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

Bonds & Oil – the recent action in bonds and oil has been irresolute. Oil has provided some technical evidence that it may have peaked, but nothing conclusive as yet. The next move of significance in the oil price will probably be to the downside, but bonds are unlikely to benefit because they are already discounting a lower oil price.

Stocks – the market is now very extended, but a further upwards surge during the coming week is probable.

Gold – the Dollar Index has remained firm and gold has continued to come under selling pressure. Unless/until the Dollar breaks lower gold is unlikely to surmount $300.

Interest Rates, Inflation and Greenspan's `Productivity Miracle'

The credit expansion has been resurrected

Figures released last week show that consumer credit continues to expand at a high rate, with the accumulation of credit card debt by low-income earners being a major driving force. Also released last week was the NYSE margin debt number for June, showing that margin debt edged higher last month after 2 months of sharp declines. Furthermore, the growth rates of the monetary aggregates are continuing to recover following a marked slowdown over the first 5 months of this year. It is therefore clear that the rumours of the credit expansion's death that were circulating during April and May, were grossly exaggerated.

As expected, the US monetary authorities seem to be once again erring on the side of inflation (excess money/credit creation). The solution to this problem is not higher `officially-imposed' interest rates, it is to remove the arbitrary whim of government from the monetary equation altogether. However, this is not going to happen anytime soon so we must work with (invest based on) what we have.

If the credit expansion continues to re-gather steam, and there is no reason to think that it won't in the lead-up to the November elections, then we should soon begin to see a reduction in short-term interest rates (as money becomes more readily available) and an increase in long-term interest rates (as rising commodity prices spur fears of inflation). In other words, we should see a shift towards a non-inverted yield curve.

Interestingly, the CFTC's latest Commitment of Traders (COT) report also points towards higher interest rates at the long-end and lower rates at the short-end, with `the Commercials' currently having a substantial net long position in 2-year notes and a net short position in 10-year notes. It should be noted, however, that the Commercials are sometimes wrong. For example, the Commercials have had a huge net short position in the S&P futures throughout the stock market's recovery from its May lows. In fact, their short position hit an all-time high about one month ago and was still at record levels based on the July 11 figures (although it no doubt contracted during the latter part of last week).

Greenspeak

Fed Chairman Greenspan delivered two speeches during the past week. On July 11 he marveled at how technological advances have provided the US with substantial and irreversible gains in productivity, also noting that today's information technology has given birth to complex financial instruments that help with the management of risk. On July 12 he spoke on the benefits of having multiple credit-creation options rather than relying solely on, for example, the banking system. Apparently, according to Greenspan, having a number of different ways of adding liquidity helps enormously when the inevitable crisis occurs.

The US Stock Market

Current Market Situation

If successful market timing was simply a matter of buying after `confirmation of strength' (an upside breakout above resistance or a particular moving average, completion of a bullish `head and shoulders' formation, etc.) or selling after `confirmation of weakness', then every market participant could easily trade profitably. Unfortunately it is not that simple and those who insist on irrefutable technical confirmation before buying or selling will often find themselves buying near short-term peaks and selling near short-term bottoms.

We have, at the present time, a stock market that has very definitely just confirmed its strength. The S&P500 has broken out of a trading range that had contained it for several weeks and is now within 3% of an all-time high, the market's leading stock (Intel) closed last week at a record high, and the advance/decline line has moved up strongly for the first time in over 12 months. So, time to buy? Absolutely not! For those who like to hold stocks for more than a few days (that is, all except the most aggressive short-term traders) a low-risk time to buy occurred during mid April and again during mid-late May. Those who buy now may well be bailed out by further speculative surges in the months ahead, but they are taking a far greater risk.

