Introduction

Every January we produce a report, imaginatively named "The Yearly Forecast", to summarise what we think will happen in the markets over the coming year and to briefly review last year's forecasts. Our Yearly Forecast doesn't include much backup information since the backup has either already been provided, or will soon be provided, in our regular commentaries. Also, any forecasts we make are obviously not fixed in stone. The current forecasts are based on our analysis of the currently available evidence (fundamental, technical, sentiment, inter-market, monetary, and political factors), that is, they are a 'snapshot' based on what we know right now. However, if the evidence changes, as it almost certainly will as the year progresses, we will try to make whatever adjustments are necessary to bring our expectations back into line with reality. 

Year 2002 Review

The US Stock Market

Last year's forecast was for the S&P500 to bottom at around 800 towards the end of 2002, representing a drop of about 30% from its level at the time we made the forecast. The actual closing low for the S&P500 was 777 on 9th October. However, around the middle of the year we adjusted our longer-term forecast for the S&P500 based on a re-assessment of technical, valuation and sentiment criteria. Rather than a major bottom at 800 during 2002 we argued that the 2002 bottom would not likely be THE bear market bottom and that much lower levels would probably be reached before the end of 2003.

Currencies

The Dollar Index

Our view at the start of 2002 was that any strength in the US Dollar would be confined to the first quarter of the year and that the Dollar Index would decline to 105 or lower by the 4th quarter (it was trading at around 119 when we made the forecast). The Dollar Index ended the year at 101.8.

The Yen

At the time we were writing last year's forecast the Yen was very weak, but our expectation was that it would reverse sharply higher from whatever low was reached during the first quarter. This view proved to be correct. However, although we expected 2002 to be an 'up' year our longer-term view remained bearish (we thought that 2002's likely rally in the Yen would be a counter-trend move within an on-going primary downtrend). This is a view that has now changed.

The Swiss Franc

We expected the SF to trend higher from whatever low was made during the first quarter, which is what happened. Furthermore, the ability of the US$/SF exchange rate to move decisively above major resistance at around the 0.65 level confirmed that last year's rally was part of a new long-term trend as opposed to a counter-trend move within a long-term bear market.

The Australian Dollar

Mainly as a result of our bullish view on commodity prices going into 2002 we expected the A$ to move sharply higher during the course of the year. It ended up gaining a bit less than 10% against the US$.

Bonds

Last year's forecast was that the abnormal inverse relationship between stocks and bonds that had been in effect since 1998 would end in 2002, as would the long-term up-trend in the bond market (the long-term downtrend in interest rates). We were wrong. The bond market continued to trade in the opposite direction to the stock market throughout 2002 and the extreme weakness in stocks was sufficient to push the T-bond price to a new multi-year high.

Gold and Gold Stocks

Last year's forecast was for gold and gold stocks to move sharply higher following a low during the first quarter and was thus roughly in line with what actually happened. Also, we said that the S&P500/XAU ratio would drop to 10:1 by the final quarter of 2002 (from its level of 17.5:1 at the beginning of 2002). The S&P500/XAU ratio bottomed at 11:1 in September.

Commodities

Our view was that stock market weakness would probably limit the upside in commodity prices during 2002. As such, although we were confident that 2002 would be a very good year for the CRB Index relative to the S&P500, we weren't so sure that it would be a great year in absolute terms. We were most bullish on silver, copper and natural gas and least bullish on oil. Oil surprised us on the upside and silver surprised us on the downside while natural gas and copper performed in line with expectations.

The Major Trends For 2003

Every year we make investment decisions based on all the known evidence, but even if we have assessed the evidence correctly there is always the possibility that some unforeseen event will occur that throws our best-laid plans into disarray. The difference, this year, is that we already know there is going to be an event and we already know some of the details (we know that the event will involve Iraq). What we don't know, and can't possibly game, is whether 'the event' will be:

a) A war against Iraq that is won quickly and efficiently by the US and its allies, or
b) A war against Iraq that takes longer and is more costly than most people currently expect, or
c) A non-military resolution of the brewing Iraq conflict

Each of the above possible outcomes will have very different implications for the financial markets. The major trends won't be altered, but the paths taken by the markets over the course of the year will be different depending on what happens with Iraq. Since we have no way of knowing what the outcome of the current geopolitical crisis will be we can't factor Iraq into our forecasts. We will just have to make whatever adjustments are necessary as more information becomes available.

The US Stock Market

In order to bring stock valuations into line with where they have been near the bottoms of previous bear markets the S&P500 Index would have to drop to around 400, that is, the market would need to fall by more than 50% from its current level. Furthermore, if the S&P500 continues to fall at the same rate as it has been falling since the first quarter of 2000 (if it remains within the channel shown on the below chart) then the earliest the index could reach 400 is the end of 2003. 

The bear market won't end until the S&P500 Index is either fairly valued or under-valued based on criteria such as the average dividend yield, the average price-to-book ratio and the average price-to-sales ratio. However, there is no reason why the market's 'valuation problem' has to be solved this year. Due to the clear message from the Fed that the money supply will be ramped-up to whatever extent is necessary to prevent prices from falling, it is not unreasonable to expect that the current bear market will take considerably longer to hit rock bottom than, say, the 1929-1932 bear market. In fact, at this stage of the 1929-1932 bear market a major capitulation, creating great values and a long-term bottom, had already occurred, whereas in the current bear market high valuations and complacency continue to reign. Therefore, although it is probable that further progress will be made this year towards the point where the overall market represents a great investment opportunity, the ultimate bottom might be delayed. In fact, as a result of the strong commitment to inflation on the part of policy-makers we think this is likely. 

In early-December of last year and during the first 2 weeks of this year sentiment became very bullish. This happened despite the lack of evidence that either the economy or corporate earnings were about to experience a substantial recovery and despite the internal weakness of the market (from a technical perspective there has never been any sign of the rally that began on 10th October being anything more significant than a 'garden variety' rebound within an on-going bear market). This bullish sentiment seemed to be based almost entirely on a belief that 2003 is almost guaranteed to be an 'up' year because the market never falls during the 3rd year of the Presidential cycle and because the market never falls for 4 years in a row. However, before another multi-month rally becomes possible this widespread optimism will have to be squashed. Therefore, regardless of how the market finishes the year we think it will have to fall far enough during the first half to convince most people that 2003 will be the 4th 'down year' in a row. The red line on the below chart roughly shows the path we expect the market to take this year.

Note that concerns over valuations won't prevent us from turning bullish on the market if, at some point, a genuine selling climax occurs. At this stage, though, there doesn't appear to be much chance of a selling climax occurring until prices have moved below last October's lows.

Currencies

Dollar Index

Last year's currency forecasts were easy because it was crystal clear that the US$ was going to spend most of the year trending lower. This was because fundamental, technical and sentiment factors were in synch (they were all 'dollar bearish'). This year, however, the situation is not straight forward because a) sentiment towards the dollar has turned very negative (which is, of course, bullish since the majority is almost always wrong) and b) the dollar is rapidly approaching price levels on the chart at which it is likely to find strong support. On the other hand the fundamentals are even worse than they were 12 months ago (the US current account deficit has increased and the Fed is talking about printing dollars at a breakneck pace in order to combat falling consumer prices).

A market that is trending strongly in a particular direction and in which the fundamentals fully support a continuation of that trend will still experience the occasional counter-trend move. Furthermore, such counter-trend moves can be substantial (they are often large enough to convince people that the major trend has changed). Another way of saying this is that no market goes from 'over-valued' to 'under-valued', or vice versa, in a straight line. With the dollar approaching an 'oversold' (a technical term that has nothing to do with value) extreme we think a substantial counter-trend move is likely to begin within the next 2-3 months.

Below is a chart of the Dollar Index showing the major uptrend-line that was decisively broken late last year and the two most likely price levels at which the current stage of the US$ bear market will halt. These support levels are defined by the 1999 and 1998 lows and correspond to Dollar Index levels of (approximately) 97 and 92. The lower level is our present target, a target we have forecast would be reached during the first quarter of this year. However, given that the euro and the SF are within 2%-4% of important resistance our current short-term Dollar Index target, which is 8% below yesterday's closing level, might be too bearish. As such, we will need to be alert to the possibility that the Dollar Index will make an intermediate-term bottom in the 96-98 range.

The above chart shows that the Dollar Index trended strongly higher from mid-1995 through to its peak in July-2001. Along the way, though, there were 3 large corrections (August-October 1998, July-October 1999, and October-December 2000). Since peaking in July of 2001 there has been one large correction (the bear market rally that ran from September 2001 through to January 2002). If the Dollar Index makes it to 92 before experiencing a large correction and if this correction retraces 50% of the preceding decline (not an unreasonable assumption), then it would rebound back to around 107 before embarking on the next stage of its bear market. If the Dollar Index bottoms at 97 then a rebound back to around 110 would be a normal 50% retracement.

Our forecast for 2003 is that the Dollar will bottom early in the year, after which a lengthy (4-8 month) counter-trend move will occur.

The Yen

Below is a 9-year chart of Yen futures. Over the past 2 years the Yen appears to have formed a head-and-shoulders bottom, although it needs to move above 88 to complete the pattern. Also, the Yen recently broke the downtrend-line that has been in force since 1995. 

This year is expected by us to be roughly the opposite of last year, that is, we expect that Yen strength during the first quarter of this year will be followed by a lengthy consolidation period. However, our longer-term view on the Yen relative to the US$ is now bullish. Following the aforementioned consolidation the Yen is likely to move well above whatever high is reached during the first quarter of this year (the completion of the head-and-shoulders bottom pattern would project a move up to around 100) roughly as shown on the below chart. As should be the case with most currencies, we expect that Yen strength over the next 2 years will be the result of extreme dollar weakness. The Japanese monetary authorities will no doubt try to stem the Yen's rise but, given that the Fed has now signaled its intention to weaken the US$ in an attempt to stimulate economic growth and given the Fed's huge advantage in the currency devaluation race (the massive US current account deficit makes the dollar a naturally weak currency), they probably won't be successful.

The Swiss Franc

Below is a 9-year chart of the SF futures including our rough projection of this year's pattern. Note that the purpose of all the projections shown on the various charts included in the Yearly Forecast is to show expected price directions, not expected price levels. However, in the SF's case major resistance defined by the 1998 peak is a likely place for the current phase of the bull market to end and this is, in fact, what we've shown on the chart.  

The Australian Dollar

In the 15th January Interim Update we explained that over the past 3 years the A$ has tended to under-perform the euro (and the SF) during periods when the US stock market has been weak and out-perform when the stock market has been rallying. Therefore, if we are correct that most of this year's stock market weakness will be confined to the first half then it is likely that the A$ will be a relatively weak currency over the next 3-6 months and a relatively strong currency thereafter. In fact, once the stock market reaches an intermediate-term low the A$ should be one of the world's strongest currencies because it will benefit from the ensuing stock market recovery and the continuing bull market in commodities.

The below 5-year chart shows that the A$ has broken above important resistance. We expect the A$ to move sharply higher following a correction during the first half of this year.

Gold

A strong inverse correlation between the gold price and the US$ has existed since the official link between the two was broken in 1971. As such, any 12-month forecast we make for the gold price should be consistent with our currency market forecast, and vice versa. Over the short-term it is not uncommon for gold and the US$ to move in the same direction, but the intermediate-term trends are almost always headed in opposite directions.

Below is a 4-year chart of the gold price showing the expected pattern over the remainder of this year. Immediately below the gold price chart we've included a chart of the Swiss Franc to highlight the strong inverse correlation between gold and the Dollar (the inverse correlation between gold and the Dollar results in a strong positive correlation between gold and the Swiss Franc). Following a peak during the first quarter of this year we expect the gold price to enter an extended correction which will, amongst other things, result in a substantial reduction to the large speculative long position in gold futures that has built up over the past few months. We expect this correction to be followed by the next phase of the gold bull market (and a MUCH higher gold price).

In general, gold stocks will move with the gold price but with greater volatility. As such, all the major gold stocks are likely to experience substantial corrections following peaks during the first quarter. However, it is quite possible that the junior gold mining companies with the best prospects and the best management will just continue to trend higher during this year's gold price pullback. A lot depends on how high they move over the next couple of months, but at this stage there is still excellent value to be found amongst the juniors (the same cannot be said for the seniors). This value is likely to prevent prices from dipping as far as would normally be expected. Also, any significant weakness in the prices of companies that control multi-million ounce gold deposits is likely to attract predators. In fact, another wave of takeovers in the gold mining sector is probable during 2003.

Bonds

If not for the strong inverse correlation between stocks and bonds that has existed for the past several years and remains in effect we would presently be extremely bearish on bonds. This is because a yield of 5% on a 30-year US Government bond doesn't come close to compensating an investor for the current dollar-depreciation risk. However, the inverse correlation does exist. 

Rather than trying to anticipate when the relationship between stocks and bonds is going to return to 'normal', a mistake we made last year, this year we will assume that the inverse relationship is in control until price action proves otherwise. As such, our bearish view on the stock market over the next 6 months dictates that we have a positive view on bonds over the same period. 

Our bond market view can be summarised as follows: The downside potential in bonds from current levels over the coming year is far greater than the upside potential, but that downside potential is unlikely to be realised until after the stock market has reached an intermediate-term bottom.

Commodities

Our 2003 outlook for commodities is almost identical to the 2002 outlook described in last year's annual forecast. Going into last year we were bullish on commodities, but were concerned that stock market weakness would prevent major price gains from occurring during 2002. Instead, we thought the really big moves would not occur until 2003.

Really big moves in the commodity market will probably occur in 2003, but not until after the stock market has reached an intermediate-term bottom. Therefore, if our current stock market forecast 'pans out' then we are likely to see a normal bull market correction in the CRB Index during the first half of this year followed by a strong rally during the second half.

Chart Sources

Charts appearing in the above commentary are courtesy of:

http://stockcharts.com/index.html
http://bigcharts.marketwatch.com/