(Our friend Chuck Cohen, a New York-based financial consultant and a raging bull on bullion, recently turned cautious on precious metals – but extremely cautious on stocks, which he says are setting up for a crash that could be worse than last May’s. The report below was prepared by him more than a week ago, but Chuck notes that sentiment extremes in gold and silver have corrected nicely since.  Although he can’t bring himself to turn as bearish on bullion as he is on stocks, Chuck says gold is nonetheless likely to violate round-number support – i.e., $1300 – before the shakeout subsides. If you’d like a free copy of his latest report, click here .  RA)   

Over the past couple of weeks, as the Dow has climbed above 11,000, gold past $1,300 and silver to $25, the sentiment indicators have also leaped sharply. The extremity of these indicators, similar to what we saw at the April top, should be taken as a clear warning of trouble ahead. Because of this, I am recommending strong caution toward all of these markets. This shouldn’t be a major correction, especially in the precious metals, but it should serve to quell the current, giddy atmosphere — and for some, allow a tradable opportunity.

It’s very possible that after this latest move is finished, in spite of some dramatic moves in stocks during 2010, we could be looking at a stock market that is at the same level as a year ago. I was shocked myself when I looked at the Dow chart. Most of my concerns are technical, focusing on extreme sentiment, charts and gaps. I believe that, viewed together, they are the best timing tools, at least for me. At certain points, when market sentiment tends to correlate strongly, as was the case in April, when the Dow was trading around 11300, and again at 9,600 in August, the markets are primed to reverse.

 Dollar Is Key

Not surprisingly, the primary influence upon the financial markets this year has been the U.S. dollar. When it has been weak, it has been the friend of both stocks, and usually precious metals, especially silver. But when it has rallied as it did in May, it has been the enemy of the stock market.  Over the past month or so, as the dollar index broke sharply from 83 to a recent low of 76, stocks, gold and silver rose together.  But the problem right now is that the dollar’s continuing weakness is taken as a given, implying the financial markets will continue to rise.  I seriously doubt this. Currently, Jake Bernstein’s Daily Sentiment Index of the dollar has dropped to an extreme 3% bulls.  That’s the same level it hit when the dollar rallied sharply in August as the Dow fell 700 points. In addition, Barron’s recently reported that call volume on the dollar was running at 4.5 times its daily average. When we see this kind of excess, there is a very high probability that a counter move is at hand.

 ‘Smart Money’ Is Short

Daily Sentiment reports that the positions in the Rydex Long vs. Short Funds are the third highest they have been over the past eight years. In each similar instance, the stock market quickly retreated. At the same time, the “Smart Money” Rydex figures show that traders have taken their largest net short position at any time in the past decade — again a negative signal.  Taken together, they suggest the stock market is ripe for a decline.

In recent weeks, the weekly AAII survey of individual investors has shown the largest bullish ratio since January of this year, when the stock market was staging for a drop of almost 10 percent. The other weekly sentiment indicator, the Investors Intelligence survey, has also climbed fairly steadily. One other note is that last month was the best September stocks have enjoyed in almost 70 years.  With these kind of excesses, it seems increasingly likely that stocks will give back some, or even much, of their spectacular gains.

Notably, the bank stocks have not joined in the rally since August. Bank of America, the nation’s largest bank, has dropped from $20 in mid-April to a recent low near $11. With the Dow stocks near their April levels, it is a scary sign that some very key stocks in the U.S. economy have gone the other way. The weakness of financial stocks presumably reflects real concerns about the problems in the mortgage market. From a technical standpoint, stocks have been wedging as they did just before last May’s crash. This time, I suspect, it could be as bad or worse, with the Dow [currently at 11146] returning to 10000 or below.

Gold and Silver

There have been troubling signs as well in precious metals.  Bernstein’s Daily Sentiment Index on both gold and silver recently climbed into the mid-90s.  In addition, the volume in silver and gold ETFs recently jumped significantly. Another worrisome sign is the lack of confirmation by the precious metals shares, especially over the past few weeks, and the low volume in the shares. Given the breakout of the HUI through 500 and $1350 gold, it is logical that the listed shares would have continued to move higher, but this has not been the case.  On the bright side, exploration stocks have resisted the recent tide of selling.

Right now, I believe the odds strongly favor a drop in the price of gold, perhaps back as low as $1265, but likely under $1300. [December Comex Gold fell as low as $1318.20 yesterday. Rick’s Picks is forecasting more weakness, to at least 1291.60, in the days ahead. RA ] Because it has risen non-stop from $18, silver should decline even more.

‘Massively Higher’ Bullion Eventually

Finally, I want to make clear that my big-picture view has not changed at all. I believe we are headed for dire, historic inflation and eventually into hyperinflation. We are past the point of the danger of a deflationary crash that many are still adhering to [your editor, for one]. Gold and silver, and especially mining shares, will ultimately reach ridiculous heights as the world currency crisis continues to unfold. But as we have seen, corrections do come — usually when sentiment reaches levels such as we have seen recently.