Here is an extract from commentary posted at www.speculative-investor.com on 10th August 2003:

Gold Stocks and Interest Rates

Over the past few years we've spent a lot of time discussing the relationship between gold stocks and interest rates. In particular, we've discussed how gold stocks, as a group, have a tendency to move in the same direction as the yield spread (the yield on the 30-year T-Bond minus the yield on the 13-week T-Bill). In other words, the environment for gold stocks tends to be positive if long-term interest rates are rising relative to short-term interest rates.

While we usually compare gold stocks with the difference between 30-year interest rates and 13-week interest rates, another way to look at this relationship is to compare gold stocks with the ratio of 30-year and 13-week interest rates. In fact, with short-term interest rates at such a low level it actually makes more sense to use the above-mentioned ratio in our analysis than it does to use the difference between long and short-term interest rates. This is because with the 13-week yield at, say, 1%, a 0.1% change in yield is very significant. However, if we calculate the yield spread as a difference, rather than as a ratio, a 0.1% change in the short-term rate would have almost no effect on our calculation.

Further to the above, below is a chart comparing the AMEX Gold BUGS Index (HUI) with the ratio of the 30-year yield and the 13-week yield. This chart clearly shows that the trends of the past few years are very much intact. It also indicates one potential cause of a change in the bullish trend for gold stocks. For example, in order to quell inflation fears the Fed will, at some point, be forced to raise short-term interest rates at a pace that exceeds the pace at which long-term interest rates are rising. This, in turn, would change the direction of the yield-spread's trend.

The US Stock Market

Current Market Situation

Watching the US stock market trade over the past 2 months has been only marginally more exciting than watching grass grow. At least, that was the case until last week. Last week's market action, however, was very interesting!

As discussed in 7th August commentary, the NASDAQ100/Dow ratio moved below its 70-day moving average during the first half of last week. This was potentially very significant because the early stages of every substantial decline in the market over the past few years have been characterised by weakness in the NASDAQ100 Index (a proxy for the large-cap tech stocks) relative to the Dow Industrials Index. We've chosen to use a cross from above to below the 70-day moving average in the ratio (as opposed to some other moving average) as a bearish early warning signal simply because the 70-day MA has worked well, in this regard, over the past 2 years.

Even though the market stabilised during the final two days of last week the NASDAQ100/Dow ratio had moved further below its 70-day MA by the end of the week. Therefore, we now have a strong indication that a major peak is in place for the NASDAQ100 Index (and, by the way, for the NASDAQ Composite Index).

But the market's confirmation that the peak in the NASDAQ100 is behind us wasn't the only interesting thing to happen last week because the market also provided some evidence that peaks in the S&P500 Index and the Dow Industrials Index are ahead of us. The evidence we are referring to is Friday's close by the Walmart (NYSE: WMT) stock price above its April peak (see chart below).

WMT has tended to lead the S&P500 Index at important turning points over the past 12 months. When WMT failed to exceed its April peak in June and July we therefore concluded that a bearish divergence had occurred. This divergence has, however, just been eliminated.

If WMT moves back below $57.50 without any significant follow-through to the upside then last week's signal will be ambiguous. However, provided there is at least $1-$2 of follow-through then the new closing high that has just been achieved by WMT suggests that we are still at least 6 weeks away from a peak in the S&P500 Index.

Below is a chart showing the S&P500/gold ratio (the S&P500 Index in terms of gold). The chart uses a log scale and shows that the rally during the first half of the year took the S&P500/gold ratio from the bottom to the top of its major downward-sloping channel. The channel that has defined 'the trend' over the past 3 years is, however, intact. The chart, as it is drawn, is consistent with other evidence that there has NOT yet been any change in the trends that have been in place over the past few years (for example, refer to the chart showing the performances of gold stocks and the yield spread included earlier in today's commentary). It also meshes with our view that even if the S&P500 Index moves to a new recovery high (as now seems likely) it will under-perform the gold price.

So, in summary, here's what we have:

a) The large-cap tech stocks, as represented by the NASDAQ100 Index, have most likely peaked

b) The S&P500 Index has probably not yet peaked in US$ terms

c) The S&P500 Index has most likely peaked in terms of gold

An expectation that the S&P500 and Dow Industrials will rally to new recovery highs over the coming few months fits nicely with our bond market view because after years of abnormal behaviour (years when bonds almost always moved in the opposite direction to stocks) stocks and bonds have, over the past 4 months, spent most of their time moving in the same direction. For example, stocks and bonds rallied together during April-June, but as soon as bonds topped and embarked on the initial sharp decline in what we believe to be a new bear market the stock indices began to consolidate. As such, when bonds experience their first large bear-market rally the stock market should benefit.

Note that although new recovery highs are probably in store for the S&P500 index over the next few months, in the short-term (the next few weeks) the stock indices are likely to fall. In fact, they have the potential to fall quite sharply.

Big Picture Update

Since the beginning of this year our 'big picture view' has been that the stock market would drop below its October-2002 low during 2003 and that a major bottom would occur during 2004. However, it now appears as though the recovery rally in the S&P500 Index is not going to peak until at least October of this year. If this is the case then unless the market crashes there won't be enough time left in the year following the peak for last year's lows to be breached. It is, though, likely that things will unravel quite quickly once a peak in the stock market and a secondary peak in the bond market are in place and we therefore still expect a major stock-market bottom to occur during 2004 (probably during the first half of 2004).