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    - 21 March 2001

Death Spiral in Japan

The above was the title of an article that appeared in the latest edition of Barrons. The following quote sums up the message of the article: 

Japan's banking woes, already well-known to Asian investors, will surely escalate. Todd Jacobson, who steers Warburg Pincus Japan mutual fund, calls Japan's problems "extreme: The economy is very bad, and there's no wiggle room left to sell equities to buttress your capital base." Says Jacobson: "The most likely scenario is we will see at least one bank nationalized in the next six months."

Articles such as the above are a contrarian's dream since they usually appear near major bottoms. Time will tell if this article was another great contrarian BUY signal, but negativity surrounding Japan's financial situation could hardly be more extreme.

Below is an updated version of a chart we have included in previous commentary. The chart shows the Nikkei225 in US Dollars (the Japanese stock market from the point of view of a US investor) and, as previously noted, we plan to turn bullish on the Japanese stock market when the downtrend line on this chart is broken. Although the Nikkei has rallied sharply this week, the downtrend remains in tact. A move by the Nikkei/Yen ratio to around 110 (with Dollar-Yen at 123 this would require a move to 13600 on the Nikkei) would turn us bullish. (Note that a chart of the Nikkei in Yen, rather than US Dollars, would show a break of the downtrend as a result of yesterday's sharp rally. However, from the perspective of a foreign investor there is little point buying Japanese stocks if stock market gains are going to be offset by currency market losses.)

The big news coming out of Japan this week is that the BOJ is now specifically targeting inflation, that is, they now have a stated objective to increase the rate of inflation. This has been the unstated policy of the other major CBs for many years, but now the BOJ has joined the party.

We've been long-term bearish on the Yen since 1997 as it seemed obvious that the Japanese authorities would eventually sacrifice their currency in a giant debt-monetisation splurge. We may have just seen the initial phase of 'Yen trashing', with much more to come (after a correction over the next couple of months).

The US Stock Market

Getting There Fast

It is becoming clear that the stock market is going to make a major bottom much sooner than we had originally expected, most likely during the next 6-8 weeks. In other words, it looks like we are very close to a bottom in terms of time, but are we close in terms of price? As far as the NASDAQ Comp. and NASDAQ100 are concerned, we'd say yes. As far as the Dow is concerned, we'd say no. The S&P500 falls somewhere in between.

The NASDAQ appears to be 'sold out', which is not surprising considering how far it has fallen. Downside progress has become laboured, and we continue to have a rather significant positive divergence in that the Semiconductor Index (SOX) currently sits more than 10% above its November 2000 low. The SOX regularly makes 10% moves in a day, so that divergence could disappear very quickly if the selling pressure intensifies. However, with the market already as deeply oversold (by some measures) as it was in the immediate aftermath of the 1987 crash, an intensification of selling is highly improbable (outside of the 'old economy safe havens' that have been propping up the Dow for the past few months).

In order to be confident that the market is near a bottom in terms of price as well as time, we will need to see the items listed in the latest WMU fall into place. Firstly, a sharp fall in the Dollar and rise in the gold price would signal the capitulation of foreign investors. We seriously doubt that a bottom can occur until foreign investors, who are usually the last to arrive at the party and the last to leave, have capitulated. As long as US$-denominated assets are perceived as being the best place to park money, that is, as long as confidence in the US$ remains at a relatively high level, we will not be near THE bottom. Secondly, we would like to see substantial strength in bond prices as evidence that the market has lost confidence in the Fed's ability to inflate. During Wednesday's session long-term bond prices were flat, despite yet another plunge in stock prices, suggesting that the market still believes the Fed will eventually be successful (most likely after one or two more rate cuts). Thirdly, a rally in the short-term that removes the oversold condition and sets the market up for another fall would also be helpful in getting us to THE bottom by early May.

Sentiment

In the latest WMU we mentioned that the TSI Index of Bullish Sentiment, although being oversold almost continuously for many months, had not indicated the sort of spike low in sentiment normally associated with major bottoms. Based on preliminary readings for the past week it looks like we are now getting that spike low. Also, the latest results of the Consensus-inc Sentiment Survey show a bullish percentage of 13. This is 4 points lower than the lowest reading that occurred at the height of the 1998 financial crisis.

Current Market Situation

We've been anticipating a short-term rally for some time, but none has materialised. The ability of this market to continue its decline without so much as a pause to refresh is indicative of a market in the throes of capitulation. A 1-2 week rally in stocks and pullback in bonds would fit neatly into our forecast for a final plunge in stocks and surge in bonds during April. Based on most of the technical indicators we watch this should happen. However, the market does not have to conform to any pre-defined pattern.

Bond Market Update

The similarities between the present time and the 1998 financial crisis continue to build. Yields are falling across the curve, with the yields on short-dated securities falling faster than those on long-dated securities. As the following chart shows, short-term yields were much higher than long-term yields (the yield curve was decisively inverted) as recently as November last year, but the situation has completely reversed since the beginning of this year.

One major difference between 1998 and now that continues to stand out is the oil price - the oil price is MUCH higher today than it was during the 1998 crisis. We cancelled our short-term bullish view on oil at the end of last week and are currently sitting on the fence, watching intently. A near-term rally in the oil price is still possible and, although such an event would not dissuade the Fed from cutting rates, it would highlight to the world something we already know: the current liquidity injection is happening at a time when there is very little 'economic slack' in the system (the supply of important resources is struggling to match demand). 

Gold and the Dollar

Gold - what would make us bearish?

Most people who have a particular view on the markets tend to latch onto any information that supports their view and to find reasons to ignore/discard any information that supports an opposing view. We almost always have a view on the markets, but try very hard not to be married to that view. We have no interest in being bullish or bearish, only in being right. 

Where we run the greatest risk of letting our views influence our interpretation of the facts, rather than letting the facts influence our views, is the gold market. We have a natural bias in favour of gold that stems from having some knowledge of monetary history and the inherent flaws in the present monetary system. As such, we will always find it difficult to be downright bearish on gold.

One thing that would make us long-term bearish on gold would be a realisation that the US was headed into a prolonged period of deflation. We see the probability of such an outcome as only marginally greater than zero and our inflationist views are constantly being solidified by the behaviour of the US monetary agents. However, if something happened that altered our forecast from an inflationary to a deflationary future we would become long-term bearish on gold. For those who are new to our writings, deflation is a contraction in the total supply of money. Falling prices are not deflation, although they can be a result of deflation. 

As far as the short-term is concerned, the following would shake our confidence in a gold rally: 
a) The Commercial traders becoming net-short COMEX gold futures before the gold price had established a solid up-trend. 
b) The US$ failing to break lower by the end of the first week in April

Current Market Situation

The next week will be a testing time. Dollar strength will probably persist for a few more days, but we are approaching the time when a reversal lower becomes likely. If the Dollar does remain firm into next week then another quick sell-off in gold would not be a surprise.

The XAU has failed to move back above its 200-day moving-average, but not so the TSI Gold Stock Index (TGSI). The below chart shows that the TGSI's 200 DMA essentially held during the recent pullback. Both the TGSI and the XAU are in up-trends dating back to last November.

Changes to the TSI Portfolio

No changes.

 
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