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   -- Weekly Market Update for the Week Commencing 12th May 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 continue to move in the same direction as the stock market, that is, new lows in bond yields (new highs in bond prices) will occur before the end of 2003.

The US stock market will move well below the October-2002 low during 2003, but a major bottom won't occur until 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.

An "unwelcome fall in inflation"

The statement issued by the Fed following last week's monetary policy meeting included this gem:

"...the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level."

When the Fed talks about inflation it doesn't mean inflation in the correct sense (an increase in the money supply), it is referring to rising prices for goods and services. Therefore, Greenspan and Co. appear to be worried about a substantial fall in prices. The question is, why? After all, computer prices fall substantially every year, yet no one complains about being able to buy better computers for less money and the computer industry hasn't collapsed. Why wouldn't it be good, rather than bad, if prices throughout the economy mimicked computer prices and fell every year?

As a result of on-going productivity improvements the natural long-term price trend for most goods is down. This trend is blatantly obvious in the computer industry because the gains in productivity over the past two decades have been spectacular, but it is also applicable in most other industries. The reason that prices actually spend most of their time rising, rather than falling, is because credit growth is typically a lot faster than productivity growth. Therefore, what the Fed is really worried about isn't falling prices, it is slower credit growth (high credit growth is what prevents prices from trending lower). 

In our 23rd April commentary under the heading "War Cycles and Peace Cycles" we explained why slower credit growth could be such a huge problem. In a nutshell, under the current monetary system almost all new money comes into existence as the result of a loan. Every newly-created dollar therefore brings with it a liability in excess of one dollar due to the obligation to pay interest, and this, in turn, means that the total of all obligations to pay money will be greater than the total supply of money. Furthermore, the more money that is borrowed into existence the greater will be the gap between the total supply of money and the total of all obligations to pay money. Obviously, all attempts to keep the system afloat by facilitating faster credit growth will only provide momentary relief while creating an even bigger problem for the future. Momentary relief is, however, the overriding goal of current Federal Reserve policy.

Interestingly, after trending lower for much of the past 16 months the rate of credit growth has recently begun to move away from what the inflation merchants at the Fed would probably consider to be the danger zone. As evidence, note the definite up-tick in the year-over-year M2 growth rate illustrated on the below chart. Based on US Government and Federal Reserve actions and statements over the past two years, we suspect that a year-over-year M2 growth rate of 6% is now considered to be dangerously low. That is, the money supply must now expand at the rate of at least 6% per year to allow most existing debts to be serviced. The M2 growth rate had fallen to 6.4% in early January this year, but thanks to massive government borrowing to finance the war in Iraq and to the lowest interest rates in many decades, momentary relief has been accomplished.

The US Stock Market

Making up reasons

When prices move substantially higher or lower in any market, fundamental reasons are always concocted by analysts and commentators to explain the price action. However, while these reasons satisfy the need for an explanation they often bear little resemblance to what is really happening. For example, every time tech stocks have experienced good-sized rallies over the past few years lots of stories have started appearing in the press about the imminent recovery in tech spending. In this respect the current rally is no exception, but as was the case in 2001 and 2002 the current talk of a recovery is simply a knee-jerk reaction to what is happening in the stock market. The below extract from the latest Goldman Sachs' IT spending survey (Goldman surveys the people responsible for setting information technology budgets at large corporations) illuminates the point that the current rally is NOT based on reasonable expectations for increased tech spending during the second half of this year.

"Our latest IT spending survey, taken in mid-April, suggests that spending continues to contract, on the margin. Contrary to the stabilization we expected from our first postwar survey, average 2003 spending intentions dropped to minus 3% from plus 1% in February. Perhaps most troubling, those expecting spending acceleration in the second half of the year virtually evaporated, pushing their expectations into 2004 or after 2004. " [Emphasis ours]

Convictionless bears

Although there is a lot of evidence that the average retail trader is very bullish, a lot of hedge funds are still trying to position themselves on the 'short side' every time the market approaches what looks like a short-term peak. This is making it difficult for the market to go down with any conviction because these 'hedgies' are, by nature, quite low on conviction. In other words, they are quick to reverse course if the market doesn't 'act' right.

As mentioned in last week's Interim Update, we are likely to see a pullback over the next 2 weeks (actually, a pullback probably began last Wednesday with Friday's rally creating a test of Tuesday's peak). However, at least one more new high might be needed following this pullback in order to convert a few more convictionless bears before a large decline gets underway. In any case, we won't be getting excited about the potential for a large decline until we see signs that investors have once again started to become more risk averse. As previously advised, one of the easiest ways to monitor the level of risk aversion in the market is via the NASDAQ100/Dow ratio.

Current Market Situation

Many of the major stock indices are still potentially forming bearish 'rising wedge' patterns (three examples shown below). This potential, though, won't be realised until or unless the indices close below the bottoms of their wedges before they close above the tops. 

Although the S&P500 made a lower high on Friday (Friday's peak was below Tuesday's peak), the Volatility Index (VIX) plunged to a new low for the year on Friday. This continues the divergence between sentiment and price action that has been so readily apparent over the past month (traders have become far more bullish than the price action warrants).

This week's important economic/market events
 

Date Description
Monday May 12 No significant events
Tuesday May 13 Trade Balance
Wednesday May 14 Retail Sales
Import / Export Prices
Thursday May 15 Industrial Production
PPI
Friday May 16 CPI
New Residential Construction

Click here to read the rest of today's commentary

 
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