Tharp’s Thoughts

Market Update for May 2004

By
Van K. Tharp

Now that Safe Strategies for Financial Freedom is  available, we will be giving you a monthly update of the models in the book on the last Wednesday of each month.

This is the first of many such updates.    In these updates, we’ll be covering each of the major models mentioned in the book:  1) the 1-2-3 stock market model; 2) the five week status on each of the major stock U.S. stock market indices; 3) our four star inflation-deflation model; and 4) our three part dollar tracking model.  

Part I:  The 1-2-3 Stock Market Model.

The stock market model has been in Yellow light mode since April 2003 and during that time the overall market has risen over 20%.   We expect that a red light signal could come any time.  After all, for that to occur all we need is for the SP500 to drop below its 45-week moving average or for the Federal Reserve to start raising interest rates.  Either one could come any time.   And then again, neither one could come before the end of the year – after all it’s a presidential election year.

Anyway, be careful here, I’ve taken two short positions in the NASDAQ based upon short patterns (without waiting for the red light mode to occur) and in each case, I’ve had to take a small loss.

Here are  a few things to watch out for:   First, we’re in a secular bear market and we are now overdue for the second leg down.   Second, we’re in a presidential election year.  Expect the Republicans to do everything they can to make the economy look good (including data manipulation and possibly even using “The Plunge Protection Team” to prevent a major downfall.  Third, we’ve just entered the weak part of the market, April), the market often starts to fall.  And May through April is typically a very weak time for the market.

Part II: The Five Week Status of Each Major Index:

All three major stock market indices are down of the last five weeks.   However, except  for one week with the NASDAQ, the  drops have been relatively minor.   For example, only during the week ending April 30^th, do we see any examples on indices dropping more than 2.5% -- which is typically the criterion for action.   However, please not that all three models are down over the last five weeks, which suggests that our 1-2-3 model moving into red light mode may not be that far away.

The chart below illustrates that the SP500 has come very close to touching its 45 week moving average recently.

The table below shows the five week status of each of the major markets.

Part III: Our Four Star Inflation-Deflation Model.

As mentioned in Safe Strategies for Financial Freedom, we are due (in terms of cycles) for a deflationary bear market.   And, indeed, there are major deflationary forces at work in the world today.  These were listed in the book. 

The United States at this time is a huge debtor nation.   Our government has the largest debt of any nation ever  (probably over 35 trillion including future obligations).  Our corporations have huge debt and individual also have huge debt.   As a result, the Federal Reserve has stated that it will do whatever it takes to make sure that we do not have deflation.   This means turning up the printing presses.

However, the printing presses are currently fighting the deflationary forces.  And the net result, right now is that inflation seems to be slightly winning.  Here’s a recent comment from Richard Russell on what’s happening.

Richard Russell (5/24/04) – “The BS is over. Surprise, even the Fed can't hide inflation any longer. Everywhere you look or read, the talk is of higher prices. Yeah, the bond market knows it too. Check this -- the yield on the 10 year T-note this morning was 4.74%. The yield on the inflation-adjusted 10 year T-note (TIPS) was 2.02%. The differential was 2.72%, near a seven-year high. That 2.72% is the bond market's expectation of the average rate of inflation over the coming ten years. This differential is up over 100 points in the past year. Inflation is so obvious that even Greenspan can't deny it any longer.”

Anyway, people’s opinions don’t really count in terms of assessing inflation vs deflation.  What does count is what the model is showing us.    Consequently, we presented a four start model in Safe Strategies for Financial Freedom – the model says that the more stars, the more likely we are to have inflation.  Let’s look at those four factors.

Commodities Prices are definitely going up – They have been in a slight correction so the short-term price trend is down, but the long-term price trend definitely favors inflation.  Thus we have our first star.

Consumer Price Index – Consumer prices are starting to show inflation even though the government tends to exclude those factors of the economy that would show the most inflation such as oil prices.   However, the trend is definitely up – although so far at only a 2% annual rate. Thus, we have our second star.

Gold Prices – Gold hit its high in March and has been going down for the last two months.   On a weekly basis the price trend is down, but on a monthly basis the price trend is definitely up.   This one is definitely a little questionable, so we’ll only give gold a ½ star rating.

Interest Rates – Short term interest rates are staying low and long term interest rates have been going up for the last two months.   This again points to inflation.   Thus, we have another star here.

What’s the net result?  The picture hasn’t changed much.   We have 3.5 stars pointing toward inflation.   Expect an inflationary bear market scenario.

Part IV: Tracking the Dollar

I was in Switzerland last week.   A Big Mac Meal was selling for almost 10 Swiss Francs – which is about $8.50 in US dollars.   This certainly doesn’t compare with Big Macs selling in the US for about $2.79.   And while we haven’t seen a Big Mac Index from the Economist magazine for some time, we suspect that dollar is fairly well valued here.

The dollar actually reached its low of 84.43 in January of 2004 and has been rising for the rest of the year.   The May reading from the Federal Reserve was 89.32.   Thus, the long term trend of the dollar appears to now big up.

Fundamentals (i.e., with the main factor being the US debt) still suggests that the dollar has a long ways to go on the downside.   However, we could have made that argument for much of the last ten years.   Consequently, we’re calling our dollar position as slightly bullish, but that could change by next month.

What does this all mean for you?   If you are a long term investor, we’d suggest a cash position with a small position in gold.   Cash looks much more attractive with the dollar in a slightly bullish mode again.   However, be ready to make short positions in the stock market.   This looks to us like a position in which cash will be very strong in the near future.