- 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.
|