YAHOO BREAKS OUT AND THE NASDAQ ISN'T FAR BEHIND -- WHY GOLD AND THE NIKKEI ARE BREAKING OUT TOGETHER -- WHY PULLBACK IN BOND YIELDS IS BOOSTING GOLD

SHIFT FROM DEFLATION TO INFLATION ... Gold and the Japanese market are breaking out to new highs together. I don't think that's a coincidence. Back on September 29 I wrote an article entitled "New Japanese Leadership May Be Signaling Shift To Global Inflation" (September 29, 2005). A headline in that article was that "Japan and Gold Are Rising Together". I won't repeat the whole story here, but I was struck by the fact that gold (and gold stocks) are hitting multi-year highs (Chart 1) on the same day that Japanese iShares are doing the same (Chart 2). A comparison of the two charts shows a remarkable similarity over the last two years. Notice that the EWJ/S&P relative strength ratio in Chart 2 started moving higher during August which coincided with the most recent upturn in gold. The gist of the earlier article is that global deflation coming from Japan has held down global inflation and global interest rates. Over the last seven years in particular (since 1998) deflation had made Japan the world's weakest market. The fact that Japan has become the strongest of the major markets suggests to me that global deflation pressures are giving way to inflation. That explains why gold is doing so well. That should also call for higher global interest rates. Why then are rates pulling back and why should that be good for gold?

Chart 1

Chart 2

BOND YIELDS ARE PULLING BACK ... Chart 3 shows the yield on the 10-year T-note over the last year. The chart shows the yield pulling back from its spring high near 4.7%. It's moving down toward its 50-day average and its August peak near 4.4%. What it does near that level will help determine is this is just a minor pullback in yields (which I suspect it is) or something more serious. My read on the week's pullback is twofold. One is simply technical as the chart shows. The other has to do with the two inflation reports which came in much lower than expected. That eased short-term inflation fears and caused bond yields to slide. Higher interest rates are a threat to gold partially because they help boost the U.S. dollar. That's why the Fed boosts short-term rates to fight inflation. This week's benign inflation reports raised hopes that the Fed may be close to ending their tightening cycle. If it does, that would be even more bullish for gold (and possibly bearish for the dollar). I suspect that line of thinking explains why bond yields pulled back this week while gold broke out.

Chart 3

OVERSOLD HOMEBUILDERS AND UTILITIES BOUNCE ... The pullback in bond yields is giving a boost to rate-sensitive groups that are in oversold conditions. Chart 4 shows the Dow Utilities bouncing off their 200-day average for the second time in a month. The 9-day RSI line has moved back over 50 which suggests a short-term bottom. Chart 5 shows the PHLX Housing Index in a similar oversold condition and trying to climb back above its moving average lines. Both rate-sensitive groups have been market underperformers of late. The utility pullback may also be tied to the selloff in energy stocks. Housing stocks peaked at the end of July as bond yields started rising. Their fate is largely tied to the direction of long-term rates. Since I believe that global bond yields are headed higher over the next year, I'm doubtful that any bounce in housing stocks will carry very far.

Chart 4

Chart 5

NASDAQ LEADS MARKET HIGHER ... Earlier in the week I expressed concerns about the market being up against some resistance barriers and in a short-term overbought. That makes today's market rally all the more impressive. The next three charts show the three main market indexes testing their highs for the year. The rising relative strength line in Chart 8 shows that the Nasdaq is continuing to exert market leadership. Today's Nasdaq gain also came on heavier trading which is another good sign. The Nasdaq 100 has already exceeded its yearly high. Internet stocks are one of the strongest groups in the Nasdaq market and Yahoo is the star of that group.

Chart 6

Chart 7

Chart 8

YAHOO BREAKS OUT ... Chart 9 shows Yahoo breaking through its 52-week highs in convincing fashion. It also did so on very heavy trading. The Yahoo/Nasdaq relative strength ratio turned up in early October and is also breaking out. Its large size makes Yahoo a very influential Nasdaq leader.

Chart 9