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    - 08 August 2001

The US Stock Market

In the short-term, money trumps value

Our reading of stock market history and our own experience tells us that, over a 12-month period, monetary conditions trump valuations. This is evidenced by the fact that four of the best years for the stock market during the 1980s and 1990s (1985, 1986, 1991 and 1998) were years during which company earnings fell dramatically below expectations (the average expectation going into each year was that earnings would grow by 16%, but the average actual result was a decline of 6%). The average performance of the S&P500 during these years was a gain of 24%, thanks primarily to a very supportive monetary environment. 

This doesn't mean we should ignore valuation levels. For example, when valuations are extremely high but the market is being elevated by a friendly monetary environment, then the stock indices will tank as soon as the monetary conditions become less supportive. Similarly, if valuations are low but the market is being held down by an unfriendly monetary environment, then stock prices are likely to surge as soon as the monetary conditions begin to improve. What it does mean is that it makes no sense, over a 12-month period, to lean against the monetary extremes that occur from time to time regardless of the average P/E ratios of the major stock indices.

This year is perhaps the biggest test ever of the power of monetary conditions over valuations, since valuations are an extreme negative (for many of the large-cap stocks) and the monetary environment is an extreme positive. The battle is on-going, with the positive monetary conditions perhaps having a slight edge. In particular, it is notable that the early-April lows have not been seriously tested despite a veritable flood of terrible corporate financial results and guidance since that time.

In our opinion, the reason that money trumps valuation over the medium-term is that the market is more of a voting machine than a weighing machine. In other words, over a 12-month period stock prices are based less on objective valuation criteria than on what people think they can justify based on some nebulous view of the future. Over the longer-term, of course, valuations revert to a level determined by the worth of the underlying businesses.

Valuation Risk

A lot of tech stocks are now priced at attractive levels. For example, Global Crossing (GX) is now selling at less than 1-times current year revenue, Motorola (MOT) is selling at less than 1.5-times current year revenue and Corning (GLW) is selling at around 2-times revenue. There are, however, many tech stocks that are still priced at ridiculously-high levels, particularly amongst the semiconductor stocks. For example, Micron Technology (MU) is selling at 8-times current year revenue, but that is downright cheap compared to the 24-times revenue that PMC Sierra (PMCS) is trading at and the incredible 35-times revenue that today's buyers of Applied Micro Circuits (AMCC) are paying for a slice of that company. Tech bellwethers Intel (INTC) and Cisco (CSCO), despite the sharp declines in their stock prices over the past 12 months, are also priced at nose-bleed levels - Cisco at 7-times revenue and Intel at 8-times revenue. Compare this to Harmony Gold Mining (HGMCY), a company that is growing faster than Intel and Cisco but is, of course, part of a sector of the market that is very much out of favour. With the gold price crawling along near 20-year lows HGMCY still managed to grow its revenue by 25% in the latest year and is likely to do the same this year assuming a stable gold price. And what do investors need to pay to get a slice of Harmony? A little more than 1-times last year's revenue.

As noted earlier in today's commentary, when valuations are extremely high but the market is being elevated by a friendly monetary environment, prices will tank when the monetary conditions become less supportive. We are bullish taking a 3-month view, but the valuations make us wary and we will be quick to reverse our position as soon as we see signs that the monetary tide is beginning to go out.

Current Market Situation

The sharp drop in the major stock indices on Wednesday makes the technical position of the market more precarious, but if this ultra-frustrating market stays true to its recent form then we should soon see another rebound. 

Any rebound in the immediate-term is, however, likely to be short-lived. Put/call ratios have been high over the past 2 days, but not high enough to make a compelling case that a major upside reversal is about to occur. Also, daily momentum indicators are nowhere near oversold. Therefore, lower levels will probably be seen over the next week.  

We think that the major stock indices will be much higher in 3 months time, but won't initiate a market-general trading position (eg, QQQ shares or call options) until we see some technical evidence of a turn or until sentiment indicators return to bell-ringing levels. In the mean time we'll just stay out of the way. 

