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   -- for the Week Commencing 16th July 2001

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 into 2002.

The US stock market is in a cyclical bull market that began in late-March/early-April and is likely to end during the final quarter of this year.

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 during the second half of 2001 and rally into 2002.

The oil price will resume its major uptrend during the second half of 2001 and rally into 2002.

The Bubble Trend

Below is an updated version of a chart comparison we've shown a couple of times in the past. It illustrates that the 12-month rate-of-change for the S&P500 Index has trended in the same direction as the yield on the T-Bond since mid-1997.

Long-term interest rates and equity market returns have been moving in the same direction for so long now that it seems normal for them to do so. It seems normal that every time bond prices trend lower for a few months, the stock market trends higher, and vice versa. It is, however, abnormal behaviour. Periods when rising interest rates occur in parallel with rising stock prices, or when falling interest rates occur in parallel with falling stock prices, have certainly happened in the past (prior to mid-1997), but such periods have seldom extended for longer than about 6 months. Under normal circumstances, rising bond prices (falling long-term interest rates) are a net-positive for the stock market and falling bond prices (rising interest rates) are a negative influence on stock prices. The reason this is so is that the present value of a company's future cashflow becomes less as interest rates rise.

When the bond market and the stock market move in opposite directions for a prolonged period it is a sign that either a) the economy is experiencing deflation, or b) the economy is experiencing a credit bubble. With the total supply of money having grown at a mind-boggling pace over the past 4 years the US has clearly not experienced anything remotely resembling deflation, nor is it likely to any time soon. With the inverse relationship between stocks and bonds now about to enter its 5th year it is clear that the US economy is under the influence of one of the all-time great credit bubbles.  

We can use the current inverse relationship between bonds and stocks in three ways. Firstly, as long as we have good reason to believe that the credit bubble is still in existence then our bond market view should, beyond the very short-term, be the opposite of our stock market view. For example, if we expect the major stock market indices to move much higher over the coming 3 months (this is what we expect), then we should also expect bond prices to move lower over this period. Secondly, we can use a move in one market to confirm a move in the other market. For example, if a multi-week decline in stocks was not accompanied by a multi-week rally in bonds then we would have cause to be skeptical about the sustainability of the stock market decline. Thirdly, we will know that the bubble has ended when we see stock prices and bond prices moving sharply lower in unison. 

Returning to the above chart we have indicated, via a vertical red line, that the beginning of April this year marked another major turning point in the stock and bond markets. We are using some artistic license here since the trends are not yet well-defined, but the fact that both markets reversed direction at that time lends some support to the idea that early-April did, in fact, give us an important turning point in the markets.

As an aside, something that has occurred during the final stages of previous major credit bubbles is weakness in the currency of the country experiencing the bubble. As such, we expect to see a substantial and prolonged decline in the Dollar's foreign exchange value before the present US credit bubble comes to an end.

Commodities

Below is a chart of the CRB Index. The CRB Index is clearly in a downtrend and, as yet, it shows no sign of bottoming. As mentioned in a previous commentary, we consider the CRB's decline since late last year to be a correction within an on-going bull market. As such, we do not expect the mid-1999 lows to be breached and expect the next rally (which should commence by September and extend until at least the middle of next year) to take the Index above last year's peak.

In the latest Interim Update we included charts of the A$ and the C$ (known as "the commodity currencies" because Australia and Canada rely heavily on commodity exports). Since these currencies tend to lead commodity prices we will not turn short-term bullish on the CRB Index until both the A$ and the C$ break-out above the downtrends shown on these charts.

Although the CRB Index is mired in a medium-term downtrend, some commodities are showing definite signs of life. Soybeans appear to have commenced a bull market in April, while corn and wheat prices have recently begun following 'the beans' higher. Lumber prices soared earlier this year and now seem to be experiencing a normal correction. The following charts are provided courtesy of www.futuresource.com.

It is always nice when a move in one market is confirmed by a move in a related market. The stocks of transport companies tend to move inversely to the oil price since fuel is such a major component of these companies' operating costs. The transport stocks (as represented by the Dow Transportation Average) have recently been strong, thus confirming the drop in energy prices.

Another "Peso Problem"

Options trader and author Nassim Taleb coined the term "peso problem" to describe a situation whereby a security or trading strategy that has exhibited great stability and produced excellent returns over a long period of time suddenly, and unexpectedly, crashes. The term derives its name from the Mexican peso which, over the past 20 years, has experienced lengthy periods of stability interrupted by short periods of extreme turbulence. The attractive yields that can be earned on peso-denominated debt entice a huge amount of investment during the periods of stability. Everything seems wonderful until one day the peso suddenly plunges and interest rates go through the roof, quickly wiping out all the gains that were made over the previous period of stability and causing many of the yield-chasing speculators to 'blow up'. 

