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    - Interim Update 21st July 2004

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Responses to e-mails

We like to receive your comments/questions via e-mail because they give us ideas on topics to discuss in the commentaries, and we can assure you that we read all incoming mail. However and as previously mentioned, time constraints and the large volume of e-mail that we receive these days prevents us from responding to most market and stock-related questions. So, keep the e-mails coming but please don't be offended if you don't receive a response.

'Greenspeak'

Alan Greenspan gave his semiannual monetary policy testimony before Congress on Tuesday (http://www.federalreserve.gov/BoardDocs/HH/2004/July/testimony.htm) and, as is his practice, he totally ignored the role played by Federal Reserve monetary policy in both the financial market instability of the past several years and the current problems/risks facing the US economy. Anyone gullible enough to accept Greenspan's analysis at face value would be left with the impression that the collapse in stock prices and corporate profits during 2000-2002, the 20% decline in the US$ during 2002-2004, and the surge in commodity prices during 2003-2004, were all just unforeseeable and unrelated accidents. Such a person would also probably conclude that the Fed, via its ultra-accommodative monetary policy, had been able to ameliorate most of the bad effects resulting from these unfortunate accidents whilst achieving its noble goal of "price stability". Nowhere in this latest testimony, or, for that matter, in any other official testimony/report that we know of, does Greenspan acknowledge the Fed's key role in fostering the enormous growth in the supply of money/credit that has wrought havoc in the financial markets since 1998 and continues to pose a huge threat to the world.

The avoidance of appearing to be responsible for the huge US credit bubble and its consequences has clearly been a major goal of the Greenspan-led Fed over the past 3 years. Events such as the 9/11 attacks, the Iraq war and the many corporate scandals (Enron, Worldcom, etc.) were therefore seized upon as excuses for many of the problems that would more appropriately have been linked to reckless monetary policy.

Perhaps the most convenient and effective of all the excuses, though, was the "deflation threat". And in his on-going efforts to re-write history Greenspan, in this week's remarks before Congress, read the epitaph of the deflation threat as though it had ever existed in the first place. What he said was "...the concerns about the remote possibility of deflation that had been critical in the deliberations of the Federal Open Market Committee (FOMC) last year can now be safely set aside. Those deflationary pressures were largely a consequence of the stock market slump, the capital goods contraction that commenced in 2000, and, as I noted earlier, the extreme business caution that followed from these events as well as from terrorist attacks, corporate scandals, and the lead-up to the war in Iraq."

When deflation threats do exist they are never a consequence of stock market slumps or any of the other things cited by the Fed-head in the above paragraph, but are, instead, a consequence of a preceding inflation. The main point, though, is that a genuine deflation threat didn't exist last year or the year before. In fact, ever since the Federal Reserve system was put in place in 1913 there's been a continual process of inflation with the only interruption occurring during the early-1930s; and that interruption only happened because the Fed's hands were effectively tied due to the dollar being convertible into gold at a fixed rate. Had the current monetary system been in effect during the 1930s we doubt that there would have been any deflation at that time, either.

The fact that the Fed has been able to inflate almost non-stop for 90 years and yet smart people are still willing to seriously consider the possibility of deflation at the drop of a hat (or a price) is testament to the wonderful job that the Fed has done, and continues to do, in the field of expectations management. From the Fed's perspective, last year's deflation scare served a useful purpose by providing a cover for more inflation; and there will almost certainly be more deflation scares over the years ahead in order to create the illusion that still more inflation is needed.

The US Stock Market

Current Market Situation

According to the mainstream financial press, when the market bounced on Tuesday it was due to Greenspan's positive comments on inflation and growth combined with Microsoft's decision to return $75B to shareholders. And then when the market fell sharply on Wednesday the fall was attributed, in the press, to fears about slowing growth in corporate profits. So let's get this straight; we are supposed to believe that professional traders and investors bought stocks across the board on Tuesday simply because a) Greenspan, a man whose forecasting record is almost completely unblemished by success, opined that the growth outlook was positive, and b) one company announced some positive news. And then we are supposed to believe that the very next day professional traders and investors promptly forgot why they had bought stocks on Tuesday because they suddenly realised that growth was actually slowing.

