Confidence back? Beware of bear market rally

March 24th, 2008

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Last week, gold prices fell from a high of around US$1020 to around US$910 at the time of writing. Oil prices fell from a high of around $US110 to around US$100. Commodities from copper, zinc, nickel, wheat to corn also fell suddenly. The US dollar then rallied.

What is going on? Is inflation suddenly being suppressed and confidence in fiat money (chief among them is the US dollar) revived? The financial media even joined in the cheer-leading, as we see this nonsensical article from Bloomberg: Commodities Drop, Rally in Dollar, Stocks Vindicate Bernanke– it said,

The biggest commodity collapse in at least five decades may signal Federal Reserve Chairman Ben S. Bernanke has revived confidence in U.S. financial firms.

Investors who had poured money into gold, oil and corn, seeking a hedge against inflation and a weak dollar, sold commodities to raise cash or buy stocks.

So, this article is saying that in the span of less than a week, confidence is being revived and returned into the global financial system? Is it implying that ‘investors’ are suddenly seeing the light at the end of the tunnel and raised cash to buy stocks in anticipation of the glorious economic recovery that Bernanke is going to orchestrate? Indeed, this article should be put into the humour section.

One common explanation of such a sudden fall in commodity prices is that ‘investors’ have to liquidate their winning trades (e.g. gold, oil) to fulfil the margin call of their losing trades (e.g. stocks). Another way to look at this is that this is an example of deflation. Anyway, whatever the reason, we are hardly surprised by such developments. Our loyal readers should not be surprised too because we have warned about it even as early as 12 months ago (see Inflation or deflation first? and Warning: gold price can still fall significantly).

Anyway, do not be fooled, dear readers. This is a great example of a bear market rally. Such rallies are very common- even in the Great Crash of 1929, the stock market rallied for 6 months in 1930 before falling to its lowest point in 1932 (see Second lesson of ?29 crash?bear rebound).

In the next article, we will explain why such kind of price fluctuations happens, which should not perturb the long term investor. Keep tuned!

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