<% 'pass = Request.Form("pass") IF ((Request.Form("pass") = 1) OR (Session("pass") = "pass")) THEN %> Speculative-Investor.com
   -- for the Week Commencing 15th April 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, but will rally to a secondary peak during the first half of 2002 before beginning a major descent.

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.

Considerable Slack

"Inflation declined during the recession and seems poised to decline further as growth accelerates in an economy with considerable slack," he [Dallas Federal Reserve Bank President Robert McTeer] said in the Dallas Fed's annual report.

The above really is an incredible statement from the president of the Dallas Federal Reserve Bank. There was apparently so little slack in the economy during 1999 that the Fed felt compelled to raise short-term interest rates a number of times, yet today, with consumer spending and the overall level of indebtedness having grown considerably over the past 3 years, the economy supposedly has "considerable slack". We wouldn't argue that there is considerable slack in those few sectors of the economy where capacity was expanded at a phenomenal rate during the Fed-sponsored NASDAQ bubble (eg, the telecom industry), but the absence of "slack" that led to an energy crisis during 2000-2001 has certainly not been addressed.

The 'lack of slack' in the US economy is evidenced by the surge in energy prices over the past 5 months despite the continuing strength of the US$ (only the recent gains were Middle East related). It is also evidenced by the behaviour of the bond market.

Below is a chart showing the yield on the 10-year T-Note during the 6-month period following the 1990-1991 recession. At the end of a recession there is typically a lot of 'slack' in the economy and this 'slack' enables long-term interest rates to fall during the initial stages of recovery. This is what happened after the early-90s recession.

Below is a chart showing the yield on the 10-year T-Note over the past 6 months. If there really was "considerable slack" in the economy and inflation really was "poised to decline further" then interest rates would still be trending lower. That is clearly not the case.

When McTeer uses the word inflation he is referring to an increase in the CPI. If we define inflation correctly (as an increase in the supply of money) then the current US inflation rate is 9.1%. This inflation will eventually put upward pressure on some prices, although anyone who truly believes that the CPI accurately represents cost of living changes, or is even an honest attempt to accurately represent cost of living changes, deserves a gullibility award. Ironically, if we define our terms correctly then McTeer's statement that inflation is "poised to decline further" is actually true since the money supply growth rate is poised to decline further. 

Commodities

At the beginning of this year we forecast that commodity prices, as represented by the CRB Index, would perform well in 2002 relative to the stock market (as represented by the S&P500 Index). Our concern at the time, however, was that the CRB Index would out-perform the S&P500 Index and still not yield a good absolute return. This concern was based on the positive correlation between the CRB and the S&P500 that had been evident over the past 2 years.

Below is a chart comparing the S&P500 and the CRB Index. Since mid-2000 the CRB Index has followed the S&P500 with a lag of 0-6 weeks. At some point we expect this relationship to breakdown and for commodity prices to start trending higher as stock prices trade sideways. It is quite possible, however, that a major rally in commodity prices will have to wait until after the stock market has reached its ultimate low (the stock market's ultimate low is expected to occur late this year).

The CRB Index has fallen sharply over the past 2 weeks but has not yet closed below its 200-day moving-average. Also, the stocks of commodity producers have held up quite well despite the recent weakness in the stock market and commodity prices. As such we are treating the recent decline as a bull market pullback but may need to ramp-down our expectations for commodity prices if the CRB Index continues to move with the S&P500.

The US Stock Market

Small caps versus large caps

The upward trend in the NYSE's advance-decline line is often cited as a reason to be bullish. The advance-decline line's upward mobility stems primarily from the strength in small-cap stocks which, in turn, is also regularly cited as a reason to be bullish.

It is easy to be bullish at the top and today's fervent enthusiasm for small cap stocks may be a sign that this sector of the market is close to a peak. The following chart of the S&P600 Index (an index of small cap stocks) certainly suggests that this might be the case. This is a close-up view of the chart we showed a couple of weeks ago to illustrate the broadening top (a sequence of higher highs and lower lows) that appears to be forming. The chart suggests that the downside risk in this popular sector of the market now vastly outweighs the upside risk.

Whereas small-cap stocks appear to be nearing an important peak, large-cap stocks reached a 'bubble peak' back in 2000 and have been working their way lower ever since. Furthermore, the decline in large-cap stocks looks like it still has much further to go.

Below is an 8-year chart of General Electric, the largest of the large-caps. GE peaked during the third quarter of 2000, making it one of the last of the large-caps to do so. Last week's drop in the GE stock price on the back of disappointing earnings news suggests that the next phase of the stock's major downtrend has begun. 

