War Cycle Update

In an article titled "War Cycles and Peace Cycles" at http://www.speculative-investor.com/new/article050503.html we drew on the work of Richard Kelly Hoskins to explain why war and peace cycles occur and how they relate to long-term trends in money-supply growth and commodity prices. Our conclusion was, and is, that if 1999 gave us THE bottom in commodity prices (we are confident that it did) then we are now in the early stages of a long-term war cycle with one of the driving forces behind this cycle being the need to stimulate money-supply growth. Importantly, this conclusion is supported by the actions of the US Government over the past few years on both the foreign and domestic fronts.

Below is a slightly modified version of the chart that originally appeared in Hoskins' book "War Cycles Peace Cycles" (we've added the 1999 bottom for the "peace cycle" that began in 1980). As explained in our above-mentioned article, one of the main reasons for this cyclical behaviour is that "... almost ALL money comes into existence as the result of a loan. This means that new money must be created at a fast enough pace to enable existing debts to be paid off, but then each new dollar borrowed into existence just adds to the problem. At some point the pool comprising all existing and potential borrowers becomes unwilling, or unable, to increase its debt burden. When this happens the money supply stops growing or even begins to contract, making it impossible for many borrowers to get hold of enough money to pay their debts. The result is that these borrowers lose a lot of what they worked hard to accumulate and the social mood, in turn, becomes more conducive to war."

One of the differences between the current cycle and previous cycles is that during the current cycle the US Government has been pre-emptive in that it began aggressively pursuing policies designed to stimulate money-supply growth (deficit spending, tax cuts, war) while the money supply was still growing at a 'healthy' pace. With the total level of debt in the US economy at an unprecedented high it appears as though the US Administration is well aware of the short-term economic (and therefore political) problems that would be created by a sustained drop in the money-supply growth rate. As is typically the case, the desire to get re-elected overrides any longer-term considerations. This means that 'Band-Aid solutions' - solutions that offer short-term respite at a cost of long-term pain - are often preferred to long-term solutions that necessitate short-term pain. Boosting the money-supply growth rate is one of the oldest-known and most effective Band-Aid solutions used by governments in their attempts to stay in power. 

Note, though, that higher money-supply growth is only effective as a temporary fix for as long as inflation expectations remain subdued. Once the money-supply growth is perceived to be having a big effect on non-financial assets and people begin to anticipate more currency depreciation relative to non-financial assets, additional money-supply growth becomes counter-productive (it leads to higher interest rates and slower economic growth).

Now to our main point: There will be periods of up to one year when a drop in the money-supply growth rate will be 'acceptable' as far as the incumbents are concerned, but the period between now and the November-2004 Presidential election is not going to be one of them. At the same time, the sharp downturn in the bond market that began in June indicates that the money-supply growth rate has either already peaked or will peak within the next few weeks (refer to last week's Interim Update for an explanation of why this is so). Therefore, an epic battle between the US Government and natural economic forces is going to occur over the next year. President Bush's recent request for an additional $87B to finance the on-going efforts in Iraq and Afghanistan over the next 12 months can be considered to be one of the first shots fired by the Government in this battle. What Mr Bush has effectively just requested/demanded is $87B of additional money-supply growth.

As an aside, it is interesting to note that the US Government is presently the only government of a first-world country with the option of initiating war as a means of stimulating money-supply growth. Other countries might be presented with the option of following the US into a war, but they don't have the power to start a war.

The US Stock Market

Current Market Situation

From the latest Weekly Market Update: "...we consider the most likely scenario to be a sharp pullback over the next few weeks followed by a rally to a new recovery high late in the year before a major decline gets underway. The next most likely outcome is that the market continues higher from its current levels and makes a major top during the next few weeks.

Below is a 1-year chart of the S&P500 Index. There is short-term support at around 1010 and if our preferred scenario is correct then the S&P500 will close below this support during the coming week and begin working its way down to intermediate-term support in the 900-950 range. However, if 1010 holds on a daily closing basis over the coming week then the alternative scenario mentioned above will become the most likely scenario."

The S&P500 Index closed at 1011 on Wednesday, so any significant weakness over the remainder of this week will provide us with some evidence that our preferred scenario (a sharp pullback over the next few weeks) is going to play out.

