(Please refer to TSI's Glossary for an explanation of terms used in the Market Update)

Bonds – The correction in bonds may be almost complete, although a re-test of recent lows is possible in the coming week. If the politically-motivated intervention in the oil market proves to be a short-term success then bonds should begin to rally within the next fortnight.

Stocks – further back-and-forth action is likely over the next few days, but last week's `washout' increases the possibility of a strong rally over the next few months.

Gold – G7 intervention to stabilise the Euro helps gold. If this intervention is successful, and we think it will be in the short- to medium-term, then a gold rally will soon occur.

The US Stock Market

Current Market Situation

From our Sep 20 Interim Update:

“This market is quite dicey for both bulls and bears and is unlikely to reward anyone who buys breakouts and sells breakdowns. For example, even a break below 1450 [basis the Dec S&P – the approximate position of the up-trend line dating back to the 1998 low] will not necessarily lead to something disastrous. It should be remembered that the most powerful rallies over the past few years erupted after the market temporarily broke below a level that, according to the vast majority of technicians, constituted critical support.

The bottom line is that Wednesday's come-back is certainly a very positive development, but the market will not be 'out of the woods' until the energy/currency pressures are reduced. If market participants do begin to see some evidence that the oil price has peaked, then we have the potential for a very strong rally.”

If the reversals in the energy and currency markets last Thursday and Friday `stick', then the market may now be `out of the woods' for at least the next few months. If not for the Intel `bomb-shell' on Thursday night the bounce in the Euro and the drop in the oil price would have resulted in a very strong market during Friday's session. Intel may have just postponed that strength.

An October high is still a possibility, but last week's `washout' could potentially lead to a more enduring rally. The market has become more `oversold' and sentiment has become more pessimistic than we thought it would during the anticipated correction following the early-Sep high. The door has thus been left open for the market to rally into December before an important top is reached.

Whilst expecting the S&P500 to reach new all-time highs before year-end, we are not bullish on the stock market over the next 1-2 years. Five of our major concerns over the medium- to long-term are:

1. The Euro has been given a temporary reprieve, but its decline is not even close to being over. The increase in the level of volatility in the financial markets over the past few years is a direct consequence of the non-convertible debt-based floating-rate monetary system in use throughout the world and the attempts of governments to `manage' markets to keep the system in tact. The Euro exemplifies all the problems inherent in fiat currency and adds a few more, such as the impossibility of framing a `one size fits all' monetary policy for an economically, politically and socially disparate group of countries.
   
   
2. The oil price won't stay down for long unless the credit expansion slows, and if the credit expansion slows then the stock market will be in serious trouble.
   
   
3. Speculative excess is still evident in the prices of some tech stocks (refer to the last included in our Sep 4 Update for examples).
   
   
4. The earnings of large multi-national corporations will remain under pressure. The strong Dollar has clearly had an adverse impact on foreign-generated revenues, but the Intel revenue shortfall highlighted another problem. Intel prices its products in Dollars and is therefore not directly affected by exchange-rate changes, but a strengthening Dollar effectively becomes a price increase to foreign purchasers. Dollar strength, in this case, tends to suppress demand outside the US.
   
   
5. The US Presidential election cycle. For anyone who doubted the powerful influence that a US Presidential election can have on the financial markets, last week's happenings should have removed those doubts. So far this year we have had overt government manipulation of the bond, energy and currency markets, all to ensure a strong stock market going into the November elections. After the election is over and particularly after Clinton leaves the Whitehouse in February, the immediate political need to support the stock market will be removed. In fact, the first two years of a new 4-year Presidential term tend to be the worst for the stock market, with the greatest weakness often occurring between the middle of the first year and October of the second year.

The real value of the S&P500

Since the Dollar is constantly changing, measuring things in terms of nominal Dollars can paint a misleading picture. In order to see the `real' performance of the S&P500 over time we can adjust for the effect of inflation, although trying to do so creates the problem of finding an accurate measure of inflation with which to do the adjustment (the CPI is certainly not appropriate). An alternative is to express the S&P500 in terms of something constant, such as gold. The following chart shows the S&P500/Gold ratio since July 1999, that is, it shows the number of ounces of gold that the S&P500 Index could have purchased over the past 14 months.

The peak for the S&P500 in terms of gold was reached in mid-July 1999. This peak was re-tested in late August 2000. Even if the S&P500 moves to a new all-time high over the next few months in nominal Dollar terms, a weakening Dollar will probably mean that the July 1999 peak in the S&P500 in terms of gold will not be exceeded.

This week's important economic/market events

Gold and Gold Stocks

More on the gold-oil relationship

Few things are as misunderstood as the relationship between gold and oil. There is a widespread belief that the gold price and the oil price should generally trend in the same direction because a rising oil price supposedly means rising inflation and gold is a hedge against inflation.

The truth is that there is very little historical correlation between the price of gold and the price of oil. If the oil price is rising due to increasing global economic growth and if the heightened demand for oil spurs greater demand for the USD (as per the recent situation), then the gold and oil prices will trade inversely to each other. However, if the oil price were rising in parallel with a weak USD then the gold price would also be expected to rise.

As we have previously mentioned, the only multi-month gold rally over the past decade occurred in 1993, in parallel with a substantial decline in the oil price. A more interesting comparison, however, can be found by looking at the prices of oil and gold during the mid-1980s as illustrated in the following chart.

In early 1985 the USD gold price bottomed and began moving up in synch with a peak and subsequent decline in the USD. However, the multi-year down-trend for gold was not broken until early 1986, at the same time as crude oil was collapsing from $32 to $10. The gold price then continued upwards, in parallel with a falling USD, until late 1987. After crashing in late-85/early-86, the oil price then recovered as global economic growth picked up.

Just prior to oil's breakdown in 85/86, the gold-oil ratio was trading at the extremely low level of 10. At last week's peak in the oil price the ratio was an even more extreme 7.3. This ratio will eventually return to its long-time average of 17-20 (at least it always has in the past), but a return to historical norms is unlikely to occur until after the oil price has turned down (which it may have done during the past week).

In the current environment a rising oil price is a major contributor to USD strength, whereas a substantial gold rally will not occur until the USD has embarked on a down-trend. It is ironic that the gold investors who have been cheering every increase in the oil price have, in fact, been cheering one of the major obstacles to a rally in the USD gold price.

The “peso problem” revisited

In our Sep 4 Market Update we used Nassim Taleb's term “peso problem” to describe the present gold market situation. A peso problem has potentially arisen because a long period of low volatility and unidirectional price action has lulled most traders into thinking there is almost no risk involved in the short-selling of gold.

Once again borrowing from Mr Taleb's writings, a mistake that is often made is to take into account the expected frequency of loss, but fail to properly account for the expected magnitude of loss. For example, if a trade has an expected success rate of 90% (9 out of every 10 trades will be profitable) and the expected profit on a successful trade is $100 whereas the expected loss on an unsuccessful trade is $10,000, then the odds are clearly stacked against someone who undertakes this trade. 9 out of every 10 trades will be profitable, but the occasional loss will wipe-out all the profits and a lot more. The same reasoning also explains why you should never sell options – an option-seller will usually make small profits at least 90% of the time, but the occasional wrong-way bet can be a disaster.

In the gold market over recent years the frequency of success for short-sellers and those who sell call options has made betting against a rise in the gold price appear to be a very attractive trade. It is not. All we can say about the large-scale short-sellers of gold is that they haven't blown-up....yet.

The S&P500 versus the XAU

Below is a chart of the S&P500/XAU ratio since 1996 showing the up-trend that has been in place since early 1997. In Oct-97, Oct-98 and Oct-99, the ratio dropped to the up-trend line. If Oct-00 is going to see another test of this up-trend and the S&P500 remains near its current level, then the XAU would need to rise to 76 over the next month.

Even if a prolonged gold rally does not commence during the next month we suspect that the S&P/XAU ratio's up-trend will be tested. If we get a gold rally with `legs', then the up-trend in this ratio will be broken.

Current Market Situation

Many gold investors may be feeling disappointed that the gold price failed to hold onto the gains achieved during Friday's early trading. However, intra-day fluctuations are really only important to day-traders. The rest of us must keep the big picture at the forefront of our minds to avoid losing perspective.

The big picture looks like this: The trend in the USD gold price is determined by the trend in the USD relative to the other major currencies (particularly the European currencies) and, at the present time, by the trend in the oil price. Both a rising oil price and an evolving crisis surrounding the Euro have recently supported the USD.

Keeping the big picture in mind, the `goings-on' in the currency and energy markets at the end of last week have very bullish implications for gold. It is possible that the USD and oil peaked last week within a few hours of each other due to coordinated government intervention on a huge scale. Speculators can be expected to test the resolve of the governments at some point over the next few weeks, so a bounce back to the mid-30s by oil and a drop back to US$0.85 by the Euro would not be a surprise. However, the intervention will most likely prove to be successful in the short- to medium-term (the longer-term is a completely different story), particularly due to a) the involvement of the US Federal Reserve in the Euro support scheme, and b) the obvious willingness of the US Administration to tap the Strategic Petroleum Reserve in order to avert a national emergency (the emergency, of course, is that rising energy prices could jeopardise Al Gore's Presidential ambitions).

As we've been saying for some time, we believe the downside in gold stocks (from current levels) is minimal (especially the stocks of the profitable gold producers). Continue to hold, or accumulate on weakness.

Previous Market Updates

18th September
11th September
4th September
28th August
21st August