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 during 2002.

The US stock market will reach a major bottom (well below the September-2001 lows) during the second half of 2002.

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

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.

Inflation, Prices and Interest Rates

Defining our terms

There may not be anything that is as universally misunderstood as inflation. Even those analysts who understand the link between money supply growth and prices usually talk about inflation as if it is an increase in prices, that is, as though inflation is a consequence of money supply growth. They hence confuse cause and effect, a mistake that leads to other analytical errors. Inflation is simply an increase in the supply of money and it results in prices being higher than they would be in the absence of the inflation.

Here is a quote from a 1951 article written by the great Ludwig von Mises on the topic of inflation:

"To avoid being blamed for the nefarious consequences of inflation the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase."

The popular and totally misleading definition of inflation (that inflation is an increase in prices) is perpetuated on a daily basis in the press, more through ignorance than malice. For example, if the oil price rises then this is deemed to be "inflationary" or to be creating "inflationary pressures", but a rise in the oil price cannot possibly cause a rise in the general price level unless the Fed monetises the increase in the oil price. If the total supply of money remains the same then a higher oil price must be offset by lower prices elsewhere. In other words, if consumers are forced to spend more money on oil and the money supply remains constant then they will need to cut down on other expenditures. Other prices will hence fall. It is only when the Fed facilitates an increase in the total supply of money (the Fed does this by holding interest rates too low) that an increase in the oil price can lead to an increase in the general price level. However, if OPEC pushes the oil price sharply higher and if this oil price increase is followed by a rise in the general price level, who will get the blame for causing the 'inflation problem'? The answer is obviously OPEC, but the true culprit in this case is the Fed.

Here's another quote from the same von Mises article:

"What the bureaucrats have in mind when talking about "fighting" inflation is not avoiding inflation, but suppressing its inevitable consequences by price control."

The bureaucrats that von Mises refers to have become a lot more sophisticated over the years. They no longer attempt to directly control prices using draconian measures such as price caps because such policies blew-up in their faces during the 1970s. These days they focus on managing perceptions. This involves, in part, perpetuating the lies that a) inflation is an increase in prices, and b) the CPI accurately represents the increase in prices. Over the past 7 years it has also involved the "strong Dollar policy". In fact, the government bureaucrats and politicians in the US have enjoyed considerable success in managing inflation perceptions over the past several years primarily because the Dollar has been in a powerful up-trend. With the Dollar now in a bear market the effects of inflation are going to become progressively more obvious as the months go by and a point will be reached when it will no longer be possible to conceal these effects by simply reporting a low CPI.

By the way, the above-quoted von Mises article can be read at: http://www.mises.org/efandi/ch19.asp

Prices and interest rates

Reuters Business Report, July 05: "I don't think there is any inflation danger that's worrying the Fed at this point," former Fed governor Lyle Gramley said. "At this juncture the Fed does not want to see the inflation rate going any lower, it does not want to see us flirt with deflation."

Of course, when Lyle Gramley talks about inflation and deflation he is incorrectly referring to changes in prices. He is either deliberately or accidentally oblivious to the fact that last year's inflation rate (money supply growth rate) was the highest it has been since 1973. He has a lot of company.

Our bullish view on commodity prices is helped a lot by the fact that the consensus view still seems to be that, out of deflation and inflation, deflation represents the bigger threat. The longer that those who set monetary policy and who influence monetary policy remain unconcerned about the rise in commodity prices or believe there are other more pressing concerns, the greater the eventual rise in commodity prices will be. We doubt that there will be any need to deviate from our inflation thesis until most people have become intensely worried about inflation and the Fed has come under enormous pressure to do something to stop the inflation.

As inappropriate as the commonly-accepted definition of inflation is, it is this definition that determines monetary policy. In other words, the rate of money supply growth can soar to incredible heights but it will not be until the inflation causes certain prices to rise that there will be a perceived inflation problem that requires some action on the part of the central bank. 

The following chart, which shows the ECRI's Future Inflation Gauge (FIG) in blue and the Fed Funds Rate (FFR) in green, illustrates the relationship between prices and monetary policy. The "Future Inflation Gauge" would be more aptly called the "Future CPI Gauge" since it is designed to predict changes in the CPI rather than changes in inflation. The chart only goes back to 1995, but trend changes in the FFR have followed trend changes in the FIG with remarkable consistency since Greenspan became Fed Chairman in 1987. Over the past 10 years the lag between a directional change in the FIG and a directional change in monetary policy has been 6-8 months. On this basis, since the FIG turned higher in February we should expect the Fed to commence a series of rate hikes by October at the latest.

Due to the problems in the tech and telecom sectors and the consequential problems faced by the large commercial banks, we would not be surprised if this year's lag between changes in the FIG and changes in the FFR turns out to be longer than usual. That is, it is probably going to take a lot more evidence of the effects of inflation, this time around, to push the Fed into action. 

The US Stock Market

Bottom Fishing

In his book "The Education of a Speculator" Victor Niederhoffer defines a stock market panic as any time when a daily Dow Jones Industrials closing price falls by at least 10% from the highest close during the preceding 30 calendar days (with no overlapping allowed). Such panics are quite rare. For example, during the 47-year period from 1950 to 1996 there were 19 panics, or an average of one every 2.5 years. However, between April 16, 1931, when the Dow was at 163, and July 4, 1932, when it hit 43, there were 16 non-overlapping 10% panic declines.

Many of the traders and investors who were smart enough to make it through the crash of 1929 relatively unscathed were eventually wiped out during the devastating and relentless decline of 1931-1932. Looking back from the present it isn't hard to imagine that each 10% panic decline during 1931-1932 would have been greeted with calls of "this is the bottom!" and would have sucked-in more speculators eager to get on board for the next bull run. However, it was only after the 16th such decline that a sustainable bottom was reached.

There are certainly some similarities between the current environment and the early-1930s, such as the chart pattern of the NASDAQ Composite Index and the crash in corporate profits in the tech/telecom sectors. However, there are also some enormous differences. For example, during the early-1930s the total supply of US Dollars was contracting at a rapid rate and the Dollar was becoming more valuable, while today we have rampant inflation and the Dollar is becoming less valuable. Therefore, although today's Dow will not escape falling to much lower levels, it won't fall by anywhere near as much as it fell during the 1930s (we think the final bottom will be somewhere in the 7,000-8,000 range). In our view, those who are predicting a total collapse in the Dow to 2,000 or lower aren't taking into account the devaluation of the Dollar. 

One of the lessons from the 1930s' bear market is that it can be very dangerous to try to pick the bottom if you are speculating with money you can't afford to lose. A lot of tech stocks have fallen by 90% or more and, as mentioned in past commentaries, it is becoming very easy to identify good value in the tech sector. However, the stocks are still falling fast and we haven't yet seen any evidence that a sustainable bottom has been reached. As such, the risks are still great. Remember, the difference between buying a stock when it is down by 90% from its high and when it is down by 95% from its high isn't 5%, its 50%. 

Current Market Situation

Our short-term forecast, as outlined in last week's Interim Update, was for:
a) Some follow-through to the upside last Friday and perhaps early this week if the July 4 holiday in the US passed without a terrorist attack
b) A subsequent drop to new lows that would probably create an opportunity to 'go long' for a 1-2 month trade

We certainly got some follow-through to the upside on Friday. The increases in the indices on Friday were impressive, but even more impressive was the breadth of the rally. For example, on both the NYSE and the NASDAQ the number of advancing stocks was almost three times the number of declining stocks. Furthermore, the ratio of up-volume to down-volume on the NYSE was almost 7:1 whereas on the NASDAQ it was a phenomenal 17:1. In fact, Friday's rally was strong enough to make us seriously consider the prospect that last Wednesday's low will hold for the next few months.

The market has been in a capitulation phase for the past several weeks and although we haven't yet seen outright panic we've certainly seen a healthy degree of fear. As noted in last week's Interim update the 10-DMA of the Arms Index recently hit its highest level in many years (perhaps even an all-time high). This indicates that the selling pressure has been narrowly-focussed and extreme ("get me out of this loser at any price!"). Also, Market Vane's bullish consensus has been 18% for each of the past 2 weeks. This is the lowest 2-week total over the past 5 years (our records for this sentiment survey only go back to 1997).

From a chart perspective the market is also showing some signs of having bottomed. For example, below are charts of the S&P500 and the Semiconductor Index (SOX). Friday's surge increases the probability that these indices have just completed successful re-tests of their September lows. The NASDAQ Composite Index moved well below its September-2001 low during the first half of last week, but closed the week well above last year's low so this index has also potentially completed a successful re-test of last September's bottom.

The NASDAQ100 Index blew right through last year's low during the recent decline and remains below this support (now resistance) level. However, the stock price of Cisco (we consider CSCO to be a leading indicator of the tech sector) remains well above last year's low. In fact, CSCO appears to have just completed a successful test of its May-2002 low with the recent decline having filled the huge gap created during the early-May surge.

Further to the above there is a chance that the stock market has just completed an intermediate-term bottom, although the probability that last week's low will be the ultimate low or even the low for this year is close to zero. 

Unfortunately, one important piece of the puzzle - the Commitments of Traders Report - wasn't released last week as per its usual schedule. Therefore, we don't yet know if the decline during the early part of last week prompted the commercials to cover a lot of their S&P500 'shorts' and the small traders to liquidate a substantial portion of their 'longs'. The COT Report will be released on Monday and we'll probably put out a Market Alert e-mail after we've had a chance to review the data.

Between now and September there is likely to be a decent (1-2 month) counter-trend rally in the stock market, with the main question in our minds being whether this rally has already begun or if it will begin following a drop to new lows over the next 2 weeks. The next fortnight is a risky time because it is the tail-end of the earnings pre-announcement season, so whatever negative surprises are still out there are likely to emerge during this period. We expect that once the actual earnings reports start to flow the selling pressure will abate.

Investors should continue to accumulate the stocks of commodity producers. Our view is that a bull market in commodities is in its embryonic stage and that the commodity stocks are going to move MUCH higher over the coming 12 months. Weakness in the overall market has caused many of these stocks to mark time or consolidate previous gains, thus allowing investors to accumulate at attractive prices. Currently, our three selections are MIM Holdings in Australia (ASX: MIM), BHP Billiton (BHP trades on several of the major stock exchanges including the ASX and the NYSE), and Chesapeake Energy (NYSE: CHK).

Before initiating any new short-term trades we'd wait for either a plunge below last week's lows (in which case we'd look at buying the QQQ and/or QQQ call options) or a sizeable counter-trend rally (in which case we'd look at buying QQQ or Dow put options). 

This week's important economic/market events
 

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