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Gold and Stock Market Update
Overview
Bonds - the potential upside from current levels is minimal for long-dated securities (in fact, a correction over the next few weeks is very likely). However, with oil having possibly just made an important intermediate peak and looking set decline, the downside in bonds should also be limited.
Stocks - going into the Labor Day weekend the market had become fully extended and a correction was therefore inevitable. The low point for this correction will probably be reached during the coming week.
Gold - a sustainable gold rally will only eventuate if the Dollar breaks important support and embarks on a long-term down-trend (rather than a short-term correction).
The US Stock Market
Credit Expansion and the Stock Market
Here is an extract from the September 1 Credit Bubble Bulletin appearing at the Prudent Bear web site:
"Not coincidentally, we see that five leading Wall Street firms – Citigroup, Goldman Sachs, Merrill Lynch, Morgan Stanley Dean Witter, and Lehman Brothers – continue to aggressively expand their balance sheets. These companies combined to increase total assets (and liabilities!) by about $220 billion during the first-half, an annualized growth rate of 24%. Also during the first-half, non-federal debt (non-federal government and non-financial sector) expanded by $610 billion, or at a rate of 9%, the largest expansion since the first quarter of 1999."
The analyses presented at the Prudent Bear web site are almost always excellent, although we disagree with their resolutely-bearish position on the stock market. The huge expansion of credit that has powered the stock market over the past several years will eventually end and when it does the consequences will be painful. The most likely outcome will be a substantially-weakened Dollar, much higher nominal interest rates, surging consumer and producer prices, higher unemployment and much lower real-GDP growth. However, while the credit expansion remains in full swing it makes no sense to take a bearish stance towards the stock market (except on a short-term basis when the market becomes overbought, as it has been for the past 2 weeks).
Until a prolonged slowdown in the rate of credit growth gets underway, cyclical bear markets will be short affairs. Even in the absence of a high credit growth rate, nothing terrible will happen to the stock market as long as market interest rates remain relatively stable (although the rapid expansion of credit is needed to push the market higher). Surging energy prices, a rising copper price and what looks like the beginning of another upward leg in the bull market for commodities are not problems for the stock market (outside of the companies whose costs are directly and substantially affected by changes in commodity prices) unless this commodity price strength causes a sharp rise in market interest rates. In fact, an environment in which commodity prices are rising in parallel with stable/falling interest rates is positive for the equity markets since it implies the dual benefits of strong growth and cheap money. Unfortunately, it is an environment that cannot possibly be sustained for an extended period since bond prices will eventually succumb to the downward pressure imposed by heightened fears of inflation.
Current Market Situation
Last week we said that "…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." So far the correction is developing in line with our expectations and we would not be surprised to see a low take hold over the coming week. The December S&P now replaces September as the nearest futures contract and any further decline over the next few days should hold in the 1480-1500 range, basis the Dec S&P (Friday's close was 1519). For the NASDAQ, a fall of around 5% from current levels would probably complete the pullback. If the downside can be contained as mentioned above, then the ensuing rally into mid-October could be quite substantial.
We have been watching Copper Mountain (CMTN) for evidence of a bottom prior to adding this stock to the TSI Portfolio. At Friday's close of around $50 the company's P/E ratio is less than its growth rate, meaning that the risk/reward balance for this stock is now very favourable from a fundamental perspective. We therefore plan to purchase it early next week (hopefully below $50), despite the absence of any technical confirmation that a bottom is in place.
This week's important economic/market events
| Date |
Description |
| Sunday September 10 |
OPEC Meeting |
| Wednesday September 13 |
Deadline for PLO statehood declaration
Report on August import/export prices |
| Thursday September 14 |
ECB Meeting
US PPI |
| Friday September 15 |
US CPI
Industrial Production / Capacity Utilisation |
Gold and Gold Stocks
Gold, oil and the currencies
If you haven't already done so, please read our latest Interim Update (http://www.speculative-investor.com/interim.htm) where we show a comparative chart of oil and the Swiss Franc and explain that oil price strength may be indirectly putting downward pressure on the gold price by boosting the strength of the US Dollar relative to its European counterparts. We're not sure of the reason for the inverse correlation between the oil price and the SF over the past 2 years, only that it exists. In general terms it is clear that the same forces are driving the SF lower (the Dollar higher) and the oil price higher.
In the Interim Update we posited that the Dollar might be benefiting from a rising oil price, relative to the major European currencies, because the US economy is perceived as being in a better position to cope with higher energy prices. We also mentioned that if a rising oil price was, in fact, putting downward pressure on the European currencies, the situation would be self-sustaining. This is because a weakening currency exaggerates the impact of a higher USD oil price, thus further depressing the currency.
There could, however, be a more basic cause to the strong inverse correlation observed between the SF and the oil price over the past 2 years. The oil price began to rise at the beginning of 1999 and, at the same time, the SF embarked on a major downward trend. It may not be just a coincidence that the Euro was introduced in January 1999. The Euro has clearly disrupted global capital markets by encouraging investment funds to exit Europe and to enter the US, turning what was already a steady out-flow into a flood. This incoming flood of investment has certainly contributed to US economic growth by keeping market interest rates below where they would otherwise have been and adding to the "wealth effect" experienced by many Americans. A fast-growing US economy has, in turn, consumed a greater quantity of oil. We therefore have the unusual scenario whereby global capital flows have caused a very strong Dollar to exist in parallel with a very strong oil price. When a bunch of politicians decided to bring a new European currency into the world they were always going to be stretching the 'law of unintended consequences' to the limit and we may now be starting to appreciate some of the consequences.
In the past, major up-trends in the oil price (and commodity prices in general) have often corresponded to periods of weakness in the US Dollar, leading many to mistakenly believe that there is a strong positive correlation between the oil price and the gold price. There is not. Gold tends to move inversely to the USD and with the European currencies, as the below chart illustrates. If the strength in the oil price and the weakness in the European currencies are, in fact, related, then a substantial gold rally will probably not begin until after the oil price has peaked.
