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   -- Weekly Market Update for the Week Commencing 31st May 2004

Big Picture View (Most recent update: 12 January 2004)

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) bottomed in June of 2003 at around 4.2% and will move considerably higher during 2004 and 2005.

The stock market rally that began in October of 2002 will end during the first half of 2004. The October-2002 bottom (775 for the S&P500) will be tested during 2005.

The Dollar will make an intermediate-term bottom during the first half of 2004 in the vicinity of its 1995 low (a Dollar Index value of around 80) and then rally for at least 6 months, but a long-term bottom won't occur until 2008-2010.

Gold will make an intermediate-term peak during the first half of 2004 and then consolidate for at least 6 months, but a long-term peak won't occur until 2008-2010. 

Commodities, as represented by the CRB Index, will make an intermediate-term peak during the first half of 2004 and then consolidate for at least 6 months, but a long-term peak won't occur until 2008-2010. 

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The keys to a long-term bull market in gold

In an article last week at www.mineweb.com (http://www.mineweb.net/sections/gold_silver/325328.htm) Jeff Christian, described in the article as a veteran metals analyst at New York's CPM Group, explains why he thinks a gold price above $400 is unsustainable in the long run. We are sometimes interested in reading diametrically opposing views to our own to check that we haven't missed something important, so given our expectation that gold will exceed its 1980 high before the end of this decade we were interested to find out why we might be wrong. After reading the article, though, we were left with the impression that if this is the best argument a gold bear can come up with then maybe we aren't bullish enough.

The main reason for Mr Christian's relatively bearish view is the growth in new mine supply that might occur over the coming years. However, there's no need to even speculate on whether Mr Christian is right about an increase in mine supply because changes in mine supply have such a small effect on the gold price they are not worth considering. Think of it this way: There are about 140,000 tonnes of gold supply in the world and this supply increases by 1.5%-2.0% per year as a result of new mine supply, so even if new mine supply were to increase by 10% this would alter the total aboveground gold supply by only 0.2%. On the other hand, changes in the investment demand for gold can have dramatic effects on the overall supply/demand situation.

How big is the investment demand for gold? Well, if the total supply of gold is 140,000 tonnes then the total demand for gold at any time must also be 140,000 tonnes because the current price is, by definition, the price that brings supply and demand into balance. And it has been estimated that investment demand constitutes at least 70% of total demand, which means that a 10% swing in investment demand would result in a 7% swing in total demand. In other words, the overall effect of a 10% change in investment demand is about 35-times greater than the overall effect of a 10% change in new mine supply. This is why any long-term forecast of the gold price should be solely based on an assessment of the factors affecting the investment demand for gold.

Jim Sinclair (http://www.jsmineset.com/) is someone who has correctly anticipated the major moves in the gold market over the past 35 years so it is not surprising that he zooms in on the factors that affect the investment demand for gold. Specifically, he believes that "...in order to have a long term bull market in gold certain foundational conditions need to be fulfilled. Not every condition will be present but when they are gold is either in or about to enter a major period of price appreciation.

The required criteria in order of importance are:

1. A Bear Market in the US dollar.
2. A Bear Market in US Treasury instruments.
3. Deficits in the US Trade and US Current Account.
4. Declining trust in paper assets as storehouses of value.
5. On balance positive market for general commodities."

By the way, while we wholeheartedly agree that a long-term bear market in the US$ is the single most important prerequisite for a long-term bull market in gold we actually aren't in total agreement with the above list. For one thing, the US trade and current account deficits are only important to the extent that they contribute to the bear market in the US$. Also, although it is likely that a bull market in gold will be associated with a bull market in commodities and a bear market in US Treasuries, these are not ESSENTIAL criteria for a bull market in gold. For instance, it is not difficult for us to envisage an environment where gold and bonds are strong while the US$ and commodities are weak. In fact, such an environment existed from the second quarter of 2001 through to the second quarter of 2003 (during this period commodity prices were strong in US$ terms, but they weren't strong in terms of most other major currencies). Our view is that instead of considering a bear market in US Treasuries and a positive market for general commodities to be foundational conditions for a gold bull market, it makes more sense to think of a bull market in gold as being a foundational condition for a bear market in Treasuries and a bull market in commodities.

