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   -- Weekly Market Update for the Week Commencing 10th March 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) will move below their 2002 lows during the first half of 2003.

The US stock market will reach a major bottom (well below the October-2002 low) during 2003.

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

A bull market in gold stocks commenced in November 2000 and will continue during 2003.

Commodity prices, as represented by the CRB Index, will rally during 2003 and 2004 with most of the upside occurring in 2004.

TSI Vacation

Thanks for your patience over the past 2 weeks. We did send out one e-mail alert while we were away (on 3rd March as forewarned in the 24th Feb Weekly Update), but fortunately nothing particularly dramatic happened during our absence. The drama can start now.

War and the Markets (Update)

The US and Britain want the UN to pass a new resolution giving Iraq until 17th March to disarm or face military action, but France, Russia and China have indicated they will veto such a proposal. The permanent members of the UN Security Council therefore remain divided over how to deal with Saddam Hussein.

The financial markets also appear to be in several minds as to what is going to happen in the Middle East. For example, the oil price has surged over the past few months, partly in anticipation of a major supply shock relating to war in the Middle East. At the same time, though, the stocks of US defense contractors - companies that stand to benefit from a war - have fared poorly (the General Dynamics (GD) stock price has fallen by 50% over the past 8 months and by 30% since the beginning of this year). It could be argued that the stock market has factored in a quick and decisive victory for the US, meaning that whatever benefit the defense contractors were going to get from a war has already occurred, but if this was really the case we would expect the US$ to be stronger and the oil price to be weaker.

Our view is that there will be some sort of resolution to the Iraq-related uncertainty before the end of this month, but that this resolution will not alter any existing trends in the financial markets. The primary trends for the S&P500 Index and the US$ will still be down and the primary trends for gold and gold stocks will still be up. There will almost certainly be a stock market rally in response to the upcoming 'war resolution', regardless of what that resolution happens to be, but if the rally begins from near current levels or higher it will be short (a few weeks at best) and weak. If, however, the rally begins from well below last October's low it will likely be powerful and definitely worth participating in. The gold market's initial reaction to a perceived resolution of the war uncertainty will probably be to take the gold price sharply lower, but the negative reaction would likely be short-lived (days, not weeks) and would create a wonderful buying opportunity for anyone brave enough to fade the knee-jerk reaction of the herd. 

Interest Rates

We've got a few important things to note with regard to the outlook for interest rates, but don't have the time today to go into any details. So, here's the synopsis:

1. The Fed Funds Rate (the interest rate set by the Fed) has followed the ECRI's Future Inflation Gauge (FIG) with great consistency over the past 15 years. At least, this was the case until early-2002. However, over the past 12 months an enormous divergence has developed between the Fed Funds Rate and the FIG (see chart below). The last time the FIG was near current levels the Fed Funds Rate was at 5.5% (on its way to 6.5%).

2. The performance of the FIG suggests that the Fed should now be aggressively hiking interest rates. However, the yield on 3-month T-Bills - the short-term interest rate set by the market - has just fallen to an all-time low of 1.10% (0.15% below the Fed Funds Rate). The behaviour of the T-Bill yield suggests that the Fed's next move will be to cut interest rates.

3. Last week, bond futures met our expectation that new highs would be seen during the first half of this year. Furthermore, if we had no information to go on apart from the below chart we would now surmise that bond futures were headed for 120. Considering the message of the FIG it is difficult to believe that bonds will move substantially above their current lofty level, but we certainly wouldn't be stepping in front of the bond train at this time. 

4. Our forecast for new highs in bonds during the first half of this year was almost solely based on our bearish outlook for the stock market. This is because bonds have, for the past few years, been trading more as anti-stocks than as the US Government debt securities they really are. Our short-term bullish view on bonds was, however, also supported by the on-going upward march of the Japanese bond market. Japanese Government Bonds (JGBs) closed at new all-time highs at the end of last week.

The US Stock Market

Current Market Situation

Over the past few years bonds have tended to reach extremes at around the same time that the stock market has been reaching opposite extremes. For example, bonds bottomed in March of 2002, within 2 weeks of the stock market reaching an important peak, and then peaked in October-2002 on the same day the stock market bottomed. So, the recent move to a new high by bond futures is probably warning us of an impending drop to a new low by the stock market.

The bond market's message is consistent with the on-going weakness in the US$ because the US$ is positively correlated with the US stock market. Last week's break by the Dollar Index to a new bear market low might therefore be a sign that the currency market is discounting a drop to new lows by the stock market.

Technical and sentiment indicators are presently 'mixed' and haven't altered significantly over the past week. In fact, the following passage from the Market Alert e-mail sent to subscribers on 3rd March is still applicable:

"...the past week's tedious drift has helped work-off the 'oversold' condition that existed when we wrote the 24th February Weekly Update. For example, the 10-day moving average of the equity put/call ratio has fallen to 0.65, one of the lowest readings of the past several months and only marginally higher than the levels reached at the early-December and early-January market peaks. Also, after being at a very oversold level of -170 only 3 weeks ago the McClellan Oscillator closed last week at +70.

