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) reached a major low in June of 2003 and will trend higher until at least mid 2004. 

The US stock market will reach a major bottom (well below the October-2002 low) during 2004.

The Dollar commenced a bear market in July 2001 and will continue its decline during 2003 and 2004.

A bull market in gold stocks commenced in November 2000 and will continue during 2003 and 2004.

Commodity prices, as represented by the CRB Index, will rally during 2003 and 2004 with most of the upside occurring in 2004.

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China

China's trade surplus

According to some US politicians, China's currency -- the Yuan -- is pegged to the US$ at an unrealistically low rate. As a result China gains an unfair trade advantage because its exports are much cheaper than they would be if the Yuan's exchange value were set by the market. This, in turn, means that local US manufacturers can't compete and US-based jobs are lost. At least, that's the way the argument goes. As is almost always the case, though, the political spin bears little resemblance to reality. 

If China's currency were significantly under-valued then China's trade surplus would be increasing. However, China's trade surplus actually fell by 40% over the first 10 months of this year and if the values of China's imports and exports continue to grow at their current rates then China will be running a monthly trade deficit within 12 months. Therefore, a reasonable argument could be made that the Yuan is actually over-valued relative to a trade-weighted basket of other currencies. 

China is running a large and growing monthly trade surplus with the US, but this surplus has not resulted from an under-pricing of China's currency. For example, despite the sharp rise in the euro relative to the US$ the US trade deficit with Europe increased by 7.5% in October (the most recent month for which figures are available). In the same month the US trade deficit with China increased by 10%. Clearly, the current Yuan/US$ exchange rate is NOT a major driving force behind the US trade deficit. 

The primary driving force behind the persistently-large US trade gap is the massive expansion of credit in the US. The US continues to spend a lot more than it produces and the current policies of both the Fed and the US Government are specifically designed to promote increased spending and borrowing. That is, the policies are designed to promote a higher trade deficit. 

China, by the way, is experiencing a massive credit expansion of its own and this is why its trade surplus is shrinking at a rapid rate. 

China, commodities, and US bonds

In a recent article at http://www.gold-eagle.com/editorials_03/field120503.html Alf Field provides a good explanation of why the Chinese have been buying loads of US Government bonds and why they will continue to do so. The key section from this article is:

"China must know that it is selling real goods to the USA and being paid in pieces of paper that will ultimately be worth a lot less.

The Chinese understand they will one day have to take a loss on their dollar reserves, but this is the price that they are willing to pay to maintain the existing order. The longer they perpetuate the system, the faster their industrial infrastructure will grow and the greater the number of Chinese finding jobs. A fall in the value of their accumulated foreign reserves is a price they are prepared to pay in the interests of laying a foundation for their country's long-term growth."

Alf Field thinks that the current situation will only change when the US takes unilateral action to change it in order to protect US jobs. However, as discussed above the Yuan/US$ exchange rate has very little to do with the loss of US jobs and, despite what they say, we suspect that senior members of the US Administration know it. And we are sure that Alan Greenspan knows it because he said so last week (http://biz.yahoo.com/rb/031211/economy_greenspan_5.html).

Our view is that the situation will change when China is forced to take definitive measures to slow its rate of credit expansion and/or when it begins to suffer the negative consequences of having a currency which is pegged to the US$. One important negative consequence of pegging your currency to a faltering US$ is that you will end up paying a higher price for much-needed commodities such as copper and oil.

The above-mentioned article by Alf Field is generally very good, but it contains two other comments that we'll take issue with. 

The first is the comment that the euro is a viable reserve asset. In our opinion, as a reserve asset the euro is no more viable the US$. The advantage that the euro has had over the US$ during the past few years and continues to have at this time is that it is relatively under-valued, which makes it a better investment than the US$ for the moment but doesn't make it a more viable reserve asset. 

The second is the comment that commodity prices will plunge in an environment in which the US$ is imploding and the US's trading partners are printing money like crazy in order to prevent their currencies from getting too strong relative to the dollar. This makes no sense at all because the price of every commodity is determined by its own supply/demand as well as by the supply/demand of the currency in which its price is denominated. In other words, if the currency is weak enough then the price of any commodity can rise during a recession. In the above-described environment the only currency against which commodity prices would likely fall is gold.

