"It's a chart."

"Right. What is it telling you?"

"A lot of things. It'll be easier if I just send you the conclusion..."

So later, he did. His note began, "Oil is up. Stocks are up. But here is the trading question: is Woodside and petroleum a buy at these levels? To answer that, you have to look at WPL and oil side by side.

"A simple comparison of the Brent crude price and WPL (see below) shows how impressive Woody's rally has been from the lows. We can see that in Fibonacci terms (useful for tracking a stock's movement over a discrete period) Woody's has retraced to its .618 of the whole move down from all time highs. In comparison oil hasn't even reached its .382 retracement. Advantage Woodside.

"You've also seen a big rally in the Australian dollar over this time. This lowers Woody's AUD earnings. But the stock is being priced for growth anyway. Investors are obviously starting to appreciate the long term value and growth in WPL over the next few years. And why not? The long term story for WPL remains very sound and one that I would want to be exposed to.

Click to enlarge

"Having said that, WPL may have gotten a bit ahead of itself at these levels. The stock price is resting on the top of the channel. And you can see the stock has moved up and down-but always stayed within-that channel since the lows of 2008. With the stock at the top of the channel now, you'd want to be cautious about entering any longs. The risk is that the stock tests the top of the channel, fails (as it has done consistently) and moves to retest the lows.

"If Woodside is ahead of itself, what about oil? The chart shows that oil itself is looking weak and could see a retest of recent lows around $60. This would definitely put some pressure on WPL. But that's not all bad news if you don't have a long term position in WPL already.

Click to enlarge

"If WPL is to maintain its current uptrend we could easily see a pullback towards $45. That could provide a good risk/reward buying opportunity. You get the stock you want to own. But you get it a technically good time, without overpaying or buying in before it retests the lows.

"But a resumption of the downtrend in the overall market could see even lower levels for the stock. And that is the big risk right now. Even though WPL is a stock you should own as a long-term energy bull, there will be an opportunity to buy it at better levels in the future. If you own it now, you ought to either take some profits off the table or prepare to have your conviction challenged.

Dan Denning
for The Daily Reckoning Australia

• The Only Thing Really Going Down Right Now is the U.S. Dollar
• Big Difference Between Stark News in Job Market and Behaviour of Stock Market
• The US Dollar Showing Signs of Life
• S&P 500 Heading Towards Some Major Long Term Resistance Levels
• Profiting From the Copper Indecision

Symmetrically, a decline of the AUD/USD makes gold more expensive for them. This foreign currency (FX) effect (also known by traders as currency risk) is a real matter for local investors.

FX markets in general and the Australian Dollar in particular had impressive volatility in 2008, especially during the second half of the year. If it continues in 2009, you'll want to understand the relationship in order to devise your own gold strategy.

On the chart above, the black line represents gold in Australian dollars (we called this composite "Aussie gold"), while the green bars represent the currency pair AUD/USD. There are three different phases that are distinct.

1) Phase 1 from August 2007 to March 2008 where "Aussie Gold" climbed sharply despite the fact that the AUD/USD exchange rate was rising too. It means that at the same time, gold prices in USD were rising faster than the AUD/USD.
In details, it means that, the AUD/USD ( how many US Dollars for ONE Australian Dollar) rose by 11% roughly between September 2007 and March 2008. For the same period, gold (therefore how many US Dollars for ONE ounce of Gold) rose by 31%
As a result, both the AUD and gold appreciated against the USD, but gold appreciated much faster. That's why the Aussie gold price (how many Australian Dollars for ONE ounce of gold) also climbed sharply. What does it all mean? It means that gold appreciated against AUD!
The Aussie gold price is a function of the velocity of the AUD/USD compared to the velocity of gold. If AUD/USD appreciates faster than gold, then the Aussie gold price declines. If gold appreciates faster than AUD/USD, then the Aussie gold price rises.

2) Phase 2 from March 2008 to September 2008 where the "Aussie gold" was cheaper as gold in USD was correcting while the local currency jumped to historical highs until July, then crashed.

3) Phase 3 from September until now where gold prices on the international markets are consolidating and rising again whereas the AUD/USD has been falling to low levels not seen since 2003. As a result, the "Aussie gold" is soaring.

Since last October, we can see that the Aussie gold price is reaching historic highs. Because of the crash of his currency on the FX markets, a local must pay today $1,250 AUD to buy an ounce of gold. At mid-August last year, the cost for the same ounce was only $917 AUD. It's a 36% increase in 5 months!

What is the conclusion of that?

