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   -- Weekly Market Update for the Week Commencing 26th July 2004

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) bottomed in June of 2003 at around 4.2% and will move considerably higher during 2004 and 2005. (Last update: 12 January 2004)

The stock market rally that began in October of 2002 ended during the first half of 2004. The October-2002 bottom (775 for the S&P500) will be tested during 2005. (Last update: 12 July 2004)

The Dollar made an intermediate-term bottom in February of 2004 and will move higher into the first half of 2005. A long-term bottom won't occur until 2008-2010. (Last update: 26 July 2004)

Gold made an intermediate-term peak during the first half of 2004, but a long-term peak won't occur until 2008-2010. (Last update: 12 July 2004)

Commodities, as represented by the CRB Index, made an intermediate-term peak during the first half of 2004, but a long-term peak won't occur until 2008-2010. (Last update: 12 July 2004)

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Important Note

Due to family commitments we are going to miss at least two reports over the coming 3 weeks, including the next Interim Update. We're not sure yet which other report(s) will be affected, but will let you know as soon as we've confirmed our schedule.

The next report will therefore be the Weekly Update on Sunday 1st August. In the mean time, if anything happens in the markets that we think requires an immediate comment from us we'll send out a brief Market Alert e-mail to all subscribers.

Is gold under-valued?

For anyone with a time horizon of one year or longer it makes no sense to analyse the gold market in isolation. This is because it is not possible to come to a sensible conclusion about the long-term outlook for gold unless you also have a well-grounded opinion on what is likely to happen to asset prices, interest rates, currency exchange rates, inflation, and real economic growth. The price of gold is just a reflection of the financial world, so even if we didn't speculate in anything other than gold bullion we would need to spend as much time analysing the other financial markets as we do now.

Further to the above, it is really not appropriate to say that gold is currently under-valued unless you specify what it is under-valued relative to. And in this respect it is not enough to say that gold is under-valued relative to the US dollar because the dollar's value, like gold's value, is determined by each individual based on his/her own perception of the world. Value is always at least partially subjective (of value to whom and for what?) and this is even more so with the dollar and gold than it is with, say, stocks or bonds or real estate, because neither the dollar nor gold has a yield that we can compare with historical records in order to quantify its current level of under- or over-valuation.

It is also not appropriate to say that gold is under-valued now simply because it is trading well below it's 1980 peak. It could be argued, for instance, that the 1980 peak was an aberration and that it has taken the past 24 years for gold to work its way back to a level where it is fairly valued.

In the cases of both gold and the dollar, the terms under- and over-valuation only have meaning for each market participant when referenced to that individual's perception of the world. As far as we are concerned, gold is dramatically under-valued because our research indicates that the markets are grossly under-estimating the US inflation problem. We are not so arrogant, though, that we rule out the possibility of a reasonable person coming to the opposite conclusion; although having said that we can't think of anyone who we would put in the "reasonable" category who thinks gold is over-valued at its current level. 

The Stock Market

Following the leader

Making semiconductor chips is generally not a great business because profit margins are usually under pressure and those chip companies that are able to maintain healthy profit margins can only do so by spending massive amounts every year on research and development. However, over the past several years the stocks of semiconductor companies have traded at high price/sales ratios, that is, they've traded as if the companies were involved in high-margin businesses. And this mismatch between stock price and underlying business value means that the stocks are inherently risky, which, in turn, causes them to be leaders to the upside when the general appetite for risk is increasing and leaders to the downside when market participants are becoming more risk averse.

The below charts of the SOX/CRX ratio (the Semiconductor Index divided by the Commodity-Related Stocks Index) and the SOX/NDX ratio illustrate the above point. In particular, they show that the semiconductor stocks trended higher relative to commodity stocks and large-cap tech stocks between October-2002 and December-2003, indicating a general increase in the appetite for risk. However, from December-2003 to the present the semiconductor stocks have been very weak on a relative basis. Interestingly, relative weakness in the SOX over the past 8 months has resulted in these ratios dropping to within 5-10% of major support. 




The below chart shows that the SOX is also within about 5% of potentially important support on an absolute basis.


As long as the SOX -- the leader to the upside during last year's recovery and the leader to the downside thereafter -- is trending lower relative to indices such as the CRX and the NDX there will be little chance that an intermediate-term low is in place. However, once we start seeing persistent relative strength in the SOX it will probably be time to back away from our short- and intermediate-term bearish views.

Remembering 2001

As a general rule, when the broad stock market falls at a rapid pace the gold stocks get taken along for the ride. There are, however, some exceptions to this rule, one of which was highlighted in 2001. Specifically, the below chart comparison of the S&P500 and the HUI illustrates that when the stock market tanked in the aftermath of the September-2001 terrorist attacks the gold stocks moved sharply higher. This is something to keep in mind in the current environment.


Current Market Situation

We've noted in previous commentaries over the past few months that the NYSE McClellan Oscillator (MO) is not a reliable indicator these days because more than half the stocks on the NYSE are interest rate plays and therefore tend to move in same direction as the bond market each day. The NASDAQ MO, however, still appears to be a useful short-term indicator on those occasions when it reaches an extreme.

The below chart shows that the NASDAQ MO is getting close to a level from which rallies have invariably materialised in the past. What this means is that if the market were weak enough during the next few days to take the NASDAQ MO down to around -60 then a 2-4 week rally would become a likely prospect. A more bearish outcome, however, would be some strength during the first half of this week to work-off the oversold condition.


A longer-term indicator worth paying attention to is the % of NYSE stocks above their 200-day exponential moving average (see chart below). Drops to 20% by this indicator have coincided with major lows over the past few years.


We expect that the stock market will continue to make lower lows between now and the September-October period (when an intermediate-term bottom is likely). We wouldn't be surprised, though, if there were an intervening rebound in the stock indices beginning from at, or just below, their May lows. The May lows for the S&P500 and the Dow Industrials are 1076 and 9852, respectively, versus Friday's closing levels of 1086  and 9962.

This week's important US economic events

Date Description
Monday Jul 26 Start of Democratic National Convention
Tuesday Jul 27 Consumer Confidence
Wednesday Jul 28 Durable Goods Orders
Thursday Jul 29 End of Democratic National Convention
Friday Jul 30 Q2 GDP (preliminary)

Gold and the Dollar

Currency Update

In last week's Interim Update we noted that the euro's break below support was a sign that the dollar had already bottomed, but that the Dollar Index had not yet displayed enough strength to convince us of this. In particular, we mentioned that it remained below its 50-day MA and that Wednesday's rebound had halted at the short-term trend-line. Friday's upward move in the US$ has, however, shifted the odds firmly in favour of a bottom being in place. For example, the Dollar Index's short-term downtrend has been decisively breached and the euro has dropped below the bottom of its upward-sloping channel (see charts below). The Dollar Index also managed a marginal close above its 50- and 200-day moving averages at the end of last week.




Our intermediate-term target for the Dollar Index over the past 2 months has been 100 and last week's action suggests that a rally to around this level has begun. This doesn't mean, though, that it's onward and upward for the US dollar from here because even if our view is on the mark there will, of course, by pullbacks along the way. In fact, we would not be surprised if last week's obvious confirmation of strength in the buck was followed, in fairly short order, by a 1-2 week pullback. What it does mean is that the dollar should now start making higher lows and higher highs.

On a side note, when a market makes a sizeable move in one direction it prompts commentators to come up with 'reasons' for the price move. These reasons will often be wrong, but as long as the price continues to move in that direction the reasons will look right. So if the Dollar Index works its way up to our target of 100 over the coming 6 months be aware that a bunch of fundamental 'reasons' will be concocted to explain the rally and most of these explanations won't be realistic. For example, it's a fair bet that strong US productivity growth and real economic growth will be trumpeted in some quarters as reasons for a dollar rally, but such explanations should be ignored unless there is a dramatic change in the structure of the US economy over the next few months. Another explanation that might emerge revolves around the idea that US consumer debt represents a massive short position on the dollar and that the dollar is experiencing a short-covering rally due to US households paying back their debts. This explanation won't make any sense, though, unless the total supply of credit happens to be contracting at the time (you can't have a short-covering rally when the short position is expanding).

As mentioned in previous commentaries, if a dollar rally does unfold as per our expectations then it will most likely be driven by technical factors, sentiment, central bank intervention, and the unwinding of carry trades and other short-term trades that were based on the perception that US interest rates were going to remain low indefinitely.

Gold Stocks

Alternatives

There are always a myriad of possibilities for each of the financial markets, but if we tried to present most of these possibilities at TSI, or even just a few of them, many of our readers would either be confused or would get the impression that we were trying to hedge our bets. Therefore, although we are always considering many different possible outcomes we usually only present what we see as the most likely outcome in these commentaries. Occasionally, though, we feel that by far the best approach is to run the risk of creating confusion and present two or three different scenarios. Now is one of those times.

In the latest Interim Update we showed that seasonal/cyclical influences pointed towards a November low for gold stocks. However, the speed of the recent decline in the AMEX Gold BUGS Index (the HUI has fallen by around 10% over the past 10 trading days) forces us to discuss two other possible outcomes.

First, the speed of the recent decline in the HUI from its rebound peak actually opens up the possibility that October-November will be a high rather than a low. This is because fast declines are invariably short declines. A November low, on the other hand, would require a lengthy (3-4 month) downward move from the recent peak. The bottom line is that if there were enough near-term weakness in the gold stocks to take the HUI back to the vicinity of its May low within the coming week or so then we would potentially have a set-up for a powerful rally into the October-November period. This would be a more bearish pattern from a longer-term perspective, but would obviously be welcomed by gold-stock investors who were eager to reduce their exposure to the sector.

