Big Picture View

Here is a summary of our big picture view of the markets. Note that our short-term views may differ from our big picture view.

Bonds commenced a secular BEAR market in June of 2003. (Last update: 22 August 2005)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000. The rally that began in October of 2002 will end during the first half of 2007. The ultimate bottom of the secular bear market won't occur until the next decade. (Last update: 02 October 2006)

The Dollar commenced a secular BEAR market during the final quarter of 2000. The first major downward leg in this bear market ended during the first quarter of 2005, but a long-term bottom won't occur until 2008-2010. (Last update: 28 March 2005)

Gold commenced a secular bull market relative to all fiat currencies, the CRB Index, bonds and most stock market indices during 1999-2001. The first major upward leg in this secular bull market ended in December of 2003, but a long-term peak won't occur until at least 2008-2010. (Last update: 13 February 2006)

Commodities, as represented by the CRB Index, commenced a secular BULL market in 2001. The first major upward leg in this bull market ended during the second quarter of 2006, but a long-term peak won't occur until at least 2008-2010. (Last update: 08 January 2007)

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Outlook Summary

Bonds

Why aren't bond yields soaring?

Currently we have:

a) Gold and oil prices at multi-decade highs

b) The prices of agricultural commodities near multi-decade highs

c) The senior US stock indices at or near multi-year highs

d) Some other stock markets at all-time highs and in parabolic upward trends thanks to rapid money-supply growth

e) Blatant evidence of an inflation problem just about everywhere

f) Foreign central banks becoming net sellers of US Treasury debt

And yet, US Government bond yields remain within the bottom third of their 2-year range. The question, then, is: given the abundant evidence of an inflation problem and the recent lack of demand for US Treasury debt from foreign central banks, why aren't US T-Bond yields soaring?

We don't have a satisfactory explanation for the ability of the bond market to hold up as well as it has over the past month. The bond market's performance would make sense if the Fed had been aggressively buying bonds with newly-created dollars, but the Fed's balance sheet tells us that this hasn't been happening.

The only thing we can think of is that the debt crisis has prompted many of the investors (individuals, funds and institutions) that must own debt securities for income purposes to shift from higher-risk to lower-risk securities, and that this shift in investment demand has been sufficient to keep T-Bond yields from responding to the obvious inflation threat. These investors, as a group, may well recognise that a US T-Bond yielding 4.8% is not a good deal, but at the moment they are more concerned about return OF capital than return ON capital.

Current Market Situation

The following daily chart shows the performance of the December T-Note futures contract over the past several months.

T-Note futures were predictably firm during June-August and have pulled back during September. The surprise is that they haven't pulled back more sharply over the past few weeks given what has been happening in the commodity and equity markets, but the fact that they have held up so well in the face of a blatantly -- at least on the surface -- unfriendly environment means that they will probably move to new highs for the year during the next multi-week equity/commodity correction.

Some quick thoughts on base metals

The Stock Market

Current Market Situation

Due to what has happened in previous Octobers the arrival of the month of October generally coincides with a marked increase in the number of crash forecasts. However, the senior US stock indices have gained enough ground over the past few weeks to suggest that the 16th August lows will not be seriously challenged over the remainder of this year. A sizeable pullback looks likely and this pullback in the broad market could result in some market sectors -- the financial sector, for instance -- dropping to new lows for the year, but we suspect that the S&P500 and the NASDAQ100 will do no worse than retrace about half the gains made since August's panic low.

Japan

Japan's stock market, as represented by the Nikkei225 Index, fell 16% from its July peak to its August low. It has therefore already experienced a mini crash this year and is currently in recovery mode. On a longer-term basis it is still in the relatively early stages of the secular bull market that commenced in April of 2003, but has under-performed most other stock markets since April of 2006.

The Japanese stock market's relatively poor performance over the past 18 months probably has a lot to do with monetary policies that unwittingly tend to drive investment away from the Yen and away from Japan. However, the long-term bull market should continue despite the best efforts of Japanese policy-makers.

