Forecast Summary

The Latest Forecast Summary

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 reach a major bottom (well below the September-2001 lows) during the second half of 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.

Next Year's Headlines

When it comes to economics we don't know very much, but this usually works to our advantage because it forces us to rely on a few simple and reliable leading indicators. Our simplistic approach has, in turn, met with some success. 

The leading indicators that we watch can be put into two categories - monetary and financial market. The most important of the monetary leading indicators is the CPI-adjusted M2 growth rate while the main financial market leading indicators are bond yields, the yield spread (the difference in yield between shorter-term and longer-term debt instruments), and the performances of economically-sensitive stocks. Today we are going to have a quick look at what the CPI-adjusted M2 growth rate and the stock prices of economically-sensitive companies are doing in an attempt to figure out what next year's news headlines are going to be.

Money Supply Growth

Paul Kasriel, the head of economic research at Northern Trust, has demonstrated that the CPI-adjusted M2 growth rate is not just a good leading indicator of economic growth, it is probably the single best leading indicator. In fact, in his 1st March 2002 commentary at http://www.ntrs.com/library/econ_research/weekly/us/020301.html PK shows that, over the past 42 years, there has been a correlation of 0.71 between the CPI-adjusted (sometimes called the "real") M2 growth rate and "Final Sales to Domestic Purchasers" when the real M2 growth rate is advanced by 6 months.  For those with no grounding in statistics, a correlation of 0.71 is very significant. 

Below is a chart showing the CPI-adjusted year-over-year M2 growth rate since the beginning of 1998. We don't like to use the CPI numbers reported by the US Government in any of our analyses because they have been manipulated well beyond the point of usefulness, but in those cases when we must use the CPI we will typically use the median CPI reported by the Cleveland Fed (refer to http://www.clev.frb.org/Research/mcpi.htm for a description of the median CPI). This is simply because changes in the "median CPI" more accurately represent changes in the cost of living than do changes in the more popular "core CPI". The M2 growth rates used to construct the below chart have therefore been adjusted for annualised percentage changes in the median CPI.

The surge in the real M2 growth rate during the second half of 1998 and the maintenance of a robust M2 growth rate during the first 10 months of 1999 ensured that economic growth would be strong throughout 1999 and during the first half of 2000. The plunge in the real M2 growth rate between October-1999 and March-2000 and the continued low growth rate throughout 2000 ensured that the economy would slow dramatically during the second half of 2000 and the first half of 2001. The pick-up in real M2 growth during the first half of 2001 would have ensured that an economic rebound was well under way by the fourth quarter of 2001 if not for the events of Sep-11, but in any case the phenomenal surge in real M2 growth during the final quarter of last year all but guaranteed strong economic growth during the first half of this year. 

The real M2 growth rate plunged during the first 4 months of this year. However, thanks to a bear market rally in bond prices real M2 has rebounded somewhat over the past 2 months (the bond market is the major influence on money supply growth). The current level of 5%, while down a long way from last year's peak, is still consistent with moderate economic growth over the remainder of this year (the economy didn't hit a brick wall in 2000 until the real M2 growth rate fell to around 2%).

We expect the US economy to expand throughout the remainder of this year, but if our forecasts for bonds and commodities come to fruition then the real M2 growth rate will have fallen to 2% or lower by the end of 2002 (rising commodity prices will put upward pressure on consumer prices at the same time as rising interest rates are crimping money supply growth). As such, we doubt that the US economy will experience any significant growth during the first half of next year.

The Stock Market

We don't consider the stock market, as a whole, to be a good leading indicator of the economy. However, the stock prices of those companies that are highly leveraged to economic growth (eg, General Motors and Caterpillar) are good leading indicators of economic growth. These companies are called "cyclicals".

We track the performance of cyclical stocks as a group via the Morgan Stanley Cyclicals Index (CYC). The below chart shows the performance of CYC since the beginning of 1998.

CYC surged by 50% between October 1998 and mid-1999, thus foreshadowing the strong economy of 1999 (economic growth peaked during the final quarter of 1999). CYC then trended lower until October of 2000, thus warning of an economic slowdown during the second half of 2000 and the first quarter of 2001. CYC moved within an upward-sloping channel during the first 8 months of 2001, suggesting that the US economic slowdown of 2001 would be short-lived. As it turned out, any thoughts of recovery were temporarily obliterated on the morning of September-11 and the economically-sensitive stocks were hard-hit. However, the rebound during the final quarter of 2001 was so dramatic that by early-2002 CYC had moved back into its pre-September-11 channel, thus foreshadowing strong economic growth during the first half of 2002. Then, CYC began to grind lower.

CYC has been very weak over the past 2 months, but at this stage the technical damage is minimal. However, a decisive move below 500 would break its intermediate-term up-trend and would be a very clear warning of another pronounced slowdown in economic growth. Note that a breakdown in CYC at this time would not contradict the message currently being sent by the real M2 growth rate since it is not uncommon for CYC to change direction 6-9 months in advance of a change in the economy.

Debt Deflation

We regularly hear the argument that it doesn't matter how much money the Fed prints because a much larger amount of money will be destroyed as a result of debt defaults and bankruptcies. Putting aside the fact that the Fed is responsible for creating only a very small portion of the money that comes into existence each year, the above-mentioned argument contains some big logical flaws.

If a company goes bankrupt, no money is destroyed.  If someone defaults on a loan, no money is destroyed. To illustrate this point lets look at a hypothetical case involving Bob, Al and Ted. Bob lends Al $1M which Al promptly spends buying optical networking equipment from Ted. Al subsequently runs into financial trouble and notifies Bob that he cannot repay the loan. Bob, realising that the equipment purchased by Al from Ted is essentially worthless and that Al has no other assets, decides to write-off 100% of the loan. So, in this example Al is now bankrupt, Bob has taken a loss of $1M and Ted has gained $1M. There is no change in the total supply of money.

Now assume that Bob is actually a major bank called Citimorgan. If the size of Al's loan is large or there are a lot of people in Al's predicament, then Citimorgan's ability to make future loans could be impaired and the money supply growth rate could therefore plunge. If people like Al keep defaulting there is even a chance that Citimorgan could become technically insolvent. The chairman of Citimorgan, a well-connected gentleman named Sanford Rubin, is concerned about his company's plight and how the entire economy could be adversely affected so he calls his friend Alan Greenspan at the Fed. Greenspan, of course, is well aware that the money supply must be continually expanded lest the whole pyramid scheme collapse and comforts his friend by saying something like "Don't worry Sandy. As I said in January 1997 and on numerous other occasions, central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank. So, we'll take those bad loans off your books at 90% of face value with payment being made immediately via a transfer of funds to Citimorgan's account at the Federal Reserve Bank of your choice."

In this example Citimorgan gets enough new money to enable them to continue their lax lending practices and, in the process, keep the total supply of money growing. And, as a result, the US$ falls in value relative to other national currencies, relative to hard money (gold), and relative to tangible assets such as commodities and real estate. And, everybody lives happily ever after. Well, not quite.

The US Stock Market

The Big Picture

Below are monthly charts of the Dow Industrials, the Dow Transportation and the Dow Utilities indices.

Current Market Situation

At the risk of sounding like a broken record (whatever that means), we think the stock market is close to a short-term bottom but it hasn't bottomed yet. Some parts of the market, such as the beaten-down telecommunications and networking sectors, almost certainly have reached short-term bottoms. As such, towards the end of last week we suggested buying Lucent on a pullback and added Nortel Networks to the Portfolio. However, we expect the Dow Industrials and the S&P500 to make new lows over the coming week. Why? Because although the evidence continues to build that we are close to a bottom, we haven't yet seen enough capitulation to give us any confidence whatsoever that anything more than a 1-3 day bounce is possible. When a downtrend has been as relentless as the current downtrend has been it is unlikely to end until the vast majority of participants have given up hope of a meaningful rally. 

Here are 3 signs that hope has not yet been abandoned. Firstly, the latest Commitments of Traders Report reveals that small traders are still clinging to a large net-long position (74,000 contracts as at 9th July), despite the sharp fall in the S&P500 over the past few weeks. Lower prices will obviously be necessary to prompt some serious 'towel throwing'. Secondly, although we saw a healthy spike in volatility over the past week the volatility indices did not come anywhere near the levels reached last September. We don't expect volatility to reach the extremes of last September unless another horrific and unforeseen event occurs, but higher levels of volatility than occurred last week will probably be needed before a sustainable upturn can eventuate. Thirdly, put-option volumes have remained quite low. In fact, over the final 3 days of last week the open interest in QQQ put options increased by only 60,000 contracts while the open interest in QQQ call options increased by 300,000 contracts.

The TSI Index of Bullish Sentiment (TIBS) is a weighted average of 6 different sentiment indicators. It is currently well into oversold territory but has not yet reached the extremes of October 1998 or March 2001 and is nowhere near the level reached last September.

So, it's certainly not time to throw caution to the wind as far as trading on the long-side of the market is concerned. A reasonable approach, however, is to begin averaging-into one or two of the most beaten-down telecom stocks. Traders should also look to exit all remaining put option positions during any day when the VIX moves above 45 or the VXN moves above 80.

A reasonable approach for longer-term investors is to maintain a large cash position and to gradually accumulate the stocks of commodity producers on weakness. Also, take small initial positions in some of the hard-hit telecom stocks (our favourites are Nortel (NT), LightPath Technologies (LPTH) and Lucent (LU) in North America and Telstra (TLS) in Australia). 

This week's important economic/market events
 

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