The idea that commodity prices will experience a dramatic decline at some point over the next few years is also at odds with long-term commodity-price charts. These charts generally show prices turning higher from long-term bases and/or consolidation patterns. For example, the below chart of CRB Futures shows a very decisive upside breakout from a 20+ year consolidation pattern. This chart suggests that the CRB Index will, at a minimum, challenge its 1980 high within the next few years.

The bull market in commodities will, of course, experience some gut-wrenching corrections along the way as all bull markets do. In fact, one such correction will probably begin during the next few months in response to a worldwide slowdown in credit growth and consequential pullback in spending/investment.

The money-supply growth slowdown continues

Transactions to buy/sell assets do not affect the total money supply. For example, when a stock or a bond or a house is purchased an amount of money is simply transferred from the seller to the buyer, but the total amount of money in the economy does not change. The only way the money supply changes is through changes in the level of indebtedness. Specifically, the money supply increases when the total mount of new debt coming into existence exceeds the amount that is being repaid and it decreases when old debts are being repaid at a faster rate than new debts are being created. 

The recent sharp slowdown in the M2 growth rate illustrated on the below chart is therefore evidence that the rate at which people are taking on new debt has been falling relative to the rate at which they are repaying their existing debts. In other words, it looks like US households might be making a decision to increase their collective savings rate. In the long-term, saving more money is something from which the country benefits. However, it must be aggressively discouraged during the 12 months leading up to a presidential election. 

The US Stock Market

Speculating on a stock market decline

We added a position in USPIX -- a fund that is designed to move by twice the inverse of the NASDAQ100 Index each day -- to the Stocks List at last Thursday's price of $22.55. 

We've mentioned in previous commentaries, including last week's Interim Update, that leveraged bear funds such as USPIX are high-risk speculations that should only be purchased with risk capital (money you can afford to lose). Such speculations need to be actively monitored and are not suitable for conservative investors. In this regard the following comments from the 20th October Weekly Update are worth repeating: "...once we get some clear evidence that the ultimate recovery high is in place for the market most people will probably be better served by simply retreating to the safety of cash and/or gold bullion as opposed to speculating on the short side. After all, if stocks fall by 50% then the purchasing power of your cash will have effectively gained 100% (the same dollar will purchase twice as much stock)."

In our opinion, your overriding goal during a major stock market decline should be to have substantial cash reserves that can be put to work after the market has bottomed. This is because it is a lot easier to make money on the long side during a rally than it is to make money on the short side during a decline (for the reasons explained in the 20th October Weekly Update). You could certainly increase your cash reserves if you made some well-timed short-side bets during the decline, but by making these short-side bets you also run the risk that you will end up with less cash to invest near the bottom. In other words, play defense during the declines so that you can be in a position to attack during the advances. 

By the way, over the past year we have made a few small bearish speculations but have generally been heavily 'long' the market via our exposure to gold stocks and commodity stocks. And, although we have just added an initial position in USPIX to the Stocks List we remain heavily long. If things go as planned we will cut back on our exposure to the stock market over the next couple of months and add one or two more bearish speculations, but the way we are positioned right now we will fare much better if the market continues to advance.

No bear...yet

There is no doubt that the tech, telecom and internet sectors of the stock market are immersed in major bear markets. However, many other sectors are clearly NOT immersed in bear markets. We say this because new all-time highs have been reached in many important sectors of the market over the past few months and stocks that are in bear markets simply do not surge to new all-time highs. For example, the Morgan Stanley Cyclicals Index (CYC) and the Morgan Stanley Commodity-Related Equities Index (CRX) have recently made decisive moves to new all-time highs (see charts below). This is not, by the way, a longer-term bullish argument because it means that the bear market, for many sectors, is yet to begin. 

Current Market Situation

There isn't much to add at this time. As discussed in recent commentaries, the market appears to be setting itself up for an important peak in early 2004.

This week's important economic events
 

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