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   -- for the Week Commencing 6th August 2001

Forecast Summary

The Latest Forecast Summary (no change from last week)

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) will move higher into 2002.

The US stock market is in a cyclical bull market that began in late-March/early-April and is likely to end during the final quarter of this year.

The Dollar will head lower into 2002.

A bull market in gold stocks commenced in November 2000 and is likely to extend into 2002.

Commodity prices, as represented by the CRB Index, are in the process of bottoming. The CRB Index will reverse higher during the second half of 2001 and rally into 2002.

The oil price will resume its major uptrend during the second half of 2001 and rally into 2002.

Money Matters

Focus on tomorrow's headlines, not yesterday's headlines

As far as leading indicators of the economy go the inflation-adjusted money supply growth rate is head, shoulders and bootlaces above anything else. And yet, time and time again we see analysts ignoring changes in money supply and, instead, choosing to focus on coincident indicators or even lagging indicators. Lagging indicators such as the employment data and the GDP numbers tell us what the economy was doing a few months ago. Coincident indicators such as the consumer sentiment surveys and the National Association of Purchasing Managers survey tell us what the economy is doing right now. Even the future-expectations component of the Conference Board's consumer sentiment survey is a coincident indicator since it moves with, not in advance of, the current component. All these lagging and coincident indicators are useful to know since they help paint a picture of where we've been and where we are. Unfortunately, they don't help us make any money because the financial markets are always adjusting prices based on an assessment of where we are going, not where we are or where we've been. In other words, in order to make money we needn't worry too much about yesterday's or today's headlines. What we need to do is figure out what tomorrow's headlines are going to be.

Below is a chart comparing the inflation-adjusted year-over-year growth in M2 (using the median CPI as the measure of inflation) with the growth rate of real GDP. M2 growth has been advanced by 6 months to account for the fact that 6 months is the typical lead-time between changes in money supply and changes in economic growth. 

The above chart reveals a strong positive correlation between inflation-adjusted money supply growth and economic growth. The correlation is not perfect, mainly because the lag between money supply changes and economic growth changes is not always the same (it is often about 6 months, but can be as much as 12 months). The most recent trough in the inflation-adjusted M2 growth rate occurred in November of last year, meaning that the second quarter of this year was the most likely time for an economic trough. The strong recovery in the money supply growth rate since November of last year points towards a period of healthy economic growth commencing by the fourth quarter of this year. Real GDP growth during this year's final quarter will probably be in excess of 3%.

The bond market is also a good leading indicator, although the signal given by the bond market usually contains a lot of noise since bond prices are adjusted daily based on emotional responses to the news of the day and technically-based trading in addition to objective assessments of the future. However, when we see definite changes in the bond price trend such as occurred during the first quarter of last year and the first 5 months of this year, and particularly when the trend changes seem to be completely at odds with conventional wisdom and the latest economic news, it is usually a valid warning that the economic backdrop is about to change.

In April last year, based on a clear trend reversal in long-term interest rates from up to down (that most analysts wrongly attributed to the US Government's debt buybacks) and a decline in the money supply growth rate over the preceding months, we forecast that US economic growth would slow substantially during the second half of the year. The best leading indicators were signaling that an economic slowdown, perhaps even a recession, was going to occur regardless of what actions were taken by the Fed. 

For the past few months the best leading indicators have been warning us to expect a reasonably strong economy by the fourth quarter of this year. Fortunately, most analysts don't agree with us because they are fixating on yesterday's headlines (we say "fortunately" because opportunities arise when there is a mismatch between what most people think is going to happen and what is actually going to happen). Assuming our economic forecast becomes a reality (there are no guarantees since even the best leading indicators can't account for such things as unexpected wars or natural disasters), the prices of stocks and bonds will have factored-in an economic recovery long before the coincident indicators start showing indisputable signs of strength.

Turning Japanese?

Is the huge growth in the amount of money invested in money-market funds over the past 8 months a sign that Americans are following the lead of their Japanese counterparts and starting to hoard cash? In a word, no.

The total supply of money in the US has ballooned since November of last year. Since an increase in the money supply is caused by an increase in debt, the flood of money into money-market funds is not the result of a growing propensity to hoard cash or to save, it is the result of a borrowing binge. 

