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    - 08 May, 2002

The Role of Luck

A person has a one-in-two chance of correctly calling the outcome of a coin toss and approximately a one-in-one-million chance of correctly calling 20 coin tosses in succession. However, if 10 million people are calling the coin tosses then after 20 tosses there will probably be 10 people who called all 20 tosses correctly. Do these 10 people have some special talent? Should we place them on pedestals and use words such as 'brilliant' and 'gifted' to describe them? Should we bet all of our savings on the ability of these 10 people to achieve a greater than 50% success rate in calling future coin tosses? No, not if we have even a basic understanding of probability.

We shouldn't make the above-mentioned bet because these 10 people do not have a better-than-average ability to correctly call the toss of a coin. The 20 correct calls were the result of luck and provide no indication of what we can expect in the future. However, we often do bet heavily on these people.

Joe Battipaglia is a good example of someone who achieved a great deal of respect through correctly calling 20 coin tosses. Back in the good old days before we quit watching CNBC we would often listen to JB's explanations as to why the bull market would continue for many more years. JB's reasoning was completely bogus - not once did he acknowledge that a massive expansion of credit was primarily responsible for fueling the gains in asset prices - but because the market kept going up he looked smart (at least he did to anyone who judges smartness purely by results). Abby Joseph Cohen is another example. She correctly called 20 coin tosses in a row and was almost deified by both the general public and the professional investment community. Unfortunately or fortunately depending on your perspective, the dominant role that luck played in her ability to make so many correct calls during the bull market (as was the case with JB, AJC's logic was faulty) has become clear over the past 2 years.

We can never know whether someone's trading/investing success is primarily the result of skill or luck unless we fully understand their methodology. However, it is often not possible to determine the process that someone went through before making a decision that turned out to be profitable. In other words, it is often not possible for us to determine whether someone's good track record is mainly the result of good luck or good judgement. 

How about our own trading/investment successes? Were they the result of good luck or good judgement? Although most people are quick to blame losses on bad luck we've found that it is rare for someone to attribute their successes to good luck. If we buy a stock based on a careful analysis of the available evidence and the price of the stock subsequently rockets higher, then we will surely congratulate ourselves on our investment acumen. The fact that the stock might have gone up for some reason that is unknown to us, meaning that our profits are totally the result of luck, will never occur to us.

We usually won't be able to determine if luck played a significant role in any of our successful investment/trading decisions since we will never know all the variables that could have affected the outcome. However, it is always prudent to acknowledge that luck could have been a factor. This is another way of saying that it is better to err on the side of caution. If we acknowledge that past successes might have at least partly been the result of good luck then we will be less likely to make a costly mistake in the future. A lot of lucky traders made fortunes during the stock market mania of 1998-2000 and then gave all the money back during the NASDAQ bust because they didn't know they were lucky. They thought they were very smart.

The US Stock Market

Current Market Situation

From the latest Weekly Update: "Some additional weakness will probably occur in the short-term - either in the form of a washout during this week or a bounce followed by a drop to re-test last week's lows - but we think a medium-term bottom is close at hand." 

One of the difficulties we have in assessing the current market is that while some sentiment indicators reveal the depths of despair that would normally lead to a multi-week or perhaps even a multi-month rally (on the basis that everyone who was going to sell has already sold), other sentiment indicators still reveal complacency. For example, while the action on Monday and Tuesday should have created panic since major support levels had either been taken out or were being tested, it did not. As such, although the market has now turned higher in-line with our forecast we are skeptical that this advance has 'legs'.

The sentiment picture might be confused, but the technical picture is showing some definite signs that a medium-term bottom was reached earlier this week. For example:

1. The S&P500/gold ratio (the number of ounces of gold it takes to buy the S&P500 - what we call the "real S&P500") reversed higher from within spitting distance of its September-21 low (see chart below). A test of the September-21 low would have required a gold price in the low-320s if the S&P500 had held above 1070, but with the S&P500 dropping into the 1040s a gold price of $312 was sufficient.

2. From our perspective the most important event that occurred during the first half of this week was Tuesday's devastating suicide bomb attack near Tel Aviv. From the market's perspective the most important event was Cisco's latest quarterly report. Cisco's results don't come remotely close to justifying its current market cap, but Wednesday's vicious rally is certainly evidence that the stock was dramatically oversold prior to the report. We follow CSCO quite closely because it tends to be a leader during both up-moves and down-moves. While we fully expect CSCO to trade in single digits before the end of this year the stock's chart provides some evidence that the decline that began in early-December has ended (see below). The big test will come when the 200-DMA is reached.

3. By spiking to new a yearly low early this week before rallying sharply on Wednesday the June S&P500 futures have set themselves up to achieve a potentially-important weekly reversal. To achieve such a reversal they simply need to close this week above last week's closing level of 1073 (yesterday's close was 1086.50).

There are two things we should see at the end of this week if this rally has some staying power. Firstly, the June S&P500 futures will close the week above 1073 as mentioned above. Secondly, the COT Report released on Friday will show a significant reduction in the commercial net-short position. Before the end of next week we should also see another high-volume 'up' day if this is the start of a 1-3 month rally rather than a short-lived bounce.

At this stage we are skeptical but prepared to give the bullish case the benefit of the doubt (particularly since this is the way we were already leaning before yesterday's surge). We have a number of commodity-cyclical stocks in the Portfolio that are likely to perform very well during a sustained advance in the overall market and added QQQ July $35 call options as per the latest Weekly Update (the options traded below our recommended buy price on Monday and Tuesday). We'll wait and see how the market finishes the week before making any further suggestions.

As mentioned in previous commentaries, if this rally does have some staying power then it is expected to present us with a wonderful opportunity to add to our medium-term bearish position at some point over the coming weeks/months.

Stocks, Bonds and the Dollar

Since the beginning of April the various financial markets have been moving in ways that are disturbingly similar to how they moved during August and early-September of last year. We've attempted to illustrate these similarities on the following chart comparing the T-Bond Yield, the Dollar Index, the S&P500 and the Volatility Index (VIX). Note that interest rates, the Dollar and the S&P500 all drove lower during the 5 week period leading up to September's crisis, while the VIX remained subdued until the final blow-off decline in the stock market. Something similar has happened since the beginning of April. As was the case last August, volatility has moved only marginally higher over the past several weeks as stocks have fallen. If we get some more 'bullish confirmation' at the end of this week as discussed above then we won't worry about another blow-off decline happening at this time. If not then the following comparison will take on greater significance.

By the way, the above chart shows that the stock market and long-term interest rates are still spending most of their time moving in the same direction (a feature of the US credit bubble). Before the end of this year we expect to see a large decline in stocks and a concurrent large rise in long-term interest rates.

Gold and the Dollar

Investing in gold

With the possible exception of Harmony Gold, the stock of every major gold producer in the world is fully priced or over-priced based on a gold price near the current level of $310. This doesn't mean that the stocks won't rise further in the short-term, but it does mean that buyers at current levels are taking a big risk. They could certainly be bailed out by a sharp rise in the gold price, but could also quickly find themselves 20-30% underwater. So, on the basis that gold has commenced a long-term bull market what action should be taken by someone who wishes to increase their exposure to gold?

One option would be to buy physical gold. Many gold stocks are sporting large speculative premiums (they are discounting a much higher gold price), but gold bullion is still extremely cheap. Whereas the stocks of the major gold producers are at risk of falling sharply if the bullion price does not shoot higher in the near future, we think the downside risk in the bullion price is minimal (we expect gold to hold above $290 during any pullbacks).

One of the most convenient ways to buy and store physical gold is via http://www.goldmoney.com/. The customers of goldmoney.com purchase physical gold in the form of GoldGrams (GoldGrams are grams of gold stored in a vault) and can use GoldGrams to make payments via the internet. When you buy GoldGrams you are buying the ownership rights to part of an allocated, securely-stored, insured private gold hoard. When GoldGrams are used to make a purchase via the internet the ownership of the specified amount of gold instantaneously changes hands while the actual gold remains within the vault. Setting up an account at goldmoney.com is quick and easy and the costs involved are small (goldmoney.com charges an annual storage fee of 0.5%). This is certainly a much more cost-effective way of gaining exposure to physical gold than, for example, investing in the Central Fund of Canada (a mutual fund that invests in precious metals). Earlier this week the Central Fund of Canada was selling at a ridiculously-high 23% premium to its net asset value.

From now on GoldGrams can be used to pay for annual subscriptions to TSI.

Buy and hold?

In the 11th April Interim Update we included a chart comparison of the Dow Industrials and Homestake Mining during 1973-1974 to demonstrate that gold stocks can provide excellent returns during those periods when confidence in the stock market and the financial system is low/falling. The Dow reached a long-term bottom in early-October of 1974 and most gold stocks peaked between August and November of 1974.

Below is a chart comparing the performance of the Dow Industrials and the US Global Investors Gold Shares fund (USERX) from 1st October 1974 until 31st December 1982. Note that:
a) Over the 2-year period beginning in October of 1974 an investment in USERX fell by around 70% while an investment in the Dow rose by around 70%.
b) Those who bought gold stocks in October of 1974 had to wait more than 5 years just to break even on their investment despite the fact that gold was in a secular bull market throughout the 1970s.

Using the performances of the Nikkei in the 1990s and the Dow in the 1930s as templates, the US stock market is most likely going to reach a long-term bottom some time between October of 2002 and January of 2003. This is therefore the most likely time for gold and gold stocks to reach a major high - probably not the ultimate high but a high that could remain in place for a few years.

The point of the above is that gold stocks should not be thought of as 'buy and hold' investments, even if gold happens to be in a secular bull market. We certainly wouldn't want to be holding a sizeable investment position in gold stocks during a period similar to 1975-1976. 

Current Market Situation

Gold stocks have been strong because the stock market and the US$ have been weak, so if Wednesday's sharp upward reversals in the stock market and the Dollar prove to be sustainable then gold stocks have probably peaked for now and gold will begin a correction without having first made it into the 320s. However, as noted above we still need to be convinced regarding the durability of this budding stock market rally. Furthermore, most gold stocks held up quite well on Wednesday even as the Dollar and the NASDAQ were surging and the gold price was sliding.

The bottom line is that while we think gold stocks are close to at least a short-term peak we haven't yet seen anything in the price action to confirm that a peak has been reached. In other words, the short-term trend is still up. We will hold onto our few remaining gold stock trading positions for now. We have not even considered reducing our core investment position in gold stocks.

Update on Stock Selections

As noted above we aren't going to make any additions/changes to the TSI Portfolio until we see how the US stock market finishes the week, but two stocks we are considering at this stage are Lucent Technologies in the US and Telstra in Australia. At current prices (around US$4.60 for LU and A$4.70 for TLS) both stocks represent good value. They both also look interesting from a technical perspective. TLS is lower risk due to its profitability and dividend yield whereas LU offers greater leverage to a stock market and economic recovery. 

 
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