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   -- Weekly Market Update for the Week Commencing 28th April 2008

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

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Bearish
(21-Apr-08)
Neutral
(21-Apr-08)
Bullish

US$ (Dollar Index)
Bullish
(10-Mar-08)
Bullish
(31-May-04)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(03-Mar-08)
Bearish
(23-Jan-08)
Bearish
Stock Market (S&P500)
Bullish
(18-Mar-08)
Neutral
(26-Mar-07)
Bearish

Gold Stocks (HUI)
Bearish
(21-Apr-08)
Neutral
(21-Apr-08)
Bullish

OilBearish
(14-Jan-08)
Bearish
(22-Oct-07)
Bullish

Industrial Metals (GYX)
Neutral
(28-Nov-07)
Bearish
(09-Jul-07)
Bullish


Notes:

1. In those cases where we have been able to identify the commentary in which the most recent outlook change occurred we've put the date of the commentary below the current outlook.


2. "Neutral", in the above table, means that we either don't have a firm opinion or that we think risk and reward are roughly in balance with respect to the timeframe in question.

3. Long-term views are determined almost completely by fundamentals, intermediate-term views by giving an approximately equal weighting to fundmental and technical factors, and short-term views almost completely by technicals.

Credit Contraction and Deflation

...there cannot be deflation as long as the money supply is expanding. ...inflation is still occurring in the US (and pretty much everywhere else, for that matter), albeit at a reduced rate.

Members of the deflation camp assert that the large-scale contraction of credit happening within the banking system means that deflation is upon us, even if the money supply is expanding. At the same time, another camp is pointing to the breathtakingly rapid growth in M3 money supply as evidence that hyperinflation is a near-term threat. In our opinion, both camps are wrong*.

The argument of the first camp can, we think, be summarised as follows: Inflation is an expansion in the total supply of money AND credit, whereas deflation is the opposite (a contraction in the total supply of money AND credit). At the present time the money supply may well be expanding, but this monetary expansion is being more than offset by credit contraction.

The flaw in the above argument can best be explained via a hypothetical example. Consider the case of Johnny, who wants to borrow $1M to buy a house. If Johnny borrows the money from his friend Freddy then the transaction results in a $1M increase in the amount of credit within the economy, but no inflation has occurred. All that has happened is that $1M of purchasing power has been temporarily transferred from Freddy to Johnny. By the same token, when Johnny pays Freddy back there is a contraction of credit, but no deflation. There is also no deflation even if Johnny defaults on his loan obligation to Freddy. In this case Freddy will have made a bad investment, but the money he lent to Johnny will still be somewhere in the economy. The point is that credit expansion is not inherently inflationary and credit contraction is not inherently deflationary.

But what if Johnny, instead of borrowing the million dollars from Freddy, takes out a loan at his local bank and the bank makes the loan by creating new money 'out of thin air'? In this case inflation has certainly occurred. Nobody has had to temporarily forego purchasing power in order for Johnny to gain purchasing power, but the total existing supply of money has been devalued to some extent.

The critical difference is that when Johnny borrows from a bank the transaction leads to an increase in the supply of MONEY. Inflation is the increase in the supply of money that SOMETIMES results from credit expansion; it is not credit expansion per se.

When Johnny pays back his loan to the bank the money that was created out of thin air disappears into thin air; that is, deflation occurs. But what if Johnny defaults on his bank loan?

If Johnny defaults on his loan then the bank will take a loss, but the money that was lent to Johnny will remain within the economy. From the bank's perspective it will be an investment gone bad, but an investment going bad is certainly not the same thing as deflation. It could be argued that when banks take large investment losses, that is, when a substantial amount of the banking establishment's capital gets written off, the collective ability of banks to lend more money into existence will be impaired and deflation may eventually occur as a knock-on effect. This is a valid argument, but as long as the money supply is expanding it is not reasonable to state that deflation IS occurring; it is only reasonable to state that the severely impaired balance sheet of the banking system could lead to deflation at some future time. Quite simply: there cannot be deflation as long as the money supply is expanding.

This leads to the question: is the money supply currently expanding?

The answer is yes, but not anywhere near as rapidly as many people think. The chart at http://www.nowandfutures.com/key_stats.html reveals that M3 has grown by a mind-boggling 19.5% over the past 12 months, but as was the case during the early 1990s it appears that this broad measure of money supply is currently giving a 'major league' FALSE signal. As noted in an earlier TSI commentary, the growth rates of both M2 and M3 plunged during 1991-1993, making it seem as if deflation were a clear and present danger, but the downturns in these monetary aggregates during that period were almost solely due to sharp declines in time deposits. And for the reasons previously explained, time deposits should not be counted as money.

M3 is currently making it seem as if there is a lot more inflation than is actually the case, mainly due to the inclusion of institutional money market funds (MMFs) in this monetary aggregate. Institutional MMFs have experienced incredibly rapid growth over the past year, but institutional MMFs are not money and should therefore not be counted when estimating the money supply.

Our preferred measures of money supply are TMS (the True Money Supply reported at http://www.mises.org/content/nofed/chart.aspx?series=TMS) and what we call TMS+ (TMS plus Retail MMFs). TMS and TMS+ currently have year-over-year (YOY) growth rates of around 3% and 6%, respectively. In other words, our assessment is that the current US inflation (money-supply growth) rate is 3-6%. Inflation is still occurring, but at a much slower rate than it was during the early years of this decade.

On a side note, the wrongness of M3's current signal is validated by the happenings in the financial world. Inflation-fueled booms generally continue until there is a deliberated or forced slowdown in the inflation rate, that is, the booms continue until the central bank takes steps to rein-in the inflation or until inflation slows under the weight of market forces. The downturn in the US housing market and the veritable collapse of the mortgage-lending industry -- the major inflation-fueled booms of the past decade -- suggest that a substantial SLOWING of the inflation rate HAS taken place. Or, to put it another way, if M3's current signal were correct then we wouldn't have seen what we have seen over the past year. Warren Buffett's quip that you find out who has been swimming naked after the tide goes out applies very well to inflation-fueled booms, in that investments that are totally reliant on high inflation will be revealed for what they really are once the monetary tide begins to ebb. 

It is also worth noting that although inflation is a major driving force behind the commodity bull market, commodity prices are generally still very low in REAL terms. Therefore, while we are anticipating a commodity shakeout over the next few months we think the long-term upward trend in the commodity world has a considerable way to go.

In conclusion, it is clear that inflation is still occurring in the US (and pretty much everywhere else, for that matter), albeit at a reduced rate. Furthermore, if it hasn't already done so it is likely that the inflation rate will bottom-out over the coming few months and then embark on its next major upward trend. It is possible that consumers are 'tapped out' and that the commercial banks are about to reduce the rate at which they lend, but the government will never be 'tapped out' and the central bank will always be able to monetise debt. 

    *There is a much bigger camp that defines inflation and deflation in terms of changes in the general price level, but we will ignore this camp because to define inflation/deflation in this way it to confuse cause and effect and to overlook the most pernicious consequences of inflation. If inflation were simply an increase in the general price level (a reduction in the purchasing power of the currency) then it wouldn't be a big problem. The reason it is a big problem is that it re-distributes wealth and results in the misallocation of resources.

Economic Bust and Deflation

Although deflation (a contraction in the supply of money) would, in the current environment, almost certainly lead to or be accompanied by an economic bust, "deflation" and "economic bust" are not synonymous. In fact, under the current monetary system an economic bust is more likely to be accompanied by rising INFLATION due to the counter-cyclical monetary and fiscal policies that have become so popular. And this is regardless of the reality that such policies can only do long-term damage by leading to more mal-investment. For example, the US economy would be in far better shape than it is today if the Fed and the US Government had not, during 2001-2003, attempted to 'inflate away' the effects of the burst stock market bubble.

That the US economy managed to recover at all following the downturn of the early-2000s is testament to the remnants of capitalism, not the massive government "economic stimulus" operations that occurred at the time. The recovery actually happened in spite of, not because of, the official stimulus, but the recovery was never particularly strong because you can't fully recover from the inevitable adverse effects of rampant inflation in the face of even more inflation.

More inflation can't possibly help, but it will almost certainly be the prescription.

Favourite Greenspan Quotes

"I've been able to string more words into fewer ideas than anybody I know, and I'm continuing to do that."

"If I have made myself clear then you must have misunderstood me."

FOMC

The market expects the Fed to cut by 25 basis points on Wednesday. That's also what we expect.

The Stock Market

Current Market Situation

Our view continues to be that the US stock market is experiencing a bear-market rally that won't end until sentiment indicators reveal the return of optimism/complacency. Significant additional price gains will probably have to occur to get the market to such a point. At the same time, the lack of belief in the recent rally limits the downside risk. We therefore remain short-term bullish.

Just for a change we thought we'd take a look at the French stock market, as represented on the following chart by the CAC40 Index.

The CAC appears to be close to completing a basing pattern. The top of the base is at 5000, and a break above this resistance would project a move up to the mid 5000s. That is, the CAC has short-term upside potential of around 10%.


