Bonds - bonds continue to hold near their yearly highs, despite strength in commodity prices. The potential upside from current levels is minimal for long-dated securities (in fact, a correction over the next few weeks is very likely).
Stocks - the market tested its mid-July highs last week and is now set to move lower over the next 1-2 weeks. New all-time highs are likely by mid-October.
Gold - with Friday's drop in the Dollar a near-term gold rally is likely. Such a rally, assuming it does occur, will only be sustainable if the Dollar breaks important support and embarks on a long-term down-trend (rather than a short-term correction).
Recent Economic Data
The following economic information, all of which points towards a slowing US economy, was released on Friday:
Counter-balancing the above was the fact that the copper price, a good indicator of economic strength, broke out to the upside during the past week. Furthermore, the CRB Index rose to its highest level in 2 years and is on the verge of confirming an upside breakout. The strength in commodities in general and copper in particular suggests that either the current US economic slowdown is temporary or that economic growth outside the US will compensate for reduced demand within the US.
The inexorable trend towards higher inflation
A small but vocal contingent of analysts has been forecasting a deflationary collapse for many years. We occasionally see forecasts, particularly from those who base their predictions on waves and cycles to the exclusion of all else, that the stock market will lose 80% of its nominal value and the oil price collapse to $10 per barrel in the years ahead.
There is another way of looking at such forecasts. If someone expects the stock market to fall by 80% and the oil price by 67%, this is the same as expecting the Dollar to appreciate by 400% relative to stocks and by 200% relative to oil. In other words, a forecast that calls for a crash in the prices of assets is, in effect, calling for a parabolic rise in the value of the Dollar. Based on our understanding of today's monetary system, the US political system, the structure of the US financial markets and the current status of the US voting public's personal savings, we believe the probability of this occurring is very close to zero.
The negativity surrounding the Euro reached such extremes last Thursday that a bounce was inevitable. Despite the overwhelmingly-bearish sentiment towards the Euro the May lows effectively held once again, so a Euro rally over the next few weeks appears to be on the cards.
Apart from the inherent flaws in the whole concept of European monetary union, the Euro may face a further challenge in the financial markets before we can be confident that a long-term bottom is in place. This challenge stems from the fact that speculators have not yet turned against the Euro in a herd-like manner. In fact, as of August 22, the Euro was the only major competitor of the Dollar that did not have lopsidedly-bullish traders' commitments ('non-commercials' were net-long Euro futures as of August 22). The recent weakness in the Euro has mainly resulted from investment capital flows (primarily the repatriation of funds by Japanese investors). It would be strange if the Euro bottomed without first having been hammered by aggressive speculative short-selling.
The US Stock Market
Copper and the SOX
Kevin Klombies, who writes a daily report called the Inter-Market Relationship Analysis (IMRA), brought to our attention the relationship that exists between the copper price and the Philadelphia Semiconductor Index (the "SOX"). Specifically, the stock prices of the semiconductor group (as represented by the SOX) tend to move with copper prices with a lag of 2-3 months. This relationship is not as weird as it might first seem. A semiconductor can be thought of as a high-tech commodity and the demand for this commodity cycles with global economic growth. In other words, the same forces drive the prices of copper and semiconductors.
Below are two charts covering the period from May 1994 to the present day, the top chart showing the SOX (with a logarithmic scale so that a 1% change in 1994 looks the same as a 1% change in 2000) and the bottom chart the copper price. Copper price peaks, and the corresponding subsequent peaks in the SOX, have been labeled as "A", "B" and "C". The charts show that a March 2000 peak in the SOX followed the January 2000 peak in the copper price (peak C). The SOX then headed south along with the whole technology sector in the April-May value restoration exercise.
Everything seemed straight-forward, with the SOX appearing to have made a major long-term high in March of this year, until last week. Last Tuesday the copper price surged past its January peak to a new high for this cycle. Therefore, if the copper-SOX relationship continues to work as it has done for many years, we should see the SOX exceed its March peak some time during the next 2-3 months. This would necessitate a rally of around 20% from current levels.
It should be noted that Mr Klombies is extremely bearish on the SOX and on the entire stock market. His reasoning is that the copper price strength and the coincident general strength in commodity prices will force bond prices down (force interest rates up) and thus put irresistible downward pressure on stock prices. We don't agree. The upward trend in bond prices must be respected until it is broken, so what we have at the present time is a friendly monetary environment and a copper price signaling an increase in global economic growth. In other words, we have an ideal set-up for a further rally in the SOX. We therefore forecast that the SOX will reach a new all-time high by the end of November unless bond prices collapse (a collapse is defined as a close below 95 in the nearest bond futures contract).
Below is an updated chart of the TSI Indicator of Bullish Sentiment (TIBS). We use TIBS to help us identify major turning points in the market, as opposed to the minor peaks and troughs that are more appropriately addressed via shorter-term indicators. When TIBS moves into overbought or oversold territory it means we are close to either a major peak or a major bottom.
TIBS has not yet reached an overbought level, but the superb rally over the past 4 weeks has pushed it higher than it has been at any time since January this year.