While the next pullback will potentially be gut-wrenching for the bulls, we expect that it will be followed by a rally to a new recovery high late this year before a major decline (a decline to below last October's lows) gets underway. One of the main reasons for this view is that the recent highs in the senior stock indices were confirmed by new highs in the NDX/Dow ratio (see chart below). As long as the riskier NASDAQ100 stocks are trending higher relative to the more staid Dow stocks there is little chance of a major decline. Furthermore, it is probable that the NDX/Dow ratio will peak at least a few weeks ahead of a peak in the Dow Industrials Index because market participants are likely to gravitate towards the stocks that are perceived to offer greater safety before they begin to exit the market altogether.

As mentioned above, the S&P500 is currently poised right at support. As the following chart shows, the Bank Index (BKX) is also very close to support. The BKX has been relatively weak since the bond market peaked in June and should confirm any break below support in the S&P500 Index by closing below 850.

The sector of the market in which there is the greatest bearish mismatch between price and underlying business value is probably the semiconductor sector. As such, we use the Semiconductor Index (SOX) as an indicator of the willingness of market participants to ignore value in their pursuit of short-term price performance. 

The SOX hit a new recovery high early this week before reversing sharply lower on Wednesday (see chart below). A normal pullback would see the SOX drop back to around 410 before resuming its upward march while a daily close below 390 would suggest that an important peak was already in place.

Over the past 12 months the Walmart stock price has made important peaks and troughs about 1-2 months prior to important peaks and troughs in the S&P500 Index. As such, we expect that the ultimate recovery high in WMT will occur several weeks prior to the ultimate recovery high in the S&P500 Index. Last week's new recovery high in WMT therefore suggests that a peak in the overall market won't occur until at least October. Note from the below chart, though, that WMT has been very weak over the past few days and has dropped below support (its prior breakout level). This, in turn, is probably a warning that a sharp correction in the overall market is about to occur.

In summary, there are presently a few preliminary signs that a sharp pullback in the market is about to unfold over the coming weeks, but nothing definitive as yet. However, the market action over the next 2 days should tell us whether or not our preferred scenario is playing out. If a correction is confirmed then we would expect the S&P500 Index to drop to at least 950, and probably to as low as 900, before the end of October.

Gold and the Dollar

Gold Stocks

Our current views on the gold sector can be summarised as follows:

a) The probability is low that gold stocks have already peaked, but a major peak will probably occur within the next few months. 

b) The most likely time for a major peak in the AMEX Gold BUGS Index (HUI) is 2-4 weeks AFTER the Dow Industrials Index reaches its ultimate recovery high (almost regardless of what happens to the gold price). Putting a major peak in place is, however, a PROCESS that usually extends over a period of a few months.

c) There is not much upside potential in the stocks of many of the large and mid-sized gold producers because their current stock prices already discount a much higher gold price. In other words, the risk/reward for these stocks is mediocre at best. However, there is still considerable upside potential amongst the juniors.

Based on the above views we have suggested that gold-stock investors gradually scale-out of the sector over the coming months. Furthermore, to reflect our assessment that it is time to begin scaling out we have recently recommended profit-taking in four of the positions in the TSI Stocks List. 

The biggest short-term risk for gold stocks is the strong possibility of a sharp decline in the overall stock market over the next several weeks. Our expectation is that a decline in the overall market that took the S&P500 Index back to around 900 would drag the HUI down to around 175. We expect that this decline would, in turn, be followed by a rally in the HUI to a new 7-year high before a major top would become likely.

It is, of course, possible (although very unlikely) that we are being overly optimistic when it comes to both the overall stock market and the gold sector and that major declines are about to begin. We therefore need to identify an early-warning signal that this is the case. For such a signal we will use the performance of the HUI/gold ratio relative to its 40-day moving average. 

Below is a chart showing the HUI/gold ratio and its 40-day moving average. In previous commentaries we've mentioned the tendency for corrections within intermediate-term up-trends in the ratio to hold at, or above, the 40-day MA. We will therefore consider two consecutive daily closes below this moving average to be a signal that something more ominous than a normal correction is afoot.

Current Market Situation

Below is a chart of the euro. It was almost a certainty that a test of support at 108 would be followed by a rally to around 111-112, but what happens from here is more difficult to forecast. 

Our expectation is that the euro will move higher over the next month or so. Also, strength in the gold price and the aggressive buying of euro futures by commercial traders near the recent lows suggests that the drop to around 108 created THE correction low for the euro. However, our level of confidence that the gold price is going to trade above $400 before the end of this year is considerably higher than our level of confidence that the euro is going to trade above its May-2003 peak within the same time-frame.

