- Interim Update 21st January 2004

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Money Supply and Interest Rates

A few years ago we noticed that intermediate-term trend changes in the T-Bond yield led trend changes in the year-over-year money-supply (MS) growth rate by about three months. This lead-lag relationship is depicted on the below charts. Note that the scale on the bond yield chart has been inverted so peaks actually represent interest-rate lows (the chart, as drawn, shows the direction of bond prices) and that the charts have been offset by about 3 months.

The MS-bond relationship has served us well because whenever a trend change has been confirmed in the bond market we have been able to correctly anticipate a corresponding change in the money-supply growth trend. For example, as soon as the bond yield began to surge last June the lead-lag relationship told us to expect a downward reversal in the money-supply growth rate by September. As it turned out, the actual peak in the year-over-year M2 growth rate occurred in late August.

Further to the above, the directional change in the money-supply growth trend that began towards the end of August last year was foreseeable. What wasn't foreseeable -- at least from our perspective -- was the magnitude of the drop in the money-supply growth rate, although the dramatic decline is consistent with the observation that it has become a lot more difficult to stimulate money-supply growth over the past two years. In particular, since early 2002 falling interest rates have had a lesser positive effect on money-supply growth while rising interest rates have had a greater negative effect. This is one reason why the Fed will be doing everything in its power to prevent bond yields from moving sharply higher.

By the way, the above charts suggest that we will probably see a bounce in the M2 growth rate over the next few months, but unless bonds surprise us by moving above last year's high the money-supply growth trend should remain down.

The US Stock Market

What everyone knows...

Almost everyone knows that there will not be a large downward move in the US stock market until after the November elections, but what almost everyone knows is seldom worth knowing. We are prepared to make a sizeable bet that this consensus view of the world -- the view that it will generally be smooth sailing for the market until November -- will prove to be about as wrong as it could possibly be. We're just not prepared to make that bet right now because the most likely path appears to be a pullback followed by a rally to a new high before the trouble begins. 

The main problem facing the stock market is that it is priced for perfection, meaning that it is acutely vulnerable to something going wrong. And there are a lot of things that could go wrong over the next 6-12 months, one of which is on-going strength in the oil price.

Our bearish one-year outlook for the stock market is not based in any way on a strong oil price (our expectation has been that the oil price would weaken). However, if the oil price does remain strong for several more months then this will add to the bearish case because it will be the equivalent of a tax hike for US households and businesses. In other words, any additional benefit that would have occurred this year as a result of Bush's tax cuts would potentially be offset by higher energy costs.

By the way, a rising oil price can never have an inflationary effect -- notwithstanding the consensus view to the contrary -- unless the Fed monetises the increase in the oil price. Right now, though, the intermediate-term money-supply growth trend is down so it is doubtful that the US financial establishment could lend enough new money into existence to allow the economy to absorb a large rise in energy costs in a relatively painless way. In the current environment a sustained increase in the oil price would be neither inflationary nor deflationary, it would simply be a drag on the economy.

But what if the money-supply growth trend were to reverse sharply higher over the coming months, in effect allowing other prices to rise in concert with energy prices? In this case the negative effects on the economy and the stock market would be less immediate and less direct, but the heightened fear of inflation that would no doubt stem from a broad-based rise in prices would bring about a substantial increase in long-term interest rates. This, in turn, would be a major problem for the stock market because the widespread belief that interest rates are going to remain low is probably the single most important factor supporting current stock market valuations.

Of all the things that could go wrong for the stock market over the next 6-12 months a substantial increase in long-term interest rates -- regardless of whether the increase is related to higher energy prices or to something else -- is, in our view, the most likely. In fact, if a substantial increase in long-term interest rates does occur it will probably be associated with something other than rising energy prices because, as explained in previous commentaries, oil prices and long-term interest rates have been inversely correlated over the past two years. Instead, a sharp rise in long-term interest rates over the remainder of this year would more likely be associated with the withdrawal of foreign central-bank support for US bonds and/or continuing across-the-board strength in commodity prices due to strong demand from Asia. 

Why would higher interest rates be such a problem for the stock market? 

The short answer, as mentioned above, is that the widespread belief that interest rates are going to remain at a very low level is probably the single most important factor supporting current stock market valuations. And we aren't just referring to the fact that the lower the interest rate the greater the present value of future company earnings. Of great relevance is also the competition for investment between stocks and bonds and between low-risk/low-yield debt and high-risk/high-yield debt. Pension fund managers, for example, are under pressure to generate returns of 8-10% per year in order to satisfy the assumptions built into corporate financial statements. These assumptions will prove to be unrealistic over the long-term and will eventually need to be ramped down, but in the mean time the fund managers must try to obtain a return on investment equivalent to twice the yield on 10-year Treasuries. And the only way to do this is to buy riskier assets such as stocks and lower-quality debt securities. However, should the yield on a 10-year Treasury rise from the current level of 4.1% to, say, 6.5%, then the game changes because these people who, as a group, manage hundreds of billions of dollars will be able to allocate a larger portion of their funds to the lowest-risk securities without sacrificing a huge amount of performance. A result would be a massive re-allocation of money from riskier investments that offer the potential for higher returns to investments that offer greater safety.

Apart from higher interest rates and oil price strength, things that could go wrong include an accelerated fall in the US$, a continuing decline in the money-supply growth rate, and a successful terrorist attack against the US. 

It is, of course, possible that nothing will go wrong over the remainder of this year and the stock market will simply work its way higher between now and the elections with just routine pullbacks along the way. Trouble is, everything must go right for the market to end the year higher than where it began whereas only one thing needs to go wrong for a large decline to occur. To use a coin-tossing analogy, someone who is bullish on the US stock market as far as the coming year is concerned is effectively expecting to call five out of five coin tosses correctly whereas someone who is bearish is only expecting to call at least one out of five coin tosses correctly.

Current Market Situation

There is no change to our short-term view; we expect that a pullback will begin soon and that this pullback will be followed by a rally to a new recovery high.

Although we see very little upside potential in the senior stock indices and considerable downside risk as far as the coming year is concerned, it will be important that we not to be so dogmatically bearish on the market that we overlook the good buying opportunities that will almost certainly emerge from time to time in individual sectors. After all, it is rare for all sectors of the market to fall at the same time. In fact, even during severe bear markets the periods during which all stock-sectors are plummeting tend to be very short. Instead, during any 6-month period there is usually at least one sector of the market that is performing well. 

At the moment, our long-side speculations/investments are focused on gold stocks and non-gold commodity stocks. However, over the course of this year that might change.

Gold and the Dollar

Gold Stocks

Our expectation is that the rebound in the gold sector that began last Thursday will be followed by another downward leg and that a correction low will be in place by the end of February at the latest (most likely within the next three weeks). We've previously mentioned a downside target of 190 for the AMEX Gold BUGS Index (HUI), but of greater significance than the HUI reaching any specific price level will be gold-stocks reaching an oversold extreme relative to the gold price. As outlined in the latest Weekly Update, we would classify a drop in the HUI/gold ratio to 13% below its 40-day moving average as an oversold extreme.

Last year the XAU broke upwards out of a 6-year base formation (see weekly chart below), in the process creating a target of 135 (equivalent to about 300 for the HUI). The XAU therefore has some unfinished business to attend to on the upside, although even if this technically-based target is valid it wouldn't necessarily have to be achieved this year. As far as the next few weeks are concerned a drop back to the top of the former basing pattern (85-90) would not be surprising.

Below is a daily chart of the XAU. If we are right about there being one more downward leg before a correction low is put in place then the current rebound is likely to fail at, or below, the 50-day moving average (presently at 105.6). The XAU could, however, move up to short-term resistance in the 108-109 area (equivalent to about 245 for the HUI) without invalidating the idea that new correction lows were in store over the coming weeks. We would consider a daily close above 109, though, to be strong evidence that the correction was over. 

While the stocks of some high-profile North American gold producers -- GG and RGLD spring to mind -- are breaking down quite badly, the stocks of the unhedged South African majors (HMY and GFI) appear to be readying themselves for moves to new all-time highs. These stocks have been in consolidation since June of 2002 and effectively 'sat out' last year's rally in the gold sector, but their chart patterns are now shaping up quite bullishly (see below). Furthermore, they are under-valued relative to their NA counterparts. 

Both stocks have some work to do to overcome the resistance that lies about 10-15% above their current prices, but the next big moves for these stocks will probably be to the upside. If upside breakouts from their 20-month-long consolidation patterns do occur then $20 for GFI and $26 for HMY would be reasonable objectives over the ensuing 3-6 months.

As promised in the latest Weekly Update, below is a table of gold/silver stocks -- some that are currently in the TSI Stocks List and some that aren't -- that might be suitable for new buying as the correction in the gold sector winds its way to a conclusion. There are many other stocks that deserve to be included in this table, but we didn't think that adding more choices would add any more value. 

Next to each stock we've suggested an under-the-market ST (short-term) buy price, but please note that these prices should not be interpreted as targets. Rather, the suggested buy prices are simply levels at which the stocks would probably work well if purchased as 3-month trades. Long-term investors who aren't concerned about monthly fluctuations in stock prices could, however, buy these stocks now because from a valuation perspective they look attractive at their current prices. 
 

 
Symbol Stock Exchange Company Name   Recent Price $ ST Buy Price $
AUY AMEX Yamana Gold US$ 2.42 2.00
AZS TSXV Arizona Star C$ 4.72 4.20
BTV ASX Batavia Mining A$ 0.14 0.13
CBD TSX Cumberland Resources C$ 4.20 3.70
CCM TSX Canarc Resource C$ 0.82 0.76
DROOY NASDAQ Durban Deep US$ 3.68 3.20
DSM TSX Desert Sun Mining C$ 1.50 1.30
GFI NYSE Gold Fields US$ 13.68 13.00
HMY NYSE Harmony Gold US$ 16.78 15.00
MRB AMEX Metallica Resources US$ 1.63 1.50
NG AMEX NovaGold US$ 5.49 4.70
NXG AMEX Northgate Exploration US$ 2.16 1.75
RSGO ASX Resolute Company Options A$ 0.67 0.60
TKO TSXV Taseko Mines C$ 2.00 1.50
WTZ AMEX Western Silver US$ 5.25 4.30
XRC TSXV Exeter Resources C$ 1.11 1.05

By the way, we've included DROOY in the above list because it looks good from a technical perspective and because we know that many of our readers follow this stock. However, we see no reason to buy DROOY as a longer-term investment when Harmony Gold -- a company with vastly superior management and assets -- offers almost as much leverage to the gold price. DROOY can, though, be a good stock to trade from time to time.

Current Market Situation

Below is a daily chart of March euro futures. The euro's rise during the final two months of last year was both relentless and orderly, but we are finally beginning to see the sort of disorderly price action in the currency market that we'd expect to see near an intermediate-term extreme (high for the euro, low for the dollar). 

As explained in previous commentaries, we don't think the euro has yet reached an intermediate-term peak against the US$. However, the euro's next intermediate-term peak is unlikely to be substantially above the high reached during the first half of January. 

Below is a chart of the euro gold price showing the potential head-and-shoulders bottom that has formed over the past 18 months. We say "potential" because the pattern won't be confirmed until/unless the gold price moves above 350. The below chart has considerable bullish potential in that a break above the downward-sloping neckline -- something we expect will occur during the first half of this year ñ would project a move up to around 390 (63 euros above yesterday's closing price). On the other hand, the downside risk at the present time appears to be limited to 15-20 euros. 

Copper has out-performed gold since the beginning of last year and the copper/gold ratio recently broke upwards out of a 2-year base, projecting a continuation of copper's out-performance over the coming 12 months. We do, however, think there is greater short-term downside risk in copper than in gold. There are two reasons for this. First, copper is vulnerable to any lowering of economic growth expectations. Second, gold is already well into its correction whereas copper has just spiked to a new multi-year high. 

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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