So, our own list of required criteria for a long-term bull market in gold would comprise just items 1 and 4 from Mr Sinclair's list. In a nutshell, a bear market in the US$ guarantees a bull market in gold in US$ terms while declining trust in paper assets guarantees a bull market in gold in terms of all fiat currencies.

In any case, the most important points are that the future gold price will be determined by the factors that affect the investment demand for gold and these factors do NOT involve the world 'going to hell in a handbasket'. The long-term bullish argument for gold does not rely on apocalyptic scenarios, it relies on a gradual loss of confidence in the US$ in particular and paper assets in general. Who could look at the world's current political and monetary leadership as well as the massive imbalances in the US economy and claim, with a straight face, that this is not a reasonable argument?

Know yourself

Are you are short-term speculator? Or a speculator trying to profit from the intermediate-term swings in the market? Or a long-term speculator (otherwise known as an investor)? If you are an investor, do you have enough conviction in your long-term outlook and the stocks you own to comfortably ride-out the short- and intermediate-term corrections in the market, or does your confidence plummet with every sharp price decline?

Where we think a lot of people go wrong is that they either try to be something they are not suited to being or continually switch between an investing approach and a trading approach in response to the most recent price action. An example would be someone who thinks of himself/herself as an investor and buys a stock based on valuation with the aim of holding for 2-5 years only to agonise over every short-term price fluctuation. Another example would be someone who thinks of themselves as a trader and buys a stock based on technical considerations only to use a value-oriented approach to justify holding onto the stock after the technical picture has turned sour.

The bottom line is that investors shouldn't need the constant validation of 'the herd' in order to have confidence in their decisions whereas traders can't afford to spend much time moving in the opposite direction to the herd.

The Stock Market

Current Market Situation

We've warned against paying a lot of attention to the NYSE McClellan Oscillator (MO) because the large number of interest-rate sensitive stocks that now trade on the NYSE was causing this indicator to move from one extreme to the other based almost entirely on what was happening in the bond market. However, the recent behaviour of the NYSE MO warrants a mention because it really is quite extraordinary.

During the first week of May the NYSE MO hit its second LOWEST level ever on the back of rate-hike fears, but last week it hit its HIGHEST level ever. In fact, last Thursday's reading for the MO was about 30% higher than the previous all-time high!


We are not sure it's worth trying to draw any conclusions from the recent performance of the MO, but looking back over the past several years there have only been two other occasions when the MO moved from below -200 to above +200 in 4 weeks or less. One of those occasions was July-August of 2002 and the other was September of 1998. In both of those prior cases the NYSE Composite Index dropped to a new correction low over the ensuing weeks before embarking on a large rally, so if the current market follows a similar pattern there will be a drop below the May low within the next month or so followed by a rally to a new high for the year.

Last week's market action certainly cast doubt on our short-term bearish view. We've speculated that the market would drop sharply into a late-June low, but in order for this view to remain valid a decisive break below the March low in each of the senior stock indices would have to occur this week. However, that now looks unlikely because the past week's action was bullish. In particular, the Dow Utility Average achieved an upside breakout (see chart below) and the NDX handily out-performed the Dow. Also, weakness in the US$ combined with significant strength in bonds and the industrial metals suggests that the markets are returning, at least temporarily, to last year's theme.


Our bearish conviction is shaken but has not yet been shattered because the market hasn't done quite enough to negate the possibility of a sharp near-term decline. For example, none of the senior stock indices have yet broken out from the downward trends that originated during the first quarter of this year. Also, take a look at the below charts of the Semiconductor Index (SOX). The first chart, which covers the 12-month period from September 2001 to September 2002, shows that the SOX broke below important support in early-May of 2002 and then immediately rebounded back to just above its 200-day moving average before collapsing in a heap. The second chart covers the most recent 12 months and shows that something similar might now be afoot.




For our short-term bearish view to have any chance of coming to fruition the stock indices must turn lower from near current levels. On the other hand, if market moves sideways for a few days and then resumes its advance we will have to make a hasty retreat with the aim of re-establishing our bearish positions when the technical evidence once again supports such positions.

We were shaken out of our USPIX positions for a small loss last month and it would be frustrating if the same thing were to happen again now, particularly since most of the bearish ducks appeared to be lined up just one week ago. However, such things are 'par for the course' in the world of speculation.

