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   -- for the Week Commencing 8th April 2002

Forecast Summary

The Latest Forecast Summary

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 during 2002.

The US stock market will make new bear market lows in 2002.

The Dollar commenced a bear market in July 2001, but will rally to a secondary peak during the first quarter of 2002 before beginning a major descent.

A bull market in gold stocks commenced in November 2000 and is likely to extend into 2003.

Commodity prices, as represented by the CRB Index, will rally during 2002 and 2003.

The oil price will resume its major uptrend during the first half of 2002.

Bonds and Stocks

Although we never trade bonds for our own account we spend a lot of time analysing the bond market. We do this because interest rates exert such a strong influence on all the other financial markets. 

We turned long-term bearish on bonds during the first week of 2001 - at the very beginning of the Fed's rate-cutting campaign. Throughout 2001 the relentless slashing of short-term rates by a panicked Fed was generally portrayed as bullish for bonds, but we certainly didn't see it that way. Our view was that the Fed's aggressive rate-cutting in the face of massive inflation (a surging money-supply growth rate) would eventually cause bond prices to move much lower. As it turned out, the US Treasury managed to engineer a rally in bonds in October that pushed bond prices to new highs for the year (pushed long-term interest rates to new lows), but the government's market-meddling simply laid the groundwork for a crash in bond prices during November and December.

The early-December low in the bond price (basis the June bond contract) is now a 'line in the sand' that represents last-ditch support for bonds. A drop below this support, when it occurs, will signal that a decline to the January-2000 low is underway (such a decline in the T-Bond price would cause the T-Bond yield to rise to around 6.75% versus its current level of 5.67%).

We expect bonds to break below the above-mentioned major support at some point during the next 2 months. However, for a number of reasons we have forecast an intervening rebound in the bond price prior to the start of the next substantial decline. In particular, sentiment towards bonds had become exceedingly bearish over the past few weeks and a situation had arisen where the 'smart money' (the large traders) was betting on an upward reversal in bonds while the 'dumb money' (the small traders) was betting on a continuation of the decline. There are, of course, smart small-traders and dumb large-traders, but the large traders as a group tend to be better-informed and more often on the right side of the market than the group defined as small traders.

Following on from the above comment regarding 'smart money' and 'dumb money', we consider large speculators and large commercials to be 'smart money'. Often these two 'smart money' groups are at loggerheads with each other with the commercials usually ending-up being right at important turning points (trend reversals) while the large specs tend to be right as long as the market is trending. We take particular notice, therefore, when the large specs and the large commercials are lined-up on one side of the trade while the small traders, as a group, are taking the other side of the trade. This has been the case with T-Note futures over the past several weeks. For example, as at the 2nd of April (the date of the latest COT Report) the large speculators and the large commercials were net-long and the combined net-long position of these two groups was around 60,000 contracts. The small traders were correspondingly net-short. By the way, a similar situation exists in the S&P500 futures market in that both the large speculators and the large commercials are net-short (their combined net-short position was a hefty 106,000 contracts as at 2nd April). This is one reason that a substantial stock market rally appears to be out of the question at this time.

Getting back on track, a bear-market rally in bonds has been a high probability over the past few weeks and is now underway. Furthermore and as explained many times in previous commentary, such a rally in the bond market was absolutely essential if the stock market was to have any chance of mounting a meaningful rally of its own over the next 3 months.

Below is the chart comparison of the Dow Industrials and the 30-year T-Bond that was originally part of our 13th March Interim Update. The chart includes rough projections of what we expected stocks and bonds to do over the ensuing 5 months. We haven't needed to do an updated version of the chart because the markets have thus far followed these projections quite closely. 

At the time the above chart was prepared we were anticipating a stock market decline and a bond market rally into the first half of April, followed by reversals in both markets. It is possible that the current moves (higher for bonds, lower for stocks) could extend into the second half of April, but our forecast remains essentially the same as that shown on the chart.

Financial markets never get where they are going in a straight line, meaning that there are always counter-trend moves along the way. The current rally in bonds is of the counter-trend variety and will almost certainly be followed by a plunge to new lows. The main problem for bonds is that some of the effects of the past 2 years' massive inflation, such as rising commodity prices, are only just beginning to emerge. As such we are confident that the bond bear-market is still in its infancy and that interest rates will move much higher over the coming 12 months. As explained in previous commentary rising interest rates will, in turn, become an insurmountable problem for an over-priced stock market.

Commodities

Forecasting commodity prices

You cannot forecast commodity prices by looking at supply/demand information such as inventory levels, current and expected mine production, industry and economic data, etc. This is because, at any given time, the market has discounted all the available data in the current price. It is possible, however, to correctly forecast commodity price trends if you understand what is happening to bonds and to the money-supply growth rate (trends in bond prices and money-supply growth lead the general commodity-price trend). It also helps to know that the Australian Dollar often leads commodity prices (and, by the way, US bond prices).

By the time the fundamentals for any commodity (or anything, for that matter) become unequivocally-bullish the price has most likely already peaked and anyone buying in response to the bullish fundamentals will lose money. Similarly, it is common for prices to bottom and turn higher just when the fundamentals appear to offer no hope of a price recovery. 

The palladium market over the past 18 months provides a good example of the dangers of reacting to the current fundamentals. At the top of the market in early-2001, with the palladium price at around $1000, the supply/demand situation looked extremely bullish. Russian suppliers appeared to have the ability to drive prices much higher through small reductions in their exports and the major auto manufacturers were scrambling to secure additional supply before the price moved even higher. However, the palladium price dropped by 70% over the ensuing 9 months. The fundamentals for palladium now look terrible as the brilliant traders at Ford - people who had been aggressive buyers of the commodity at $800-$1000 per ounce - desperately try to unload their company's huge excess supply at the current market price of around $360. Furthermore, the Russians now appear to be powerless to halt the decline in the palladium price.

Has the palladium price already bottomed? We don't know, but we seriously doubt that there will be substantial further downside because today's massive over-supply has already been discounted in the current price.

Copper

We've held a positive view on copper over the past several months, but in the 25th March Weekly Update noted that a bull-market correction in copper would likely occur in parallel with the anticipated bear-market rally in bonds. By breaking its post-November up-trend last week the copper price has signaled that a correction is underway.

The Australian Dollar

A medium-term bullish view on commodities and bearish view on bonds goes hand-in-hand with a bullish view on the A$ (due to Australia's reliance on commodity exports the A$ tends to move in the same direction as commodity prices and in the opposite direction to bond prices). We expect the A$ to move much higher relative to the US$ over the next 12 months, but it looks vulnerable to a sharp fall in the short-term.

Despite edging lower last week the Oz Dollar's short-term up-trend remains intact. There are, however, a few reasons to expect a break of this up-trend in the near future. One obvious reason is the current counter-trend moves in commodities and bonds (lower for commodities, higher for bonds). One not so obvious but potentially very important reason is the A$'s tendency, since the beginning of 2001, to move in the same direction as the US stock market.

Over the past few weeks the A$ has continued on its upward path as the major stock indices have fallen. The only other period over the past year when the A$ moved higher as the stock market ground lower occurred last August. This divergence was subsequently removed via a plunge in the A$ during September.

The below chart of the A$ shows the developing similarity between the current period and last August. It may not be a coincidence that this price action is occurring just as the situation in the Middle East appears to be approaching its boiling point. 

The US Stock Market

The Big Picture

We are short-term bearish on the stock market but could turn short-term bullish at some point over the next few weeks if certain conditions are met (as outlined in previous commentary). However, we are very bearish on the market taking a 6-12 month view and would almost certainly look at any sizable rally over the next 2-3 months as a wonderful opportunity to bet against the market.

The main reason for our longer-term bearish view is valuation. Our concern is not so much that price/earnings ratios are high since these can be distorted by collapsing earnings, but that price/sales ratios were much higher at last September's bottom than they should have been if a long-term bottom had been put in place.

The stock market can remain over-valued or under-valued for a very long time. The reasons we expect the valuation problem to be addressed this year are a) rising interest rates and b) a falling money-supply growth rate. Rising interest rates are important because, as previously discussed in detail, they reduce the present value of future cashflows. In fact, the basis for the secular bull market in stocks that began in 1982 was a secular downtrend in interest rates. The money-supply growth rate is important because if stock prices are not supported by the fundamentals then they can only remain elevated through currency depreciation. It was rapid money-supply growth that kept the major stock indices moving higher between the fourth quarter of 1998 and the first quarter of 2000.

The year-over-year M2 growth rate (see chart below) began trending lower in December of last year. Trends in money-supply growth usually last for at least 12 months so we can expect the money-supply growth rate to remain on a downward path throughout 2002. This is going to create a big problem for the stock market by the third quarter of this year and a big problem for the economy by the first quarter of 2003.

Current Market Situation

We continue to expect the stock indices to reach lower levels before the current pullback is complete. Up until now the decline has been orderly, but before it ends we expect to see one or two days of panic selling (as indicated, for example, by an equity put/call ratio above 0.9). We assess the likely downside over the next 2 weeks for both the NASDAQ100 and the S&P500 to be around 5% from Friday's closing levels. However, events in the Middle East have the potential to convert a nervous pullback into a rout.

A few weeks ago we suggested that short-term traders buy QQQ June $30 put options. As noted in the latest Interim Update we would take profits on these options if the NASDAQ100 drops to near 1300 (it closed at 1377 on Friday). 

In last week's Weekly Update we suggested that longer-term traders/investors purchase an initial bearish position immediately (via, for example, a bearish mutual fund or LEAPS) with the aim of adding to the position during periods of general market strength over the next 3 months. This longer-term bearish trade is being recommended in anticipation of a substantial stock market decline during the second half of this year.

The Japanese stock market, which has been leading the US market since the beginning of last year, remains within a short-term downtrend that looks, at this stage, like a normal breakout pullback. It must continue to hold at support in the 10800-11000 range for this to remain the case.

This week's important economic/market events
 

Date Description
Monday April 08 No significant events
Tuesday April 09 No significant events
Wednesday April 10 No significant events
Thursday April 11 Import and Export Prices
Friday April 12 PPI
Retail Sales

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