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   -- for the Week Commencing 12th March 2001

Forecast Summary

The Latest Forecast Summary (no change from last week)

'Bubble-omics'

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US aluminium production is being substantially reduced. This is not happening as a result of a decline in the demand for aluminium, but because it has become more profitable for the aluminium producers that have contracted to purchase electricity at attractive prices to re-sell the electricity rather than use it to power their production facilities. Manufacturing output is thus falling, leading to increased unemployment in the manufacturing sector, while demand is not falling. Higher prices are the obvious end result. The Fed's solution? Facilitate the further expansion of credit, thus boosting demand

There are some very nasty surprises in store as far as future CPIs and PPIs are concerned, probably not this month but certainly within the next 6 months. Needless to say, we remain bearish on bonds.

Bond Market Update

We are starting to feel quite lonely in our bearish view on bonds. Most technicians are forecasting a surge to around 110 in the T-Bond futures (versus last Friday's close of 105-23 and the Jan-03 peak of 106-20). Most fundamentalists are also bullish on the basis that the economy is slowing and the Fed is cutting official interest rates. However, the way we see it is that despite 1) a continuing stream of negative economic news over the past few months, 2) a correction in commodity prices, 3) a stable oil price, and 4) a very weak stock market, the bond price has not yet traded above its Jan-03 peak. The financial environment is unlikely to get any more positive, as far as bonds are concerned, than it currently is, so the inability of bonds to make new highs appears to be a bearish omen. Although the vast majority of analysts disagree with us, our view is given some support by the fact that the 'smart money' is net-short T-Bond futures and heavily net-short T-Note futures (based on the latest COT Report, the commercial traders are bearish on bonds and notes).

If we are wrong and bond futures move to new highs, we will probably only be wrong in the very short-term. In other words, any move to new highs would likely be a 'head fake' and be followed by a sharp decline.

The Biggest Surprise

Over the past few years we have written extensively about the massive expansion of US$ credit, noting how the huge growth in the money supply had brought about a boom in asset prices. We have also pointed out, on numerous occasions, that a high rate of money supply growth equals a high rate of inflation (they are the same thing) and that the on-going surge in the supply of US Dollars would inevitably lead to a substantial drop in the value of the US$ (especially relative to gold). Because we had understood the nature of the US economic boom of the late 90s (it was based more on increased debt than on increased productivity), we had expected that the explosive growth in credit (money) and the surge in stock prices would come to an end at around the same time. We confess to being absolutely stunned that the NASDAQ Composite could fall by 60% while the credit expansion has been able to continue with barely a hiccup. 

The continuation of the credit bubble, despite the precipitous drop in the stock market, has had profound effects on the currency and gold markets. Rather than the currency of the bubble economy falling and the gold price rising prior to the stock market reaching its peak, as had been the case during the other major bubbles of the 20th Century, the US$ remained strong and the gold price remained weak right up to and beyond the collapse of the NASDAQ bubble.

The US credit bubble remains very much in tact and we still expect its impending implosion to be signaled by a period of substantial US$ weakness and gold price strength. The Dollar peaked last October and has been trending lower ever since. A break in the Dollar Index below the Jan-03 low of around 108 would indicate that we have entered the final phase in the life of the world's greatest credit expansion.

The US Stock Market

Sentiment

One of the main drawbacks of using sentiment indicators to forecast the market is that, these days, almost everyone uses sentiment indicators to forecast the market. The greater the number of people that use a particular indicator the less likely it is that the indicator will provide useful information. 

Market bottoms always occur amidst strongly bearish sentiment and market tops amidst strongly bullish sentiment, the real problem is how that sentiment is measured. The difficulty of measuring sentiment is highlighted by the huge discrepancies in the results of the most popular sentiment surveys. While the Consensus-inc and Market Vane surveys have recently shown bullish percentages in the low- to mid-20s, the Investors' Intelligence survey has been indicating a bullish percentage in the 50-60% range. An inherent problem with the surveys is that many of the respondents use sentiment in determining their forecasts, which means that the results of the surveys affect the results of the surveys (the financial market equivalent of Heisenberg's Uncertainty Principle).

