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.

Bonds commenced a secular BEAR market in June of 2003. (Last update: 22 August 2005)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000, where "secular bear market" is defined as a long-term downward trend in valuations (P/E ratios, etc.) and gold-denominated prices. This secular trend will bottom sometime between 2014 and 2020. (Last update: 22 October 2007)

The Dollar commenced a secular BEAR market during the final quarter of 2000. The first major downward leg in this bear market ended during the first quarter of 2005, but a long-term bottom won't occur until 2008-2010. (Last update: 28 March 2005)

Gold commenced a secular bull market relative to all fiat currencies, the CRB Index, bonds and most stock market indices during 1999-2001. This secular trend will peak sometime between 2014 and 2020. (Last update: 22 October 2007)

Commodities, as represented by the CRB Index, commenced a secular BULL market in 2001. The first major upward leg in this bull market ended during the second quarter of 2006, but a long-term peak won't occur until at least 2008-2010. (Last update: 08 January 2007)

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Outlook Summary

What's gold worth?

Gold doesn't have any intrinsic value. Rather, the value of gold, like the value of most things, is subjective (it's in the eye of the beholder). For example, if you are stranded on an island by yourself with no hope of ever being rescued then gold will probably have no value to you whatsoever; however, if you are living in a city and are concerned that the government is systematically destroying the purchasing power of your country's money then you will probably assign a high value to gold.

Although it is not possible to determine an objective value for gold, by looking at how the metal has performed relative to other things throughout history we can make some reasonable assumptions about its future performance. For example, previous long-term bull markets in gold have never ended until after the Dow/gold ratio has dropped below 5, so it is probably reasonable to assume that gold will trade at more than one-fifth the price of the Dow before the current gold bull market comes to an end.

Another way of quantifying gold's potential upside is to review the monetary metal's performance relative to the supply of US dollars. Along these lines we include, herewith, a chart of the gold/M2 ratio (the US$ gold price divided by M2 money supply, with M2 expressed in billions of US dollars).

Our chart makes the point that there tend to be long periods when gold lags money-supply growth (inflation). It then catches up to where it should be based on the growth in the supply of money that has occurred over preceding decades. And finally, due to widespread fear/anticipation of further rapid inflation, it moves way above the price that would be justified solely by changes in the money supply.

Interestingly, relative to M2 the 1971 bottom for gold was roughly the same as the 2001 bottom.

Gold's first multi-year rally during the 1970s took the gold/M2 ratio up to around 0.2 and our thinking is that this first rally was primarily about getting the gold price to where it 'should' have been based on money-supply considerations alone. In other words, we suspect that multiplying M2 by 0.2 is another way of arriving at a minimum upside objective for gold's long-term bull market.

M2 is presently $7630B, giving us a minimum long-term upside objective of around $1500 for gold assuming a static M2. A more realistic assumption is that M2 will at least double over the coming 10 years, leading to a minimum expectation of $3000/oz for the US$ gold price.

Of course, gold will likely garner a substantial speculative (fear-related) premium towards the end of the current bull market. During the 1970s this speculative premium took the price more than 100% above the level that would have been justified by changes in the money supply.

The Stock Market

Current Market Situation

...the January panic pointed to a re-test within three months and the re-test is currently in progress.

The 10-day moving average of the equity put/call ratio has only been higher than its present level on three occasions over the past 10 years -- September-2001 (at the finale of the 9/11-related panic), September-2002 (within three weeks of the 2000-2002 bear market's ultimate low), and February-2003 (within three weeks of the successful test of the October-2002 low). Furthermore, the current extreme high in the 10-day MA of the equity put/call ratio is accompanied by a relatively low reading in the 10-day MA of the OEX put/call ratio, which suggests that the public is now very fearful while professional money managers are relatively complacent. The situation is illustrated by the following chart (note that put/call highs appear as lows on the chart due to the inverted scale).

