The US Stock Market

Overview

The current market environment reminds us more of the manic 1998-2000 environment every day. Between October-1998 and September-2000, knowledge was a dangerous thing. The less you understood about the fundamentals the more money you could make because the companies whose stocks were rising the fastest were the ones with the worst future profit-making potential. We were, at the time, prepared to trade these stocks because the major trend was up and business momentum was up (business momentum, here, refers to the popular metric of the day, which evolved during the mania from mundane considerations such as price/earnings ratios and price/sales ratios to more creative measures such as price-to-page-hits and the number of PhDs employed by the company per billion dollars of market cap). In fact, at this time 3 years ago the TSI Stock Selections List was dominated by tech and internet stocks in the same way that gold stocks currently dominate the list. 

We aren't, however, prepared to jump into the current crop of absurdly-priced market favourites, even for a short-term trade. This is because the market's technical situation is poor (the major trend is down and the quality of the advance has not been good) and business momentum is down. Furthermore, with leading indicators pointing towards a further slowdown in economic growth next year the probability of business momentum improving during the coming 6-12 months is low. 

The evidence might change and if it did we would certainly consider taking a more positive view towards the overall market. However, any sustainable improvement in the economic backdrop would likely favour the stocks of commodity producers over, for example, financial, tech or retail stocks. Despite everything that has happened in the world over the past year the CRB Index is only about 2% below its 2000 peak and about 13% below its 1996 peak. A move above the 1996 peak would provide confirmation that the primary trend for commodities had turned bullish. Considering that the stocks of many commodity producers are priced as though the current commodity rally is a counter-trend move in a bear market, a moderate gain in commodity prices from here would probably lead to a sharp upward re-valuation of the stocks of the commodity producers.

Reality Check

The semiconductor equipment companies are NOT early-cycle stories. These companies sell the equipment that the chipmakers use to manufacture computer chips. However, chipmakers such as Intel, Micron and Taiwan Semiconductor have excess capacity and won't need much in the way of new equipment until the demand for computer chips has been rising for some considerable time. Currently, though, the demand for chips is not rising and won't begin to rise until there is a marked pickup in the demand for computers. But, according to Microsoft and Dell the demand for computers is flat and presently shows no signs of turning higher. An upturn in the business of the semiconductor equipment companies is, therefore, probably at least 12-18 months away. And yet, the stocks of these companies have been at the forefront of the October-November rally.

While the absurdly overpriced semiconductor stocks with bleak prospects have been rocketing higher, anything to do with home building or home improvement has shown few signs of life. For example, the below charts of Toll Brothers (a homebuilder) and Home Depot (the largest home-improvement retailer) show that both of these stocks are near their October lows. The Home Depot (HD) stock price plunged on Tuesday after the company confirmed that its growth rate was slowing, but at its current level there is very little growth factored into the stock (HD has an unleveraged balance sheet, a price/earnings ratio of about 16 and a price/sales ratio of about 1). Toll Brothers (TOL) is currently trading at a price/earnings ratio of 6.5 and a price/sales ratio of 0.6, so the market appears to be saying that TOL's business is going to shrink.

What is wrong with this picture? Simply that the housing industry has supported the economy in two important ways over the past year. Firstly, rising house prices have offset the negative wealth effect related to the decline in the stock market. Secondly, rising house prices combined with falling interest rates have allowed home-owners to increase their mortgage debt and thus increase their spending. If this support is in the process of collapsing, as the performances of HD, TOL and other housing-related stocks suggest, then the US economy is going to be extremely weak next year and the semiconductor stocks are even more over-priced than they appear at first glance.

Current Market Situation

Below is a chart showing the TSI Index of Bullish Sentiment (TIBS), a weighted index of 6 different sentiment indicators. The chart shows that sentiment is now significantly more bullish than it was at the August peak even though the market has gone almost nowhere over the past month and the S&P500 Index is still 5% below its August high.

The rise in bullishness over the past few weeks has no doubt been related more to the surge in the prices of some tech stocks than to the performance of the overall market. For some time now the NASDAQ Composite has been threatening to breakout to the upside (see chart below). And, on Wednesday, the NASDAQ100 Index closed at a new recovery high (above the August peak) while the stock price of Cisco closed above its 200-day moving average for the first time since February. 

As mentioned in the latest Weekly Update we don't think that an upside breakout at this time would hold any great significance beyond the very short-term. It would, however, generate a lot of enthusiasm and probably lead to an important peak within a few days of the breakout occurring. In this case we expect that a breakout above resistance would shake out most of the remaining weak-handed 'shorts' and set the stage for the next decline.

If you don't already own a bearish position on the market, such as the QQQ put options we've suggested (the QQQ June-2003 $20 puts - QAV RS-E) or the Prudent Bear Fund, then it would be reasonable to purchase an initial position now. However, if you already have a position there isn't a lot to be gained by adding to it now. We expect the rally to fail soon, but would prefer to wait and see what happens with the on-going probing of resistance before taking any further action.

Gold and the Dollar

The US$ and US Bonds

As far as we can tell there isn't much correlation between the US Dollar's exchange value and long-term US interest rates, at least in the medium-term. Sometimes bonds will trend in the same direction as the Dollar and at other times they will trend in opposite directions. For example, bonds and the US$ trended higher together for several months leading up to August 1998, at which point the US$ tanked while bonds continued to push higher. Bonds then peaked and turned lower in October of 1998. At the same time the US$ bottomed and turned higher.

Over the past 20 years there are several examples of US T-Bonds rallying while the US$ fell, so it is wrong to think that a falling Dollar will necessarily lead to higher interest rates. One of the best of these examples occurred during 1985-1987. The US$ made a long-term peak in March of 1985 and then lost half its value, in terms of the Swiss Franc, in less than 3 years. During the first 15 months of the Dollar's decline from its March-1985 peak the US T-Bond rallied (long-term interest rates fell). In fact, it wasn't until after the Dollar had been falling for about 2 years, in the process losing about 40% of its value, that the US bond market really began to come under pressure. 

The below chart compares the performance of the US$ and US T-bonds during the 1985-1987 period. Note that the bond-yield section of the chart has an inverted scale, so as shown the chart reflects the direction of the bond price. Just for fun we've also included the Barrons Gold Mining Index in the chart comparison.

Between March of 1985 and July of 1986 (15 months), bonds rallied as the US$ fell. Bonds then peaked and spent several months trading sideways near their highs before collapsing in April of 1987. Based on what was happening in other markets it appears that bonds were able to ignore a falling dollar up to the point where the falling dollar started to generate fear of inflation. 

Note that gold stocks bottomed when bonds peaked and accelerated higher in 1987 when bonds accelerated lower. Gold stocks were, in actual fact, moving with the yield spread (when bonds turned lower in July of 1986 the yield spread - the T-Bond yield minus the T-Bill yield - began to widen).

Interestingly, we have just experienced another 15-month period (July 2001 to October 2002) during which bonds rallied while the Dollar fell (see chart below). At this stage we don't know whether the early-October high in bonds will turn out to be a long-term peak or just an interim peak, but if bonds fail to make a new high over the coming month or so then the current dollar-bond situation will look a lot like 1986. However, it doesn't matter whether or not the recent period during which bonds rallied while the US$ fell turns out to be exactly the same length as the 1985-1986 period. What does matter is that bonds can continue to rally in parallel with a falling US$ for as long as the falling dollar is not perceived to be creating an inflation problem. Furthermore, once the falling dollar is perceived to be creating an inflation problem we should not only see bond prices start to trend lower, we should also see a very powerful advance in the gold sector.

Using yourself as a sentiment indicator

There were times during May and September when there was almost uniform exuberance expressed in the media with regard to gold's short-term prospects. It seemed that the gold price was about to blast higher, leaving the 325-330 resistance-area in the dust. This exuberance was a sign of a short-term peak.

In addition to monitoring how the financial news media portrays the prospects of a particular investment, try using your own emotions as an indicator of the prevailing sentiment. Remember how you felt at what turned out to be important tops and bottoms in the past and use this information to gauge market sentiment in the future. For example, if you were long gold stocks and were bubbling over with excitement at the thought of much higher prices near the top in late May, or if you were enticed to buy near the top, take note for future reference. Similarly, if you were pressured into selling near the bottom in July or were too afraid to do any buying at that time, also take note of how you felt. You may find that your own feelings are an excellent contrary indicator!

Sometimes people who correctly identify that sentiment has reached a bullish extreme refuse to do any selling because they are worried that prices are about to rocket higher. Certainly, at important tops there will never be any shortage of analysts explaining why prices are on their way to the moon. However, if you do sell when exuberance reaches what appears to be a short-term peak and the price then moves considerably higher, it doesn't matter. When Bernard Baruch, one of the most successful speculators of all time, was asked how he was able to make so much money in the stock market he said "I always sold too early".

Current Market Situation

In the latest Weekly Update we included a chart of the HUI showing what we consider to be the two most likely outcomes for gold stocks over the next several months. Both projected outcomes involved the HUI dropping to near its medium-term uptrend-line (currently around 110) before breaking upwards out of its consolidation pattern. We also mentioned that we would be buyers of gold stocks if the HUI did make the anticipated drop to its trend-line.

Below are 6-month charts of the HUI and the XAU. We plan to do some more buying when the HUI trades below 113 and/or the XAU trades below 62. For those who don't already have a sizeable position in gold stocks, it would be reasonable to do some buying now.

Amongst the juniors (where most new buying should be focused) the stocks we like the most at current prices are, in no particular order, Golden Star Resources (AMEX: GSS), Cumberland Resources (TSX: CBD), American Bonanza (TSX: BZA), Silverado Gold (OTCBB: SLGLF), and Red Back Mining (ASX: RBK). Amongst the majors we prefer the large South African producers (HGMCY, GFI and AU). We suggest steering clear of the highly-priced North American majors such as MDG and GG.

Over the past few months our view has been that silver would drop back to at least $4.20 and perhaps as far as $4.00 before a sustainable advance would begin. There has been nothing in silver's recent price action to indicate that this view is wrong, but the recent price action of silver stocks has been constructive. It was around this time last year that we turned bullish on silver for the main reason that the prices of silver stocks were diverging, in a positive way, from the price of the metal. There are signs that a similar situation might be developing now. We plan to review silver and silver stocks in the next Weekly Update.

Update on Stock Selections

Copper/coal producer MIM Holdings (ASX: MIM) was up 22% in Australian trading today after the company confirmed that it was in talks with Xstrata Plc with regard to a "friendly" takeover of MIM by Xstrata. No offer has yet been made and the talks might lead to nothing, but the announcement has effectively put MIM in play. If you don't already own MIM then don't buy it now, but if you already own it then we suggest holding. If a deal is done we expect that it would be priced significantly above today's closing price of A$1.52. 

Russian company Norilsk Nickel is going to buy a 51% stake in Stillwater Mining (NYSE: SWC) at US$7.50/share. The idea of being a minority shareholder in a company controlled by Norilsk doesn't appeal to us, so we will exit SWC today. We will use the average price during the first half-hour of trading for record purposes.

Chart Sources

Charts used in today's commentary were taken from the following web sites:

http://stockcharts.com/index.html