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.

Bonds commenced a secular BEAR market in June of 2003. (Last update: 22 August 2005)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000. The rally that began in October of 2002 will end during the first half of 2007. The ultimate bottom of the secular bear market won't occur until the next decade. (Last update: 02 October 2006)

The Dollar commenced a secular BEAR market during the final quarter of 2000. The first major downward leg in this bear market ended during the first quarter of 2005, but a long-term bottom won't occur until 2008-2010. (Last update: 28 March 2005)

Gold commenced a secular bull market relative to all fiat currencies, the CRB Index, bonds and most stock market indices during 1999-2001. The first major upward leg in this secular bull market ended in December of 2003, but a long-term peak won't occur until at least 2008-2010. (Last update: 13 February 2006)

Commodities, as represented by the CRB Index, commenced a secular BULL market in 2001. The first major upward leg in this bull market ended during the second quarter of 2006, but a long-term peak won't occur until at least 2008-2010. (Last update: 08 January 2007)

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Outlook Summary

Is the long-term equity bull still alive?

In a world where money can be created in unlimited quantities 'out of thin air' it is vital to differentiate between a bull market in an asset and a bear market in the currency in which the asset is priced, but differentiating can be a challenge because an upward price trend for the asset will be the likely result in both cases.

Richard Russell is one of the most astute stock market observers/commentators around so we hesitate to single him out for criticism, but the recent dramatic change to his big picture view of the US stock market provides us with the ideal opportunity to re-visit what we consider to be the financial world's most important long-term chart. But first, to make sure everyone is on the same page we've included, below, an excerpt from Mr Russell's 9th May daily report.

"The first phase of the bull market occurred during 1982 to probably 1987. This is the phase where the big money investors took their early positions. The erratic and complex second phase began around 1987, and may still be in force. The second phase is the phase in which the public participates -- to varying degrees. The second phase is usually the longest phase, and it's characterized by one or more (often more) frightening secondary reactions which are almost always mistakenly taken to be primary bear markets.

The 2000 to 2002 collapse reminds me very much of the frightening decline of 1957-58, which was widely taken to be a bear market. I turned very bullish at the end of 1957, and that's when I started Dow Theory Letters.

The second phase of the bull market may still be in force, it's difficult to tell. I suspect we're now nearing the end of the second phase, and the period ahead may be ("should be") accompanied by some erratic and confusing action with very probably a secondary correction.

If we are, in fact, close to the end of the second phase of this huge bull market, then between now and the fourth quarter of 2007 we could see a serious correction, a correction that would serve to turn the public from their current skepticism to extreme bearishness. This would serve to prepare the stock market for the final third phase of the bull market.

The third phase of a bull market is usually the most profitable of the three phases. The third phase sees the public come into the stock market in full force and with "both feet." I believe a coming third phase will be international in character and in speculative intensity it will go beyond anything we've seen before."

Prior to last week Mr Russell had spent years explaining that US equities were in the midst of a secular BEAR market, with the 2000-2002 decline being the bear market's first downward leg. However, he now suspects that the 2000-2002 decline was a sharp correction within the context of a secular BULL market and that the most lucrative phase of the long-term bull market lies ahead of us. Furthermore, he now likens the 2000-2002 decline to the severe bull market correction that occurred during 1957-1958.

Just to be clear, we have absolutely no problem with someone altering their opinion in response to evidence that clearly points to an error in their logic. In fact, we hope to have the good sense to change our own opinions in situations where new evidence proves us wrong. What we have a problem with is the REASON given by Mr Russell for his opinion change.

In a world where money can be created in unlimited quantities 'out of thin air' it is vital to differentiate between a bull market in an asset and a bear market in the currency in which the asset is priced, but differentiating can be a challenge because an upward price trend will be the likely result in both cases. The doubling of an asset's price could, for example, be due to a) the asset becoming worth twice as much in real terms, b) the currency in which the asset is priced losing half of its purchasing power, or c) some combination of increased real value on the part of the asset and decreased value on the part of the currency. The point is that from an investment perspective there is a big difference between a real price increase and an inflation-fueled price increase.

Which brings us to the main reason for Mr Russell's change of heart: last month's simultaneous moves to new nominal price highs by the Dow Industrials Index, the Utility Index and the Transportation Index.

Mr Russell is taking the concurrent moves to new all-time highs by the aforementioned indices as confirmation that the bull market of the 80s and 90s is still alive and that much higher prices lie ahead. Well, it's true that much higher prices may lie ahead but if the higher prices are solely the result of inflation (growth in the money supply) then they will NOT be indicative of an on-going secular bull market in US equities; they will, instead, be the result of a US$ bear market.

