<% 'pass = Request.Form("pass") IF ((Request.Form("pass") = 1) OR (Session("pass") = "pass")) THEN %> Speculative-Investor.com

    - Interim Update 29th June 2005

Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

Confidence Remains High

The cornerstone of our outlook is that confidence is presently close to a peak and is set to slide over the coming 1-2 years, resulting in a shift away from those investments that are generally considered to be risky (relatively speaking) or to be geared towards strong economic growth. If we are right then the sorts of things we should begin to see over the next several months are strength in gold relative to cyclical commodities, strength in gold stocks relative to the stocks of industrial metal producers, strength in US Government debt relative to the debt of emerging market governments, widening credit spreads in general, and weakening stock markets with those sectors that benefit the most from a strengthening economy being the worst performers. These things should become evident during the second half of this year, although they probably won't become blatantly obvious until next year.

That's what we expect to happen, but at this stage there aren't many cracks in the bullish veneer. For example and as illustrated by the below chart, the NEM/PD ratio (the stock price of gold producer Newmont Mining divided by the stock price of copper producer Phelps Dodge) trends in the opposite direction to the US stock market; that is, NEM out-performs PD when confidence in financial assets is falling and under-performs when confidence is rising. With NEM/PD languishing near a 2-year low it is clear that this particular indicator has not yet signaled a trend change.

Now, we have not expected NEM to show significant relative strength until the second half of this year so the fact that there hasn't yet been a trend reversal in NEM/PD is not a reason for us to doubt the validity of our intermediate-term view. The chart's message is simply that confidence remains at an elevated level. This, by the way, is one of the main reasons we don't think the recent rebound in the gold price represents the early part of a major multi-year advance.


The above chart illustrates how our views on a number of different markets are linked. In particular, it shows that our expectations for strength to emerge in gold and gold stocks relative to base metals and base metal stocks is tied to our bearish intermediate-term view on the broad stock market. In other words, if the stock market were to defy our expectations and continue to trend higher over the coming 1-2 years then it is likely that other markets would also move counter to our current expectations. Specifically, it is likely that the NEM/PD ratio would continue to trend lower, copper and oil would continue to do better than gold, emerging markets would continue to benefit from large capital in-flows, credit would remain readily available at cheap rates, and the semiconductor stocks would be amongst the best performers in the market.

The consumer has NEVER been the primary engine of inflation

...the idea that the Fed would be powerless to prevent deflation if consumers were to cut back on their borrowing or, heaven forbid, if consumers were to reduce their collective level of indebtedness, is absurd. This is because the Fed's ability to monetise assets and debt is limited only by the need to maintain some confidence in the currency.

Many of the arguments we've read in favour of an imminent deflationary outcome hinge on the belief that US consumers are rapidly approaching the point where they will be 'tapped out' (unable or unwilling to borrow more money into existence), partly because household debt levels are already so high and partly because the combination of rising unemployment and falling/stagnant incomes will prompt people to become more frugal. This, so the argument goes, will lead to a contraction in the total quantity of money and credit (deflation).

The thing is, if you begin with an incorrect premise and then apply perfect logic then you are guaranteed to arrive at an incorrect conclusion. And when it comes to the inflation/deflation debate, the premise that the consumer is the primary engine of inflation is incorrect.

In the US there has been inflation and nothing but inflation since official gold convertibility was eliminated in 1933. Through economic expansions, economic contractions, periods of high unemployment, periods of low unemployment, periods of high consumer spending/borrowing, periods of low consumer spending/borrowing, financial crises, war times, peace times, natural disasters and man-made disasters, there has been inflation. The reason is that the central bank, not the consumer, is the primary engine of inflation.

Of course, during normal times consumers do a lot of the heavy lifting when it comes to inflating the money supply. Over the past few years, for example, the single most important contributor to money-supply growth has been mortgage financing/re-financing by US households, while the Fed's direct contribution to the total supply of money has been very small. This doesn't mean, though, that the Fed is incapable of directly causing the money supply to expand; it simply means that it hasn't yet become necessary for the Fed to boost the money supply directly*.

As an aside, a few years ago the world was treated to a display of what Greenspan and Co. are capable of doing when they set their minds to the task of directly injecting money into the economy. Within the space of a few days following the September-2001 terrorist attacks the Fed was able to engineer a $170B increase in M2; not too shabby when you consider that they had almost no time to plan this inflation.

