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

    - Interim Update 8th June 2005

Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

Non-receipt of TSI e-mails

Due to the exponential growth in the number of junk e-mails flooding the internet many ISP's and individual mailbox holders are being forced to take increasingly aggressive actions to block junk -- also known as spam -- e-mails. An unfortunate side effect of these actions, however, is that there is now a greater chance of legitimate e-mails being blocked.

Every week we get messages from subscribers reporting that TSI e-mails have not been received. E-mail delivery is never 100% reliable, but when the same subscriber consistently misses e-mails the cause is almost always spam-filtering by the subscriber or by the subscriber's ISP. However, please remember that you can always access the TSI commentaries by logging in at the web site regardless of whether or not you have received the e-mail notification. Except in those cases when we have provided advance warning of a schedule change our market updates are posted at the web site within the same 2-hour time window (5.00am-7.00am US Eastern Standard Time) every Thursday and Sunday.

Also, the date at which the latest update has been posted to the web site is identified in the "Latest Updates" box at the top right hand corner of the TSI Home Page (www.speculative-investor.com), so you can always quickly check to see if you've missed anything.

Conundrums

The conundrum, for us, is the performance of the bond market in relation to the performances of the stock and commodity markets. ...To be of genuine value, fundamental analysis must stand alone; that is, it cannot be a knee-jerk reaction to price action.

Earlier this year Alan Greenspan called the low level of long-term interest rates a conundrum and this week he said he couldn't explain why bond yields were at such a low level. In both cases he was referring to the fact that bond yields have moved lower even though the Fed has raised the official short-term interest rate many times. This sort of thing has never happened before, so in that respect we are in uncharted waters.

From our perspective the performance of bond yields over the past year is also a conundrum, but for a different reason. Although it is unprecedented it would not, under certain circumstances, be illogical for long-term interest rates to move lower from the time the Fed began pushing short-term rates higher. For one thing, if inflation expectations were already quite low prior to the first rate hike then a concerted effort by the Fed to tighten would tend to further suppress such expectations and perhaps even ignite fears of deflation. Also, as long as government bond yields in Europe and Japan remained at ultra-depressed levels it would not be unexpected to see US bond yields fail to move higher in response to a monetary tightening by the Fed. The conundrum, for us, is the performance of the bond market in relation to the performances of the stock and commodity markets. Specifically, that bond yields could languish near generational lows, ostensibly in anticipation of an economic slowdown or deflation, at the same time as growth-oriented markets such as the NASDAQ and inflation-oriented markets such as copper were very strong. It could be argued that the bond market is 'seeing' something that the other markets are not, but this doesn't make sense because bond traders are no more prescient than the traders of stocks or commodities.

If anything, the conundrum has grown bigger over the past 6 weeks because stocks and bonds -- all bonds, from low-risk US Treasuries to relatively high-risk emerging market debt -- have surged in parallel with a strengthening US dollar. This is a reversal of the inter-market action that prevailed during 2003-2004. It's like the world's financial markets are fighting the Fed; the Fed is tightening and over the past few months this tightening has started to have a significant effect on the currency market, but while the Fed and the currency market have been moving in ways that would tend to reduce liquidity the bond market has been doing its best to BOOST liquidity.

As enigmatic as the bond market appears to be, it is, of course, always possible to concoct fundamental reasons to explain ANY price action. In fact, much of what passes for fundamental analysis is just an attempt to come up with a story that matches the recent price action. Such 'analysis', however, is of no value.

To be of genuine value, fundamental analysis must stand alone; that is, it cannot be a knee-jerk reaction to price action. Price action can provide clues as to whether or not a particular piece of fundamental analysis is on the right track. In particular, an apparent divergence between price action and the fundamentals should prompt an analyst to question his/her assessment of the fundamentals. However, such a divergence, in itself, should never be the primary reason for a change in an analyst's fundamental outlook because large divergences between the price action and the fundamentals regularly occur in the financial markets. Such divergences, in fact, lead to some of the best money-making opportunities.

It is worth mentioning, as well, that a particular interpretation of the fundamentals is not necessarily correct just because it happens to be in synch with the price action. In other words, someone can be right for the wrong reasons. For example, during the final quarter of last year you couldn't swing a cat without hitting someone who KNEW that the huge US current account and budget deficits would result in the US$ continuing along it's downward path. This widely held view looked absolutely right for a while because it matched the price action, even though 35 years of historical data indicate that there is no relationship between the sizes or directions of these deficits and the dollar's trend over the ensuing 12 months.

