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

Bonds – bond prices remained firm during the past week despite the release of some `stronger than expected' economic data. The next major move in bonds will give us an important clue as to the extent of the coming US economic slowdown.

Stocks – the market's correction over the past 2 weeks has not, as yet, provided us with a satisfactory buying opportunity. The risks outweigh the potential rewards at this time.

Gold – gold and the Dollar are stuck in trading ranges. We await the market's next move.

Interest Rates, Commodities and 1998-Similarities

In our May 1 Weekly Update we compared this year's unfolding events with the occurrences of the July-October period of 1998. In particular we noted the following similarities:

• A strong Dollar during the initial equity market decline
• Widening credit spreads
• The build-up of an enormous short position in a leading currency (the Yen in 1998, the Euro in 2000)
• High-profile hedge fund problems
• A proliferation of bearish gold market commentary

We then suggested that a continuation of the similarities would lead to a sharp drop in the stock market within 2 weeks in parallel with a bottoming of the gold price. In actual fact both stocks and gold bottomed about 3 weeks later (stocks on May 24 and gold on May 25).

In our May 8 Update we then noted an important difference between the occurrences of 1998 and 2000, namely the performance of the bond market (during 1998's financial turmoil bond prices rose as stock prices fell, whereas this year saw stocks and bonds declining in parallel throughout April and May).

The reason for resurrecting the 1998-2000 comparison at this time is that bond prices have recently been moving higher in parallel with falling stock prices. We are also seeing gold come under selling pressure and the Dollar firming against both the Euro and the Yen. Our interest in comparing the two time periods has therefore been rekindled, particularly as we are now venturing into a time of year when currency crises tend to happen.

Although there are some significant similarities between '98 and '00 there are two stark differences, the first of these being illustrated by the following chart comparison of the yields on short-term and long-term US Government debt.

The chart shows that both short and long-term interest rates fell during the crisis of 1998, whereas this year has seen short-term interest rates continue to rise in parallel with declining rates at the long-end. The result is a slightly inverted yield curve at the present time. In a nutshell, 1998 saw the large-scale buying of US Treasury instruments across the entire yield curve in a massive flight to safety, eventually leading to the urgent lowering of official interest rates. This year, however, has not (at least not yet) seen any `panic to quality', with continued relative weakness at the short-end of the curve suggesting that the demand for money is still strong and that we are not close to the point where the Fed will begin reducing official interest rates.

The other major difference between the two time frames is the performance of the commodities market. Going into the 1998 turmoil commodity prices had been declining for 12 months. They continued falling throughout the remainder of '98, bottoming and reversing higher in early '99. At the present time, however, commodity prices are strong, having risen steadily since early '99.

So, where does that leave us? Firstly, the recent firmness in bond prices may be signaling a substantial slowdown in US economic growth over the next 12 months. The economic numbers released last week painted the picture of an economy that was powering ahead, but it should be remembered that these numbers are backward-looking. The bond market, however, is forward-looking. If the bond market is correctly anticipating a slowdown then the CRB Index would be unlikely to exceed its recent high of around 227 and its next major move will be lower. Bond yields would continue to fall, as would yields across the entire curve, and the US Dollar would weaken as reduced US growth (and hence profit) prospects prompted the repatriation of foreign capital. This would be similar to the 1998 scenario, although less extreme. Alternatively, commodity prices may just be consolidating prior to another upward leg in their bull market. In this case the recent strength in bond prices would not be sustainable and yields would rise from current levels.

Under both scenarios outlined above we would expect short-dated debt securities to out-perform their long-dated cousins, that is, we expect the yield curve's inversion to dissipate. The second scenario would most likely occur if the rate of money supply growth continued to rise and we therefore assign it a higher probability.

The US Stock Market

Current Market Situation

From last week's Update: “If 1490 [in the Sept S&P] is taken out decisively (to the downside) on a closing basis then a quick drop of another 70-80 S&P points is possible. While this is not our expected outcome (we suspect that 1490 will hold) the short-term situation is quite dicey. If the market does drop to 1420 or so it will almost certainly be a buying opportunity.”

At its low point on Friday the Sept S&P contract (SPU) hit 1424, so have we reached a buying opportunity? The short answer is no, or at least not yet, for the following reasons:

1. Most sentiment indicators do not reveal an unusually high level of fear at the present time. This is not uncommon as sentiment seldom turns from optimism to pessimism during a sudden drop. Hope springs eternal and those who are caught by a quick and unexpected (by them) decline will usually anticipate an equally-quick recovery. After a sharp drop there is often a bounce that acts to solidify the hopes of the `longs'. It is only after this bounce fails to blossom into a sustainable rally that sentiment turns decidedly negative.
   
2. We have yet to test major support in the 1390-1420 range. A successful test of this range, combined with an improvement in sentiment indicators (an increase in fear/pessimism), would create an attractive risk/reward balance for a long-side trade.

During the mid-April and late-May stock market plunges we were reasonably comfortable `buying the dip' because a number of factors lined-up to create a favourable risk/reward ratio. For example, we not only had sentiment indicators hitting market-bottoming levels, we also had a very clear (as we saw it) mismatch between what the market expected the Fed to do and what the Fed was actually going to do. At the current time, however, there is simply very little evidence that the market (as represented by the S&P500) is `sold out'.

Although sentiment indicators, on the whole, are currently not confirming the imminent exhaustion of selling pressure, there are two NASDAQ indicators that have just hit `oversold' extremes. The first is the NASDAQ TRIN (we discussed the TRIN in relation to the NYSE in our July 10 Update). The second is the NASDAQ100 (NDX) put/call ratio. On Friday the volume of NDX options was more than 4 times higher than normal and the put/call ratio was an astounding 9 (that is, there were 9 NDX put option contracts traded for every 1 call option contract). This is by far the highest reading of the year and may, in fact, be an all-time record. It is so far outside the normal range that we are left to question whether or not it really means anything. One possibility is that the NDX's drop below the 200 day moving average on Friday panicked one or more mutual funds into hedging their exposure to large-cap tech stocks using NDX put options.

The coming week holds the promise of some very large oscillations. There will no doubt be an attempt to press the downside early in the week followed by an obligatory rebound. If this rebound fails (it probably will) then the market will most likely head back down towards its early-week lows. This is when the situation will become most interesting, particularly since the July Employment Report is released before the market opens on Friday morning. Depending on the condition of the market going into next Friday a `bad' Employment Report (less people out of work) may lead to a selling climax whereas a `kind' report will potentially begin the market's recovery process.

This week's important economic/market events

Gold and Gold Stocks

Current Market Situation

To a man with a hammer everything looks like a nail, so perhaps we interpreted the recent drop in the Dollar Index as a “reversal lower” simply because that is what we were looking for. In any case the market action last Thursday and Friday has proven that the Dollar's July 20 swoon in the wake of Fed Chief Greenspan's `dovish' testimony was not an important reversal.

Markets only trend 10-20% of the time, with the remaining 80-90% of the time being spent oscillating within a range. We try to anticipate trend changes, or when a market is going to resume the previous trend, but sometimes doing so proves exceedingly difficult. Such has been the case for the Dollar Index and the US Dollar gold price over the past few weeks, as both have continued to oscillate within their respective trading ranges.

Although the market has not been kind enough to provide us with an upside breakout in the gold price or a downside breakout in the Dollar, it has also done nothing to negate our bullish view on gold. It has simply been non-committal.

While we await the market's next move we thought it would be helpful to list the short-term positives and negatives for gold. So here they are:

Short-term positives

1. The latest Commitments of Traders (COT) Report showed that large speculators were only marginally net-long as at July 25. Based on the contraction in open interest since the COT Report was issued it is very likely that the large specs are now net-short and the commercial interests are net-long.
2. COMEX open interest is at its lowest level in more than seven years.
3. The XAU has stopped going down.
4. The XGO (the Australian Gold Stock Index) is in an up-trend and has outperformed the All Ordinaries Index over the past 2 months (see chart below).
5. Sentiment is extremely depressed.
6. The Dollar is `overbought'.
7. There is almost no speculative long interest in the Yen, meaning that the Yen should soon experience at least a brief rebound.

Short-term negatives

1. The recent strength in the Dollar and, in particular, the weakness in the Euro (since gold tends to trade with the European currencies)
2. Firm US Government bond prices (with a stable or rising Dollar and stable or rising bond prices there is little incentive for investors to buy gold)

The three stocks we recommended in last week's Update made small gains during the past week. Continue to hold unless sell-stops are hit.

Previous Market Updates

24th July
17th July
10th July
3rd July
26th June