Lastly, terrorism warrants a mention. Terrorism will remain a constant threat and there's a significant chance that a major terrorist attack will be attempted in either the US or Europe within the next few months. Also, just yesterday (Saturday) there was another attack in Saudi Arabia that was focused on the oil industry and the de-stabilisation of the current Saudi regime. This latest attack could push the oil price higher and cause some nervousness in the stock market this week.

A successful terrorist attack against the US would cause the stock market to plunge, but it's unlikely that the market would behave in a bullish manner during the weeks leading up to such an event. This is because an 'unexpected' attack would not be unexpected by everyone. Recall, for instance, the persistent weakness in the stock market during the lead-up to the September-2001 attacks on the World Trade Center. In other words, the worst things tend to happen when the technical situation is already bearish.

This week's important US economic events

Date Description
Monday May 31
US markets closed for Memorial Day
Tuesday Jun 01
ISM Index
Construction Spending
Wednesday Jun 02 No significant events
Thursday Jun 03 Q1 Productivity and Costs
Factory Orders
ISM Non-Manufacturing Index
Friday Jun 04 Employment Report
Future Inflation Gauge

Gold and the Dollar

Gold versus the Swiss Franc

Occasionally we read an argument to the effect that gold and the US$ are going to move higher TOGETHER over the coming years. However, while it is certainly possible that this could happen it is, in our opinion, extremely unlikely. We say this for two reasons. First, the investment demand for gold would be unlikely to increase if the US$ were in a long-term upward trend (why buy gold when you can buy a strengthening dollar?). Second, since the official link between the US$ and gold was severed in 1971 there has been a strong inverse correlation between these two forms of money.

The inverse correlation between gold and the US$ results in the positive correlation between gold and the Swiss Franc illustrated on the below chart (the chart compares the performance of gold and the SF since the beginning of 1995). Note that there are often enough leads, lags and divergences in the short-term to make it look like the relationship between gold and the SF is breaking down, but the chart suggests that a multi-year period of gold price strength combined with SF weakness would be highly improbable.


Zooming in on the past 2 years (refer to the below chart) we see that gold and the SF sometimes diverge quite markedly, but that they inevitably come back into line with each other.


At some point over the next few years we think gold will start moving higher against the US$ at a much faster rate than the SF is moving higher against the US$, that is, we expect gold to out-perform the SF by a wide margin over the coming years. This will occur due to declining confidence in paper assets throughout the world. However, we find it difficult to envisage an extended period of gold price strength combined with SF weakness and there is certainly no evidence at this time that such a period has begun. As such, we would not be long-term bullish on gold unless we were also long-term bearish on the US$.

Currency Market Update

The Japanese Yen has two big things going for it. One is that Japan runs a large current account surplus every year. The other is that the Japanese stock market probably made a secular low last year, which, if true, would mean that the Nikkei225 Index was now in the early stages of a secular bull market. Despite these major positives, though, the Yen is the only major currency that is yet to surpass its 1998-1999 highs against the US$.

The below weekly chart shows that the Yen broke above important resistance during the third quarter of last year but has thus far been unable to surpass its late-1999 peak. During April it plunged to its former resistance (now support) at 87 but has since rebounded and is now between intermediate-term support in the 85-87 range and long-term resistance in the 95-100 range. Our view is that the Yen will eventually move well above 100 due to the fundamental positives mentioned above, but the high for this year is probably in place.


Last week's action in the currency market indicated that what we've called the 'red dollar scenario' is in progress. In other words, we think the US$ will test its February low within the coming 1-3 months and then embark on a lengthy (> 6 months) rally.

A test of this year's low for the US$ would involve the Dollar Index dropping to the 83-86 range (a successful test of a low can result in a slightly higher low or a slightly lower low). Our thinking is that some currencies -- almost certainly the Swiss Franc and probably the euro -- will move above their January-February highs over the coming months while currencies such as the Yen, the Australian Dollar and the Canadian Dollar make lower highs.

Just to recap, the main reason we are expecting the US$ to complete a test of its low over the next few months rather than embark on a new bear-market leg is that the price action in the currency market and related markets points to the dollar rebound that began in February being a correction of the entire 2002-2004 decline. At this stage, though, the correction has only retraced about 20% of the preceding decline in terms of price and 12% in terms of time. If the Dollar correction has already ended then this would amount to an unusually small retracement.

