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   -- Weekly Market Update for the Week Commencing 10th November 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.

Commodities: Beneficiaries of the inflation

We've included, below, extracts from commentaries we wrote in October and November of 2001. Bear in mind that at a time these commentaries were written the CRB Index was near a 20-year low, the fear of deflation was widespread, and the consensus view was that strong money-supply growth would have little effect on prices.

From the 8th October 2001 Weekly Update: 

"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."

From the 5th November 2001 Weekly Update: 

"Our forecast for the next 12-18 months is that the high rate of inflation (money supply growth) over the past 12 months will boost prices and that commodities will be the major beneficiaries of the inflation. As is usually the case when commodity prices are pushed higher by inflation, bonds will not fare well.  

The above may seem like strange things to say with the CRB Index close to its lowest level of the past 20 years and the T-Bond price approaching its 1998 peak. However, last week's Treasury-engineered bond market rally actually solidifies our belief that large gains in commodity prices will be seen during 2002-2003."

From the 19th November 2001 Weekly Update: 

"Substantial and sustained increases in the supply of money always cause prices to rise. The only question is which prices will eventually benefit from the money supply growth. If a large proportion of the excess money is exchanged for imported goods then the trade deficit will grow and there will be downward pressure on the Dollar. Unless the rising trade deficit is offset by an increase in the demand for dollars from foreign investors, the dollar will fall. If the dollar falls then imports will become more expensive, thus allowing US-based manufacturers to also increase their prices. If the foreign investment demand for the dollar increases at a fast enough pace to offset the downward pressure on the dollar exerted by the trade deficit then US asset prices will rise. If most of the excess money is spent on domestically-produced goods and services then the prices of those goods and services will rise. Whatever happens, a price rise will occur somewhere as a result of the money supply growth. Our view is that the effect of this year's rampant money supply growth will be most evident in the prices of commodities over the next 2 years and that bonds will continue to 'take it on the chin'."

The above might seem like a shameless attempt at self promotion on our part, but with commodity-related investments having recently become the 'flavour of the month' we wanted to show that what is happening now was foreseeable during the darkest days of 2001. 

The commodity bull market is most likely still in its infancy. In fact, all the CRB Index has done over the past 2 years is complete the right side of a long-term basing pattern (see chart below). The CRB has strong resistance in the 250-265 range, but once above 265 we expect that a move up to the 1980 high (around 340) will occur rather quickly (within 12 months of a breakout from the base).

Apart from the price action in the CRB Index and many individual commodities, another reason to suspect that the commodity bull is still young is that almost all gains to date have come about as a result of US$ weakness. For example, the following chart of the CRB Index divided by the euro-US$ exchange rate shows that commodity prices have been drifting lower over the past two years when measured in terms of a strong currency. However, all the major fiat currencies are now being devalued through inflation at a rapid rate so commodity prices should soon start moving sharply higher against them all. 

As an aside, although CRB/euro has been moving lower over the past 2 years the price action illustrated on the below chart appears to be a consolidation within a continuing long-term upward trend. This type of price action usually ends via an upside breakout. 

Further to the above, we can only assume that those who were long- or intermediate-term bearish on commodities during the final quarter of 2001 either weren't sufficiently bearish on the US$ or didn't appreciate what a weakening dollar would do for dollar-denominated commodity prices. And that those who are currently long- or intermediate-term bearish on commodities don't appreciate what effect the worldwide race to inflate is going to have on prices over the next few years. 

As far as the commodity markets are concerned, the two biggest downside risks over the coming year are that the rate of US money-supply growth will continue to slow and that China's growth rate, much of which is credit-induced, will slow. These are legitimate concerns that could lead to substantial bull-market corrections in commodity prices at some point, but aren't likely to come into play until at least the second quarter of next year. In the short-term there is a good possibility of moderate pullbacks based on technical factors because the prices of some important commodities -- copper and soybeans being two examples -- have recently hit resistance.

The US Stock Market

The market and the latest economic news

There's been a lot of good economic news of late, topped off by last Friday's better-than-expected Employment Report. This news did not manage to push the stock indices sharply higher, but then again there is no reason why it should have. The stock market is always trying to discount the future, so while backward-looking economic data might seem important to the public and to many financial journalists it is of little relevance to the market.

The way the market reacts to data can, however, provide some useful information. For one thing, a failure to react to data would suggest that the data had not significantly altered the market's expectations. For example, if the market had already moved prices sharply higher in anticipation of good news then the actual announcement of good news would be unlikely to have much effect. Currently, the market is priced as if rapid growth over the next few years were all but guaranteed, so there is little scope for any positive surprises. There is obviously some scope for negative surprises, although the normal pattern is for the stock market to turn lower months before the economic news starts to deteriorate. In fact, at stock market peaks the economic news tends to be universally bullish, which is why backward-looking analysts such as Alan Greenspan are always extremely bullish at major stock market peaks.

Of more significance than the stock market's recent failure to surge on the back of positive economic news was its inability to capitalise on a reasonably bullish technical position (the S&P500 appeared to be poised for an upward thrust last week, but closed with a weekly gain of only 2 points). Furthermore, when last Friday's impressive downward reversal in the US Dollar is considered alongside the stock market's indecisive price action we are left thinking that a few more weeks of consolidation might be required before the final surge (in the stock market) gets underway. 

Current Market Situation

The S&P500 Index in terms of gold has once again moved up to the very top of its long-term channel (see chart below). Therefore, either we are about to see a major breakout or gold is going to out-perform the S&P500 over the next few weeks. We expect the latter. 

Below is a 6-month chart of Japan's Nikkei225 Index. The Nikkei is showing signs of having made an intermediate-term peak during the second half of September.

The senior US stock indices made new highs for the year last week, but the year-to-date high in the Walmart (WMT) stock price occurred back in early September. This is a significant divergence because WMT has tended to lead the overall market over the past 18 months. A daily close by WMT above $60.20 would remove this divergence and project at least 1-2 months of additional upside in the overall market.

As yet, none of the bearish early warning indicators discussed in the 29th September Weekly Update have been triggered. Of particular importance, the NDX/Dow ratio has remained in an upward trend and closed at a new high at the end of last week (see chart below). Just as there is no reason to be worried about an imminent major decline in the gold market as long as the HUI is out-performing the gold price there is no reason to be worried about an imminent major decline in the stock market as long as the NDX is out-performing the Dow. 

By the way, we will update our list of bearish early warning indicators over the coming week to take into account recent price action.

This week's important economic events
 

Date Description
Monday Nov 10 No significant events
Tuesday Nov 11 No significant events
Wednesday Nov 12 No significant events
Thursday Nov 13 Trade Balance
Import / Export Prices
Friday Nov 14 Industrial Production
PPI
Retail Sales

Click here to read the rest of today's commentary

 
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