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    - 16 May 2001

Interest Rate Update

Long-term Interest Rates

We were bullish on bonds for much of last year and then turned medium-term bearish in early-January 2001. Our thinking was, and still is, that aggressive easing by the Fed and an explosion in the supply of money would prompt bond-buyers (lenders) to demand compensation for the on-going inflation. If you think that money will be worth less in the future than it is today, you will demand a higher interest rate on any long-term loans you make to compensate you for the likelihood that the loan will be repaid in depreciated currency. We would not be surprised to see a bond rally soon, but see no reason to change our forecast that bond yields are headed much higher over the coming 12 months. On the contrary, the fact that the US Fed is proclaiming that inflation is contained is a reason to be even more bearish on bonds beyond the short-term. There is no reason for us to stop believing in an inflationary future until the Fed starts believing in an inflationary future. The first step in solving a problem is to admit that you have a problem, so the Fed and most financial pundits are yet to take that first step.

But what about the US Government budget surplus? Won't the projected surplus lead to a reduction in the supply of T-Bonds (since part of the surplus will be used to re-purchase debt) and, therefore, higher bond prices (lower long-term interest rates)? The problem with that argument is two-fold. Firstly, the projected surplus will almost certainly not materialise because it is based on invalid assumptions regarding future economic growth and capital gains tax revenue. Secondly, the only means by which tax revenue can be elevated sufficiently to produce the projected surpluses is through inflation. In other words, depreciation of the currency is necessary in order for the surpluses to eventuate. In this situation, will bond buyers really be happy to accept a rate of interest that does not adequately compensate them for the depreciation of the Dollar just because there might be less government bonds on the market? We think not.

Short-term Interest Rates

One of our major worries, as far as the stock market is concerned, is that short-term interest rates continue to fall (the T-Bill yield dropped to 3.48% on Wednesday). This means that the debt market is prepared to anticipate higher inflation, as indicated by the rise in long-term interest rates, but is not yet ready to anticipate higher economic growth. The stock market therefore appears to be ahead of itself. 

The US Stock Market

The disconnect between earnings and stock prices

The information in the following table was sourced from an article by Doug Kass at RealMoney.com. The table shows that the stock market put in some of its best performances in years when actual company earnings results were far worse than the earnings expectations at the beginning of the year.
 

Initial Consensus Forecast for Earnings Growth
Actual Earnings Growth
S&P500 Performance
1985
+17%
-5%
+28%
1986
+18%
-1%
+15%
1991
+14%
-15%
+26%
1998
+14%
-2%
+26%

The above table shows why monetary and technical indicators are important. In the 4 years mentioned in the table the average expectation going into the year was that earnings would grow by 16%. However, the average actual result was a decline of 6%. And yet, the average performance of the S&P500 was a gain of 24%. Apart from an apparent disconnect between the fundamentals and the performance of the market, what do these 4 years have in common? Answer: a very positive monetary environment.

In early-April we stated that the conditions were falling into place to support a rally through to the end of this year. We saw the Feb-Mar capitulation as providing the right sentiment platform from which a 6-8 month rally could be launched, but the main source of our medium-term bullish outlook was/is the extremely positive monetary environment. We are not talking about falling short-term interest rates, although lower rates are certainly a factor. The key point was, and still is, the rapid expansion of the money supply. Our belief is that the flood of money will overwhelm the on-going negative news on company earnings and the still-rich valuations of many companies.

The disconnect between current-year earnings and current-year market performance is not as irrational as it first might seem, because this year's stock market performance is based on the market's expectations of next year's earnings. A positive monetary environment usually occurs when the economy is weak and earnings are falling, and it usually results in a sharp recovery during the following year. 

Although we are generally bullish as far as the remainder of this year goes (we do expect a gut-wrenching correction in the June-September period, but the market should be significantly higher by year-end), we already have some concerns regarding next year. We would not be surprised if next year turns out to be the exact opposite of this year in that the earnings news will be a lot better (the comparisons with this year will look terrific), but the monetary environment will be a lot worse. In fact, at this early stage we suspect that the Fed will need to raise interest rates during the first half of 2002 and that higher long-term market interest rates will have caused a meaningful slowdown in the rate of money-supply growth. As such, those who wait for a definite upturn in fundamentals before buying will most likely end up buying just before the next big decline.

By the way, we consider ourselves to be the tellers of a story for which the ending is re-written every day. Based on our understanding of the characters in the story and our knowledge of their past behaviour, we try to predict what they will do in the future and thus anticipate how each chapter will end. However, as happens in any good story the characters sometimes do the unexpected. This is just a roundabout way of saying that none of our forecasts are set in stone and if conditions change we will (hopefully) change our forecast accordingly. As such, although we currently expect to remain bullish until the end of this year we are open to turning bearish earlier or later than year-end if our indicators dictate that we do so. 

Current Market Situation

In the May-07 WMU we suggested taking profits on the QQQ shares purchased in late-March/early-April when a) the QQQ trades above $50, or b) the June S&P500 futures trade up to 1290, or c) the Dow trades up to 11,200. b) and c) were achieved on Wednesday, but we will continue to hold the QQQ positions for now. The reason is that we expect this rally to extend into the end of this month with the focus of investment shifting away from the stocks perceived as representing 'safety' towards the stocks perceived as representing 'growth'. In other words, we expect the NASDAQ to out-perform over the next couple of weeks. As such we will hold-out for a price north of $50 on our QQQ positions (and raise sell-stops to $43.30).

One positive aspect of yesterday's rally was a general absence of the ridiculous 20-30% daily surges in the prices of some of the more speculative stocks that have often been seen during past rallies.

Gold and the Dollar

Gold Stocks

We were going to show some charts of gold stocks that have achieved upside breakouts, but since every gold stock chart we look at shows an upside breakout on strong volume we decided not to. Suffice to say, the technical picture looks great. In the latest WMU we included charts of the Australian Gold Stock Index (XGO) and Lihir Gold (LHG), showing that both were bouncing up against resistance. After easing back during the first 2 days of this week, XGO and LHG have since blasted through their respective resistance levels. We expect LHG to reach $1.30 over the next few months assuming a modest amount of help from the gold price (LHG closed at $0.90 today, up 14% on the day and up 50% since early-April).

The prices of gold stocks and other commodity-related stocks are presently well ahead of the prices of the underlying commodities. This is not unusual, but it means that commodity prices will need to start moving higher soon in order to support what is happening in the equity market. In 1992/1993, gold equities rallied for 3-4 months before the gold price began its own rally. The current rally in gold equities has been going for 6 months, during which time the gold price has barely moved. Clearly, equity investors are anticipating a break higher in the gold price and a break lower in the Dollar.

Current Market Situation

Gold has surprised us with its strength so far this week (first time we've said that in a few years!). We came into this week expecting a 1-2 week pullback before a major up-move began, but at this stage the gold price is having trouble dropping for more than a few hours before the buyers show up. Helping the situation for gold is that the US$, after rising to its highest level since April-18 on Monday, reversed course and headed lower on Tue and Wed.

We suspect that the drag on the US economy and the earnings of multi-national US corporations from the strong Dollar has become a concern of the US monetary authorities and that the Apr-18 and May-15 interest rate cuts were partly motivated by a desire to weaken the Dollar. We certainly don't expect to see US officials 'talking down' the Dollar anytime soon, but a surreptitious 'weak Dollar policy' may have been initiated.

Gold has still failed to confirm strength by moving above the Mar-12 peak of 274.80 (basis the June contract) and many gold stocks are up 20-30% over just the past week, so a pullback in the short-term remains a distinct possibility. However, if this is the bull market we think it is then we are still in the early stages and most surprises will be on the upside. Outside the realms of goldbugs the rally in gold stocks over the past several months has garnered very little attention. This is bullish. As such, the greatest risk remains in NOT being invested in the gold sector, with pullbacks towards up-trend lines presenting opportunities for those without sufficient exposure to accumulate stock. 

Changes to the TSI Portfolio

No changes.

 
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