<% 'pass = Request.Form("pass") IF ((Request.Form("pass") = 1) OR (Session("pass") = "pass")) THEN %> Speculative-Investor.com
   -- for the Week Commencing 28th May 2001

Forecast Summary

The Latest Forecast Summary

Inflation Update

Growth versus Inflation, Part 2

Last week we explained that real economic growth should result in lower long-term interest rates and that the rise in bond yields over the past two months was therefore a result of the market discounting higher inflation, not higher economic growth as some analysts have contended. In his May-23 commentary, Northern Trust's Paul Kasriel included a chart (reproduced below) that provides rather conclusive evidence that the entire up-move in long-term interest rates over the past 2 months has, in fact, been the result of heightened inflation expectations.

The above chart compares the yield on the 10-year Treasury Note with the yield on the equivalent-maturity inflation-indexed note. The only difference between the yields on these two notes is the market's expectation regarding inflation. If the debt market had really been discounting higher growth over the past two months then the yield on the inflation-indexed note (the 'real' yield) should have moved higher with the yield on the non-inflation-indexed note. In actual fact, however, the real yield has fallen over the past two months. This means that more than 100% of the rise in long-term interest rates since bond yields bottomed in late-March has been due to expectations of higher inflation. The debt market has therefore not yet begun to discount any improvement in the economy, a conclusion that is confirmed by the fact that short-term interest rates remain near their lows.

The power of positive speaking

Quoting Descartes: "I think, therefore I am". Paraphrasing Greenspan: "I say inflation is contained, therefore it is".

Greenspan will keep telling us that inflation is contained for as long as he can say it with a straight face because:

a) He needs the freedom to cut interest rates further, something he wouldn't have if inflation was widely perceived to be a problem.

b) Money-supply growth must continue at a fast pace in order to support asset prices and, in turn, consumer spending. However, there is a strong inverse correlation between the money-supply growth rate and long-term market interest rates (when bond yields trend higher, the money-supply growth rate trends lower with a lag of 3-6 months). As such, the Fed's goal of using monetary policy to support asset prices and, in turn, the economy, becomes impossible if the bond market begins anticipating much higher inflation.

There is some irony in point b) in that the bond market sees the inflation and would actually be far more comfortable if it perceived that the Fed also saw the inflation and was doing something about it. 

The US Stock Market

The Trend

We like some tech stocks and think the overall market will continue to trend higher into the final quarter of this year, but in general we like resource stocks more than tech stocks. Within the realm of resource stocks we like the gold stocks most of all. We think that resource stocks will continue to out-perform the overall market over the next 6 months and we think that gold stocks will out-perform the other resource stocks. The reason is that gold stocks are dramatically under-valued relative to other resource stocks, even after the recent rally. This under-valuation, as well as providing the potential for greater upside than, for example, oil stocks, also provides a margin of safety.

When rising long-term interest rates cause the monetary environment to become unfavourable late this year or early next year, we expect the entire market (including resource stocks and gold stocks) to get hit. However, at this early stage we believe that a secular change in the focus of investment has occurred. The stock market's secular up-trend remains in tact, but the focus of investment is shifting from the stocks that benefit the most from low inflation to the stocks that benefit the most from high inflation. We expect this trend to survive whatever stock market catharsis occurs over the coming 12-18 months because the central banks and the private banks of the world will fight, tooth and nail, to sustain the expansion of credit.

Current Market Situation

The rally over the past 2 months has been based on anticipation of an economic turnaround later this year. The Fed is perceived to be doing everything it needs to do and the money supply is expanding rapidly, thus creating a friendly monetary environment and setting the scene for strong corporate earnings growth next year.

We expect a correction to commence by early June that will most likely be based on disappointment that the economy is not yet showing any signs of recovery (as noted in previous commentary, we should not expect any marked improvement in the economy until at least September). Other potential catalysts are negative news on inflation and a sharp fall in the Dollar. 

The technical condition of the market and market sentiment also point to a near-term correction. The major stock market averages have recently confirmed strength, enticing into the market those who like to buy after technical breakouts, and some short-term indicators are showing dangerous levels of bullish sentiment. If the market hasn't already reached a short-term top we would expect it to do so this week.