Markets never move in a straight line for long and when a downward-trending market becomes extremely oversold, as was the case with the US stock market in mid-late February, a rally will often occur to alleviate the pressure. However, when an oversold extreme leads to only a weak rally, as has also been the case with the US market over the past 1-2 weeks, there is a good chance that the downtrend is still in force. As such and although the major sentiment surveys still show moderate levels of bearishness, with the oversold condition reflected in a number of indicators having now been eliminated without the market making much upward progress it is likely that the short-term downtrend is about to resume."

In all likelihood the market will move lower before a significant rally occurs. Also, our view remains that a low will be in place by the end of March. Whether the rally following this low will be worth trading aggressively or not will be determined, to the greatest extent, by how far the market falls in the mean time. 

World Markets

The Australian, French, German, UK and Japanese stock markets are currently below last October's lows, while the US, Canadian and Hong Kong markets remain above their October lows (by only 1.5% in the case of Hong Kong's Hang Seng Index). With its drop to a new bear market low at the end of last week Japan's Nikkei225 Index was the latest casualty.

What to do?

The stock market, since October of last year, has been one of the most frustrating markets we've ever had to deal with because there has been no follow-through in any direction at any time. The market reached its closing low on 9th October of last year and then embarked on what many commentators have, from time to time, labeled a new bull market. However, all that really occurred following the 9th October low was a sharp 4-day bounce. Subsequent to that 4-day bounce most major stock indices have either drifted lower or traded sideways, with no meaningful swings occurring in either direction. There is clearly little buying interest in the market, no doubt as a result of unattractive valuations, non-bullish price behaviour, concerns over the prospect of war and the fact that the vast majority has remained heavily 'long' throughout the entire bear market. There has also been minimal selling interest, seemingly because retail investors have decided to 'ride out' the storm and professional investors are too worried about the prospect of the much-discussed war rally to 'short' the market with any real conviction. The end result: A market that has been difficult to trade, particularly for those using options in an attempt to profit from the expected 'swings'.

The below chart of the S&P500 Index in terms of gold (the S&P500/gold ratio) does a good job of illustrating the indecisive nature of the current market environment (indecisive, that is, from a short-term perspective only because the longer-term outlook could not be more decisive). A low-risk trading opportunity would occur if the S&P/gold ratio moved to either the top or the bottom of the major channel shown on this chart. Unfortunately, the ratio is currently near the mid-point of its channel.

We have done very little in the market over the past several months because we haven't been able to identify trades with attractive risk/reward ratios. We have suggested a few option trades and managed to exit a Dow put-option trade with substantial profits. At the same time, though, we have seen the prices of our QQQ put options get whittled down by the market's tedious grind, despite the fact that the QQQ is lower now than it was when the put options were added to the Stocks List. Also, we recently suggested that traders take an initial position in Alcoa (NYSE: AA) and expect to add to this position, as well as purchase a few other commodity-oriented stocks, during any general market shake-out over the next few weeks. The problem is, the market is resisting all attempts to take it significantly lower and without some sort of selling climax we will not be presented with a good buying opportunity (we doubt that any rally beginning from above last October's lows will add more than 10%-15% to the major indices). If we don't get a genuine selling climax it will come down to the question of whether or not it is worth buying just for the sake of gaining some exposure to the rally that might occur once the war-related uncertainty is temporarily removed. The answer to this question is a qualified no. We say "qualified" because even if the risk/reward in the overall market is unattractive as far as new buying is concerned there may be good opportunities to buy individual stocks or to use call options to gain some exposure to the potential upside without putting much money at risk.

We've identified Alcoa as a reasonable buy near its current level and have noted that its risk/reward ratio would improve substantially if it dropped to near the bottom of its major channel (see chart below). As such, we've added an initial position in AA and plan to buy more if it drops to the $14-$15 area. Note that it would also be reasonable to do some buying near the October low (around $18). The reason for 'scaling in' during weakness, rather than simply waiting for a plunge below $15 before doing any buying, is that the risk/reward is acceptable at current levels from both valuation and technical perspectives and the price might not drop to major support before the next significant rally occurs. 

Other potential long-side speculations over the next month or so, depending on market action, include copper producer Phelps Dodge (NYSE: PD) and chip-maker Micron Technology (NYSE: MU). From a fundamental perspective Micron has very little going for it, but it is a stock that should rally sharply if the overall market temporarily recovers (especially if it first spikes down to a new bear-market low below $6.60).

The tedious grind of the past few months will end soon with the market following-through to either the upside or the downside. As discussed above we think there will be some downside follow-though (a move to new lows for the year), followed by a rally, with the size of the rally being determined mostly by how far the market falls over the next few weeks.

One point worth reiterating at this time is that the market is destined to move MUCH lower than current levels before the bear market ends. In fact, we expect the major US stock indices to trade 30%-50% below their current levels at some stage during the coming 18 months. What this means is that longer-term investors should not be considering any buying at this time. The buying opportunity that will potentially emerge over the next few weeks will not be 'investment grade' because valuations are still way too high. At best, it will just be another trading opportunity.

This week's important economic/market events
 

Date Description
Monday March 10 No significant events
Tuesday March 11 No significant events
Wednesday March 12 Trade Balance
Thursday March 13 Retail Sales
Import / Export Prices
Friday March 14 Current Account for Q4 2002
PPI
Industrial Production

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