Not everything on the Japanese policy front is negative, though, in that the first phase in the privatisation of Japan's postal system -- the world's largest depository of savings -- occurs this week (refer to http://biz.yahoo.com/ap/070929/japan_postal_privatization.html?.v=4 for further details). The privatisation plan, which was put in place by former Prime Minister Koizumi, should have a significant positive effect on Japan's economy over the coming years by paving the way for the more efficient allocation of investment.

We continue to believe that that longer-term investors should build up exposure to the Japanese stock market via EWJ, JEQ and JOF. Most accumulation should be done on weakness, but we'd wait for a breakout to new multi-year highs by EWJ before making the final one-third commitment to this market.

This week's important US economic events

Gold and the Dollar

Currency Market Update

The currency market is in the driver's seat

We've addressed, ad nauseam, the important role of Yen weakness in the elevation of asset and debt prices throughout the world. We haven't, however, devoted much space to the similar role played by US$ weakness. Despite the fact that US$ weakness is often cited in support of bearish stock market views, the evidence strongly suggests that most stock markets and stock market sectors are being helped, rather than hurt, by dollar weakness.

To illustrate this point we've included, below, a short-term chart comparing the performances of the HUI, the Hong Kong stock market (as represented by the Hang Seng Index) and the Australian Dollar. Notice the very strong positive correlations between these three markets. Clearly, strength in the US$ relative to the A$ between mid July and mid August went with pronounced weakness in equities of all descriptions, whereas the subsequent weakness in the US$ relative to the A$ has gone with a huge rally across a broad range of equities.

If the speed of the US dollar's decline went from gradual to rapid then the resultant equity market strength would almost certainly become far more selective, but a rapid US$ decline relative to other fiat currencies does not have a realistic chance of happening. This is because the US$ is very oversold and very under-valued relative to most of the other major fiat currencies. In addition, foreign central banks would not want their currencies to strengthen rapidly against the US$ and would take steps to prevent this from happening.

The two realistic possibilities are that the dollar continues its slow water-torture-style decline over the next few months, interrupted only by the occasional weak rebound, or that the dollar embarks on an intermediate-term advance. In the former case the markets and sectors that had been particularly strong since mid August would probably continue to trend upward, while in the latter case there would probably be a market-wide shakeout followed by a shift in relative strength away from commodity-related equities and Asia (ex-Japan).

Current Market Situation

We expect that the Dollar Index will be significantly higher two months from now and a lot higher eight months from now, but at this time we can see no evidence that a bottom is already in place. The Dollar Index obviously closed at a new low on Friday, but more importantly the gold price and the Baltic Dry Index both closed at new highs. In other words, prices that tend to move up in ANTICIPATION of additional dollar weakness are still making new highs.

A dollar reversal could come at any time, but there's no way to predict exactly when. It could happen this week, but, on the other hand, speculative selling could pressure it lower for a short while longer.

Gold and Gold Stocks

A Commitments of Traders (COT) extreme to be reckoned with

The Commercial net-short position in COMEX gold futures was 208K contracts as at Tuesday 25th September (the cut-off date for the latest COT report), which roughly matches the all-time high reached in early October of 2005. This Commercial net-short position is, of course, balanced by an equally large speculative net-long position.

Although it reveals unbridled optimism on the part of speculators in gold futures, the current COT situation is not a reason, in and of itself, to expect anything more than a routine pullback in the gold price. That this is the case becomes evident when we look at the following chart showing the performances of gold and gold stocks (as represented by the HUI) during the second half of 2005. Note, in particular, that after the Commercial net-short position peaked in early October of 2005 the gold market began to work its way back towards its 50-day moving average. Following a test of this moving average in early November, another strong rally got underway. Also note, though, that the HUI peaked almost two weeks prior to gold bullion and experienced a more substantial correction. Specifically, a 5% correction in gold was accompanied by a 14% correction in the HUI.

With reference to the following daily chart, the 50-day moving average for the December gold futures contract is currently at $695. However, it is rising and four weeks from now will probably be around $710. A 5% pullback to around $710 over the next few weeks would therefore be consistent with what happened the only other time the COT situation was roughly the same as it is today.

