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   -- Weekly Market Update for the Week Commencing 14th June 2004

Big Picture View (Most recent update: 7 June 2004)

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 will end during the first half of 2004. The October-2002 bottom (775 for the S&P500) will be tested during 2005. (Last update: 12 January 2004)

The Dollar made an intermediate-term bottom in February of 2004 and is likely to test its low by August of 2004 before moving higher into the first half of 2005. A long-term bottom won't occur until 2008-2010. (Last update: 7 June 2004)

Gold will make an intermediate-term peak during the first half of 2004 and then consolidate for at least 6 months, but a long-term peak won't occur until 2008-2010. (Last update: 12 January 2004)

Commodities, as represented by the CRB Index, will make an intermediate-term peak during the first half of 2004 and then consolidate for at least 6 months, but a long-term peak won't occur until 2008-2010. (Last update: 12 January 2004)

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Inflation Expectations

The US Producer Price Index (PPI) for May should have been released last week, but it was delayed to give the Government's statisticians more time to conjure-up a lower number. This wasn't, of course, the official explanation for the delay, it's just the explanation that rings true. The PPI will probably be released sometime this week, but we have no idea what the final number will be. What we can confidently predict, though, is that the number that ends up being reported will be substantially lower than the number that would have been reported had an honest attempt been made to calculate what was actually happening to producer prices.

Manipulating statistics and 'jawboning' are the two main tactics used by the US monetary authorities to manage inflation expectations and in so doing keep a lid on the gold price. In fact, the management of inflation expectations is the ONLY effective way to contain the gold price. This is because central banks don't own anywhere near enough gold to suppress the price through direct intervention should inflation expectations begin to surge. 

Right now, inflation expectations are under control. We can say this with confidence due to the way the markets are reacting to inflation news and 'Fed speak'. In particular, the US$ is rallying on any news that confirms the presence of inflation because the markets are taking such news to mean that the Fed is going to bump official interest rates up by one or two percent. However, if inflation expectations were running out of control then the markets would not be anticipating a quick and relatively painless end to the inflation. They would, instead, be going crazy because the Fed has STILL not made its FIRST rate hike despite all the obvious signs of inflation.

The bottom line is that most people currently perceive some FUTURE inflation risk, but very few people realise that the US has a major inflation problem right NOW. Hence the counter-intuitive response to news of higher inflation and the strength in the US$ every time a Fed representative hints at the prospect of higher interest rates.

What will the Fed do?

According to the Fed Funds Futures, which at any given time represent the market's best guess as to what the Fed is going to do, the Fed will hike rates by 0.25% at the June FOMC Meeting and by a total of 0.75% over the coming three months. And the Greenspan Fed always tries not to surprise the market, so unless something happens to change the market's expectations then rate hikes totaling 0.75% are what we are likely to get over the coming three months.

There's a good chance, of course, that something WILL happen to change the market's expectations. For example, the PPI and/or the CPI might turn out to be much higher than currently anticipated and cause the market to begin discounting additional rate hikes. Or stock and commodity prices might fall, thus resurrecting the deflation fears that were so prevalent just 12 months ago and causing the market to ramp-down its expectations with regard to official rate hikes.

An important point to understand, though, is that if deflation fears can potentially be resurrected simply by pullbacks in commodity and/or stock prices, or if the markets really believe that the Fed can get the inflation situation under control with a few 0.25% rate hikes, then inflation expectations are quite low to begin with. This, in turn, simply confirms that the gold bull is young.

Commodities

Our view is that the US$ will test its lows before experiencing a 6-12 month rebound, and if this view proves to be correct then the commodities that performed so well between the second quarter of last year and the first quarter of this year will probably test their highs within the next couple of months. However, the inverse correlation between commodity prices and the US$ suggests that once the dollar turns higher, and particularly once it breaks upwards out of the downward-sloping channel in which it has been mired since the beginning of 2002, we should expect a lengthy correction in the CRB Index.

The 'China story' provided the fundamental basis for the huge run-ups in the prices of the industrial metals during the final quarter of last year and the first quarter of this year, while fears that China's growth was about to slow contributed to the subsequent sharp declines in metal prices. The latest figures show that China's rate of growth has slowed, but is still very fast. For instance, during May the year-over-year increases in China's imports, money supply and production were 35%, 17.5% and 17.5%, respectively. These are down from the levels of 42%, 21% and 23%, respectively, reached earlier this year, but are still very high. Therefore, strong Chinese demand remains an important factor in the commodity markets.

China's growth, even though it has slowed from the torrid pace reached earlier this year, is no doubt largely responsible for the on-going draw-down in copper inventories. As at the end of last week the LME copper inventory stood at 122,225 tonnes, down an incredible 72% since the start of this year and down by 17% over just the past month. Judging by the performance of copper futures the financial markets continue to expect that copper inventories will be replenished over the coming 6 months, but there is little margin for error here.

Below is a daily chart of July copper futures. There was an upward reversal in the copper price last Thursday following a plunge to near the May low, so it is possible that a successful test of the low has just occurred.



Below is a daily chart of July oil futures. The sharp spike above resistance and subsequent plunge at the beginning of this month looks like an important reversal and probably means that an intermediate-term peak (a peak that will be followed by a correction lasting 3-12 months) is now in place. It would, however, be normal for this peak to be tested at some point over the coming 1-2 months. Terrorist attacks against the oil industry in the Middle East would, of course, have the potential to negate the downward reversal in the oil price.



We expect that the stocks of oil and gas producers will continue to do what they usually do -- move with the broad stock market more so than with energy prices. That is, if the broad stock market remains firm then oil and gas stocks will probably perform well almost regardless of what is happening to the oil price, but if the broad market begins to accelerate lower then the oil stocks are likely to follow suit even if the oil price happens to be rocketing higher at the time.

Bonds

Japanese Government Bond (JGB) prices plummeted last week and, in the process, appear to have broken below the neckline of a 3-year head-and-shoulders topping pattern (refer to the following weekly chart). They ended the week at support defined by the August-2003 low. After such a sharp downward move it wouldn't be surprising to see the JGBs consolidate for a few weeks before continuing their fall. However, prices look set to move much lower over the coming 6 months.



The weekly chart of US T-Bond futures is not quite as bearish as the JGB chart, but it still has the look of a large topping pattern. A weekly close below the support line shown on the below chart would indicate that the next downward leg in the bond bear market was underway, but we think it is likely that bonds will consolidate for a few more weeks before this breakdown occurs.


The Stock Market

The Secular Trend

Last year at around this time we asked the question: "Has a bear market started yet?" We thought this was a reasonable question because the NYSE advance-decline line had been trending higher for three years and several important sectors of the market were clearly not in long-term downward trends. And the question seems even more relevant today than it did 12 months ago because the NYSE advance-decline line hit an all-time high early this year, and although the senior stock indices have never looked like challenging their 2000 peaks many sub-indices have moved to all-time highs over the past 12 months. The question really doesn't exist, though, if we make the sensible decision to define the secular trend in terms of valuations rather than prices.

When we try to define secular stock market trends in terms of prices we run up against two problems. First, nominal prices are expressed in terms of a currency that is constantly changing. Second, when a currency depreciates as a result of inflation an effect, at least during the early stages of the inflation, can be higher earnings and higher stock prices.

It is possible, however, to eliminate the 'smoke and mirrors' effect that massive monetary stimulation can cause because over long periods the stock market has always differentiated between real earnings growth and earnings growth caused by inflation. Specifically, investors have historically paid less for earnings that stem from inflation than for earnings that stem from real (productivity-driven) growth. In other words, if earnings are being artificially boosted by currency depreciation then P/E ratios will trend lower.

Further to the above, if we define secular trends in terms of the average P/E ratio, as opposed to the nominal level of a stock-market index, the secular trends will not be obscured by changes in the value of the currency. For example, the below chart shows how long-term trends can appropriately be defined by the trends in the S&P500's P/E ratio. By the way, thanks to David Fuller at www.fullermoney.com for helping to clarify this issue for us.

The logical conclusion is that a secular bear market began following the major peak in the P/E ratio during the first two years of this decade and will, if history is any guide, continue until well into the next decade.


The one problem with defining secular trends in terms of P/E ratios is that the P/E ratio will sometimes fluctuate wildly during any given 1-5 year period. As a result it is really only possible to 'see' the trend in the P/E ratio when looking at very long-term charts, whereas during a normal investment timeframe the secular trend in the P/E ratio might not be evident or even relevant. Fortunately, there is a method of defining the secular trend in the stock market that gets around the problem of nominal prices being substantially altered by changes in the currency AND is of more practical use than the long-term trend in the average P/E ratio. The method, which we've illustrated on the below chart, is to let the trend in the Dow/gold ratio define the secular trend in the stock market.

Note: Gold and the US$ were officially linked prior to 1971 and this resulted in a very short and very sharp downturn in Dow/gold during the early 1930s followed by a very lengthy recovery into 1966, but if the US$ had not been convertible into gold at a fixed rate we suspect that the downward trend in Dow/gold that began in 1929 would have been more gradual and would have bottomed during the first half of the 1940s.


The above chart suggests that the secular bear trend in the stock market is in its early stages in terms of both time and price. In fact, if history is any guide the bear trend will end sometime next decade at a Dow/gold ratio of between 1 and 5. With the ratio presently at 27 this means that it would be reasonable to expect an investment in gold bullion to perform at least 5-times better, and perhaps as much as 27-times better, than an investment in the Dow Industrials Index if both investments were held over the next 10 years. 

Current Market Situation

There has only been one trading day since we wrote last week's Interim Update and that day's low-volume rally did not change anything.

The one thing that is becoming more obvious as each day passes is that in the current environment US$ strength is a big short-term negative for the US stock market. Our expectation is that the US$ will drop over the coming 1-2 months and that any intervening rebound in the Dollar Index will hold below the channel top (refer to the chart in last week's Interim Update). However, if the Dollar Index surprises us by breaking out of its 2.5-year channel then the near-term outlook for the stock indices will turn decidedly bearish.

This week's important US economic events

Date Description
Monday Jun 14
Trade Balance
Retail Sales
Tuesday Jun 15 CPI
Wednesday Jun 16 Industrial Production
Beige Book
New Residential Construction
Thursday Jun 17 Leading Economic Indicators
Friday Jun 18 Q1 2004 Current Account

Gold and the Dollar

Gold stocks and the yield-spread

Gold and gold stocks are positively correlated with the yield-spread, although the correlation appears to be stronger with the stocks than with the bullion. We say this because during 1985-1986 and 1999-2000 gold stocks continued to trend lower with the yield-spread for about 16 months AFTER the gold price had bottomed. In fact, during both 1986 and 2000 a large advance in gold stocks began on almost the same day that the trend in the yield-spread (the yield on the 30-year T-Bond divided by the yield on the 13-week T-Bill) reversed from down to up.

Relative to its 20-year average the yield-spread is currently very high, but the absolute level of the yield-spread appears to be far less important, as far as the currency and gold markets are concerned, than the direction in which it is moving. This can be seen on the below chart. Notice that when the yield-spread turned higher in November of 2000 its level was very low, but as soon as the yield-spread reversed course a major bull market in gold stocks got underway. Similarly, the trend reversal in the yield-spread in January of this year led to a trend reversal in the gold sector.

By the way, trend-lines drawn on charts are always somewhat arbitrary. For example, trend-lines will usually be in different places depending on the type of chart (candlestick, line, P&F, etc.) and on whether the chart's vertical scale is linear or logarithmic. Also, experienced chartists will regularly draw trend-lines in different places even when using the same scale and the same type of chart. This is why, when identifying support/resistance levels on charts, we usually place a lot more importance on former peaks and troughs than on trend-lines. It is also why the yield-spread's trend-line break in January could have been meaningless until it was confirmed by the April-May breakdown in gold stocks (the yield-spread broke below similar trend-lines in August of 2002 and April of 2003, but in both cases subsequent market action proved that it was still in an upward trend).


The above chart doesn't tell us that a major top is in place for either the gold stocks or the yield-spread because an upward trend-line formed by connecting the lows during the first few years of a long-term bull market is never likely to remain intact throughout the entire bull market. Instead, what tends to happen is that some larger-degree corrections along the way will establish a trend-line that is less steep. In other words, the bottom of the current correction (which might, by the way, already be in place) will probably determine the slope of the long-term upward trend.

What the chart does tell us is that as long as the yield-spread is moving lower, that is, as long as short-term interest rates are rising RELATIVE TO long-term interest rates, the gold stocks will be facing a substantial headwind. The Fed could therefore bring about much greater weakness in the gold sector than has already occurred by getting genuinely aggressive on the rate-hiking front. The thing is, if the Fed did do that it wouldn't just take down the gold stocks; it would take down the entire stock market. And that's why it almost certainly won't happen, at least over the next several months.

Gold and interest rates -- the 1970s analogue

An argument we've seen made quite regularly by gold bulls over the past few months is that the performances of the gold, currency and interest-rate markets during the 1970s prove that rising interest rates are not bullish for the US$ or bearish for gold. However, the logic in this argument is faulty. The fact that gold and interest rates rose together during the 1970s simply tells us that if everything were the same today as it was during the 1970s then a rising gold price would likely occur alongside rising interest rates. The thing is, there are some very big differences between the current situation and the situation during the 70s and these differences all but guarantee a different outcome.

The US has experienced a high inflation rate (money supply growth rate) over the past few years and our expectation is that it will experience a lot more inflation over the next several years. In this and a few other respects the current situation is similar to the 1970s, but the amount of debt in the system is now MUCH greater than it was during the 70s and asset valuations are currently MUCH higher than they ever were during the 70s.  

Our expectations are that:

a) The outward signs of inflation will be less prevalent during the second half of this decade than they were during the 1970s, particularly if real estate prices and construction activity taper off (as will probably occur over the next few years). As a result, the Fed will be forced to remain stimulative (the real Fed Funds Rate will generally remain low and the yield-spread will generally remain high), although there will be brief periods -- right now, for instance -- when the markets start to fear a non-stimulative Fed.

b) Once the US consumer becomes unwilling or unable to act as the primary engine of inflation the Fed will take-over this role and start directly ramping-up the money supply.

In a nutshell, we expect that those who are forecasting a repeat of the 1970s will be wrong because there are huge differences between now and then, while those who are forecasting deflation will be wrong because the Fed's ability to print money is unlimited. We are in are uncharted waters.

Current Market Situation

Over the past couple of years the 18-day moving average of the nearest gold futures contract has regularly provided support or resistance during minor corrections. Furthermore, crosses of this moving average have been reliable signals of changes in the short-term price trend. August gold closed below its 18-day moving average last Wednesday and butted up against it on Thursday morning before dropping back. 

Our thinking is that gold will find support around $380 during its current pullback and then move up to $415-$420. Other likely support levels are $375 (the May low) and $367 (the bottom of the channel shown on the following daily chart of August gold futures), but these lower levels should only come into play if the US$ is a lot stronger over the coming 1-2 months than we currently expect.


With Newmont Mining (NEM), the HUI and the XAU all having turned lower without first moving above their former breakdown levels ($41 for NEM) there is a chance that the gold stock indices and some individual gold stocks will drop below their May lows over the next month or so. However, the downside risk does not appear to be great. For example, the following log-scaled weekly chart of NEM shows that there is major support in $33-$35 range versus last week's close of $37.94.

Note that a drop back to near the May lows would most likely require an upside breakout by the Dollar Index.


Update on Stock Selections

First Majestic Resource (TSXV: FR) has acquired "...a district-size property package [in Mexico] which includes three previously operated mines. These mineral assets will complement the company's recent acquisition of the La Parrilla silver mine and will give the company a strategic position in an area in which the geological potential for additional discoveries is high and combined mining infrastructure will optimize the use of the company's financial resources."

Several acquisitions have been made with the main one being the Perseverancia silver mine. This mine has reportedly produced 3.2M ounces of silver in the past at grades of 500-1500 g/t, as well as significant amounts of lead and zinc. And, according to FR, "further additional potential within the mine and surrounding area is very promising taking into account that this mine was operated in a very small and reduced way, without modern exploration techniques or a professional development approach."

Under the terms of the acquisition agreements FR has 6 months to carry out due diligence on the projects, during which time it will spend US$300,000. Based on the results of this due diligence FR will decide whether or not to proceed with the acquisitions.

This latest news from FR is in line with the company's goal of buying silver assets that can be quickly developed to the point where they are producing positive cashflow. Like all silver miners FR stands to benefit from a higher silver price, but it is a lot more than just a call option on the silver price.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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