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   -- for the Week Commencing 8th October 2001

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 into 2002.

The US stock market is in the process of making a major bear market bottom.

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 by the first quarter of 2002 (at the latest) and then rally over the ensuing 1-2 years.

The oil price will resume its major uptrend by January 2002.

Another Inflation Play

We are confident that the central banks of the world will be successful in their mission to avoid deflation, because how could they not be? How could institutions with unlimited power to create money, including the power to monetise every public and private sector debt in the land if they chose to do so, not be able to depreciate their currencies via inflation if they really set their collective minds to the task? The US Fed has certainly set its mind to the task. No doubt aware that the supply of money is more important than the cost of money, the Fed is working hand-in-glove with the private banks and the GSEs (Government Sponsored Enterprises) to rapidly expand the US money supply. This money supply expansion is inflation. One of the effects of this inflation will be higher prices somewhere within the economy (unless this turns out to be the first time in the history of the world that a large and sustained increase in the supply of money does not lead to higher prices). 

The investment landscape has undergone a change over the past 2 years and the major beneficiaries of the inflation of the late 1990s will not be the major beneficiaries of the inflation of 2001 and beyond. Of all the changes that have occurred we think the one with the greatest long-term significance is the downward reversal in the US Dollar's exchange rate. The US Dollar's rising trend over the past several years made dollar-denominated financial assets irresistible to investors outside the US and has helped suppress commodity prices in US$ terms. As long as the Dollar was strengthening there was little incentive to hoard commodities because it was perceived that commodity prices (in US Dollars) were not going to be any dearer in the future than they were in the present. With the US$ having probably embarked on at least an intermediate-term downtrend, we think the greatest effect of this current bout of inflation will be seen in the prices of commodities. 

Gold, due to its monetary quality, is usually the first commodity to respond to an inflation-induced rise in commodity prices (gold will sometimes respond 1-2 years in advance of such a trend change). So far this year we've seen good relative strength in the prices of gold and gold stocks, something that is consistent with our view that a bull market in commodities is likely during 2002 and 2003. If we are correct then it is still very early in the new cycle and gold should remain our major focus for now. However, it is not too early to start thinking about the next opportunity: copper.

Copper has been in use for about 7,000 years and, nowadays, is used in everything from telecommunications to refrigeration, from lighting to industrial valves, from electronics to automobiles, from aircraft to plumbing and heating, from coins to power generation and countless other applications. However, despite copper's widespread and growing usefulness throughout the economy the copper price is, today, little changed from where it was 20 years ago. Over the same period the Dow Jones Industrial Average is up by over 1,000%. In inflation-adjusted terms, the copper price is probably lower now than it has ever been.

Copper's historically-low price has led to the closure of copper mines and will probably lead to further reductions in mine supply over the coming months. It is likely that the mines that have been and will be closed will not be re-opened until after the copper price has moved much higher and has demonstrated an ability to stay at that higher level. As such, any increase in demand resulting from the massive inflation that rages behind the scenes and the planned increases in government spending (the military build-up plus the misguided attempts to stimulate the economy via greater spending on infra-structure) should have an out-sized effect on the copper price. Note that the copper price will begin to move up in advance of any increase in demand for the physical commodity because speculators in the futures markets will anticipate such changes in demand.

So, what is the best way to profit from the coming bull market in copper? In our opinion, becoming a part-owner of the world's second-largest copper producer (Phelps Dodge, NYSE: PD) is a good option.

The dismal performance of the copper price since 1997 is reflected in the following chart of Phelps Dodge. PD is now trading at a level not seen since the 1990-1991 recession.

It is preferable to buy stocks after they have pulled-back within an overall up-trend. However, buying a cyclical stock after it has just reached its lowest price in 10 years and is close to the bottom of a long-term channel can also work well.