Gold and the Dollar

Gold and the Swiss Franc

The following chart compares the gold price with the Swiss Franc since mid-1998. The vertical red lines indicate the points at which the SF made a medium-term low. On the gold chart we've noted the number of weeks that elapsed from the time the SF bottomed and turned higher to the time the gold price turned higher.

The chart shows that significant upward reversals in the SF have led upward reversals in the gold price by as few as one and as many as seven weeks. The gold price also bounced a couple of times (Feb 2000 and Apr-May 2001) without any assistance from the currency market.

The upturn in the SF that occurred in early-July looks real (it looks like the start of a major rally). If this is the case and history is any guide (the positive correlation between the gold price and the SF goes back much further than the 3 years depicted on this chart), then we should expect an upward reversal in the gold price by August-24 at the latest (August-24 is seven weeks from the July-06 upturn in the SF). Most likely gold will start to rally as soon as the Dollar completes its current counter-trend bounce.

Confirmation from the Utilities

The Dow Jones Utilities Index (DJUI) tends to lead the bond and currency markets. The weakness in the DJUI over the past 3 months is telling us to expect a substantial fall in the T-Bond and/or the Dollar.

As the following chart shows, the recent bounce in the 'utes' ended just shy of the short-term downtrend line. With the bond market holding its ground and certainly not appearing to be on the verge of a collapse, the action in the 'utes' is probably pointing towards an acceleration in the Dollar's decline over the next few months.

Gold Lease Rates

Gold interest rates, which are usually referred to as lease rates, have fallen almost every day for the past 2 months and are now back to their traditionally-low levels. This means that a) the central banks have increased the supply of gold to the leasing market, and/or b) there has been a decline in the borrowing demand for gold.

We can't imagine why anyone would want to borrow gold in the current environment since the upside risk in the gold price is so much greater than the downside risk and the interest rate spread that can be earned on a gold carry trade (selling borrowed gold and investing the proceeds in US Government debt) is low. However, it is unlikely that there would have been a significant change in borrowing demand over the past couple of months since the gold price has been very calm over this period (a stable gold price makes the risk of borrowing gold appear to be less). Therefore, the relentless decline in gold lease rates over the past few months is almost certainly the result of central banks or the IMF making more gold available to the leasing market with the aim of keeping a lid on the gold price. 

We don't think the official sector's efforts to suppress the gold price will be successful once the Dollar's bull market is perceived to have ended, but we should find out for sure over the next couple of months. Once the Dollar completes its current rebound and then breaks decisively below its recent lows, the complexion of the gold market should change quite dramatically.

Current Market Situation

The Dollar's counter-trend rally was temporarily de-railed on Wednesday when further evidence emerged that the US economy continues to be very weak (how this information could have been a surprise is, in itself, surprising). However, we still expect the Dollar to move higher into next week.

At this stage the XAU's test of its medium-term up-trend has been successful. Gold has been almost dead flat so far this week, with the main action being in the silver market. As mentioned in yesterday's e-mail, silver appears to be in the final wash-out stage of its bear market and has a good chance of reversing higher over the next week or so. 

In our opinion the gold sector represents an outstanding opportunity for profit. The inflation that is already in the pipeline and the huge US current account deficit will combine to put downward pressure on the Dollar. Furthermore, the recent technical breakdown in the Dollar is signaling that the downward pressure is having an effect. With real interest rates near zero and the Dollar weakening, the investment demand for gold will grow. 

We expect the US economy to soon embark on a recovery, albeit a short-lived one. However, if we are wrong and the economy continues to deteriorate into year-end then the Dollar will be even weaker than we currently expect. Also, if the economy fails to rebound then the Fed will push short-term interest rates well below the official inflation rate, thus setting the scene for a bigger inflation problem next year. In other words, if we are wrong about the economy then our gold investments should still fare very well. 

Gold would not be a good investment in every conceivable situation. For example, if the US experienced a period of true deflation (a contraction in the supply of money) then the gold price would fall along with the prices of other assets. However, given the Fed's unlimited power to monetise debt the probability of deflation occurring in the US is extremely low.

Changes to the TSI Portfolio

Natural gas producer Chesapeake Energy (NYSE: CHK) dropped below our nominated buy zone on Wednesday and will be added to the Portfolio. 

 
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