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)

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Outlook Summary

Sometimes it actually is different

...there has been the odd occasion throughout history when, due to a major structural change, it actually was different. ...a critical mass of people came to realise that a knock-on effect of the changing nature of money would be unrestrained growth in the money supply, making bonds inherently riskier than stocks over the long haul.

The "it's different this time" argument will routinely be dragged out in the latter stages of a long-term bull market to justify valuations that simply can't be justified by traditional methods. In the end, however, valuations always revert to their long-term average. In fact, once valuations reach a major peak and reverse course they invariably keep shrinking until they have moved well below their long-term average, at which point a new version of the "it's different this time" argument will typically surface to explain why valuations are doomed to remain low. As a result, investors who buy into the idea that "this time it's different" tend to end up in the poor house.

The valuation cycle -- from under-valued to over-valued and back again -- is clearly evident on the following long-term chart of the S&P500's P/E ratio. The secular bull markets for the S&P500 are the 10-25 year periods on the chart when valuations (P/E ratios, etc.) expanded and the S&P500's secular bear markets are the 10-25 year periods on the chart when valuations contracted.

Having said all that, there has been the odd occasion throughout history when, due to a major structural change, it actually was different. For example, in his book "Against the Gods -- the Remarkable Story of Risk" Peter Bernstein explains that prior to 1959 the US stock market's average dividend yield was almost always greater than the yield on long-dated US Government bonds. Furthermore, a drop in the average dividend yield to below the bond yield had traditionally been a reliable indication that stocks were very over-valued and that a substantial stock market correction lay in the not-too-distant future. As a result, many prudent investors would automatically reduce their exposure to the stock market whenever dividend yields dropped below bond yields. However, in 1959 the US stock market's average dividend yield fell below the Treasury bond yield and stayed there. Those prudent investors who exited the stock market in 1959 and began to wait for the S&P500's dividend yield to move back above the bond yield -- something it had always done in the past -- prior to re-building their equity portfolios, are still waiting.

The conventional wisdom in 1959 was that stocks should, and invariably did, yield more than bonds because they were riskier, but this age-old relationship was turned on its head by inflation. As an asset class stocks will be riskier than bonds -- and generally yield more than bonds -- in a world where the currency maintains its purchasing power over the long-term. However, in a world where the currency is almost guaranteed to lose its purchasing power at the rate of more than 3% per year there will be a strong tendency for equity yields to be lower than bond yields. The reason is that as prices rise throughout the economy the nominal earnings, and hence the nominal dividend payments, of most companies will also rise. A typical bond, on the other hand, will continue to provide the same nominal income regardless of how much the currency devalues.

Now, inflation didn't suddenly emerge in 1959. There was, instead, a multi-decade transition from a stable currency to one that consistently loses its purchasing power. This transition began in 1913 with the creation of the Federal Reserve, took a quantum leap in 1934 with the elimination of US citizens' right to convert their dollars into gold at a fixed rate, and ended in 1971 with the severing of the last remaining official link between the US$ and gold. 1959 just happened to be the year when a critical mass of people came to realise that a knock-on effect of the changing nature of money would be unrestrained growth in the money supply, making bonds inherently riskier than stocks over the long haul. 

The above-mentioned change in the nature of money also altered other traditional relationships. For example, gold went from being a hedge against deflation to being a hedge against the loss of confidence in the official currency caused by inflation. Despite this there are still plenty of people who buy gold as a hedge against deflation because they have looked at gold's long-term historical record but have failed to account for the major structural changes that have taken place within the monetary system. In doing so they have, over the past several years, proven that in the investment world it is possible for two wrongs to make a right (they were wrong to expect deflation and wrong to expect that gold would do well if genuine deflation did actually occur, but they ended up in the right place anyway because they bought gold).

Additionally, the stock market's long-term valuation cycle is clearly still in effect, but the fact that valuations at the end of the most recent secular bull market were more than 50% above those at earlier secular peaks is most likely a consequence of the greater amount of inflation (money supply growth) made possible by changes to the monetary system.