Current Market Situation
Speculation in the stock market is once again reaching epic proportions, but since the April-May realignment it tends to be just the good businesses that are being allocated the ridiculous valuations (rather than anything with an appealing story or an interesting name). For example, many of the 'dot-coms' that should never have been public companies in the first place have disappeared or have become single-digit stocks. However, young high-profile tech companies that have sound business plans and are executing extremely well against those plans are still being valued in the stratosphere. Ariba, Juniper Networks, Sycamore Networks, JDS Uniphase and I2 Technologies are examples of hot stocks in hot industries that are consistently exceeding expectations and that have been accordingly rewarded with astronomical market-caps (see table below). These are good companies, but their stock market valuations indicate that price is still not an important consideration to many investors. Over the next few months these stocks will probably move even higher, but whereas the April-May bear market brought the bad companies back to earth the next bear market is likely to normalise the valuations of the good companies.
|Name||Recent Market Cap||Annual Revenue (latest quarter annualised)||EPS (based on forecast 2001 earnings)||Price to Earnings Ratio||Price to Revenue Ratio|
As sentiment becomes more bullish and valuations of the popular stocks become increasingly stretched, we are becoming less enthusiastic about the market. As far as we are concerned, the move from 3,000 to 4,300 on the NASDAQ was the easy (low-risk) money. The move from 4,300 to 5,000 (assuming it gets that high later this year) is the high-risk money. Those who jump into the market now simply because it has gone up are applying the "Greater Fool Theory" of investing, that is, buying at high prices in the hope that someone else will be foolish enough to pay even higher prices in the future.
As strange as it may seem, there is a good chance that higher prices will be paid at some point over the next 2 months. Many fund managers have been surprised by the strength of the rally from the May low and are caught under-invested and under-performing the S&P500. If we do not get something close to a market catharsis over the next 2-3 weeks (we certainly don't expect one) then they will have no alternative other than to pay whatever the asking prices are in order to have any hope of manufacturing a market-beating performance for the year. If they are forced to 'pay-up', we will take the opportunity to realise some profits.
At Friday's closing prices a bearish case can still be made from a technical viewpoint because the S&P futures have not broken decisively above their mid-July peak, giving the appearance of a double-top. If the market corrects over the next couple of weeks and then rebounds above the mid-July and early-September highs then a certain type of market technician – the type that likes to buy following upside breakouts or confirmations of strength – will become very bullish. When the market then breaks above its March 24 peak into new all-time high territory they will become even more exuberant. When the S&P500 bursts above the 1600 level the excitement will no doubt be palpable and usher-in a very attractive selling opportunity.
Anyway, we're getting a bit ahead of ourselves here. First of all the market needs to correct over the next 2-3 weeks and hold somewhere above 1450 (preferably above 1480) in the Sept S&P in order for the anticipated rally to unfold.
September 13 is the date that Yassar Arafat has threatened to declare Palestinian statehood unless a settlement is reached. According to Ariel Sharon, the announcement of an Israel/PLO agreement has purposely been delayed so that it can be made closer to the US elections and thus boost the chances of both Al Gore and Hillary Clinton.
The probability of a settlement being reached is extremely high given the monetary incentives on offer. However, the major difficulty revolves around constructing an agreement that allows both sides to maintain 'face', that is, to avoid the appearance of either side having given too much ground. This difficulty will probably be worked around and a settlement announced prior to September 13, but until this happens the on-going negotiations present an unknown risk to the world's financial markets.
This week's important economic/market events
|Wednesday September 6||Q2 Productivity (revised)|
|Friday September 8||Consumer Credit|
Gold and Gold Stocks
A "Peso Problem" in the making
During the 1980s the Mexican Peso would experience long periods of stability which would suddenly, without warning, be followed by a period of extreme turbulence. Such unpredictable and 'unmodelable' behaviour caused many traders to lose everything during the turbulent periods and led Nassim Taleb (an author, a philosopher and a successful options trader) to coin the term "peso problem" to describe any market behaviour where the adage "beware of calm waters" can hold. Writes Mr Taleb: "Peso problems are always unexpected, otherwise they would not occur. The typical case is as follows. You invest in a fund that enjoys stable returns and no volatility until, one day, you receive a letter starting with "An unforeseen and unexpected event, deemed of rare occurrence…". Peso problems exist because they are unexpected. They are generally caused by panics, themselves the results of liquidations. If the fund manager or trader expected it, he and his like-minded peers would not have invested in it, and the peso problem would not have taken place."
The gold market is a peso problem in the making. For many years the borrowing and short-selling of gold has been a means of earning reasonable returns with minimal volatility. In the early days of the gold carry trade the participants would no doubt have been wary of the risks they were taking. However, with each passing year confidence in the trade would have grown to the point where the risks seemed so small as to be not worth considering. After all, even if something unexpected did happen the central banks would be there to bail-out those caught on the wrong side of the market.
Current Market Situation
The Euro's successful test of its May low during the past week (a marginal new low was briefly hit before a rebound occurred) increases the probability of a gold rally in the short-term. However, if a correction in the Dollar over the next few weeks fails to break important support (a drop in the cash Dollar Index below at least 107 is required) then the next rally in the Dollar will have a good chance of making a new yearly high.
We expect the Dollar to rally to a new high at some point during this year's final quarter (probably in October), an outcome that would lead to selling pressure in the gold market. As such, a gold rally over the next few weeks will most likely not be sustainable (unless the Dollar breaks below important support) and will be followed by another decline (although we suspect that the lows in both the gold price and the XAU have already been seen). We expect that the gold rally that follows this intervening decline, and which is likely to begin late this year or early next year (depending on when the Dollar peaks), will be substantial.
4 September 2000
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