In our opinion, the idea that the Fed would be powerless to prevent deflation if consumers were to cut back on their borrowing or, heaven forbid, if consumers were to reduce their collective level of indebtedness, is absurd. This is because the Fed's ability to monetise assets and debt is limited only by the need to maintain some confidence in the currency. To be specific, the Fed will be able to inject as much money as it wants into the economy as long as inflation fears aren't spiraling out of control (as indicated by bond yields rocketing skyward). Therefore, let's get to the point where INflation fears are spiraling out of control before we start worrying about the possibility of DEflation.

    *Articles such as the one at http://www.gold-eagle.com/editorials_05/mchugh061905.html paint an erroneous picture of the money-creation process. The fact is that the Fed is not directly responsible for any of the growth in M3 since the beginning of this year. Rather, growth in private- and public-sector indebtedness -- increased mortgage-related borrowing and government deficit-spending, for instance -- have caused whatever money-supply growth there has been. Furthermore, measures of money supply often fluctuate quite wildly on a month-to-month basis so it makes no sense at all to draw conclusions by annualising the most recent figures. The fact is that the year-over-year growth rates of M2 and M3 are presently near 10-year lows.

The Relationship Between Bonds and Oil

...the fact that oil has just made a new high suggests that the next pullback in the bond market will be followed by a rally to a new high for the year.

In the 25th May Interim Update we wrote:

"Over the past 4 years there has been a consistent lead-lag relationship between the US bond market and the oil price...

...The relationship, which is illustrated on the below chart comparison of the T-Bond price and the oil price, can be described as follows: significant turning points in the oil market lead equivalent turning points in the bond market by 3-4 months.

This lead-lag relationship between oil and bonds has predicted every important turning point in bonds over the past 4 years with the exception of the downward reversal in the bond market that occurred during the first half of 2004. Furthermore, there have been no important turning points in the oil market over the past 4 years that were not followed, 3-4 months later, by a similar turning point in the bond market.

If the relationship continues to work then the bond market will remain surprisingly strong until the first half of July, after which there will be a sizeable correction. We have difficulty imagining bonds remaining elevated for an additional 6 weeks or so, but perhaps another sharp decline in the stock market will do the trick. In any case, the oil-bonds relationship will become particularly interesting IF the oil price continues to trend lower over the next couple of months and the bond price is still near its highs as we head into July."

Since we wrote the above the oil price has moved to a new high, thus altering the message of the bonds-oil relationship. As illustrated on the below chart, the rather strange lead-lag relationship between bonds and oil that has worked quite well over the past 4 years indicates that a pullback in the bond market will probably commence by mid July. However, the fact that oil has just made a new high suggests that the next pullback in the bond market will be followed by a rally to a new high for the year. It also suggests that October is the most likely time for a bond market peak IF oil has either just peaked or reaches its ultimate high within the next few weeks.



A higher bond price is a bullish short-term influence on gold, industrial metals, oil and the broad stock market, but at a time when the Fed has its mind set on additional monetary tightening a rising bond market is an intermediate-term negative for all these markets because it will lead to a narrower yield-spread.

The US Stock Market

Current Market Situation

In the latest Weekly Update we said the stock market appeared to have unfinished business on the upside, but that we didn't have any idea whether this upside would occur over the next few weeks or following a sharp multi-week decline. Our views on other markets -- the likelihood of some additional short-term strength in gold stocks, for example -- pointed towards additional short-term gains in the broad stock market, but the weekly trend reversal in the NDX/Dow ratio that occurred in May pointed towards one more sharp decline prior to the start of a tradable rally.

Unfortunately, the market action over the past three days has done nothing to clarify the short-term outlook.

Although we don't have an opinion on what the market will do over the next few weeks, we do have a pretty good idea on how we will react under different conditions. We will, for instance, likely view a breakout by the S&P500 to a new high for the year as an opportunity to initiate or add to bearish positions while we will probably view a plunge below 10,000 by the Dow Industrials as an opportunity to reduce bearish positions (assuming, of course, that the new low for the Dow was not confirmed by a new low for the NDX).