Summing up, "it's different this time" is usually a dangerous notion to enter an investor's mind. However, there are rare occasions when relationships that have held without fail for generations suddenly stop working due to major structural changes; and for this reason it can also be dangerous to blindly assume that just because things happened in a particular way in the past they will necessarily happen that way in the future.

You really have to understand WHY things happened the way they did in the past before coming to any conclusions about the future.

Natural Gas Update

The Stock Market

Current Market Situation

There are two significant bearish divergences 'on the go' at the moment in the US stock market. The first of these is the failure of the NASDAQ100 Index (NDX) to confirm the new highs by the other senior stock indices. The other is illustrated below and is the failure of the AMEX Broker/Dealer Index (XBD) to exceed its early-January peak. If things are really as bullish as they superficially seem to be then why has there been a sequence of declining peaks in the XBD over the past 6 weeks?

We have two short-term scenarios in mind for the US stock market, one being that the NDX and the XBD will soon confirm the new 52-week highs recently achieved by most other indices and the other being that the overall market will turn down prior to the aforementioned confirmations. In the first of these scenarios the overall upward trend would be expected to continue until at least May, whereas in the second scenario an intermediate-term peak would be close at hand.

Sub-Prime Carnage

...the current assessment of the financial markets is that the trouble in 'sub-prime land' will NOT have a substantial adverse effect on the overall US economy.

The following two charts show the spectacular rises and equally spectacular falls in the stock prices of two of the largest companies that specialise in sub-prime lending to US homebuyers. If there's anyone who truly believes that the stock market efficiently discounts the underlying fundamentals, well, they should take a look at these charts.

After a long period of complacency the stock market has obviously now gone a long way towards discounting the effects, on sub-prime lenders, of the burgeoning quantity of sub-prime mortgages that are in default.

Based on a desire to improve short-term earnings growth that overrode normal risk management considerations, these lenders made loans that could aptly be described as absurd. In fact, in plenty of cases they granted mortgages for 100%, or even more than 100%, of home value without obtaining any evidence that the borrowers had the financial means to meet the loan repayments. It is therefore not surprising that these loans are now going bad at a rapid rate. The timing of the collapse was difficult to foresee because what's happening in the world of sub-prime financing now could just as easily have happened two years ago or could potentially have been postponed for another year or so, but it was always a matter of when, rather than if, these companies were going to get into deep trouble.

What is perhaps a surprise is that the carnage in the sub-prime lending market has not yet had much effect elsewhere. In particular, the stocks of the major commercial banks and investment banks have generally maintained their upward trends, yield and credit spreads have generally remained narrow, and the senior stock indices are close to 52-week highs. Clearly, the current assessment of the financial markets is that the trouble in 'sub-prime land' will NOT have a substantial adverse effect on the overall US economy.

In the past the markets haven't always been right about such things. For example, the Asian debt crisis of 1997-1998 brewed for about 12 months before signs of fear began to appear in the US financial markets. The current crisis, however, is home grown and very well known, so if there were a good chance of it spreading through the economy then the markets should have already begun to anticipate such an outcome.

This week's important US economic events

Gold and the Dollar

Currency Market Update

...we consider the COT situation to be one of many indicators of market sentiment. ...short-term price extremes (a high for the US$ and lows for the dollar's main fiat currency counterparts) are already in place.

Today we will take a look at the Commitments of Traders (COT) data for the Swiss Franc, but before we do it's worth making some general comments regarding the usefulness -- or lack thereof -- of the weekly COT reports put out by the CFTC (Commodity Futures Trading Commission).

We don't think there's any point doing in-depth analysis of the COT data. Like just about everyone else involved in the markets we look at this data, but the mere fact that just about everyone looks at it immediately reduces its usefulness (in the financial markets you are never going to gain an advantage by looking at the same stuff that everyone else looks at). This, however, is not the only reason to minimise the importance of the COT data.

Also of significance is that the main pieces of information that can be extracted from the COT data are the net positions of the speculators and the commercials, but there are no lasting benchmarks as far as these net positions are concerned. For example, in the gold futures market the large speculators are always on the right side of the long-term price trend, but when the speculative position reaches an extreme (an extreme net-long position in a long-term bull market or an extreme net-short position in a long-term bear market) there will invariably be a reaction against the prevailing price trend as speculators take profits. The problem for someone using the COT data in their decision-making process stems from the fact that there is no way of knowing, in advance, what will constitute an extreme. What constituted an extreme speculative net-long position in the gold market three years ago, for instance, did not come close to the extreme reached over the past year, and the extreme reached over the past year will almost certainly be dwarfed by the extremes that will be reached over the coming three years.

Something else worth considering, particularly in relation to gold, is that the ETFs created over the past few years have attracted some of the speculative demand that would otherwise have been directed towards the futures market. The trend is for more alternatives to be provided to speculators and this trend further reduces the significance of the COT data.

Finally, a comment last year by Frank Veneroso caught our attention. When outlining his reasons for being bearish on the base metals Mr Veneroso happened to mention that speculators in copper futures were disguising themselves as commercials in order to paint a false picture of the copper market's structure. He didn't go into the mechanics of how this was being done, but we doubt that he would have made the comment unless he was privy to substantiating evidence; and we suspect that the mechanics wouldn't be very difficult to manage. It would, we believe, be possible for speculators to execute their buy/sell orders via entities defined by the CFTC as "commercial", making it look as though positions were being accumulated by commercial traders rather than speculators. Our point is: if this has been going on in the copper market then it has probably also been going on in other markets, even further reducing the usefulness of the COT data.

Further to the above, we consider the COT situation to be one of many indicators of market sentiment. We view it as a small piece of a large puzzle and don't see a good reason to assign it greater importance than other sentiment indicators such as put/call ratios, sentiment surveys and the various Rydex ratios.

We'll now take a look at what, if anything, the COT data is saying about the Swiss Franc's short-term prospects.

The following chart compares the Swiss Franc (the SF/US$ exchange rate) with the net position of speculators in Swiss Franc futures over the past two years. The arrows on the chart mark the times when the speculative net-short position in SF futures moved above 60,000 contracts.

Notice that whenever speculators have become excessively bearish on the SF, as indicated by the speculative net-short position rising above 60,000 contracts, a Swiss Franc rally lasting at least 1-2 months has ensued. The current COT situation is therefore consistent with our view that a 1-2 month rally got underway during the past couple of weeks.

Also notice, though, that over the past two years the speculative net-short position in SF futures has been reaching progressively higher extremes prior to the start of each SF rally, the implication being that if this pattern continues then the speculative net-short position will have to rise to at least 90000 before the SF commences a decent rally. This is a risk, but the market action suggests that short-term price extremes (a high for the US$ and lows for the dollar's main fiat currency counterparts) are already in place. 

Gold and Gold Stocks

The following chart shows that the AMEX Gold BUGS Index (HUI) spiked up to test its early-December high on Friday but ended the session almost 2% below this resistance level. The chart also shows that the gold price ended the week comfortably above its early December high.

When new multi-month highs in gold bullion are not accompanied by new multi-month highs in the gold stock indices it is a bearish divergence because the stocks usually lead. However, divergences between the stocks and the metal are not always reliable. For example, when the HUI surged to new multi-month highs in early September in parallel with a lower high in the bullion it was interpreted by many analysts (but not us) as a bullish divergence. But as you can tell from the chart, this so-called bullish divergence was followed by sharp multi-week declines in both the stocks and the metal.

Our guess is that if short-term peaks are not already in place for gold and the gold stock indices then they will be put in place within the next week or so. However, we expect that any pullback over the coming few weeks will be followed by a move to new multi-month highs.

A reason to anticipate additional gains prior to more sustainable peaks being put in place is encapsulated by the charts of Newmont Mining (NEM) and Gold Fields Ltd (GFI) included below. Both of these stocks tested resistance late last week -- GFI has lateral resistance at $19 and NEM has a confluence of resistance at $47.50-$48.00 -- and then pulled back, but both are clearly a long way from being overbought and appear to be completing basing patterns rather than topping patterns.

From a longer-term investment perspective we much prefer GFI to NEM. In fact, at current prices GFI is the only major gold stock in which we'd be interested in making a long-term investment.

GFI's price has been held back over the past few months by the purchase of the South Deep mine, but we think this purchase will eventually be viewed by the market as a huge plus because the company has added an operational mine with almost 30M ounces of P&P reserves to its stable at a cost of only US$100 per reserve ounce. If the market is not valuing this asset at more than $200/ounce in two years time then we will eat our hat.

NEM, on the other hand, offers less in the way of long-term value but does appear to offer reasonable upside potential as far as the coming three months are concerned. In particular, a decline in the company's production during 2007 has already been fully discounted by the market whereas we don't think the boost to earnings that will come from the expiry of its copper hedges -- the last of the disastrous hedges expire this month -- has yet been factored in.

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)

Gryphon Gold (TSX: GGN). Shares: 47M issued, 57M fully diluted. Recent price: C$0.84

14 members of the TSI Stocks List (AAU, CGR, GQM, GRS, HL, MFN, MRB, SBB, MAW, SXR, USU, CML, CUU, and IRC) ended last week at, or near, 52-week highs. At the same time, however, a few of our stocks were languishing near 52-week lows.

GGN is one of the stocks languishing near its 52-week low. It hasn't, as yet, recovered from last November's bad news relating to an error in resource estimation made by one of the company's consultants. As a result of that bad news, GGN's management lost some credibility and the investment world lost interest in the stock.

The stock market's reaction to bad news can sometimes create opportunities to purchase assets at well below their true worth. This, we think, is the current situation with GGN. Specifically, our back-of-the-envelope valuation for GGN's Nevada-based Borealis gold project is US$75M, calculated by assigning a value of US$50/oz to the project's 1.2M-ounce measured-and-indicated resource and a value of US$25/oz to the project's 0.6M-ounce inferred resource. This is approximately double GGN's current market capitalisation and is probably close to where the stock would now be trading if not for the stigma associated with last November's disappointment.

GGN has a 72-hole drilling program planned for 2007 to upgrade and expand the Graben sulphide deposit's resource (the Graben deposit is part of the Borealis project and currently has a total resource of 875K ounces) as well as explore for new gold deposits within two newly-identified gold-bearing systems within 5km of the Graben deposit. This drilling program is fully funded by the company's cash on hand (we estimate that GGN presently has about US$8M in the bank) and has the potential to provide a stream of market-moving news over the next several months.

In addition, an updated resource estimate for the Graben deposit is scheduled to be completed during March and could also be market-moving. This updated estimate is being done by AMEC and will take into account the results of drilling since March of 2006.

With reference to the following chart, GGN has been drifting lower over the past month on almost no volume. The lack of volume makes it difficult to buy the stock in any real quantity, but investors who are prepared to sit patiently with bids near current levels might be rewarded as existing shareholders become frustrated with the lack of stock-price action and 'throw in the towel'. The probability of getting a buy order filled will improve if the gold sector experiences a correction during March as presently appears likely.

Although it is very much in the micro-cap category, we don't think there's a lot of downside risk in GGN near its current price because the company's in-the-ground gold ounces already sell at a large discount -- meaning that expectations are low -- and these ounces are in a safe geographical location (Nevada). The worst case might be that an investment in GGN proves to be 'dead money' for many more months, but note that if we are right to expect sector-wide strength to persist until at least May then speculation sufficient to lift very under-valued micro-caps to much higher levels could easily occur within the coming three months.

    Chesapeake Energy (NYSE: CHK)

The Chesapeake Energy April-2007 $32.50 call options (CHKDZ) are in the TSI Stocks List.

Good news on the earnings front broke CHK upward from a multi-week consolidation pattern on Friday and additional gains are likely over the coming weeks. However, we doubt that there will be sufficient strength in the oil-and-gas sector of the stock market to enable CHK to breakout to the upside from its 17-month price range (see chart below) prior to the expiration of our options.

For those who currently hold the CHK April call options our suggestion is to exit into strength over the next 3 weeks, whereas those who hold CHK call options expiring in July or later could consider maintaining a position in anticipation of sector-wide strength persisting until May.

Chart Sources

Charts appearing in today's commentary are courtesy of: