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Year 2001 Forecast

Following is an extract from the "Year 2001 Forecast and Year 2000 Review" that was recently posted at The Speculative Investor Web Site.

The Major Trends for 2001

Below is a list of what we think will be the major trends in the financial markets over the coming year and, perhaps, beyond. This list represents our 'big picture' view as of January 2001 and will be adjusted, as needed, as the year progresses. Understanding the major trends at work in the markets hopefully prevents One from getting thrown off-guard by the daily, weekly and monthly price fluctuations and the 'news of the hour'.

In most cases the reasoning behind each of the following items has previously been outlined in one of our weekly commentaries. Rather than repeat the explanation here we will simply reference the relevant Weekly Market Update (WMU) or Interim Update (IU).

The markets will no doubt take a few unexpected twists and turns during the year. We will do our best to identify these "twists" as they occur and adjust our strategy as needed.

1. Currencies

We devoted a lot of time, during October and November last year, to explaining why we thought the US Dollar had peaked and was about to embark on an extended decline. Price action since the Dollar's October 26 peak has increased our confidence that we are in the early stages of a USD down-trend. We expect that down-trend to continue throughout 2001, interspersed with the occasional counter-trend rally. The reasons behind our medium-term bearish view on the Dollar and bullish view on the European currencies (euro and SF) were summarised in the Dec-04 WMU and in our article "The Fall and Fall of the Euro".

As discussed in the Nov-27 WMU we are extremely bearish on the Yen beyond the next few months. Over the past few months the Yen has been excessively weak due to a combination of a) negative news on the Japanese economy, b) aggressive Yen-printing by the BOJ, c) the withdrawal of foreign money from the Japanese equity market, d) a resurgence of the Yen carry trade, and e) speculative selling. At the time of writing (late January) the speculative net-short position in the Yen is huge and, with a worst-case scenario already seemingly discounted by the market, a substantial counter-trend rally in the Yen is likely during the first half of the year.

As noted in the Jan-10 IU, we expect the Australian Dollar to be one of the best-performing currencies in 2001.

2. Interest Rates

The major trend in long-term interest rates is DOWN (the major trend in bond prices is UP), as outlined in the Dec-04 and Jan-15 WMUs. However, we expect that trend to be tested this year in response to an increase in the rate of inflation. The Fed has begun a rate-reduction/reliquefication cycle at a time when commodity prices are near multi-year highs and the year-over-year growth in liquidity is still running at a healthy clip. We doubt that this will go unnoticed by the bond market and a much higher inflation premium will eventually be built into long-term interest rates.

3. Gold and Gold Stocks

The weakening Dollar and higher inflation discussed in items 1 and 2 above create an ideal environment for a rally in the prices of gold and gold stocks. With the Fed trying to push short-term interest rates lower we should also see a rising yield spread (long-term rates increasing relative to short-term rates). As outlined in the Jan-17 and Jan-24 IUs, gold stocks often rally after the yield spread begins to rise.

Further to the S&P500/XAU ratio chart presented in the Dec-04 WMU, we expect gold stocks to substantially out-perform the S&P500 over the next 12 months.

4. The US Stock Market

We explained, in the Jan-15 and Jan-22 WMUs, why we do not think the US bubble has burst. A characteristic of this bubble is that equity returns and bond yields move in the same direction (in a 'normal' market they tend to move in opposite directions - rising interest rates are 'normally' associated with falling equity returns). If the bubble remains in tact with long-term interest rates moving higher as discussed above, then this could be an UP year for the stock market (the S&P500) in nominal Dollar terms. However, Dollar-depreciation should ensure that it is a DOWN year when the S&P500 is measured in terms of gold.

This year's preliminary forecast for the stock market is Up into April (but with a nervous pullback during February), DOWN into September (probably giving us new yearly lows for the S&P500), and then UP into January 2002. Our thinking has changed during the past month because it is now clear that the Fed is determined to short-circuit the 'liquidity cycle'. The Fed has recently demonstrated a willingness to 'reflate' earlier and more aggressively than it has in past cycles. By doing this the ultimate stock market bottom (and an investment-grade buying opportunity) will probably be delayed until well into 2002.

5. Commodity Prices

If we are correct in our view that the supply of money will continue to be expanded at a rapid pace then commodity prices will remain in a major up-trend, although a downward correction is likely during the first half of 2001.

In the Jan-15 WMU we used a chart comparison to illustrate the lead/lag relationship between bond prices and copper prices. If bond prices peaked on Jan-03 of this year, as is our current thinking, then the copper price should bottom and turn upward by June.

The supply/demand equations for oil and natural gas are very bullish. The capacity utilisation for electric and gas utilities was 93% during the final quarter of 2000, the highest since 1973. And, with the monetary authorities making an all-out effort to maintain liquidity at a high level the total demand for energy is probably not going to significantly decrease. However, the oil price got ahead of itself in Sep-Nov last year and the natural gas price went 'parabolic' in December. Both are now consolidating in preparation for a resumption of their bull markets. This consolidation/correction phase will probably extend into the second half of this year.

Investing and Trading

The "buy and hold" approach to the stock market worked quite well during the 18-year period ending in 1999 and it worked extremely well during the 1990s. The following chart illustrates that between January 1991 and October 2000, apart from a very brief and shallow dip during 1994, the 12-month return on the S&P500 did not go negative. In other words, an investor could have purchased an S&P500 Index Fund at any time during this period and, 12 months later, he/she would have had a profit. What most investors do not realise is that the US stock market's performance over the past decade does not represent normality, it represents an aberration. When the S&P500's 12-month rate-of-change moved into negative territory late last year it may have signaled the end of the "buy and hold" era. Of course, even if this turns out to be the case it will be years before 'the herd' recognises the shift that has taken place in the investment landscape.

One of our goals for 2001 is to trade less frequently. However, this may not be achievable as all trends are likely to be short-lived.

Steve Saville
Hong Kong

2 February 2001

The reader is invited to respond to Mr. Saville's wisdom via email:
sas888@netvigator.com

Regular financial market forecasts and analyses are provided at our web site:
http://www.speculative-investor.com/new/index.html