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High-Confidence Views

Below is an extract from a commentary originally posted at www.speculative-investor.com on13th March 2005:

The 12-month forecasts we can make with the greatest amount of confidence are, in no particular order:

a) The US$ will rise relative to the other major fiat currencies

b) Gold will rise relative to oil and the industrial metals

c) There will be a pronounced shift away from risk

The basis for our US$ forecast has been covered extensively in previous commentaries. We won't repeat our arguments today since nothing has changed, but we do intend to summarise the intermediate-term bullish case for the US dollar in one of our next two commentaries. We will now deal with the last two of these high-confidence opinions.

The reasoning behind our bullish view on gold relative to most other commodities was outlined in the "Gold versus Oil" discussion in the 7th March Weekly Update and the section titled "Confidence is high" in the 9th March Interim Update. It is summed up by the following extract from our 7th March commentary:

"The reason that gold is currently low relative to economically-sensitive commodities such as oil and the industrial metals is that confidence in governments and their central banks remains high. However, if confidence is near a peak and is about to embark on a lengthy decline then a substantial upward re-rating of the gold price relative to the prices of oil and most other commodities is inevitable."

One way to clearly see the effect that a sea-change in confidence has on the relative performances of gold and the more economically sensitive commodities is to compare the relative stock-market performances of gold producers and copper producers with the performance of the stock market as a whole. When the broad stock market is rising it usually means that the general level of confidence is also rising, and vice versa, so what we would expect to find is that gold stocks out-perform during intermediate-term downtrends in the broad stock market and under-perform during the intermediate-term up-trends. Fortunately, this is what we do find when we look at the empirical evidence (we say fortunately because it's helpful when the markets behave in a way that makes sense). For example, in the below chart comparison we've used the AMEX Gold BUGS Index (HUI) as a proxy for gold stocks, Phelps Dodge (PD) as a proxy for copper stocks, and the NYSE Composite Index as a proxy for the broad stock market. And what stands out is that a period of dramatic out-performance by the gold stocks began shortly after the September-2000 peak in the broad stock market and continued until the stock market bottomed in October of 2002. Thereafter, it was the turn of the industrial metal producers to out-perform for an extended period.

Further to the above, IF the broad US stock market is within a few weeks of commencing a 1-2 year decline (we think it is) then it is extremely likely that we are close to the start of another major upward trend in the gold sector relative to the industrial metals sector.

Moving on, our belief that there will be a pronounced shift away from risk really just encapsulates many of the other things we expect to happen over the coming year. In an environment where investors are becoming more risk averse, for instance, we should see gold out-perform most other commodities and a generally poor performance by the broad stock market. But there's one aspect of this expected shift away from risk that we'd like to focus on right now and that's the high probability that credit spreads -- the differences between the yields on bonds of differing quality (risk) -- will widen.

Below is a chart showing the Salomon Brothers Emerging Markets Income Fund (EMD) -- a fund that invests in the dollar-denominated bonds issued by the governments of emerging-market countries such as Brazil, Mexico, Russia, Colombia and Turkey -- and the US T-Bond. A rising trend in the EMD/Bond ratio indicates that credit spreads are falling, that is, that investors are becoming more willing to take on risk, whereas a falling trend indicates the opposite. Clearly, there has been a strong trend TOWARDS risk since October of 2002. This, in turn, has been a result of the massive liquidity injection into the global financial system facilitated by the Fed and other central banks. At some point, though, central banks will be forced to make the liquidity 'dry up' to prevent inflation expectations from getting out of hand, and the first two years of the current US Presidential cycle are a likely time for such a 'drying up' to occur.

As things currently stand the emerging market economies look strong, but this strength has a lot to do with the trend towards risk that began in 2002. Like most trends this one is self-reinforcing in that a shift towards risk results in more capital flowing towards the emerging markets which then makes these markets appear fundamentally stronger, thus attracting more investment and so on. This is what George Soros refers to as "reflexivity" whereby changes in perception cause changes in fundamentals, which, in turn, feed back to cause changes in perception. An implication of this self-reinforcing process, though, is that once the trend reverses it will become self-reinforcing in the opposite direction.

And what will cause the trend towards risk to reverse cours

As mentioned above, the current trend was set in motion when central banks threw caution to the wind and decided to facilitate a massive injection of liquidity into the global financial system. In particular, it began shortly after the Fed became an OVERT promoter of inflation as opposed to its historical role as a covert promoter of inflation (recall Governor Bernanke's Q4-2002 comments about cranking up the monetary printing presses and dropping money from helicopters). Therefore, if it doesn't end of it's own accord then the current trend will likely end when the Fed does something or says something to create the impression that financial market conditions are about to become considerably tighter. By the way, it's quite possible that the trend has ALREADY changed but that a few more months will transpire before the evidence of this change becomes obvious in most price charts.

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