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, where "secular bear market" is defined as a long-term downward trend in valuations (P/E ratios, etc.) and gold-denominated prices. This secular trend will bottom sometime between 2014 and 2020. (Last update: 22 October 2007)

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. This secular trend will peak sometime between 2014 and 2020. (Last update: 22 October 2007)

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

Random speculations about the year ahead

  *The US stock market's upside will be limited by falling corporate profits (and profit margins), continued pressure on the financial sector, political uncertainty, inflation fears, and a lack of growth in consumer spending.

  *The stock market's downside will be mitigated by the beating already dished out to housing-related and financial stocks, as well as by the fact that the investing public is already very pessimistic.

  *The upward trend in the US yield-spread that began in 2007 will persist through 2008, due initially to long-term interest rates falling less than short-term rates and then, later in the year, to long-term interest rates rising faster than short-term interest rates. This will create a generally positive environment for gold, although gold's bull market will be interrupted by a substantial 2-4 month correction that begins during the first two months of the year.

  *Gold's H1-2008 correction will be driven by a strong US$ rally as currency speculators belatedly come to the realisation that the dollar's large purchasing-power discount to the euro is unwarranted.

  *In a desperate effort to revive the economy and the electoral chances of the Republican Party, the US Federal Government will become the primary engine of debt/money expansion (inflation) during 2008. As a result, the people who doubt the ability of the powers-that-be to maintain a high level of monetary expansion in the face of a 'tapped out' consumer will receive an "Inflation 101" course. They will learn that there is no limit to the amount of bonds that the US government can issue to the Fed in exchange for newly-created currency.

Note: The "pushing on a string" analogy often cited in discussions about the inflationary abilities of governments and central banks is based on the patently false assumption that every increase in money supply will be met by an equivalent increase in money demand with no change in the price (purchasing power) of money. This assumption goes against basic economic law. Until the law of supply and demand is repealed there will be no question that an entity with the power to expand the supply of money ad infinitum will also have the power to reduce the purchasing power of the money (bring about a general increase in prices, that is). The challenge facing the monetary authorities isn't to maintain a high level of inflation; it's to do so whilst keeping inflation FEARS in check.

  *Weakness in the economy will result in a deflation scare during the first half of 2008 (a "deflation scare" involves widespread fear that deflation is a threat, as opposed to something resembling actual deflation), but the nature of the current monetary system and political environment will ensure that the weaker the economy the greater the INFLATION.

Base Metals Update

The Stock Market

2008 Outlook for the US Stock Market

There's a lot of discussion in the press about whether the US economy will go into recession during 2008, but we think such discussions are irrelevant because the US economy is ALREADY in recession. The US government reported strong GDP growth for the third quarter of last year and might report some additional growth for the fourth quarter, but these government-produced numbers seldom reflect reality.

Properly accounting for the effects of inflation would, we strongly believe, reveal that the US economy has been contracting in real terms for many months. This makes intuitive sense given a) the depression in the residential housing sector and the effect that the housing/construction-related downturn must be having on consumer spending, and b) the deleterious effects on non-energy-related spending of the sharp rise, over the past 12 months, in the price of energy.

Recession-like economic conditions combined with the currency's loss of purchasing power have caused corporate profit margins to contract and the S&P500's rate of earnings growth to fall over the past six months, and more of the same is likely over the coming 2-3 quarters. In fact, there's a good chance that S&P500 earnings will be lower in 2008 than they were in 2007. But as far as the stock market is concerned the relevant question is: how much of this downturn in corporate profitability is factored into current stock prices?

Even though the overall market's relatively high P/E ratio suggests that the aforementioned downturn in corporate profitability has not yet been fully discounted, the above question is difficult to answer due to the huge disparities between different sectors. For example, the housing depression will most likely extend through 2008 and cause the homebuilding business to become even worse than it is today, but the homebuilding sector has already lost 75% of its collective market capitalisation (as measured by the Dow Jones US Home Construction Index -- DJUSHB). One or two major homebuilders will probably go bankrupt before the depression runs its course, but the entire industry is not going to disappear. Considering that the homebuilding sector's decline is already in the same league as the NASDAQ's 2000-2002 bust it is reasonable to assume that the stock market has come close to discounting the worst in this case. It's a similar story in the financial sector in that almost every company involved in the originating, intermediating, packaging and/or insuring of mortgage-related debt has already been taken out back and shot. The stock prices of some high-profile financial companies could go to zero during 2008, but the entire industry is not going to disappear. Furthermore, it is reasonable to expect that at some point this year the better-managed financial companies (and their stocks) will begin to rebound strongly.

