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    - 30 May 2001

The US Stock Market

An inflationary tide lifts all boats

Below is a chart showing (in red) the year-over-year %-change in M2. If we had to pick one single reason for the strength of the US stock market from early-April until late-May, this chart would be it. Furthermore, there is a good chance that the money supply growth that has already occurred will underpin the stock market for several more months and lead to an increase in consumer spending during the final few months of this year.

Below are charts of the NASDAQ Composite and the XAU since the beginning of March. Notice how the two have been moving together over the past 2-3 months. More often than not, gold stocks move counter to the overall stock market so the recent action is unusual, but not unprecedented. Our thinking is that an inflationary tide is, essentially, lifting all boats. However, some boats - the ones that benefit directly from higher inflation - are being lifted higher than others. This is quite similar to what happened during the 12-month period leading up to the 1987 stock market crash.

Unlike the inflationary tide that swept across the US economy in 1998 the current one is having a different effect because, this time around, there is no 'slack' in the economy. There is now a chronic energy shortage due to decades of under-investment in energy infra-structure and this shortage is keeping energy prices at a much higher level than they would otherwise be during a period of slow economic growth. Also, consumer prices and labour costs are rising at their fastest rates in many years. This is why it has, to date, been the stocks of companies that benefit the most from a depreciating currency that have gained the most as a result of the friendly monetary environment.

We expect the monetary environment to remain friendly for at least a few more months and that this tide of money will continue to support all asset prices. 

If the experiences of the past 2 years are anything to go by then the time to get very concerned about the stock market (all stocks, including gold stocks) will be when the M2 growth rate falls to around 6%. Unless the extremely unlikely happens and bonds exceed their March highs over the next few months, the M2 growth rate should begin to decline by August and be approaching the danger level by late this year or early next (refer to the Apr-16 WMU for a chart showing that the bond market, not the Fed, is the single greatest influence on the money-supply growth rate).

Current Market Situation

The "hey, the Fed's doing the right thing and the economy is sure to recover soon" rally ended last week. Now we are into the "oh dear, maybe things are even worse than expected and all the easy money in the world is not going to help us" correction. This correction will then be followed by the "to hell with this year, the Fed is still on our side and things will be great next year" rally (probably the final rally in the cyclical bull that commenced in late-March/early-April).

It looks like we managed to exit our QQQ positions right at the peak early last week. Of course, it would have been nice if we had sold everything else at the same time, but unfortunately our foresight is never as clear as our hindsight. 

A bottom of the very short-term variety is likely to occur during the next couple of days, but we doubt that any low that is reached this week will be sustainable. We expect that this correction will continue for at least another 2 weeks, but that the major indices will handily exceed their recent peaks during the next few months.

Gold and the Dollar

The only viable alternative

We've said on several occasions in the past that gold represents the only viable alternative to the US$. By this we meant that the Dollar's major competitors in the fiat currency world suffer from the same ailments as the Dollar - they all come into existence through the expansion of credit and are thus someone's liabilities. They are as good as a politician's promise not to over-spend or a banker's promise not to over-lend. Choosing between fiat currencies is therefore like choosing whether you'd prefer to be eaten by a crocodile or by a shark.

There is, however, another reason that gold is by far the best alternative to the US$ - its supply is essentially fixed meaning that as overall demand increases its price must rise. Supply cannot be arbitrarily increased to satisfy a greater demand. This is in marked contrast to the fiat currencies of the world, the supply of which can be expanded at will. If one of the national currencies should happen to appreciate against the Dollar then the suppliers of that currency can, and almost certainly will, increase the quantity of the currency in an attempt to maintain a strongly-positive trade balance with the US. For example, although the ECB and the euro-zone governments are no doubt unhappy with the euro's plunge below US$0.90, we suspect that they would act aggressively to reduce the euro's relative value (by increasing its supply or reducing its price) if it should ever move well above parity with the Dollar (as it is likely to do over the next 6 months). 

The suppliers of gold do not have the option of responding to increased demand with a corresponding increase in supply. Newly-mined gold supply will add no more than 1.5% per year to the total above-ground gold stock for at least the next few years, regardless of how high the gold price goes (it takes years to bring new production on line). 

Gold versus Gold Stocks (the Gold/XAU Ratio)

A characteristic of a gold bull market is that gold stocks consistently out-perform the bullion price. This occurs because the profits of gold mining companies are leveraged to the gold price (some of them are, anyway), so if the gold price is expected to be higher in the future than it is today then a disproportionately-large increase in profits will be factored into gold mining company stock prices. The Australian company Lihir Gold (LHG) provides an excellent example of such leverage. According to a recent report by Johnson Taylor Potter, a $10 increase in the spot gold price will result in a 42% increase in LHG's earnings for the year 2002.

Below is a chart of the Gold/XAU ratio (with the scale reversed so that the line rises when the XAU out-performs the gold price). If a gold bull market has begun then the up-trend shown on this chart should remain in tact.

The resilience of gold stocks in the face of the recent plunge in the gold price might be the result of delusional thinking on the part of equity investors, or it could be the result of equity investors presciently looking beyond today's commodity-price fluctuations. Based on a) what we think is about to happen in the currency market, and b) what continues to happen with the supply of Dollars, equity investors will most likely be proven correct.

Current Market Situation

Over the past few weeks we've said that a test of the Dollar Index's October 2000 high was a distinct possibility before a substantial decline got underway. The Dollar is now in the process of completing such a test. We would actually be more confident that an important peak was in place if the Dollar Index spiked above its October 2000 intra-day high of 118.90 over the next few days before reversing lower.

We've noted, in the past, that:

a) A gold rally in the face of a strong Dollar was/is a very low probability event.

b) If the Dollar moves to decisive new highs, then any gold rally will probably be another unsustainable spike.

c) Gold equities have been moving higher, without much support from the gold price, in anticipation of a lower Dollar.

At some point in the future we expect that gold will de-couple from the Dollar as people panic out of all fiat currencies. However, we are presently nowhere near that point of mass-realisation. We continue to be bullish on gold and gold stocks because we expect the effects of inflation to become more obvious over the months ahead and because we expect a Dollar decline to commence very soon.

In the latest WMU we included a chart of the XAU and noted that support in the 55-57 range should hold on any near-term pullbacks. Although the gold price itself has fallen further than we had anticipated (we had thought that gold would consolidate in the 270-280 range for 1-2 weeks), the XAU is just approaching the top of its support band.

Below is a chart of Newmont Mining (NEM), which provides a good example of the pattern being followed by the XAU and a number of individual gold stocks. NEM appears to be pulling back in a test of its previous breakout. 

In summary, although the gold price has fallen sharply we have seen nothing over the past week that would cause us to deviate from our bullish view of the gold market. In particular, the trend of gold stocks out-performing the gold price is still very much in tact. A fall in the Dollar, something we expect to begin very shortly, continues to be the key to a sustainable gold rally.

We wanted to discuss the traders' commitments again in today's Update, but have run out of time so we'll do it in the coming Weekly Update. 

Changes to the TSI Portfolio

HTA (Hutchison Telecom, an Australian mobile phone company), was stopped out. There are clearly one or two large sellers that want out of this stock at any price and it is also suffering from tax loss selling (June 30 is the end of the Australian tax year). We may re-purchase it after we see some evidence that the selling has been exhausted.

We are going to add two new resource stocks - Mount Isa Mining (ASX: MIM) at A$1.24 and Crew Development Corp (TSE: CRU) at C$1.15. We will explain why in the next WMU.

 
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