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   -- for the Week Commencing 30th December 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 below their 2002 lows during the first half of 2003.

The US stock market will reach a major bottom (well below the October-2002 low) during 2003.

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

A bull market in gold stocks commenced in November 2000 and will continue during 2003.

Commodity prices, as represented by the CRB Index, will rally during 2003 and 2004 with most of the upside occurring in 2004.

An appropriate quote

"The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists."
-- Ernest Hemingway

China - the other side of the story

Over the past several months we've read many articles that discuss China's emergence as a major economic power and the threat that China's economic growth poses to the US. There is, however, another side to the 'China story' that has received very little attention in the recent past. The other side of the story deals with massive and increasing unemployment, a potentially insolvent banking system, over-stated economic growth, corruption on a huge scale, lack of profits, the absence of an objective and effective legal system, and falling productivity.

Here is a link to an article explaining why, over the next few years, China is more likely to experience an economic implosion than a substantial economic expansion: http://www.tnr.com/docprint.mhtml?i=20021216&s=kurlantzick121602 (you will need to register to access the article). Some of the article's main points are:

a) The Chinese Government usually claims annual GDP growth of 7-10%, but such growth rates are inconsistent with China's rising unemployment and falling energy usage. The main reason that the reported national GDP growth figures are far from reality is that the national figures are compiled from provincial figures that are, in turn, 'manufactured' by local Party officials to meet targets set by Beijing.

b) According to Joe Studwell, editor of the China Economic Quarterly, less than 10% of the foreign companies that sell to China are making a profit on their China business.

c) China's banks are directed to support inefficient and loss-making State Owned Enterprises (SOEs). As a result, it is estimated that more than 50% of the bank loans in China are non-performing. Standard and Poor's estimates that it will take at least US$540B to re-capitalise the Chinese banking system and Nicholas R. Lardy, a China specialist at the Brookings Institution, predicts that the rising burden of non-performing loans could make the country's entire banking system insolvent by 2008.

d) With the banks being weighed down by bad loans and the on-going need to 'prop up' uneconomic SOEs, many private businesses with good prospects are often unable to borrow the money they need to grow. 

e) The government's auditing body has admitted that more than two-thirds of China's biggest companies falsify their accounting.

f) China's rating on the World Competitiveness Scoreboard, a ranking of powerful countries based on efficiency of economic performance, has fallen sharply over the past five years, from 21 to 31, a drop that signifies China's economy is becoming less efficient and competitive.

g) China's economy is becoming dependent on massive government deficit-spending (during the first three quarters of 2002 government expenditures rose by around 20%).

h) The rule of law has deteriorated and most independent-minded judges dedicated to creating a proper legal system have either quit or been dismissed. As such, most legal decisions follow the 'Party line'.

i) China is likely to experience increasing social unrest due to its unemployment problem and the brewing crisis in its banking system.

Our purpose in mentioning the above is to warn that the generally bullish outlook for China that is now commonly portrayed in the Western press should not be accepted blindly. China is confronting some major obstacles and there does not appear to be any way that it can transition smoothly from where it is now to the economic powerhouse that some commentators have speculated it will become. The downside risk appears to be substantial and we would therefore steer clear of, or tread lightly when it comes to, mutual funds that invest in stocks listed on the Chinese stock market. 

In addition to a fundamental picture that looks murky at best, the Chinese stock market (as represented by the Shanghai Stock Exchange Composite Index) looks bearish from a technical perspective. The Shanghai Stock Index (SSEC), which regularly moves counter to the major stock markets of the world, has been in a powerful bear market since peaking in June of 2001 (see chart below). More to the point, an end to the bear market does not appear to be close at hand.

Regardless of whether or not China is able to achieve, rather than just report, economic progress over the next few years, as more and more goods are manufactured in China the global demand for commodities is likely to rise. As such, China's internal economic troubles don't appear to present an imminent threat to the budding bull market in commodities.

Bonds

In terms of price movement not much happened while we were on vacation during the past week (thankfully), but two very important technical developments did occur. One was the Dollar Index's decisive breakdown below its July low. The other was the upside breakout in the bond market that occurred last Friday.

From the 23rd December Weekly Update: "...if the next decline in the bond market holds at, or above, the uptrend-line on this chart, or if bonds move decisively above the downtrend-line at any time, then our medium-term bearish view is wrong. If this proves to be the case you can be sure that we won't stay wrong." As the following updated version of the aforementioned chart shows, bonds moved decisively above their downtrend-line at the end of last week. As such, the odds are now in favour of the bond price moving above this year's peak at some point during the next 6 months. 

What does the upside breakout in the bond market mean? First, it means that our medium-term bearish view on the stock market is probably correct (we doubt that bonds would be showing signs of moving to new highs unless the stock indices were headed for new lows). Second, it could mean that the biggest gains in commodity prices won't occur until 2004. Third, it might be further confirmation that the market has taken recent comments by Fed Chairman Greenspan and Fed Governor Bernanke to heart.

Greenspan and Bernanke have recently mentioned that the Fed could, and would, go well beyond its normal procedure of setting a short-term interest rate if it was felt that falling prices were becoming a problem for the US economy. Along these lines both Bernanke and Greenspan have broached the possibility that the Fed would, under certain conditions, start targeting long-term interest rates (up until now these have been set by the market). For example, rather than simply adjust bank reserves to keep the Fed Funds Rate at a target level, the Fed would start buying long-term bonds with the aim of bringing long-term interest rates down to some arbitrary level. Since the Fed has the wherewithal to buy the entire US bond market tomorrow if it chose to do so, it certainly has the power to force long-term interest rates down. Of course, if the Fed forced rates below where they would otherwise be then the Fed would eventually become the only buyer of US bonds and everyone else would sell because the real returns on US bonds would become prohibitively low. As such, one effect of the Fed following through with its recently-stated idea of targeting long-term interest rates is that the US$ would collapse as foreign investors fled the US bond market. Last week's breakouts in bonds and the dollar (up for bonds, down for the dollar) might therefore be linked.

The US Stock Market

Too many bulls

There is still a lot of talk along the lines that the low reached on 10th October was either the major low for this bear market or at least a low from which a 1-2 year bull market will evolve. However, even if we put aside the fact that valuations are still much closer to what would normally occur near a bull market peak than a bear market bottom and the fact that sentiment never reached the sort of bearish extreme normally seen near important bottoms, we would still have a hard time accepting the bullish argument. This is because the price and volume action since 10th October is not consistent with what would normally occur in the early stages of a new bull market. It is, however, totally consistent with what we would expect to see in a 'run of the mill' bear market rally. In fact, all that has really happened since the market reached its closing low on 9th October is a 4-day rally. On 15th October, 4 days into what many people believe to be a new bull market, the S&P500 Index closed at 881. At the end of last week it closed at 875. 

So, why are so many people so bullish? After all, the market seems to have nothing going for it. Valuations are generally excessive, price/volume action and market breadth have been unimpressive, and the geopolitical situation is unstable to say the least.

The underlying bullishness appears to be based mainly on timing factors such as a) the market hasn't fallen for 4 years in a row during the past 70 years, b) the 4-year and 20-year cycles were due to bottom in the second half of 2002, and c) the third year of a presidential term is usually a good one for the stock market. Also, some analysts have justified the high valuations by arguing that low interest rates mean it's OK for stocks to trade at much higher PE ratios than they ever have in the past. In other words the bullish case is flimsy, but if someone has a bullish bias they will usually be able to find some reason to buy, or to remain long, even when the evidence is stacked against them.

Current Market Situation

The S&P500 Index has not yet closed below 872, the November pullback low, and has therefore not provided definitive confirmation that the bear market rally has ended. Last Friday it did, however, close below support defined by a short-term uptrend-line (see chart below). Furthermore, Friday's upside breakout in bonds is certainly a negative omen for stocks.

The S&P500 doesn't look particularly healthy when measured in terms of the dollar, but it looks downright sick when measured in terms of hard money. 

Below is a chart showing the S&P500 in terms of gold. While the S&P500 Index in dollar terms is still marginally above its November low, the S&P500 in gold terms has fallen to within 3% of its October low. Also, note how weak the rally that began in October of this year has been compared to the rally that began in September of 2001. During the final quarter of 2001 the S&P500/gold ratio surged to the top of its major downward-sloping channel before it started to roll over whereas the current rally didn't make it to anywhere near the channel top before the downtrend resumed.

A drop to the channel bottom shown on the above chart looks likely during the first half of 2003. 

In our view the two most likely scenarios over the next few months are:

1. The market makes a short-term bottom during the coming week, rallies for 2-3 weeks to convince the majority of participants that the worst is over, then resumes its decline. This would be similar to what happened in 2001 when a 2-3 week January rally was followed by a 2-month plunge, which, in turn, resulted in a tradable bottom in early-April.

2. The market plunges during January and February.

Both scenarios are clearly bearish with the main difference being that Scenario 2 results in a tradable bottom 1-2 months earlier than Scenario 1. Unless you are a short-term trader, though, the market's twists and turns don't really matter. The main point is that regardless of whether we look at the market from a fundamental or a technical perspective, there still appears to be considerable downside risk. There are a lot of different paths the market might take to get from where it is now to where it is going and we'll do our best to figure out the details, but the final destination is a long way below the current level.

This week's important economic/market events
 

Date Description
Monday December 30 Existing Home Sales
Tuesday December 31 Consumer Confidence
Chicago PMI
Wednesday January 01 Markets closed for New Year's Day
Thursday January 02 ISM Index (formerly NAPM)
Friday January 03 ECRI Future Inflation Gauge
Construction Spending

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