A lot of the daily fluctuations in stock prices are random and it often makes no sense to attempt to explain why stocks did what they did on any given day. And even when there is a good explanation for the market action on a particular day that explanation is generally not the 'news of the day' to which the press tends to link to the market's behaviour.

As far as this week's back and forth action is concerned we think there are two explanations that make some sense.

First, the small picture is that some of the senior stock indices began Tuesday's session having just tested important support levels the day before, so it was a logical time for traders to enter the fray on the long side and for short-sellers to cover some of their positions. For example, the below chart shows that the NASDAQ Composite Index tested its May low on Monday and was therefore in a good position to bounce on Tuesday.


Second, the bigger picture is that US$ strength has gone with stock market weakness over the past 15 months and the dollar has just begun to show signs of strength. For example, the below chart indicates that the recovery in the Dow Industrials Index from its May low went with dollar weakness while the preceding decline went with dollar strength, so if the dollar has just bottomed then the rebound in the stock market is probably kaput. Now, we expect that there will be a bit more downside in the dollar over the next few weeks, but yesterday's action demonstrates that the inter-market relationships that have been in force over the past 1-2 years are intact and that a resumption of the dollar's post-February recovery would be a big problem for the US stock market.


Over the past few months all breakouts -- those of both the upside and downside varieties -- have been quickly followed by reversals. A breakout is eventually going to stick, but if the stock market is true to its recent form then a break below the May lows will be quickly followed by a significant bounce. In fact, traders have been conditioned by the market's performance over the past few months to expect breakout failures, so there's a good chance that if a break below the May lows does occur over the coming days then it will be followed by a rebound. In all likelihood such a rebound would, though, just be a 'pause to refresh' within a continuing short-term downtrend.

Our view is that the stock market is going to head lower into a traditional September-October bottom, but a 1-2 week intervening rebound would not be surprising following a downside breakout.  

Gold and the Dollar

Gold Stock Seasonality

In the 22nd September 2003 Weekly Market Update we discussed the strong tendency of gold stocks to reach an extreme during the October-November period. The time has come to re-visit this topic.

As shown in the below table, gold stocks have made either an important low or an important high during October-November in 9 of the past 12 years with 3 of the 4 highs occurring in October and 4 of the 5 lows occurring in November.

Year
Extreme (High or Low)
Oct-Nov 2003
High (Nov)*
Oct-Nov 2002
Low (Oct)
Oct-Nov 2001
Low (Nov)
Oct-Nov 2000
Low (Nov)
Oct-Nov 1999
High (Oct)
Oct-Nov 1998
High (Oct)
Oct-Nov 1997
High (Oct)
Oct-Nov 1996
-
Oct-Nov 1995
Low (Nov)
Oct-Nov 1994
-
Oct-Nov 1993
-
Oct-Nov 1992
Low (Nov)

*In 2003 the actual closing high for the XAU occurred on the second trading day of December

The above-described gold stock seasonality suggests that the October-November period this year will provide us with either a major peak or a major trough. But which will it be?

If our intermediate-term dollar view is in the right ballpark then the most likely outcome would be a low. Also, the idea that we will get an October-November trough this year meshes with our views that a) the May low in the gold sector will have to be tested before the next major upward leg gets underway, and b) there will be substantial stock-market weakness over the coming few months (gold stocks seldom do well when the broad stock market is moving lower at a brisk pace).

Taking the seasonality one step further, gold-stock lows have tended to occur in November whereas highs have tended to occur in October. Furthermore, unlike last year when many seasonal patterns were reversed, this year is shaping up to be a more normal one as far as seasonality is concerned. Therefore, we think that November is the most likely candidate for a gold-stock bottom.