All of our readers are undoubtedly familiar with the on-going Argentinean financial crisis. The Argentine peso is pegged to the US$, so the bulk of the stress is being felt in the debt market where Argentinean bond yields have risen to 36%. The crisis has over-flowed into neighbouring Brazil - the Brazilian real has plummeted against the Dollar and interest rates have risen dramatically. Strangely enough, however, the Mexican peso has, to date, been relatively unscathed by the crisis. In fact, although the Mexican peso dropped 2% against the Dollar last week it is the world's best performing currency so far this year. 

To ascertain whether the present crisis will be 'contained' or whether it will lead to a global panic as happened in 1998, we will be watching both the Mexican peso and the Bank Stock Index (see charts below). If this crisis is going to broaden then we should soon start to see substantial weakness in the Mexican peso (as speculators try to exit while they still can) and in the stocks of the major banks (the major banks have immediate and direct exposure to any such crisis). 

The US Stock Market

Stocks and Money 

The monetary environment remains extremely positive and will continue to underpin this cyclical bull market over the next few months.

How important is a positive monetary environment? Well, just think back on all the terrible corporate financial news that has hit the market since early-April and look at where the major stock indices are today compared to where they were back then. The news and the forward-looking guidance from companies has been so bad over the past 3 months that almost everyone has now given up on the second half recovery story that was so popular a short while ago, yet the S&P500 and NASDAQ Composite are presently more than 10% above their early-April lows. This has partly resulted from the extreme pessimism that prevailed in late-March/early-April (everyone who was going to sell had already sold), but mostly it is the result of the continuing flood of newly-created dollars.

We think the old saw "don't fight the Fed" has little practical relevance these days since the Fed simply follows along in the financial markets' wake, adding to market volatility but not adding any real value. We prefer to think along the lines of "don't fight the money supply".

We expect the money-supply growth rate to soon reach its peak and by late this year or early next year the monetary conditions will no longer be a positive influence on the stock market. This is when major downside risk is likely to re-emerge - ironically, just as the economy and corporate earnings are showing definitive signs of recovery.

Current Market Situation

We expect another 'testing' pullback after the current rebound runs its course and before the main event (a rally that takes the major indices well above their May-22 highs) gets underway. Whether or not the next pullback takes the indices to new correction lows will be determined by how high the market moves during the coming week. If the September S&P500 can achieve a daily close above 1248 this week then the lows reached during the subsequent pullback would almost certainly be higher than the recent correction low (reached on July-11). We will monitor both price action and sentiment indicators in an attempt to time another long-side speculation whilst continuing to hold the QQQ call options purchased in late-June.

This week's important economic/market events
 

Date Description
Tuesday July 17 Industrial Production / Capacity Utilisation
Wednesday July 18 CPI
Housing Starts
Thursday July 19 Trade Balance
LEI
Friday July 20 July Options Expiration

Gold and the Dollar

Current Market Situation

The euro and the SF were not able to break above their medium-term downtrends last week, but they remain poised to do so. We expect these currencies to break-out to the upside soon, perhaps as early as this week.

Gold was as flat as a pancake last week. Upside breakouts in the European currencies will probably be needed to 'kick start' the next gold rally. We doubt that gold will benefit from the financial crisis that is brewing in Latin America unless the crisis results in a drop in the US$.

Gold stocks drifted lower on very light volume on Friday, thus under-performing the gold price following 3 days in a row of out-performance. As mentioned in previous commentary, gold stocks have moved with the spread between the yields on the 30-year T-Bond and the 13-week T-Bill with great consistency over the past 12 months. This relationship will not necessarily work on a daily basis, but whenever long-term interest rates fall relative to short-term interest rates (as was the case on Friday), gold stocks will face a significant head-wind. The ideal environment for gold stocks would see interest rates increasing at both the short-end and the long-end, but with long-term rates rising more than short-term rates. Such an environment is likely to appear later this year as a tentative economic recovery boosts short-term rates and inflation fears cause long-term rates to surge. In the short-term, any widening of the yield spread would most likely result from short-term rates remaining flat, or even declining, while long-term rates drift higher.

Below are updated charts of the gold/TGSI ratio (TGSI is our own gold stock index and is a better representation of the performance of gold stocks than is the XAU) and the gold/XAU ratio. The gold/TGSI ratio remains within its up-channel, thus confirming the continuation of the bull market that began last November, while the gold/XAU ratio is making an attempt to return to its up-channel (note that the chart scales are inverted so that a rising trend indicates out-performance by the gold stocks).

Both gold and silver appear to be on the verge of a rally. By declining to its March low and then bouncing silver may, however, have left some unfinished business on the downside. Although we would be more confident that a bottom was in place for silver if it had spiked below its March 2001 low, we are going to give ourselves some exposure to a potential rally in the silver price by adding Coeur d'Alene Mines (NYSE: CDE) to the TSI Portfolio at $1.15 with an initial sell-stop set at $1.05 (the stop would be activated on a daily close of $1.05 or lower). CDE is not profitable at the current silver price and has a high debt burden, meaning that it is high-risk and therefore not suitable for a large investment. However, the things that make it unsuitable as an investment give it a huge amount of leverage to any half-decent rally in the silver price.

Changes to the TSI Portfolio

CDE added at US$1.15.

 
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