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, where "secular bear market" is defined as a long-term downward trend in valuations (P/E ratios, etc.) and gold-denominated prices. This secular trend will bottom sometime between 2014 and 2020. (Last update: 22 October 2007)

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. This secular trend will peak sometime between 2014 and 2020. (Last update: 22 October 2007)

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

Industrial Metals

In Dollar Terms

China continues to grow rapidly and consume a lot of metal in the process, but increased Chinese demand was never likely to fully offset the effects on metal prices of reduced Western-World demand stemming from the downturn in the US housing market and the debt-crisis-induced reduction in liquidity. There are three reasons for this: First, expectations of continued strong Chinese demand were already factored into current metal prices. Second, the severity of the downturn in the US housing market was NOT factored into current metal prices (an average house uses 200-300 pounds of copper and the annual rate of new housing starts in the US gas dropped from 2.1M to 1.1M over the past 20 months). Third, it would be strange, indeed, if China's growth rate were to accelerate at a time when its major export markets were slowing down and its own government was taking steps to cool-off the rampant speculation underway in the stock and property markets.

It does not surprise us, therefore, that the pattern revealed by the following chart of the Industrial Metals Index (GYX) has the look of a major top. The Index is very oversold on a short-term basis so lateral support in the 375-400 range will probably hold for now. In fact, we are expecting a counter-trend rebound  -- a rebound that could complete the "right shoulder" of the major topping pattern evident on our chart -- to occur during the first few months of next year. But if we make the reasonable assumption that the current trends in housing and liquidity won't come to an end in the near future then it is also reasonable to assume that the cyclical bear market in the industrial metals sector has a considerable way to go.

We have been short- and intermediate-term bearish on the industrial metals since June-July and remain so, although in all likelihood we will soon upgrade our short-term outlook in anticipation of seasonal strength during the first half of next year.

In Gold Terms

The yield-spread (the zero-risk long-term interest rate versus the zero-risk short-term interest rate) can widen in response to rising inflation expectations, but over the past ten years the lengthy periods of widening have been primarily driven by the combination of contracting financial-market liquidity* and increasing risk aversion. On the other hand, lengthy periods of yield-spread narrowing, such as the period that began during the third quarter of 2003 and ended late last year, have been indicative of expanding liquidity as speculators became increasingly eager to "borrow short" in order to purchase relatively high-risk assets and debt. 

Given what we know about gold's historical role as money and the fact that the amount of gold held for monetary/investment purposes dwarfs the amount of gold consumed each year in commercial/industrial applications, the above brief description of what drives intermediate-term trends in the yield-spread suggests that gold should fare well relative to the industrial metals when the yield-spread is in a widening trend and poorly relative to the industrial metals when the yield-spread is narrowing. The following chart comparison of the gold/GYX ratio and the US yield-spread (in this case, the 30-year yield divided by the 5-year yield) shows that what should have happened has, indeed, happened.

The trend towards a wider yield-spread will naturally be interrupted by occasional corrections, but the problems in the credit markets and the associated contraction in liquidity aren't likely to end anytime soon. We therefore think that the yield-spread is presently about 1 year into a 2-4 year period of widening, which, if so, implies that the upward trend in gold relative to the industrial metals will continue for another 1-3 years.

    *Note that a contraction in liquidity is not the same as a contraction in the money supply or a fall in the rate of money-supply growth. "Liquidity" relates to the ease with which investments can be traded in size, with a highly liquid financial environment being characterised by the ability to buy and sell large quantities of relatively high-risk investments without disrupting the market.

Bonds

The Stock Market

Current US Market Situation

Most of the sentiment indicators we follow are back to the pessimistic extremes reached in mid August, which also means that market sentiment is now as pessimistic as it has been at any time since April of 2003. This is quite remarkable given that the S&P500 Index hit an all-time high early last month and is still within 8% of its high.

The sentiment backdrop is therefore consistent with the idea that a short-term bottom is either already in place or will be put in place within the next few weeks.

Our guess is that the market will drop to lower levels before a sustained advance gets underway, mainly because there was a significant widening of credit spreads over the past week. We doubt that a rally worth trading will get underway in the stock market until after some semblance of stability returns to the credit markets, although the bottom of the current decline is unlikely to be far below last week's low.

The current price weakness and depressed sentiment is setting the stage for a strong stock market during the first few months of next year, but the jury is still out as to whether the next rally will be another upward leg in a continuing cyclical bull market or a counter-trend rebound within a new cyclical bear market. We are presently leaning towards the latter.

Hong Kong

Hong Kong's Hang Seng Index (HSI) has pulled back sharply over the past few weeks, but a correction low is probably not yet in place. As evidenced by the following chart, at last week's low the HSI was still about 13% above its 200-day moving average and none of the previous corrections over the past three years ended until after this moving average was reached.

Putting it another way: despite its recent sharp decline the HSI is still too high for this to be a low-risk buying point.

Longer-Term Outlook

A lot of investors, even experienced ones, believe that broad exposure to the stock market will always yield good returns in the long run regardless of when the exposure is purchased. It is strange that this belief is so widespread considering that even a cursory examination of the stock market's long-term performance will reveal it to be completely wrongheaded.

The reality is that if you make a long-term commitment to the S&P500 Index during those periods when valuations are extremely high then you are guaranteeing yourself poor returns over the ensuing 10-20 years. That this is so can be quickly explained with the aid of the following chart. The salient points are:

a) Someone who bought the S&P500 near its 1929 peak was not back to 'break-even' until 1955 (26 years later).

b) Between 1966 and 1982 the S&P500 achieved a nominal gain of approximately ZERO. Moreover, this was a period of high inflation and, as a result, the S&P500's REAL return over this 16-year period was a LOSS of more than 70%.

c) Over the most recent 10-year period the total return on the S&P500 Index has been less than the total return on 3-month T-Bills, but, again, this has been a high inflation period so the lousiness of the performance in nominal terms pales in comparison to the lousiness of the REAL performance.

Valuations are currently a lot more attractive than they were at the 2000 peak, but not much better than they were at the 1966 and 1929 peaks. In fact, valuations are still high enough to guarantee that someone who buys the S&P500 now will achieve lousy real returns over the coming decade.

Still, just because poor real returns are all but set in stone as far as the next 10 years are concerned doesn't mean that the market's performance over the next 1-2 years will be sub-par. Valuations are unattractive on a market-wide basis, but if the general willingness of market participants to take-on risk begins to increase -- as occurred during 2003-2006 and for about 18 months following the 1998 financial crisis -- then the S&P500 could achieve good returns over the intermediate term.

We are open to the possibility that 'investors' will put the mortgage-related turmoil of 2007 behind them, thus allowing 2008 and perhaps even 2009 to be good years for the broad stock market. However, this is not the most likely outcome. As noted in the "Industrial Metals" section of today's report, "the problems in the credit markets and the associated contraction in liquidity aren't likely to end anytime soon". We are therefore looking forward to a reasonably strong stock market during the first quarter of next year, but at this stage we would not bank on the rally continuing much beyond that.

This week's important US economic events

Gold and the Dollar

Gold

Below is a daily chart of the December gold futures contract. Gold gained enough ground last Friday to suggest that a short-term bottom was put in place in the low-770s at the beginning of the week, but the odds favour a test of last week's low before the correction comes to an end.

A near-term bullish scenario would entail the gold price pulling back to successfully test last week's low while the gold-stock indices made higher lows.

Gold Stocks

With the exception of gold's poor performance relative to oil -- an exception that we expect will be eliminated over the next few months -- the financial backdrop is currently very supportive for the shares of gold-mining companies. For example, the following chart shows that the HUI (AMEX Gold BUGS Index) tends to move with the gold/SPX ratio (the gold price divided by the S&P500) and suggests that if gold builds on its recent upside breakout relative to the S&P500 Index then the HUI should remain in an intermediate-term upward trend.

Our main concern continues to revolve around what will happen to gold and gold stocks during the first few months of a US$ rally. The US dollar's exchange value does not play a dominant part in our intermediate- and long-term analyses of the gold market, but a lot of speculators own gold-related investments (gold futures, physical bullion, gold ETFs and gold-mining shares) primarily because they expect the US$ to continue its decline against the euro. This leaves the gold market acutely vulnerable to a reversal of fortune in the currency market.

We suspect that a reversal of fortune in the currency market would create only a 2-3 month problem for gold-related investments as long as most other factors remained 'gold bullish', but investors in gold, and especially investors in gold stocks, could experience considerable pain during this 2-3 month period. For example, during June-July of 2002 the financial backdrop was just as 'gold bullish' as it is today and yet the HUI suffered a peak-to-trough decline of around 40%.

Here are some of the other nagging concerns we have, expressed in the form of questions that need answers:

1. Royal Gold (RGLD) is the purest play on gold amongst the large and mid-size gold stocks, so why has it not only failed to make a new high but also failed to break a sequence of declining tops dating back to January of 2006?

2. Why did the stocks that offer the most leverage to gold generally performed relatively poorly during the August-November rally? Note that we are not just referring to the lacklustre performances of many exploration-stage gold stocks, but also to the fact that Gold Fields Ltd (GFI) has done surprisingly little over the past few months. Within the group of large gold producers that are not being weighed down by company-specific problems, GFI offers the most leverage to gold; and yet, the following chart shows that it is languishing in the bottom third of its 2-year price range.

3. With zinc clearly mired in a cyclical bear market why was Agnico Eagle (AEM), a primary ZINC producer with a gold byproduct, one of the leaders to the upside during the August-November GOLD rally?

4. Why did the HUI close below the peak of its preceding upward leg (its May-2006 peak) last Monday -- something it has never done during any of the other major upward legs in its long-term bull market?

The above questions could quickly be made irrelevant by price action. For example, questions 1 and 3 would no longer apply if RGLD and GFI were to break above resistance at $35 and $20, respectively, and question 4 would be meaningless if the HUI were to re-confirm its upward trend by closing above 463 (this month's intra-day peak). As things currently stand, though, the questions are relevant.

We continue to emphasise the risks and our concerns because we get the impression that many of the people who are heavily exposed to gold are operating on the belief that this market is presently a one-way bet. It's not.

Our expectation is that the upward trends in gold and gold stocks will resume following the completion of a fairly normal correction, but at the same time we are constantly on the lookout for developments that could turn a normal correction into a large one. Unfortunately, prices tend to move so quickly in the markets these days that selling after evidence emerges that things have changed for the worse will often result in selling near a short-term bottom. This means that precautionary steps need to be taken when prices are relatively high.

The current situation provides a good opportunity for investors to take some precautionary steps because the HUI has rebounded to within 4% of its all-time closing high (448) and to within 8% of its all-time intra-day high (463). These steps could include: a) doing some selling near current levels with the aim of buying back if the HUI subsequently re-confirms its upward trend by closing above 463, and/or b) buying some March-2008 GDX put options with the plan to immediately sell them if the HUI closes above 463.

Moving from short-term risks and concerns to something more positive, there were three significant bullish developments last week. First was the fact that although the HUI closed slightly below support defined by its May-2006 peak on Monday there was absolutely no follow-through to the downside. As things currently stand, therefore, it can be said that a successful test of intermediate-term support has occurred. Second was the strength in gold equities relative to Asian equities. For example, the HUI ended the week with a gain of 4% while the Hong Kong stock market lost 4% over the course of the week. This was potentially significant because the short-term downward trends in the Asian stock markets are probably not over. And third was Friday's move by gold bullion above its May-2006 highs in C$ and A$ terms. This third bullish development is probably the most significant and could be why many of the exploration-stage gold stocks finally caught bids on Friday.

The bottom line is that the short-term outlook remains bullish, but this is a reasonable time to obtain some insurance 'just in case'. As stated above, the insurance could be eliminated as soon as the HUI re-confirmed its upward trend by closing above 463.

As noted in an earlier commentary, if a major upward leg is underway then it should result in the HUI moving up to at least the low-600s, meaning that a lot of profit potential will remain following re-confirmation of the upward trend.

Currency Market Update

Current Market Situation

The following chart comparison of the Australian Dollar and the Yen shows that:

a) The A$ rallied from March through to July while the Yen trended lower, but when the Yen broke its downward trend during the third week of July the A$ plunged

b) Between the third week of August and the first week of November the A$ trended relentlessly upward while the Yen consolidated

c) When the Yen's consolidation ended via an upside breakout in early November, the A$ plunged

As explained in previous commentaries, the inverse correlation between the A$ and the Yen comes about because A$-denominated investments have been major beneficiaries of the Yen carry trade. To be more specific, a very popular trade has been to borrow Yen (sell Yen short, in effect) in order to fund the purchases of investments priced in Australian dollars. Due to interest rate differentials this trade makes sense as long as the Yen is trending downward or is moving sideways, but losses are incurred whenever the Yen rallies and these losses cause carry-traders to close-out their positions.

Our view is that the Yen is on its way to the high 90s. If this view is accurate then significant additional short-term weakness lies in store for the A$. 

We continue to anticipate a strong rebound in the US$ against the euro. The euro is becoming increasingly over-valued relative to the US$ on a purchasing power basis and optimism about the European currency remains near an extreme. However, the main catalyst for a substantial rally in USD/EUR may be the realisation that the debt crisis' effects on European economic growth, banks and monetary policy will be similar to its effects in the US. In particular, the markets seem to believe that the ECB will leave its targeted interest rate unchanged over the next several months, but we think this is very unlikely. In our opinion the ECB will soon commence a rate-cutting campaign, prompting a loud collective "oops!" from the speculators that have built up huge long positions in the euro.

An interesting way to hedge against a strong US$ rebound

As discussed in last week's Interim Update and a number of earlier commentaries, there has been a strong inverse correlation this year between the oil price and the Dollar Index. This means that the next rally in the US$ should be accompanied by a downward trend in the oil price. Given that there is almost always a strong inverse correlation between the airline sector of the stock market and the oil price, this also means that when the US$ eventually rallies the airline stocks should also rally. Therefore, those who have substantial exposure to stocks that are being driven upward in the short-term in response to weakness in the US$ -- gold stocks, for instance -- could purchase airline stocks or call options* on airline stocks as hedges against the likely adverse effects on their portfolios of a US$ rally.

We are bullish on the airline sector because we think the oil market is close to an intermediate-term peak. Oil is currently priced at a very high level relative to almost everything, including gold, but the debt crisis and associated liquidity contraction should eventually take its toll on oil in the way that it is already taking its toll on the industrial metals. This could occur with or without a US$ rally; it's just that the way the markets have been trading over the past several months the initial phase of the next significant downturn in the oil market is likely to coincide with a US$ rebound.

Many airline stocks traded at new lows for the month early last week, which might have resulted in traders being stopped out of their positions (it would depend on how closely the stops were placed to the early-November lows). If you were stopped out then you could consider re-establishing long positions, either immediately or following a sign of strength such as a daily close above 42 by the AMEX Airline Index (XAL).

   *Note: we wouldn't buy call options that expired before March of 2008.

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)

Chart Sources

Charts appearing in today's commentary are courtesy of: