Monthly Portfolio Review & Outlook
2004: A Year of Reversals?
13 January 2004

By Ed Bugos

Please note that the performance figures for the BGI gold stock index above reflect a revision to October's data. I switched the index from a price-weighted to geometric return index in February 2003, and didn't realize my new program was double counting the adjusted cost base (the denominator in the return formula). Ergo, it was understating the value of the BGI.

The figures I used in the Jan 2nd issue (Give It to the Monkey) in the section on our report card were correct, because I had computed them by hand, which is how I discovered the error in the formula calculating the index in my spreadsheet.

See the table to the right for a history of changes to the index components as well as increases and decreases in our allocation for anyone that would like to confirm our data. My apologies if it caused any inconvenience.

Unlike 2002, the performance of our allocation model was closer to mediocre in 2003 in light of the gains made elsewhere.

(see our Jan 2nd report to review the report card on our gold stock decisions in the BGI Index throughout the year).

Mainly weighing down the performance of our outlook last year were subpar returns in some of our gold stock selections, the subpar returns in some of our minority positions - like oil and the CRB which were up less than 10% for the full year - and a short position against the broad (equity) market just as the averages went into orbit during the final quarter.

Our two thirds weighting in precious metals (shares and bullion) contributed most all of the gains in the year indicating that our move to concentrate our allocation on this sector in late 2002 was exactly right at any rate.

Clearly we are wrong to be short the broad market as of late, however. At least early.

As far as gold stocks are concerned, better performance could have been obtained had we added one of the silver stocks to the index (instead of just featuring them), and by moving down the risk curve to the more speculative plays - where the gains were most rewarding in 2003.

Still, a lot of people probably fared worse in 2003 than owning a couple of laggards in one of the hottest sectors of the market. Remember, there were many stock bears that remained short the broad market throughout the year, and many sectors that performed worse than the gold sector.

So what's in store for January, and the rest of 2004?

New Year Party Turns to Controversy Amid USD Bounce Attempt
The year started out with an inflationary bang as central bankers assured markets that the Fed would stay accommodative on monetary policy - i.e. yields would stay down - for as long as the labor market was slack, despite the reeling US dollar, and commodity prices challenging 15-year highs. What a buy signal for gold that turned out to be, especially since Friday's labor market news was indeed so bad.

But central bankers put a Band-Aid on subsequent market developments at a meeting in Switzerland this weekend by expressing their concern over the extent of the US dollar's weakness, implying the prospect of forthcoming intervention.

Then, almost out of the blue, an interview with Paul O'Neill (the prior secretary of the treasury in charge of US dollar policy) on "60Minutes" yesterday opened a fresh can of worms on the US-Iraq front.

O'Neill basically alleged that the Bush administration was intent on going to war with Iraq even before 9-11, and that it appeared disinterested in any opposite viewpoints, or the facts. The White House retorted that the policy for regime change in Iraq existed even before Bush got into office - it was an ongoing objective in other words - and that O'Neill was just trying to justify his opinions.

The word "attacked" is being used by both sides to describe the event. The Treasury is looking into whether O'Neill revealed confidential documents to reporters. So there's a bit of a flare up on the Hill. The development is significant because it's rare for Treasury Secretaries to get caught up in a war of words with the Oval Office. It's also surprising because I thought O'Neill was mostly in their camp on those matters.

Good for him for being honest! I doubt he meant to "attack" anyone. If anything, the use of the word and the potential retaliatory action by the Treasury is an indication that the administration is being a touch defensive.

Nevertheless, the greenback is showing some life this week. It could be fleeting, I dunno. But a case could be made for a bounce from an oversold position now. Central bank threats (vague as they are) of intervention appear to be giving traders the excuse they need to book some profits on their dollar shorts. Look to gold for a confirmation.

I think the likelihood is high that gold pulls back to the $405/410 range before running up to our higher targets. This scenario could be getting underway, but I'm looking for support to break at $420 before concluding it has arrived. Otherwise we remain bullish on gold, and bearish on the dollar in the short run (and long run - but not intermediate).

Initial Signs of Change in Gold:HUI Ratio: Since the peak in gold stocks - so far - a month ago, gold prices have surged $20 more points. They have surged $50 since we first started shifting the proceeds of gold share profits to support our bullion longs at the end of August.

In that latter period, however, the HUI is up 26%, or twice the gain in gold prices. So our timing isn't perfect, but we are observing a change in the relationship I believe now. During gold bull markets, this ratio can trend downwards relentlessly, but not without retracement. And we see plenty of reasons why gold prices should continue to rise without the full participation of gold shares over the next month or two... or that such a retracement is likely in other words.

The chart above (Stockcharts) is a one year picture. The one to the right here is an 18-year history of the ratio of gold to the XAU (the HUI only goes back a few years) using my own data (average monthly prices).

As you can see, gold shares mostly outperformed gold itself during their bull market phase (according to this particular ratio at any rate) from 1985 to 1996, and underperformed gold during it's bear market years in the late nineties. This long term fact merely reflects their volatility.

However, it is observable that this ratio tends to perform best during periods of general stock market weakness, as well as during bear markets in gold. Consequently, it performs worst during bull markets in gold, and/or periods of broad market strength. The only exception to this fact in the past 18 years occurred between November 2000 and May 2001 when gold and stock prices were generally both weak, yet the ratio fell anyway.

Thus I believe it's anomalous.

In any case, what this suggests then is - if we're right about gold, bonds, and the Dow - that this ratio is about to turn up for anywhere from six months to two years. Hence, our rationale for shifting to bullion over gold equity.

The question is, does the action in the first chart above (specifically since December 3rd) confirm that upturn is around the corner, and thus that we'll be right about the Dow? Or is it just a congestion before gold shares explode to the upside and drive the ratio lower?

There is room for gold shares to move higher in the short term so long as the bond market continues to refute the bearish (bond) case, and any broad equity weakness is confined to an orderly correction in the averages.

But I do believe that increasingly, the odds suggest that bullion itself will outperform them in both the short and intermediate term, from current levels.

At the risk of being repetitive, I'm bullish on this primary bull leg until it hits my minimum target at $450. And I'm bearish on the US dollar until the trade weighted index hits its '92 low (78). But the gold shares are increasingly a real tough call here.

If the fourth wave in gold's primary sequence is complete, gold stocks may have already peaked. On the other hand, the fact that bond yields continued lower this year so far continues to underpin gold's momentum and to postpone even the small dip we're looking for... in other words, to extend the fourth wave if you will.

There are some bearish indications in the US producers' shares again this week, but the South Africans continued to shine. Shares of Goldcorp fell to below where we removed it from our index, while some of the other usual leaders are also limping - down to their December lows. Harmony on the other hand has soared since we added it to the index.

(Agnico Eagle has staged a comeback on bullish drilling results, and is a point higher than where we sold it, but still expensive on a cashflow basis - for my taste in a N.A. producer.)

Thus, the signals are mixed, with the HUI stuck in a sideways consolidation of sorts - it looks like a rotational correction at the moment as the market's interest seems to be shifting to the S.A. producers, silver shares, and Agnico Eagle, at the expense of yesterday's leadership.

If I were pinned to the wall to make a call, it would be for a higher high in the gold share indexes to put in a final intermediate peak in this trend sequence. So yes, I think we're close to a top here. The following section below is meant to illuminate my rationale and outlook for the remainder of 2004.

While we're on the subject of ratios, however, a lot of people have been observing the gold:oil ratio near the top end of its four year range.

While this is true, I thought a longer term perspective might be worth more than a thousand words (see chart).

I suspect there's lots of room for gold to outperform oil, even if I'm very bullish on oil. Imagine gold back up at 30 times the oil price - even if oil prices should drop to $20 a barrel! The trouble (for dollar bulls) is that we expect oil prices to shoot up to north of $50/barrel in 2004.

Bulls are eyeing the $40 level right now, and are making new contract highs almost daily - driven by a blast of unexpected cold weather in some of the highest energy consuming regions in the US (and Canada), ongoing supply shortfalls, and the prospect that OPEC will cut production at its Feb 10 meeting in order to head off a demand shortfall that some members think might occur by the second quarter.

Back to gold...

Gold's Correction will be due to Technicals, Election Rhetoric, not Rising Yields
The most relevant economic news of the week will be the government's price data for December due out Wednesday (PPI) and Thursday (CPI):

The core consumer price index is expected to have risen only 0.1 percent in December, leaving the annual rate at 1.1 percent or its lowest level since 1963. Just a week ago Fed governor Ben Bernanke warned that inflation was already near the bottom of the range the central bank would consider acceptable, so any further weakness in CPI will support those calling for no rate hikes for a long time to come - Reuters, 12 Jan 2004

Is it bullish or bearish for gold when the CPI drops? I know you know it's bullish. At the moment anyway. Look how gold's been reacting to a weak CPI all along. Of course, the reason it's bullish is because of what a weak number implies for monetary policy in these nutty times.

So does that mean it's bearish for gold when the CPI rises?

Sometimes, yes. But not simply because it means yields are likely to rise. The question is arising already, whether rising interest rates are going to cause the dollar to rise and gold to fall.

My answer is no.

Sometime over the next year I anticipate a correction in both gold and gold stocks of a larger extent than what has been seen thus far in the bull-stretch. This view is premised on several factors, including a technical assessment of the primary sequence in gold that began either in 1999 or 2001, the significance of the break through $420, as well as the likelihood for a "meaningful" US dollar bounce and higher yields.

However, the latter two developments are going to be a function of gold, not the other way around. Strong gold prices push yields up sooner or later, and weak gold prices will ultimately lay the footing for a dollar bounce. So the question really is, when gold corrects, and the dollar bounces, shouldn't yields fall?

Not quite, because the intervention driven buying of Treasury bonds will likely dry up on a dollar bounce, and bonds can more easily float to their real levels - which we argue to be lower in price.

Gold's breakout through the 1996 high ($420) signals a major bull market so obviously even the first year student of technical analysis could spot it, especially if our $450 minimum target is reached to confirm it.

However, if the move started in 1999 - as I believe it did - we've just finished year four (in Oct '03) of this move, which means it's getting a little long in the tooth relative to most similar chart sequences historically. I have found that primary bull and bear legs generally tend to last from two to four years in most all tradable things.

Apply it to the Dow for instance, just because it's a market people know. Studying the bull market that ran from 1984 to 2000, there were four meaningful corrections to the primary sequence - in 1987, 1990, 1994, and the period 1997-1998 saw two steep pullbacks before the great bull market finally ended in 2000, or 2001. Some say that 1998 was the end since that's when the advance/decline line peaked.

Let me qualify this. As a rule, the faster the moves are - up or down - the shorter the time they need to spend moving in that direction.

Gold bull markets tend to be much faster and shorter, presumably because they reflect a bust sequence in the currency. Boom/bust sequences are asymmetrical, which simply means that booms tend to grow gradually while the busts happen much faster.

Moving back to our argument, the case for a bounce in the dollar is similarly technical. In the dollar's case, it has fallen more consistently if not faster than gold has risen (in the period that began Feb 2002). Moreover, the trade weighted US dollar index is only about 7 points away from its lowest level in 20 years. That record is currently defended by the low made during the fall of 1992 at 78.43.

The current slide is thus two and a half years old and 30% under water. The market already looks oversold, and we're approaching the 1992/1995 lows (78 to 80) where there ought to be some kind of chart support.

Two political factors are also weighing into our outlook: the US Presidential election, and the upcoming decisions on whether and by how much to extend the Washington Agreement on gold that expires this next September.

Gold's bull market signal is dangerous ground for bond-holders, because it suggests the likelihood that yields will go up in 2004. The thing is, the President is not going to want that happening during his campaign effort since his voters are by and large cash strapped home-owners already suffering from skyrocketing fuel prices.

In order to ease the inevitable adjustment in bond yields, the strong dollar policy must be effective, and that includes both currency interventions as well as the targeting of gold prices - necessarily from their point of view, in order to succeed. Central bankers will probably target gold in at least two relevant ways - besides the usual:

• with the rhetoric associated with dealings on the Washington Agreement beginning sometime at the end of the first quarter I'm guessing by past reports, and
• by claiming that rising yields will quash the growth in inflation expectations that threatens to become more apparent now that gold has breached $420.

However, rising yields are only truly bearish for gold if they are the product of a serious tightening of Fed policy, rather than merely a pricing in of inflation expectations, or risks, before they're set to grow further. In other words, so long as the Fed lags the market in pushing up interest rates, money is not tight because it suggests that the official interest rate is kept below market.

We should be able to monitor this through the behavior of the inflation premium and yield curve, as well as the rate of growth in money & credit. At the moment, our presumption that the Fed is going to remain timid on policy rests with (aside from recent speeches) the hypothesis that they know that if they shifted to tight money at current stock and bond market valuations, they'd cause an accident... for the currency as well.

Nonetheless, as is the case with the dollar - where Fed representatives have shrewdly planted the seed that the dollar's weakness is a deliberated policy - when yields go up, out will come the bearish gold talk by analysts everywhere, starting with those closest to the Fed... specifically, implying that rising yields are bearish for gold, as if the Fed was making them rise all along in order to fight off the growth in inflation expectations that will actually be driving them higher.

The convenience of that angle doesn't stop with gold. If the dollar is due for a bounce, technically, and a rise in yields upsets stock markets, it would be a good time to start promoting deflation fears again... to cause yields to drop. The key is in the timing. Rhetoric alone is not sufficient to cause a trend, but it's sufficient to fuel one. In other words, if the current gold sequence were to become overextended...

However, a new bear market leg in both stocks and bonds would be "fundamentally" bearish for the US dollar because the world is overowned in dollar assets, which is why I believe the Fed is not able to shift to a tight monetary policy at the moment.

In fact, the real issue is how they'd react to an upset in the stock market specifically. They can promote deflation fears all they want, but if that causes them to open the money spigot wide, it amounts to building a new base for gold.

Anyway, I'm moving too far out on this. There are many more possible scenarios no doubt. But it's this one that seems to be coming in over the horizon of my outlook.

To summarize, I expect gold's break to new 15-year highs to result in higher yields in 2004, and then to fall into a corrective mode until after the US election (at the longest), while the US dollar bounces, and the major stock market averages make a new bear market low in the interim.

My rationale for the resumption of the bull market in gold to begin after the election is that the political motivations opposing gold will have diminished by then, and because most corrections to a primary trend tend to last from 9 to 18 months. However, much rests with the conduct of monetary policy between now and then.

Rhetoric aside, I don't foresee a shift in Fed policy to tight money. The correction in gold that I foresee is mainly related to technical factors (and rhetoric) in my outlook, not the anticipated rise in yields. Similarly, the bounce in the US dollar will also be related to technical factors (and policy), not the anticipated rise in yields.

Of course, these outlooks are always subject to change; I'll keep you appraised. For now, let me just say that I don't think we're there yet.

Intervention Noise Confirms USD Bounce Hypothesis
Europe has two immediate monetary problems. The first is the strength of European currencies (notably the Euro, Pound, and Swiss Franc) on foreign exchange markets. The second is the potential that this strength does not translate into lower prices domestically, as it did for the United States economy during the late nineties' dollar bull market when the USD price of oil was a third of today's levels.

The reason I mention it is: "Raffarin (French PM), making his traditional New Year's address to the press, said that inflation remained too high in France. The latest readout on French inflation showed it was still above the two percent threshold that is used by the European Central Bank" - Reuters, 12 Jan 2004

Truthfully, I don't know what to make of it except to wonder whether that played into the ECB's recent rate decision (i.e. not to drop them as some expected) in spite of the strong Euro.

At any rate, G10 central bankers met in Basel, Switzerland this weekend reportedly to discuss the weak US dollar, as well as Basel II (a regulatory accord on capital adequacy standards integrating an increasing number of banking systems throughout the world) and the scandal involving Italian dairy group Parmalat.

The message on the currency issue was to show discomfort towards further instability. China's central bank said it would be prepared to float the Yuan against the US dollar after "financial reform." I don't know if they meant Basel II. China's central bank has resisted floating the Yuan apparently because it isn't confident that its banking system is efficient enough to deal with the two way flow of funds.

"Actually the Chinese government and central bank have said we have agreed to gradually reform our exchange rate regimes and our target is that ultimately we will use the floating exchange rate. That is not for today. First we should wait," (central bank governor) Zhou told Reuters on the sidelines of the meeting. "We need to do some reform in the financial sector and capital account. So logically we should do this step by step." But revaluation of the yuan was not very urgent at this stage, Zhou said, as upward pressure on the currency, which is pegged at about 8.3 to the dollar, was waning. "As trade balance changes, the economic situation changes, and the U.S. economy picks up very quickly, it seems things are changing. (Upward pressure on the yuan) is much weaker," Zhou told reporters - Reuters, 12 January 2004

Europe's leaders, meanwhile, also appear uncomfortable about the strength of the Euro. I can imagine two reasons: a) it cuts into export profits (which the economy somewhat depends on), and b) if the Euro is too strong, when it falls it will fall too fast for a central bank that is trying to build confidence in a new currency (especially if prices are going up even while it's strong).

Current ECB President Jean-Claude Trichet said as much: "Trichet, speaking after a meeting of G10 central bankers in Basel, Switzerland, said: "There was a mention by Europe that excess volatility and brutal moves were not welcome and not appropriate. We are concerned. We are not indifferent, he added" - Reuters, Jan 12

So there seems to be a consensus developing among central bankers now that the US dollar is too weak, or at least that currencies are too volatile. My question would be, what are they going to do about it?

Whatever they're going to do it's been discussed, or it's being discussed. It's unlikely that the US will join in on any official intervention publicly any time soon. But it's clear that political pressures are moving in that direction.

Edmond J. Bugos

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