<% 'pass = Request.Form("pass") IF ((Request.Form("pass") = 1) OR (Session("pass") = "pass")) THEN %> Speculative-Investor.com
    - 06 March, 2002

Growth and Interest Rates 

Long-term interest rates bottomed way back in October of 1998 and spiked-down to test their 1998 lows in early-November of last year. They've since bounced, ostensibly because the economy is recovering. While we believe the economy is recovering and will continue to grow over the next several months, we do not accept the argument that the re-emergence of economic growth is the cause of the recent rise in long-term interest rates. Why? Because the argument is not supported by either history or logic.

Let's start by looking at history. Below is a chart comparing the yield on the 10-year T-Note with the GDP growth rate since 1980. The two shaded areas on the chart highlight the periods immediately following the 1981-1982 and 1990-1991 recessions when economic growth rebounded while interest rates fell.

There have certainly been periods when interest rates rose together with rising economic growth. However, rather than rising as they have been doing since the economy bottomed late last year, it is normal for interest rates to fall during the initial stage (at least the first 12 months) of a sustainable economic recovery. 

The recessions of 1981-1982 and 1990-1991 were followed by prolonged economic expansions and were supported, in their initial stages, by falling long-term interest rates (in fact, both the economy and the stock market received some support throughout the 1980s and 1990s by the secular trend towards lower interest rates that began in 1981). This pattern was particularly evident in the early-1990s when long-term interest rates continued to move lower for 3 years after the recession had ended, thus setting the scene for a prolonged period of economic growth and rising asset prices.

What happens when interest rates rise as the economy moves out of recession as they are doing now? The 1980-1981 period provides us with an example of such a situation. Economic growth rebounded strongly during the second half of 1980 and the first half of 1981, but interest rates also moved higher. Rising interest rates then cut-short the economic expansion and by late-1981 the economy was back in recession.

To recap the above, long-term interest rates have fallen during the early stages of the two prolonged economic expansions of the past 22 years. This makes some intuitive sense because in a 'normal' economic environment a rebounding economy reduces the risk of long-term lending. When interest rates rise in parallel with a growing economy it isn't economic growth that the bond market is concerned about, it is inflation. During a 'normal' economic environment the money-supply growth rate falls to a low level during a recession and then begins to rebound when the economy recovers. It then usually takes years for the money supply growth rate to rise to a level that prompts the lenders of long-term money (eg, the buyers of bonds) to begin building a large inflation premium into long-term interest rates.

We keep referring to a 'normal' economic environment, but the current environment is most definitely not normal. During last year's supposed recession the money supply growth rate surged to its highest level in 30 years. Now we have a recovery, but rather than interest rates falling and the money supply growth rate rising as the economy embarks on a period of expansion we have exactly the opposite scenario. The money supply growth rate peaked at a very high level towards the end of last year and is now falling while long-term interest rates work their way higher. Rather than a normal economic environment, what we are seeing today is just another phase of the same old credit bubble. 

The implication for the stock market is that the post-September rally does not represent a new bull market (as is the case with sustainable economic expansions, the initial stages of new bull markets occur in parallel with falling long-term interest rates) . In fact, it doesn't represent a new anything. In some respects it doesn't even make sense to refer to it as a bear market rally since the real bear won't appear until the credit bubble bursts. 

In the next weekly update we'll review the money-supply growth situation in light of what is happening in the bond market and revisit a point we've made many times over the past 2 years: that the current US situation is very different from the situation in early-1990s' Japan.

Quick bond market update

We remain extremely bearish on bonds taking a 12-month view because we think the inflation premium that is currently built into long-term interest rates is way too low. Refer to the 2nd January Interim Update ("Bond crash to continue in 2002") for further explanation. We do, however, still think there is a reasonable chance that bonds will make one last-ditch bear-market rally attempt before a major decline begins. That rally is likely to occur some time between now and May.

The US Stock Market

Current Market Situation

In the latest Weekly Update we mentioned that a decisive move by the S&P500 above its 200-day moving-average would be sufficient to invalidate our short-term bearish view. As it turned out, however, we didn't wait for the S&P500 to surmount this technical hurdle before putting our short-term bearish view on hold. 

When the Japanese Nikkei225 Index exploded above resistance and its 200-DMA during Asian trading on Monday we put out an e-mail alert canceling our recommendation to buy QQQ put options. Based on the lead/lag relationship between the Nikkei and the US stock market that has worked so well over the past year it became clear, once the Nikkei had made such a pronounced upside breakout, that the US stock indices were headed much higher. As such it made no sense to buy put options, at least until some evidence emerged that the rally was running out of steam. The below chart, in which the NASDAQ100 (NDX) is used to represent the US market, illustrates this relationship. Note how the Nikkei has led the NDX at every important turning point since the beginning of last year.

Below is a chart of the S&P500 Index. The price action is unequivocally bullish and should be respected.

During the final quarter of last year and the first two weeks of this year our thinking was that the stock indices would remain strong during the first few months of the year and would likely reach a peak during the March-May period. However, after seeing the S&P500 fail in its second attempt to break above its 200-DMA in early-January and the Nikkei break below the bottom of its trading range in late-January, we turned short-term bearish on the market and profitably traded some QQQ put options. Now, after providing a few levels of bearish confirmation over the past several weeks, the market has just done another 'about face'.

Earlier in today's Update we argued (persuasively, we hope) that the post-September rally does not constitute a new bull market. What it does constitute is another phase of the on-going credit bubble. Furthermore, our assessment is that we are much closer to the end of something than to the beginning of something. 

