next.

Another way to play the trend is through the iShares Dow Jones Transportation Average (IYT), which for obvious reasons is getting a major lift from declining energy prices. The IYT chart shows it made its bear market, corrective low on January 6 at 72.86, and went to new highs after that at 99.09 on May 18. The July 15 low at just under 82 was the pullback low after that new high, and from there it's gone to just above 92 as of Wednesday's close, a 12% gain in just a week. Tuesday was the first time it closed above its 50-day moving average since the first week of June, suggesting the IYT is in a new upleg and heading directly back to 99 to test that high.

Other commodity indexes are confirming what the IYT is suggesting, like the PowerShares DB Agriculture ETF (DBA), which closed below its 200-day moving average for the first time in a year on Tuesday. The PowerShares Commodity Index Tracking Fund (DBC) closed for the second day in a row below its 50-day moving average and looks like it has considerable room to go down as well.

In addition, the streetTRACKS Gold Shares (GLD) looked like it was on its way to retest high levels at around 98 early Tuesday but instead ran out of gas at around 96.20 in the pre-market hours and then reversed in a big way and closed at 93, falling to 90.57 as of Wednesday's close. Chances are the GLD now will move back to below 90, and possibly towards a full-fledged test of its rising 200-DMA, now at 86.80, which must contain any further sustained weakness to avert a total breakdown in gold prices towards $800 ($80 in the GLD).

The financials, transports and stock index ETFs are turning up, while we have sell signals in the, energy, agricultural and precious metals sectors. For people who have followed markets for a long time, this inverse relationship between equities and commodities makes intuitive sense and suggests there are trading opportunities developing that will last longer than a few hours!"

Mike Paulenoff is author of MPTrader.com, a diary of his intraday technical chart analysis and trading alerts on ETFs for gold, oil, equity indexes and other major markets. (mptrader.com)