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    - 05 June, 2002

Bonds, Commodities, and Wave 2 Corrections

We are not, by any stretch of the imagination, practitioners of Elliott Wave analysis. We do, however, appreciate the tendency of markets to move in waves with the most common pattern being a 5-wave sequence. In such a sequence waves 1, 3 and 5 are in the direction of the trend whereas waves 2 and 4 are counter-trend moves or corrections. The biggest moves usually occur during Wave 3. 

We don't use Elliott wave analysis to forecast the markets because wave patterns are always much clearer in hindsight than they are in real time. However, we occasionally make reference to wave counts in our commentaries because doing so can help us illustrate what we think is happening. Furthermore, a basic understanding of the tendency of markets to move in waves helps an investor to appreciate how mass psychology changes during the course of a major trend. For example, the point of maximum pessimism does not usually occur at the bottom of the downtrend. Rather, it typically occurs near the bottom of the Wave 2 correction during the new up-trend. Similarly, the point of maximum optimism will often occur near the top of the Wave 2 correction in a new downtrend.

Now, let's take a look at some examples. 

Below is a chart showing the T-Bond price since 1998. T-Bonds reached a long-term peak in October of 1998 and then embarked on a Wave 1 decline that bottomed in January of 2002. We then saw a Wave 2 correction that retraced almost all of the Wave 1 decline and peaked on 1st November last year (the day after the US Treasury told us that future US budget surpluses were going to make the T-Bond obsolete (Hah!!)). The failure to make a new high and the spectacular fall in the bond price following the 1st November peak suggests that bonds are now in the early stages of their Wave 3 decline.

Below is a chart showing the CRB Index since 1998. The CRB is moving in a similar pattern to bonds but with a lag of about 2 years. Whereas bonds now appear to be in the early stages of a Wave 3 decline the CRB appears to be in the early stages of a Wave 3 advance. Definitive technical evidence that these are, in fact, 3rd-wave moves within major 5-wave sequences won't be available until bonds move below their January-2000 low and the CRB moves above its October-2001 high. However, the stock market (where we do our trading) usually rewards those who correctly anticipate major moves, not those who react to obvious technical breakouts.

The lead/lag relationship mentioned above between commodities and bonds can be clearly seen if we compare charts of the CRB Index and the T-Bond and offset them by 2 years as shown below.

The gold market provides another good example of a market that shows signs of being in the early stages of a Wave 3 move (see chart below).

The US Stock Market

2 + 2 still equals 4

The following was taken from Jim Stack's InvesTech web site (www.investech.com):

"Something doesn't add up between the economics of Main Street and the financial world of Wall Street. The stock market, which normally leads and foretells the outlook for the economy, has been heading down since mid-March. Many indexes are at 6-8 month lows. That seems to warn of another dip back into recession for the U.S. economy.

Yet some of the most leading and reliable economic barometers are on stable footing or moving higher - including consumer confidence and the Purchasing Managers Survey (shown here). Monday's release of this survey data for the manufacturing sector showed a rebound to 55.7 -the best reading in over two years. Clearly, either these economic barometers will experience new weakness in the months ahead... or Wall Street's woes and concerns are overdone."

We don't want to pick on Jim Stack, but he is bullish on the stock market and his growing sense of frustration at the stock market's lack of response to positive economic data provides a good example of where many stock market bulls are going wrong. One of the reasons that today's stock market bulls are bullish is that the economy is recovering. Conversely, almost all stock market bears are bearish on the economy and have found reasons to doubt the generally bullish economic data over the past 6 months. Our view differs from that of most bulls and most bears in that, as far as this year is concerned, we are bearish on the stock market whilst being bullish on the economy.

Rather than wondering if Wall Street's concerns are overdone or if the economic barometers are going to experience new weakness in the months ahead Mr Stack would do better to pose the following questions:

1. Is it reasonable to expect a stock that is twice as expensive as it should be to become even more expensive just because the economy returns to a moderate growth path?

2. Is it reasonable to expect stocks that are already over-priced to become more over-priced in a rising interest rate environment, that is, in an environment where price/earnings ratios will tend to contract?

3. Why should this month's reading of 55.7 for the Purchasing Managers' Survey cause investors to pay substantially more for stocks than they were prepared to pay during the many other times over the past 35 years when the survey result was at this level or higher?

The major problem faced by the stock market - the main reason that the senior stock indices continue to sink in the face of bullish economic data - can be quickly recognised by doing a valuation analysis of almost any of the large-cap tech stocks. For example, let's take a look at Intel. Intel should benefit greatly from a strengthening economy since it is, in effect, a commodity-cyclical company (the computer chips Intel produces are 'new age' commodities). The problem is - and this is the problem faced by the entire market - Intel is selling at twice its historic price/sales ratio.

'Old age' commodities, however, are quite cheap (in CPI-adjusted terms many commodities are selling near their lowest levels of the past 80 years). So, there is every reason to expect a strengthening economy, even if the strength is only nominal, to result in considerably higher prices for 'old age' commodities such as copper.

In summary, it's all a matter of valuation. The bullish analysts who expect an improving economy to push the major stock indices higher will continue to be disappointed because these indices are still heavily influenced by the leaders of the last bull market. And, in most cases, the leaders of the last bull market remain very expensive. The best the bulls can reasonably hope for is that the improving economic backdrop will limit the downside. Then again, if the stock prices of Intel, Microsoft, et al, get cut in half over the next few months then we really could have an excellent set-up for a bull market.

Current Market Situation

There is no change to our short-term view. The market is edging higher and we wouldn't be surprised to see it maintain an upward bias for another week or so, after which the downtrend is likely to resume. At this stage we plan to use any significant strength over the next week to add to medium-term bearish positions.

Gold and the Dollar

The Rand Gold Price

The last time we looked at the gold price in terms of the SA Rand was in the 21st November 2001 Interim Update. At that time we concluded as follows:

"...although we expect the Rand's depreciation to enable some of the SA gold mining companies to report substantial increases in earnings for the current quarter, thus minimising downside risk in the stock prices, by far the biggest influence on the stock prices of all major gold producers is the US$ gold price. For example, the Rand gold price has been in a strong uptrend since mid-1999 and yet the SA gold stocks trended lower throughout much of last year [2000]. They bottomed and turned higher in November 2000 along with the US$ gold price and most North American gold stocks. It is a similar story with the Australian gold stocks. Although the earnings of the Australian gold miners may be more directly tied to the A$ gold price, the Aussie gold stocks usually only rally in response to (or in the expectation of) a rally in the US$ gold price.  

In summary, it is only at those times when the US$ gold price is expected to rally that we get significant upside in the stock prices of the South African and Australian gold producers. This tells us that the stock prices of gold-producing companies are determined more by confidence in the US$ than by company earnings."

Below is a 2-year chart of the Rand gold price. Due to a strengthening Rand the gold price, from the perspective of South African investors and gold producers, has been trending lower for the past 6 months. Over the same period the shares of the unhedged SA gold producers have made spectacular gains. This is evidence that the US$ gold price, not the gold price in local currency terms, is the most important driver of gold stock prices. It also reflects the influence of foreign investors on the prices of SA gold stocks (investors in North America and Europe seeking to take advantage of a weakening US$ can do so by buying SA gold stocks).

If the Rand continues to strengthen it will limit the future earnings growth of the SA gold producers, but a stronger Rand presents a much lower risk than would a substantially weaker Rand. Continuing strength in the Rand will encourage additional foreign investment in South Africa. It will also tend to put downward pressure on local prices and, hence, on local interest rates. By contributing to economic stability a stronger Rand might also contribute to political stability. As such, we are not at all concerned with the negative effect that continued Rand strength would have on the earnings of our SA gold producers.

Current Market Situation

It is estimated that the BOJ has spent $25B buying dollars over the past 2 weeks in an attempt to strengthen the US$ against the Yen. This massive intervention has temporarily halted the Yen's advance but has not altered the short-term trend. This is an interesting battle since there are no objective limits on the amount of money that can be printed by a central bank, that is, there are no limits on the amount of Yen the BOJ can sell in its efforts to support the US$.