A big factor in this build-up of money has been the mortgage refinancing boom that began late last year. People have borrowed against the equity in their homes and are using money-market funds as temporary parking places for this money. The money is, no doubt, earmarked for spending or investment or the repayment of other debts (most likely spending and/or investment since consumer credit has been growing in parallel with money-market fund assets).

The US Stock Market

Zooming out

As we've noted on numerous occasions over the past 4 months, we expect the major stock indices to reach much higher levels during the second half of this year. We are not, however, bullish beyond the final quarter of this year.

Our forecast has been, and continues to be, based on the extremely positive monetary environment that has developed since late last year. As discussed earlier in today's commentary, the lagged effect of this monetary stimulation will ensure a strong economy during this year's final quarter and probably during the first several months of next year. It will also boost asset prices when part of the additional liquidity that has stemmed from the accelerated expansion of credit is channeled into stock and real estate investments.

The reason we are not longer-term bullish is that if our bond market forecast comes to fruition (we expect long-term interest rates to move higher over the next 12 months) then the positive effect of the monetary stimulation will be short-lived. Rising long-term interest rates will slow the pace of credit expansion and any significant slowdown in money-supply growth (less credit growth means less money-supply growth) will be anathema to the stock market, the real estate market and to the economy. In fact, if things develop the way we currently expect then a large decline in asset prices and a severe recession are going to occur during the coming 18 months.

One more piece of the puzzle may be falling into place

In the July-25 Interim Update, with Japan's Nikkei Index having fallen to around 11,600 (within 2% of its March-2001 low), we wrote: "Our opinion is that the recent decline [in the Japanese stock market] will turn out to be one of those consolidations that retraces 100% of the preceding advance, but does not make new lows and is followed by a substantial rally to new recovery highs (in this case, above the early-May peak). One reason we think this is because of the capitulation that led to the March bottom (the Nikkei dropped in almost a straight line between September 2000 and March 2001). It is unlikely that a bottom reached following such a severe and relentless decline would be exceeded only 4 months later."

So far so good as the Nikkei held above its March-2001 low of 11433 and has since moved back above 12,000. Based on the pattern of the past six months an upward reversal in the Nikkei, which may or may not have happened over the past week (still too early to tell with any certainty), is something we expect to occur prior to the commencement of a sustainable rally in the US stock market. The recent action in the Nikkei provides further evidence that the US market has probably seen its correction lows.

Current Market Situation

The evidence has gradually been building that the correction lows are in place. Firstly, as mentioned above, the Nikkei's recent action has been constructive. Secondly, the recent strength in the oil price supports the notion that a new short-term up-trend has begun in the stock market (refer to the Jul-23 WMU for a discussion of how the oil price and the S&P500 have been moving with each other since the beginning of this year). Thirdly, the Dollar is now headed lower (an excessively-strong Dollar was becoming a big problem for the stock market). Fourthly, at the correction lows on Jul-24 there was almost universal agreement that the market was about to plunge at least as far as the early-April bottom and probably much further (in other words, the sentiment backdrop was well-suited to an upward reversal). Fifthly, market internals did not confirm the recent declines in the major indices. So, is it onward and upward from here?

No. We are still expecting one more significant pullback before a substantial rally gets underway, primarily due to short-term sentiment indicators such as the 5-day moving-average of the equity put/call ratio (see chart below). 

A bit more upside is likely in the very short-term (the next few days), after which we should see a 1-2 week pullback that acts to rebuild the "wall of worry" that all bull markets climb. If everything goes according to plan we will recommend a trading position in QQQ shares and/or QQQ call options during this pullback in preparation for a potential 2-3 month surge. We are also immediately going to add two tech stocks to the Portfolio as described below under "Changes to the TSI Portfolio".

The Argentine Crisis

We've mentioned the Argentine financial crisis a couple of times but haven't been overly concerned about its global implications. The following chart explains why. If the crisis was going to become global then the major US banks would have a big problem on their hands and the market would be quick to discount the worst case in the prices of bank stocks. The stability of the PSE Bank Stock Index over the past 2 months is a clear sign that the crisis that has enveloped large parts of South America will not have dire implications for the world's major economies.

This week's important economic/market events
 

Date Description
Tuesday August 7 Q2 Productivity Report (prelim)
Consumer Credit
Cisco earnings report
Thursday August 9 Import/Export Prices
Friday August 10 PPI

Gold and the Dollar

Click here to view the remainder of this week's commentary  

 
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