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    - 24 January 2001

The US Stock Market

Bull or Bear?

There is a lot of discussion going on as to whether the current rally will turn out to be a bounce within an on-going bear market or a new bull market. The bullish case is quite persuasive and revolves around the following points:

a) The rally has been broad-based.

b) The market has been rising on heavy volume.

c) The response to news has generally been positive (stocks have been holding their ground on bad news and rallying strongly on good news).

d) Official interest rates are moving lower (the Fed is no longer an obstacle).

e) Money supply is expanding at a rapid pace.

f) Investment motivation is shifting from 'return of capital' to 'return on capital' as indicated by the move away from the safety stocks that became so popular during the second half of last year (for example, the drug and utility stocks).

The bearish case is also persuasive and revolves around the idea that current stock prices are way too high by historical standards, particularly when the deteriorating fundamentals are taken into account (earnings growth is decelerating, not accelerating).

Our view can be summarised as follows:

a) Whatever is happening now is just another stage in the bubble that began in mid-1997. Classifying it as a 'bull' or a 'bear' only clouds the picture.

b) We have forecast that the stock market would reach its ultimate low by September 2001 at the earliest. However, if the monetary authorities are determined to short-circuit the 'liquidity cycle', and at this stage it appears that they are, then the market will not necessarily make new lows in nominal Dollar terms. The ultimate low may only look like a low when the S&P500 is measured in terms of gold.

Current Market Situation

The rally that began on Jan-08 is probably near its completion. If the market spikes upward as a result of Greenspan's Humphrey Hawkins testimony later today we will use that strength to take some profits in LDIG, RNWK, and QQQ, all of which were purchased in late December. 

Oil Stocks

We are not short-term bullish on oil and gas and suspect that corrective action will continue for some time. We are, however, very bullish on the prospects for energy prices over the next 6-12 months. As such, and because the stocks of resource companies tend to move well in advance of moves in the commodity markets, we will add an oil and gas producer to the Portfolio. We have chosen Occidental Petroleum (OXY) based on the fundamental research of Adam Hamilton. Adam writes regularly for the Gold Eagle Web Site and also runs his own web site (www.zealllc.com). The following extract from the December issue of Adam's monthly "Zeal Intelligence" report summarises the OXY opportunity. Note that OXY reported yesterday that its year 2000 earnings per share were $4.26. Based on Wednesday's closing price of $22.75 it has a P/E ratio of 5.3. Rather than the 10% trailing stop suggested by Adam we will exit if the stock closes below its 200-day moving-average (currently situated at $21.80) on 3 consecutive trading days.

Extract from Zeal Intelligence:

"Occidental Petroleum (OXY-NYSE) represents a rare combination of bullish fundamental and commodity factors that are converging to create an extraordinary speculation opportunity.  Based in Los Angeles, OXY has two primary businesses, oil and gas exploration and production, and chemicals.  The oil and gas segment is OXYís primary business and has accounted for 83% of its income and cashflow this year.  Although OXY has oil and gas production facilities in nine countries, a geopolitically reassuring 70% of OXYís oil and gas income and cashflow comes from the good old US of A.  22% is derived from the Middle Eastern countries of Qatar, Oman, and Yemen, and 7% is from Colombia and Ecuador.  Occidental is producing at 467k BOE per day levels (Barrel of Oil Equivalents ó includes oil and natural gas), and that number is expected to approach 500k by December 31.  OXY has enough proven oil and gas reserves to last over a dozen more years at current production levels.  It is almost fully exposed to upside oil and gas price appreciation.  The company has been able to sell crude oil at 89% of the spot price this year, and natural gas at 96%.  OXY is the largest oil producer in Texas and also the largest gas producer in the very lucrative California market.  California is facing severe energy shortages and OXY is positioned to capitalize.  The First Call consensus analyst estimate for 2000 earnings per share is over $4 per share.  We expect that these analyst expectations will be exceeded to the upside as OXY delivers a record quarter ending December 2000.  OXY is currently the most undervalued medium to large oil company, trading at under 5x earnings and yielding a fantastic 4.6% in dividends.  Due to its relatively high debt load, which management is aggressively reducing, the market has temporarily overlooked OXY and its valuation is destined to approach normal industry multiples.  In addition, with a valuation this attractive, the possibility of takeover attempts can not be discounted.  Although a relatively low risk speculation, a tight 10% trailing stop loss should be deployed.  For an exit strategy, we simply recommend letting OXY back into its trailing stop since the crude market has become so volatile.  We do not want to cut out any appreciation potential for this rare convergence of a great valuation play AND a fantastic commodity speculation play." 

Gold and the Dollar

Current Market Situation

The gold market action so far this week can best be described as 'noise' - there has been a lot of activity, but nothing meaningful has really happened. The results of Tuesday's BOE auction were positive in that they revealed strong demand for physical gold, although the market's reaction to the results was certainly not positive. Gold stock prices bounced on Monday as traders bought in anticipation of a good auction result, but settled back to last Friday's levels when the gold price failed to rally. As things currently stand, the TSI Gold Stock Index remains above our sell-stop (so there is no change to our trading position) and the fundamental backdrop remains extremely bullish.

We previously mentioned that a move back to the 112-113 area by the Dollar Index would be a normal counter-trend rebound following December's sharp decline. It has almost reached that level and is now approaching an 'overbought' condition. It is probably significant that the Dollar is becoming overbought just as the Fed is about to make a further reduction in official US interest rates. Whether the Fed cuts by 25bp or 50bp is not as important as any hints it may give regarding the on-going need for additional rate cuts. For example, we suspect that a 25bp rate cut combined with a statement suggesting the need for future rate cuts would be more 'Dollar-bearish' than a 50bp cut that was accompanied by a return to a neutral policy stance. In this regard Alan Greenspan's testimony later today could be a 'currency market mover' if the Fed Head provides some decipherable signals on the need for a continuing sequence of rate reductions.  We think the Dollar will reverse lower between now and next Monday unless the Fed makes an 'about-face' and starts talking-up the prospects for the US economy.

In last week's Interim Update we included a chart comparing the XAU with the yield spread between the 30-yr T-Bond and the 13-wk T-Bill to show that the yield spread typically begins to rise (long-term rates begin to increase relative to short-term rates) prior to a rally in gold stocks. This makes some sense as the yield spread usually rises because the market is discounting higher inflation. Following is a chart showing the yield spread since the beginning of 1998. Notice that the yield spread plummeted from Q4 1999 until Q4 2000, one of the worst periods on record for gold stocks, before turning higher towards the end of last year. The more the Fed cuts interest rates at the short-end the higher the spread will become and the more upward pressure will be applied to gold stock prices.

In the latest WMU we suggested that an upward reversal in the gold price was likely during the second half of this week, analysis that remains in tact at this time. However, an upward reversal in the gold price depends on a downward reversal in the Dollar. 

What was he thinking?

From CBS MarketWatch: Placer Dome said it sees "no prospect of a significant rise in the price of gold. While we were expecting the gold price to move higher, weakness in demand and other fundamentals has increased the risk that the current gold price environment could prevail for some time," said Placer Dome President and CEO Jay Taylor. 

If Placer Dome (PDG) CEO Jay Taylor is right then there is no reason to own any gold stocks. If he is wrong, and we think he is, there is no reason to own PDG (why take the risk of owning a company's stock when the person responsible for setting strategy does not understand the market for the company's product?). So, whether Jay Taylor's analysis turns out to be right or wrong, there is no reason to own PDG.

Changes to the TSI Portfolio

OXY will be added as noted above.

Happy Chinese (Lunar) New Year!

Kung Hei Fat Choy!

 
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