To illustrate our point using an extreme example, the hyperinflation of the early-1920s caused the German stock market to gain more than one TRILLION percent in nominal currency terms while it was collapsing in real terms. During this period German equities were immersed in a major BEAR market, but had there been the equivalent of the Dow Industrials Index, the Dow Utility Index and the Dow Transportation Index within that market at that time then these indices would undoubtedly have been making new highs almost every day (almost every hour, actually).

So, how do we ever know whether the long-term stock market trend is bullish or bearish?

We can never know for certain because, as discussed in the past, any market's current trend is always a matter of opinion. However, it is generally possible to 'see' the real long-term trend by looking at things in terms of valuations and gold-denominated prices, rather than dollar-denominated prices. This is where the financial world's most important long-term chart comes into play.

The chart we are referring to is included below. The top part of the chart shows the Dow/gold ratio and the bottom part of the chart shows the S&P500's price/peak-earnings ratio. Not coincidentally, long-term trends in the US stock market's average valuation (as represented here by the S&P500's P/E ratio) are similar to long-term trends in the Dow/gold ratio. Note, in particular, that if investors believe that earnings growth is being fueled more by inflation than by real/sustainable improvement then they will pay less for each dollar of earnings (P/E ratios will fall) and there will be greater investment demand for gold (the gold price will rise relative to the Dow).

Looking at this chart we are left with little doubt that long-term downward trends in the Dow/gold ratio and the average stock market valuation commenced during 1999-2001; that is, we are left with little doubt that US equities are about 7 years into a secular bear market. Furthermore, when looked at in valuation and gold terms the situation during 2000-2002 could hardly be more different to the situation during 1957-1958. In 1958 Mr Russell was right to turn bullish on the stock market because at that time valuations were relatively low and rising. Now, however, they are relatively high and falling.

The bottom line is that if you use the dollar or any other non-redeemable currency as your measuring stick then you stand a good chance of being hoodwinked by inflation. In our opinion, Mr Russell has just been hoodwinked.

The Stock Market

The Euro/Yen Factor

It's worth re-visiting the following chart comparison of the S&P500 Index and the euro/Yen exchange rate because it neatly encapsulates what's happening in the financial world at this time. Notice the closeness of the relationship between the US stock market and euro/Yen. Even the minor twists and turns line up quite well.

Even though our chart shows the US stock market, we could have made the same point using almost any of the world's stock markets. Clearly, strength in the euro relative to the Yen is somehow linked to strength in equities. And during the brief period earlier this year when the Yen suddenly rallied against the euro, equity prices momentarily became very weak.

It's reasonable to expect that the next substantial Yen rally will be associated with a sharp stock market decline. However, a non-leveraged position in the Yen probably wouldn't be an effective hedge against the effects of a Yen rally on an equity portfolio. The reason is that a rally in the Yen, when it eventually occurs, will likely have an outsized effect on the markets that have been elevated by low-priced Yen credit. And someone who takes a leveraged position in the Yen will be putting himself/herself in the position where a Yen plunge would create a big problem, so this is also not the way to go.

In our opinion it makes sense for part of an investor's cash position to be Yen-denominated simply because the Yen is a very under-valued currency, but we wouldn't specifically buy Yen (or Yen futures or Yen options) to hedge against the downturns in other markets that will likely occur when the Yen carry trade eventually begins to unwind.

Current Market Situation

Below is a chart of the NDX/Dow ratio (the NASDAQ100 Index divided by the Dow Industrials Index), one of the most reliable leading indicators of the broad US stock market's intermediate-term trend.

The weakness in NDX/Dow from late November through to mid February in the face of general stock market strength was a warning that things were not as bullish as they seemed on the surface, while NDX/Dow's resilience during the February-March decline was a sign that this decline would not evolve into an intermediate-term correction.

We would describe NDX/Dow's current situation as neutral. It has been slowly drifting lower over the past several weeks and has therefore failed to confirm the stock market's rally to new multi-year highs, but the downward drift does not YET qualify as a bearish divergence. However, if NDX/Dow were to break below its December and February lows then we would have a glaring bearish divergence on our hands. Alternatively, if NDX/Dow were to break above its February-March highs, and especially if it were to break above its November-2006 high, it would be a clear signal that the stock market's advance was probably not close to an end.

Below is a chart showing the 10-day moving average of the CBOE put/call ratio. Note that the chart's scale is inverted (a falling line indicates a rising put/call ratio).

When the put/call's 10-day MA hit an all-time high during the first half of March it meant that sentiment had become so bearish so quickly that it wasn't reasonable to anticipate significant additional downside in the short-term. We therefore upgraded our short-term stock market outlook from "bearish" to "neutral", although with the benefit of hindsight we should obviously have shifted all the way to "bullish".

The extreme fearfulness that was apparent during the first half of March has since completely evaporated and the put/call's 10-day MA has moved back to the bottom quartile of its 3-year range (the top quartile on the chart), which is hardly surprising given the price action.

Sentiment indicators are generally pointing toward a short-term pullback, but the public does not appear to be as optimistic about the stock market's prospects right now as it has been near intermediate-term peaks in the past. We note, for instance, that small traders as a group have a small net-SHORT position in S&P500 futures and that the latest AAII sentiment survey revealed a bullish percentage of only 42.9. Therefore, in the absence of a breakdown in the NDX/Dow ratio we will assume that the next pullback will not mark the start of an intermediate-term correction.

This week's important US economic events

Gold and the Dollar

Gold Stocks

In the 2nd May Interim Update and in subsequent commentaries we said it would be reasonable for short-term traders to 'go long' the gold sector in anticipation of a rebound over the coming weeks. The idea was that risk could be managed by placing protective stops just below the 1st May lows, thus limiting the potential downside to around 3% versus the potential for a quick gain of around 10%. Due to the favourable short-term risk/reward we also upgraded our short-term outlook from "neutral" to "bullish" at that time. Note, though, that the upgrading of our short-term view did not reflect a significant change to our assessment of the short-term upside potential as we had already been anticipating a bit more strength. The key points were the establishment of a well defined demarcation line (the 1st May low), affording the ability to limit downside risk, and the likelihood that the late-April correction had acted to extend the overall advance by at least a couple of weeks. 

The gold sector thoroughly tested our pre-determined downside limits on Thursday, but didn't quite do enough to invalidate our modestly bullish short-term outlook. Specifically, the HUI closed 1 point below its 1st May low on Thursday while the GDM and the XAU remained above their 1st May lows. All of these indices then bounced on Friday.

Below is a chart of the GDM (the AMEX Gold Miners Index). With sentiment toward the major gold stocks seemingly 'in the toilet' it is difficult for us to imagine that a large decline could soon get underway, but we don't consider sentiment to be a primary indicator and so if we had any short-term trading positions we would probably exit them if the gold stock indices sent a consistent message by closing below their respective 1st May lows. 

On a side note, we don't alter our investment strategy in response to changes in our -- or anyone else's, for that matter -- short-term views, and we don't think you should either. Our investment strategy is always based on long- and intermediate-term risk/reward considerations. We take shorter-term positions from time to time and endeavour to use short-term volatility to improve our longer-term returns, but if the long- and intermediate-term risk/reward considerations don't change then our overall exposure generally doesn't change by much. In particular, we would almost never make a significant alteration to our overall exposure based on the expectation of a 10% move in either direction in the short-term.

We know that many traders devote a lot of their time/energy to scalping moves of a few percent and that some of them are even able to consistently generate good annual returns by doing so. From our perspective, however, a 10% move in the gold stock indices in either direction would be of minor interest only. Assuming our assessment of the intermediate-term risk/reward remained unchanged then we would almost certainly do some selling in response to a quick 10% advance and some buying in response to a quick 10% decline, but our overall market exposure would not shift by much (our cash reserve is presently around 40% and will probably remain within the 35%-45% range until our intermediate-term outlook changes).

Further to the above, the following extract from our 30th April commentary remains applicable:

"There is probably some more upside in store for the gold sector over the coming weeks. But with the HUI having touched the bottom of our 370-400 target range earlier this month and with the likely time-window for a turning point now just around the corner, this is not the time to be cavalier. As we noted in our 23rd April report, people who are substantially overweight the gold sector should be looking for opportunities to scale back to a "core" position (a position from which you could watch a 20-30% intermediate-term decline with equanimity whilst retaining significant long-term exposure to the bull market). In other words, people who have a lot of exposure to gold should consider buying some insurance. This insurance could take the form of put options, but in general it is much better to insure yourself against a bull market correction by increasing your cash reserve than by purchasing put options."

Gold

We had previously drawn a line in the sand at $670 for the June gold futures contract, but the following chart suggests that this is not the time to downgrade our short-term outlook. For one thing, last week's decline terminated right at the bottom of a well-defined intermediate-term channel. For another thing, the correction that began in mid-April currently looks like a smaller version of the one that began in early December. We will therefore give our short-term bullish outlook a bit more rope.

A daily close below $660 (basis the June contract) would decisively breach the channel bottom and project a drop to around $600.

Currency Market Update

Below is a weekly chart of the Dollar Index.

The momentum low is probably in place for the US dollar, but the modest rebound of the past two weeks does not have the look of a trend reversal. Sentiment is mixed, with traders a) frothing-at-the-mouth bullish on the euro, the British Pound and the Australian Dollar, b) moderately bullish on the Canadian Dollar, c) moderately bearish on the Swiss Franc, and d) frantically-scrambling-to-be-first-to-the-short-selling-window bearish on the Yen.

An upward reversal in the Dollar Index could occur at any time and the main risk, as far as the dollar's performance over the next few months is concerned, is most assuredly to the upside. However, the price action puts the odds in favour of a drop to (marginal) new lows prior to the start of a tradable US$ advance.

Update on Stock Selections

(Note: To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question)

Natural Gas Trusts

The pace of consolidation is beginning to pick-up within the realm of Canadian energy trusts. Consolidation is normally bullish for stock prices, but about three weeks ago the management of Thunder Energy (TSX: THY.UN) sold the company at ZERO premium to the current market price and late last week it was announced that Shiningbank Energy (TSX: SHN.UN) had agreed to sell itself to PrimeWest Energy (TSX: PWI.UN, NYSE: PWI) at almost no premium to the current market price.

Whereas we were annoyed by the THY takeover, we are satisfied with the SHN takeover for three main reasons. First, it's a stock-swap deal so SHN's unit-holders will retain exposure to the upside. Second, at the time we established the TSI Energy Trust Index (TETI) we almost included PWI and will have no qualms about replacing SHN with PWI in the future if/when the merger is approved. Third, PWI has a US listing in addition to its Canadian listing, which gives it exposure to a larger group of investors -- the greater exposure will become a significant advantage when the natural gas bull market heats up again -- and will potentially make it attractive to a US-based predator should the consolidation trend continue within the energy trust sector.

In general, the 'gassy' trusts look like they are in the early stages of upward trends or about to complete lengthy basing patterns. Of the ones we follow, Daylight Resources (TSX: DAY.UN) looks particularly interesting at this time; as does Vault Energy (TSX: VNG.UN), although Vault has already rebounded quite strongly from its lows. Shiningbank is also suitable for new buying. SHN's price will track the price of PWI for now, but there's a small chance of a competing (higher) bid; and in any case, PWI appears to be in reasonable shape.

    Gammon Lake Resources (AMEX: GRS). Shares: 115M issued, 126M fully diluted. Recent price: US$14.10

GRS reported its Q1 results following the close of trading last Thursday. The results included lower-than-expected production and higher-than-expected costs, causing the stock price to take a 9% hit on Friday.

In our opinion it doesn't make sense to buy or sell a stock such as GRS in reaction to a single quarter's financial performance, especially with the company having just recently reached commercial production at its Mexico-based mining operations. The sailing is rarely smooth during the first few months of gold mine's life.

But plenty of people obviously have just sold in reaction to the company's latest quarterly results.

The recent price action makes last month's decision by GRS's management to sell 10M new shares look even smarter than it did at the time because the price at which the new shares were sold was 28% above Friday's closing price. Good for GRS, but bad for the people who participated in the financing.

Friday's sell-off might have created a short-term buying opportunity. Note, though, that even at US$14/share the stock sports a significant valuation premium. We think the premium will prove to be justified because GRS will be an extremely low-cost gold producer once the new mine is operating smoothly and also because there is huge expansion potential within the company's existing stable of assets, but it could take a while to regain the confidence of the market. Furthermore, from a technical perspective there appears to be more downside in store. In particular and with reference to the following chart, GRS tested its 2006 peak earlier this year and has just broken decisively below support at US$15. It would not be surprising to see a bounce back to $15 (support turned into resistance) over the coming days, but our guess is that the stock will become available at lower prices within the next couple of months.

If the market is kind enough to give us the opportunity (there's no guarantee that it will be so kind) then we will almost certainly be buyers of GRS in the US$11.50-$12.50 range. This stock will, we think, be one of the best performers on a risk-adjusted basis during the next upward leg in the gold sector's long-term bull market.

    Metallica Resources (AMEX: MRB, TSX: MR). Shares: 92M issued, 118M fully diluted. Recent price: US$4.91

If you are looking for a junior gold producer or soon-to-be producer to buy at this time then you should look no further than MRB. The stock is in the process of becoming a market favourite and is not the screaming bargain it was 11 months ago, but it remains under-valued -- at current metal prices we can easily justify a valuation of more than US$6/share -- and looks reasonable from a technical perspective (see chart below).

MRB would be suitable for new buying in the US$4.50-US$5.00 range.

Chart Sources

Charts appearing in today's commentary are courtesy of: