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   -- for the Week Commencing 29th July 2002

Forecast Summary

The Latest Forecast Summary

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) will move higher during 2002.

The US stock market will reach a major bottom (well below the September-2001 lows) during the second half of 2002.

The Dollar commenced a bear market in July 2001 and will continue its decline into 2003.

A bull market in gold stocks commenced in November 2000 and is likely to extend into 2003.

Commodity prices, as represented by the CRB Index, will rally during 2002 and 2003.

The oil price will resume its major uptrend during the first half of 2002.

Gold Market Overview

We are going to dispense with our usual format today and just launch straight into a ramble on the gold market.

We've read a few theories as to why gold was hit so hard last week, one of the most popular being that the sell-off was related to JP Morgan's huge derivative position. Also, after such a sharp decline it is natural to question whether or not gold is still in a bull market. 

Before we get into the broader issue regarding whether or not our "gold is in a long-term bull market" thesis is intact, let's focus on what happened last week. The popular theory (amongst goldbugs) is that JPM needed to force the gold price much lower in order to mitigate the risk of major losses associated with its massive position in gold-related derivatives. This is probably true, although it is only part of the story. 

The collapse in bank stock prices last week indicates that the market perceives a significant risk of a banking crisis. If the market is right then the banks are in a desperate situation and would be expected to use all resources at their disposal to cover-up the mistakes that have put them in such a precarious situation in the first place. In the case of JPM a large (relative to the size of its capital) position in gold derivatives has been accumulated over the years and this position appears to have been undertaken on the basis that gold prices will not rise beyond the $300-$325 range. As such, it is highly probable that JPM and other large bullion banks have recently been doing whatever they can to reduce the gold price. However, as we mentioned above this is only part of the story.

The other part of the story explains why the heavy-handed intervention in the gold market has, to date, been successful. After all, with the financial markets in turmoil any short-selling of gold would be extremely hazardous and could just create an even bigger problem for the vulnerable banks and other 'shorts'. In this case, however, it worked.

The reason it worked is that sentiment in the gold market had become lopsidedly bullish. We know that sentiment was lopsidedly-bullish because the net-long position of small traders in COMEX gold futures was at an all-time high when the gold price peaked at around $330 two months ago. Furthermore, as at 23rd July (the date of the latest data) the small traders' net-long position was still quite close to this all-time high even though the gold price had, by that stage, dropped by $15 from its early-June peak. The following chart, provided courtesy of Nick Laird at http://www.cairns.net.au/~sharefin/Markets/Charts.htm, illustrates the 'problem'. As at 23rd July, with gold trading at $312, the net-long position of small traders (the dumb money) was around 41,000 contracts, similar to its levels at the major gold market peaks of 1993 and 1996 and only slightly below the level reached at this year's peak. 

In last week's Interim Update we said that a brief drop below $300 would probably be needed to set the stage for the next gold rally. This is because a break below a psychologically important level will likely be required to cause the small traders, who relentlessly clung to their long positions during the first $15 of gold's correction, to give up. 

The commitments of traders data are of almost no use as far as timing the market is concerned because there is no telling how extreme the positions will become before a trend change occurs. However, they do help to indicate the level of risk in the market. We've highlighted this risk on numerous occasions over the past 3 months, although we are somewhat surprised by the resiliency being shown by the small traders (we are surprised that only minimal 'dumb money' liquidation occurred during the drop in the gold price from the high-320s to around 310).

Small traders being resilient in the face of a decline in price is a bearish factor because the decline won't end until they capitulate. So, the longer the 'dumb money' hangs on the greater will be the duration and magnitude of the decline. Digressing for a moment, the current situation in the S&P500 futures market is quite extraordinary in that the small traders actually increased their net-long position by a hefty 19,000 contracts during the 2-week period ended 23rd July, a period during which the S&P500 fell by 153 points. The following chart, also courtesy of Nick Laird, shows the persistent bullishness of the 'dumb money' in the face of the S&P500's relentless decline. Until these small traders finally 'throw in the towel' there is little chance of a stock market rally lasting more than a few days.

Now to the main issue raised as a result of last week's fall in the gold price and collapse in the prices of gold shares, that is, the issue of whether gold's bull market has ended. The only way that gold's bull market could possibly have ended is if the US$ has finished going down and is about to embark on another bull market. This, in turn, could only happen if the real returns (or perceived real returns) on US$-denominated investments make a recovery of sufficient magnitude to enable the US to once again attract net foreign investment in-flows of around $40B per month. Anything is, of course, possible, but such an outcome seems unlikely in the extreme and is certainly something we feel comfortable betting against.

We shouldn't be stubborn, however, because we never know what we don't know, that is, there could always be some important piece of information that we are missing. As such, we must always make sure that price action is not in conflict with what we think is going to happen. If it is then we should make some adjustments.

Last week all the major gold stocks fell below what would have been ideal support levels for a normal correction, but none of the large or mid-sized unhedged producers fell far enough to break their primary up-trends. Let's take a look at the Amex Gold BUGS Index (HUI), a proxy for these unhedged stocks. 

Below is a 2-year chart of the HUI. Primary trend support for the HUI lies at around 60 (this was the previous low within the 2-year up-trend), a level that is too far below Friday's close to be of much practical value (we'd want to know that a trend change was in the works well before the HUI fell to 60). However, if the bull market is still intact then we should not get a daily close back below the May-2001 closing high of 76.58. Therefore, if the HUI closes below 76 we will assume that we are missing something and will sell most of our gold and silver stocks.

Lastly, there are a number of ways to manage risk when trading and investing. One way is to use sell-stops positioned just below support levels and another is to hedge via options. We sometimes use sell-stops, but our preferred way to manage risk is to use a scale-in/scale-out approach and to never be committed to the extent that a sharp correction is going to put us under duress. By "scale-in/scale-out" we mean buying in stages during periods of substantial weakness and then taking money off the table in stages during those periods when the market becomes 'frothy'. Not being over-committed allows a trader or investor to focus on doing the right thing as opposed to focusing on the money. 

The US Stock Market

Current Market Situation

Based on the dramatic action in gold last week and the lack of any change in the stock market's situation we decided to devote most of the space in today's commentary to the gold market. We'll just make a few brief comments on the stock market.

Firstly, as mentioned above the commitments of traders situation has not improved despite the recent sharp decline in the S&P500 Index. In fact, it has deteriorated.

Secondly, the NASDAQ100 Volatility Index (VXN) and put/call ratios have yet to confirm that even a short-term bottom has been reached.

Thirdly, following Wednesday's huge rally the NASDAQ Composite Index and the NASDAQ100 Index have had 2 'inside' days (days when the high and the low are within the range of the previous day). This suggests to us that the market is preparing to make another large move. We don't know the direction of the move, but if it is up we would consider it to be another brief interlude within an on-going downtrend.

Fourthly, our forecast for this year has been that a major bottom would be reached during the final few months of the year. However, the relentless nature of the short-term downtrend that began in March opens up the possibility that the low that occurs during the next few weeks will be the low for this year. This would mean that the major bottom would be postponed until well into next year. We'll explore this possibility further in future commentaries.

This week's important economic/market events
 

Date Description
Monday July 29 No significant events
Tuesday July 30 Consumer Confidence
Wednesday July 31 Preliminary GDP Estimate for Q2
Thursday August 01 ISM Index
Construction Spending
Friday August 02 Employment Report
ECRI Future Inflation Gauge
Personal Income and Expenditure

Gold and the Dollar

Current Market Situation

Below is a long-term monthly chart of the Dollar Index. When the Dollar broke below its January-2001 low last month it confirmed that a major trend change was in the works, although at this stage it remains above the post-1995 trend-line.

If the Dollar Index closes this month at around its current level or higher it will achieve a monthly gain for the first time in 6 months, that is, the sequence of consecutive down-months will end at 5. The only other times over the past 10 years when the Dollar Index fell for 5 months in a row occurred during the periods immediately preceding the major Dollar bottoms in 1992 and 1995. This doesn't mean the Dollar has reached a major bottom (we certainly don't think it has), but it does increase the probability of a counter-trend rally lasting at least 1-2 months.

The powerful rally in gold and gold stocks during the first few months of this year correctly anticipated the sharp decline in the Dollar over the past few months. The sharp decline in gold and gold stocks over the past several weeks has probably, in turn, discounted a Dollar rebound. As discussed earlier under "Gold Market Overview" this decline in gold and gold stocks will eventually be seen as a correction within an on-going bull market unless we are wrong about the Dollar, that is, unless the Dollar has, in fact, reached a long-term bottom and is about to commence a new bull market. With the US current account deficit at an all-time high, with the real returns on US$-denominated assets and debt likely to remain poor for some considerable time to come, and with policy initiatives on the part of the US Administration designed to prop-up asset prices and the economy likely to contribute to the US' inflation problem, the probability of a new Dollar bull market commencing anytime soon is extremely low.

Regardless of whether we are right or wrong about the recent decline in gold share prices being a bull-market correction, a short-term bottom has either already been reached or will be reached within the next few days. Gold stocks will then bounce. After the sort of panic sell-off that has occurred over the past week it would be normal for a test of the low to occur some time within the ensuing 2 months, after which the next phase of the bull market will begin. The following chart of the HUI illustrates the ideal pattern.

There are, of course, no guarantees that a test of the lows will occur and that if it does occur it will be a successful test. This is what makes it interesting and challenging.

Note that the low that was formed last Friday, or the low that will be formed over the next few days if Friday's low is breached, will become the highest low within the primary up-trend. This level will then become our major 'stop-out' point. In other words, if Friday's intra-day low of 92.82 holds and the HUI rebounds immediately then we will set our major sell-stop at 92 as opposed to the 76 level mentioned earlier in today's commentary.

Long-term investors should scale into the top-quality major gold producers at around current levels, but should not be mortgaging the final 40 acres in order to do it. In our view the stocks of the major producers that offer the best risk/reward ratios are HGMCY and GFI. This is because their current stock prices are fully justified by current earnings, that is, the stocks are not discounting any increase in the gold price. Furthermore, we expect that any additional weakness in the gold price will occur in parallel with weakness in the SA Rand, meaning that the earnings of Harmony and Gold Fields are naturally hedged against a falling gold price. This doesn't mean that their stock prices won't take a further hit (gold-stock prices are affected far more by the US$ gold price than by the gold price in local currency terms), but it does limit the downside because fast-growing companies never sell at low P/E ratios for long. DROOY also looks attractive at its current price and would be our third choice.

Before making any additional purchases of speculative gold stocks or short-term trading positions we would wait until a) a new short-term up-trend is confirmed, b) gold stocks begin to out-perform the metal, and c) the net-long position of small traders in COMEX gold futures falls below 10,000 contracts. We would also wait before making any additional purchases of silver stocks. As was the case in the previous gold rally, we expect the next gold rally to be led by the major gold producers with the speculative gold stocks and the silver stocks following along behind them.

By the way, as discussed in previous commentaries we do not think the new SA Mineral Rights bill presents a significant problem for either Harmony or Gold Fields. Harmony currently has 49M ounces of reserves and 295M ounces of resources, so even if it doesn't convert any of its vast resources into reserves it presently has enough reserves to produce gold at the current annual rate of 3.3M ounces per year for the next 15 years (existing assets are not jeopardised by the new legislation). Also, even if it is prevented from acquiring any additional assets in SA it can simply continue doing what it has been doing for the past few years - buy gold-producing assets in Australia.

Commodities

Below is a weekly chart of oil futures. The oil price peaked in May, dropped sharply into early-June, and has since 'flagged' higher to a lower peak in July. Oil has been sporting a substantial 'war premium' over the past few months, but recent price action suggests that this premium is about to be removed. We expect the oil price to drop to the low-20s over the coming 1-2 months.

Below is a long-term chart of Phelps Dodge (NYSE: PD). PD is the world's largest privately-owned copper producer and is a highly-leveraged play on the copper price.

Copper futures closed last week at 68.70, about 15% above last November's low. We are confident that last November gave us THE bottom for copper, but expect more downside in the short-term. However, if we are right that last November's low will hold then it is highly probable that PD will also hold above last year's low. As such we will probably add PD to the TSI Portfolio if it falls to $28 (whether we actually do or not will depend on what is happening in the stock, bond and currency markets at the time). A daily close above $43 is needed to break the 5-year downtrend.

Update on Stock Selections

In the 12th June Interim Update we did a valuation comparison of several of the major gold stocks. We plan to update this comparison in about 2 weeks time after all the companies have reported their June-quarter financial results.

Volatility has certainly been the order of the day. Last week our Chesapeake Energy (CHK) traded as low as $4.50 and as high as $6.13 before closing the week at $5.50. CHK reported good financial results during the week and at its current price it is selling at less than 3-times operating cash-flow. Value buying will eventually overwhelm momentum selling, but in the short-term a lot of babies are being thrown out with the bath water.

Chart Sources

Charts used in today's commentary were taken from the following web sites:

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

 
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