Beware the US congressional elections!

The mid-November elections to the US Congress are a serious business as the Republican Party stands to loose control of both houses. This has galvanized supporters of the Bush administration into concerted action to ensure that financial markets remain positive.

This week a nuclear bomb was exploded in North Korea and yet capital markets barely moved, except in South Korea. Surely in a rational investment world such a blatant threat to world peace and security would demand a flight to quality, or at least a boost to the gold price.

But this did not happen. In the gold market central bankers once again battered the yellow metal into submission when it should have rallied. Yet perhaps a more subtle market manipulation is also in progress, as the markets know that the big beasts of the Republican jungle are waiting to respond to anything negative and so appreciate a one-way bet when they see it.

Stocks too high

Hence we see the Dow Jones Index at an all-time high, although that is a bit of an illusion too as the more widely followed indexes like the S&P 500 are still well off their all-time highs of 2000. Even the US dollar has perked up a bit.

The question, of course is what happens after the mid-November elections? Logic would suggest that the same markets that are currently dancing to the Republican tune will recognize that the party is over. Stock valuations are far too high for this point in the cycle, according to many analysts.

You do not have to look far to see the cracks in Wall Street. The US housing market is in free-fall, and will impact on consumer spending this year and next, probably producing the recession that George Soros forecast at the start of 2006 for 2007.

US real estate crisis

This will widen into a full-scale US real estate crisis as a downward spiral picks up speed. Debts will be bigger than equity on many homes, repossessions will follow, prices will fall further - it is not going to be a pretty picture. Commercial real estate will follow.

So that leaves investors a little time to think how to respond. Selling US equities into the current rally looks a good option and it is by no means certain that US bond prices will fare much better. Bonds have already had a good run and the risk is to the downside if interest rate cuts are slower in coming than expected or do not come at all.

Indeed, the main beneficiary may well be the much maligned US dollar. For as US assets are sold down the dollar will rally with money pouring into cash, so to speak. This would not normally be good for precious metals, and yet the flight to quality will almost certainly be good news for gold and silver but precious little else.