Well, we have calculated the correlation between gold and the Australian currency, both the strength of their relationship and the degree of their relationship. From 1991 to date, this correlation is equal to 81%. Gold and the Aussie are positively correlated, as they typically move in the same direction because they are both traded against the US Dollar. But they don't move at the same pace. And this is that difference of pace or velocity that drives the Aussie gold price.

On a historical basis, a strong Australian dollar is NOT a 100% guarantee of a cheaper gold for local investors, but it is clearly often the case.

That's why if you want to buy gold, I would suggest you to wait for the Aussie gold price to correct. Currently these are the historical highs. If we have a look at the Aussie gold itself on a weekly chart (above), the MACD shows that the bullish momentum is likely to be over. It has peaked at unprecedented high levels on early January and has already started to curve downward.

Historically a similar configuration happened twice, in May 2006 and March 2008 (circled on the chart). If the MACD crosses below its signal line, it would be a clear signal of trend reversal, and would drive the Aussie Gold much cheaper. We will keep an eye on that in the coming weeks!

Gabriel Andre
for The Daily Reckoning Australia

• Prices of Gold in the Top 10 World Currencies
• The Aussie Dollar as a Measure of Global Risk Appetite
• September is the Best Month for Gold
• Aussie Dollar Ready to Storm Past US Dollar
• Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy

The government wants people to understand their money is safe in the banks. That's why that last bit is in there. It's designed to keep foreign holders of Aussie dollars from engaging in a run on the dollar and bringing their money home, wherever home might be (Japan, for example).

The Australian dollar is up in early trading. But its huge slide in just a few months is remarkable. It's good for exporters (especially farmers). Aussie agricultural goods now become relatively cheaper on foreign markets. It's not as good for consumers, who could see higher prices on imports (and there are a lot of imports in the consumer goods sector of the economy).

The big question, of course, is how shares will react to the weekend's events? So far so good. They're up 6% in early trading.

Polling the crowd this weekend and the Melbourne Investment Expo, we got the impression that there was a bit of capitulation on Friday. Investors who could not afford to lose anymore capital may have exited the market during the big 8.3% slide. Fear gave way to abject terror.

There may also be another reason-aside from the panic in the banking market-for Friday's frenzied selling. When Lehman Brothers was allowed to fail, it defaulted on some US$130 billion in senior debt. Against that debt, hedge funds and other Wall Street investment banks had sold some US$400 billion in credit default insurance.

Remember, anyone can sell credit default swap (CDS) insurance. It's a little like writing options. You collect the premium and hope you never have to pay out on the policy. So firms like Goldman Sachs (NYSE: GS), JP Morgan Chase (NYSE: JPM), and Morgan Stanley (NYSE: MS) sold huge amounts of credit insurance against default in Lehman bonds.

One theory making the rounds last week was that those investment banks and hedge funds were selling assets and hoarding cash in preparation for judgement day on how much of that insurance they would actually have pay out. An auction was held last week to determine the value of the outstanding Lehman CDS.

Based on the results of the auction, it looks like anyone who sold default insurance on Lehman bonds will have to pay out around 90.25 cents on the dollar to the holders of the CDS. Obviously, that could be a huge number, based on the gross value of the CDS outstanding ($360 billion). But if the banks and hedge funds have already hedged against their risk in writing these credit default swaps, it won't be any big deal.

If, on the other hand, you were a hedge fund selling CDS on Lehman's debt without making any provision that you'd actually have to pay up, well you, my friend, are in a sorry state. And you were probably selling assets like cheap underwear to raise cash last week. What does any of this have to do with the Aussie share market?

Blue chip Aussie mining shares like BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) and OZ Minerals Limited (ASX: OZL) have been the darlings of hedge funds wanting to own commodity stocks. The Aussie dollar has also been a popular commodity currency and yield play. If hedge funds and investment banks were liquidating commodity positions to raise cash for the Lehman CDS auction, it would most likely hammer Australian stocks.

That's one reason Aussie stocks fell much harder on Friday than stocks on Wall Street. Australia has a high percentage of stocks that were attractive to leveraged speculators when commodity prices were high. Now, those assets have seen a large amount of selling. With the Lehman CDS auction behind us, will the selling end?

We'll see. Beyond Lehman, there are the larger issues in the global financial system. On that score, politicians in Europe raced against the opening of global markets this morning. They announced a package of reforms that would: guarantee interbank lending, guarantee debt issued by banks until 2009, give government's permission to buy preferred shares in banks, make provisions to directly recapitalise any banks that were deemed "systemically critical."

While the Euro nations try to unfreeze the banking sector by effectively guaranteeing all lending, regulators in the U.S. and the U.K. are taking similar steps. The British government will take controlling stakes in the Royal Bank of Scotland and HBOS Plc. The Brits have also decided to inject about A$125 billion in capital directly into the banking system.

We covered the big-picture implications of this policy response in yesterday's special Sunday edition of the Daily Reckoning. If you missed it, you can find it here (Australian Resource Shares, What's Next). But it's not hard to see what's going: government guarantees to all bank lending, and direct, unsecured government lending to anyone who asks for it.

Will putting more money (credit) into the hands of those who created the problem in the first place actually help? Probably not. As Jim Rogers told CNBC, it's setting the stage for an 'Inflationary Holocaust.' It's hard to believe at first that the current deflation in financial assets will give way to astonishing inflation. But that's just what we expect to happen.

Specifically, governments will boost lending to the private sector via central banks. You can also expect direct stimulus for households via rebate packages and tax breaks. In the long-run, big government spending programs on public works, infrastructure, and energy are a certain political winner.

And where will the money come from? Good question. It will be printed or borrowed into existence. Money supply will rise. And with the banking sector effectively nationalised, private investors will look for a real hedge against the inflation being unleashed.

We would take a strong look at over-sold Aussie oil stocks right now. Not only are they over-sold from a technical perspective, but the oil price has nearly halved from its highs earlier in the year. You may not get a better chance to buy them at this price.

Of course, if the market gets any worse than it got last week, it will no longer be the worst financial crisis since the Depression. It will be the worst financial crisis of modern times, full stop. If that is the case, it marks the end of one era and the beginning of another.

In the meantime, however, you could do worse than build a "Robinson Crusoe" portfolio. That is, when his ship ran aground and all his colleagues were lost at sea, Crusoe spent three days salvaging anything from his ship that would be of use in living on his deserted island. His misfortune was severe. But he had enough sense to realise the ship contained items that would be essential for his survival after the shock of his shipwreck.

The stock market offers you a similar opportunity, once the selling abates. You will get an excellent chance to buy Australia's best shares at very low prices.

Dan Denning
The Daily Reckoning Australia

• Dubai Debt Story More Like Bear Stearns Less Like Lehman Brothers
• The Asian Banks Have Finally Been Heard From
• Short Selling Ban May Kick Off Market Liquidation
• $4.1 Billion in Investor Funds Have Been Frozen Overnight
• Big Australian Resource Stocks Up 24% in 2008

"The Aussie is hostage to competing forces right now. On one hand, the endless rise of world commodities prices and the great fall of the US Dollar are good reasons to back the Australian currency. Indeed, Australian exporters can take full advantage of rising gold, metals and energy prices."

"Demand from Asian countries hasn't flagged and you still have speculative flows on the relative future contracts too (investment demand). What's more, the gap between US and Australian interest rates is widening. The Fed will probably cut rates again tomorrow, maybe by as much as one full percent if the futures markets are to be believed."

"The RBA, on the other hand, may still raise the cash rate by a quarter point at its next meeting. Those different monetary polices are explained by the fear of recession in the US and the fear of inflation in Australia. It should be bullish for the Aussie.

"On the other hand however, there is a new event on the FX markets which is bearish for the Aussie: the liquidation of carry trades. Those long-term positions were based on the different interest rates on government bonds in different countries (a basic carry trade being to buy the high yield currency and sell the low yield one).

"The dominant carry trade of the last few years was a strong bearish force for the Japanese Yen. It was cheap for global speculators to borrow the yen because of ultra-low interest rates in Japan for years. Since last November roughly, investors become more and more risk averse, fearing a global slowdown and the unknowns of the credit crisis.

"So what have they done? Yen carry traders are getting out of long-term winning positions to lock in profits. They're also making a big change in their asset allocation, which should favour commodities. That's why the Yen is currently in a massive up trend. It's rallied against all the high yield currencies, including the Aussie. And the U.S. dollar…well you have to see the chart to believe it."

"The chart shows the fall of the US Dollar index during this past year. It also shows its next important level of resistance (which was previously its main support). As you can see, the index tried four times since last October to break the down trend. It failed four times. The dollar doesn't have any support.

"If, by some miracle we haven't foreseen, the dollar index rallies above 76, it will break its technical downtrend. The downside is much harder to figure, mainly because the dollar index has never been this low before. How low can it go? In a world of floating exchange rates, it can go much lower. But tomorrow we will look at the dollar in terms of gold to get a better idea."

"Technically the AUD is still in a bullish channel against the US Dollar (chart below). However the parity with the Greenback might be more difficult to reach than you imagine as the main resistance between 0.94 and 0.95 has been holding so far. On the downside the pair found some support yesterday on the 50-day moving average at 0.9125, which is also the support line of the current medium-term bullish channel.

Dan Denning
The Daily Reckoning Australia

• None Found