Energy Stocks

Although their fundamentals are quite different, the stocks of oil, natural gas and coal producers have been trading in unison over the past few months. For example, when the oil price jumped on Friday in response to news of short-term oil supply disruptions (a strike at a Scottish oil refinery and more problems in Nigeria) and potential disruptions (it was reported that a ship under the control of the US Navy fired shots at another vessel in the Strait of Hormuz), traders drove up the prices of natural gas and coal stocks along with the prices of oil stocks.

The oil market will always gyrate in response to the sort of news that hit the wires on Friday, but over the past year the currency market has been the dominant driver of oil's price trend. Specifically, oil has had a strong inverse correlation with the US$ (a strong positive correlation with the euro). Therefore, with more evidence of a US$ bottom (a euro peak) having emerged during the second half of last week the short-term downside risk in the oil market has just increased. Given the tendency for natural gas, oil and coal stocks to trade together, a sharp downward correction in the oil sector is likely to put irresistible downward pressure on natural gas and coal stocks.

If, like us, you have substantial exposure to natural gas and coal, and especially if you have substantial exposure to oil, you should consider scaling back a bit over the coming week or so. However, make sure that you retain a sizeable core position in energy.

The uranium sector is marching to the beat of its own drummer. It did not participate to any meaningful extent in the recent energy rally and may not participate in the coming pullback.

China's Stock Market

China's Government made many attempts during the second half of 2006 and the first half of 2007 to dampen stock-market speculation, including, in May of last year, tripling the stamp duty charged on stock trading from 0.1% to 0.3%. The Shanghai Stock Exchange Composite Index (SSEC) continued its relentless ascent, however, until last October when it finally buckled under the weight of the Government's cooling-off tactics and its own massive over-valuation.

By the middle of last week the SSEC was down by 50% from its October-2007 peak and at the low end of the 3000-3500 range we'd previously identified as a likely area for a bottom. It was at this point that the Government became worried enough to cut the stamp duty on stock trading back to 0.1%. The 0.2% change in stamp duty might seem trivial, but it was rightly taken as evidence of a 180-degree shift in official policy towards the stock market and was the catalyst for the market's biggest single-day gain in more than six years.

Last week's price action suggests that the market has made a low that will hold for at least a few months, but we aren't jumping to the conclusion that the ultimate correction low is in place. In our opinion, there's a significant risk that China's stock market will follow the example set by the Saudi stock market during 2006. The following chart comparison of the Shanghai Composite Index and the Tadawul All Share Index (a proxy for the Saudi stock market) -- using weekly charts from www.fullermoney.com -- illustrates what we mean. Notice that the Saudi market was cut in half by the initial decline from its bubble peak, but didn't reach a sustainable bottom until it had lost about two-thirds of its value. If the SSEC follows a similar path then it will rebound/consolidate for 1-3 months before declining to around 2000.


Two things lend credibility to the "Saudi model", the first being that although China's stock market is nowhere near as over-valued today as it was 6 months ago it is still very expensive by traditional valuation metrics. This was why we suggested, a few weeks ago, that a potential bottoming and upward reversal in the Shanghai market should be played by taking a long position in the more attractively valued Hong Kong stock market.

The second reason to take the "Saudi model" seriously is the awkward position in which China's Government finds itself due to the rampant effects of inflation and other ill-conceived policies. Soaring commodity prices and electricity shortages are much bigger issues than the weakness in the stock market, meaning that the Government probably isn't in a position to use monetary easing to support the stock market. Its first priority, we think, will be to do whatever it can to suppress the prices of the basic necessities of life. These efforts at price control will inevitably lead to more shortages, but economic logic rarely gets in the way of any government's action plans.

This week's important US economic events

Date Description
Monday Apr 28
No important events scheduled
Tuesday Apr 29
Consumer Confidence
Wednesday Apr 30 FOMC Policy Statement
Chicago PMI
Employment Cost Index
Thursday May 01 ISM Index
Personal Income and Spending
Construction Spending
Friday May 02 Monthly Employment Report
Factory Orders

Gold and the Dollar

Currency Market Update

Last week provided us with more evidence that the US$ has made an intermediate-term bottom. Of particular note: the Swiss Franc broke decisively below the support level mentioned in the 21st April Weekly Update (0.9750) and, as illustrated by the following daily chart, the June euro futures contract achieved consecutive daily closes below its 18-day moving average.


In our opinion, the Dollar Index is 5-6 weeks into a rebound that will last 3-6 months. One way for speculators to 'play' this potential outcome would be to average into FXE Sep-2008 $150 put options (FXE is an ETF that tracks the euro), preferably on days when the euro is bouncing. A protective 'stop' could be placed just above the recent high, the idea being to exit if the euro closes at a new high.

