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    - Interim Update 6th April 2005

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The coming deflation scare

...the story is unfolding in a way that makes another big deflation scare a likely prospect within the next few quarters. ... If a deflation scare did eventuate it would likely have short-term bullish implications for the dollar and bearish implications for gold.

In the 5th January Interim Update we said: "...if the various markets do roughly what we expect them to do then another big deflation scare is probably on the cards for 2005-2006. In particular, if a) gold and gold stocks experience normal mid-cycle corrections over much of this year, b) the stock market peaks during the first quarter of this year and then declines into the next 4-year cycle bottom (due in the second half of 2006), and c) commodities trend lower between the second quarter of this year and the third quarter of 2006 in synch with reduced global growth expectations and a strengthening US$, then deflation fears will once again begin to dominate the financial landscape. However, it's a very good bet that the end result of the 2005-2006 deflation scare will be the same as the result of every other perceived deflation threat of the past 70 years -- more inflation, one of the main effects of which will be currency depreciation."

We are now into the fourth month of the year and at this stage the financial markets are doing roughly what we expected them to do, that is, the story is unfolding in a way that makes another big deflation scare a likely prospect within the next few quarters. As mentioned in previous commentaries, these deflation scares are quite useful as far as the Fed is concerned because they provide the justification for more inflation. In fact, inflation confers no benefits whatsoever -- not even the transitory kind -- if the public recognises the inflation problem and takes action to protect itself. However, when most people are unconcerned about inflation or believe deflation to be the bigger threat then the Fed is free to inflate to the fullest extent of its powers. That the Fed retains this freedom to inflate is critical because for every dollar in the world there are several dollars of debt, the result being that inflation is the lifeblood of today's monetary system. Or, putting it another way, the current monetary system is effectively the world's largest-ever "Ponzi scheme" in that new money must be continually brought in to allow earlier obligations to be met.

The main difference between genuine deflation and a deflation scare is that the former is a contraction in the total supply of money whereas the latter is a psychological reaction to falling prices. In particular, although a fall in prices that is not preceded by a reduction in the total supply of money has absolutely nothing to do with deflation, many people wrongly think that falling prices and deflation are one and the same. Therefore, whenever there's a broad-based sell-off in the commodity markets the idea that the country is headed towards deflation becomes popular and the call goes out to the Fed to inflate-away the looming threat. The Fed then answers the call even though genuine deflation was never a serious threat in the first place.

If a deflation scare did eventuate it would likely have short-term bullish implications for the dollar and bearish implications for gold. The reason is that inflation expectations would almost certainly start to fall BEFORE the Fed had completed its rate-hiking campaign, meaning that there would be a brief period -- a few months, perhaps -- when real US interest rates* were rising quite sharply. However, gold would likely begin its next major advance as soon as the market sensed that the Fed, in response to the deflation scare, was about to shift from a modestly restrictive monetary stance to an extremely loose one.

As far as the debt markets are concerned, the thing we can say with the greatest amount of confidence is that the outcome of a deflation scare would be a flight to quality. In other words, a highly probable outcome would be an across-the-board widening of credit spreads (under-performance by emerging market debt relative to US Treasury debt, high-grade corporate debt relative to US Treasury debt, and low-grade corporate debt (junk bonds) relative to high-grade corporate debt). We can also confidently predict that the Fed would make an about-face soon after the markets began to agonise over the prospect of deflation. In fact, the way things are panning out there's a good chance that the next official rate-CUTTING campaign will begin before year-end.

Although US Treasury bonds would likely perform well relative to almost all other bonds during a deflation scare, we don't have a strong opinion on how they would perform in absolute terms. A lot, we suspect, will depend on what the market does over the coming 2-3 months. A sharp sell-off in the T-Bond market during the next couple of months, for example, would set the scene for a powerful rally over the remainder of the year.

    *The real interest rate is the nominal interest rate minus the EXPECTED inflation rate

The US Stock Market

The Nikkei Model

At this stage we prefer the "1970s Model" to the "Nikkei Model"...

In the latest Weekly Market Update we re-visited the "1970s Model" for the US stock market. This model is based on the idea that today's market is following a similar path to the one taken by the market during 1972-1974.

The "1970s Model" took centre stage in our analysis last September when the odds shifted in favour of the market breaking out to the upside from the range in which it had traded since the first quarter of the year. Furthermore, the potential for today's market to experience a downturn during 2005-2006 that was roughly equivalent to the 1973-1974 downturn was underlined by a few significant political, economic and geo-political similarities between 1972 and 2004.

Prior to last September, however, we had been favouring the "Nikkei Model". Specifically, our thinking had been that the performance of the Japanese stock market during 1994-1996 represented a rough outline of what we could expect from the US stock market over the ensuing two years. For old times' sake let's now take another look at the Nikkei Model.

Below is a chart comparison of the post-bubble Nikkei and the post-bubble NASDAQ100 (NDX). Both charts begin at the day of the bubble peak and extend for 6 years. Interestingly, the charts suggest that although the NDX's move to a new recovery high during the final quarter of last year was a deviation from the Nikkei Model, the model might still be valid.


It is quite reasonable to have a roadmap in mind when contemplating the future performance of any market, but it's critical not to be married to any view of how the story will unfold. In other words, you must be willing to adopt a new outlook if the facts no longer support your current one.

At this stage we prefer the "1970s Model" to the "Nikkei Model" because the former is in synch with the 4-year Presidential Cycle and meshes with our views on other markets. Also, we think there are more similarities between the US of 1973 and the US of today than there are between Japan of 1995 and the US of today. In any case, the only real difference between the two models is in the speed of the decline back to the October-2002 lows. For example, if the US stock market were to experience a fast-enough decline over the coming several months to take the NDX back to near its October-2002 low by the final quarter of this year then the odds would shift strongly in favour of the "Nikkei Model".

Current Market Situation

The below chart of the NASDAQ100 Index (NDX) shows that the market is working off its 'oversold' condition via a modest upward drift. This is bearish and supports our view that the next big move will be to the downside. Further consolidation is likely over the coming 1-2 weeks with resistance at 1550 being our assessment of the NDX's maximum near-term upside potential. The 50-day moving average is, however, a more reasonable upside goal for the rebound.


During February and March we said to allow for the possibility that the Semiconductor Index (SOX) would manage a short-lived surge above resistance at 450 before commencing a large decline. The chances of such an upside breakout are now lower than they were, but note that triple tops are rare so a move back to around 450 would almost certainly lead to a breakout above resistance.


Gold and the Dollar

The US$ and US debts

...we are long-term dollar bears so we clearly don't accept the idea that the current high level of US indebtedness will turn out to be a significant positive for the US currency.

US$ bears regularly point towards the massive public- and private-sector debt levels in the US as reasons to expect a much weaker dollar. Debts that have already been accumulated do not, however, exert any direct downward pressure on the dollar. In fact, the high debt levels constitute a potentially positive influence on the dollar's value relative to other currencies and tangible assets because these existing debts represent obligations to obtain dollars in the future; in other words, all else being equal these debts will increase the future demand for US dollars. This is the essence of a theory developed by Bob Hoye many years ago and subsequently embraced by a few other analysts including Richard Russell.

Now, we are long-term dollar bears so we clearly don't accept the idea that the current high level of US indebtedness will turn out to be a significant positive for the US currency. Our reasoning is summarised below.

There are three ways in which the size of the US debt burden could be reduced. The first way would be for borrowers to incur the bulk of the repayment cost by cutting back on their expenditure and allocating every spare dollar to the repayment of debt. This would increase the demand for currency and simultaneously reduce its total supply, resulting in substantial upward pressure on the dollar and a severe recession. The second way would be for lenders to incur the bulk of the repayment cost by writing off a large portion of their outstanding loans. This would ultimately lead to a lower supply of dollars and, therefore, a higher dollar. But once again it would result in a severe recession due, in part, to the collapse in asset prices that would occur when lenders re-possessed and sold the assets that had originally been posted as collateral for the written-off loans. The third way would be for the bulk of the repayment cost to be passed along to everyone in such a surreptitious and gradual way that most people wouldn't realise what was happening until it was too late. That is, for the extent of the debt burden to be reduced via inflation.

We have little doubt that the US monetary authorities will choose the third way because doing so would allow the illusion that everything is OK to be maintained for as long as possible. And in any case, given the "Ponzi scheme" nature of the current monetary system they don't really have a choice. In fact, it is clear to us that the US monetary authorities have ALREADY chosen the third way. THIS is why we aren't anticipating any dollar strength, especially relative to gold, beyond the intermediate-term.

Current Market Situation

In the latest Weekly Update we mentioned that last Friday's performance by the dollar in the wake of a weak US monthly employment report was very similar to its performance following weak employment reports in early-January and early-February. We also noted that a continuation of the similar trading pattern would result in the dollar peaking by this Tuesday and then pulling back.

The below daily chart of the Dollar Index shows that the recent rally has resulted in a test of hefty resistance at around 85. This resistance is most likely going to be breached within the next several weeks, but perhaps not until after an intervening pullback/consolidation. It is possible that an interim peak was put in place on Tuesday in line with the post-employment-report pattern mentioned above and that such a pullback has begun. A normal pullback within an on-going upward trend would take the Dollar Index back to near its 50-day moving average.


The pound/euro ratio generally trends in the same direction as the Dollar Index and often leads the dollar at important turning points. The below chart shows that pound/euro continues to support the short-term bullish case for the dollar.


If the dollar were to consolidate its recent gains over the coming 1-2 weeks then gold would probably move back into the 430s. Note, though, that it's very unlikely that gold has already bottomed for the year.


Gold Stocks

Current Market Situation

With reference to the below chart of Newmont Mining (NEM), we suspect that the gold sector is currently experiencing a short-lived consolidation similar to the ones that occurred during December and January. We remain short- and intermediate-term bearish on the gold sector, but think the odds are in favour of a modest amount of additional upside over the coming 1-2 weeks.


South African Gold Stocks

Some of the problems facing the major South African gold producers include low/falling profit margins due to a combination of the depressed Rand gold price and escalating costs, industrial action (the workers at one of Harmony's largest operations have gone on strike and there are likely to be more strikes over the next few months as part of the process of negotiating new wage/benefit deals), and a government intent on following a socialist agenda that involves redistributing mining wealth. Although the problems with the unions and the government are not likely to disappear in the foreseeable future, we expect that the SA gold stocks will turn into relative-strength leaders once the market starts to believe that a major advance in the Rand gold price has begun.

As things currently stand, the Rand gold price remains within the midst of a drawn-out basing pattern (see chart below). A decisive move above 2800 would be a clear sign that an intermediate-term advance was underway.


Update on Stock Selections

We mentioned in previous updates that one of the most likely results of DRDGOLD's (NASDAQ: DROOY) financial dilemma wasn't that the company would go bust, but that the interests of existing shareholders would get diluted via an equity issue. Dilution was almost inevitable and it has begun via an issue of 33M new shares at R5.5 per share (around US$0.90 per share at the current Rand/US$ exchange rate). We see this as a minor positive because although it will result in a 13% increase in the total number of outstanding shares the overriding consideration for the company is to stay in business long enough to benefit from the increase in the Rand gold price that is likely to occur over the coming 12-18 months.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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