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   -- for the Week Commencing 13th May 2002

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 during 2002.

The US stock market will make new bear market lows in 2002.

The Dollar commenced a bear market in July 2001 and will continue its decline into 2003.

A bull market in gold stocks commenced in November 2000 and is likely to extend into 2003.

Commodity prices, as represented by the CRB Index, will rally during 2002 and 2003.

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

Oil Update

Strength in the oil price from mid-January to around mid-March could be put down to monetary and economic factors. It occurred in parallel with a rising CRB Index, strength in cyclical stocks and a generally weak bond market, that is, it was consistent with the behaviour of other markets (all the markets appeared to be responding to expectations for higher inflation and economic growth). However, over the past 2 months the CRB Index and the stock market have pulled back and bond prices have risen, and yet the oil price closed at a new high for the year at the end of last week. The below chart illustrates the recent divergence between the oil price and the CRB Index.

The oil price has clearly been responding to something other than economic or monetary forces over the past 2 months, and that 'something' is almost certainly the situation in the Middle East. Our guess is that there is currently a $3-$5 premium in the oil price specifically related to an expected further escalation of conflict in the Middle East. The implications of this are that:

a) If the market perceives that relative stability is temporarily returning to the Middle East then the oil price would likely experience a sharp correction

b) If the current speculative premium in the oil price represents an accurate assessment of risk then the Middle East is closer to breaking-out into all-out war than most people think

The war premium that is currently in the oil price can also be seen by looking at the spreads between the different crude oil futures contracts. Oil futures are usually in 'backwardation', meaning that the longer the time to expiry the cheaper the price. In other words, August crude would usually be slightly cheaper than June crude. For example, on the 11th of March the June crude futures contract on NYMEX closed at 24.73 and the August contract closed at 24.60, so the spread was 0.13. At the close of trading last Friday the spread between these two contracts had blown-out to $1.08, that is, June crude is currently 4% more expensive than August crude. There appears to be a sense of urgency in the oil market.

In inflation-adjusted dollars a $30 oil price ($2 above Friday's close) is not high, particularly in an enviroment in which the US$'s foreign exchange value is falling. As such it is unlikely that a rise in the oil price to $30 would create a serious problem for the US economy. A $30 oil price is high, however, in terms of most other commodity prices simply because most commodities are phenomenally cheap. We therefore expect the oil price to fall sharply once (perhaps we should say if) some semblance of stability returns to the ME. This will be necessary in order to bring the oil price into line with other commodity prices. 

The US Stock Market

Japan versus the US

Daily news reports tell us that the economic situation in Japan is dismal, not just in absolute terms but also in relation to the economic situation in the US. The news reports might be accurate, but as investors we are far more interested in how things are going to look in 6-12 months time than in how they look today. Interestingly, the performances of the stock and currency markets suggest that the economic situation in Japan is going to be much better in 6-12 months time than it is today, both in absolute terms and relative to the US.

As mentioned over the past few weeks, one of the things that the US stock market has going for it at this time is the relatively good performance being put in by the Japanese stock market. However, although turning points in the US market still appear to be following turning points in the Japanese market as has been the case since the beginning of last year, about 3 months ago large-cap stocks in the US began to dramatically under-perform their Japanese counterparts.

Below is an updated version of the Nikkei225-NASDAQ100 chart comparison that we've shown many times in the past. A few weeks ago the Nikkei appeared to break upwards out of a short-term downtrend, but it has actually just entered a wider channel. The Nikkei's short-term trend is still down, but unlike the US market's bearish price action the March-May decline in the Japanese market has the appearance of a counter-trend move within an emerging bull market.

The Nikkei will have to achieve a daily close above its early-March peak (12,034) before we will be confident that the next upward leg in its bull market has begun. 

The Dow in terms of Gold

Lest anyone get the idea that the Dow is close to a major bottom and the gold price is close to a major peak, below is a long-term chart of the Dow/gold ratio. Looking at the big picture we can see that the Dow, in terms of gold, is still very close to the secular peak reached in 1999. Note that the previous secular peak was reached in 1966, following which the Dow trended lower for 14 years relative to gold. In a world where the US$ loses its purchasing power at a rapid rate a substantial decline in the Dow/gold ratio will tend to come about more from a rising gold price than from a falling Dow.

The timing of a major stock market bottom

Below is a chart comparing the Dow Industrials (1929-1932), the Japanese Nikkei225 (1989-1992), and the NASDAQ Composite (2000-2003). The chart for each index begins at the day of the major peak and extends for exactly 3 years.  

If the duration of the NASDAQ's decline from its major peak to its long-term bottom roughly matches that of the other two major post-bubble declines of the past hundred years then the NASDAQ will reach a long-term bottom between October-2002 and January-2003. Since the NASDAQ has, to date, followed a similar pattern to the previous post-bubble declines and since the one constant in the financial markets throughout the ages is human emotion, it is not unreasonable to expect the NASDAQ to bottom roughly in line with the 1930s Dow and the 1990s Nikkei.

There is no reason to expect that every twist and turn on the NASDAQ chart will match the twists and turns on either the Dow or Nikkei charts, although over the past 12 months the NASDAQ has been following a path that closely matches that of the Nikkei at the same stage of its decline. In any case, the message we get from both historical charts is that a) the NASDAQ is likely to fall 30%-60% from its present level between now and its ultimate bottom, and b) the absolute maximum gain that we should expect during any bear market rally over the next several months is 30% (10%-20% is more likely).

Current Market Situation

Following Wednesday's ferocious rally we wrote (in the Interim Update): "There are two things we should see at the end of this week if this rally has some staying power. Firstly, the June S&P500 futures will close the week above 1073 as mentioned above. Secondly, the COT Report released on Friday will show a significant reduction in the commercial net-short position." The June S&P500 futures closed the week at 1054 and the latest COT Report showed an insignificant 6000 contract reduction in the Commercial net-short position. So, at this stage there is no evidence that last Wednesday's surge was the start of something meaningful. Other negatives at this time are:

a) The decline during the final 2 days of last week did not result in significant increases in volatility or put/call ratios

b) Middle East tensions continue to percolate (as evidenced by oil price strength)

c) Large traders are still heavily net-long T-Note futures (since bonds and stocks are moving in opposite directions the smart-money's bullishness on T-Notes compliments, and confirms, their bearish outlook for the stock market).

The good news is:

a) By closing near its low for the year at the end of last week the June S&P500 has another good chance to achieve an important reversal this week. It simply needs to spike below 1045.80 at some point during the coming week and close the week above 1054.10.

b) Although the major stock indices closed the week above last Tuesday's lows there is now almost universal belief that Wednesday's upward reversal was a 'one-day wonder'. This means that a lot of traders could once again be caught leaning the wrong way as was the case last Wednesday.

In the 8th May Interim Update we said we'd wait and see how the market finished the week before making any further suggestions. Since the market has failed to provide any evidence whatsoever that last Wednesday's upward reversal was the start of a tradable rally there is no reason for us to suggest any additional long-side trading positions. However, our commodity-cyclical stocks continue to hold up well and investors who wish to increase their exposure to this sector should consider pullbacks in stocks such as CHK and BHP as buying opportunities. The QQQ call options suggested during last week's WMU are, at best, a 50/50 proposition. They are worth holding if you already have them. 

We have no intention of adding to our medium-term bearish position during the current weakness (the TSI Portfolio contains long-dated put options on MSFT and the Dow), but would be interested in adding to this position if the market does manage to put together a decent rebound at some stage. It is also worth noting that gold stocks have been trading like S&P500 put options over the past 8 months and should continue to perform well in the event that a multi-week rebound in the overall stock market does not materialise.

This week's important economic/market events
 

Date Description
Monday May 13 No significant events
Tuesday May 14 Retail Sales
Wednesday May 15 Consumer Price Index
Industrial Production
Thursday May 16 Residential Construction
Friday May 17 Trade Balance

Gold and the Dollar

Gold versus Silver

In our 6th May commentary we said that our expectation has been, and still is, that gold would out-perform silver "until the general level of commodity prices, as represented by the CRB Index, began a major up-trend. Being as much an industrial commodity as it is a form of money silver tends to do better than gold during those periods when commodity prices are trending higher." This comment sounds quite logical (even if we do say so ourselves) and, strangely enough, is supported by what has actually happened over the past 30 years.

Below is a long-term chart comparison of the silver/gold ratio and the CRB Index. Note the general tendency for the two to trend in the same direction over extended periods, indicating that silver does usually out-perform gold when the general level of commodity prices is in a long-term up-trend.

There are, in fact, two times when silver tends to out-perform gold - when commodity prices are trending higher or when the stock market is in a multi-year up-trend. Strength in silver relative to gold was a characteristic of the period from 1991 through to 1999, an era of considerable stock market strength. It also occurred during the cyclical stock bull market of 1975-1976 and during the 1982-1983 stock market rally.

Further to the above, gold will probably continue to out-perform silver until either a) the CRB Index provides some technical evidence that it has commenced a major up-trend, or b) the stock market reaches a long-term bottom. As noted earlier in today's commentary, a likely time for a major stock market bottom to occur is during the period from October-2002 to January-2003.

Even if silver performs poorly relative to gold for the remainder of this year it is still likely to do well in absolute terms. There is little chance that the gold price will move sharply higher without the silver price also experiencing a sizeable gain. Furthermore, if silver under-performs gold it does not necessarily follow that the stocks of silver mining companies will under-perform the stocks of gold mining companies. As stated in the 1st May Interim Update: "The gold stock universe is tiny compared to the overall stock market or even compared to many individual corporations, but it is enormous compared to the silver stock universe. As such, once the silver price finally breaks above the brick wall of resistance at $4.80 the silver stocks will fly." The combined market capitalisation of all the word's silver producing/exploring companies is so small that even a small amount of interest from the investment/trading herd could produce massive gains in the prices of silver stocks. 

Due to silver's lethargic price action over the past several months most silver stocks currently do not have as much of a speculative premium built into their prices as do most gold stocks. As such, they will probably hold up better than gold stocks during the next correction. They are also likely to make large catch-up moves at some point.

Corner Bay Silver (BAY.TO) remains our favourite silver stock. It is effectively a core investment (it is one of the stocks with which we plan to ride-out the bull market), although it won't officially be a core investment until the feasibility study on its Alamo Dorado Project has been completed. We also have a trading position in Silver Standard (NASDAQ: SSRI), a company that owns a large silver resource but, unlike BAY, needs a silver price of at least $6 before its resources will become economic. And, we are now going to add one more silver mining company to the Portfolio as a core investment. That company is Apex Silver (AMEX: SIL).

Apex has a number of interesting exploration-stage projects and one development-stage project. We'll ignore Apex's exploration potential for now and just focus on the project that is currently under development (the San Cristobal Project) since it, alone, makes Apex a worthwhile investment at the current share price. 

The San Cristobal Project in Bolivia contains a silver/zinc deposit with current proven and probable reserves of 470 million ounces of silver and 8.8 billion pounds of zinc (US$5.4B of metal at today's low prices for Ag and Zn). It is expected to produce 27M ounces of silver and 570M pounds of zinc per year during its first 5 years of operation, thus generating annual revenue of US$335M assuming today's low commodity prices. During this first 5 years of production the cash operating costs are expected to be $1.23/oz for silver (net of lead by-product) and $0.23/lb for zinc. It is estimated that life of mine cash costs will be $1.83/oz for silver and $0.27/oz for zinc. At Friday's closing price of US$13.30 per share Apex has a market cap of US$465M.

Apex's disadvantage, in the short-term, is that about 60% of the revenue from the San Cristobal project will come from the production of zinc. However, over the longer-term this makes Apex an interesting commodity-cyclical play as well as an interesting precious metals play. The Apex stock price is presently near the top of its trading channel (see chart below) so now is not an ideal time to buy from a technical perspective, but the fundamentals are compelling and there are no guarantees that a better opportunity will present itself in the future. In our view a reasonable approach would be to take a position now with the aim of adding to the position during any significant pullback over the next few months.

Current Market Situation 

From the 8th May Interim Update: "The bottom line is that while we think gold stocks are close to at least a short-term peak we haven't yet seen anything in the price action to confirm that a peak has been reached. In other words, the short-term trend is still up. We will hold onto our few remaining gold stock trading positions for now. We have not even considered reducing our core investment position in gold stocks."

The above quote still applies. In fact, two of our core gold-stock investments - Harmony Gold and Gold Fields Ltd - closed at new all-time highs on Friday, confirming that the short-term trend is most definitely still up.

In a nutshell, our views are that a) gold and gold stocks are in a bull market that will last at least until the end of this year and quite possibly until the end of this decade, and b) although the short-term trend is still up many gold stocks are sporting large speculative premiums that make new purchases at this time quite risky. Ideally, all of our readers will already have a sizeable investment position in gold stocks and will therefore not feel the need to buy into the current frothy market. In reality, however, this will not be the case, particularly for those who have joined us over the past few months. So, what should someone do if they don't already have a large exposure to gold stocks?

Firstly, they can buy physical gold and silver. The upside potential is not as great with the physical metal as it is with the mining stocks, but neither is the downside potential. Secondly, they can buy the stocks of silver producers as discussed above. Although silver has been lagging gold we expect it to play 'catch-up' at some stage, thus sending silver stocks into orbit. Thirdly, they can buy the stocks of small exploration-stage companies that are yet to benefit from the speculative fever. We recently added one such stock to the TSI Portfolio (Northern Dynasty) and will probably add one or two more over the next few weeks.

Acknowledgement

The Dow/Gold and Silver/Gold ratio charts included in today's commentary are modified versions of charts available at Nick Laird's (Sharefin's) excellent web site: http://www.cairns.net.au/~sharefin/Markets/Master.htm

Update on Stock Selections

Apex Silver (AMEX: SIL) added as discussed above.

 
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