The pound/euro exchange rate has exhibited a strong tendency to make important reversals a few weeks in advance of similar reversals in the US$. We therefore use pound/euro as a leading indicator of the US$.

As the following chart shows, pound/euro has just broken below its 60-day moving average. This is a bearish omen for the dollar, although it is possible that pound/euro could spend a few more months oscillating around this moving average (as it did during the final quarter of 2001 and the first quarter of 2002) before making a sustainable move lower. In any case, this is another reason to conclude that the odds favour a lower US$ over the coming months.

Below is a daily chart of December gold futures showing the support levels that exist at $377 and $370. Gold is trading as though it is being accumulated by some very well-financed individuals or groups, so if there is a near-term pullback (we have no opinion on whether there will or won't be) then strong buying support is likely to emerge at, or above, $370. $410 remains our minimum upside target for gold between now and year-end.

Update on Stock Selections

In the Stock Selection Update e-mail sent to paid-up subscribers on Monday morning we said we would take profits of around 170% and 150%, respectively, on the Wheaton River shares and warrants in the Stocks List. We also said we would add Afrikander Lease (OTC: AFKDY) and Patricia Mining (TSXV: PAT) to the List. For further details refer to http://www.speculative-investor.com/new/stockemail.asp

Below is a table containing all the gold/silver stocks that are presently in the TSI Stocks List. Next to each stock we've noted our short-term price target (in those cases where we have a short-term target) and a comment on whether we think the stock is a buy, hold or sell at the current price. If you own a stock then you might consider exiting at least part of your position when the stock approaches our ST price target, although any decision you make will obviously need to take into account your own financial situation (including your total exposure to the market). In the TSI commentaries we provide our assessment of the likely future performances of the markets and stocks we follow, but you need to decide how to best utilise the information presented at TSI with respect to your own investments.

In the below table the difference between a "Speculative Buy" and a "Buy" is that we perceive a greater margin of safety with a stock that is noted as being a "Buy".

Symbol	Stock Exchange	Company Name		Recent Price $	ST Price Target $	Comment
BZA	TSXV	American Bonanza	C$	0.31	0.45-0.50	Hold
CAU	AMEX	Canyon Resources	US$	2.05	none	Hold
BDG	ASX	Bendigo Gold	A$	0.21	0.30	Speculative Buy below 0.22
CBD	TSX	Cumberland Resources	C$	4.10	4.80	Hold
WTC	TSX	Western Silver	C$	5.25	none	Hold
RBK	ASX	Red Back Mining	A$	0.50	0.70	Speculative Buy in 0.46-0.50 range
DSM	TSX	Desert Sun Mining	C$	1.73	2.00	Hold
RIC	AMEX	Richmont Mining	US$	4.57	none	Hold
RSGO	ASX	Resolute Mining Options	A$	0.42	0.45-0.50	Hold
MVG	TSX	Metallic Ventures	C$	5.55	none	Hold
CDU	TSXV	Cardero Resource	C$	1.06	2.00	Speculative Buy below 1.20
WRM	TSX	Wheaton River	C$	2.71	2.80-2.90	Target achieved. Sell.
AQI	TSXV	Aquiline Resources	C$	0.87	1.50	Buy below 0.90
NGX	TSX	Northgate Exploration	C$	2.33	2.90	Hold
WRM.WT	TSX	Wheaton River Warrants	C$	1.34	1.40-1.50	Target achieved. Sell.
GPXM	OTCBB	Golden Phoenix	US$	0.39	0.55-0.60	Speculative Buy in 0.35-0.39 range
CTO	ASX	Charters Towers Gold	A$	0.23	none	Buy below 0.20
NRI	TSX	NovaGold	C$	5.05	6.00	Buy below 5.00
MWA	TSX	McWatters Mining	C$	0.145	0.30-0.35	Speculative Buy below 0.16
EMP	ASX	Emperor Mines	A$	0.81	1.10-1.20	Hold
METLF	OTCBB	Metallica Resources	US$	1.58	1.90	Buy below 1.50
K.WT	TSX	Kinross Gold Warrants	C$	1.35	2.50	Speculative Buy below 1.35
AFKDY	OTC	Afrikander Lease	US$	0.89	none	Buy below 0.90
PAT	TSXV	Patricia Mining	C$	0.52	0.80	Speculative Buy at 0.50 or lower
NNO	TSX	Northern Orion	C$	1.90	none	Buy below 1.80

Chart Sources

Charts appearing in today's commentary are courtesy of:

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