The major currency with the most downside potential over the coming months is the Australian Dollar (see chart below), so speculators could also consider averaging into FXA Sep-2008 $90 put options (FXA tracks the A$). Note, though, that FXA puts are quite illiquid. Note also that the A$ has not yet signaled a peak, which means that a final surge could still be in store and that there is no obvious chart-based level at which to place a 'stop'. In other words, a bet against the A$ is more risky than a bet against the euro, but if offers greater profit potential.


Gold and Silver

Gold and the Euro

No financial-market relationship always works. The markets are just not that simple! However, a relationship that USUALLY works is gold's tendency to lead the euro at important turning points.

A great example of the lead-lag relationship between gold and the euro occurred during 2004-2005. With reference to the following chart, note that gold peaked near the beginning of December-2004 whereas the euro didn't peak until the final day of that month. Note, as well, that gold then bottomed in February of 2005 whereas the euro didn't bottom until November. In other words, gold peaked 3-4 weeks ahead of the euro and then bottomed about 9 months ahead of the euro.


The current situation is that gold's peak appears to have led the euro's peak by about 5 weeks. As was the case during 2005, we suspect that gold will reach its correction low many months before the euro reaches a correction low of its own.

Our best guess at this time is that gold will bottom at $800-$850 (probably closer to $800) during either May or June.

Silver

In the 19th March Interim Update we said that a pullback to $800-$850 by gold would probably be accompanied by a pullback to around $15 by silver. As evidenced by the following monthly chart from www.mrci.com, $15 represents the long-term resistance (now support) that was surmounted in January. When a market breaks above long-term resistance it will often move sharply higher and then pull back to 'test' the breakout before resuming its advance.

Once silver's breakout has been properly tested -- an event that could entail a short-lived move below $15 -- the stage will be set for the next phase of silver's bull market.


Gold Stocks

The following chart shows that the S&P500 Index in gold terms (the SPX/gold ratio) ended last week at a 3-month high. Strength in the broad stock market relative to gold creates a substantial headwind for gold stocks.


Correction lows for gold-stock indices such as the HUI probably won't occur until the SPX/gold ratio peaks, and the SPX/gold ratio probably won't peak until stock market sentiment once again becomes optimistic. This could happen within the coming month, but in the mean time there is likely to be significant additional weakness in the gold sector.

In last week's Interim Update we mentioned that the HUI had dropped to near support at 420 after falling for 5 days in a row, and might therefore rebound for a few days before resuming its decline. It ended up falling for a 6th day in a row, decisively breaching support at 420 in the process, before bouncing on Friday.

There is very little chance that a correction low is already in place because: a) the price action is bearish (a "head and shoulders" top appears to have just been completed), b) momentum indicators have not yet reached the sorts of 'oversold' extremes that normally occur PRIOR to important correction lows, and c) the main drivers of the correction (rebounding broad stock market, narrowing credit spreads, rebounding US$) remain intact. One positive is that most gold stocks are at very depressed levels relative to gold bullion. This mitigates the downside risk to some extent and means that there should be a very powerful rally in the gold sector once gold bullion bottoms out, but we suspect that gold bullion is still about 10% above its ultimate correction low. So, even if the HUI doesn't get any cheaper relative to gold we could still see it drop to the mid-300s within the coming few weeks. 

We won't be surprised if there's some consolidation in the gold sector this week. Note, though, that the support in the 420s that was breached last Thursday -- refer to the following chart for details -- now constitutes considerable overhead resistance. We therefore will be surprised if the HUI closes above 430 in the near future.


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)

Japan

We are 'long' Japan via JEQ (the Japan Equity Fund) and some January-2009 EWJ (iShares Japan) call options.

The following chart shows that EWJ has broken above resistance at US$12.90 and is approaching more significant resistance at 13.25. A decisive move above 13.25 would be a clear sign that an intermediate-term bottom was put in place during the first quarter of this year.


JEQ is a low-risk way to play the Japanese stock market's considerable upside potential. At Friday's closing price of US$7.23 it is low in absolute terms and relative to EWJ. Furthermore, it is trading at a 7% discount to its net asset value. It has resistance at US$7.25-US$7.50, so rather than establishing a new position or adding to an existing position immediately it would be reasonable to wait for a daily close above 7.50.

Another way to participate in Japan's recovery would be to buy the shares of Mitsubishi Financial (NYSE: MTU), Japan's largest bank. As indicated by the following chart, MTU bottomed at $8 between November and March. It has since rebounded to the near the top of its 2-year channel and its 9-month trading range. Any significant additional strength from here would be a clear signal that an intermediate-term rally had begun.

MTU has greater upside potential than JEQ, but more downside risk.


By the way, the Japanese bond market has just experienced its biggest 2-week decline in many years. This is a POSITIVE omen for the Japanese stock market.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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