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   -- Weekly Market Update for the Week Commencing 8th September 2003

Forecast Summary

The Latest Forecast Summary (no change from previous update)

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.

Monetary Policy Under Uncertainty

On 29th August Alan Greenspan gave a speech in which he explained why it is no longer appropriate to use economic models to determine the correct monetary policy. Rather, according to Greenspan, the complexity and ever-changing relationships within today's economy mean that a flexible risk management approach must be adopted with a key element of this approach being the judgement of policy-makers. The speech can be read in its entirety at http://www.federalreserve.gov/boarddocs/speeches/2003/20030829/default.htm.

The above-mentioned speech is another in a long line of thinly veiled attempts by Greenspan to re-write history and to portray the Fed as an innocent observer of the build-up of massive imbalances within the US economy (as opposed to the important facilitator of these imbalances which it really was). Some aspects of the speech are, however, worth reviewing at TSI because they provide clues regarding how things could have become so messed up.

The first clue is contained near the start of the speech when Greenspan talks about devising "a strategy for policy directed at maximizing the probabilities of achieving over time our goal of price stability and the maximum sustainable economic growth that we associate with it." When Greenspan and many other analysts refer to price stability they are referring only to the stability of price indices such as the CPI. However, the greatest asset price bubbles tend to occur during periods when consumer prices are stable and these bubbles have devastating after-effects.

The second clue is contained in the following extract from the speech:

"Recent history has also reinforced the perception that the relationships underlying the economy's structure change over time in ways that are difficult to anticipate. This has been most apparent in the changing role of our standard measure of the money stock. Because an interest rate, by definition, is the exchange rate for money against non-monies, money obviously is central to monetary policy. However, in the past two decades, what constitutes money has been obscured by the introduction of technologies that have facilitated the proliferation of financial products and have altered the empirical relationship between economic activity and what we define as money, and in doing so has inhibited the keying of monetary policy to the control of the measured money stock."

We certainly agree that new types of money have proliferated over the past 10 years and that the traditional measures of money supply no longer come close to fully accounting for all the varieties of money sloshing around the economy. However, in spite of the many monetary/credit innovations, M2 and M3 (the traditional measures of money supply) continue to work very well as indicators of monetary trends. For example, the CPI-adjusted M2 growth rate was a reliable leading indicator of economic growth over the past 50 years and has continued to be a reliable leading indicator over the past 5 years. Also, M3 continues to do a perfectly fine job of indicating the rate at which the total stock of money is growing. 

The real issue isn't that the traditional measures of money supply are no longer adequate, it is that analysts in general and policy-makers in particular refuse to perceive excessive money-supply growth as an inflation problem unless consumer prices are rising at a rapid rate. If the inflation is pushing up asset prices it is not generally perceived to be a problem. However, the truth is that excessive money-supply growth ALWAYS causes prices to rise somewhere in the economy and ALWAYS has adverse consequences.

The third clue is the irony of someone who didn't recognise the great stock and credit market bubbles for what they were, and who, by his own admission, believes that it is only possible to identify bubbles with the benefit of hindsight, telling us that the Fed's risk management practice relies, to a significant extent, on his personal judgement. Risk management involves putting things in place today to prevent a crisis from happening in the future. It doesn't involve reacting to crises after they happen. 

The fourth clue is the underlying assumption that the only choice we have is between a central bank setting short-term interest rates using rigid models or a central bank setting short-term interest rates using a vague and flexible risk-management approach. It never ceases to amaze us how people who comprehend why it would be impossible for a bunch of bureaucrats to do a better job than the market of setting the price of something as simple as tomatoes fail to see how ridiculous it is to give a bunch of bureaucrats the power to set the price of something as complex as money.

Copper Update

We are bullish on copper as far as the next year is concerned, but are neutral as far as the next month is concerned. This is because the copper price is poised right at important resistance, a likely place for a pullback to begin.

Bond Market Update

Last week we said "even if the intermediate-term downward trend [in the Japanese Government Bond market] remains in place it would be normal for the JGBs to find support at around the 136 level and rebound back to 138-139."

Even if a support level is destined to hold, a market will often spike below it (to punish those who react to breakouts) before rebounding. As the below weekly chart of Japanese Government Bond (JGB) futures shows, this is exactly what the Japanese bond market did last week. Specifically, the JGBs spiked well below the obvious support at 136 early in the week and then rebounded sharply to close the week at 137. If the rally that began last week is just a counter-trend move within a continuing intermediate-term downward trend then the JGBs should NOT achieve a weekly close above 139.

Note that we are focusing on the JGBs because the Japanese bond market exerts a strong influence on the other major bond markets of the world.

The US Stock Market

The 'real' S&P500 Index

Below is a chart showing the S&P500 Index in terms of gold. Regardless of what happens to the nominal S&P500 Index, our view is that the S&P500 has peaked relative to gold. This is because the S&P500 can only be supported near current levels by on-going rapid dollar inflation and gone are the days when financial assets were the primary beneficiaries of this inflation. Actually, it is difficult to see how even a further increase in inflation will help support the S&P500 near current levels beyond the short-term. This is because as soon as the inflation becomes obvious in the prices of non-financial assets it results in higher long-term interest rates and lower average price/earnings ratios.

In any case, the channel top for the S&P500/gold ratio is very well defined. Given the fundamental backdrop, as long as the channel top continues to hold it will make sense to anticipate a drop to the channel bottom before the next major rally commences. 

Current Market Situation

Because last week's new recovery highs in the major US stock indices were confirmed by indicators such as the NASDAQ100/Dow ratio, we doubt that a peak in the US stock market is already in place. As discussed in last week's Interim Update, we consider the most likely scenario to be a sharp pullback over the next few weeks followed by a rally to a new recovery high late in the year before a major decline gets underway. The next most likely outcome is that the market continues directly higher from its current levels and makes a major top during the next few weeks.

Below is a 1-year chart of the S&P500 Index. If our preferred scenario is correct then the S&P500 will close below the short-term support that exists at around 1010 during the coming week and begin working its way down to intermediate-term support in the 900-950 range. However, if 1010 holds on a daily closing basis over the coming week then the alternative scenario mentioned above will become the most likely scenario.

In last week's Interim Update we explained that the current chart pattern of Kinross Gold (TSX: K) was not the type of pattern we'd expect to see for this stock if a peak in the gold sector was imminent. Similarly, the below charts of International Paper (NYSE: IP) and Alcoa (NYSE: AA) show patterns that we would not expect to see if the commodity-cyclical sector of the stock market was close to a major peak. These charts are, however, consistent with the view that a pullback will occur over the next few weeks.

This week's important economic events
 

Date Description
Monday Sep 08 Consumer Credit
Tuesday Sep 09 No significant events
Wednesday Sep 10 No significant events
Thursday Sep 11 Trade Balance
Import / Export Prices
Friday Sep 12 PPI
Retail Sales

Click here to read the rest of today's commentary

 
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