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

Bonds – bonds have benefited from evidence that the US economy is slowing. At this time it looks as though bond prices may have reversed lower on Friday so long-term interest rates will probably move higher over the next week or two. After that we expect to see firmer bond prices in parallel with a drop in the oil price and further signs of an economic slowdown.

Stocks – in the May 29 Weekly Update we described the action during the preceding week as irresolute. This past week's action was anything but irresolute and we are now very confident that the cyclical bear market in technology stocks has ended.

Gold – gold has begun to move up in parallel with a weakening Dollar and strengthening Euro.

Inflation Watch

During the first 20 weeks of this year M3, the broadest measure of the money supply, grew at the miserly annualised rate of 2.9%. Over the same period M1 and M2 actually experienced small reductions. So far this year inflation in the US has, therefore, been non-existent. Consequentially, the US is now experiencing high real interest rates for the first time in many years (for much of the past 4 years real interest rates, which we calculate by subtracting the money supply growth rate from the nominal interest rate, have actually been negative).

Rising commodity prices and rising long-term interest rates are effects of inflation. The general increase in prices we see today are effects of the inflation that occurred months, or even years, ago.

We predicted some time ago that the Fed would raise rates by 25 basis points at the June FOMC Meeting and that this would be the last rate hike for the year. A June rate rise is still quite likely, although there may now be sufficient evidence to suggest it is unwarranted. The rate of inflation (the rate of money supply growth) is now falling, but if the Fed waits for the backward-looking indicators to reflect this fact before taking the appropriate action (holding off on further rate rises) they will drive the economy into a severe recession. If the US goes into recession so will the rest of the world since the economic recoveries throughout most of Europe and Asia over the past 2 years have been built on the burgeoning US trade deficit.

The US Stock Market

Has the bear market ended?

Some commentators quibbled that the volume during the huge rally on both Tuesday and Thursday of last week was unconvincing, that is, a genuine rally should supposedly have occurred on much higher volume (the NASDAQ volume on both days was less than the average daily volume this year). The problem with that argument is that a high volume up-move requires a large amount of selling. If there is not a high volume of shares offered for sale then you will not get a high trading volume. However, although the NASDAQ volume during both the Tuesday and Thursday surges was not exceptional, the ratio of up-volume to down-volume was 9-to-1 on Tuesday and almost 7-to-1 on Thursday. The week then ended with Friday's extraordinary up-to-down volume ratio of almost 17-to-1. The significance of strong up-volume to down-volume days is highlighted by the following extracts from Marty Zweig's book “Winning On Wall Street”:

“...the 9-to-1 up day is a most encouraging sign, and having two of them within a reasonably short span is very bullish. I call it a “double 9-to-1” when two such days occur within three months of one another.” Note – we've just had a “double 9-to-1” in the space of one week.

“Every bull market in history, and many good intermediate advances, have been launched with a buying stampede that included one or more 9-to-1 up days.”

Dr Zweig's analysis was based on NYSE data, but the same logic should apply to the NASDAQ.

Another positive technical development that occurred last week was a break-out, by the S&P500, above a `declining tops' pattern. This suggests that we could see a new all-time high in the S&P500 as early as July.

We are about as confident as we can be that last week's NASDAQ action was not a bear market rally. There are no guarantees in the financial world and there is always the chance that some market-derailing event will come out of left field, but taking a 6-month view the odds are now heavily stacked in favour of the bulls (we thought they were anyway, but last week's happenings have provided some technical backup to our positive medium-term view).

Current Market Situation

Last week we speculated that a rolling 2-year bear market was about to end with a sharp decline in the `super-techs' (Cisco, Oracle et al). It would certainly make investing in the market more comfortable if these universally-loved stocks weren't selling at such huge premiums to their earnings growth rates. However, successful investing and trading is about acting based on the way things are, not the way we would like them to be. It now seems probable that the super-techs bottomed on May 24 and, although they should suffer significant pullbacks over the next 1 – 3 weeks, will most likely be challenging their all-time highs in the months ahead.

Also in last week's Update we suggested that a mismatch existed between what the majority thought the Fed would do and what the Fed will actually do. We saw this as an opportunity that would evolve over the space of a couple of months as evidence of an economic slowdown mounted. We certainly did not expect the mismatch to be corrected in the space of one week, something that appears to have just happened.

We're happy to have bought tech stocks on April 14 and during the week commencing May 22. However, despite our positive medium-term outlook we have no desire to chase stocks during the current buying panic. On the contrary, for those so inclined (particularly those who have a significant long position in tech stocks) any continued strength in the market on Monday could be used to purchase close-to-the-money QQQ put options (QQQ is the symbol for the NASDAQ100 tracking stock) with the idea of selling them during any sharp decline over the next 3 weeks. This is just a suggestion for those who appreciate the high-risk nature of options and is not something we plan to follow-up on as far as specific buy/sell recommendations.

Our concerns in the very short-term come about because the market is over-extended and sentiment has become too bullish. For example, there were over 1 million equity call options traded on Friday on the CBOE compared to only 320 thousand put options, the sort of imbalance that normally occurs at short-term peaks. A pullback is required during the next week or so to cast some doubt into the minds of those who panicked into the market on Thursday and Friday and to give the bears some hope. This pullback may see the June S&P500 futures contract drop back to the low 1400s, but if we are correct in our assessment that a new up-trend has commenced then the June contract should certainly not close below 1380.

Will a declining US Dollar create a problem for the stock market?

A substantial decline in the Dollar (a decisive break in the major up-trend dating back to the April 1995 low) is something we expect to happen prior to the end of the secular bull market in US stocks. However, a moderate drop in the Dollar may not be an immediately negative factor for the stock market. For example, it took a 40% fall in the Dollar over a 2-year period in the 1980s to prompt the panic withdrawal of capital that led to the '87 stock market crash. Furthermore, over the past 18 months European stock markets have soared as European currencies have weakened.

A sharp fall in the Dollar would have a large adverse effect on the stock market, but we see such an outcome as highly unlikely in the short to medium term. There is a `chicken and the egg' relationship at work here in that a large drop in the Dollar will not occur in the absence of a protracted bear market in US equities and/or debt, but with the US stock market confirming its intention to move higher and US bond prices not showing any signs of breaking down we should not see anything more than a normal correction in the Dollar Index in the near future. A probable scenario is that a reduction in the capital flows from Europe into the US will be offset by an increase in the capital flows from Japan into the US, giving us a stronger Euro, a weaker Yen and a relatively stable US Dollar Index.

Gold and Gold Stocks

We are quite sure that manipulation occurs in all the financial markets, including the gold market. However, we do not make manipulation of the gold price (or any other price) our primary focus because the important inter-market relationships still appear to be working. Our opinion is that manipulation has not altered the direction of the gold price trend, although it may have exaggerated the existing trend.

Some analysts consistently make the mistake of focussing on the difference between new mine supply and fabrication demand (what they call the “supply deficit”) to the exclusion of almost all else and conclude that such a large deficit in parallel with such a low gold price is proof of manipulation. They are, however, using faulty reasoning. As illustrated by Paul van Eeden in an article entitled “Understanding the Gold Price”, a large supply deficit almost always occurs in parallel with a low gold price and vice versa. This happens because the gold price is the primary determinant of fabrication demand – as the gold price moves lower fabrication demand increases and as the gold price moves higher fabrication demand reduces. Therefore, the largest supply deficits should occur when the gold price is at multi-year lows. This is exactly what we are seeing at the present time.

Whilst a low gold price naturally leads to a large so-called supply deficit, the reverse is not true. A large deficit between new mine supply and fabrication demand will not necessarily lead to a rise in the gold price because new mine supply constitutes only a small fraction of the total available gold supply.

Investment demand, which fluctuates based on confidence, determines the price at which the existing holders of monetary gold will exchange their gold for fiat currency and the price at which the holders of fiat currency will exchange their currency for gold. This price cannot be calculated because it is based on the subjective assessments of billions of individuals throughout the world.

By far the strongest influence on the US Dollar gold price is the level of confidence in, and thus the demand for, US Dollars. Since the US Dollar and gold were officially de-coupled in the early 1970s the gold price has consistently moved counter to the Dollar Index. This doesn't mean that every day the Dollar moves down the gold price will necessarily move up. It does mean that when the Dollar is in a down-trend the US Dollar gold price is usually in an up-trend, and vice versa.

On May 25 the Dollar reversed lower and commenced a short-term down-trend (it may remain short-term or it could grow into something more prolonged). On May 26 the US Dollar gold price reversed higher and commenced at least a short-term up-trend. We expect gold's up-trend to remain in effect unless/until the Dollar reverses higher. Since gold stocks have not yet reacted to this trend change in any meaningful way, they can still be accumulated at current prices. It should be noted that the Dollar Index has closed lower on 5 of the past 6 trading days, so a rebound within the on-going down-trend is likely to occur soon. However, we would not expect this to pose a problem for the budding gold rally unless the Dollar Index closes at a new high (refer to the sell stop mentioned in last week's Update).

With sentiment in the gold market having recently hit a bearish extreme (meaning that everyone who was going to sell has already sold), with many analysts having turned more negative within a few dollars of the bottom and with a large outstanding speculative short position, a sharp up-move in the gold price would not be a surprise.

Previous Market Updates

29th May
22nd May
15th May
8th May
1st May