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

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.

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Gold versus Commodities

The below chart compares the gold price, since 1970, with the ratio of the gold price and the CRB Index. Interestingly, the two chart patterns are almost identical over this 34-year period. (Thanks to Nick Laird at www.sharelynx.com for supplying some of the data used to create this chart.)

The implication of the above chart is that when gold is in a long-term up-trend it not only rises against the US$ (and other fiat currencies), it also rises against most commodities. Similarly, when gold is in a long-term downtrend it not only falls against the US$ it also falls against commodities. In other words, if we are right that the US$ gold price is in a long-term upward trend then over the remainder of this decade we should expect that the gold price will continue to trend higher relative to the CRB Index. There will probably be some individual commodities that do better than gold over the next five years and there will no doubt be periods during which the CRB Index will out-perform the gold price, but long-term investors looking for a relatively low-risk way of participating in the emerging bull market in commodities should just buy gold.

The US Stock Market

Current Market Situation

The evidence continues to build that the US stock market is within 4-6 weeks of making an important peak. For example, the NDX/Dow ratio -- a measure of the level of risk aversion in the market -- has just edged below its 70-day moving average for the second time in the space of a month (see chart below). And perhaps of even greater significance, the new recovery highs in the Dow Industrials Index and the S&P500 Index that occurred last week were not confirmed by new highs in the NDX/Dow ratio. 

Our expectation has been that the NDX/Dow ratio would turn down prior to a major peak in the market, so while the recent weakness in this ratio is not exactly decisive it is consistent with our view that January-2004 is a likely time for a major peak.

Another sign that market participants might be starting to become a little more circumspect (a little less willing to ignore valuation risk) is the recent weakness in the Micron Technology (NYSE: MU) stock price. Micron is a perennial money loser, but facts such as this tend to be conveniently ignored as long as a general trend towards more risky investments remains in force. 

The below chart shows that MU has just dropped below the bottom of the range in which it has moved over the past 5 months, although all is not lost for the Micron bulls because the stock has, to date, managed to hold above its 200-day moving average.

From a US-centric perspective the US stock market has had a very good year, but from the perspective of a European investor the US market's performance has been unimpressive. In fact, when measured in terms of the euro the S&P500 is currently about the same as it was during the first week of January. Furthermore, the S&P500 in terms of the euro is yet to make a higher high on an intermediate-term basis (the below chart shows that S&P500/euro has made a sequence of lower highs since August 2002). 

Critical support for the S&P500 in terms of the euro exists at 850 and a decisive move below this support could prompt Europeans to exit the US market en masse. At the current exchange rate, 850 for the S&P500/euro ratio corresponds to 1033 for the nominal S&P500 Index.

There's another Federal Open Market Committee (FOMC) Meeting this Tuesday and it will be interesting to see if there is any significant change in the wording of the monetary policy statement. Unless we've under-estimated the incompetence of the Committee members the announcement should be worded in such a way as to indicate that the risks of rising inflation and falling inflation are now in balance. If this turns out to be the case then the FOMC Meeting probably won't have much influence on the markets apart from causing a temporary increase in volatility. If, however, Tuesday's monetary policy statement still contains the ridiculous assertion from previous statements that "the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future" then the US$ will probably accelerate lower. And this would no doubt generate some negativity in the stock market.

This week's important economic events
 

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

Gold and the Dollar

Gold and Currencies - contemplating some possibilities

At the end of last week the December Swiss Franc closed at 78.42 (versus our upside target range of 78-80), the December euro closed at 121.63 (versus our target of 122), the cash Dollar Index closed at 89.15 (versus our target of 89), and February gold closed at $407.30 (versus our short-term target range of $410-$420). So, if our targets are roughly 'on the mark' then the US$ is within 1% of a short-term bottom and gold is within 3% of a short-term top.

As discussed in last week's Interim Update, we expect a 1-2 month rally in the US$ to soon begin from near the current level. This rally would likely be shallow and, we think, coincide with a final surge in the US stock market and some consolidation in the gold market.