The below chart reveals a weakening in the US stock market's 'internals' over the past 18 months in that it shows a sequence of lower lows in the percentage of NYSE stocks above their 200-day moving averages. In other words, it shows that a smaller number of stocks have participated in each successive rally since the beginning of last year.

The market's weakening internals don't give us any clues about what is likely to happen over the next few months, but they are consistent with our intermediate-term bearish view.


Gold and the Dollar

Gold in A$ terms

...a breakout above long-term resistance doesn't, in itself, tell you a lot about what the price will do over the ensuing 12 months.

In an attempt to explain what might follow the recent upside breakout in the euro gold price we showed, in the 20th June Weekly Update, three examples of upside breakouts from long-term basing patterns. Two of these breakouts (oil last year and US$ gold in 2002) were followed by sharp multi-month rallies and then pullbacks to 'test' the breakouts, while the third (the Yen gold price during 2003-2004) was followed by a lengthy period of uneventful range trading.

The weekly chart of the Australian Dollar gold price shown below provides us with a fourth example of performance following an upside breakout from a long-term base. Notice that the 'major' upside breakout in gold/A$ at the end of 2002 occurred very close to an intermediate-term peak and that anyone who bought gold/A$ in response to this breakout experienced a 20% draw-down over the ensuing 6 months. Furthermore, gold/A$ is still about 10% below its late-2002 breakout level.


Our purpose in showing the above example and the three examples in the 20th June commentary is to make the point that a breakout above long-term resistance doesn't, in itself, tell you a lot about what the price will do over the ensuing 12 months. It is important to understand why gold is destined to move considerably higher against all the fiat currencies over the coming years, but the best way to use this understanding is to buy following drops to support; not following breakouts above obvious resistance.

By the way, we are very bullish on the A$ gold price and expect that it will be at a new high (above $650) within 12 months.

Gold Stocks

Gold stocks were very strong on Wednesday, both in absolute terms and relative to the metal. The implication is that the AMEX Gold BUGS Index (HUI), a daily chart of which is included below, will see additional gains before a short-term peak is put in place. However, yesterday's action doesn't really give us any information as far as how much higher the price will go and how much longer the rally will last. For example, a similar one-day surge occurred on the 8th of March -- the day prior to an important peak and the start of a large 2-month decline.

Our guess is that the rally will continue for another 1-2 weeks with the HUI moving up to near the top of the 200-210 resistance range, but a lot will probably depend on what happens in the broad stock market. Strength in the broad stock market over the next two weeks, for instance, would be supportive of additional gains in the gold sector.

In the Weekly Update we'll review the main reason we remain intermediate-term bearish on the gold sector.


Current Market Situation

The below daily chart of the Dollar Index shows that the currency market has been consolidating over the past 12 trading days. This chart pattern, viewed in isolation, suggests that the dollar is preparing to resume its advance. However, the bullish performances of gold and gold stocks indicate that a pullback by the Dollar Index to near its 50-day moving average -- in similar fashion to what happened in April -- might be on the cards.

Further to the above, our short-term currency market view can be summarised as follows: We remain confident that the Dollar Index will trade up to the low-90s and that the euro will trade down to 1.18 within the next two months, but would allow for some additional consolidation over the next two weeks.


Below is a daily chart of the Australian Dollar.

The A$ broke above the top of a downward-sloping channel during the first half of June, ushering in the possibility that it would test or perhaps even marginally exceed its March high before resuming its decline. However, this breakout now appears to have been a 'head fake'.

We are very bearish on the A$ as far as the coming 12 months are concerned, but would be surprised if this currency became seriously weak prior to serious weakness occurring in the stock and commodity markets. In the mean time we suspect that it will remain between support at 75 and its mid June rebound peak (just above 78).


Below is a daily chart of August gold futures. The weakness during early trading on Wednesday proved to be a successful test of the 18-day moving average (the green line on the chart) and this, combined with Wednesday's substantial strength in the major gold stocks, indicates that gold is probably going to exceed last week's high in the near future. A move up to the 455-465 range remains a distinct near-term possibility.


Update on Stock Selections

As mentioned in the 20th June Weekly Update, we will add the Newmont Mining January-2006 $35 put options to the TSI Stocks List if they trade at US$0.90. In order for the options to drop down to this price (they closed at $1.15 on Wednesday) NEM will probably have to move up to around $41.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
Copyright 2000-2005 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>