If the HUI also mimicked its performance following the Oct-2005 COT extreme then it would drop back to the mid-340s over the coming few weeks. Furthermore, a 5% pullback in gold combined with a 14% pullback in the HUI would satisfy the requirement, discussed over the past week, for the HUI/gold ratio to trade at least a few percent below its 40-day moving average in order to create a short-term bottom.

The main risk for gold isn't the COT; it's the dollar

One of the big differences between the current situation and the situation in early October of 2005 is that in October of 2005 the US$ had been trending upward for 9 months and was close to an intermediate-term peak, whereas the US$ is currently (in our opinion) at the tail-end of an intermediate-term decline. Putting it another way, the US$ has considerably more upside potential now than it had in October of 2005. In fact, we think the US dollar can currently be likened to a beach-ball that is getting pushed further and further underwater. The pressure being applied by speculative selling may continue to force it lower in the very short-term, but at some point in the not-too-distant future it will catapult upward.

We therefore continue to perceive significant downside risk for gold and substantial downside risk for gold stocks associated with a US$ recovery.

The downside risk for gold stocks is much greater than the downside risk for gold bullion, for two reasons. First, the gold-stock indices recently became extremely 'overbought' relative to gold bullion. Second, US$ weakness has been one of the propellants of the global stock market rally, so the initial phase of the US dollar's next upward trend will probably be associated with parallel declines in the gold market and the broad stock market. This, in turn, will result in gold stocks being simultaneously hit from two directions.

That being said, it is quite possible that the dollar will undergo a 2-3 month bottoming process rather than a 'V reversal'. For example, rather than commencing an upward trend and not looking back until after it has gained a lot of ground, a bottom for the dollar could entail an initial rebound and then a pullback to test the low prior to the start of a large rally. If it happens like this then some of the markets that have been feeding off US$ weakness over the past year could make new highs during the dollar's pullback to test its low.

The same stock and the same chart pattern, 10 years apart

In one of the recent editions of his daily report Kevin Klombies showed an intriguing chart comparing the performance of Newmont Mining (NEM) during 1995-1997 with its performance during 2005-2007; so intriguing, in fact, that we decided to steal the idea (Kevin hopefully won't mind) and present a similar chart-based comparison herewith.

The top section of the following chart shows what NEM did over the 27-month period ending last Friday while the bottom section of the chart shows what it did over an equivalent-length period during 1995-1997. The two chart sections have been positioned so that the late-January peak of 2006 lines up with the late-January peak of 1996.

Notice that NEM trended lower within a well-defined channel from January of 1996 until the third quarter of 1997, at which time it broke out to the upside. It then pushed upward into the final week of September-1997, when it abruptly reversed course and entered a steep downward trend. Notice also that NEM trended lower within a well-defined channel from January of 2006 until the third quarter of 2007, at which time it broke out to the upside. It then pushed upward into the final week of September-2007 before reversing course.

Obviously, it is yet to be seen whether last week's downturn was the start of a large decline or simply a routine pullback within an on-going advance.

The above is interesting, but comparisons such as these should always be viewed with a sceptical eye because there are usually enough differences between the current period and any prior period to create different twists and turns in the financial markets. In many respects, for example, the fundamental backdrop today could hardly be more different to what it was in October of 1997.

As we've said before, the short-term key is the US dollar. IF the dollar soon commences a strong multi-month rally then the 1997 analogy has merit and NEM will probably trade at new multi-year lows within the next few months. This is the risk being taken by those who are betting the farm on a continuation of the gold sector's upward trend. On the other hand, if the dollar continues to grind lower then every pullback in the gold sector will probably be followed by a move to new highs.

Before leaving the 1997 comparison we'll highlight the fact that NEM's stock price is roughly the same now as it was 10 years ago. However, 10 years ago the gold price was only $335, versus today's level of around $740. In other words, since the end of September-1997 NEM has gone nowhere while the gold price has gained about 120%.

NEM's performance over the past 10 years supports our view that the major gold stocks are NOT leveraged plays on gold over the long haul. There will be periods when gold stocks offer excellent leverage to upside in the gold price, particularly those periods when gold is trending higher relative to other commodities; but long-term investors should favour the bullion over the stocks of gold producers.

Outlook

Gold bullion ended last week at a new multi-decade high while the HUI finished the week about 2% below its 11th May-2006 and 21st September-2007 peaks. This is a bearish divergence because the stocks typically lead the metal at important turning points, although it clearly wouldn't take much additional strength from here in the gold-stock indices to eliminated the divergence.

Regardless of whether the HUI is in the process of completing a major double top or is immersed in an intermediate-term upward trend that will take it much higher over the coming months, a sizeable pullback is likely to occur over the next few weeks. As previously advised, history tells us to expect the HUI/gold ratio to trade at least a few percent below its 40-day moving average prior to the next short-term bottom. If this happens over the next few weeks and gold concurrently pulls back by around 5% then the HUI will drop to the 340s.

The sort of pullback described above is the most likely short-term outcome even if the overall upward trend is going to remain intact.

The risk is that a top of longer-term significance is currently being put in place. This possibility doesn't mesh with the current fundamental backdrop and is therefore not the most likely intermediate-term outcome, but the fundamentals could change and therefore need to be continually re-assessed. The main fundamental drivers of the gold price are credit/yield spreads, nominal interest rates, inflation expectations (the expected rate of purchasing-power loss), and currency exchange rates. Note that the combination of the nominal interest rate and the expected rate of purchasing-power loss creates the real interest rate.

We reacted to last Friday morning's surge in the gold sector by taking more profits in a stock that had run-up a lot over the preceding few weeks, but we didn't want to reduce our overall exposure to the sector (our cash reserve was already large enough) so we also did some buying of a gold stock that, despite being a highly leveraged play on gold, had done very little since the August bottom. The stock in question is the new addition to the TSI Stocks List discussed below.

Update on Stock Selections

(Note: To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question)

New stock selection: Gold Reserve (AMEX: GRZ). Shares: 55M issued, 58M fully diluted. Recent price: US$4.38

GRZ owns the development-stage Brisas gold project in Venezuela. Brisas contains 10.4M ounces of low-grade (0.67 gpt) gold in the "proven and probable" reserve category and adjoins the larger/higher-grade Las Cristinas deposit owned by Crystallex (AMEX: KRY). Despite its low grade, Brisas is expected to have a total production cost per ounce of only around US$250 thanks to its by-product copper production.

GRZ's in-ground gold is currently being valued by the stock market at an extraordinarily low US$23 per proven-and-probable ounce. This low valuation is largely due to the high country-related risk, but the country risk is no higher today than it was when the stock was trading above US$9 in May of 2006 or when it was trading above US$7 in April of this year. As illustrated by the following, this highly leveraged play on gold is presently languishing near its lows of the past 18 months despite the recent strong gains in the gold price.

We don't want to minimise the country risk because there are few countries in the world that are less secure, from a property rights perspective, than Venezuela. However, it is very unlikely that Hugo Chavez will threaten the rights of GRZ/KRY shareholders at this early stage of project development. As far as we can tell, the main political risk hanging over both GRZ and KRY at this time is that there will be additional delays in the issuing of the government permits required to enable the projects to be fully developed. Note that GRZ received something called an "Authorization to Affect" in March of 2007, but while enabling the commencement of certain infrastructure work this does not constitute government approval for the company to construct the mill and exploit the mineralization at Brisas.

Despite the political risk, GRZ is the sort of stock that will probably rocket upward if a sector-wide pullback over the next few weeks is followed by a rally to new highs. At the same time, the downside risk is partially mitigated by the extremely low valuation.

Our suggestion is to take an initial position now and add during an October pullback. The stock will hopefully drop back to around US$4.00 over the coming weeks, but it is reasonable to take an initial position now to obtain some exposure in case the anticipated pullback fails to materialise.

Chart Sources

Charts appearing in today's commentary are courtesy of: