Yearly Forecast

Below is a snapshot of how we think stocks, bonds, the US$, gold, gold stocks and commodities will perform during 2005. Note, though, that what will determine our success over the coming year isn't the accuracy of forecasts we make in January, but rather our ability to adjust if/when the facts change (it would be very unusual if the facts did not change in at least some of the major markets over any given 12-month period). In other words, real-time analysis of risk versus reward, not our ability to predict where prices are going to be in 6-12 months time, will determine how much money we make.

By the way, this is not an admission that we have no confidence in our current views. It is, instead, both an acknowledgement that change is the only constant in the financial markets and a warning not to become married to any forecast. That is, we should always keep our minds open to the possibility that things could play-out differently to what we currently expect.

    The US Stock Market

Over the past 4 months we've discussed the possibility that today's market was following a similar path to the one followed by the market during 1972-1974. In order for this idea to remain valid a strong rally during the final few months of 2004 had to end early in 2005 and give way to a major downward trend lasting 1-2 years. And so far, the current market has followed the 1972-1974 model as closely as could reasonably be expected. In particular, a strong rally occurred when it should have and we are now seeing signs that a major top is being put in place.

Bullish sentiment is now so ingrained that a consistent downward trend is unlikely to begin in the near future. Instead, we suspect that a top will evolve during the first quarter of this year with, for instance, a new recovery high in the Dow Industrials Index in February or March being unconfirmed by the NASDAQ100 Index.

Our thinking is that the US equities will trend lower from the first quarter of 2005 through to the third quarter of 2006, although as discussed in our 3rd January commentary the decline could prove to be quite erratic with enough 'head fakes' along the way to make betting against the market a difficult proposition. In fact, if today's market continues to move roughly in line with the 1972-1974 model then the best short-selling opportunities won't emerge until 2006.

So, our forecast is simply that the stock market will reach its high for the year during the first quarter and that 2005 will be a 'down' year.

    Bonds

In a report titled "Global: The Lessons of 2004" published on 3rd January, Morgan Stanley's Stephen Roach wrote the following about the US bond market:

"And that takes me to the second lesson of 2004 - a shockingly benign climate in US and global bond markets. Take yourself back a year ago: If you had known that the Fed would tighten by 125 basis points (I publicly urged Chairman Greenspan to go by 200 bps), that the US core inflation rate would essentially double, that crude oil prices would shoot up into the mid-$50 range, that the US economy would grow by nearly 4.5%, that America's twin deficits (budget and current-account) would soar, and that the dollar would come under renewed pressure, the bearish call for longer-term US interest rates would have been a no-brainer. And yet yields on 10-year Treasuries basically ended the year where they began at approximately 4.2% - with a modest increase in inflationary expectations largely offset by a surprising decline in real interest rates (as captured in the inflation-indexed TIPS market). Hard as it may be to admit, this result basically turns the art of interest rate forecasting inside out."

We second Mr Roach's view that last year's performance by the US bond market made no sense in light of everything else that happened. In fact, as far as we are concerned the ability of the US bond market to end 2004 approximately unchanged was the year's biggest surprise (we had expected bonds to end the year with a large loss) and makes us wary about making any bond market predictions this year.

The weekly chart of bond futures included below has bearish implications in that it shows a lengthy period of consolidation following an initial sharp decline (the odds are in favour of such a pattern eventually breaking to the downside), and bond valuations appear to be unreasonably high in that current yields provide buyers with minimal compensation for inflation risk. The problem is, even if we are right to be intermediate-term bearish there is no reason why the drawn-out consolidation that began in August of 2003 couldn't continue for several more months. Furthermore, foreign central banks -- large-scale buyers of bonds that really don't care if they are being adequately compensated for the risk of future dollar depreciation -- continue to be a big factor in the US bond market.

Despite the difficulties we will, however, venture a forecast and it is that bonds will achieve their highs for the year during the first quarter and break below their August-2003 and May-2004 lows before year-end. And this weakness, we think, will be precipitated more by a rally in the US$ and a resultant reduction in central bank purchases of bonds than by a surge in inflation expectations.

    The US$

We've devoted a lot of space in previous commentaries to explaining our intermediate-term bullish view on the US$, so we won't go into any detail now. Suffice to say that we expect the dollar to trend higher during 2005 from whatever low it makes during the first quarter of this year. There's a significant possibility that the aforementioned low was put in place on the first trading day of the year, but even if it wasn't we doubt that there will be anything more serious on the downside than a drop to a marginal new low later in the first quarter.

    Gold

With the dollar looking set to trend higher for at least 6-12 months 2005 will probably turn out to be a down year for gold. However, gold's downside potential from its current level of around $420 looks quite small (10%-15%), particularly in comparison to its longer-term upside potential.

If the US$ drops to a marginal new low at some point over the next 3 months then gold could surge up to the $470-$500 range before embarking on a 6-12 month correction. In fact, a surge to a new high in the gold price during the first quarter of 2005 has been our favoured outcome for some time. However, the action in the currency market during the first week of the year has increased the probability that a major low is already in place for the dollar and this, in turn, has reduced the likelihood that gold will trade above its December-2004 high at any time over the next several months.

    Gold Stocks

We turned short-term bearish on gold stocks, as represented by the AMEX Gold BUGS Index (HUI), within 1 week and 3% of last November's peak. We then turned intermediate-term bearish a week later with the HUI still within 3% of its high.

As far as 2005 is concerned it's fair to say that we are much more bearish on gold stocks than we are on gold bullion. And the reason the stocks continue to have a lot more downside risk than the metal, despite the 18% drop in the HUI that has transpired over the past 8 weeks, is their massive out-performance over the preceding 4 years. To be specific, a trough-to-peak gain of 80% in the gold price during the first leg of the current secular bull market was accompanied by a gain of around 550% in the HUI.

The extent of the HUI's out-performance during the bull run that began in November of 2000 is not unprecedented. In fact, even greater out-performance occurred during the first upward leg in the secular gold bull market of the 1960s and 1970s. However, these periods of dramatic out-performance by gold stocks are invariably followed by periods of dramatic under-performance, and we think that such a period began last November and will continue throughout much of this year.

Price targets generally aren't useful and can actually be destructive if they become fixed in a speculator's mind. In this case, though, we are going to mention some targets because doing so should help to clarify what we mean when we say we are intermediate-term bearish and long-term bullish on gold stocks.

As far as the HUI is concerned, we have 120 in mind as a downside target for this year and 700-800 in mind as an upside target-range over the coming 4 years. These 'guesstimates' are mostly based on the performance of the gold sector during the major mid-cycle corrections and subsequent multi-year advances that occurred within the context of the last secular bull market in gold stocks. They are also consistent with our currency market views (this year's dollar rally should give way to another multi-year period of weakness) and the need for the major gold stocks to substantially under-perform the gold price during 2005 in order to move from a level of over-valuation to one of under-valuation.

By the way, our expectations for silver and silver stocks are roughly in line with our expectations for gold and gold stocks.

    Exploration- and Development-Stage Gold Stocks

It is not uncommon for individual junior gold stocks to buck the intermediate-term price trend in the gold sector due to company-specific news on the exploration front. As a group, though, they invariably move with the overall sector, but often with greater volatility and significant lags. For example, whereas Newmont Mining might gain 30% over a 6-month period via a steady upward trend, over the same period a speculative junior might go nowhere for 5 months and then double within the space of a month for no apparent reason. Therefore, if the HUI were to drop to a much lower level over the coming 12 months as per our current view then it would be normal for a portfolio of juniors to do the same, except that the juniors would probably get from 'A' to 'B' in a far more erratic manner.

As things currently stand, though, many of the juniors we follow did not fully participate in last year's May-November rally and were very under-valued at the beginning of the current correction. It's not uncommon for an under-valued stock to become even more under-valued, but the price action in many of the juniors suggests that there are few 'weak hands' left in these stocks. This, in turn, might lead to the small stocks holding up better than their large- and mid-size brethren throughout the anticipated sector-wide correction.

In any case, as discussed in the 20th December Weekly Market Update there are several junior gold/silver stocks in the TSI List that are currently priced so far below where we expect them to be trading in three years time that we would be prepared to hold them through a substantial correction.

    Commodities

As discussed in previous commentaries, we think the bull market in commodities that began in 2001 is primarily a currency story and, therefore, that there will be a lengthy correction in the CRB Index if there is a lengthy recovery in the US$. We also expect that downturns in global stock markets and economic growth expectations during the second half of this year and the first half of 2006 will put downward pressure on commodity prices, particularly the industrial metals. We are therefore bearish on commodities as far as the coming 12-18 months are concerned.