In general, it seems to us that the sectors that have suffered due to a substantial deterioration in business fundamentals -- whether it be the homebuilding sector due to the obvious problems in the housing market or the financial sector due to the rampant mispricing of credit risk or the airline sector due to the dramatic increase in the price of oil -- have already been pummeled to levels where the negatives are close to being fully discounted. On the other hand, the sectors in which business conditions remain firm do not appear to have much downside risk. For example, although we expect the price of oil to drop back to the 70s during 2008 we don't think this will lead to substantial weakness in the major oil stocks because valuations remain low and because oil-related equities generally didn't react in a meaningful way to the final $20 increase in the oil price. 

Another point worth noting is that long-term interest rates (bond yields) are currently at levels that should be supportive for equities. We perceive significant upside risk in bond yields, but while they remain low the effects on stock prices of the ramping down of earnings expectations will be mitigated. By the same token, if bond yields establish a strong upward trend then the stock market's situation will take a dramatic turn for the worse.

The bottom line is that the conditions are not in place to make 2008 a good year for the stock market, but, on the other hand, we can't see where the downside leadership is going to come from to make it a particularly bad year. Our guess is that the S&P500 will end the year with a small loss due primarily to the continuation of downward pressure in the financial sector and weakness in the stocks of companies that rely on discretionary consumer spending, offset by stability or modest strength elsewhere. 

The biggest risk is that inflation fears propel bond yields sharply higher. A sharp rise in bond yields would lead to P/E-ratio-compression in the stock market and limit the Fed's ability to provide monetary stimulus.

Current Market Situation

The price action has become more bearish. For example, the S&P500 Index and the Dow Industrials Index ended last week marginally above their November lows, but the NASDAQ100 and NASDAQ Composite indices did not. This is a bearish divergence since the NASDAQ tends to lead at important turning points. Furthermore, the Russell2000 Index, the Semiconductor Index, the Dow Transportation Index and the S&P600 Small Cap Index ended last week below their November lows AND their August lows. Worst of all, the Bank Index (BKX) ended the week at its lowest level since the second quarter of 2003!

That's the bad news.

The good news is that regardless of whether or not a cyclical bear market has begun, the US stock market is now sufficiently oversold and sentiment sufficiently pessimistic that a short-term bottom will very likely be in place by the end of this week. We note, in particular, that at 25.7% the bullish consensus indicated by the latest AAII sentiment survey is close to its lows of the past decade, and that the percentages of S&P500 stocks trading above their 200-day and 50-day moving averages are near their lows of the past 4 years (refer to the following chart for details).

It will be interesting to see whether the S&P500 can hold above 1400. The S&P500 hasn't closed below 1400 since 16th March of last year, and, as evidenced by the following chart, a close below 1400 would breach significant lateral and channel support.

We suspect that if a break below 1400 were to occur this week it wouldn't be sustained because it would be occurring with the market near an oversold extreme. However, it would still have bearish implications beyond the next few weeks in that it would be evidence that the market's intermediate-term trend had turned downward.

This week's important US economic events

Gold and the Dollar

Currency Market Update

Although the relationship between the US stock market and the euro/yen exchange rate has weakened a little over the past two months, the following chart shows that euro/yen and the S&P500 are still moving together. That is, the Yen is still tending to strengthen against the euro when the stock market declines and weaken against the euro when the stock market rallies.

The euro/yen-SPX relationship suggests that if the stock market is close to a short-term bottom then the Yen is close to a short-term peak. If we were long the Yen we would therefore be looking to take profits over the coming week or so.

The US employment numbers reported last Friday were very weak, but we pay almost no attention to economic data produced by the US government because the data are lagging indicators at best and often bear little resemblance to what's really happening. Our only interest is in the way the financial markets react to the data.

Friday's market reaction -- a knee-jerk sell-off in the US$ in the immediate aftermath of the employment report followed by the retracing of the knee-jerk reaction -- suggests that the Dollar Index is going to move higher over the coming 1-2 weeks.

Gold

2008 Outlook

We are presently short-term bullish on both gold and the US$, but this does not mean that we expect gold and the Dollar Index to rally together over the next few months. Rather, it means that we think the upside potential outweighs the downside risk in both markets. In the case of the Dollar Index we think that a bottoming process is underway and that while this process continues the downside risk will be limited to a test of the November low (74-75). In gold's case, the potential will exist for significant additional gains until the dollar's bottoming process is almost complete, following which a sizeable gold-market correction is likely to begin.

If the dollar's current bottoming process follows the typical historical pattern then it will take 3-4 months to complete, after which a strong multi-month rebound should begin. This suggests to us that intermediate-term US$ rally will start before the end of March and that gold will reach an intermediate-term peak during the first two months of the year (since turning points in the gold market usually lead turning points in the currency market).

We expect that yield and credit spreads will continue to widen during 2008; that real interest rates will remain low; and that financial market volatility will increase. If so then the backdrop will remain 'gold bullish' and a US$-inspired 2-4 month downturn in the gold market during the first half of the year will be followed by another powerful advance. Our guess is that gold will end 2008 above $1000, but will trade below $750 at some point during the first half of the year.

Gold's upward trend relative to the base metals should continue during 2008. Also, we expect that gold will move sharply higher relative to oil.

Current Market Situation

Further to the above discussion, we suspect that gold is within about 6 weeks of an important peak. In the mean time, however, significant additional gains are likely.

The following chart shows that in C$ terms gold broke out to the upside from an 18-month consolidation late last year. It then pulled back to 'test' the breakout before resuming its advance. This price action suggests additional upside of 10-20% over the coming 1-2 months.

Gold Stocks

2008 Outlook

With one exception (Gold Fields Ltd), we perceive considerably more downside risk in the major gold stocks than in gold bullion and only slightly more upside potential. As a result, we don't see a good reason to take long-term investment positions in the major gold stocks. This has, in fact, been our view for at least four years. The major gold stocks periodically become oversold relative to gold bullion and at such times they make good trading vehicles, but on a longer-term basis they are not worth the hassle. There are simply too many things that can go wrong with them compared to the amount of additional upside potential they offer. In our opinion, if you are risk-tolerant and looking for ways to leverage gains in the price of gold bullion then you should own a portfolio comprising mid-tier and junior gold mining equities, but if you are risk averse you should focus on gold bullion or gold bullion surrogates such as GLD.

The gold-stock indices can be expected to track gold bullion during 2008, falling further during gold-market corrections and rebounding faster thereafter. However, if the broad stock market were to become very weak then we could encounter a period during which the gold sector falls while gold bullion rises. 

We expect to see an increase in takeover activity in the gold sector during 2008, with mid-tier miners seeking to acquire juniors and majors seeking to acquire mid-tiers.

Possible surprises:

1) Barrick Gold makes a takeover bid for Kinross Gold

2) A major diversified miner (BHP, Rio Tinto, Xstrata, etc.) decides to increase its exposure to gold by making a takeover bid for a major gold mining company

Current Market Situation

The following chart shows that the HUI has rocketed upward over the past couple of weeks. As a result, there will probably be some consolidation over the coming days as traders take profits.

Note that a bearish divergence between gold stocks and gold bullion will remain in place until the HUI closes above its early-November high of 463 (as things currently stand, gold bullion's recent move to a new all-time high has not been confirmed by the gold-stock indices). The current divergence between the stocks and the metal is bearish because the stocks tend to lead at important turning points.

Chances are that this bearish divergence will be eradicated within the next couple of weeks, but until/unless that happens it will be prudent to take precautions (boost cash reserves or perhaps purchase some insurance in the form of GDX put options).

Even though we don't have any financial interest in the stock, one thing that continues to bother us is the failure of Royal Gold (NYSE: RGLD) to break upward from the drawn-out consolidation pattern shown on the following chart. RGLD is the purest play on gold within the universe of gold-mining equities, so the fact that it has made a sequence of declining tops since January of 2006 is more than a little strange given the performance of the bullion market.

As has been the case for the past few years, our main focus for 2008 will almost certainly remain on the junior end of the gold mining sector. The juniors, especially the exploration-stage miners, were a source of considerable frustration during the second half of last year because they generally failed to respond in a meaningful way to the strong advance in the gold price. However, the nature of the junior end of the resource market is that all of the gains tend to occur in 10% of the time, with prices drifting lower or going nowhere over the remaining 90% of the time. Also, the prices of junior mining stocks are often poorly correlated in the short-term with the prices of the underlying commodities. As a result, to be a successful speculator in junior gold and other resource shares you need a lot of patience and foresight.

We imagine that people who only became involved with junior gold shares over the past year are feeling disgruntled because they haven't yet experienced, first hand, what happens to these stocks when the speculative juices begin to flow, whereas those who have been involved in the sector for at least 2-3 years will realise just how quickly prices rise once the rise begins.

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)

Friday's stock market plunge took the Semiconductor HOLDRS Trust (SMH) below our 'stop'. SMH will therefore be removed from the Stocks List at a loss of around 11%. However, with the semiconductor sector having just fallen for six trading days in a row and with the overall market now at an oversold extreme there is a good chance that SMH will soon begin to rebound. Therefore, instead of exiting immediately it probably makes sense for those who are still 'long' to retain their position in anticipation of at least a 5-10% bounce.

Chart Sources

Charts appearing in today's commentary are courtesy of: