Spring Break Comes to the Market

Includes: CHN, GLD, UDN, USO, UUP
by: Dr. Stephen Leeb

Today's outlook reminds us of the old Irish blessing, “May you be in heaven half an hour before the devil knows you're dead.” The good news is that the short-term picture looks considerably brighter. For the next month or two, we expect to enjoy a temporary reprieve from the long-term trends. Too bad it won't last.

Thursday morning the euro hit a new four-year low, which ironically may be a positive event for the European countries. It should benefit European exports, which will boost the European economy. That in turn should help put a floor under the euro. Combined with the nearly $1 trillion bailout package announced last week, this should help stabilize the continent's current drift towards recession.

Of course a cheaper euro may not be such a good thing for U.S. exports. Our dollar is an innocent beneficiary of euro weakness and has risen accordingly. However, the business cycle in the U.S. is in a powerful trend. As my friend at the Economic Cycle Research Institute pointed out to me the other day, the group’s leading indicator shows the business cycle is in our favor. One sign of this is the recent uptrend in employment. We've gained 200,000 jobs recently, a move which will inspire more people to look for work and it implies more spending and growth.

Another near-term positive is the recent decline in commodity prices. Copper, oil, and other industrial materials have corrected sharply, which bodes well for business costs.

All these factors add up to another possible rally in the U.S. markets, in addition to a possible bottoming of both European stock markets and the euro. It could also indicate that gold may hit some short-term resistance at around $1250 (before resuming its long-term upward spiral). This is the first time we've seen any resistance in gold prices for some time, so it's probably due.

But while we enjoy this brief Spring Break, let's not forget that the long-term trends remain unchanged.


In the months to come, we expect to see the long-term trends reassert themselves, most notably in China.

The Shanghai Composite Index, the most-watched Chinese stock index, has taken a steep 20% plunge so far this year. While that decline overstates weakness in Chinese stocks in that other indices such as Hong Kong’s Hang Seng Index is only down 10%, it still adds up to a buying opportunity. Perhaps the safest investment and maybe the best is the closed-end China Fund (NYSE:CHN).

China Fund offers you the easiest way to get broad exposure to China, and it's currently 7% off its high – so it has outperformed both the Shanghai Index and the Hang Seng. (While China Fund remains our top Chinese pick, we would also have no quarrel with investors who want to follow George Soros in picking up shares in China's largest e-commerce company, Alibaba.)

When trying to figure out China, you must remember that the rules are different over there. The government has more flexibility in managing the economy and can take more focused action.

For example, the Chinese government's efforts to curb the property bubble have probably paid off. Property prices at the high end have already started to come down – and may come down sharply. That may surprise Western analysts who currently are calling for higher interest rates in China. It's more likely that China has now come to the end of its interest rate tightening cycle, which it accomplished by specifically targeting higher-end urban properties. General monetary measures have been restricted to three relatively minor rises in the reserve ratio.

Now China can return to its major long-term trends of increasing infrastructure and urbanization, and – utterly critical – creating a country that is to the greatest extent possible energy independent. We expect this will require...

1) Lowering interest rates.

2) Allowing the yuan to gain value vs. the U.S. dollar.

While these two policies might seem to contradict each other, they make perfect sense when looking at China’s long-term goals. A rising yuan looks like a deflationary event, since it will raise prices for Chinese exports. But that is the direct effect. A rising yuan will also lower the price China has to pay for commodities, which might even offset the rise in exported goods.

Lowering interest rates tends to be reflationary, since it stimulates growth. Not many countries try to stimulate growth and revalue their currency at the same time. One reason is that virtually no other major country would be in a position to do both at the same time. But China is, and from their perspective it is likely to lead to a wonderful combination of stronger growth and lower inflation.

Ironically, lower rates will stimulate lower-end housing demand – and urbanization – without boosting higher-end demand. Again, demand at the high end has been stopped in its tracks by very specific measures. (Does anyone really believe that “bubbles” in China are analogous to “bubbles” in the U.S.)

As we mentioned above, commodity prices have retreated – possibly a result of less Chinese buying. After all, if you know you're going to let your currency rise, why not wait and buy those commodities when your currency is worth more? In 2005 commodities took off after the yuan rose. The world was a lot different then, but it is worth noting that despite robust worldwide growth in 2004-2005, commodity prices were essentially flat for seven months prior to the Chinese revaluation in mid-2005. So, at the risk of sounding conspiratorial, the current retreat in commodity prices should not surprise anyone who closely follows the Chinese.

Similarly, the worse people think China is doing, the lower commodity prices will go, and the bigger the bargains will be after China cuts loose the reins on the yuan. That's when Chinese buying will pick up sharply and prices will start climbing again.

When commodity prices approach and past previous highs, our Spring Break will end. Higher prices will put more pressure on the economies of developed nations like Europe and the U.S. Divisions within the European Union, and especially the European Monetary Union, will increase as the effect of the recent bailout starts to wear off. Longer-term, we hold little hope that the euro will hold together. France, Germany, Greece – these are not countries that make natural bedfellows.

So for now, enjoy the brief sunshine, which may even include a rally in U.S. stocks. Gold may consolidate during this brief holiday, but should not drop much more than 10 percent and remains a critical and compelling long-term holding. When it comes down to it, what other freely trading highly liquid currencies are there?

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