Yearly Forecast

Below is a snapshot of how we think stocks, bonds, the US$, gold, gold stocks and commodities will perform during 2006. Hopefully, we will be able to adjust our expectations if/when the facts change during the course of the year.

  Overview

Last year the Dollar Index did the minimum we were expecting (rally up to the low-90s), but everything else -- stocks, bonds, gold, commodities -- did better than we were expecting. The reason revolves around liquidity. We had expected that a strengthening US$ would be accompanied by a contraction in global liquidity due to the combination of tighter monetary policy in the US and reduced buying of US bonds by foreign central banks (with the dollar trending higher it was expected that foreign CBs would grab the chance to reduce the rate at which they were purchasing US debt). The US$ rallied, the Fed did its part by flattening the US yield curve, but foreign central banks still bought close to $200B of US Government and Agency debt and the rate of liquidity creation outside the US accelerated. As things turned out, 2005 was a year during which a group of non-US central banks took over from the Fed as the primary driver of global inflation.

Despite being wrong about a contraction in global liquidity during 2005 we have a similar expectation going into 2006. The fact that gold was so strong in terms of the euro, the Pound and the Yen in 2005 is likely to prompt the central banks of Europe, the UK and Japan to be less accommodative. Also, the US real estate market has begun to soften and if this softening continues throughout 2006 (we think it will) then US homeowners will borrow significantly less money into existence this year than they have over the past few years and the main engine of global consumption (the US consumer) will run more slowly than it has in the recent past.

  The US Stock Market

Our expectation throughout the past 12 months was that 2005 would be a choppy year with a slight downward bias and that a large decline was likely during 2006. As things turned out, 2005 was a choppy year with a slight upward bias (the S&P500 ended the year 3% higher than where it started), but we see no reason to alter our expectations for a large decline in 2006. In summary, we expect that some strength during the first few months of 2006 will be followed by a tradable decline to a bottom during the final few months of the year. Another multi-year upswing would then get underway.

Over the past two years we've used two models -- the 1970s Model and the Nikkei Model -- to explain our outlook for the US stock market. Both of these models remain applicable, although in different ways.

The 1970s Model drew parallels between 1972-1974 and 2004-2006. In particular, the Presidential election year of 2004 was likened to Presidential election year of 1972 (both were years during which a Republican president was re-elected despite the country's involvement in an unpopular war). A rally during the months following Nixon's election victory in November-1972 led to the formation of an important top during the first quarter of 1973 amidst wildly bullish sentiment, but even though the market peaked in January of 1973 a major decline didn't begin until June of 1974. There were, in effect, almost 18 months of distribution before panic began to set-in. A similar outcome this time around would lead to the start of a large decline during the second quarter of 2006, which is our current expectation.

As an aside, the multi-year rally that ended in early-1973 was a counter-trend move within a secular bear market, which is exactly how we perceive the multi-year rally that began in March of 2003. Remember: secular bear markets do not necessarily involve large declines in NOMINAL prices. Instead, they involve declines in VALUATIONS (price-to-earnings ratios, price-to-dividend ratios, etc.) over many years and are usually most apparent when prices are measured in terms of gold. In other words, it is possible for inflation to prevent nominal stock prices from falling, but when this happens the gold price soars and stock prices tank relative to gold. The current secular bear market in US stocks will do what all secular bear markets do -- it will continue until valuations are low; that is, it will continue until the average P/E ratio is below 10 and the average dividend yield is above 5%.

From a longer-term perspective we think the Nikkei Model is appropriate. The following chart shows how the performance of the NASDAQ100 Index since its March-2000 'bubble peak' compares with the performance of the Nikkei225 Index from its December-1989 'bubble peak'. The intermediate-term twists and turns in the two markets don't match and there's no reason to expect them to match; however, the overall pattern of the Nikkei's secular bear market -- a large initial decline followed by many years of 'ranging' and then a final capitulation -- might be applicable to the NASDAQ.

  Bonds

In real terms, US bonds have been a poor investment over the past few years and will probably be a poor investment for many years to come. Current yields simply don't come close to compensating investors for the risks associated with bonds, with the main risk, of course, being that bond values will be eroded by inflation. Anyone who thinks that inflation is not a major risk at this time either doesn't know what inflation is or hasn't been paying attention.

During 2005 long-dated US Government bonds traded up and down, but ended the year close to where they began it. We wouldn't be surprised if something similar eventuated during 2006 with, for example, bonds moving lower during the first half of the year and then 'catching a bid' due to stock market weakness during the second half.

The main obstacle faced by bond bears over the past few years has been the huge demand for bonds coming from buyers that don't care about the inflation risk. Chief amongst these buyers are the central banks of Japan and China, but the Japanese public also played a big role prior to the final few months of 2005 (yield-hungry Japanese savers, unable to get more than 1.5%/year by investing in Japanese Government debt, have been large buyers of higher-yielding foreign bonds). The upward pressure on bond prices exerted by the aforementioned buyers has mostly offset the downward pressure exerted by the selling of value-oriented investors, leading to a wide trading range since the major peak in June of 2003 (refer to the following weekly chart of T-Bond futures).

Although the bond market has been frustrating for bulls and bears alike over the past 3 years, we think the overall pattern remains decidedly bearish. We expect the bearish fundamentals to eventually win out, resulting in the T-Bond price breaking down through its August-2003 and May-2004 lows. The question we can't answer with any conviction is: when will this breakdown occur?

There are easier ways to make money than betting for or against the bond market, but there is enough risk of a breakdown occurring during 2006 for us to re-establish an intermediate-term bearish view on this market. As far as the next 6 months are concerned, one of the main risks we perceive is that the Fed will not want to push short-term interest rates well above long-term rates because doing so would virtually guarantee a recession within the ensuing 12 months. We suspect that the Fed would have no problem with a modest inversion of the yield curve and would welcome a slowdown in economic growth over the coming year, but a recession is something they would almost certainly want to avoid. Therefore, either long-term interest rates will rise (bond prices will fall) over the next several months, allowing the Fed to continue its rate-hiking without causing a dramatic yield curve inversion, or the Fed will have to end its monetary tightening after one or two more rate hikes. The thing is, if the Fed were to signal that its rate-hiking campaign was coming to an end before the stock and/or commodity markets became seriously weak, bonds would potentially sell-off in response.

Although there isn't yet any evidence that the recent rebound in bonds is over, we don't think there's much more in it and are therefore downgrading our short-term view from "bullish" to "neutral".

  The US$

It was a lot easier being bullish on the US$ at this time last year than it is right now because at the beginning of 2005, in addition to the positive interest rate situation, there was a huge speculative net-short position in the dollar and the potential for the Homeland Investment Act to boost capital in-flows to the US. Interest rate differentials are still very much in the dollar's favour as we enter 2006, but whatever boost the dollar was going to get from the Homeland Investment Act has already happened and there is now a large speculative net-LONG position in the dollar.

Interest rate differentials are by far the most important intermediate-term drivers of currency exchange rates and the interest rate backdrop is likely to remain in the dollar's favour for at least another 6-12 months. Furthermore, changes in interest rate differentials tend to work on currency exchange rates with a substantial lag. For example, the following chart shows that over the past 6 years there has been a lag of around 15 months between major trend changes in the US yield-spread -- in this case, the yield on a 30-year T-Bond divided by the yield on a 3-month T-Bill -- and major trend changes in the Dollar Index. The chart's message is that the cyclical bull market in the dollar that began in January of 2005 is likely to continue throughout 2006.

Our expectation is that the dollar's recovery will continue throughout 2006. However, there will probably have to be a multi-month consolidation during the first half of the year in order to substantially reduce the speculative net-long position and set the scene for the next upward leg. This consolidation might have begun last month, but if not it should begin following a move up to the mid-90s over the coming 1-2 months.

  Gold and Gold Stocks

Gold and gold stocks performed very much as we had expected them to do during the first 8 months of 2005, but thanks to a big rally during the final 4 months of the year they ended up doing much better over the course of the year than we had expected.

We went wrong by concentrating too much on what was happening in the US, while the biggest boost to the price of gold and, in fact, the prices of many investments, ended up coming from outside the US. In particular, whatever effect a less accommodative Fed was expected to have was offset by the monetary largesse of other central banks. Also, the gold market was given a very strong and unexpected (by us) push when the Japanese public began piling into gold futures in response to the weakening Yen.

Here's an extract from the 12th December Weekly Market Update that outlines our current expectations for the gold sector of the stock market, as represented by the HUI, and the gold price. With the HUI having moved decisively above its December-2003 peak over the past few weeks the "red scenario" appears to be in effect.

"We've attempted to roughly map-out our expectations for the gold sector on the below chart comparison of the HUI (the top half of the chart) and the London gold price.

As noted in a previous commentary, the gold shares and the metal are out of synch in that gold is still in the first upward leg of its long-term bull market whereas the HUI is at the tail-end of the primary correction separating its first and second upward legs (it's first upward leg having ended in December of 2003). It is not necessary for them to move back into synch, although the blue lines on the chart depict a scenario that would, in effect, bring the shares and the metal into synch.

Under the "blue scenario" the rally in the HUI from its May-2005 bottom is considered to be a rebound within the context of an on-going primary correction and is projected to be followed by a final downward move to complete this correction. Due to the absence of enthusiastic public participation in the gold sector's rally over the past 5 months -- as underlined by the extraordinary withdrawal of money from the Rydex Precious Metals Fund in the face of a substantial gain in the fund's price as well as the lacklustre performance of most exploration-stage gold/silver stocks -- this final downward leg would likely not be as big as the declines that began near the ends of 2003 and 2004.

Under the "red scenario" the HUI's move up from its May-2005 bottom is considered to be the first intermediate-term rally within the context of a new major bull market leg. Under this scenario the current rally could extend into the first quarter of next year, although not likely beyond the first quarter of next year. A correction lasting at least 6 months would then get underway. We make the preceding statements because the intermediate-term rallies and the intermediate-term corrections during the HUI's first major bull market leg -- the one that began in November of 2000 and ended in December of 2003 -- lasted 6-9 months. The rally that began in May of 2005 is presently 7 months old, so if it were to duplicate the LONGEST intermediate-term rally of the 2000-2003 bull-market leg it would end in February of next year."

If the "red scenario" is in play then the first intermediate-term advance in the HUI's second major upward leg should end by early February at the latest. A reasonable expectation would then be a correction that lasts about 6 months and retraces about 50% of the preceding advance. This secondary correction in the HUI would, we think, coincide with gold bullion's first primary correction.

On a side note, there has been a lot of discussion at various gold-focused web sites about whether gold is still in the first phase of its secular bull market or whether the second phase began during 2005. We don't want to give the impression that such labels are important or worthy of much discussion, but our view is that the gold market is at the tail end of its first phase. Here's why:

a) A price chart of the US$ gold price shows a steady advance over the past few years with no sign of a primary correction. You can't go from "Phase 1" to "Phase 2" without a primary correction.

b) "Phase 2" is sometimes described as being a period when gold begins to rise in terms of all currencies, as opposed to just the US$. This makes no sense, however, because gold has been trending higher in terms of the major non-US$ currencies since 1999. The following chart, for example, shows the gold price from the perspective of someone outside the US. What we have is a steady upward trend beginning in 1999 and then an accelerated move away from the long-term trend-line to complete the first upward leg.

c) "Phase 2" is also sometimes described as the period when the pubic begins to cotton-on to what's happening, but the Commitments of Traders reports and the amount of money flowing into precious metal funds reveal no evidence of increasing public participation over the past several months.

Clearly, we will need to update the "Big Picture View" shown at the top of each Weekly Market Update to reflect the extension of gold's first phase throughout 2005 and, perhaps, into the first quarter of 2006.

Regardless of whether or not gold is able to hold above $500 over the next several months, the fact that it has at least temporarily exceeded its 1987 high ($500) and its 1983 high ($509) is important. The price action of the past few months has put another nail in the coffin of the idea that gold's rally from its 1999-2001 lows has been a cyclical, rather than a secular, phenomenon.

  Commodities

We expect the CRB Index to drop during 2006. However, in real terms commodity prices are very low despite the large rallies that have occurred over the past few years, which probably means that the commodity market isn't going to be the first domino to topple in response to contracting liquidity (assuming, of course, that we do actually get a contraction in global liquidity at some point). In other words, we probably shouldn't expect a large downturn to begin in the commodity market until after some of the major stock markets have begun to trend lower in earnest.

The copper market and perhaps one or two of the other base metal markets are special situations because if they've been manipulated higher by hedge funds, as we have suspected and as Frank Veneroso has argued, then sharp price declines could begin at any time regardless of what's happening elsewhere.