Big Picture View

Here is a summary of our big picture view of the markets. Note that our short-term views may differ from our big picture view.

Bond yields (long-term interest rates) will continue to move in the same direction as the stock market, that is, new lows in bond yields (new highs in bond prices) will occur before the end of 2003.

The US stock market will move well below the October-2002 low during 2003, but a major bottom won't occur until 2004.

The Dollar commenced a bear market in July 2001 and will continue its decline during 2003 and 2004.

A bull market in gold stocks commenced in November 2000 and will continue during 2003 and 2004.

Commodity prices, as represented by the CRB Index, will rally during 2003 and 2004 with most of the upside occurring in 2004.

How are currency exchange rates determined?

A complete answer to the above question would necessitate a book (one we are not qualified to write). However, we'd like to just make a couple of points in response to a recent article by Frank Shostak titled "The Dollar and the Balance of Trade". In this article, which can be read at http://www.gold-eagle.com/gold_digest_03/shostak052203.html, Dr Shostak asserts that it is 'purchasing power parity', not the balance of trade, that determines currency exchange rates. Using a simplistic example, this means that if 1kg of potatoes can be purchased with 1 US dollar in the US and 2 euros in Europe then US$1 is equivalent to 2 euros, that is, the euro/US$ exchange rate should be 2. In this example it would certainly be possible for the euro/US$ exchange rate to move a considerable distance from 2 in either direction, but it would eventually move back to purchasing power parity (2 euros = 1 dollar).

We are in partial agreement with Shostak's argument because a trade deficit can be thought of as an effect of a mismatch in purchasing power. In other words, if goods produced in Europe are cheaper than the equivalent goods in the US then US consumers will buy from Europe rather than buy the home-grown product. In this case the US would be in deficit with respect to trade with Europe. However, we think it is important to take into consideration the fact that trade in goods and services accounts for less than 10% of total international capital flows, with investment accounting for the remaining 90+%. So, even if purchasing power parity exists between the US and the EMU this could only bring approximately 10% of total capital flows into balance. What happens with the remaining 90% will be determined by the expectations of investors regarding future 'real' returns on dollar-denominated investments relative to euro-denominated investments. As such, if it takes an average of 24 dollars to buy one dollar of expected future company earnings in the US and 12 euros to buy 1 euro of expected future company earnings in Europe then the dollar might be vastly over-priced at a level of 1 euro = 1.17 dollars (the current rate) even if 1kg of potatoes cost the same in Europe and the US.

At the current exchange rate the US$ and the euro are probably close to achieving purchasing power parity as far as the prices of goods and services are concerned. As far as investments are concerned, whether or not purchasing power parity has been achieved will be determined by what investors expect the real returns in Europe and the US to be over the next 1-2 years. 

Purchasing power parity at an investment level is not measurable, but the effect of a disparity is observable in the currency market. For example, the dollar will continue to fall against the euro if investors are not sufficiently bullish on the US relative to Europe. 

Our view is that the dollar continues to sport an enormous investment premium - a premium that is evident in stock and bond market valuations (inflation-adjusted earnings, dividend and bond yields are very low) - relative to the euro and most other currencies. This, in turn, implies that the dollar is valued at a level that can only be sustained if investors throughout the world remain optimistic with regard to the prospects for US economic growth, earnings growth and interest rates. 

The US Stock Market

The Tax Cut

Below are extracts from a Wall St Journal article about the tax-cut package that has just been approved by the US political establishment:

"Congressional leaders' embrace of a package officially priced at $350 billion over 10 years reflects concerns that the economy could be slipping back into recession. The true price tag could as high as $810 billion, if, as expected, various temporary provisions are ultimately extended. But Mr. Bush is particularly eager to lift the economy and investors' spirits before he has to face the voters in November 2004. He's looking to avoid the election result his father suffered after winning a war with Iraq but letting the economy slide."

"Economists believe Ö the tax bill should add about half of a percentage point to the economy's annual growth rate in the second half of this year and another half to a full percentage point next year. That would push the economic growth rate -- barring unhappy surprises -- to between 3% and 4% over the 18 months."

"White House spokesman Ari Fleischer said Thursday the tax cut will pump $226 billion into the economy in the first two years, more than the $191 billion that would have resulted from the president's initial proposal."

The tax cuts that have just been approved will need to be financed via more government borrowing. If the new debt is monetised (purchased by the Fed or by private banks using money created out of thin air), then this means higher inflation (higher money supply growth). Using the figures quoted in the Wall St Journal and assuming that the new debt is monetised (it almost certainly will be), an effect of the tax cuts is that the money supply has just been given a $350B-$810B boost (the actual figure will depend on whether or not the temporary provisions are extended) over the next 10 years. Furthermore, $226B of this increase in the money supply will occur over the next 2 years.

If the new debt is not monetised then the tax cuts will simply result in a few hundred billion dollars being transferred from one group of people (the people who buy the new debt) to another group (the beneficiaries of the tax cut). 

Either way there will be no sustainable increase in real economic growth (sustainable growth must be based on savings, not on debt). However, it is likely that GDP growth will be given a boost over the next 12-18 months (growth will be higher than it would have been, although it still probably won't be very high).

In our opinion, the tax cuts represent a slight positive for the overall stock market over the next year or so and a very significant positive for commodity prices (including the gold price). This, in turn, will likely mean that if the stock market can hold above support during the current pullback (see below) then the ensuing rally should result in substantial out-performance by the commodity-cyclical stocks. As such, if we see some evidence that support is going to hold then we'll probably add one or two more non-gold commodity stocks to the TSI Stocks List.

Current Market Situation

A pullback has been underway in the stock market over the past couple of weeks. There was an initial drop and, as almost always happens, a partial retracement of the initial drop. If the market continues to follow a normal corrective pattern then the next stage of the decline should commence in the near future (this week).

As the pullback progresses we will be watching a number of indicators to help us determine whether it represents the first stage of a major decline (one that will eventually result in last October's lows being decisively breached) or simply a correction within an on-going rally. Our guess is that it will turn out to be the latter and that a major decline won't begin until at least the third quarter of this year, but fortunately we don't have to rely on guesses. 

We've mentioned in previous commentaries that the performance of the NASDAQ100 Index relative to the performance of the Dow Industrials Index will help us figure out whether the current pullback is a normal correction or something far more significant. Some examples of other things we'll be monitoring are:

1. The Walmart (WMT) stock price. WMT has been a leading indicator for the overall market during the past year. For example, WMT peaked about 6 weeks before the overall market during the final quarter of last year and bottomed about 5 weeks before the overall market during the first quarter of this year. 

As the below chart shows, WMT peaked at the end of April and has recently been very weak. It has reached support in the 51.50-52.00 range and will probably soon bounce, but if the next rally in WMT makes a lower high (below the April high) and the stock subsequently makes a lower low then the overall market is most likely in big trouble.

2. The semiconductor stocks, as represented by the Semiconductor Index (SOX), failed to confirm the recent moves to new recovery highs by the NASDAQ100 Index and the NASDAQ Composite Index.  It would now be a bearish sign for the overall market if the SOX closes below the uptrend-line shown on the below chart.

3. The Dow Transportation Index has been one of the best-performing stock indices over the past 2 months. If the 'transports' can hold above support at 2260 during this pullback then we are probably seeing a correction within an on-going rally rather than the start of a major decline.

The SARS Threat

Current indications are that the impact of SARS on the economies and stock markets of the world is not going to be as great as appeared likely just one month ago. Although new cases and deaths are still occurring, the rate at which the disease is spreading has slowed dramatically over the past few weeks and the WHO has just removed its travel warning from Hong Kong. SARS still represents a risk, but it appears as though the disease has been contained.

This week's important economic/market events
 

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