If we could ignore valuations and just look at the market action, the sentiment picture and the monetary environment, we would be very confident that the coming correction will be shallow with the greatest risks, in the medium-term, being on the upside. In fact, if we could ignore valuations we wouldn't have bothered taking profits on our QQQ shares early last week and would, instead, have been prepared to ride-out any correction. However, we can't completely ignore those pesky valuations. We are not concerned at all about the NASDAQ Composite's 300+ P/E since tech stock P/E ratios will plummet next year when earnings growth re-accelerates, but we are very concerned about the Dow's P/E of around 29. Many of the non-tech blue-chips will, at best, achieve earnings growth in the single-digits or low double-digits, so current valuations are already stretched to the limit. As such, although we expect the market to reach significantly higher levels later this year we are going to proceed cautiously from here on.

This week's important economic/market events
 

Date Description
Monday May 28 Memorial Day Holiday in the US
Tuesday May 29 Personal Income and Spending
Consumer Confidence
Friday June 1 Employment Report

Gold and the Dollar

Official Sector Gold Supply

The news out of Russia last Thursday (Vladimir Putin's comment that he is considering the sale of part of Russia's gold reserves to help victims of floods in Siberia) means that it is now a good time to review the effect of official sector gold sales on the gold price. Another member of the Russian Government commented on Friday that Russia's deal with the IMF would prevent the sale of gold from the Central Bank's reserves, so it seems that official Russian gold may not actually hit the market. However, it is likely that news stories regarding potential, actual, rumoured or imagined central bank gold sales will mysteriously appear every time the gold price shows any sign of strength in the same way that the possibility of IMF gold sales was trotted out repeatedly during the late-1990s. So, will worries over future central bank gold sales nip the recent gold rally in the bud?

Gold has been in a bear market for so long that people have forgotten what happens when the investment demand for gold is rising. An environment in which the investment demand for gold is rising is one in which confidence in the Dollar (investment demand for the Dollar) is falling. In such an environment a reduction in a country's gold reserves causes a further loss of confidence and a rise in the gold price in terms of that country's currency. That is, official sector sales lead directly to a higher gold price. This is what happened during the 1970s - the US and the IMF tried to conceal the public face of inflation and governmental ineptitude by auctioning huge quantities of gold.  Their objective was to reduce the gold price, but the gold price rose after every auction. The auctions were therefore stopped. The difference between then and anytime during the past 10 years is an intangible factor called confidence - there has been widespread confidence in the US economy and the US Federal Reserve over the past decade whereas there was a general lack of confidence during the 1970s.  Over the past decade official sector gold sales were seen as another element weighing on the gold price, whereas during the 1970s they were seen as a clear sign of central bank weakness and government failure. 

It is our belief that confidence in the US economy and the US Federal Reserve peaked in the October-November period last year as indicated by the blow-off top and sharp reversal in the S&P500/XAU ratio.

In a gold bull market, what happens if official sector gold is brought to the market surreptitiously via gold loans that are not reported? Won't central banks be able to suppress the price in this way? This won't be an issue because there will be very little borrowing demand for gold in a gold bull market and without willing borrowers gold cannot be loaned. The large-scale lending of gold by central banks is a by-product of gold's bear market because borrowing gold is only feasible if there is a high probability that the gold price will be the same, or lower, when it comes time to repay the loan. That is, gold borrowing is only feasible if the gold price is mired within a long-term downtrend.

In summary, if gold remains in a bear market then official sector gold sales, or rumours of same, will weigh on the gold price. If, however, gold has embarked on a new bull market then official sector gold sales will have no lasting negative effect on the gold price and may, in fact, have a positive effect. 

News regarding actual or potential increases in the supply of gold due to central bank sales or lending is sure to surface from time to time and when it does it can be considered to be a litmus test as to whether we are, or are not, in a gold bull market. It will, first and foremost, be a test of market sentiment since the size of any actual sales/loans will not be large enough to dampen the gold price. After all, to put things in perspective, at the current gold price the total value of all the gold reportedly held by central banks is about the same as the market capitalisation of one loss-making heavily-indebted company called AOL Time Warner.

Bull Market Comparison

In the Feb-12 WMU we noted the similarities between the 1986-1987 and 1992-1993 gold stock bull markets and suggested that the coming gold stock bull market may follow a similar pattern. Below are the charts showing the 86-87 and 92-93 XAU bull markets previously included in the Feb-12 WMU and a chart of the TSI Gold Stock Index from March 2000 to the present day. Apart from a false start rally in early March this year, the current pattern continues to look similar to that of the previous bull markets. If the similarities continue then a medium-term peak (the Wave 3 peak) would be likely to occur around mid-July.

More on the Enigmatic Dollar

In the latest Interim Update we briefly explained why we thought the recent strength in the US$ was not due to flight-to-safety buying or an impending currency crisis but was, instead, due to highly-leveraged speculations in the US credit market. Last week's sharp rise in the Yen and counter-balancing sharp drop in the euro support our contention. We think the following extract from Doug Noland's latest Credit Bubble Bulletin at the Prudent Bear web site (http://216.46.231.211/credit.htm) is 'on the money' as far as what is most likely driving the currency market.

"It is precisely because the Fed and the GSEs are committed at all costs to sustain the bubble, and that the contemporary US credit system has the means and willingness to perpetuate the inflationary monetary expansion necessary to keep asset prices levitated, that has placed the U.S. credit system firmly as the last great refuge for the monstrous global leveraged speculating community. The speculators have learned that liquidity is absolutely a necessity for playing, while loving monetary inflation as long as they can profit from it. No reason to play in Europe, with the sometimes-feisty ECB much less amenable than the Greenspan Fed (besides, they don't have GSEs!). No safe place to play in emerging markets, especially with the demise of pegged currency regimes and global currency markets so unsettled. Certainly there is no reason to play in Japan, or anywhere in Asia for that matter, with their historic bubbles already having burst. The speculators know what they like, a central banker that will surprise them with timely "treats," while giving them plenty of advance warning in the unlikely event of needing to administer a bit of a "trick". And with Greenspan and the GSEs providing assurances of marketplace liquidity that no other country can come even close to matching, there simply is little reason to place bets anywhere else - there's only one hot casino left in town. The good news is that all this "hot money," does wonders for what should be an acutely vulnerable dollar. The bad news is that there sure is a lot riding on what appears to be one massive and increasingly vulnerable speculation and derivative bubble that fuel the perpetuation of the historic U.S. Credit Bubble. I have said before that I see the current bets placed in the U.S. interest rate market as probably "history's most crowded trade." Furthermore, I see the dollar acutely vulnerable when this speculation falters and the "hot money" runs for cover." 

Current Market Situation

The latest Commitments of Traders data for gold is decidedly bearish, with Commercial traders shown to be net-short to the tune of 65,000 contracts. However, the situation could now be very different as the latest COT report does not include the final 3 days of last week. In particular, there was huge volume traded on Thursday following the bogus Russian news. It will therefore be important to pay attention to the next COT report as it will reveal the extent to which the Commercial Traders used price weakness on Thursday and Friday to cover their 'shorts'. The traders' commitments for the major currencies are generally Dollar-bearish and are therefore in-line with our expectation for an imminent Dollar peak.

Thursday's low for June gold was 276 and Friday's low was 275.50, so the previous breakout level around 275 has held thus far. If 275 continues to hold it would be a very definite sign of strength, although a drop below 275 would not be the end of the world. The short-term movements in gold have become even less predictable than usual, but our expectation is that the gold price will spend 1-2 weeks consolidating in the 270-280 range before attempting an assault on $300. Lease rates remain stubbornly high at around 2.5%, so the physical market is still 'tight'.

Price action in the gold stocks has, over the past 2 months, been unequivocally bullish. We expect that the XAU will hold in the 55-57 range on any further near-term pullbacks.

Oil Market Update

We noted in TSI Market Alert #34, e-mailed on May-22, that some tentative signs of an oil price peak were emerging. The subsequent $2 per barrel drop in the oil price provides some technical evidence that a peak is now in place.

The supply-demand equation for oil that has been so bullish for the past year is no longer supportive of a $30 oil price. As the following chart shows, oil inventories have rocketed higher over the past 3 months. This probably means that some OPEC countries have been exceeding their quotas and also suggests that there has been only a modest increase in demand. With economic growth in the industrialised world likely to remain subdued until late this year the demand side of the equation is not going to be a positive influence on the oil price over the next few months.

The technical picture, as illustrated by the oil price chart included below, is consistent with the deteriorating medium-term supply-demand fundamentals. A drop to the low-20s over the coming 3 months would not be a surprise. A moderate decline in the oil price over the coming months also meshes with our short-term view on bonds - bond prices and oil prices tend to move in opposite directions and we expect a bear-market bounce in bonds to begin during the next 1-2 weeks.

Taking a longer-term view we are still bullish on oil and expect to see last year's highs exceeded during the next 12 months.

Changes to the TSI Portfolio

No changes.

 
Copyright 2000-2001 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>