Looking beyond the short-term the stock market is in a hopeless position because the more successful last year's Fed-sponsored monetary expansion is in boosting prices and consumer spending, the worse it will be for the bond market. As we've explained in the past, current stock valuations can only be justified if we are entering a prolonged period of strong economic growth and falling long-term interest rates. If interest rates continue to rise, as they must do to discount the effects of the monetary inflation that has already occurred, then the major stock indices will eventually fall to much lower levels. 

As to how the story will unfold over the next few months, we are probably within several days of a short-term peak. However, there is now a good chance that the next pullback will make a higher-low (at least as far as the Dow Industrials and the S&P500 are concerned) and will be followed by another move to new post-September highs. 

Although higher levels are now a distinct possibility over the next 2-3 months, the major risk remains on the downside. As such and as discussed in E-Mail Alert #73 sent to subscribers on Monday morning, we think the best risk/reward balance can still be found in the gold sector. This is because gold stocks have the potential to benefit from a general stock market decline, a falling Dollar or a situation where massive inflation pushes the stock indices higher. Also, we continue to like the stocks of the commodity producers (as we have done since September-October of last year).

Commodities

Prior to September-11 last year our forecast was for commodity prices, as represented by the CRB Index, to bottom in September and then embark on a multi-year bull market. As a result of the events of September-11 we said that the bottom for the CRB would probably be delayed by 2-3 months, but that the eventual upturn would be more pronounced given the massive monetary injection in the wake of the terrorist attacks. The "big picture view" for commodity prices that we include at the top of every Weekly Update has been unchanged since 1st October of last year and states that the CRB Index "will reverse higher by the first quarter of 2002 (at the latest) and then rally over the ensuing 1-2 years"

We've been waiting for technical confirmation of a bottom in the CRB Index before turning short-term bullish on commodities, with part of that technical confirmation being strength in the major commodity currencies (the A$ and the C$). The below chart of the A$ is certainly bullish, although the upside breakout is not yet decisive.

Below is a chart of the CRB Index. The CRB Index broke-out from its 12-month downtrend last December, then made what now clearly appears to be a normal breakout pullback before surging to a new post-September recovery high. It has also closed above its 200-DMA.

Both the A$ and the CRB Index are moving with the S&P500, so the biggest risk with commodities (and with the A$) is that the stock market tanks. However, the evidence of a CRB bottom is now compelling enough to bring our short-term view into line with our bullish longer-term view.

Gold and the Dollar

The BOE Fire Sales

We've read several articles over the past week explaining that the BOE gold auctions that began in 1999 were a disaster for the UK Treasury because the gold was sold too cheaply. Apparently, the gold was sold for $200M-$300M less than what it is now worth on the spot market. However, to measure the success or failure of the auctions by looking at what the gold is now worth versus what they got for it is to completely miss the point. 

Claiming that the auctions were some sort of stupid mistake because the gold was sold too cheaply assumes that the goal of the auctions was to get the best possible price. Nothing could be further from the truth. The purpose of the auctions was to sell gold at the lowest possible price, not the best possible price. 

The world's leading central bankers and treasury officials aren't mentally-challenged, they are ethically-challenged. The fact that gold is still below $300 indicates that the auctions were a resounding success and we give the BOE, the UK Treasury, the Fed and the US Treasury top marks for designing and successfully implementing a strategy that has helped them achieve one of their objectives. The two hundred million dollars or so of opportunity cost sustained by the UK Treasury is just a drop in the ocean compared to the money that has been made/saved by prolonging the life of the credit bubble by a few more years. However, the fact that the gold price is presently $40 higher than it was in July-1999 (at around the time of the first auction) means that natural market forces are beginning to overwhelm the price-fixers.

Current Market Situation

The Dollar has displayed enough weakness over the past week to significantly reduce the probability that a rally over the next few weeks (what we expect to be the final rally prior to a major decline) will take the Dollar Index to new multi-year highs. It now looks like the best case for the Dollar will be a re-test of the January high.

Below is a chart of the euro. We are looking for a break above the 6-month downtrend to confirm that a major euro rally (Dollar decline) has begun. 

Gold appears to be in a state of suspended animation with bears defending $300 and bulls defending $290-$292. Another surge over the next month is still a likely prospect, while the maximum downside potential that we can envisage if the $290 level gives way is to the low-$280s.

Update on Stock Selections

In E-mail Alert #73 we recommended buying Barrick Gold (ABX) July $20 call options. This is the first time we've ever recommended taking any position in ABX. The way some gold market commentators talk you get the impression that ABX deserves to be included in George Bush's "axis of evil". Our view, however, is that ABX's senior management just don't 'get it'. They don't understand their product and they don't understand what motivates investors to buy gold stocks. The management problem is a reason not to invest in ABX, but it is not a reason to forego a short-term trade when an opportunity presents itself.

Below is a chart of ABX. The action over the past 4 weeks looks like a consolidation within a continuing up-trend.

Our trading position in TVX was stopped-out for a small profit on Tuesday when the stock sold off on news of a large write-down and a 1-for-10 reverse split. With speculative stocks such as TVX it is important to rigidly adhere to protective stops and not to second-guess the market. As such, we are officially 'out' of the stock. Having said that, TVX's recent price action is not particularly bearish. In fact, the below chart shows that the recent decline found support at the 50-day moving-average and did not violate the short-term up-trend. A close below the 50-DMA would, however, be very bearish. We may come back to TVX in the future (perhaps after the 1:10 split has been completed) since the reasons we liked it in the first place (its American gold assets) are intact.

 
Copyright 2000-2002 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>