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   -- Weekly Market Update for the Week Commencing 13th September 2004

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) bottomed in June of 2003 at around 4.2% and will move considerably higher during 2004 and 2005. (Last update: 12 January 2004)

The stock market rally that began in October of 2002 ended during the first half of 2004. The October-2002 bottom (775 for the S&P500) will be tested during 2005. (Last update: 12 July 2004)

The Dollar made an intermediate-term bottom in February of 2004 and will move higher into the first half of 2005. A long-term bottom won't occur until 2008-2010. (Last update: 26 July 2004)

Gold made an intermediate-term peak during the first half of 2004, but a long-term peak won't occur until 2008-2010. (Last update: 12 July 2004)

Commodities, as represented by the CRB Index, made an intermediate-term peak during the first half of 2004, but a long-term peak won't occur until 2008-2010. (Last update: 12 July 2004)

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More on the "synthetic dollar short" theory

In a very detailed article at http://www.gold-eagle.com/editorials_04/norcini091104.html Dan Norcini argues, as we have done at TSI on three occasions over the past six months, that the "synthetic dollar short" theory* doesn't hold much water. However, although the aforementioned article makes many good points and arrives at the same conclusion as us we think it misses the main point and contains a critical error. The error we are referring to is Mr Norcini's contention that the multitude of dollar negatives that exist today would prevent the US$ from strengthening if the US experienced deflation, while the missing main point is that the probability of the US experiencing genuine deflation (a sustained contraction in the total supply of money and credit) within the foreseable future is EXTREMELY low. And by the way, it is absolutely vital to understand that falling prices are not related to deflation in any way unless the CAUSE of the falling prices is a contraction in the total supply of money and credit.

As far as we are concerned there is no question that the US$ would strengthen and the US$ gold price would weaken if the US experienced genuine deflation. What must be appreciated is that the US$ is weak due to inflation and the effects of inflation. For example, the massive US trade deficit is simply an effect of inflation. Therefore, if the US moved from inflation to deflation then the factors that have been pushing the dollar lower would start to diminish and would, if the deflation persisted, eventually disappear. It is also worth mentioning that the reduction in the foreign demand for US assets during a period of dollar deflation would probably be offset by a surge in the demand for US Government debt. This is because the US Government is an institution with unlimited access to dollars and, hence, an institution that will never be unable to meet its NOMINAL dollar obligations. In other words, under the current monetary system there will never be any DIRECT default risk in US Government debt, just the risk of indirect default via inflation, so during a period of genuine deflation the demand for treasuries would soar.

The important question to ask, therefore, is: What is the probability of the US experiencing genuine deflation over the next several years?

As explained repeatedly in TSI commentaries over the past 5 years, we think the probability is close to zero. The reason is that in the unlikely event of a contraction in US household debt -- we say "unlikely" because although it is feared that US consumers are now close to their collective debt limit such fears have emerged during every decade since the 1950s and yet the total debt has invariably continued to expand -- the Fed stands ready, willing and able to monetise anything and everything in order to ensure that the supply of dollars continues to grow. After all, the Fed, not the US consumer, is the primary source of inflation (chronic inflation didn't exist in the US before the Federal Reserve was created).

On a side note, whenever we mention our view that the Fed has the power to prevent deflation we always receive a few questions along the lines of "But what about Japan? If a central bank can prevent deflation then why was the BOJ unable to stop the deflation in Japan during the 1990s?"

Sidestepping, for now, the point that Japan did NOT experience deflation during the 1990s, the Japanese chose not to go down the path of massive debt monetisation. Instead, the bad loans were essentially left in place and government spending programs were implemented with the aim of stimulating growth. However, based on the way the US monetary authorities have reacted to every economic/financial crisis of the past 15 years there should be little doubt that any future debt problem that poses a serious threat to the US economy will be monetised out of existence. And that the situation will be handled in this way regardless of the adverse consequences for the dollar and long-term economic growth prospects. In any case, we are starting to wonder just how far the US of today will have to diverge from Japan of the 1990s in order to bring an end to the idea that the US is following the Japanese path.

