As we have predicted repeatedly in these pages, the fallout from the mortgage crisis has continued for the top names in finance: USB, Merrill, JPMorgan, AIG, Goldman, Wachovia, Morgan Stanley, HSBC, Citigroup, and on and on. Not just writedowns, but buying back their crap securities, raising more capital, and generally fighting for their survival. Meanwhile, the losses of Fannie and Freddie have been socialized, with a massive taxpayer-funded bailout.

And how did the markets react to this terrible news? The financials boomed, rising about 15% since the bottom on July 15, with some players like Merrill Lynch rising 32% in the first five trading days of the rebound.

With a hallucination of confidence in the health of the US financial system restored, the dollar charged back up, while European and Asian markets took their hits.

The action in oil has been likewise counter-intuitive. The loss of approximately 1.5 million barrels a day of oil supply from the world market due to the conflict in Georgia caused a mild one-day uptick in its steady decline from a peak of $147 to $113.

In a normal world, such a cut in supply would be enough to pack another $20 or more onto the price of oil. If the Saudis were to suddenly cut 1.5 mbpd of production, you can bet it would have a huge impact on the price. But this isn’t a normal world.

Upside-Down World

This is Upside-Down world, where everything does the opposite of what you expect. For a short while.

Is the renewable energy business so much worse this year than it was last year, such that the best names deserve to have their stocks whacked by 40%? No, not at all; in fact the business has grown substantially since last year.

Is the world suddenly losing its appetite for oil and natural gas? No, demand is still higher than ever before. Although the rate of growth is slowing somewhat due to record prices, demand in Asia and the Middle East is still red-hot and will continue to outweigh declining demand in the US and Europe.

Is demand for base metals, fertilizer, and food so much lower now than it was in the first half of this year? No, we still want more and more of everything.

So what’s the deal?

The recovery of the dollar, however illusory, is the main factor taking down the price of gold, oil and other commodities. As I have said here more than once, the daily news about oil inventories, demand levels, even pipeline attacks isn’t nearly as important as the valuation of the dollar. (And no, it’s still not because of the evil speculators.) Consider this chart:

As the dollar (the lower red line) has recovered, oil (in blue) and agricultural commodities (DBA, in green) have fallen off. They are the mirror images of each other.

The reason is simply that when traders have lost confidence in the stock market, they fly to the safety of commodities, energy and gold. When confidence returns, they fly right back out and look for bargains in the carnage they just left behind.

Stay the Course

In short, what we have here is a trader’s market. The fundamentals have been thrown out the window, and now it’s all about herd mentality.

That makes it a particularly dangerous market for longs like you and me. If you’re not a very active trader who’s on top of every move, you’re going to take some hits. And if you’re not such a trader, you’re going to get killed if you try to play it.

Your best strategy is to simply stay the course. I have no doubt that my long term theses are still solid. Energy, commodities—particularly agricultural commodities—and gold are still the right place to be for long investors, and I don’t see that changing for several years…not until global peak oil is clearly behind us, and the consequent global recession sets in.

But you have to have a strong stomach in a market that has simply lost its mind. When chaos is happening all around you, there’s nothing harder than standing your ground.

And times like these, when the trendlines have returned to their 200 dma’s and the whole sector that you know is right for the long term has been sold off, are ripe for bargain hunting.

Just don’t try to be a hero. Watch the important support levels closely and choose your buy points carefully. Be patient. Accumulate your favorite long positions-and a few shorts for good measure, like SKF and FXP-gradually. And then hold them and hold on.

The commodity boom is far from over, and the panic over energy supply and a fundamentally unsound US economy will always return after these bear market rallies. This Tuesday’s selloff destroyed half the gains or more in the financial sector over the last three weeks. And today, the bears are out in force, driving the major indexes lower while the gold/commodities/energy complex charges back up. (See my past articles for stock picks in those sectors.)

Likewise, the correction in oil will overshoot, as it always does, and then it will overcorrect to the upside again. I thought the new floor was around $120, but it could be $110, or it might even dip lower for a short while. But it will be back. I expect to see $150 again before the year is out.

I also expect this wicked volatility to increase as we make our way into the heart of this beast. Vladimir Putin isn’t done in his campaign to renationalize the resources of the former Soviet Union, oil and gas supply is still as tight as a drum, and there are still far too many mouths to feed. So take your Pepto-Bismol and hold on tight.

When the markets finally come to their senses again, your clearheadedness will be rewarded.

Until next time,

Chris