Current Market Situation

It is almost time to move to the bullish side of the fence as far as the short-term is concerned. Here's why:

1. As indicated by the following chart, the 10-DMA of the equity put/call ratio has moved up to a high level (telling us that option traders are, as a group, fearful). Note that the chart scale is reversed so that the line falls as the put/call ratio rises. Furthermore, there is a pronounced divergence between the equity put/call ratio and the OEX (S&P100 Index) put/call ratio. As mentioned in the past, the equity put/call ratio is a good contrary indicator (meaning that equity-options traders, as a group, are invariably caught leaning the wrong way at important turning points) while the OEX put/call ratio is not a good contrary indicator (OEX-options traders tend to be right as often as they are wrong). In fact, it is usually worth paying attention when the equity put/call ratio is at one extreme while the OEX put/call ratio is at the opposite extreme, as is currently the case. When these large divergences occur the OEX traders are almost always correct. The OEX-options traders have just taken a bullish stance while the equity-options traders have taken a decisively bearish stance.

2. The Arms Index 10-DMA has just hit one of its highest levels of the past 40 years. High Arms Index readings occur when declining volume on the NYSE is high relative to the number of stocks that are declining, that is, they occur when most of the selling pressure is concentrated in a relatively small number of stocks.

3. The June bond futures have rallied and have now built a 4-point cushion between their current level and their December low. A further gain of another point or so is all we can reasonably expect from this bear market rally, but the immediate danger of a collapse in bonds has been removed.

It is almost time to turn bullish, but it is not yet time. While the high Arms Index reading tells us that a substantial rally is likely to begin during the next few weeks, the rally could begin from a MUCH lower level. For example, the extreme Arms Index reading during the second half of August last year was followed by a 20% plunge in the NYSE Composite Index over the ensuing 4 weeks. Unless we get the emotional equivalent of September-11 a 20% plunge from current levels over the next 4 weeks won't occur, but a drop of another 5%-10% is certainly possible.

Three other reasons to remain very cautious at this time are:

1. The Japanese stock market remains in a short-term downtrend.

2. The large commercial traders have not yet begun to cover their huge short position. In other words, the smart money is betting on a further decline.

3. Volatility remains at a very low level. Low volatility is not, in itself, a concern since volatility could increase from its low levels via either a sharp rally or a sharp decline. However, a sharp rally is not likely going to begin with the commercials net-short to the tune of 91,000 contracts.

We will continue to hold our June QQQ put options for now, but an opportunity to close-out this bearish position and move to a long position in the QQQ is likely to present itself during the next few weeks.

Traders and investors should continue to accumulate the stocks of commodity producers during weakness. These stocks are likely to be amongst the leaders once the current decline runs its course and a rally begins.

This week's important economic/market events
 

Date Description
Monday April 15 No significant events
Tuesday April 16 CPI
Industrial Production
Wednesday April 17 Trade Balance
Thursday April 18 Leading Economic Indicators
Friday April 19 No significant events

Gold and the Dollar

Platinum versus Gold

Although they are both precious metals the prices of platinum and gold respond in very different ways to different economic and monetary environments.

Below is a long-term chart of the platinum/gold ratio. The chart was taken from http://www.cairns.net.au/~sharefin/Markets/Master.htm, an excellent resource for financial market data. We've added notes and lines to the chart to illustrate (labour?) the point we are about to make.

Platinum tends to out-perform gold during prolonged periods of economic growth or perceived monetary stability and to under-perform gold during prolonged periods when confidence in the economy and the financial system is deteriorating. This relationship occurs due to gold's status, a status that has developed over thousands of years, as the ultimate form of money outside the financial system.

With reference to the above chart we can see that the platinum/gold ratio plunged (the gold price rocketed higher relative to the platinum price) during the early-1970s and bottomed, in late-1974, at around the same time that the stock market was hitting its major low. It is also apparent that the platinum/gold ratio trended higher from 1982 through to 2000, reaching what looks like a bubble peak in late-2000 at around the same time that the stock market bubble began to lose air at a rapid rate.

If the decline in the stock market and real economic growth over the past 18 months represents nothing more significant than an interruption to the 1990s' boom then the platinum/gold ratio will move above its 2000 peak over the coming 2 years. However, if we have just witnessed the end of an era characterised by, amongst other things, growing confidence in government, central banks and the fiat money system, then the year 2000 gave us a multi-decade peak in the platinum/gold ratio.

Our analyses of all the financial markets over the past few years strongly suggest that the level of confidence in government and government-sponsored money made a secular peak in 2000 and is now in a secular downtrend. As such, the downturn in the platinum/gold ratio in late-2000 represents a major trend reversal. 

The above chart shows that trends in the platinum/gold ratio, once set in motion, tend to continue for at least 4 years. In other words, we should expect the gold price to trend higher relative to the platinum price until at least the second half of 2004. This means that although some exposure to platinum (via the stocks of platinum/palladium producers) is desirable we should, based on the evidence at hand, continue to substantially overweight gold relative to platinum in our investment portfolios.

There are certainly going to be extended periods over the next few years - periods when the prospects for economic growth temporarily take a turn for the better - when platinum will out-perform gold. However, the trend in the ratio is now DOWN and we will not be surprised if gold trades higher than platinum at some point over the next 2-3 years.

The S&P500 in terms of gold

Below is another look at the S&P500/gold ratio that we show from time to time. This chart suggests that a quick move into the 320s by the gold price is still a distinct possibility before an extended (2-3 month) correction gets underway. This is because the Wave 3 decline does not appear to be over, meaning that the prospect of a drop to, or below, the September-21 low lives on. Assuming the S&P500 doesn't completely fall out of bed the only way this can happen is via a surge in the gold price. 

Last September's closing low for the ratio was 3.32. If the S&P500 falls to 1070 (a reasonable short-term objective) then an S&P500/gold ratio of 3.32 would require a gold price of $322.

Current Market Situation

The euro is still unable to break its downtrend, but this can't get any closer (see chart below). If we traded currencies (we don't) we'd be more inclined to be short the euro than long the euro at this time because the channel looks like it is going to hold for now. However, we would quickly move to a long position following a daily close of 88.40 or higher (basis the June futures). 

In the 8th April Weekly Update we mentioned that the A$ looked vulnerable to a sharp fall. The A$ continues to trend higher but the short-term downside risk remains high (longer-term we are very bullish on the A$). The below chart shows one reason for our concern. The chart shows percentage movements in the A$ and the S&P500 since the beginning of 2000. Notice that the A$ and the S&P500 have moved in the same direction throughout this period with the exception of a couple of brief divergences. One such divergence has occurred over the past month with the A$ moving higher as the S&P500 has moved lower. This divergence will probably be closed and since we expect more downside in the S&P500 in the short-term we think it will be closed via a drop in the A$.

The Dollar Index is more likely to move higher than lower over the next few weeks, but the downside risk is greater than the upside risk. What we mean by this is that while a near-term rally is likely we would expect such a rally to halt at, or below, the low-120s (2%-3% above the current level), whereas a reasonable initial downside target once the inevitable decline does get started is around 105 (11% below the current level). 

Anglogold generated a bit of excitement in the gold world over the past week when they announced that further steps were being taken to reduce the extent of their gold price hedging. However, unless Anglogold's senior executives are the world's worst traders the hedge buy-backs would have already occurred when the announcement was made. In other words, if your goal is to get the best possible price you don't announce your intention to buy before you buy. As such, the direct effect of Anglogold's buy-backs on the gold price would have been 'in the market' before the announcement was made. What wasn't in the market was the psychological effect of the news.

Anglogold's change of policy and Newmont's takeover of NDY mean that 2 of the 4 largest forward-sellers of gold over the past 10 years are no longer sources of downward pressure on the gold price. The stock prices of the other two - Barrick Gold and Placer Dome - will continue to under-perform until the managers of these companies change their hedging policies or are replaced by those who will make the necessary changes. 

Our views on gold and gold stocks are unchanged from those outlined over the past few weeks. While a move into the 320s is possible in the short-term, the bearish traders' commitments and recent speculative frenzy in gold stocks tell us that a medium-term peak is forming. However, we expect to see much higher prices for gold/silver bullion and our favourite gold/silver stocks during the second half of this year.

The Middle East

http://www.debka.com/ is a good site to visit on a daily basis to keep up with the latest developments in the Middle East.

Update on Stock Selections

Now is not a good time to be buying gold stocks, buy anyone who feels an irresistible urge to buy at this time should steer clear of the major producers and focus on the small exploration companies that still represent good value in terms of their market caps relative to their in-ground resources. These stocks should hold up better during the coming correction.

Although the SA gold stocks generally sell at large discounts to their NA counterparts due to the perception of political risk, in one important respect - earnings - they are far less risky. When Harmony and Gold Fields report their first quarter earnings we suspect that their current stock prices will seem fully justified.

 
Copyright 2000-2002 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>