Rather than paying attention to what people are saying in order to determine the prevailing sentiment, it is probably more instructive to look at what they are doing. Here are a few objective measures of sentiment that are based on what people are actually doing with their money:

a) The put/call ratio and the VIX (Volatility Index). The equity put/call ratio has been hovering near market-bottoming levels for several months and the VIX recently spiked up to a level normally seen near intermediate-term lows. However, rather than just looking at the levels reached by these indicators during the periodic sell-offs in the market, it is instructive to watch how they react when the market begins to recover. For example, during the first half of last week a fairly unimpressive rally in the stock market resulted in both the put/call ratio and the VIX dropping sharply, indicating that traders were very quick to exit their bearish bets or hedges at the first sign of any strength. This shows that there is still a longer-term bullish bias in the market.

b) The Rydex Ratio. This ratio indicates where investors are putting their money. When people become more bearish they will allocate a greater proportion of their money to defensive positions such as money-market and bear funds. As the following chart shows, the Rydex Ratio is presently at its highest level in more than one year (investors are becoming more defensive), but it is still a long way from reaching the levels normally seen at major bottoms.

Chart Source: www.decisionpoint.com

c) Fund flows. This is similar to the Rydex Ratio, but shows how the net-inflows into mutual funds are split between equity funds, bond/balanced funds and money-market funds. The following chart appeared in an article by Ian McDonald at the realmoney.com site on Mar-05 and contrasts the fund-flows in February 2001 with those of February 2000. In Feb 2000, which was near the top for the stock market and near the bottom for the bond market, money gushed into stock funds and out of bond funds. Feb 2001, however, saw the opposite with money flowing into bond/balanced funds and net redemptions from equity funds totaling $13.4B. Note that Feb 2001 was the first month of net redemptions from equity funds since August 1998 (as it turned out, the bottom of the 1998 stock market sell-off occurred on 31st August).


Chart Source: www.thestreet.com/realmoney

d) The gold price. Although any market analyst with at least half a brain would realise that the gold market is manipulated, the gold price is still a good barometer of confidence in the financial system. The fact that the gold price is still near 20-year lows, or the fact that it has been possible to manipulate the gold market such that the gold price is still near 20-year lows, indicates a general lack of fear. It is highly unlikely that we will have reached the level of fear needed to create a lasting bottom in the stock market until the gold price has risen by at least $100.

Sentiment-wise, things are headed in the right direction but we are not yet close to a bottom. That doesn't mean the senior averages will need to fall far below current levels, but it does mean that much more time will be necessary in order to establish the levels of fear and loathing that major equity-market bottoms are made of. We continue to believe that the earliest possible time that a major bottom could occur, allowing for at least one meaningful counter-trend rally, is September 2001.

The Utilities

We expect the Dow Jones Utilities Index (DJUI), which is currently trading at around 390, to trade below 300 before this year is out. The 'utes' have been supported by a strong bond price, a strong Dollar and a general flight to safety, but we expect them to be one of the hardest hit sectors of the market when bonds and the Dollar eventually plummet. At the moment, however, our main interest in the DJUI is to use it to substantiate, or otherwise, our bearish view on bonds. A daily close above 398 for the DJUI would suggest that bond prices are going to remain firm for a while longer.

Current Market Situation

The stock market continues to surprise on the downside. There are some positive divergences developing, such as the ability of the Semiconductor Index (the SOX) to hold above the low reached last November despite a barrage of bad news and analyst downgrades. The market is, however, still tending to sell-off on bad news. The news will, of course, continue to get worse for months after the market has bottomed and turned up, but we are clearly a long way from a lasting bottom at this time.

Last week we mentioned that a rally that failed without first moving above the previous breakdown area (around 1320 in the S&P500 futures) would be followed by another sharp decline. In actual fact the market only made it as high as 1270-1280 before falling back. With the S&P500 and NASDAQ100 already having moved back to oversold levels we do not expect much more downside over the near-term and anticipate further attempts to rally over the next 2 weeks. If the oversold condition can be worked off over the next 2 weeks without making substantial upside progress then a drop to new lows would be on the cards for April/May.

One final point. Back in October last year we said that when Ariba (NASDAQ: ARBA) traded below $10 (it was then trading at $130) it would be a signal that speculative excess had been removed from the market. Ariba closed at $11.50 on Friday, so by that measure we are getting close.

This week's important economic/market events
 

Date Description
Tuesday March 13 Retail Sales
Wednesday March 14 BOE Gold Auction
Thursday March 15 Current Account Balance
Friday March 16 PPI
Industrial Production / Capacity Util.
March Options & Futures Expiration
OPEC Meeting

Gold and the Dollar

XAU Update

We have been using the 86/87 and 92/93 gold stock bull markets as rough road-maps as far as what to expect during the 00/01 bull market. The XAU will not necessarily continue to follow this map over the next few months and our bullish view on gold stocks is certainly not dependant on historical chart patterns, but the similarities remain quite strong at this time. Following is an updated version of the table that was originally included in the Feb-12 WMU. Note that during the previous bull markets the dynamic Wave 3 up-move was of a similar duration to the preceding Wave 2 consolidation. If the present rally unfolds in a similar way then the duration of Wave 3 will be around 10 weeks, meaning that a peak would occur in early May.
 
Bull Market ->
1986-1987
1992-1993
2000-2001(?)
Duration of initial bounce (Wave 1)
7 weeks
10 weeks
5 weeks
Duration of downward consolidation (Wave 2)
14 weeks
28 weeks
10 weeks
Duration of dynamic up-move (Wave 3)
15 weeks
28 weeks
2 weeks and counting
% increase during Wave 3 after Wave 2 down-trend was broken
79%
86%
?

Assuming we do get a sizable rally over the next few months, and there are certainly no guarantees, we will be watching the gold/XAU ratio to determine when to take profits. Last October/November we pointed out that the gold/XAU ratio had reached an all-time high, meaning that gold stocks had never before represented such excellent value relative to the bullion price (the ratio was above 6:1 at the time). A drop in the ratio to around 3.5:1 would suggest that the best part of the gold stock rally is complete.

Lease Rates

The collapse of the Turkish Lira might have been the catalyst that has recently caused gold lease rates to spike from below 1% to above 6%. There are, apparently, a number of borrowers of gold in Turkey who are now unable to repay their loans. The UK Treasury's decision to persist with the auctioning of British gold reserves may also be putting upward pressure on lease rates if the gold which is to be auctioned has already been loaned-out. Whatever the reason for the higher lease rates it is clear that there is a serious shortage of physical gold at the current low gold price. There are really only 2 ways that such a shortage can be addressed - either the gold price will have to move much higher in order to bring private supply onto the market, or a large price-insensitive seller (that is, a government) will have to make a substantial amount of gold available to the market (via additional lending or sales).

With short-term (1-3 month) lease rates having moved higher than the yield on short-term US Government debt, the gold carry trade is no longer feasible. Furthermore, if 12-month lease rates continue to move higher then some gold producers could have a problem. When a gold producer declares that they have forward-sold gold at a certain price, that price is based on a lease rate assumption. The assumed lease rate will almost certainly be in the 1-2% range. Some producers have fixed the lease rates associated with some of their forward sales, but it is virtually impossible (or, at least, prohibitively expensive) to 'lock in' a lease rate for longer than 1 year. So, if lease rates remain high then those producers that have forward-sold a large quantity of gold may find that the prices they actually receive are nowhere near as attractive as previously thought (higher lease rates translate into lower forward sale prices).

Even if a producer has locked in a lease rate for the next year, that just means that someone else in the leasing chain will suffer the consequences of the higher rates. Derivative pricing models assume that markets will always be continuous and liquid. When an interest rate that has drifted along at less than 1% for over 12 months surges to 6% in the space of 2 weeks, someone is going to take a large loss. Therefore, even producers that had the foresight to 'fix' their lease rates could potentially have a problem due to counter-party failure. The best bet is to just steer clear of the heavily-hedged producers.

Current Market Situation

The Dollar Index still needs a daily close below 110.81 (basis March) or 110.95 (basis June - the new front month) to confirm the start of a new short-term downtrend. At this stage it looks like the Dollar will remain firm, or at least stable, until late-March.

Regarding gold and gold stocks, our thinking is that the bulk of the rally will occur during April in parallel with a sharp fall in the Dollar and another gut-wrenching decline in the stock market. Those who feel under-invested should take advantage of any pullbacks over the next 2 weeks to accumulate shares of unhedged, or lightly hedged, producers.

The latest COT Report showed that, as at Mar-06, the Commercial net-long position in gold futures had dropped to 40,000 contracts (from 48,000 the previous week). 

Changes to the TSI Portfolio

No changes.

 
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