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    - Interim Update 2nd April 2003

The Oil-Euro-Dollar Link

A hot topic of late has been the idea that the US invaded Iraq as part of a plan to dissuade OPEC countries from deciding to price their oil in euros rather than US Dollars. The thinking is that demand for the US$ gets a significant boost from the fact that oil is traded in US Dollars and that if other OPEC nations followed Iraq's lead and decided to sell their oil in euros, the relative value of the US$ would fall. This would, in turn, create economic problems for the US.

The above-described idea is interesting, but in our view makes no sense. If the OPEC countries, or any oil-exporting countries for that matter, decided that they were accumulating too many US Dollars and that they would prefer some other currency, they could simply sell their dollars in the foreign exchange market. In fact, this is exactly what Mexico is doing right now with the 'surplus' dollars accumulated via oil sales. As far as the relative values of the US$ and the euro are concerned there is no difference between a) selling the oil for dollars and then exchanging the dollars for euros in the currency market, or b) selling the oil in euros in the first place. In other words, if the OPEC countries desired more euros and less dollars they could be acting on that desire right now.

Further to the above, the US Dollar's relative value is not determined by the currency in which oil is priced, but by the desire of foreign investors to hold dollars or investments denominated in dollars. And this desire to hold dollars is, in turn, determined by the expected return on dollar-denominated investments relative to the expected return on investments denominated in other currencies. Therefore, if you believe (as we do) that the returns on dollar-denominated investments over the next year or more will be insufficient to entice the massive capital in-flows needed to offset the huge US current account out-flows, you should be bearish on the US$. We are very bearish on the US$ beyond the next 1-2 months.

So much misinformation is dispersed by governments and the news media on a daily basis in an attempt to prevent us from seeing things as they really are that it makes no sense to blindly accept the official, or widely publicised, explanations for anything. Therefore when George Bush and Tony Blair state their reasons for invading Iraq, reasonable people are naturally suspicious. In this case, though, it is entirely possible that the openly-stated motive for invading Iraq (genuine security concerns) is the real motive. While it is certainly arguable as to whether such concerns are justified and, even so, whether invading Iraq is the right course of action to address these concerns, why search for an ulterior motive when the openly-stated motive makes the most sense?

Commodities

Below are charts of the CRB Index (commodity prices from a US perspective) and the CRB Index divided by the US$/euro exchange rate (commodity prices from a European perspective). When these charts are compared it becomes clear that US$ strength made commodity prices appear weaker than they really were during 2001 while US$ weakness made commodity prices appear stronger than they really were during 2002. 

When we talk about being bullish on commodity prices we mean that we expect commodities to become more valuable relative to the US$. In fact, we expect the US$ to be weak enough over the next 1-2 years to enable commodity prices to continue trending higher in US$ terms even if economic growth remains weak. We are much less bullish on commodity prices in euro terms, although the inflationary policies of all central banks are likely to result in commodity prices moving higher in terms of most, if not all, fiat currencies.

Referring to the above charts, the CRB Index in US$ terms has pulled back to its breakout point. This important support is holding for now, although the CRB could drop all the way back to around 210 without doing serious damage to the longer-term bullish case. The CRB in terms of the euro is, however, in a more precarious position because it is only about 5% above its October-2001 bottom. 

Below is a chart of the Industrial Metals Index (GYX). The prices of industrial metals tend to be sensitive to changes in economic growth and currency exchange rates, so it is not surprising that the GYX has a) tended to move in the same direction as the stock market (the stock market is also sensitive to economic growth), and b) been stronger than the stock market since early 2002 (the GYX has been boosted by US$ weakness). The vertical arrows on the below chart identify the important turning points for the Dow Industrials since the beginning of 2000, each of which has corresponded with a turning point in the GYX. 

It is interesting that the GYX has not yet confirmed the latest rally in the stock market. If the stock market rally that began on 12th March is going to last a few months, rather than just a few weeks, then the industrial metals prices should soon start moving briskly higher. Putting this another way, if the prices of industrial metals such as copper, aluminium and nickel don't start moving higher in the very near future then we should be even more skeptical than we already are with regard to the sustainability of the current stock market rally.

The US Stock Market

Current Market Situation

Our view has been that a 1-2 month rally began on 12th March and that while we expect the 21st March peak to be exceeded before the next major decline gets underway, we don't expect it to be exceeded by a wide margin. The rough targets we've mentioned over the past few weeks are 9000 for the Dow Industrials, 925-965 for the S&P500 Index, and 1550-1600 for the NASDAQ Composite. 

Below is a chart of the S&P500 Index showing the downtrend that has been in force since the first quarter of 2000. The initial stage of the latest rally ended at the same trend-line that almost every other rally over the past 3 years has ended (the blue line on this chart). The market then experienced what appears to be a normal pullback before once again rising to the blue trend-line during Wednesday's trading. The red line on the chart identifies the major channel top and a likely short-term target if the S&P500 can manage a daily close above 895.

Below are short-term charts of the S&P500, T-Bond and Dollar Index futures. These charts show that Wednesday's minor upside breakout in the S&P500 was confirmed by breakouts in bonds and the Dollar.

Below is a chart showing the NASDAQ100 Index (NDX) and the NASDAQ100 Volatility Index (VXN). It is amazing how often a market that breaks out of a trend will move back to its previous trend-line before continuing in the direction of the breakout. This is exactly what the NDX appears to have just done.

The above charts paint a picture of a market that has rallied to a logical resistance level, experienced a normal pullback, and is now on its way to a new recovery high. However, we included the chart of the VXN above to highlight one of the reasons why there is little chance of the market making substantial gains from current levels. Pullbacks within uptrends are necessary to enable the 'wall of worry' to remain in place and volatility indices such as the VXN are one measure of how much worry, or fear, there is in the market. Interestingly, the VXN, which typically moves in the opposite direction to the NDX because a falling market usually generates fear, actually sunk to lower levels during the recent market pullback. In other words, traders became less worried as the market pulled back. Needless to say, this is not the type of sentiment platform from which major rallies are launched. 

The Commitments of Traders Data

In the past two Weekly Updates we noted the substantial reduction in the net-short position of the commercials (the 'smart money') in S&P500 futures. This was mentioned as being a bullish development. However, a few of our readers correctly pointed out that there has been a huge increase in the net-short position of the commercials in the E-mini S&P500 contracts (an E-mini contract is one-fifth the size of the full contract). We don't usually take the E-mini contracts into consideration, but in this case we will because the E-mini positions are currently so large. Therefore, in the coming Weekly Update we'll discuss what story is being told by the commitments' of traders data when the total positions (full contract + e-mini contract) of the commercial traders and the small traders are taken into account.  

Gold and the Dollar

Back to the 70s

Throughout the course of last year we would occasionally show a chart comparing the progress of the Amex Gold BUGS Index (HUI) since its November-2000 bottom with the progress of gold stocks from their major bottom in January-1972 (using the Barrons Gold Mining Index (BGMI) to represent the performance of the gold stocks during the 1970s). Each time we showed the chart we marveled at how closely the latest gold-stock bull market was tracking its 1970s' counterpart, although we never took the chart too seriously because we could never come up with a good explanation as to why the remarkable similarity should continue into the future. In other words, we thought the chart comparison was interesting and that it provided some confirmation that we were witnessing a major bull market in gold stocks rather than just another bear market rally, but we doubted that the chart had any predictive ability.

Below is an updated version of the chart (the blue line on the chart shows the percentage change in the BGMI from its 1972 bottom while the pink line shows the percentage change in the HUI from its 2000 bottom). The chart continues to interest us because although there have been large differences in the magnitudes of the moves made by the BGMI during the 1970s and the HUI over the past few years, the correlation between the two sets of data has remained high. Also, the major turning points have continued to line up extremely well. For example, the peaks in May of 2001, May of 2002 and January of 2003 occurred within a few days of corresponding peaks in July of 1972, July of 1973 and February of 1974. If the major turning points continue to coincide then gold stocks should be bottoming now and there will be another important peak near the end of June this year.

Our other work indicates that the correction low is in place for the HUI. This means that the pattern is, at this stage, unfolding as the above chart implies it should.    

Current Market Situation

In the latest Weekly Update we said that it would not be surprising to see the HUI 'back and fill' for 1-3 days following last Friday's surge, but that even if the gold price fell back to $320 in the short-term the HUI should remain above last Friday's low. We've now had 3 days of 'backing and filling' and it is certainly possible that a few more days of consolidation will occur, particularly if the war news remains positive for the "coalition". However, the price action in the gold stocks over the past few days has been consistent with our view that a bottom is in place and that prices will work their way higher over the next several weeks. 

Below is a chart of the HUI/gold ratio. The HUI/gold ratio bottomed on 12th March and has since moved higher. In other words, gold stocks have been moving higher relative to the gold price over the past 3 weeks, which is exactly what should be happening if the correction low for the HUI was already in place. 

Late last year and early this year we mentioned the 1.08-1.10 range as a likely place at which the US$/euro exchange rate would peak during the first quarter of this year. The euro did pullback after reaching this range and the pullback is probably not yet complete. It has substantial support in the 0.96-1.01 range which we expect will hold during any further weakness over the coming 1-2 months. The below chart shows the major support and resistance levels for the euro as well as a rough projection of what we think the European currency will do over the coming few months. A reasonable target for the euro over the coming 18 months is 1.35 (about 25% above yesterday's closing level).

TSI commentaries in MS Word format

In addition to being able to access the commentaries at the web site, paid-up subscribers have the option of receiving the Weekly and Interim Updates as MS Word documents attached to e-mails. However, the computer problems that delayed last week's Interim Update have also forced us to suspend the delivery of the TSI commentaries in this format. After undergoing the electronic equivalent of a triple bypass operation our other computer should be back with us tomorrow, so we should be able to resume sending the commentaries in MS Word format beginning with the next Weekly Market Update.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/

 
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