The historical record of the put/call ratio suggests that the US stock market is close to an important low in terms of time, but doesn't preclude an additional sharp price decline over the coming few weeks. The message of other sentiment indicators is similar.

Our view over the past several weeks has been that the January low would, for all intents and purposes, prove to be the low for the first half of 2008 even if a cyclical bear market had begun (we think that a cyclical bear market commenced last year), but that this low would very likely be tested before a multi-month rebound got underway. The market is currently in the process of testing its low for the year and could spike to new lows as part of this process, but it shouldn't make a sustained move under the January low. The ideal bullish set-up would involve a drop to new lows, followed quickly by an upward reversal.

One thing lacking at this time is price-related evidence that a low is in place. The following chart, for example, shows that the S&P500 Index reversed lower from the vicinity of its channel top late last month and has since dropped back to near the middle of this channel. It is near support defined by its January low, but is still about 60 points (5%) above its channel bottom. We think the channel bottom defines the immediate downside risk.

The following chart also shows the HYG/LQD ratio, which is, in effect, a credit spread whereby a rising ratio reflects a contraction in corporate credit spreads (bullish). There is potentially a positive divergence in the works in that last week's decline in the S&P500 was not confirmed by HYG/LQD, with "potentially" being the operative word at this stage.

To summarise, the January panic pointed to a re-test within three months and the re-test is currently in progress. We think there's a risk of a brief spike to new lows as part of the testing process, but we do not think that there's a significant risk of a new downward leg getting underway at this time.

The "1973 Model", which we are applying in our analysis of the gold sector, could also have relevance to the broad stock market. We have therefore presented, below, a decisionpoint.com chart showing the US stock market's performance during 1972-1974 (the top section of the chart shows the NYSE Composite Index and the bottom section shows the number of NYSE stocks making new lows).

Our thinking is that the May-1973 day on which there were more than 1100 new lows could be akin to 22nd January-2008 -- a day on which, for only the fifth time in the past 40 years, there were also 1100+ new lows. If we take the "1973 Model" literally then the current test of the January low will be followed by a short rally and a second test of the low next month, but the main point is that the May-1973 panic low -- the equivalent of the 22nd January low -- was not decisively breached for more than 5 months, even though a major bear market was in progress.

Hong Kong

With reference to the following chart, the rally in Hong Kong's Hang Seng Index (HSI) during August-October of last year was truly extraordinary. In fact, it was the fastest 50% rise in a major developed-world stock index that we can recall ever seeing. Hong Kong's long-term equity bull market probably remains intact, but this hasn't prevented the HSI from doing what most markets do following breathtaking run-ups -- retrace the bulk of its near-vertical ascent.

We are featuring the HSI in today's report because we think it has reached the point where its intermediate-term upside potential outweighs its downside risk. The ideal time to buy exposure to the Hong Kong market -- via EWH in the US -- would be when the HSI trades in the 20000-21000 range, but there is no guarantee it will get that low so investors could START averaging in immediately.

By the way, it is reasonable to expect that the grain markets will go the way of the HSI once their parabolic up-moves come to an end.

This week's important US economic events

Gold and the Dollar

The US$

Current Market Situation and Risk/Reward Discussion

...the 'oversold' extreme registered at the end of last week suggests that the short-term risk/reward is skewed toward reward.

A market's reaction to news is only really interesting to us when the market does the opposite of what conventional wisdom suggests it should do in response to the news. For example, if the Dollar Index had sold off in reaction to Friday's dismal US employment data and retained most of its losses through to the close it would have simply meant that nothing had changed; but the fact that the Dollar Index sold off in reaction to the bearish news and then recouped all its losses is potentially a sign that the trend is changing. This price action combined with the Dollar Index's position within its well-defined channel (see chart below) has prompted us to return our short-term US$ outlook to "bullish".

Does this mean we think the Dollar Index has bottomed?

In a word: no. In real time we never know, and never claim to know, when a market we follow is at a top or a bottom (it will only ever be possible to confidently identify a market top or bottom some time after -- usually at least several weeks after -- the event). Instead, we base our outlooks, including our current short-term bullish outlook on the US$, on an assessment of risk versus reward.

By way of further explanation, the words "bullish" and "bearish" have no meaning to us except as ways of describing how we view the probability and expected magnitude of a market's upside relative to the probability and expected magnitude of its downside. For example, if we think a market has a 70% chance of rising 5% and a 30% chance of falling 20% over the timeframe in question, then we will either be "bearish" or "neutral" on that market even though we think the odds favour a rise. The reason is the magnitude of the perceived downside risk. If you place bets where the risk-reward equation is the same as in our hypothetical example then you should expect to win 70% of the time, but your expected outcome over a large number of such bets will be a loss of 2.5% (0.70*5% + 0.30*(-20%)). In this hypothetical situation it may be possible for you to manufacture a favourable expected outcome by using some sort of risk management strategy, such as a protective stop, but this is beside the point. When we describe our outlook as being "bullish" or "bearish" we are not presenting a specific trading recommendation; we are simply expressing an opinion.

The difference between a trading recommendation and an opinion was discussed in the 24th September 2007 Weekly Update under the heading "Opinions, Facts, Trading and Investing", and was exemplified by the recommendation in our 13th and 18th February commentaries that traders go 'long' GDX (the Gold Miners ETF). At that time our short-term gold-stock outlook was "neutral", but we thought it made sense to buy this gold mining ETF for a trade at around $47.70 because downside risk could effectively be limited to around 5% by placing a sell stop just below support defined by the early-February low. Our thinking was that either support would quickly give way, signaling additional downside and taking a trader out of their position with a small loss, or a rally yielding a double-digit percentage gain would soon begin. As it turned out a rally soon began, so the trading idea worked well.

Getting back to the US$, the 'oversold' extreme registered at the end of last week suggests that the short-term risk/reward is skewed toward reward. Even a counter-trend rebound back to the channel top over the coming 1-2 months would result in a meaningful gain of around 7%, although if we thought that 7% represented the maximum upside potential we wouldn't be bullish because the short-term downside risk is probably around 5%. We are bullish because we think the dollar's upside potential is around 20%.

This doesn't, however, mean that we would buy the Dollar Index for a short-term trade. In our opinion the odds are in favour of the US$ out-performing the euro over the coming 3 months and over the coming 12 months, so if our only options at this time were to be 'long' the euro or 'long' the US$ then we would choose the US$. Fortunately, though, these aren't our only options.

We think the best position at this time is to have NO large bets that require the financial world to do anything in particular in the short-term, and to be heavily exposed, on an INTERMEDIATE-TERM basis, to gold-related investments/speculations. Gold is an anti-official-currency play more than an anti-US$ play and therefore stands to benefit from problems in either, or both, of the senior currencies.

Why is the US$ so weak?

The downward pressure on the dollar stems from what's happening on the interest rate front, which is, in turn, a ramification of the on-going debt/credit crisis. Short-term US interest rates have recently gone into freefall, causing the Fed to fall much further behind the market. The US central bank now finds itself in the position where it must slash its Funds Rate target yet again in order to catch up with what the market has already done. The market, of course, knows this, and has discounted a fall in the Fed Funds rate from its current level of 3% to below 2% over the coming three months, with 75 basis points of this decline expected to occur at the 18th March FOMC Meeting.

But in its efforts to perpetuate inflation the Fed is currently doing, and will continue to do, more than simply reduce the Fed Funds rate target. For example, via the Term Auction Facility (TAF) that came into being last December, an expansion of which was announced on Friday, and via a new method of conducting its "repo" operations, also announced on Friday, the Fed is helping US banks by taking relatively illiquid securities off the banks' balance sheets and replacing them with highly liquid US Treasuries. A well-written review of the Fed's recent actions can be found at http://interfluidity.powerblogs.com/posts/1204920896.shtml.

The current interest rate situation and Fed actions are certainly 'dollar bearish' fundamentals, but they are fundamentals that are well known; and "well known" means fully (or almost fully) discounted in the current price.

What the market does not appear to have come remotely close to discounting are the problems within the European Monetary Union, one of which is discussed HERE. It seems that most traders are fixating on the US dollar's negatives whilst turning a blind eye to the euro's negatives.

Gold

Below is a daily chart of April gold futures.

The gold market is 'overbought', but unlike some other commodities it has not yet experienced an 'upside blow-off'. As a result, any downward correction that begins from near the current price has a good chance of being the routine short-term variety (a downward move within the context of an on-going intermediate-term advance). A routine short-term correction beginning from near the current price is one of the two most likely outcomes. The other is that gold's rally will soon enter 'blow-off mode', leading to a peak of intermediate-term significance within the coming several weeks.

For an upside blow-off to remain a likely near-term prospect the gold price should not close below last week's low and must not close below support defined by the January high.

If the gold market does experience an 'upside blow-off' over the coming several weeks it will probably be because we have under-estimated the dollar's short-term downside risk, although a moon-shot in the price of the monetary metal could also be driven by more widespread recognition of the euro's problems.

Gold Stocks

Below is a chart showing GDX (the Gold Miners ETF) and the GDX/gold ratio. Short-term traders who are 'long' GDX should, we think, raise their sell stops to around $51.50.

As we've shown on the chart, the price pattern over the past several months could be interpreted as a "rising wedge". Such patterns are widely considered to be bearish, but based on our experience a "rising wedge" is just as likely to end in an upside breakout as in a downside breakout.

We have no opinion on whether GDX is more likely to break upward from its 'wedge pattern' in the near future and surge to an April-May intermediate-term peak, or 'correct' for about two months before resuming is intermediate-term advance. Hence, our short-term neutral view on the major gold stocks.

We are, however, unequivocally bullish on the junior end of the gold sector over every timeframe. If the majors and the mid-tiers pull back over the coming two months then the juniors will certainly follow suit, but at the junior end of the market the downside risk is low RELATIVE TO the potential rewards (due to the immensity of the potential rewards). Many juniors are very under-valued and, as noted in last week's Interim Update, immersed in lengthy consolidation patterns that should act as launching pads for quick and substantial gains once upside breakouts occur.

The following chart from the Resource Stock Guide web site is interesting. It compares the performance of a group of high-performing mid-tier gold stocks (the "Benchmark Index", shown in blue) with the performances of junior producers, 2nd-stage explorers (exploration-stage gold miners with proven resources) and 1st-stage explorers (exploration-stage gold miners that don't yet have any proven resources), and illustrates what we know from experience -- that the small-cap gold stocks have been relatively poor performers over the past few months. It is partly this recent relative weakness that creates the additional upside potential amongst the small-caps.

Note that our primary focus is on the junior producers and the 2nd-stage explorers. Once in a while we will make an exception, but we generally aren't interested in companies that don't yet have proven in-ground resources.

Update on Stock Selections

(Note: To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question)

First Majestic Silver (TSX: FR). Shares: 63M issued, 77M fully diluted. Recent price: C$5.07

FR announced a sizeable equity financing after the close of trading last Wednesday, which had the effect of pushing the share price down from the C$5.60s to support in the low C$5 area. 

The timing of this new issue of shares was bad in that the stock had only just broken out to the upside from a lengthy consolidation and appeared to be building some upward momentum. However, the bad news for those of us who already have full positions in the stock is good news for those looking for opportunities to buy.

FR offers substantial leverage to the silver price, and due to its 4.5M ounces/year of current production is not as risky as most juniors with similar market caps. It is suitable for new buying near the current price.

Chart Sources

Charts appearing in today's commentary are courtesy of: