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.

Bonds commenced a secular BEAR market in June of 2003. (Last update: 22 August 2005)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000. The rally that began in October of 2002 will end during the first half of 2007. The ultimate bottom of the secular bear market won't occur until the next decade. (Last update: 02 October 2006)

The Dollar commenced a secular BEAR market during the final quarter of 2000. The first major downward leg in this bear market ended during the first quarter of 2005, but a long-term bottom won't occur until 2008-2010. (Last update: 28 March 2005)

Gold commenced a secular bull market relative to all fiat currencies, the CRB Index, bonds and most stock market indices during 1999-2001. The first major upward leg in this secular bull market ended in December of 2003, but a long-term peak won't occur until at least 2008-2010. (Last update: 13 February 2006)

Commodities, as represented by the CRB Index, commenced a secular BULL market in 2001. The first major upward leg in this bull market ended during the second quarter of 2006, but a long-term peak won't occur until at least 2008-2010. (Last update: 08 January 2007)

Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

Outlook Summary

A sustained or a momentary liquidity contraction?

...liquidity can disappear in an instant with no change in money supply. ...the combined performances of emerging market equities and debt should provide a timely signal that a sustained and widespread liquidity contraction...is occurring.

The way we define the terms, there's a big difference between liquidity and money. This difference revolves around the fact that once money is borrowed into existence it remains in existence until/unless the debt is repaid*, whereas liquidity can disappear in an instant with no change in money supply. For example, the rate of US money supply growth hit a multi-decade high in late-2001 and remained at a well-above-average level throughout 2002, but by the second half of 2002 the financial markets were suffering from a massive loss of liquidity. The rapid growth of the US money supply during 2001-2002 and the rapid growth of the global money supply during 2003-2006 ultimately led to substantial liquidity within the financial markets, but the point is that high money-supply growth can co-exist with low market liquidity for an inconveniently long period (inconveniently long, that is, for those who hope that surging money-supply growth will bail them out of the leveraged speculations they entered during the preceding boom times).

Recently, investors in sub-prime mortgage debt have discovered how quickly liquidity can disappear once confidence takes a hit. At this stage the liquidity contraction has largely been confined to the sub-prime mortgage sector, but it could spread throughout the financial world. If it does then the pundits who claim that the recent high rates of money-supply growth all but guarantee rising asset prices over the next several months will be in for a big surprise.

In conjunction with our favourite yield-spread indicators, the combined performances of emerging market equities and debt should provide a timely signal that a sustained and widespread liquidity contraction -- as opposed to just a momentary restriction of liquidity in response to problems in one area -- is occurring. The reason is that the goings-on of the past few weeks suggest that the emerging markets theme is presently the focal point of speculation and is, therefore, amongst the most vulnerable of the many investment themes to a MAJOR change in the liquidity trend. 

To be specific, if the financial world is going to experience more than a momentary loss of liquidity then what we should see over the coming month or so is substantial weakness in emerging market equities ALONGSIDE a substantial widening of emerging market credit spreads. With reference to the below chart, such an outcome would entail both EMD/USB ratio (the Emerging Markets Income Fund divided by the US Treasury Bond) and the EEM (an Emerging Market Equities ETF) moving to much lower levels. EEM and EMD/USB dropped between mid-February and early-March, but at this stage the declines look no worse than the other routine corrections that have occurred over the past few years.

At the same time as speculative bets on emerging market equities and debt are being exited en masse there should be a sharp rally in the Yen because the Yen carry trade has been such an important source of speculative financing and, therefore, liquidity. A Yen rally based on the unwinding of carry trades is, however, likely to be just a temporary phenomenon because as long as Japan's monetary authorities insist on keeping the official short-term interest rate close to zero there will be little chance of a major bull market in the Yen.

As things currently stand it is possible to make a reasonable case that we are witnessing the initial phase of a sustained liquidity contraction and resultant 1-2 year bear market in growth-oriented investments. But at the same time there are also signs that it could turn out to be just another shakeout within a continuing liquidity-driven bull market. After all, in order for a bull market to climb the proverbial "wall of worry" it is essential that worries be injected into the mix every now and then. In either case, though, the downturn is probably not yet over.

    *Many people believe that debt defaults cause the supply of money to shrink, but this is not so. A debt default will probably reduce the wealth of the person/company making the loan, but if the loan originally resulted in new money being created -- for example, a loan made by a commercial bank to finance the purchase of a home -- then that money will have been spent by the debtor and will remain within the economy following the loan default. Of course, if the customers of a lender default on their loans then the ability and/or desire of that lender to make additional loans may be hampered. It is therefore possible for debt defaults to bring about a reduction in the future rate of money supply growth, but debt defaults do not directly affect the existing supply of money.

Copper

The Stock Market

Current Market Situation

As noted in recent TSI commentaries, the stock market decline that began during the final week of February has resulted in a mind-boggling increase in fear/pessimism. For example, we've previously mentioned that the sell-off caused market participants to purchase sufficient put options to take the 10-day moving average of the CBOE put/call ratio to an ALL-TIME high. Furthermore, short-selling statistics just published by the NYSE reveal that the total number of shares sold short by the public more than DOUBLED during the week ended 2nd March. We've never before seen such a dramatic increase in short-selling.

The extreme shift in sentiment in parallel with what has, to date, been a relatively minor correction is a bullish factor. Also on the positive side of the ledger is the fact that the NDX, after warning of an impending correction by being relatively weak for a few months, has recently been holding up better than the Dow Industrials Index. Largely due to the NDX's recent resiliency, the NDX/Dow ratio's weekly Price Momentum Oscillator is yet to turn down (see chart below).

On the negative side of the ledger as far as the short-term outlook is concerned, other US stock market corrections over the past few years haven't ended until a) the S&P500 Index has traded below its 200-day moving average, and b) the number of S&P500 components trading above their respective 200-day moving averages has dropped to around 40%. As at Friday's close, however, the S&P500 was still about 35 points above its 200-day MA and 66% of S&P500 stocks were still trading above this moving average (see chart below).

In our opinion there's a high probability that the stock indices will trade below their March lows within the coming month. However, the fact that so many people have recently 'jumped on the bearish bandwagon' has substantially reduced the probability of the indices trading a LONG way below their March lows in the short-term. We've therefore upgraded our short-term outlook from "bearish" to "neutral". 

Intermediate-Term Outlook

...we perceive a very significant risk that equity valuations will be hit later this year by the 'double whammy' of rising interest rates and shrinking profit margins.

The current correction was in the works for months before it actually began, but was finally catalysed in late February by a single-day plunge in China's stock market and some unwinding of the Yen carry trade. The troubles in the sub-prime mortgage world have since moved to centre stage, providing the news backdrop to justify more weakness and prompting a veritable stampede to the bearish side of the fence.

As discussed in last week's commentary, however, we think there are things out there that pose much bigger threats to the cyclical bull market in US equities than do the current front-page stories. Specifically, we perceive a very significant risk that equity valuations will be hit later this year by the 'double whammy' of rising interest rates and shrinking profit margins.

Both of the aforementioned risks stem, in part, from the upward pressure on food prices caused by the US Government's ethanol policy. The idea is that the upward pressure on grain prices resulting from the government-sponsored drive to rapidly expand ethanol production will translate into broad-based hikes in food prices. Furthermore, this is going to be happening at a time when a) the average wage-earner will no longer be experiencing the positive wealth effect of an upward-trending home price and will thus have more incentive than before to obtain wage increases that offset his/her rising cost of living, and b) near-record profit margins will provide considerable scope for corporations to pay higher wages in order to retain their best workers.

Concurrent increases in food prices and labour costs will, in turn, likely cause even the fudged government price indices to shout "inflation problem", thus putting irresistible downward pressure on bond prices (upward pressure on bond yields). And with labour grabbing a larger slice of the pie, corporate profit margins will shrink.

Note, though, that the above-mentioned intermediate-term risks do not appear to pose a short-term threat. In particular, long-term interest rates are more likely to fall than rise over the coming 1-2 months.

This week's important US economic events

Gold and the Dollar

Gold and the Euro

...it is extremely likely that gold and the EUR/USD exchange rate will eventually de-couple. ...It's just that they haven't de-coupled YET.

We never cease to be impressed by peoples' willingness to latch onto the smallest piece of evidence that supports their preconceived view of the world whilst ignoring a veritable mountain of conflicting evidence. Such is the case regarding the relationship between the gold market and the foreign exchange market.

The traditional inverse relationship between gold and the Dollar Index manifests as a positive correlation between gold and the euro (EUR/USD). For many years gold and the euro appeared to be 'joined at the hip', but during the 6-month period from May through to November of 2005 they went separate ways with gold trending higher while the euro drifted lower. However, this 6-month period proved to be a temporary divergence similar to the one that occurred during 1993. The following chart, for instance, shows that since November of 2005 gold and the euro have, again, behaved as if they were joined at the hip. And yet, due to the aforementioned 6-month divergence many gold market commentators now labour under the assumption that gold and EUR/USD have de-coupled.

Make no mistake -- it is extremely likely that gold and the EUR/USD exchange rate will eventually de-couple. The reason is that if the supplies of US dollars and euros continue to be inflated at rapid rates then the monetary backdrop will inevitably become conducive to strength in gold relative to BOTH currencies, regardless of what is happening with the EUR/USD exchange rate.

It's just that they haven't de-coupled YET.

In the financial markets the most useful information is often in the divergences, and this is certainly true when it comes to the relationship between gold and the euro. In particular, strength or weakness in the euro tends to be unsustainable unless it is associated with strength or weakness in gold. Or, putting it another way: gold tends to be the lead market at turning points, with the euro sometimes diverging for a while before falling into line with gold. For example and with reference to the above chart, gold's downward reversal last May was a clear sign that the euro's rally was effectively over even though the euro went on to marginally exceed its May high in early June; and when the euro's 'moonshot' during the second half of November-2006 was not confirmed by similar strength in gold it was an indication that the sharp currency market move was an end rather than a beginning.

The current situation is starting to look similar to the situation during the second half of November last year in that the euro has recently been significantly stronger than gold. This suggests to us that there isn't much scope for the euro to make additional gains.

For some time our expectation has been that the euro would test resistance defined by its December-2004 peak (1.36). This intermediate-term resistance also roughly coincides with the top of the euro's short-term channel (see chart below) and remains a viable target. In other words, we think the euro could gain an additional 2% from here, but no more than that.

As far as gold's near-term prospects are concerned our best guess is that the rebound will continue for another 1-2 weeks, after which the downward correction will resume. We expect gold to hold up better than the euro during the next decline, but in order to shake-out sufficient speculative 'longs' to set the scene for the next tradable rally the March lows will probably have to be breached.

Gold Stocks

Beyond the very short-term a weakening stock market would likely become a positive for the gold sector...

The gold sector of the stock market is becoming very oversold, as evidenced by the gold stock indices dropping to near their lows of the past 6 years relative to gold bullion and the recent drop to new multi-year lows by Rydex PM's cumulative cash flow (the amount of cash invested by the public in the Rydex Precious Metals Fund). In fact, if not for our view that the broad stock market will have to take-out its March lows before a decent rally becomes probable we would now be operating under the belief that short-term bottoms are already in place for the major gold stocks. But as it is, a plunge by the S&P500 Index to new lows for the year will probably result in the HUI and the XAU moving below their early-March lows as market participants, motivated by blind fear and/or margin calls, sell whatever stocks they can.

We doubt, though, that the gold stock indices will trade more than a few percent below their March lows over the next few weeks. Furthermore, they should rebound quickly once some stability returns to the broad market in similar fashion to the way a beachball held under water will rebound once the force that's holding it down is removed.

Beyond the very short-term a weakening stock market would likely become a positive for the gold sector because it would prompt the monetary authorities to abandon all pretense at inflation fighting. The problem for gold stocks occurs during the transition period -- the period from the beginning of pronounced stock market weakness to the point where the markets become convinced that the central bank is about to loosen monetary policy in an effort to counteract the weakness. We therefore don't view the potential for persistent stock market weakness as a longer-term threat to the gold sector.

We've included the following monthly chart of the XAU to show three things:

First, the chart clearly shows the long-term resistance at 155-160 that was re-tested during the second quarter of last year. We have no doubt that this resistance will be taken-out and left a long way behind within the next two years; the only question we have is whether it will be taken out this year following a bit more consolidation in the 120-150 range (our "red scenario") or during 2008-2009 following a large decline that takes the XAU back to 80-100 (our "blue scenario").

Second, the chart shows that the XAU's monthly Price Momentum Oscillator (PMO) has turned down. Taken in isolation this means nothing because once the monthly PMO has moved above 15 then almost every intermediate-term correction will cause it to momentarily turn down.

Third, the chart shows that the XAU/gold ratio is close to its lows of the past 6 years, but it's not quite there yet. This suggests that the XAU's downside risk relative to gold is only about 7%.

Update on Stock Selections

(Note: To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question)

European Minerals (TSX: EPM). Shares: 277M issued, 417M fully diluted. Recent price: C$1.19

EPM has recently come to life. After trading as low as C$0.88 during the first week of March, it traded as high as C$1.30 late last week before easing back to end Friday's session at C$1.19.

We don't know whether the increased speculative interest in EPM is due to unfounded rumours of a takeover bid for the company; or due to well-founded rumours of a takeover bid; or simply due to the market belatedly coming to the realisation that EPM's Kazakhstan-based gold/copper mine should generate enough cash during 2008 to justify a higher valuation. Whatever the reasons for the renewed interest in the stock, we would view a move up to around C$1.40 within the coming fortnight as an opportunity to take PARTIAL profits. On the other hand, if the stock were to pullback to around C$1.00 on the back of some additional sector-wide weakness within the coming month then we would view it as a buying opportunity.

    Gryphon Gold (TSX: GGN). Shares: 47M issued, 57M fully diluted. Recent price: C$1.00

It is said that every cloud has a silver lining, although our personal experience has been that only some clouds do. Last November's bad news that forced GGN's management to shelve plans to put the Borealis oxide deposit into production and, instead, focus on the project's exploration potential, might turn out to be one of those silver-lined -- or, in this case, gold-lined -- clouds. The reason is that a junior gold mining company can add a lot more shareholder value by discovering a large metal deposit than it can by putting a small mine into operation, and the results from the first three holes of GGN's current 72-hole program were very promising indeed.

With reference to the following chart, the spike from C$0.86 to C$1.20 at the beginning of March was the market's reaction to the results from the first three holes. GGN's price then dropped back in response to the market-wide downturn and, no doubt, the selling of 'stale longs' who viewed the stock's sudden strength as an opportunity to get out near break-even. Since then the stock has been consolidating just below trend-line resistance.

There's a lot of resistance in the C$1.10-1.20 range and this resistance could keep a lid on the stock for a while. However, the company should have a steady stream of drilling results to report over the coming months and if future results confirm the potential indicated by the first three holes then this resistance will almost certainly be overcome.

GGN is a small stock with a relatively low average daily trading volume, so it is not for everyone. Having said that, it is not as risky as many other exploration plays. In particular, there is very little political or environmental risk associated with this company and the valuation is under-pinned by the in-ground resources that have already been proven-up.

Speculators who can tolerate the micro-cap world's volatility and lack of liquidity should consider picking away at GGN in the C$0.95-C$1.05 range.

Chart Sources

Charts appearing in today's commentary are courtesy of: