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    - Interim Update 7th May 2003

The US Stock Market

Don't worry, be happy

Over the past year, two of the most powerful trends in the financial markets have been the downward trend in the US$ and the upward trend in the bond market. It seems to make sense, therefore, to conclude that when things really do start to get better we will see a change in at least one these trends, that is, we will see the dollar start to strengthen and/or bonds start to weaken. As discussed in last week's Interim Update, one way to determine if this is happening is to look at the bond/dollar ratio (the price of a 30-year Treasury Bond divided by the Dollar Index).

Last week we included a chart of the bond/dollar ratio to highlight what we consider to be an important non-confirmation of the stock market's rally. In a nutshell, the powerful up-trend in the bond/dollar ratio caused by a strengthening bond market combined with a weakening US$ was showing no signs of abating. In fact, the ratio appeared to be headed for a new high. This was, in our opinion, one piece of evidence that the stock market's rally was based far more on hope than on any genuine improvement in the fundamentals.

We'll now take another look at the relative performances of bonds and the US$, this time over a longer period of time and using the dollar/bond ratio as opposed to the bond/dollar ratio.

There are two points we want to make with respect to the below chart of the dollar/bond ratio (note, by the way, the line on the chart rises when the US$ is rising relative to US bonds). First, as if in mockery of the 'feel good' rally that has occurred in the stock market, the dollar/bond ratio has just sunk to a new low for the year. This is a glaring divergence - either the currency and bond markets are completely wrong or the stock market is wrong. Second, the dollar/bond ratio has just moved down to near the level that was reached during the height of the August-October 1998 financial crisis (when the Asian currency/debt crisis, a Russian debt default and the failure of a massive hedge fund combined to almost bring down the house of cards known as the world's financial system). At that time, fear was rampant in the stock market (the VIX was above 50 and 48% of the newsletter writers surveyed by Investors' Intelligence were bearish) and stock prices were plunging. Now we have a similar extreme in the dollar/bond ratio, once again indicating a crisis, but this time stock-market participants couldn't be more complacent (the VIX is around 23 and only 24% of newsletter writers are bearish).

When the crisis dissipated in 1998 the dollar/bond ratio moved sharply higher, as did the stock market. Note, though, that the stock market wasn't able to begin its recovery in 1998 until the dollar/bond ratio turned higher. As long as the dollar/bond ratio was falling the stock market remained under immense pressure. Today, however, the things that are causing the crisis (economic weakness in most of the major economies and the massive US current account deficit) obviously aren't perceived to be big problems for stock market. That, however, will change.

Another non-confirmation of the bulls' case

While we are on the subject of non-confirmations, lets take a look at a chart of the A$ in terms of the euro (the below chart shows the number of euros per Australian Dollar, so the line on the chart rises when the A$ is rising relative to the euro). Over the past few years the A$ has out-performed the euro during periods of stock market strength and under-performed during periods of stock market weakness. For example, the important stock market peaks in September-2000, May-2001 and March-2002 (identified by the down arrows on the below chart) corresponded very closely with peaks in the euro/A$ exchange rate while the important bottoms in April-2001 and September-2001 (identified by the up arrows on the below chart) corresponded almost exactly with troughs in the euro/A$ exchange rate. Also, huge rallies in the A$, relative to the euro, followed the intermediate-term bottoms in the stock market that occurred in April and September of 2001. However, there clearly hasn't been anything similar over the past 9 months (the shaded area on the chart). In fact, the chart of the euro/A$ rate reveals the same sideways trading since last July as the chart of the S&P500 Index. 

The above chart is actually consistent with the generally sideways action in the stock market, but it is inconsistent with the prevailing stock market sentiment.

Current Market Situation

Below is a chart showing the NDX/Dow ratio (the NASDAQ100 Index divided by the Dow Industrials Index). The uptrend in the NDX/Dow ratio is one of several signs that investors have become less risk averse over the past several months (the NASDAQ100 stocks are generally considered to be more risky than the Dow stocks). Furthermore, the early and middle stages of all the major declines over the past 3 years have been characterised by weakness in the NDX relative to the Dow. Therefore, and as discussed on many occasions since late February this year, as long as the uptrend shown on this chart remains intact we shouldn't get excited about the prospect of another major decline in the stock market (a drop in the stock indices to well below last October's lows).

Further to the above, a decline in the stock market over the next few weeks that does NOT result in a break of the uptrend in the NDX/Dow ratio is probably going to create a buying opportunity for short-term traders. Note: Given how bullish most traders currently are, a pullback has a very high probability of occurring over the next 1-2 weeks.

Several weeks ago we mentioned that the stock price of the world's largest company (Walmart) had been a reasonable leading indicator for the overall market over the past year or so because it had peaked and troughed in advance of the S&P500 Index. We also mentioned that a new recovery high in the S&P500 Index that was not confirmed by a new recovery high in the Walmart stock price would be a sign of trouble for the market.

Interestingly, this week's new high for the S&P500 Index was not confirmed by a new high for WMT. As the following chart shows, WMT peaked at the end of April in the midst of a resistance range. It is too early to know whether this non-confirmation of the recent new high in the S&P500 is important because WMT might just be pulling back in preparation for another rally. However, the significance of this non-confirmation would increase if WMT now closes below its April low ($51.50).

Bond market Update

The below chart of June bond futures shows that bonds made a new high for the year on Wednesday. This is surprising, to say the least, considering that the stock market had moved to a new recovery high just one day earlier. 

We can come up with three possible explanations for the recent strength in the bond market. They are:

a) The inverse relationship between stocks and bonds that has dominated the financial landscape since 1998 is no longer in effect and bonds have begun to respond to economic fundamentals.

b) The Fed is surreptitiously following through on its threat to cap long-term interest rates at an artificially low level by buying bonds. 

c) A huge divergence is building and this divergence will be resolved, in the near future, by a sharp drop in stock prices OR a sharp drop in bond prices. 

Of the above, explanation a) is the least likely. In the absence of a panic that pushes money towards the lowest-risk investments it is extremely unlikely that US bonds would remain strong in the face of such a weak US$. We are clearly NOT in the midst of a panic at this time. In fact, as we've pointed out many times over the past 2 months there are definite signs that investors are becoming less risk averse, not more risk averse. We would take explanation a) more seriously, though, if at some stage we witnessed just one trading day during which both stocks and bonds dropped sharply.

Explanation b) has the advantage of explaining how US bonds could be so strong in parallel with both a plummeting US$ and a rising US stock market since any effort by the Fed to cap long-term rates would encourage foreign investors to exit dollar-denominated debt. If this explanation is the correct one then the dollar will remain very weak, bonds will remain surprisingly strong and the stock market will not plummet in the short-term. Also, the gold price should soon start to show considerable strength because it is the one currency that central banks can't create out of thin air and, therefore, can't devalue at will. 

At this stage we think explanation c) is the most likely. However, if the market believes the Fed is capping long-term interest rates by buying bonds, or that it will do so in the future, then this belief will certainly be contributing to the bond market's rally.

Gold and the Dollar

Currency Update

Since early last month our expectation has been that the Dollar Index would bottom in the 95-96 range during May. We are obviously now in May and the Dollar has fallen to the 95-96 range, so this is not the time to be aggressively bearish on the dollar as far as the short-term is concerned. However, as discussed in the latest Weekly Update a near-term spike below 95 is a definite possibility. In fact, a drop down to our long-standing target of 90 would be technically perfect and would set the stage for a substantial counter-trend rally. 

The below monthly chart of the Dollar Index shows the break of the long-term uptrend that occurred during the final quarter of last year as well as the major support corresponding to the 1998 and 1995 lows. In our opinion the US$ would be a strong BUY in the 90-92 range in anticipation of a multi-month counter-trend rally. However, the term 'counter-trend' must be emphasised because last year's break below the major upward-sloping channel projects an eventual decline to the 1995 low. 

Gold doesn't move inversely to the US$ so much as it moves in the same direction as the Swiss Franc (gold's positive correlation with the SF is much stronger than its negative correlation with the Dollar Index). For this reason we spend more time looking at charts of the SF than at charts of any other currency. Interestingly, the sharp decline in the gold price in terms of the euro over the past few months has been mirrored by a sharp decline in the SF relative to the euro.

What appears to have happened since the beginning of this year is that the relatively weaker currencies have made catch-up moves against the currencies that had previously been relatively stronger. For example, coming into this year gold and the SF were the two strongest currencies while the C$ was one of the weakest, but since the start of this year we've seen the euro and the A$ make up some ground against gold and the SF while the C$ has made up ground against almost all other currencies. 

Gold Stocks

From the latest Weekly Update: "Two weeks ago it looked like gold stocks were in the early stages of a rally that would take the HUI to a new high over the next few months. However, although gold stocks recovered nicely during the second half of last week the entire rally since the 13th March low is starting to look more like a rebound within a continuing downtrend than a new uptrend. This view would be reinforced if the HUI turns lower from at or below the top of the channel shown on the below chart. And a move below the bottom of the channel would strongly suggest that the 13th March low was not the final low for the correction that began in January."

As the following chart shows, the HUI hit its short-term channel top on both Tuesday and Wednesday before reversing lower. This, in turn, improves the chances that the rally since 13th March has been a counter-trend move and not the initial stage of a new uptrend as previously suspected. 

As discussed in the Weekly Update, we do not think that a drop below the 13th March low would have long-term bearish implications for gold stocks. In fact, a pullback to around the 105 level in the HUI over the next few months would potentially be far more bullish, as far as the next 1-2 years are concerned, than would a near-term surge above the May-2002 and January-2003 peaks.

Note that the possibility of a drop below the 13th March low won't become a high probability until after the HUI moves below the bottom of the channel shown on the above chart, but if you feel over-committed to gold stocks then it is better to get your house in order while prices are higher than to wait for confirmation of the short-term bearish case. By the way, as previously mentioned we don't plan to do any significant selling of junior gold stocks in our own account. We have purchased these stocks in anticipation of MUCH higher prices over the next 2 years and would welcome another opportunity to add to existing holdings over the next few months. However, in order to be comfortable enough to ride-out the periodic gut-wrenching declines in these stocks you need to fully understand the big picture and you must have plenty of cash in reserve.

Gold and Silver

The gold price has moved quietly higher in 'stair step' fashion since bottoming in early April (see daily chart of June gold futures below). It jumped above its 50-day moving average last week and has subsequently consolidated within a narrow range around $342. A breakout from this range will very likely occur within the next 3 trading days.

So far gold has done nothing to negate our forecast for a move up to around $360 within the next few weeks, although given the price action in gold stocks and the likelihood that the US$ is close to an important low we don't think this is a great time to be buying gold for a short-term trade. 

In the latest Weekly Update we noted that silver had moved up to resistance in the 4.80-4.90 range and said "...if the recent rally is going to fail then now is a likely time for it to do so. As is the case with the Yen, there is little to be gained by trying to anticipate an upside breakout in the silver price because the move following a breakout will be substantial in terms of both time and price." There is nothing to add at this stage except to note that the silver price did turn lower once it hit resistance at 4.80. In general, the worst time to be bullish on anything is following a sharp rally up to, but not through, important resistance. 

Update on Stock Selections

Newmont Mining (NYSE: NEM, ASX: NEM) has not been one of our favourite gold mining companies over the past few years. However, as a result of the company's good operational performance during the 4th quarter of last year, the substantial shrinkage in the size of its hedge book late last year and early this year, and the ability of the stock price to hold above important support during the January-March pullback in the gold sector, our opinion changed during the second half of March. If fact, we recommended NEM in the 24.50-25.00 range for anyone wanting exposure to major gold stocks. 

NEM's latest quarterly report, which was released yesterday, has increased our bullishness. NEM is clearly now a very well run company that offers good exposure to the spot gold price. Furthermore, unlike some of the other high-profile North American gold producers NEM is reasonable value at its current price.

As a long-term investment NEM looks attractive at its current price. However, from a short-term technical perspective the outlook is not particularly bullish. As the following chart shows, NEM has just reversed lower from near its channel top. For this reason we are going to take a small profit now on the NEM January-2004 $30 call options added to the TSI Stocks List in early April. We'll look for an opportunity to purchase some January-2005 NEM call options over the coming months.

Lucent (NYSE: LU) has broken decisively above important resistance at $2.00, projecting a move up to $3.00-$3.50 over the next few months. Note, though, that a pullback to around $2 to 'test' the breakout would not be surprising before the next rally phase gets underway. We'll increase our sell-stop to $1.79.

American Bonanza (TSXV: BZA) released excellent drill results on Tuesday. If we have time we'll provide some details on these results in the next Weekly Update. 

One of the things that interests us about high-potential juniors such as BZA is that their stock prices are not totally dependant on the gold price in that good drill results can cause the prices of these stocks to rise even when the gold price is trending lower. As such, they are generally not stocks that should be traded based solely on a view of the gold price.

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Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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