PD's current market cap is about $2B. At this year's depressed copper price its total sales are going to be around $4B. This means that a 10% increase in the copper price will add roughly $400M to PD's pre-tax cash-flow and a 10% decrease will subtract $400M (this is not strictly correct since PD does not generate all of its revenue through the sale of raw copper, but is a reasonable assumption for our back-of-the-envelope calculation). In other words, PD offers huge leverage to the copper price - its market cap is very small compared to the amount of money it could make or lose if the copper price moves by only 10%. 

We are going to immediately add PD to the TSI Portfolio. We are confident that the stock price will be much higher in 12 months time than it is now, but the risk is we could be a few months early. As discussed in last week's Interim Update the copper price bottoms, on average, about 3 months after long-term interest rates bottom. Based on last week's bond market action it is likely that bond yields are in the process of making at least a short-term low (which is why we turned short-term bearish on bonds last week), but at this stage we can't rule out the possibility that even lower yields will be seen over the coming months before a major bond bear market gets underway. As noted in previous commentary we think that now is a reasonable time to start building positions in a few of the major commodity producers, but it is certainly not the time to mortgage the last 40 acres and put the proceeds into commodity plays.

The US Stock Market

Current Market Situation

The week of September 17-21 saw such extremes of bearish sentiment (as measured by a number of reliable sentiment indicators) and selling pressure that even if the market is destined to reach even lower levels in the years ahead the Sep-21 lows are unlikely to be penetrated for some considerable time (at least 6 months). The fear was palpable in the days following the market's re-opening on Sep-17, with months of selling and margin liquidation condensed into 5 days. The selling pressure was made more intense than it would otherwise have been by insurance companies dumping part of their stock holdings in preparation for claims related to the Sep-11 disaster.

Although last Friday's close for the S&P500 Index was about 14% above the Sep-21 intra-day low, fear still prevails judging by the way traders run for cover (the cover provided by put options) at the first sign of trouble. The overall put/call ratio was 0.96 on Friday, an extraordinarily high level for a day on which the major market indices finished in positive territory. This suggests that any pullback towards the Sep-21 lows in the near future will be a successful test of those lows rather than the start of another bear market leg.

Our view was and is that an important bottom for the market was created by the waterfall decline that ended on the morning of Sep-21, but that a test of the Sep-21 low would occur by the end of October. With everyone in the world expecting such a test (the bulls expect a successful test, the bears expect an unsuccessful test), the likelihood is that the market will find support at a level that is comfortably-above the recent lows and then rally anew. Note that although we say "comfortably-above", it won't feel comfortable for anyone with substantial long-side exposure since a decline to a higher low will initially look the same as a plunge to new lows.

So far, things are coming together as they should if the Sep-21 bottom is going to endure beyond the short-term. In particular, the latest COT Report showed that the Commercial net-short position had fallen to 43,000 contracts as at Oct-02, down 40,000 contracts in the space of 12 trading days. Furthermore, the Japanese stock market is showing signs of having turned higher. When the US stock market pulls-back to test its lows it will be important that the Nikkei also finds support above its lows of the past few weeks.

It looks to us like the market began its 'testing' pullback last Thursday morning after the December S&P500 futures contract spiked up to 1087, with news regarding the potential for more tax cuts giving the market a temporary boost on Friday. We bought one position in the QQQ (NASDAQ100 Trust) on Sep-25 and plan to add another position during the coming weeks if we see the sentiment, technical and inter-market evidence we are looking for to confirm a successful test of the lows. The next rally has the potential to be spectacular. 

The difficulty with trying to come up with any short-term forecast for the markets at this time (all the markets, not just the stock market) is the high probability of events occurring that could cause huge moves in either direction. For example, if the US-led coalition begins its military assault and meets with some early success then the major stock indices could add a quickfire 10%. By the same token, another terrorist attack in the US would precipitate a sharp decline. All we can reasonably do is trust our indicators and not bet the ranch on any particular short-term view of the future.

This week's important economic/market events
 

Date Description
Thursday October 11 ECB Meeting
Import / Export Prices
Friday October 12 PPI
Retail Sales

Gold and the Dollar

Current Market Situation

From last week's Interim Update: "There is still a chance that a pop in the gold price could occur in parallel with the up-coming pullback in the stock market, but traders should be quick to exit at the first sign of weakness." One sign of weakness was identified as being a daily close below $290 in the December futures contract. Another would be a break of the up-trend in the ratio of gold stock prices to the bullion price.

At this stage we haven't seen any sign of weakness and have therefore not yet done any selling. December gold did not close below $290 and last week was the second 'inside week' in a row (the gold price traded within the range of the previous week). The weekly chart (see below) illustrates the contracting trading range over the past 3 weeks and can be likened to a spring that is progressively being coiled more tightly. Unfortunately, the chart doesn't tell us which way the price is going to break when the spring uncoils. 

As the following chart shows, the ratio of gold stocks (represented by the TSI Gold Stock Index - TGSI) to the gold price remains within its up-trend. A short-term, and possibly a medium-term, sell signal would be generated if the ratio breaks below this up-trend. However, a major peak in the gold bull market is unlikely to occur until the ratio moves to about 3:1.

The reason we developed the TSI Gold Stock Index was because the existing gold stock indices did not do a good job of representing the performance of the world's major gold stocks. TGSI comprises Barrick Gold, Placer Dome, Newmont Mining, Homestake, Anglogold, Harmony Gold, Gold Fields, Normandy Mining, Lihir Gold and Franco Nevada, with each stock given an equal weighting. Below is a chart comparing the TGSI and the XAU since March 2000. Note that the two indices tracked each other quite well until May of this year when a divergence began to develop. Whereas the XAU is currently about 13% below its May peak, the TGSI has moved to new highs for the year.

If the gold price is going to make a final upward thrust before beginning a correction then the most likely time for that to happen is in parallel with a pullback in the stock market. Since a) there is some evidence that a stock market pullback has already commenced, b) the weekly gold chart is poised for a breakout, c) the TGSI is already surging, and d) the Australian and South African gold stocks have recently begun to out-perform their North American counterparts (something that tends to happen in the latter stages of a gold rally), the coming week is a definite candidate for such a final thrust.

The Dollar Index continues to flag higher within its downward-sloping channel (see the chart in last week's IU), thus leaving the door open to a sharp near-term drop to around the 108 level. There is a good chance that this week's action in the currency market will set the stage for the coming few months since it will now take very little movement in either direction to create a breakout, one way or the other.

Adding Liquidity

As evidenced by the behaviour of short-term lease rates, central banks have practically been giving gold away to anyone who wished to borrow it over the past 2 weeks. This is most likely being done to create the illusion of financial market stability. Governments and their bankers are doing their best to distort our view of the fundamentals, but the fundamentals are what they are. A gold rally was stopped in its tracks in 1999, but the fundamental backdrop is now very different. 

In the short-term the price-fixers might be successful, particularly if the military operations in Afghanistan can achieve some initial success and thus give a temporary boost to confidence. Beyond the next couple of months they cannot be successful because central banks can create currency, but they can't determine how that currency is used. The 165 billion dollars that was added to the total US money supply during the week ended Sep-17 is sufficient to purchase about 13% of all the gold ever mined in the history of the world. The $900 billion dollars that have been added to the total US money supply over the past 12 months are enough to purchase about 75% of all the gold mined in the history of the world. If we also take into account the money created outside the US then enough new fiat currency has been manufactured over the past year to purchase all the gold ever mined. Unless central banks can either find a way to convince investors throughout the world to ignore the massive inflation that continues unabated or a way to create new physical gold as quickly as they can add 'ones' and 'zeros' to the memory banks of computers, they will be powerless to prevent a dramatic rise in the gold price. This doesn't mean that we should stubbornly cling to our gold stock holdings no matter what (our goal is to make money every year, not hold-out for one magnificent pay-day at some undefined point in the future), but we need to keep this big picture view in mind. The attempts of central banks to keep a lid on the gold price will inevitably be swamped as a result of their own profligate monetary policies.

Changes to the TSI Portfolio

PD added at $27.30 with an initial sell-stop set at $23.00.

 
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