Forecast Summary

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Bonds and Inflation

Inflation - the Cornerstone of our Monetary System

As is often the case, the financial markets and the financial media are currently agonising over what the Fed's next move will be and when it will occur, as if a change to official interest rates will have a dramatic monetary effect. A Fed rate cut at this time would certainly have a big effect, particularly if it was an inter-meeting 'surprise' rate cut, but the effect would be psychological not monetary. The market has already taken short-term interest rates well below official interest rates and the financial sector has been adding liquidity at one of the fastest rates in decades, so a fully-fledged monetary easing has already happened. Whether the Fed slices a few more basis points from the Fed Funds Rate is neither here nor there. We don't, however, under-estimate the psychological effect of an 'official' cut, especially as far as the stock market is concerned. If enough people believe a Fed rate cut will be good for the stock market and the economy, it will be good for the stock market and the economy.

As far as the monetary environment goes, US Government bond prices are more important than the Fed. As we've previously shown, the M2 growth rate follows the T-Bond such that major peaks in year-over-year M2 growth occur a few months after major peaks in the bond market. Below is a chart that illustrates this point.

Once the purchasers of long-term bonds begin to anticipate higher inflation they will demand compensation in the form of higher interest income. In other words, they will pay less for the bonds. We think we are close to the point of realisation, the point when the market begins to accept that one of the consequences of the explosive growth in the supply of dollars is that a dollar will be worth less. Inflation has happened and is happening, all that is left for the market to do is to account for the inflation in the prices of bonds.

Inflation is not only happening at this time, it must continue to happen because that is the only way the existing monetary system can survive. A 'ponzi scheme' collapses as soon as the money coming in from new investors becomes insufficient to pay-off the earlier investors. A system in which money comes into existence through the creation of debt (our current monetary system) is similar. Firstly, each new dollar brings with it a liability in excess of one dollar (due to the obligation to pay interest). Secondly, the debt is backed by assets, so the general level of asset prices cannot be permitted to fall lest gaping holes appear in the balance sheets of the banks. The only way that old debts can be paid and asset prices supported is through an increase in the supply of money. 

Getting back to the relationship between T-Bonds and the M2 growth rate, if we are right and bonds have either peaked or are within a few weeks of peaking then the M2 growth rate will peak by August this year. If recent history is anything to go by the financial markets are going to run into difficulty whenever the M2 growth rate drops to around 6% (like a junkie needing higher and higher doses of a drug in order to get the desired effect, the US financial system now appears to need an M2 growth rate of at least 6%). The chart below shows the current situation. Our guess is that it will probably take approximately 12 months of declining bond prices for the M2 growth rate to drop to this level. Therefore,  around the middle of next year things will get very interesting because the evidence of inflation will be obvious to everyone, yet more monetary stimulus will be required at that time to keep the system ticking along.

Bond Market Update

We are going to cancel our short-term bearish view on bonds. We have good reason to believe that bond prices will be much lower in 6 months time than they are today (interest rates will be much higher), but there is a distinct possibility that bonds will experience a rally in the short-term. 

Investing in an Inflationary World

We are going to have inflation for at least the next 12 months. Actually, the fact that inflation is a 'necessity of life' for our present financial system means that we are highly likely to have inflation for many years to come. The challenge, for we investors, is to figure out where to put our money in order to profit from the inflation.

Firstly, cash and debt are generally not good investments in an inflationary environment once the inflation is recognised. The interest earned on cash sitting in savings accounts will not adequately compensate for the loss of the currency's purchasing power, and once people begin to anticipate future inflation the prices of debt instruments will drop. A rapid increase in the supply of money will tend to boost asset prices, but which assets will benefit the most? During the years leading up to the NASDAQ peak in March 2000 it was the 'dot.coms' and anything remotely related to technology that benefited. That particular asset-price bubble burst, but the underlying debt bubble lives on. As long as the debt bubble remains in tact, the ability of the US financial sector and the Fed to create another asset bubble should not be under-estimated. What we want to know now is where the next bubble(s) will be. 

We think the next speculative mania will be focused on the shares of resource-producing companies and that the following sectors will be major beneficiaries:

1. Oil and Gas Producers

During a period when commodity speculation is reaching a fever pitch we would expect to see the related equities move way above their long-term trends and become expensive relative to the underlying commodity. This is because the stocks of commodity producers offer leverage (a change in the commodity price results in a disproportionately-large change in the profits of the commodity producers). 

Below is a chart of the AMEX Oil Index (XOI) with a logarithmic scale. Despite the surge in the oil price since early 1999 the fact that the XOI has remained quite close to its long-term trend shows that there has been no speculative bubble. Furthermore, the present ratio of the XOI and the oil price is near its average levels of the past decade, indicating that there is no speculative premium built into today's stock prices. 

This means that if the oil price moves higher over the next 12 months, which we think it will, there is a reasonable prospect of seeing a speculative premium built into the prices of oil (and gas) stocks. Bull markets usually don't end until a speculative blow-off occurs.

The best time to buy the oil stocks would be during an XOI pullback into the 475-500 range (versus the current level of around 550). However, there is no guarantee that it will drop that low.

2. Palladium and Platinum Producers

This is a similar story to oil and gas in that scarce commodities (the platinum-group metals) have experienced impressive bull markets over the past few years, yet there has been very little speculation in the associated equities. Below is a chart of Stillwater Mining (SWC), North America's largest PGM producer, showing that it has spiked above its uptrend on a few occasions only to quickly drop back to the trendline each time. Other PGM producers have fared better than SWC, but considering the size of the rallies in the underlying commodities (the palladium price rose by 960% from the beginning of 1997 to its January 2001 peak), the performances of the related stocks have been muted to say the least. We should therefore see much more upside in the stocks of PGM producers before this bull market ends.

Our favourite stock in this sector is North American Palladium (PDL.TO). We've been hoping to add it to the Portfolio at a sub-C$11 price, but since it is already exceptional value we will bite the bullet and add it at the current price of C$12.55.

3. Uranium Producers

Below is a chart of Cameco (CCO.TO), the Canadian uranium producer we added to the Portfolio last October. Uranium producers are going to benefit from the increasing cost of other types of fuel, and a less-restrictive energy policy from the new US Administration. CCO should not be bought unless it pulls back to its up-trend line, but other uranium producers that have not already experienced such large rallies could be worthwhile investment prospects.

4. Gold Producers

Due to the extreme under-valuation of gold stocks relative to almost everything else in the world, this is the area that holds the greatest upside potential of all. Due to the size of the above-ground gold supply and gold's monetary role, it also entails more risk than the other opportunities mentioned above. 

Below is a chart of the TSI Gold Stock Index (TGSI). The gold price is presently trading below its levels of last November, yet the TGSI has been in an up-trend since November. This is a bullish divergence.

5. Technology

Technology doesn't fit into the inflation theme because most technology companies do not have much pricing power, but there is one area of technology that already 'bubbled' in 1999-2000 and has a good chance of 'bubbling' again in the years ahead. That area is optical networking.

Global Crossing (NYSE: GX) has laid thousands of miles of undersea fibre-optic cable such that its network now links approximately 200 cities around the world. The physical construction is almost complete, the challenge now is to sell capacity on the network. The key points are that with the on-going developments in photonics the capacity of GX's network is going to be effectively unlimited and the way the capacity is sold is going to change. Rather than renting a physical part of the network or a certain amount of bandwidth (capacity), GX's clients (which will generally be multi-national corporations, stock exchanges, governments, ISPs and other telecom carriers) will purchase wavelengths of light. Each single strand of optical fibre will carry light that will contain thousands of separate wavelengths (thousands of different frequencies or colours), with each wavelength potentially carrying separate data (or video or voice) belonging to different clients. Prices to transmit data/video/voice signals around the world will plummet and traditional carriers will not be able to compete. Companies such as GX that were able to build their networks when capital was readily available will take the lion's share of the market. And the market will grow because plummeting prices will stimulate demand. If the GX management team can continue to execute its business plan (the build-out of the network has certainly been well-executed), the company will become a 'cash cow' in the years ahead as a large percentage of each new dollar of revenue will become cash in the bank. 

In the current market GX is being valued at less than 1.5 times revenue, with the low valuation being mostly attributable to the company's high level of debt. It is currently not part of the TSI Portfolio, but we expect to add it during the next few months. At this stage we have significant optical exposure via companies that design and build the components that will maximise the potential of GX's (and its peers') networks. We like Corning (GLW), LightPath Technologies (LPTH) and Avanex (AVNX). We don't like Nortel, Cisco, Lucent (or its Agere spinoff), or JDS Uniphase.