We are bullish on the stock market as far as the next few months are concerned, but we have the following reservations in the short-term:

1. The Volatility Index (VIX) is around 22, a low reading that indicates widespread complacency.
2. Over the past few sessions the ratio of put option volume to call option volume has been low. Friday was particularly notable in that the volume of CBOE equity call options reached an uncommonly-high 934,000 (3 times the volume of put options traded). The chart shown below plots the 5 day moving average of the CBOE equity put/call ratio for the year to date. A reading of around 0.35 usually corresponds to a short-term peak (note – the 3 day moving average currently sits at 0.35 so 2 more days of low readings will give a `sell' signal).
3. The speculative juices have once again started to flow as demonstrated by the 25% one-day leap in the price of Ariba after the company came in well ahead of Wall St estimates. Ariba's revenue growth rate is certainly spectacular, but a $30B market cap seems absurd for a young company that has yet to even remotely approach profitability.
4. Whereas `fear of the Fed' was rampant during May, the majority view now seems to be that a soft landing will be accomplished.

With the July `options expiration' occurring on this coming Friday we would not be surprised to see some more upside during the latter part of the week. We are also due to receive another dose of Greenspeak on Thursday as the Fed Head delivers his semi-annual Humphrey Hawkins address to Congress. Based on last week's verbal efforts it seems that Mr Greenspan is in no mood to roil the markets, so we doubt that the up-coming testimony will have any meaningful effect on stock prices.

A `set-up' in the making?

Something that may receive some attention in the press over the next 2 weeks is the fact that in both 1998 and 1999 the S&P peaked at the time of the July options expiration and then proceeded to drop quite sharply. If the market does close the coming week on a firm note and then begins to decline at the start of the following week (a likely scenario), the similarities to the past 2 years will be obvious to everyone. We therefore have a potential set-up for another rally. Why? If a market is going to reach higher levels it must periodically decline in order to facilitate the build-up of the liquidity and the skepticism that are needed to fuel the next move up. The healthiest markets move up by taking 2 steps forward and then one step backward. When the `one step backward' is prompted by something of no fundamental significance then the subsequent `two steps forward' can be quite brisk.

The other stock markets

Although our analysis focuses on the US stock market we pay close attention to what is happening in other stock markets around the world. In fact, the performance of other world markets has contributed to our confidence, over the past 2 months, that the US stock market would recover to new highs. For example, the major European markets suffered only normal corrections while the US market was going through its dramatic perturbations during the April – May period. Also, foreign markets that have close ties to the Dollar and that looked quite precarious for a while, such as those of Hong Kong, Argentina, Mexico and Brazil, have been making solid gains since May. Lastly, the Canadian (Toronto) and Australian markets have recently hit new all-time highs after suffering only moderate corrections earlier this year. The fact that most of the world's stock markets have either held up well or recovered strongly suggests that there is unlikely to be a major currency crisis or derivatives blow-up over the next few months.

Gold and Gold Stocks

Current Market Situation

Although the BOE auction was blamed for gold's downward move over the past week, a firming US Dollar was of far greater significance. Since hitting its correction low on June 16 the Dollar Index has established a sequence of higher lows. If the Dollar Index does not close below 106.9 at some point during its next pullback (likely to occur in the coming week) then there is a good chance that the Dollar's correction has run its course and we will see new highs within the next few months.

A collapse in the Dollar is not a prerequisite for a gold rally, but some sort of catalyst is certainly required. Even a quick decline in the Dollar Index to re-test important support in the 105.5-106 range may be sufficient to spur a $20-$30 bounce in the gold price. Once the gold price breaks decisively above the down trend-line dating back to the Feb '96 peak (a break above $305 is currently needed) the rally will feed on itself as short positions are covered and trend-following speculators jump on board.

On the positive side of the ledger, the Australian gold stocks continue to act well. In particular, NDY and LHG look very interesting and may provide some upside regardless of the gold price.

The bottom line is that despite the recent strength in the Dollar and the sluggish behaviour of the XAU, the gold rally that commenced on May 25 is in tact (we have, thus far, simply seen a normal 50% retracing of the initial up-move). As such we are continuing to give the bullish case the benefit of the doubt, particularly since the potential upside in gold stocks is so much greater than the potential downside.

Previous Market Updates

10th July
3rd July
26th June
12th June
5th June