In summary, the main point doesn't revolve around whether the dollar will strengthen or weaken IF the US enters a prolonged period of genuine DEFLATION. Instead, it revolves around whether or not the Fed will remain committed to INFLATION. Our view, as you know, is that it will.

   *"...the idea is that during a period of intense deflation, American citizens who have managed to amass significant amounts of indebtedness will attempt to reduce their debt by selling their goods or possessions in an attempt to raise cash with which to pay off their debts. This will result in increased demand for dollars as people will tend to hoard cash as the deflationary spiral worsens. In a deflationary environment of falling prices, the purchasing power of the U.S. Dollar will actually increase since falling prices will allow holders of cash to actually obtain more goods for the same amount of money. The claim is that this increased demand for dollars will result in the dollar actually strengthening much to the consternation and surprise of many who are expecting a severe decline in the dollar." From "The Synthetic Short Dollar Theory Weighed in the Balance" by Dan Norcini

The shorter the term the greater the uncertainty

The shorter the timeframe the greater the role played by emotions, technical factors, news events, and just pure randomness, and the lesser the role played by valuation. What this means is that on a daily, weekly, or even monthly basis, the markets can do almost anything.

Long-term trends are, however, dictated primarily by valuation and once these trends are set in motion they ALWAYS continue until valuation has reached an extreme. For example, if we accept that the US stock market embarked on a secular bear trend in 2000 -- and there's a huge amount of evidence to support the view that it did -- then the trend is not going to end until the average stock becomes extremely under-valued as indicated by ratios such as price/sales, price/earnings and price/book. Similarly, the dollar's long-term downward trend is not going to end until the dollar has become under-valued as indicated by the US having a monthly trade SURPLUS. And of course, the direction of gold's long-term trend will be up as long as the direction of the dollar's long-term trend is down. 

Commodities

Outlook

We are currently long-term bulls on commodities, as we have been for the past three years, and expect that the CRB Index will move well above its 1980 peak later this decade. In fact, we think the CRB Index has a reasonable chance of challenging its 1980 peak by the middle of next year.

We have, however, been intermediate-term bears on commodities since early this year. For example, in the 8th March Weekly Update we said:

"...in order for the overall advance [in commodity prices] to continue it will need to be punctuated by a multi-month correction; and as far as we are concerned the most likely time for such a correction is the second and third quarters of this year. There are three reasons for this. First, although there is no evidence that peaks are already in place, some commodities (the industrial metals and soybeans, for example) are presently making what look like blow-off moves to the upside. Second, money-supply trends predict a substantial slow-down in US economic growth over the coming two quarters. Third, the US$ is likely to experience a substantial rally from whatever low it makes over the coming 3 months."

We subsequently mentioned a target of 240-250 for the above-cited correction in the CRB Index, but like the stock market the CRB has been surprisingly resilient and has simply drifted lower without much momentum (downward moves have, to date, halted in the 260s). As we think is also the case with the stock market, IF the CRB is going to break to new lows for the year then it will need to do so during the seasonally-weak September-October period. Otherwise, the next breakout of consequence will probably be to the upside.

Current Market Situation

The below chart shows that the CRB Index has climbed higher within the confines of a well-defined channel over the past three years. Note that in late February of 2003 the CRB was at the channel top and its 50-day moving average was well above its 200-day MA, but then a 5-month consolidation occurred that took the index back to its channel bottom and the 50-day moving average back to near the 200-day MA. Also, note that something similar has happened over the past 5 months.

Now, even though we expect the bull market in commodities to continue for much of this decade it is extremely likely that the CRB Index will break below its channel bottom at some stage over the next two years. This is because a channel as steep as this one is unlikely to extend throughout a secular bull trend. As far as the coming 3-9 months are concerned, though, an ability to hold within the channel during any further short-term weakness would be a good sign.


The Stock Market

The Dow in terms of Gold

In nominal terms the US stock market has oscillated within a trading range for much of this year following last year's strong upward trend. The below chart of the Dow/gold ratio shows that in real terms, however, it has traded sideways since the middle of LAST year.

Our view is that a recovery high is in place for the Dow/gold ratio and that when a breakout from its trading range eventually occurs it will be to the downside. In other words, we expect that if the nominal Dow Industrials Index makes a new recovery high over the coming 6 months that most of the gains will be due to inflation and not to any 'real' progress.


Recovery in housing

As recently as 6 weeks ago the Philadelphia Housing Index (HGX) -- an index comprising the stocks of homebuilding companies -- appeared to be forming a large head-and-shoulders top. However, a strong rebound has since invalidated the aforementioned topping pattern and resulted in a move back to near the all-time highs reached earlier this year. When bearish patterns resolve bullishly it is something worth noting.

As has been the case with other interest-rate sensitive sectors of the stock market, the key to the recovery in the homebuilding stocks has been the 4-month rally in the bond market. The below chart comparison of the HGX and the T-Bond price shows what we mean (it shows that the HGX and the bond price have been moving in synch with each other).

The upshot is that the interest-rate sensitive sectors of the market aren't likely to come under much pressure until the T-Bond price drops below its short-term channel bottom and aren't likely to take-out their May lows until bonds do the same. This, in turn, suggests that the next substantial decline in the stock market will be similar to the one that occurred during April-May in that it will go hand-in-hand with a sharp fall in the bond market.

By the way, and as we also noted in the Interim Update with reference to the Dow Utility Average and the Real Estate iShares (two other interest-rate sensitive sectors), the Housing Index is extended on a short-term basis and is therefore likely to pullback over the coming weeks.


Current Market Situation

Over the past few months it has been apparent that the extreme weakness in the influential and economically-sensitive semiconductor sector would spread to the rest of the market OR that selling within the semiconductor sector would dry-up, thus removing the chip stocks as a source of downward pressure. Judging by the market action over the final two trading days of last week the latter might have happened.

It's generally not a good idea to get enthused by powerful 1-2 day advances during bear markets because they happen quite often and are seldom the precursors to multi-month rallies. However, two things happened last week to make us seriously consider the possibility that the semiconductor stocks have bottomed for the year. First, Texas Instruments, one of the world's largest and most important chip-makers, reduced its sales forecast and, in response, the stock market bid-up its shares by 15% over the ensuing two days. This, in turn, was a huge departure from the market's reactions to previous bad news. Second, the below chart shows that there has just been a large and potentially significant upward spike in the SOX/CRX ratio (the Semiconductor Index divided by the Commodity-Related Equities index).


In last week's Interim Update we spoke of the odds being evenly matched as to whether a breakout from the market's trading range of the past 6 months would be to the upside or the downside. However, in light of the above-mentioned relative strength in the SOX and the fact that the NASDAQ100 Index has just confirmed the multi-week highs recently achieved by the S&P500 and the Dow, we now think the odds favour an upside breakout.

As also discussed in the latest Interim Update, if there is an upside breakout over the coming few months we think it will result in a similar outcome to the upside breakout that occurred in November of 1972; that is, it will likely result in a major peak being put in place within three months of the breakout. Interestingly, 1972 was not only an election year but was an election year during a secular bear trend (like now) in which the incumbent Republican president was re-elected (like now?).

With volatility indices near their lowest levels of the year there's a good chance of a pullback over the coming 1-3 weeks, but it's now likely that any pullback will make a higher low. As such, we don't expect to be recommending any more bearish speculations until at least the first quarter of next year.

New Investment/Trading Ideas

Our view continues to be that most investors will be best served by maintaining a high proportion of cash and limiting equity market exposure to the gold sector and, to a lesser extent, non-gold commodity stocks. However, it is possible that an intermediate-term rally in equities commenced last month so those with a 3-6 month timeframe might consider adding some 'long' exposure to the stock market. In this respect, one option would be to purchase some exposure to the semiconductor sector via the Semiconductor HOLDRS Trust (AMEX: SMH). The 'semis' have been the main recipients of selling pressure over the past 8 months and are therefore likely to bounce back strongly if market participants become more willing to take-on risk.

A reasonable approach for speculators interested in playing a continuation of the recent stock market rebound would be to take an initial position in SMH near the current level of $30 with the aim of buying a second position during a pullback over the coming few weeks.

Another option would be to purchase exposure to several Asian stock markets using various exchange traded funds (ETFs). This is a speculation that should work well over the next few months if the US stock market continues to rebound and should also work well for investors with a 2-5 year timeframe because the Asian markets are generally supported by attractive fundamentals. Once again, a reasonable approach would be to take an initial position now with the aim of averaging in during future weakness.

In one of the next two commentaries we'll present some charts and discuss the pros and cons of the Asian markets. In the mean time, below (in no particular order) are some Asian funds that we think look interesting.

Japan: iShares Japan (AMEX: EWJ)
Malaysia: iShares Malaysia (AMEX: EWM) or The Malaysia Fund (NYSE: MF). The Malaysia Fund is presently selling at a 7% discount to its net asset value* and offers a 4% yield.
Taiwan: iShares Taiwan (AMEX: EWT)
India: The India Fund (NYSE: IFN)
Thailand: Thai Capital Fund (AMEX: TF), which is currently selling at a 9.6% discount to net asset value*.

  *Note: The discount/premium to net asset value at which an ETF is trading can be found at http://www.etfconnect.com/

This week's important US economic events

Date Description
Monday Sep 13No significant events
Tuesday Sep 14Current Account Balance for Q2 2004
Retail Sales
Wednesday Sep 15Industrial Production
Thursday Sep 16CPI
Friday Sep 17
No significant events

Gold and the Dollar

Current Market Situation

The Dollar

The Dollar Index closed below its 50- and 200-day moving averages on Friday (see chart below), a modestly bearish development but not something that has great significance because the dollar has been oscillating around its 200-day MA since May. In other words, Friday's action was just a continuation of the pattern of the past several months.

Critical support for the Dollar Index lies at 87. A daily close below 87 wouldn't negate our intermediate-term bullish view on the dollar but it would suggest that we were going to get a full test of the February low (around 84.50) before the next phase of the dollar's recovery got underway.


So, what would negate our intermediate-term bullish view on the dollar?

Based on the way the currency market has behaved over the past several months, if we saw evidence that the current dollar-positive TREND in interest rate differentials had reversed course or that the dollar was no longer reacting to small changes in short-term interest rates then we would probably have to abandon our current view. In this regard, Friday's weakness in the dollar wasn't an issue because what we saw, once again, was the sort of counter-intuitive response to "inflation" news that has characterised the currency market over the past 18 months. This, in turn, simply confirms how important small changes in short-term interest rates (or interest rate expectations) are to currency exchange rates right now.

To further explain the above comment, a low PPI -- something that most commentators on the markets and the economy incorrectly consider to be a sign of low inflation -- should be a POSITIVE for the dollar (the strongest currencies tend to have the lowest inflation rates). However, over the past 18 months, and especially over the past 6 months, the dollar has tended to rise in response to signs of higher inflation and fall in response to signs of lower inflation. The reason is that few large traders in the currency markets, including those that are up to their eyeballs in US$ carry trades, believe that the price indices reported by the US Government bear any resemblance to reality. Rather, the significance of the official price indices and other so-called inflation data is the effect they have on the actions of the Federal Reserve. In other words, if the US Government reports a low PPI or CPI it doesn't mean that inflation is low but it could well result in a slower pace of official rate increases. For the same reason, gold has tended to rally in response to news of low inflation and fall in response to news of higher inflation.

Gold

There have been no significant changes in gold's short-term technical situation over the past week so we've included, below, a long-term monthly chart of the gold price. The chart shows the long-term resistance that will need to be decisively breached in order to provide belated confirmation of gold's secular bull market. It's possible that such confirmation will occur this month, although the more likely outcome is that it will occur next year.


Gold Stocks

It was a minor negative that most of the major gold stocks closed near their session lows on Friday, but apart from that the price action remains quite constructive. For example, the below charts show that the AMEX Gold BUGS Index (HUI) has spent the past three weeks edging lower in what looks like a bullish flag while NEM appears to have just completed a successful 'test' of its 200-day moving average.




We continue to expect that the HUI will drop back to test its May low during October-November. It would, however, make sense to us if it first surged up to around 220, the reasons being that:

a) The chart patterns of both the HUI and the XAU suggest the likelihood of more upside in the near-term

b) The recent consolidation in the gold market has not been accompanied by any weakness in the HUI/gold ratio (see chart below)

c) Sentiment towards gold and gold stocks does not yet appear to be bullish enough to support a substantial pullback. However, it is likely that a decisive move by the HUI above its 200-day moving average (currently at 210.5) would instill the sort of optimism that typically occurs near a significant peak


Update on Stock Selections

In the 6th September Weekly Update we made the following comment with regard to the "stop work" directive issued by the Government of Eritrea to Nevsun Resources (TSX: NSU) and two other companies exploring for minerals in that country:

"The first thing that occurred to us when we read the above press release was that the Eritrean Government wanted to 'agree' a higher equity stake in the projects owned by Nevsun, Sunridge and Sanu (the government is currently entitled to a 10% stake in Nevsun's Bisha project) and that the letter instructing the companies to stop work was sent in order to improve the government's negotiating position. On further reflection, though, a more likely possibility is that work has been halted due to security concerns."

If the information in Doug Casey's article at www.321gold.com (http://www.321gold.com/editorials/casey/casey091004.html) is accurate, and we are not certain that it is, then our first reaction was the correct one. In any case, as mentioned in last week's e-mail alert we would not be buyers OR sellers of NSU until more details are known about the fate of the Bisha project.

With the stock price in the low-C$2.00 area the company's market value is underpinned by its cash and its development-stage project in Mali. However, there are a lot of under-valued exploration/development-stage gold stocks in the world right now, but the one thing that differentiates NSU from the pack is its Bisha project in Eritrea.

We think that averaging down can be a good idea, but only if it is done as part of a pre-determined strategy. For example, if you plan to invest $12,000 in a stock via 3 purchases of $4,000 at different times as opportunities arise then your second and third purchases may well result in averaging-down your cost per share. Once you have made your full $12,000 investment, though, we generally wouldn't consider it prudent to buy more of the stock simply because the stock price drops. The reason is that an important aspect of good risk management is to set limits and then stick to those limits.

Speaking of averaging down, if you currently don't have a full position in the stock then now would be a good time to average down in Metallic Ventures (TSX: MVG). By the same token, if you have no position in the stock then now would be a good time to start averaging in. There were fundamental reasons for the sell-off in MVG over the past few months but the weakness in the stock price appears to be totally out of proportion to any adverse fundamental developments. This, we think, is partly due to the general lack of investment demand for junior gold stocks and partly due to the exit of a large shareholder.

    Due to the addition of Gold Fields Limited (GFI) to the TSI Stocks List last week we had to change the risk ratings for many of the other stocks in the List. The reason is that our risk rating is relative, that is, it doesn't indicate how risky we think a stock is but rather how risky we think a stock is relative to other stocks in the TSI List. Therefore, in order to slot GFI into the List with the lowest risk rating (GFI is a major gold producer with a diverse range of high-quality gold-producing assets) we had to shift most other ratings downward one notch. 

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/



 
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