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   -- for the Week Commencing 12th November 2001

Forecast Summary

The Latest Forecast Summary (no change from last week)

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 higher into 2002.

The US stock market will rally into the first quarter of 2002, but will subsequently make new bear market lows.

The Dollar will head lower into 2002.

A bull market in gold stocks commenced in November 2000 and is likely to extend into 2002.

Commodity prices, as represented by the CRB Index, are in the process of bottoming. The CRB Index will reverse higher by the first quarter of 2002 (at the latest) and then rally over the ensuing 1-2 years.

The oil price will resume its major uptrend during the first half of 2002.

Commodities Update

Copper

Think back to late-1998/early-1999 when the oil price was wallowing just above $10. At that time the consensus view was that the world was awash in oil and that the excess supply would ensure a low oil price for a long time to come. Even when OPEC began to cut production during the first quarter of 1999 very few analysts thought these cuts would have much of an effect. Within the next 2 years the oil price tripled.

Now consider the current situation in the copper market. The consensus view is that the world has an enormous over-supply of copper that will ensure a low copper price for a long time to come. Phelps Dodge recently announced a production cut of 222,000 tonnes per year and last week BHP Billiton announced a production cut of 170,000 tonnes per year, but these cuts are perceived as having little effect. Is there any reason to expect a surge in the copper price over the next 2 years of similar magnitude to the 1999-2000 oil price rally, or is the consensus view correct this time?

While the OPEC production cuts no doubt helped boost the oil price in 1999, our view is that the bulk of the 1999-2000 rally in the oil price resulted from an increase in demand that, in turn, resulted from excess financing (money supply growth). The massive increase in the money supply during 1998 and 1999 was guaranteed to have an effect on prices with the only question being which prices. For a number of reasons, including the fact that the very low oil price over the preceding few years had removed incentives to invest in oil production and to cut-down on oil consumption, the oil price was a major beneficiary of the inflation of 1998 and 1999. The stark similarity between early-1999 and now is that we are in the midst of an enormous monetary expansion and we have the price of one of the world's most indispensible resources (copper) sitting near multi-decade lows. In 12 months time the major copper producers will be rushing to bring more production on-line as the copper price skyrockets in response to an apparent under-supply of the metal.

As we've explained in the past, buying the stocks of commodity producers after the underlying commodity prices have shown definitive signs of strength usually doesn't work particularly well. This is because the stocks rally in anticipation of a rise in the commodity prices, not in response to such a rise. We'll use the following charts of the copper price and copper producer Phelps Dodge (PD) to illustrate this point. Note that in 1999 the copper price made a major bottom in mid-March, had a bounce of about 20% into early-May, and then dropped to re-test its March bottom in late-May. PD, however, began to rally in early-February and by the time the copper price was making its initial rebound peak in early-May PD had rallied by 70% from its low. Despite the fact that the copper price continued to rally throughout 1999 PD was never able to move decisively above its May-1999 peak (it made a marginal new high in early-2000 that is not shown on the below chart).

Two more points on the subject of copper. Firstly, last Wednesday's low in the copper price was roughly equivalent to the 1999 low, but PD traded at around $27 last Wednesday versus a low of $41 in 1999 (PD represents better value now than it did in 1999). Secondly, the copper price experienced what looks like a significant upside reversal last week - it hit its lowest level since 1987 before recovering to close the week above the highs of the preceding two weeks. 

Oil

The oil price was very strong late last week on the back of threatened supply cuts from OPEC and Russia. The sharp rebound from around $19.50 earlier in the week to Friday's close of around $22 indicates that we have probably seen the bottom for oil this year. However, as explained in the Oct-17 Interim Update oil at $22 may be cheap in terms of the over-valued US$, but it is still expensive in terms of most other commodities. The ratio of the CRB Index to the oil price would need to rise to around 11:1 to bring the oil price into line with commodity prices in general. A CRB Index of 190 therefore implies a reasonable price for oil of around $17. So, unless there is an enormous rally in commodity prices over the next several months it is unlikely that we have seen THE bottom of the cyclical bear market in oil that began in late-2000.

Our decision to add an oil stock (OXY - Occidental Petroleum) to the TSI Portfolio last Friday was only partly based on expectations for a near-term oil price recovery (when we sent the e-mail recommending the purchase of OXY the news that Russia was going to support OPEC's production cuts had not been released and the oil price was only up 13c). Our major reasons were: a) the AMEX Oil Index had remained within its 3-year uptrend throughout the general stock market panic, and b) oil stocks are likely to be bid-up as the stock market continues to discount next year's economic recovery.

General

We do not think that commodity prices are ready to commence a major rally, but a rally into year-end followed by a test of the lows during the first quarter of next year is a distinct possibility. Since Sep-26 we've been recommending that investors begin building positions in the stocks of some of the major commodity producers and we continue to believe that this is a sensible approach. 

There is no inflation?

From the Oct-01 WMU: "At the moment the inflation is in the pipeline, but the future effects of the inflation are only apparent to those who can, and want to, see. With the economic news being generally quite lousy and likely to get even worse as a result of the terrorist attacks, with the effects of the inflation not being evident in any of the popular price indices and unlikely to become evident over the next few months, and with the drop in energy prices likely to further suppress the obvious signs of inflation in the near-term, there will be no pressure on the Fed to deviate from their inflation policy. In actual fact, there will probably be a lot of pressure on the Fed to step even more firmly on the monetary gas pedal."

The drop in energy prices caused the Producer Price Index to plunge 1.6% in October, thus ensuring that a) there are very few of us thinking about the growing inflation problem and b) the Fed has carte blanche to expand the money supply and cut interest rates.

The US Stock Market

Current Market Situation

Below is a chart of the S&P500 Index highlighting the eerie similarities between the rally since the Sep-21 panic low and the rally that occurred during April and May. If the similarities persist then the market will gradually roll over and drop to a new low.

We do not think the similarities will persist, primarily due to the enormous difference between the current sentiment of market participants and the sentiment that prevailed in May. In particular, we've been amazed at the heavy put-option buying that has occurred in the QQQ (a popular trading vehicle that tracks the NASDAQ100) over the past few weeks. The QQQ's average put/call ratio over the past 2 weeks has been much higher than it was during the weeks leading up to the panic lows of April and September, despite the NASDAQ's obvious recent strength. This means that option traders, as a group, do not believe that the rally off the September lows has any staying power (these same people were aggressively buying call options in May). The similarities in the charts between the current rally and the April/May rally is probably also contributing to the skepticism.

There appears to be an expectation in the air that something is going to go horribly wrong and many traders are positioning themselves accordingly. We are told that the commentators and guests on CNBC are waxing as bullish as ever (we don't know this from first hand experience since we never watch CNBC), but based on the eagerness of traders to bet against the market the CNBC message is clearly not getting through. 

There are certainly a lot of legitimate worries at this time. Most of the industrialised world is involved in the bombing of Afghanistan, there is the distinct possibility of more terrorist attacks on the US, there are rumours floating around that bin Laden has obtained nuclear weapons, and there is the on-going deluge of terrible economic news. All of this is known and therefore factored into the market, but things can always get worse. However, what happens if things don't get worse? What happens if they get better with so many traders expecting the worst?

The next rally has the potential to be very strong, but despite the generally-bullish sentiment picture we do not think it is wise to leap into the market at this time. We've added a few commodity producers to the Portfolio since the September bottom and these stocks will give us reasonable long-side exposure if the market decides to rocket higher without first stopping to re-fuel (the commodity producers we've recommended also appear to have minimal downside risk). However, we still expect a pullback before the next major advance gets underway (unfortunately, the pullback is almost certainly not going to be quick enough or deep enough to add any significant value to our November QQQ put options). Five reasons for not throwing caution to the wind at this time are:

a) Although traders have been betting heavily against the NASDAQ100 Index, they have been betting heavily in favour of some of the major components of the index (Cisco is an example).

b) The rally of the past few weeks has been led by some of the most over-priced stocks (Cisco, once again, is an example). This is not 1999 and those who pay 8-times revenue for a loss-making company are unlikely to be rewarded beyond the very short-term.

c) Although option traders have demonstrated disbelief in the NASDAQ's rally, two of the more reliable sentiment surveys (the Market Vane and Consensus-inc surveys) show that bullish percentages are approaching levels that have, in the past, coincided with short-term peaks.

d) The debt market has not yet begun to discount an economic recovery. This is something that will probably change over the next few weeks, but until it does (until short-term interest rates begin to move higher) we have to be a little suspicious of any stock market rally.

e) The Japanese stock market has been leading the US market by 1-3 weeks for most of this year and the Nikkei has already experienced a significant pullback (see chart below).

The most bullish thing the market could do would be to pullback sharply over the coming week, thus building on the doubts that already exist and setting the stage for a subsequent strong advance into year-end. If, instead, the market continues higher over the coming week then a longer pullback would likely ensue thereafter.

This week's important economic/market events
 

Date Description
Monday November 12 US bond market closed for Veterans' Day holiday
Wednesday November 14 Retail Sales
Friday November 16 CPI
Industrial Production / Capacity Utilisation

Gold and the Dollar

The Commitments of Traders (COT) Report

Our impression is that many gold analysts misinterpret the COT Report because they always consider the traders' commitments to be bullish for gold when the commercial traders are net-long and bearish for gold when the commercial traders are net-short. The thinking is that the commercials have the best handle on the supply/demand situation in the market and will therefore tend to be right most of the time. 

This might sound reasonable, but it is not supported by the historical data. For example, the commercials were net-short throughout most of 1993, 1994 and 1995, a period during which the gold price remained quite firm. Furthermore, the commercials were almost continuously net-long from early-1997 until September 1999, a period during which the gold price declined relentlessly. The commercials were also net-long throughout much of last year as the gold price declined. However, they have been mostly net-short since the gold price began trending higher in April of this year. 

The fact is that the commercials are usually wrong. This actually makes some intuitive sense to us because a) the fundamentals lag the financial markets (traders in the futures markets are acting today based on what they think the fundamentals are going to be tomorrow), and b) speculators usually try to position themselves in line with the price trend, so in any market where there is a definite price trend (gold was most definitely trending lower between 1997 and 1999) the speculators are probably going to be right. The commercials are, however, invariably right at those times when the trend is about to change.

Speculators have been heavily net-long gold futures and commercials have been heavily net-short for the past couple of months. As discussed above this is not in itself bearish since the specs are usually on the right side of the market. However, if the specs are heavily net-long and a correction commences, the correction is unlikely to end until the speculative net-long position has been mostly eliminated. 

When the gold price broke below its short-term uptrend on Oct-09 it signaled that a correction was commencing. This correction will continue until the speculators are either flat or net-short (the latest COT Report showed that large speculators were net-long 13,500 contracts and small traders were net-long 22,000 contracts). It is most likely going to require a drop below $275 before that will happen.

Gold - the Big Picture

From the point of view of someone outside the US, gold's long-term bear market has ended. The following chart was provided by Nick Laird (http://www.sharelynx.net/Markets/Charts.htm) and shows the US$ gold price multiplied by the US$ Index. It therefore illustrates the average performance of the gold price in terms of the currencies of the US' major trading partners.

Gold - the Small Picture

After the gold price broke below its short-term uptrend on Oct-09 we speculated that the ensuing correction would occur in 3 waves (an A-Wave decline to the initial low followed by a B-Wave rebound followed by a C-Wave decline to the final low). The below chart shows that the C-Wave decline probably began last Thursday. As noted above, the odds are in favour of gold's correction continuing until the speculative net-long position has been eliminated. This is likely to take 2-3 more weeks, after which the market might do the right thing and present us with another low-risk opportunity to buy short-term trading positions in gold stocks. In the mean time we are retaining a core investment position in several high-quality gold stocks.

The ratio of gold stock prices (represented by the TSI Gold Stock Index) to the bullion price is still trending higher, although it is currently in the process of testing its uptrend for the fifth time since early-September.

The Dollar

It was a quiet week in the currency market. There was very little movement in either the Dollar or the euro, although the Yen provided a few tentative signs of strength. The Yen's current situation is quite interesting since it's recent price action has been mildly bullish while the COT Report shows that speculators are betting heavily against it. This potentially creates a set-up for a powerful Yen rally fueled by short-covering speculators (when a market begins trending higher at a time when most speculators are short the speculators must reverse their position in a hurry to put themselves in synch with the new trend). At the same time the Japanese central bank and Ministry of Finance are desperately trying to weaken the Yen. So, a tug-o-war seems to be developing here - Ms Market is starting to pull the Yen higher and the BOJ is saying "not so fast".

We continue to be very bearish on the Dollar, but are unsure if another sharp decline will occur this year or be postponed until next year. We had hoped that the market would have tipped its hand by now, but short-term technical indicators remain unclear. 

Changes to the TSI Portfolio

OXY and BHP were added to the Portfolio as per Market Alert #60.

 
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