The current conundrum will, in all likelihood, be resolved over the next few months via a collapse in growth-oriented markets; or via a sharp rise in long-term interest rates; or, most likely, via a combination of the two (a moderate rise in long-term interest rates in parallel with weakness in the stock and commodity markets).

The US Stock Market

General theme for 2005-2006

We've expected that a downturn in confidence would be one of the dominant themes in the financial markets during 2005-2006. This theme, in turn, was/is expected to result in those investments that are generally perceived to be low risk out-performing the investments that are generally perceived to entail higher risk; or, putting it another way, to result in safety-oriented investments out-performing growth-oriented investments.

If we are on the right track with our general theme then some of the things we should see over the coming 18 months are:

a) Strength in the gold price relative to the prices of industrial metals such as copper, aluminium, nickel and silver. If this relative strength materialises it will result in the gold/GYX ratio (the gold price divided by the Industrial Metals Index) trending higher.

Below is a chart illustrating the inverse relationship between gold/GYX and the S&P500 Index. The chart's message is that rising growth expectations, as indicated by an intermediate-term upward trend in the S&P500 Index, will result in gold under-performing the industrial metals, whereas a downturn in growth expectations will result in the opposite. Over the past 10 weeks there has been an up-tick in gold/GYX, but nothing of great significance as of yet. This is not, however, out of line with the forecasts we made early this year because we didn't think that a ramping down of growth expectations would gather momentum until the second half of this year.

A move above 2.0 by the gold/GYX ratio would confirm that we are on the right track.


b) Weakness in emerging market government debt relative to US government debt.

The EMD/USB ratio -- the Salomon Brothers Emerging Markets Income Fund divided by the US T-Bond price -- is a measure of how emerging market debt is performing relative to US debt. The below chart shows that there has been a sharp decline in this ratio since the beginning of the year, indicating a shift in preference towards the lower-risk US government debt. However, the ratio has been stable since mid-April.

A decisive break by EMD/USB to new lows for the year would support our intermediate-term outlook.


c) Strength in emerging market stocks

The stock markets of the emerging economies of Latin America, South-East Asia and Eastern Europe were relative strength leaders during 2003 and during the second half of last year (periods during which 'investors' threw caution to the wind in a frantic bid to obtain higher returns). However, in an environment where confidence is declining and risk aversion is increasing we should see substantial weakness in the stock markets of these countries.

The below chart shows that EWZ (a proxy for the Brazilian stock market) surged to a peak at the beginning of March, fell quite sharply during March-April, and then bounced back to a slightly lower peak. If our intermediate-term outlook is on the mark then EWZ should break to a new low for the year within the coming three months.


Current Market Situation

Last week was a likely time for a rebound peak and by some measures (the S&P500/gold ratio, for example) last week's high was close to a likely level for a rebound peak. However, although the market action over the first three days of this week had a bearish bias we don't yet have any clear evidence that a peak is in place.

As far as the Dow Industrials Index is concerned, initial confirmation that a peak is in place and that a decline to a new low for the year is underway would be provided by a daily close below the early-May high (10400). And once this happens it will, we think, be reasonable to anticipate a drop to test major support at 9700-9800 over the ensuing 2-3 months.


Gold and the Dollar

Opinions versus Facts

...a statement such as "XYZ is in a bull market" will always be an opinion and never a fact. Furthermore, it is a potentially dangerous opinion because it might prevent its holder from assessing the current situation with objectivity.

In an interesting article at http://www.hussmanfunds.com/wmc/wmc050531.htm John Hussman makes the point that "bull" and "bear" labels can only be applied to a market in retrospect. Here's an extract:

"...it's not particularly useful to ponder whether stocks are in a bull market or a bear market. Certainly, after the market has moved a large distance in one direction or another, we can eventually say we've experienced a so-and-so, but as soon as investors start using those concepts in a predictive way ("stocks are in a bull market, so..."), they become blind to every bit of conflicting evidence that doesn't come with a swift kick and a hot poker. Bull markets and bear markets don't exist in real time. Better to focus on the influences we can actually observe, which include the level of valuations and the quality of market action."

In other words, a statement such as "XYZ is in a bull market" will always be an opinion and never a fact. Furthermore, it is a potentially dangerous opinion because it might prevent its holder from assessing the current situation with objectivity. If, for instance, we were to begin all of our analyses with the assumption "gold is in a bull market" then when it came to gold we would effectively be wearing blinders. It is a FACT that gold experienced a bull market during 2001-2004, but whether or not gold is in a bull market today is a matter of OPINION. The main point to take away, though, is that it's not necessary to have any opinion on whether or not gold is currently in a bull market. What we know is that under certain financial conditions gold will generally provide very good returns, so what we must do is focus on the current conditions and de-emphasise the popular labels. In this way we stand a good chance of being able to identify those times when the reward/risk ratio is high and those times when it is low.

We can further explain the difference between fact and opinion using a couple of gold-related examples.

First, at the bottom of the following monthly chart of the AMEX Gold BUGS Index (HUI) is a momentum indicator known as the MACD. Notice that a) shortly after the beginning of the HUI's major advance the faster moving average (the black line) moved above the slower moving average (the blue line) and remained above it for about 3 years, and b) downward corrections that occurred during 2001-2003 ended before the faster moving average was able to move below the slower moving average. Now, observe the change in the performance of the MACD from December-2003 -- the time of the HUI's major peak -- to the present day. In particular, notice that a) a few months after the HUI's December-2003 peak the black line broke decisively below the blue line and has remained below it to this day, and b) the only substantial rally of the past 18 months (the rally that occurred between May and November of last year) ended before the black line was able to move above the blue line.


Further to the above, with respect to the monthly MACD's performance it is a FACT that the correction that began in December of 2003 is very different to the corrections that occurred during 2001-2003. This doesn't mean that the HUI will necessarily plumb considerably lower levels before its next major advance gets underway (although our OPINION is that it will). What it means is that any opinion based on the assumption that the current correction is similar to the corrections that occurred during 2001-2003 has a good chance of being wrong.

Next, on the below weekly chart of the gold price we've drawn a trend-line connecting the lows. It's a FACT that the pullback in the gold price over the past 6 months has not resulted in a break of this trend-line, but this fact is neither bullish nor bearish because it tells us nothing about what's likely to happen to the gold price in the future. It is simply a statement of the obvious. In our OPINION, however, a break below the trend-line followed by a drop to the 370s would have BULLISH implications because it would mean that the short- and intermediate-term downside risk had been significantly reduced.


Current Market Situation

In the latest Weekly Market Update we said that 1-3 weeks of consolidation were likely in the currency and gold markets prior to a resumption of the dollar's advance and gold's decline. The below chart of the Dollar Index shows that the currency market has now been consolidating for 5 trading days, so nothing surprising is happening at this stage.

Our best guess is that something along the lines of the consolidation (pullback in the US$, rebound in the euro) that occurred in April is currently underway. It probably has further to go, but should not result in the Dollar Index moving below the support that exists at 85.0-85.5. Our view continues to be that the Dollar Index will move up to the low-90s before a more substantial pullback becomes probable.


Gold has important support at around $416 (basis the August futures contract) and important resistance just above $440. Gold's rebound from its recent low is probably not over, but we'll be very surprised if it manages to exceed $440 in the short-term. Our expectation continues to be that gold will drop to new lows for the year at some point over the next three months, but the downside risk in the metal does not appear to be great (no more than 10-15%).


Gold Stocks

In the latest Weekly Update we said: "As far as the coming 1-3 weeks are concerned, our guess is that the HUI will consolidate its recent gains and then move a few percent above last week's high before commencing the next downward leg in its major correction."

There is no reason to alter this near-term outlook. In particular, if you take a look at the below daily chart of the HUI and the HUI's RSI (Relative Strength Index) you will notice that the current rebound appears to be following a similar pattern to the February-March rebound. If the similarities persist then we'll get a surge to a new recovery high before the next downward leg gets underway.


Update on Stock Selections

Large unhedged South African gold stocks Gold Fields Ltd (GFI) and Harmony Gold (HMY) continue to look interesting to us, particularly during periods of short-term weakness such as now. GFI appears to be the better long-term investment, but due to its greater leverage to the Rand gold price HMY has the greater potential upside.

The fundamentals for these companies have probably turned the corner due to the recent substantial rebound in the Rand gold price and the re-structuring efforts that are now largely complete. Unlike the major North American gold producers, which will probably experience one or two more quarters profit-margin erosion, GFI and HMY are likely to now begin reporting improved results. Also, the 'cash crunch' that put so much downward pressure on the stock price of Harmony earlier this year has ended.

The industrial relations situation will no doubt create some angst over the next few months because the standard negotiating tactic of the mineworkers' union is to ask for a ridiculously high increase in total compensation and then threaten to go out on strike when the mining companies refuse to pay-up. If/when this happens it could lead to another good buying opportunity, but if the Rand gold price continues to rally it's quite possible that future buying opportunities will occur at higher levels.

As we keep saying, don't attempt to buy at the absolute bottom. Instead, continue to average in during the selling squalls over the remainder of this year.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
Copyright 2000-2005 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>