The possibility of a lengthy dollar rally will, however, need to be re-assessed based on what is happening in other markets IF/WHEN the dollar drops to near its February low. For example, if the US$ has just embarked on another bear-market leg then one thing we would expect to see over the next several weeks is substantial strength in gold stocks in both absolute terms and relative to the gold price. To be specific, by the time the Dollar Index dropped to the vicinity of its February low we'd expect the HUI to be well on its way to new highs.

The Commitments of Traders (COT) Report

Over the past two years the lowest levels for the net-long position of small traders in COMEX gold futures occurred during March and July of 2003. On both of these occasions the net-long position was around 25,000 contracts and the drops to this level coincided with important price lows in the gold market. We therefore think it is reasonable to assume that a small trader net-long position of around 25,000 contracts represents the sort of negative sentiment that would generally be apparent near the bottoms of gold-market corrections.

Now, as of last Tuesday (the date of the latest COT data) the net-long position of small traders was 27,000 contracts, which means that from a sentiment perspective we are currently where we would expect to be if an important bottom had just been put in place in the gold market. Furthermore, when the net-long position of small traders was near current levels back in March of 2003 the gold price was $330, versus $388 last Tuesday, so it could be said that the small traders are just as disinterested in gold today as they were when it was trading $58 lower back in March of 2003. This is obviously bullish from a contrarian perspective.

Small traders aren't very bullish on gold, but they are downright bearish on bonds and notes. For example, the net-short position of small traders in 5-year T-Note futures is at an all-time high and their net-short position in 10-year T-Notes is also close to an all-time high. This should help to support the bond market over the coming weeks.

Merger Mania II

When IAMGold (IAG) and Wheaton River (WHT) announced their planned merger at the end of March our comment was: "...the proposed IAG/WHT merger looks like a wonderful deal for WHT shareholders and a horrible deal for IAG shareholders. It also looks like the type of deal seen near cycle tops; although it is, of course, nowhere near as extravagant as some of the deals that were done by tech and internet companies in 1999-2000."

After the market closed last Thursday competing bids were launched for IAG and WHT by Golden Star Resources (GSS) and Coeur D'Alene (CDE), respectively. The competing bids were launched at significant premiums to the pre-bid stock prices of IAG and WHT, but the premiums mostly evaporated during Friday's trading due to reductions in the stock prices of GSS and CDE.

Our guess is that the competing bids will be successful, mainly because the newly-proposed merger of GSS and IAG makes much more sense for IAG shareholders than the previously-proposed tie-up with WHT. The original plan for IAG to merge with WHT made no sense at all for IAG because there were no synergies between the two companies and because the agreed price represented a huge growth premium for a company (Wheaton) whose best growth was behind it. Also, IAG's management had agreed to pay top gold-sector multiples for a 'gold company' that generates a lot of its profits from the production of copper.

All four companies involved in the bidding process look expensive based on current production and reserves, but the GSS/IAG combination would be a company worth owning for the long-term because it would combine good management, high-quality gold assets and a strong growth profile. We think Wheaton's management has done a masterful job of promoting the company and putting it in play at the most opportune time, but investors who are still holding this stock should seriously consider making their exit now. A reasonable course of action, in our opinion, would be to sell WHT and buy GSS (we don't know how the stock prices will perform relative to each other in the short-term, but we are confident that GSS will out-perform WHT over the coming 12 months). CDE is poorly managed as well as being over-priced and should therefore be avoided.

Current Market Situation

Below is a daily chart of June gold futures. Following a test of the 200-day moving average and the 395 resistance level last week it would be normal for gold to pullback this week, but if it can hold above 385 during any near-term pullback then the subsequent rally would have a good chance of taking the price back to 415-420.


The AMEX Gold BUGS Index (HUI) is in a similar position to the gold price and will probably consolidate for a week or so in the 190s before resuming its advance.

Copper

Below is a daily chart of July copper futures. By closing above its 'breakdown level' at the end of last week the copper price has done enough to suggest that a correction low was put in place during the week before last. A test of this year's highs is possible within the next two months, but we doubt that another major upward leg in copper's bull market is about to get underway. A more likely outcome is that copper will spend the rest of this year in a range bounded by its March high and its May low.


Update on Stock Selections

We'll send an e-mail to subscribers on Tuesday with updates on a few stocks.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/
http://www.decisionpoint.com/
http://bigcharts.marketwatch.com/



 
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