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   -- Weekly Market Update for the Week Commencing 3rd November 2003

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.

Bond yields (long-term interest rates) reached a major low in June of 2003 and will trend higher until at least mid 2004. 

The US stock market will reach a major bottom (well below the October-2002 low) during 2004.

The Dollar commenced a bear market in July 2001 and will continue its decline during 2003 and 2004.

A bull market in gold stocks commenced in November 2000 and will continue during 2003 and 2004.

Commodity prices, as represented by the CRB Index, will rally during 2003 and 2004 with most of the upside occurring in 2004.

Inflation versus Inflation Expectations

For a few years now the US Treasury has been issuing what are commonly known as TIPS (Treasury Inflation-Protected Securities). The idea behind these securities is to offer investors a way to buy US Government bonds without the need to take on the risk that the bond will fall in value due to inflation. And this supposed 'inflation protection' is achieved by regularly adjusting the principle amount of each bond based on changes in the CPI. For example, if you buy one of these inflation-protected bonds and the CPI increases by 3% during the ensuing 12 months then the principle amount of the bond -- the amount that would be due to you at the eventual repayment date -- would be increased by 3%. Furthermore, future interest payments would be based on the revised principle amount. 

The thing is, TIPS aren't really inflation-protected because the CPI is not inflation or a proxy for inflation. It is not even an accurate representation of the effects of inflation. The CPI is simply a number that is concocted by the government each month in such a way as to minimise inflation expectations and social security payments (most social security payments are linked to the CPI). However, because most people do incorrectly associate the CPI with inflation the performance of 'inflation-protected' securities relative to the performance of non-inflation-protected securities can provide us with useful information.

Below is a chart showing the ratio of the Vanguard Inflation-Protected Securities Fund (VIPSX) and the US 30-year T-Bond. The line on this chart rises when the TIPS -- represented here by the VIPSX -- are out-performing the regular government bonds. Out-performance by TIPS is, in turn, an indication that investors are becoming more concerned about inflation. Obviously, the market is a lot more concerned about inflation than the Fed pretends to be.

The US Stock Market

Current Market Situation

Over the recent past our commentaries have been heavily loaded with discussion on gold, gold stocks, and currencies, with only scant attention being paid to the overall stock market. This is because we tend to devote the most space in each TSI commentary to the markets that are presently the most interesting. In this context, "interesting" means trending strongly or appearing to be close to an important trend change. 

The US stock market has recently been anything but interesting. In fact, the market has essentially gone nowhere since early June; a lethargic performance that is reflected in the multi-year low just posted by the Volatility Index. Now, a long period of inactivity in the market is invariably followed by a period of dramatic action and the current situation will not be an exception in this regard. In other words the current tedium will be followed by a period of considerable excitement, most likely as a result of a decline that starts out looking like 'nothing' and ends up causing widespread panic as one support level after another gives way. 

Sentiment is currently overtly bullish and valuations are generally at bubble-peak levels. This means that market risk is extremely high, but it doesn't mean that a large decline is necessarily going to get underway during the next few weeks. In fact, last week's upside breakout by the German stock market (see chart below) shifts the odds in favour of new recovery highs being seen in the US stock market over the coming month.

Natural Gas Stocks

In the 22nd September Weekly Update we mentioned that the Natural Gas Index (XNG) was precariously positioned near its channel bottom. This, in itself, wasn't a problem, but a break below the channel bottom would have been a warning that a sizeable correction was underway. 

From a technical perspective the situation is unchanged because the XNG has remained in an upward trend but is once again testing trend-line support (see chart below). 

The stocks of natural gas companies have a stronger positive correlation with the overall stock market than with the natural gas price so the ability of the XNG to remain within its upward-sloping channel will be determined, to the greatest extent, by what happens to the overall market. Furthermore, the ability, or otherwise, of the XNG to hold above trend-line support in the short-term will give us a clue as to what to expect from the overall market. For example, a rebound in the XNG over the coming week would have short-term bullish implications for the overall market.

This week's important economic events
 

Date Description
Monday Nov 03 Construction Spending
ISM Index
Tuesday Nov 04 No significant events
Wednesday Nov 05 Factory Orders
ISM Non-Manufacturing Index
Thursday Nov 06 Q3 Productivity and Labour Costs
Friday Nov 07 Employment Report
Consumer Credit
ECRI Future Inflation Gauge

Click here to read the rest of today's commentary

 
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