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   -- for the Week Commencing 15th October 2001

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 into 2002.

The US stock market is in the process of making a major bear market bottom.

The Dollar will head lower into 2002.

A bull market in gold stocks commenced in November 2000 and is likely to extend into 2002.

Commodity prices, as represented by the CRB Index, are in the process of bottoming. The CRB Index will reverse higher by the first quarter of 2002 (at the latest) and then rally over the ensuing 1-2 years.

The oil price will resume its major uptrend by January 2002.

Fiscal Stimulus

Even though it is a tactic that has been tried many times in the past and has never worked, the US Government seems intent on increasing its spending in an attempt to stimulate the economy. The fiscal stimulus package is likely to be around $100B, with the only disagreement between Republicans and Democrats being how the money will be spent.

In a letter to the Wall St Journal last week Milton Friedman points out that extra government stimulus doesn't actually stimulate the economy because government spending simply replaces private spending, and private spending is almost always more productive than government spending. While we agree with Friedman's conclusion - that extra government fiscal stimulus will not make any meaningful contribution to economic growth - we do not agree with his reasoning. If the Fed monetises any additional government spending (if the additional government debt resulting from the stimulus is purchased by the Fed with newly-printed dollars), something that is apt to happen, then the extra government spending will not replace private spending. In this case it will, however, be inflationary and will put upward pressure on long-term market interest rates and thus cannot possibly have any long-term beneficial effect.

While railing against the proposed $100B of additional fiscal stimulus, Friedman brushes aside the $900B of monetary stimulus that has occurred over the past year. Our view is that the fiscal stimulus will be inflationary because it will be monetised by the Fed, but it is almost inconsequential when measured against the increase in the money supply that has already occurred. The past year's massive money supply growth is going to have a huge effect on prices over the next two years with, we think, commodity prices being the major beneficiaries. It is not going to result in real growth, although the reported growth in real GDP will look healthier due to the way the inflation rate is understated in these official reports.

Whenever the economy runs into a rough patch politicians always seem to feel the need to do something, regardless of the fact that history clearly shows that the more a government tries to manage the economy the worse it gets. If the current bunch can't find it in themselves to stand aside and do nothing, let them make way for those who can!

The US Stock Market

Current Market Situation

Let's do a quick review. 

1. When the market was hitting its lows in September the level of fear, as measured by a number of reliable sentiment indicators, reached an extreme that has only ever occurred near major bottoms. 

2. In our Sep-17 and Sep-24 commentaries we said that a substantial reduction in the commercial net-short position in S&P500 futures would be expected to occur if a major bottom was in the process of forming. This has occurred (the latest Commitments of Traders Report shows that the commercial net-short position has fallen to 39,000 contracts, down from 83,000 contracts just 4 weeks ago).

3. We've mentioned on several occasions that the Japanese stock market has been leading the US stock market for much of this year and that an upturn in the Nikkei would therefore likely precede a sustainable upturn in the US market. As the following charts illustrate, the recent upward reversal in the NASDAQ Composite was preceded by an upward reversal in the Nikkei. Note, however, that neither index has yet moved above the downtrend that began in May, so there is not yet any technical evidence that the upturns in either market are anything more than oversold bounces.

4. The monetary environment, which has been positive throughout this year, became phenomenally bullish in the wake of the Sep-11 terrorist attacks due to the provision, by the Fed and the private banks, of a veritable flood of new credit. This flood of new credit will be very supportive for the stock market over the next few months, although the longer-term effects will not be bullish because interest rates will inevitably be pushed higher to account for the Dollar depreciation that will result from the increased Dollar supply.

5. Valuation levels for many of the large-cap stocks may still be too high, although the price-earnings ratios of cyclical stocks do tend to be very high near the bottom of the cycle due to plunges in earnings.

6. If the panic sell-off that culminated on Sep-21 did create a long-term bottom, a test of the Sep-21 lows would still be likely at some point over the ensuing 6 weeks.

So far we've seen the initial bounce off the lows and now expect to see a test of the lows. While we expect the test to be successful (the coming pullback should see the major indices find support above the panic lows of Sep-21), we were not prepared to ride-out this decline and therefore sold our QQQ shares (purchased on Sep-25) last Friday. Last week saw massive short-covering and some spectacular gains in many tech stocks, but there were signs at the end of last week that the rally had almost run its course. If all goes according to plan over the next 1-2 weeks and we see some evidence that a successful test of the lows has occurred or is in the process of occurring (the behaviour of sentiment indicators and market internals will give us important clues in this respect), then we will do some buying to position ourselves for what should be a powerful rally thereafter.

This week's important economic/market events
 

Date Description
Tuesday October 16 Industrial Production / Capacity Utilisation
Intel Earnings (after the close)
Wednesday October 17 AOL Earnings (after the close)
Friday October 19 Trade Balance
CPI

Gold and the Dollar

The Traders' Commitments - an indicator of sentiment

It is usually better to gauge sentiment in any market based on what people are doing with their money rather than what they are saying. As far as the commodity and currency futures markets are concerned, the Commitments of Traders (COT) Report can provide a good indication of the prevailing sentiment.

The large speculators in the futures markets tend to be right most of the time, but are invariably wrong at important turning points. This is because they position themselves in line with the existing price trend and will generally stay with the trend until there is a change. When the speculators build up a large net-long position it demonstrates a high level of confidence in the existing up-trend, that is, it means that the prevailing sentiment in the market is extremely bullish. Similarly, when they are substantially net-short it demonstrates a high level of confidence that the price will continue to decline, that is, it means that sentiment is extremely bearish. However, short-term trend changes, or at least shake-outs, often occur after the majority becomes convinced that an existing trend is going to remain in place.

As the speculative net-long position in a market grows, thus pointing to increasingly-bullish sentiment, the commercial net-short position will correspondingly increase. The commercial traders tend to be more value-oriented than the speculators and will often sell as the price rises and buy as the price drops. Also, trades undertaken by the commercials in the futures markets are often done for the purpose of hedging a position in the underlying physical market (to lock-in a profit or limit the risk of loss). 

The latest COT Report showed that speculators had built-up a large net-long position in gold futures and commercial traders had accumulated a large net-short position. The commercial net-short position was around 65,000 contracts as at Oct-09 (the date of the latest report), although it is reasonable to assume that the commercials would have covered some of their 'shorts' when the price fell sharply on Wednesday and Thursday. The large speculative net-long and commercial net-short positions in gold futures were signs that sentiment had become too exuberant and that the risk of a correction was high. However, they do not suggest that we have just seen anything more than a short-term peak in the gold price. If the last gold bull market (1993) is anything to go by, a major top will not occur until the commercials are net-short to the tune of at least 120,000 contracts.

Based on past experience, now that a correction has commenced it is not likely to end until the commercial net-short position has fallen below 20,000 contracts. This is probably going to take at least a few weeks to transpire, particularly if we get an intervening rebound in the gold price that prematurely entices speculators back to the long-side.

As far as currency futures are concerned, the commitments for the European currencies (the euro and the SF) are very bearish (most speculators were positioned for a continuation of the SF/euro rally) whereas the commitments for the C$ and the A$ are bullish. We therefore expect to see the A$ and the C$ out-perform the European currencies over the next few weeks. This is consistent with our view that the general trend in commodity prices will turn higher during the next few months (the A$ and the C$ - the commodity currencies - tend to move in advance of commodity prices).

The footprints of big government

With speculators in gold futures having positioned themselves for a rally, it is not strange that last Tuesday's rally failure led to a swift decline. What is strange is that the preceding build-up of speculative long positions combined with increased demand for physical gold did not result in a much larger rally in the first place. The bullish fundamentals combined with motivated long-side speculation should have been good for at least a $100 rally in the gold price, as opposed to the $25 rally that actually transpired.

The reason for gold's inability to move higher than it did should be obvious to anyone who watches the gold market closely and objectively. We noted on two occasions over the past few weeks that the low and falling gold lease rates were a clear sign that central banks had been aggressively supplying physical gold to the market, almost certainly with the goal of capping the gold price and thus creating the illusion of stability.

The efforts of central banks to keep a lid on the gold price will eventually fail because each price-capping attempt requires that additional physical gold be supplied to the market. This is important - a physical supply deficit cannot be filled using paper claims to gold. Unfortunately for the banks the supply of physical gold is severely limited and, relative to the supply of fiat currency, is becoming less every day. There is persuasive evidence that 10,000-15,000 tonnes of official gold reserves, or between one-third and one-half of the total gold reserves of the world's central banks, have already been unofficially dumped on the market via loans and swaps. Most of this gold has been surreptitiously supplied to the market over the past decade, but the volume required to effect the on-going price-suppression has jumped over the past 2 years. 

With investment demand already increasing and looking set to surge over the coming year as the effects of this year's massive Dollar inflation start to become evident, the CBs are simply not going to have enough physical gold to continue their price-capping operation. In the mean time, government manipulation of the gold market is another variable that we must consider when constructing our forecasts. As much as we detest the way that governments regularly interfere in supposedly free markets in order to achieve short-sighted political gains, we must trade based on the way things are not the way they should be.

Current Market Situation

With sentiment in the gold market having become very optimistic and with speculators in gold futures having piled on to the long-side, any technical failure had the potential to cause a large sell-off (this is why we exited trading positions following Tuesday's trendline break and had previously identified $290 as a stop-out point). However, this sell-off does not disrupt our medium-term bullish view on gold. In fact, declines in bull markets tend to be sharp and usually end as soon as a healthy level of skepticism emerges.

As far as how this correction in the gold market will unfold, we suspect something along the lines of an A-B-C decline with the 'A' (the initial decline) perhaps having ended last Thursday. The following chart illustrates what we mean.

We have no preconceived ideas regarding how long this correction will last. Instead, we will monitor the COT report, various ratios (such as the ratio of the TSI Gold Stock Index to the bullion price), the behaviour of inter-related markets (eg, currencies and interest rates), and the behaviour of gold and gold stock prices as they approach support levels, with the goal of identifying another low-risk buying opportunity (for traders). In the mean time we are maintaining our core investment position in gold stocks.

Here's what the charts are saying. Firstly, last week the XAU bounced exactly where it needed to bounce in order to keep the medium-term up-trend in tact. Also, last Thursday several gold stocks (eg, FN, AEM, NEM, DROOY and HGMCY) dropped to near the initial support levels identified in last week's Interim Update before rebounding strongly.

Secondly, the ratio of the TSI Gold Stock Index (TGSI) to the bullion price remains in an up-trend.

Thirdly, the S&P500/gold ratio (the number of ounces of gold it takes to buy the S&P500 Index) has been trending lower within a well-defined channel since August 2000, but the reactions of the markets to the events of Sep-11 caused the ratio to spike below the bottom of its channel. The action of the past 2 weeks has brought the ratio back toward the middle of the channel and the next rally in the stock market will probably move the ratio back to near the top of the channel (with gold at 285 a return to the channel top would require the S&P500 to rally to around 1200).

Fourthly, the Dollar Index broke out of its downward-sloping channel last week. The Dollar is overbought and for the coming 1-2 weeks is probably going to lose the tailwind that has recently been provided by a rising stock market, so the risk of a breakout failure is significant. However, if the Dollar can pullback over the next week without re-entering its downtrend then an extended Dollar rebound is likely.

Financial markets remain extremely unsettled, to say the least. Acts of terrorism and the US response to these acts have naturally taken centre-stage, but most of the financial problems that existed prior to Sep-11 are still festering. For example, the Argentine debt crisis has been pushed off the front pages by the dramatic events of the past month, but it continues in the background and may be worsening. Last week Moody's cut Argentina's credit rating to the lowest of any country, thus highlighting the distinct possibility that Argentina will default on its $132B of foreign debt. The US$ would probably move lower (relative, at least, to the Swiss Franc) in advance of any Latin American financial 'blow-up', so excessive weakness in the Dollar versus the SF should be considered as an early warning sign of trouble ahead (especially since a rally in the SF at this time would be counter to the SF's bearish traders' commitments). 

Summary

Assuming no 'bolts from the blue', such as a further escalation of Argentina's debt crisis, the next 1-2 weeks are likely to see some strength in gold and gold stocks (the 'B-wave' rebound), and pullbacks in the Dollar and the US stock market (both to higher lows).

Changes to the TSI Portfolio

QQQ sold on Oct-12 for a gain of about 20%.

 
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