The Reserve bank of Australia hiked official interest rates by 0.25% earlier this week, the second official rate hike in Australia over the past 2 months. As more and more central banks around the world raise short-term interest rates to rein-in inflation while the Fed keeps US rates at multi-decade lows because, as everyone knows, there is no inflation in the US (snicker, snicker), the downward pressure on the US$ will continue to increase.

Below is a daily chart of June gold futures showing the 18-day, 50-day and 200-day moving averages. Although Wednesday's $7 drop seemed rather dramatic the price has not yet fallen to even the 18-DMA.

With a lot of weak-handed 'longs' having taken positions in gold futures and gold shares over the past 2 months the risk of a sharp pullback in the prices of the shares and the bullion had become very high. The major unhedged SA gold shares reversed lower at the beginning of last week while some gold stocks actually made new highs on Tuesday before reversing course. Yesterday's drop in the gold price was apparently initiated by someone dumping several thousand contracts onto the market during the thinly-traded after-hours session. This action on the part of one aggressive seller was clearly carried out with the intention of knocking the price down, rather than getting the best price, but it should be noted that the ploy was only effective because the market was dramatically overbought. 

If this is the bull market we think it is then the gold price will find support at or above its 50-DMA (currently at $310.50). There is more downside risk in the gold shares than in the bullion because stock prices, in many cases, had already moved up in anticipation of a $350-$400 gold price.

At this stage we don't know how long or how deep the correction in gold stock prices will be. Based on what we think is going to happen in the currency and stock markets (we expect any counter-trend rallies in stocks and the Dollar to be short-lived) it could well be over within the next week or so. The worst case (for the bulls) that we can envisage would be a 2-3 month correction. At a similar stage of the 1972-1974 gold-stock bull market the average gold stock fell by 30%-40% over a 2-3 month period before climbing almost vertically over the ensuing 3 months.

For those who have not yet built-up a sizeable position in gold stocks this pullback is a god-send. We suggest averaging-in to some of the high-quality gold and silver stocks (eg, HGMCY and SIL) on weakness and building positions in a few of the more speculative issues as the opportunities present themselves. Many of the small stocks are extremely volatile so one way to approach this 'building' process is to place some bids well under the market in the hope of getting 'hit' during an emotional selling squall. Here are some suggestions (the first number is our suggested under-the-market bid price and the number in brackets is Wednesday's closing price). Note that the less exposure you currently have to gold and silver stocks the less stingy you can afford to be with any new buying.

Cumberland Resources, CBD.TO, C$2.50 (2.80)
American Bonanza, BZA.V, C$0.14 (0.18)
Western Copper, WTC.TO, C$1.90 (2.62)
Croesus Mining, CRS.AX, A$0.75 (0.83)
RSG options, RSGO.AX, A$0.25 (0.30)
Dundee Precious Metals Fund warrants*, DPM.WT.A, C$2.00 (3.15)

*Go to http://www.etfconnect.com/select/fundPages/sectors.asp?MFID=3729 for details on the Dundee PM Fund. The warrants have a strike price of $25 and an expiry date of Feb-2004.

Update on Stock Selections

BHP Billiton has recently been weak due to a hike in the UK petroleum tax, a strike at BHP Steel and rises in both the A$ and the Rand (a lot of BHP's costs are denominated in A$ and Rand whereas it generates US$ revenue). The tax hike and the strike are short-term issues. Strength in the A$ and the Rand is, we think, the beginning of a longer-term trend that is based on the emerging bull market in commodities. If this is the case then the market should soon stop worrying about the hit to this year's earnings due to unfavourable exchange rate movements and start focusing on the boost to earnings due to rising commodity prices. We think BHP is a strong buy near current levels for investors with a 12-18 month investment timeframe.

The Gold Fields Ltd (GFI) stock price has recently been very weak (the price has dropped 25% since the beginning of last week). It has fallen to its 50-DMA and should find support near current levels. 

 
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