The US CPI and the Global Inflation Trend

Those who think of inflation and deflation in terms of changes in prices, rather than as purely monetary phenomena, will be forced to perform logical contortions later this year to explain the coming sharp decline in US Government bond prices (rise in long-term interest rates). After all, there is no direct repayment risk associated with US Government bonds (the Fed stands ready, willing and able to monetise all debt instruments issued by the US Government) so major bond-market declines should be the result of indirect repayment risk (higher inflation or the anticipation of higher inflation). However, bonds have already experienced a substantial drop over the past 3 months and yet the ECRI's Future Inflation Gauge is telling us not to expect any significant increase in the Consumer Price Index this year. So, what gives?

The answer is that price increases are not inflation. They are sometimes, but not always, an effect of inflation. For example, consider the situation in which the US has a high inflation rate (money supply growth rate), but the US' trading partners have even higher inflation rates. In this case the Dollar could remain strong relative to other currencies, thus causing the prices of imported goods to fall in US$ terms and keeping downward pressure on domestically-produced goods and the CPI. If the CPI does not reflect a high rate of Dollar inflation due to the effects of even higher inflation rates in other countries, does it really make sense to conclude that the US does not have an inflation problem? We don't think so and neither does the bond market. The bottom line here is that the current inflation is global in nature and is resulting in a deterioration of bond prices throughout the world. US bond prices are simply moving in synch with this global trend.

In this year's Barrons Roundtable discussion Marc Faber made the point that China is likely to become the workshop of the world - a huge manufacturing centre where goods are produced far more cheaply than could be done in the West. As more and more of the world's manufacturing is done in China and other low-cost countries, downward pressure will be maintained on the prices of manufactured goods. These low-cost manufacturing centres will, however, consume a lot more commodities, thus putting upward pressure on commodity prices (the low-cost regions tend to have substantial untapped human resources, but not necessarily commodity resources). 

Further to the above the effects of inflation are far more likely to be seen, over the next 2 years, in the prices of commodities than in the prices of manufactured goods and the widely-watched CPI. That will, at least, be the case from the perspective of someone in the US. Increases in the prices of raw materials will, of course, eventually put upward pressure on other prices, but even then we doubt that the CPI will be allowed to reflect anything like the full effects of inflation. 

The US Stock Market

Cyclical Stocks

Applied Materials (NASDAQ: AMAT) released its latest quarterly financial report after the close of trading on Tuesday. The results were in-line with expectations and good enough to give the stock a 7% boost during Wednesday's trading. Below is a 1-year chart of AMAT.

AMAT is one of the world's leading manufacturers of semiconductor equipment. Most analysts consider the semiconductor industry to be cyclical, although there was a time not that long ago when the cyclical nature of these stocks was temporarily forgotten amidst dreams of a never-ending economic expansion. AMAT, therefore, is a cyclical company that is likely to make a lot of money at the top of the cycle and to lose money at the bottom of the cycle (it is presently losing money). 

One of the strange things about cyclical stocks is that they tend to rally strongly just when their current fundamentals and their medium-term prospects look terrible (near the bottom of the economic cycle). This occurs because the market begins to anticipate the next upturn well before there are any signs of improvement in the underlying businesses. The best opportunities to buy cyclical stocks therefore usually occur when their prospects appear to be dismal based on the 'news of the day'. This is, of course, also the hardest time to buy from an emotional perspective.

From being extremely profitable in 2000, AMAT is now losing money and its business prospects look terrible. Since the economy is probably near an intermediate-term bottom and we know that the stock market tends to move cyclical stocks much higher well in advance of an actual improvement in business conditions, does AMAT's recent rally make sense and is the stock currently a buy? The answers are no and no. Here's why:

Although AMAT is a cyclical stock it is not priced like a cyclical stock. It is presently trading at more than 9-times its annual revenue, meaning that it is priced as if it already had a high profit margin and was going to achieve high revenue and earnings growth rates as far as the eye can see. At cycle bottoms cyclical stocks should sell for less than 2-times annual sales. Herein lies the problem for many cyclical stocks in the tech sector - they are cyclical but they are not priced as such. 

Many commodity stocks, however, are trading at the sort of price-to-sales ratios we would expect to see near a cycle bottom and, in typical fashion, have rallied strongly over the past few months despite the fact that commodity prices have only shown a slight improvement. Take the example of Australian-based diversified miner MIM Holdings (ASX: MIM) which we added to the TSI Portfolio last September (see chart below). MIM has risen by around 75% from its September low, but is presently valued by the stock market at less one-times this year's revenue. Despite its rally over the past few months the upside risk with this stock still looks far greater than the downside risk and a pullback to A$1.25-$1.30 would present a good buying opportunity for investors. AMAT, on the other hand, looks like an accident waiting to happen. (Note: Trading in MIM was halted today due to the company's announcement of a new equity raising to fund the acquisition of more coal assets. Equity fund-raisings such as this will often put short-term downward pressure on a stock and, in this case, could provide a reasonable opportunity for new buying over the next few days.)

Up to this point we've tended to focus on a few fairly large, high-profile commodity-cyclicals because these are normally the first-movers in a commodity bull market. As these larger stocks become overbought (and assuming the commodity story continues to unfold according to our medium-term bullish view) we'll move down the food chain and add a few small-cap resource stocks to the Portfolio.

The S&P500 in terms of Gold

In the latest Weekly Update we mentioned that the trend in the S&P500/gold ratio (the number of ounces of gold it takes to buy the S&P500 Index) pointed towards the ratio falling to 3.00-3.25 over the next few months. Such a move would necessitate the S&P500 falling around 10% from current levels relative to the gold price. A chart of the ratio is shown below.

Strangely enough, the above chart suggests that a rising gold price could actually be a net-positive for the overall stock market because the ratio could move to the channel bottom via a 10% fall in the S&P500 or via a 10% rise in the gold price or via some combination of a falling S&P500 and a rising gold price.

Current Market Situation

As noted in the latest Weekly Update the stock market commenced a rebound last Friday that could last for up to 2 weeks. Once the rebound is complete we expect to see a drop to new lows for this year, although we do not expect a full re-test of last September's lows until late this year. Sentiment indicators are in the process of working-off the 'oversold' extremes reached last week and are currently what we would call 'mixed'. We remain short-term bearish, but would not be surprised to see the market maintain an upward bias for another week or so. We continue to hold QQQ March $35 put options.

One individual stock that we will be watching closely over the coming days is Cisco. This tech bellwether led the NASDAQ indices during the final few months of last year and recently broke below its 200-day moving-average. The ability, or otherwise, of Cisco to move back above its 200-DMA over the next few days will help us gauge the underlying strength of the overall market.

Gold and Gold Stocks

Australian Gold Stocks

Below is a 6-year chart of the Australian Gold Stock Index (XGO). Moves such as the one made by the XGO over the past 12 months are not followed by declines to new lows (this rally does not look like the bear market variety). On the contrary, the chart suggests that a major bull market is in progress. It would be normal, however, for such a move to be followed by a pullback or a sideways consolidation lasting several weeks. 

Although the XGO has risen by around 60% since last September we have not yet seen the type of rampant speculation in the Australian gold stocks that would typically occur near a major peak. In fact, while panic-buying of selected gold stocks was going-on in the US market over the past few weeks the Australian gold sector has been relatively subdued. Lihir Gold (LHG), our favourite amongst the medium-large Australian gold producers, has been quite strong. However, unlike some of its US-traded counterparts it has not experienced a huge upward spike and appears to be only marginally overbought.

Gold

Below is a weekly chart of the gold futures price (nearest month). There are no guarantees that a pullback has begun, but if it has then a drop to 288-290 could occur without invalidating the recent breakout (a drop of this magnitude would be a normal breakout pullback) while the gold price could fall to around 279 without breaching its medium-term up-trend.

The below chart of copper futures illustrates the pattern that often occurs following an upside breakout. The market breaks-out (point A), pulls back (point B), and then surges to a new high for the rally (point C).

A good position to be in right now is to have taken enough trading profits in gold stocks during the recent rally to be relaxed about the prospects for a pullback, but to have retained some trading positions (in addition to a core investment position) to provide upside exposure in case a pullback does not materialise. Note that the downside risk in most gold stocks at this time is far greater than the downside risk in gold itself. We do not think that the bounce in the bullion price to $300 represents a profit-taking opportunity, but a large speculative premium was recently built-up in many gold stocks.

The Dollar

There is no change to our currency market view. We expect the Dollar to remain strong for another month or so with the Dollar Index having a reasonable chance of exceeding its July-2001 peak before the end of March. We do not expect this peak to be confirmed by new lows in the euro, the Swiss Franc or the A$ (these currencies are expected to remain above last year's lows).

Update on Stock Selections

Prudential Securities put out a research report on NEM earlier this week with a SELL recommendation and a reduction in price target from $21/share to $10/share. The timing of this report was quite strange (why reduce the price target on an unhedged gold stock by 50% just after the gold price has reached its highest level in 2 years?), but we had a look at it to see what the analyst's concerns were. Here are our thoughts:

Firstly, the analysis of the Normandy assets and finances appears to be flawed, possibly because the Prudential analyst is using June 2001 figures and not the latest figures. We have no idea why he did that when the Dec-2001 figures have been available for a few weeks. In any case, the marked-to-market loss on NDY's hedge book currently sits at around US$240M (not the $550M quoted in the report) and this is not an actual loss that needs to be offset against cash. Also, the NDY management have always been extremely conservative in their reported estimates of reserves. 

Secondly, the analyst's major concern seems to be that NEM is not replacing its reserves at a fast enough rate. This may be a legitimate concern, but it is one that NEM can easily overcome through acquisition. For example, the reserve life could be immediately boosted by a few years via a takeover of Lihir Gold. Since former Franco Nevada 'head honchos' Schulich and Lassonde will now be making the investment decisions for NEM we can have some confidence that future acquisitions will be astute.

Thirdly, the new Newmont will be a must-own stock for institutional investors in a gold bull market due to its size and liquidity.

Prior to the NDY takeover we would not have wanted to invest in NEM because it seemed over-priced, the management seemed mediocre and there were far better investment opportunities in the gold sector. We wouldn't argue that it now represents good value, but it is certainly a reasonable stock to have as part of a gold stock portfolio because it provides good leverage to the spot gold price and geographical diversity.