An argument to the effect that gold stocks will be trading lower in 3-4 months time than they are right now would probably not be music to the ears of most investors in this sector, but in one important respect it should be. This is because if the seasonal tendencies hold this year then a drop into the October-November timeframe would have very bullish implications for the ensuing 12 months. On the other hand, a surge into this timeframe would likely create a secondary peak and usher in a 6-12 month downward trend.

Current Market Situation

Gold and Gold Stocks

For the past 2 months our short-term upside targets have been $415 for gold and 205-215 for the AMEX Gold BUGS Index (HUI). At the same time, our intermediate-term view has been that tests of the May lows were likely to occur later this year. In other words, we've been expecting rallies up to near the aforementioned targets followed by pullbacks to the May lows.

This week's action, however, suggests that the markets have turned lower without first achieving our short-term goals. For example, the below charts of gold, the HUI and Newmont Mining (NEM) show that:

a) Gold has fallen back below its 18-day MA, its 200-day MA, and important support at $400

b) The HUI has dropped below its short-term trend-line and has broken a sequence of rising bottoms by closing marginally below its late-June low on Wednesday

c) NEM, which had broken out to the upside early this month, dropped back below its breakout level on Wednesday






The above-described technical evidence is not definitive, but it does suggest that rebound peaks are already in place for gold and gold stocks. If this proved to be the case it would be disappointing, but wouldn't have any significant effect on our intermediate- or long-term outlooks. The one effect it potentially would have is that a downward reversal in the HUI prior to a move above the former breakdown level (208) would increase the probability that we are going to get a spike below the May low before the next major advance gets underway.

In the coming Weekly Update we'll devote some more space to the SA gold shares because the impending low for the US$ will potentially result in these stocks displaying substantial relative strength.

The Dollar

There are some signs that a bottom for the dollar is already in place. For example, the below chart shows that September euro futures closed below important support on Wednesday.


The Dollar Index has not yet, however, displayed enough strength to convince us that the low is 'in'. In particular, it remains below its 50-day MA and yesterday's rebound halted at the short-term trend-line shown on the below chart. A daily close above yesterday's high would be needed to swing the odds in favour of a low being in place.


At this stage we think the odds favour some more downside in the dollar over the coming 2-3 weeks, but the recent action in the gold market is consistent with the dollar being close to a low in terms of both time and price. Also, given that our short-term downside target for the Dollar Index is 83-86 while our intermediate-term upside target is 100 we certainly perceive more upside risk than downside risk in the dollar as far as the coming 6 months are concerned.

Hedging your gold stock exposure

We are generally not in favour of using put options to hedge exposure to the stock market, for two reasons. First, if we use our favoured approach of scaling into the market during extreme weakness and scaling out of the market during extreme strength then we should end up having substantial cash reserves during the declines, meaning that we should not need the insurance provided by put options. And in general -- not just in the financial markets but in all aspects of life -- you shouldn't pay someone else to assume a risk that you can comfortably assume yourself. Second, put options are a very expensive form of insurance.

Right now, though, we are in a situation where the likely time window for a decline in the gold sector is quite narrow (3-4 months), so while buying put options would not be a good substitute for having a substantial cash reserve if you were ever going to buy put options for insurance purposes then now would be a reasonable time to do so.

It is not possible to buy put options on the majority of gold stocks and for gold stocks where options are available they are often so illiquid they are difficult to trade. However, Newmont Mining (NEM) almost always moves with the gold sector so buying NEM December puts -- preferably during strength in the NEM stock price over the coming 1-2 weeks -- would be one way to hedge a diversified gold stock portfolio.

Update on Stock Selections

A couple of weeks ago we added some Phelps Dodge (PD) put options to the TSI Stocks List to reflect our view that stock and commodity prices would likely be weak over the ensuing few months. The PD stock price has dutifully dropped quite sharply over the past three days (see chart below), but no significant technical damage has yet been done. For example, yesterday's decline halted right at short-term trend-line support. The $70-$71 area should also provide some support if/when it is reached.


If we get the sort of weakness we are expecting in the stock market over the next few months combined with some weakness in the copper price then PD should, at a minimum, drop back to test its May low. 

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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