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 make new bear market lows in 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.

The Very Big Picture

On a few occasions over the past 2 years we've reviewed long-term charts of the ratio between the Dow Industrials Index and the gold price (the Dow/gold ratio tells us the number of ounces of gold it takes to buy the Dow). The following chart shows where the ratio currently sits relative to where it has been over the past 73 years.

The Dow/gold ratio made what clearly appears to be a major peak in August of 1999. The major peak of 1929 was not exceeded until 1959 and the major peak of 1966 was not exceeded until 1998. Therefore, if history repeats itself the 1999 peak will remain unchallenged until at least 2029. Furthermore, before embarking on a climb to its next major peak the ratio will first drop below 5 and will perhaps fall as low as 1. Past declines from peak to trough have occurred with greater speed than the ascents from trough to peak, so a major bottom would likely be reached before the end of the current decade.

It is all well and good to draw conclusions based purely on historical data, but are there actual reasons (other than the expectation that the cyclical pattern will continue) why the Dow/gold ratio should plunge below 5 and subsequently soar to a new high?

We can come up with a good explanation as to why the ratio is going to fall to a much lower level (see below), but we can't explain why it will necessarily fall to the lows reached at the bottoms of previous cycles. Also, we doubt that we will ever see the Dow/gold ratio trade up to its 1999 levels again, even if we live to be 150. The distortions during the late-1990s were so great that even after a 2-year readjustment period the Dow/gold ratio is still above where it was at its previous major peak in 1966.

To understand why the ratio is almost guaranteed to fall to a much lower level it needs to be understood that, over the very long term, most of the gains achieved by investing in the stock market stem from inflation and dividends. Actually, using the word "most" here is a gross understatement. More than 99% of stock market returns over the past 200 years have come from inflation and dividends. Since re-invested dividends aren't included in the Dow Industrials Index, almost the entire gain in the Dow over the past 200 years can be attributed to the effects of inflation (the loss in the purchasing power of the Dollar).  A reduction in the Dollar's purchasing power will also, over the long term, result in a corresponding rise in the dollar price of gold. Therefore, the gold price and the Dow Industrials should move higher at roughly the same pace (they should, over the very long-term, maintain a roughly constant ratio).

We don't know, and it is not possible to quantify, how many ounces of gold should be needed to purchase the Dow. That is, it is not possible to calculate a fair value for the Dow/gold ratio. What we do know is that a) the ratio periodically gets pushed way above and way below its historical mean, and b) once the ratio has reached an extreme and reversed course it tends to head in the opposite direction until it once again reaches an extreme. 

We can't be sure that the ratio will once again return to the 1-5 range that marked the bottom in previous cycles over the past 120 years, but the probability is very high that the ratio will fall far below its present level over the next few years. Obviously, the ratio can plunge as a result of a much higher gold price or a much lower Dow or a combination of a higher gold price and a lower Dow. Our view is that the gold price will do most of the work since we expect a depreciating US$ to underpin the Dow.

The US Stock Market

Stocks, Bonds and Money Supply Growth

Over the past 80 years or so major bottoms in the US stock market have tended to occur at the same time as, or a few months after, important bottoms in the bond market. Looked at from a different angle we can say that major stock market bottoms occur when interest rates are near multi-year highs, not when they are near multi-year lows. This is one reason that last September's low in the stock market has never looked like a long-term bottom (it occurred at around the same time that interest rates were approaching a multi-year low). 

So, if we are going to get a long-term bottom in the stock market this year we will need to see a sharp fall in bond prices over the next several months. The problem is, bonds are continuing to move in the opposite direction to the major stock indices. As has been the case now for more than 4 years, substantial weakness in the stock market is causing bond prices to rise (long-term interest rates to fall) and every significant rally in stocks is accompanied by a sell-off in bonds (a rise in long-term interest rates). The following chart illustrates this inverse relationship.

Extreme weakness in the stock market over the past 3 months has given bond prices a hefty boost and there is every indication that bonds will continue to benefit from a falling stock market over the short-term. One implication of this is that the stock market bottom that appears likely to occur during the next 4 weeks will not be THE bottom. Another implication is that the money supply growth rate is being pushed higher.

Below is a chart that we've shown several times over the past couple of years. It compares the year-over-year change in the M2 growth rate with the T-Bond yield (the scale on the yield chart is reversed so a rising line is indicative of a falling bond yield or a rising bond price). 

The above chart shows that the money supply growth rate and the bond market have consistently moved together over the past 7 years and that the bond market has led the money supply growth rate at turning points. The typical lead-time has been around 3 months. In other words, over the past 7 years it has been the bond market, not the Fed, that has controlled the money supply growth rate. Furthermore it was this relationship that prompted us, in November of last year following the peak in the T-Bond price, to forecast that the money supply growth rate would begin trending lower by early-2002.

Periods of stock market weakness over the past 4 years have resulted in rising bond prices and the higher bond prices (lower interest rates) have, in turn, pushed the money supply growth rate upward. The higher money supply growth has then given a boost to asset prices and consumer spending. 

Unless bonds do something we absolutely do not expect and move above last year's peak, the recent recovery in the money supply growth rate will be short-lived and its overall downtrend will persist. However, we should be on the lookout for another ferocious liquidity-induced rally in the stock market beginning from whatever low is reached over the next few weeks.

Current Market Situation

With one exception all the sentiment indicators we follow have either hit, or are rapidly approaching, bell-ringing oversold extremes. For example, the 10-DMA of the total put/call ratio has moved up to 0.93, the VIX hit a high of 36 on Friday before closing at around 30, the 10-DMA of the Arms Index is 1.53, and all the major sentiment surveys are showing low bullish percentages. Also, the TSI Index of Bullish Sentiment (TIBS), a weighted index of several sentiment indicators, has dropped into extremely oversold territory (see chart below).

In addition to sentiment indicators reaching the sort of levels that are normally associated with important lows, it is getting very easy to find good value in the tech sector. We now have Corning trading at less than one-times current depressed revenue, Lucent trading at 0.7-times revenue and Sprint PCS trading at only slightly more than 50% of this year's revenue. Unfortunately, there are also plenty of stocks that are still grossly over-priced.

The one sentiment indicator that is presently not confirming that a bottom is close at hand is the Commitments of Traders Report. As at the 11th of June the net-long position of small traders (the dumb money) was still near an all-time high. We would need to see this net-long position fall from its current level of 105,000 contracts to around 50,000 contracts before we would start to feel confident that at least a multi-month low had been put in place. The Commitments of Traders data could change from being bearish to being bullish within the space of a few days, but it is probably going to take an additional drop of 50-100 S&P500 points to make this happen.

The bottom line is that we are probably within a few weeks of reaching important lows in the major stock indices, but these lows are likely to be well below Friday's closing levels. The way we currently see things unfolding is that the market will either continue to grind lower and reach a bottom within the next 2 weeks or there will be a 1-2 week bounce followed by a sharp decline to new lows. Also, as discussed under "Stocks, Bonds and Money Supply Growth" we do not think that the low that is reached over the next few weeks will be the ultimate bottom.

We may, at some point over the next few weeks, exit all bearish positions and look to enter some long-side trades in anticipation of a 1-2 month rebound.

A change in focus

Over the past 2 years the greatest selling pressure has clearly been seen in the tech sector, but that might soon change.

Below is a chart of the Bank Stock Index (BKX). The banks have felt some pain as a result of corporate bankruptcies, but the negative effects of problem loans have been largely offset, to date, by widening profit margins as a result of the plunge in short-term interest rates. As such, the BKX is currently less than 20% below its all-time high (its all-time high was, by the way, hit within hours of the Fed's first rate cut). It has, however, made a sequence of lower highs and lower lows over the past 18 months.

The bubble in telecom debt has deflated, thus creating significant problems for many banks, but the bubbles in consumer debt and mortgage finance are yet to burst. We don't see any way that these bubbles can continue to expand in a rising interest rate environment. Furthermore, many of the banks' largest corporate customers outside the distressed telecom sector are acutely vulnerable to higher interest rates. Since we expect interest rates to be much higher at the end of this year than they are now we think the primary focus of selling pressure in the stock market could soon shift from the tech sector to the interest-rate sensitive stocks such as the banks.

The Nikkei

Below is a chart comparing the Nikkei225 Index and the NASDAQ100 Index (NDX) since the start of last year. The Nikkei has consistently led the NDX at important turning points over the past 18 months, although the relationship has recently become muddled.

Since the beginning of April the Nikkei has essentially traded sideways while the NDX has driven relentlessly lower. The Nikkei actually looked like it was about to break out to the upside about 3 weeks ago, but failed to do so and has since fallen quite sharply. It is now nearing important support in the 10750-10900 range and must hold above the bottom of this range to maintain a bullish posture.

One possible cause of the Nikkei's recent weakness is that it has been dragged lower by the US market. This, however, doesn't quite add up since the Nikkei had ignored the weakness in the US market up until about 3 weeks ago. Another possible, and we think more plausible, explanation for the Nikkei's sudden reversal is the BOJ's concerted attempt to push the Yen lower against the US$.

With all government meddling in the financial markets the one certainty is that there will be unintended negative consequences. Up until the time the BOJ began to aggressively sell Yen in an effort to prop-up the US$ the Yen and the Nikkei were trending higher in tandem. By stopping the Yen's rise has the BOJ also stopped the Nikkei's rise? When a central bank appears determined to weaken its own currency it is certainly off-putting to existing and potential foreign investors (central banks have an unlimited capacity to print their own currencies and, therefore, an unlimited capacity to weaken their own currencies).

This week's important economic/market events
 

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