Second, with reference to the below chart of the HUI note that:

a) The rebound in the HUI from its May low to its July peak (point C to point D) was almost identical to the February-March rebound (point A to point B) in terms of time, and was very similar in terms of price action.

b) The time between the HUI's peak at the beginning of April and its May low (B to C) was 26 trading days. 

The current decline is 10 trading days old, so if the similarities to the February-May period persist then a bottom will occur after 16 more trading days (mid August). This would, in all likelihood, be the ultimate correction low (the low that preceded the next major upward leg in the gold-stock bull market).


We still favour the "November low" scenario discussed in the Interim Update because it meshes with our expectations for the US dollar and the broad stock market, but if the HUI drops back to near its May low within the coming 1-2 weeks we will need to give more serious consideration to the above-described alternatives.

The HUI/gold ratio

Below is a chart showing the HUI/gold ratio and its 40-day moving average from the beginning of the gold-stock bull market to the present day. The chart shows that a) HUI/gold has remained above its 40-day MA during the upward legs with pullbacks finding support at this moving average, and b) during the major corrections HUI/gold tends to oscillate around its 40-day MA.

Belated confirmation that a new upward leg was in progress would therefore be provided by HUI/gold moving above its 40-day MA, dropping back to 'test' this moving average, and then moving to a new recovery high. However, we will hopefully have identified the new upward leg well before this technical confirmation occurs.


What to do?

During a long-term bull market you should endeavour to do most of your buying into weakness and most of your selling into strength.

Right now is not a good time to be selling and, in fact, many of the gold stocks we follow and all of the gold stocks in the TSI List look like strong buys from a valuation perspective. Furthermore, many gold stocks are within 10% of long-term technical support levels. For example, the below weekly charts of Newmont Mining and Golden Star Resources show that these high-profile stocks ended last week about 10% above the bottoms of their long-term price channels.

Most gold stocks are probably going to trade below current levels at some point over the next 4 months, but the longer-term outlook is extremely bullish. Anyone who has taken our advice to maintain substantial cash reserves this year should therefore be looking forward to more short-term weakness as an opportunity to add to existing positions, or to purchase new positions, in a sector of the market that has enormous profit potential over the coming few years. There was a great buying opportunity in May and there will probably be another great buying opportunity soon (perhaps as soon as the coming fortnight but almost certainly within the coming 4 months).




Hedging your exposure

In the latest Interim Update we discussed Newmont Mining put options as a way of hedging a gold stock portfolio. It shouldn't be necessary to buy puts for insurance purposes if you have substantial cash reserves, but for someone who is light on cash and heavy on gold stocks it might be an appropriate tactic. Unfortunately, the market didn't provide much of an opportunity to buy NEM put options at attractive prices following the Interim Update because NEM was up a little on Thursday but then tanked on Friday.

Buying some NEM September or December $35 put options into any strength over the coming few days would be something to consider if your gold stock exposure was causing you to lose sleep, but as a standalone trade we much prefer the Phelps Dodge (PD) October $60 put options recommended two weeks ago at TSI. This is because we perceive considerably more downside risk in the industrial metals and the stocks of industrial metal producers than we do in gold and gold stocks. In particular, in the case of a large-scale terrorist attack in the US or Europe -- a possibility that needs to be seriously considered -- gold-related investments would probably move sharply higher while copper-related investments would most likely plunge (refer to the 2001 chart shown earlier in today's report). Also, from a technical perspective NEM appears to be much closer to a correction low than does PD.

Current Market Situation

Gold broke below the bottom of its short-term channel on Friday (see chart of August gold futures below), indicating that a test of the May low will probably occur within the next few weeks. Judging by the Commitments of Traders data and the performance of gold stocks relative to the metal, there didn't seem to be much speculative enthusiasm in the gold market when the gold price was near its peak earlier this month. Therefore, we don't think there is significant downside risk beyond the May low.


Copper

Weakness in the US$ from mid May through to mid July contributed to the rebound in the copper price over this period, but if the dollar has turned higher on an intermediate-term basis then the copper market is now facing a substantial headwind. In fact, if the dollar has just bottomed then the 2-month rebound in the copper price most likely peaked about one week ago.

The below daily chart of September copper futures shows the support that exists at 120 and at the 112.50 'double bottom'. We've also noted, on the chart, that the initial decline in copper's correction lasted 2.5 months. If the second, and most likely final, decline also lasts 2.5 months then copper will bottom in early October. Interestingly, this would mesh with our view that the stock market is going to experience substantial weakness between now and October because a big slide in equities would lead to economic growth expectations being ramped down and this would, in turn, prompt speculators to anticipate less demand for copper.


Update on Stock Selections

The story, at the moment, is a market story, with positive developments in individual stocks generally being overridden by the market-wide downward pressure.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/
http://www.decisionpoint.com/



 
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