An alternative worth considering, though, is that the currency and gold markets are going to overshoot our targets over the next 2-3 weeks. For instance, our target of 89 for the Dollar Index was arrived at by assuming that the Dollar would find support at the bottom of the downward-sloping price channel that began to form in October of 2000. However, in previous commentaries we've also mentioned the possibility that the steeper downward-sloping channel that began towards the end of 2001 (this channel is shown on the below chart) would remain in force. In this were the case then the Dollar Index would need to fall to around 85 before year-end in order to reach the channel bottom.

A drop of that magnitude in the US$ would probably light a fire under a gold price that has been consolidating nicely in the low-$400 area, resulting in our longer-term target of $460 being achieved within the next 2 weeks. 

The below chart shows the channel in which the gold price has been moving since the final quarter of 2000. Notice that prior to last week the only move outside this channel occurred in January of this year and that after breaking above the channel top in January the gold price continued higher for about 2 weeks before reversing course. With gold having just broken above its channel top for only the second time in more than three years something similar could be on the cards, perhaps in response to an overshoot to the downside (as far as our short-term targets are concerned) by the US$.

If the above-described alternative scenario plays out then the resultant extremes (a bottom for the dollar and a peak for the gold price) would probably be followed by much larger and longer counter-trend moves than we are currently anticipating. In particular, we've long expected that a drop in the Dollar Index to near the major support that exists in the low-80s would complete the first phase of the Dollar's bear market and be followed by a rebound (or stabilisation) lasting 1-2 years. 

One problem with the idea that a downward spike in the Dollar over the next few weeks could create a bottom that holds for 1-2 years is that it doesn't mesh with what we see happening in the US economy and stock market over the next 6 months. Specifically, the evidence is steadily building that we are going to get a major peak in the stock market during the early part of next year and that the US economic recovery will run out of steam by the end of next year's first quarter. This, in turn, would make it unlikely that the US$ could experience anything more significant than an 'oversold bounce' over the next few months. 

It is, of course, possible that the Dollar Index will fall to 85 over the next 2-3 weeks, then rebound for 1-2 months, and then collapse anew to well below the long-term support that exists in the low-80s. However, considering the enormous amount of central bank intervention that would no doubt occur if the US currency threatened to break below long-term support, such a dire short-term outcome for the Dollar looks unlikely. 

It is also possible that we are under-estimating the underlying strength of the US economy and/or the ability of the US financial establishment to create enough liquidity to keep stock prices elevated for many more months. If this were the case then a 1-2 year period of US$ strength or stability would not be out of the question. However, this appears to be even less likely than the Dollar collapsing below major support in the face of massive and coordinated central bank intervention. 

Hopefully, the above discussion hasn't created too much confusion. In our opinion the odds continue to favour a short-term bottom for the US$ occurring near its current level, but the probability of a near-term overshoot is high enough to warrant a mention. If we do get such an overshoot we'll deal with the implications in more detail and, if necessary, revise our forecasts for the first half of next year.

We are presently short-term neutral on the US$ and will turn short-term bullish (whilst remaining long-term bearish) following a daily close in the cash Dollar Index above its 50-day moving average.

The A$ versus the euro

Over the past several years the Australian Dollar has tended to dramatically out-perform the euro during those periods when global stock markets were rallying and dramatically under-perform during stock market declines, most likely because the A$ is a 'growth' currency whereas the euro is a 'safety' currency. Therefore, once the US stock market begins heading lower in earnest we should expect the euro to start out-performing the A$, although if we are right about the stock market not peaking until January then the A$ could remain strong, relative to the euro, for another 1-2 months.

The A$ might be headed for a period of weakness relative to the euro during the first half of next year, but the longer-term downward trend in A$/euro has been broken (see chart below). In fact, A$/euro bottomed with commodity prices back in September-October of 2001 and has since been working its way higher. Therefore, if we are right about the bull market in commodities then A$/euro should make a sequence of higher highs and higher lows over the remainder of this decade. 

Gold in terms of the SA Rand

The South African Rand is continuing to make new multi-year highs against the US$ on almost a daily basis and this Rand strength is causing the Rand gold price to drift lower. However, whereas the Rand is making new highs against the Dollar the Rand gold price is still comfortably above the low reached in April of this year (see chart below). In fact, the relentless slide in the Rand gold price over the past 6 months looks more like a consolidation within a new intermediate-term upward trend than a continuation of the previous downward trend.

If there is a general pullback in the gold sector over the next 2-3 weeks (as per our current short-term forecast) then we will consider adding another SA gold stock -- either Gold Fields (NYSE: GFI) or Harmony Gold (NYSE: HMY) -- to the Stocks List.

Silver

When silver broke out of the contracting triangle shown on the below chart it created an upside target of around $5.80. This chart-based projection also happens to correspond with long-term resistance, so $5.80 was (and remains) our upside target for silver. We should, however, allow for an overshoot to around $6.20. This is because if the gold/silver ratio remains at its current level of 74 then our target of $460 for the gold price -- a target that should be reached within 6 months and could be reached as early as this month -- implies a silver price of $6.20.

Update on Stock Selections

A decision to sell a good stock in reaction to bad news when that news has no significant bearing on the company's longer-term fundamentals might look right in the immediate-term but often won't look right several weeks later. Such has been the case with Aquiline Resource (TSXV: AQI) over the recent past. 

The AQI stock price dropped from the C$0.90-C$1.00 range to around C$0.70 in response to a legal threat from IMA Explorations (TSXV: IMR). Our view was that this drop represented a buying opportunity because there didn't appear to be any downside to AQI as a direct result of the dispute with IMR (the only real threat appeared to be that AQI's management would be forced to devote resources to a lawsuit). As it turned out, buying AQI following the legal-threat-inspired sell-off would have worked out quite well as the stock-price has gained 50% over the past 4 weeks.

Is AQI still a buy at Friday's closing price of C$1.18? Well, we expect the AQI stock price to continue trending higher, but the real question is; if you decided NOT to buy last month in the 0.70-0.80 range why would you buy now? The only difference between now and then is that the stock price is now 50% higher.

In a bull market one of the most reliable strategies is to buy good stocks following sharp pullbacks.

We removed Northern Orion (TSX: NNO) from the Stocks List a couple of weeks ago when it traded up to C$3.40. We will return this stock to the List if it trades down to intermediate-term support at around C$2.50 before year-end. Note that the aforementioned price is not a forecast, it's just a price we would be happy to pay if the opportunity presented itself. 

Now is not a good time to be buying gold stocks for anyone who already has substantial exposure to the gold sector because the valuation risk is greater than it has been at any time since May of 2002. This valuation risk applies mainly to the large and mid-tier North American gold stocks, many of which are priced as if gold were already trading north of $500, and anyone with a lot of money invested in these stocks should probably be scaling out now.  

As far as our favourite junior gold stocks are concerned, now is a good time to 'sit tight'. These stocks would suffer from a downturn in the market (a downward reversal in leading stocks such as Newmont and Goldcorp would be likely to affect the entire sector), but in many cases are still under-valued relative to the current gold price and have huge upside potential. This large upside potential, relative to the general market risk, means that these stocks remain attractive from a risk-versus-reward perspective. 

The junior stocks are, of course, very volatile, and many people start to fret when the price of a stock they own suddenly drops by 10%-20% (daily moves of 10%-20% in either direction are not uncommon for the junior gold stocks). However, the effect on your portfolio of a sharp move in any individual stock can be dampened by making sure that a) your exposure to the juniors is spread over at least 7-10 stocks, and b) you always have a substantial cash reserve.

Despite the general market risk, for those that have almost no exposure to the gold sector some buying is warranted at this time and this buying should be focused on the under-valued juniors. Here are a few ideas for those looking to start a gold stock portfolio:

  - Exeter Resource (TSXV: XRC) at around C$1.00
  - Cumberland Resources (TSX: CBD) at around C$4.50
  - Northgate Exploration (AMEX: NXG) at around US$2.00
  - NovaGold Resource (AMEX: NG) at around US$4.80
  - NovaGold warrants (TSX: NG.WT) at around C$2.50
  - Patricia Mining (TSXV: PAT) at around C$0.80
  - Northern Orion (TSX: NNO) at around C$2.50
  - Metallica Resources (AMEX: MRB) at around US$1.50
  - Canarc Resource (TSX: CCM) at around C$1.00

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/



 
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