Big Picture: The decision to increase equities from 35% to 42% has prompted some inquiry. While we have called or anticipated all of the intermediate rallies, we did not increase the recommended weightings for pension funds because the valuations were extraordinary, bullish opinion was adamant, and the bear market was nowhere near the minimum duration of 3 years.

Of course, it is quite likely that the market will go to outstanding valuations [outstanding valuations are 1 times book and a 6% dividend yield, which are found at the end of bear markets.] but, until that is accomplished, valuations will continue to be of little guidance on intermediate rallies or declines.

While we still have high valuations, prices are lower than at any rally point in the past 2 ½ years and, of most importance, the bulls are becoming dismayed. The latter is shown in the S&P registering capitulation on the ChartWorks proprietary model. The weekly reading is kicking in as it has on 13 such periods of heavy liquidation over the past 100 years.

Our view in 2000 was that there would be a number of capitulations until the post-2000 bear was over. This is Number 4.

Also worth noting is that, once the capitulation registers, it could last for up to 6 weeks or more before the low is accomplished. We are now at the condition reached in October and again in December, 1931. Thus our view for a tradable rally out of the eventual hole.

Outlook For 2003: The point to be made is that, while the stock market has been as bad as it was from 1929 to late 1931, the economy is not in the same category. The unprecedented continuation of the median home boom is the only reason and, like any bubble since Asia blew out in 1997, every speculation has reached saturation and has collapsed. This is inevitable and will fit the Austrian School's theory that the boom and bust are proportionate.

Our work has been empirical rather than theoretical and concludes that all of the requirements to conclude a post-bubble contraction seem unlikely to be accomplished within the shorter three-year duration. Without the intensity of 1929 to 1932, the contraction will likely be prolonged, as followed the 1873 bubble. The combination of 3 different approaches suggests that a very worthwhile rally could run from when the low is accomplished (perhaps in November) until around May.

Thus our advice to increase the equity weighting from 35% to 42%. Why the 7 points? - 7 is lucky.
There are about 50 sub-groups and not all will bottom at the same time.

Confidence: In early January, 2000 we noted that short dated treasury rates typically soared for some 18 months as a stock mania blows out. This began the regular reminder that March would be the "18th month". On January 28, 2000, the Boom Indicators had reversed from the most positive reading of +12 to +6 and we advised reducing equity exposure from 60% to 40%. The reading has now improved from -12 to -11.

At important lows, as in late 1998, it took from October, 1998 until February, 1999 to become convincingly positive. It's slow, but some solid improvement by, say, around March would suggest the end of the bear.
In the meantime, let's consider it as a good potential rebound within a more leisurely contraction, such as followed the new financial era that ended in 1873.

Sector Comment: Preliminary work suggests that the utilities could lag and golds could rally with the orthodox market.

INTEREST RATES

Credit Spreads: Last year, the model expected credit spreads to widen until around November. The 9/11 atrocity accelerated this and the crisis drove the junk spread to 825 bp over treasuries on October 2. After November, spreads were expected to narrow with the other "good stuff" until around March.

This was prolonged as spread action, seemingly compelled by a shortage of junk, drove the spread to 535 bp in May. Fortunately, a remarkable increase in "Fallen Angels" eased the shortage and this week the spread reached 923 bp.

Our July 19 edition discussed the fact that widening would accelerate in September to dislocating conditions by December and noted that "this would involuntarily turn investors into sub-prime lenders".
This seems to be working out.

Yield Curve: Shorter-dated treasuries were expected to increase with the "good stuff" until around March and then resume the long decline with the opposite stuff. For example, the 90-day bill rate rose to 1.84% in March and has declined to 1.55% this week. Our eventual target has been around 1%.

This natural decline is feeding into the long end for some 6 weeks longer than we thought possible, but steepening due to long rates rising could be starting.

The Long Bond: The long bond has become speculative. The refi game is an unstable loop that is connecting a soaring median home market to soaring bond prices. Just because everyone is watching the phenomenon and calling for its end doesn't mean that it won't end.

Part of the play has been to buy SUVs and this seems to be faltering. With the discounts and zero financing costs, the depreciation on a new car is larger than ever and is forcing prices down in the second-hand market. The average car now is a sound driver for at least 10 years so the rage to have a new one will rapidly be seen as uneconomical.

Perhaps 4 years of record light vehicle sales will be done in by the 3-year bear market. If so, the house mania will follow and, as odd as it seems, this will be tied to the end of the mania in longer maturities.

Confirming this is the ChartWorks note, as of today, that the 10-year yield has given a weekly capitulation "buy" reading. This means a significant increase in longer term interest rates.

Spreads Again: Since May, Merrill's junk index has increased in yield from 1096 bp to 1395 bp this week. In the same interval, the yield for a medium grade corp has gone from 788 bp to 701 bp on September 17. Considering the appropriate carnage in the junk market, this seemed inappropriate. However, since then the yield has increased to 742 thus ending the divergence as the spread has widened from 226 bp to 270 bp this week. This spread narrowed to 197 bp in March.

Real Long Interest Rates: Clearly, real rates have been rising for junk but have been declining, since May, for better credits. While this is part of the remarkable speculation in bonds, it should be recognized as favourable and that section of the Boom Indicators turns one notch positive. This improves the reading from -12 to -11. The worst reading possible is -14 and the worst reading reached was the recent -12.

COMMENTS FOR METAL PRODUCERS

Gold: Gold's price relative to commodities sold off from 263 on May 29 to 228 on August 21, from which it based until September 12. Under the appropriate conditions of the liquidity contraction resuming, the index has improved to 241.

Gold Shares: Beyond the treasury curve and gold's relative price share action, at times gold shares anticipate gold rallies.

This was reviewed in our September 20 view that "the stock market plunge could take gold shares with it". The plunge is on and, using Newmont as the proxy, the ChartWorks suggests that it is within a week of a "buy" condition. For those who are underweighted, we would start aggressive buying now.

Gold/Silver Ratio: Money market spreads have finally joined the distress being suffered by the junk bonds since late July. Needless to say, this is serious and was confirmed by a rather quick increase in the gold/silver ratio to 74. This may ease over the next week and last week's edition discussed the action in brief terms that are worth repeating:

Our June 7 edition noted that silver was at an important top, from which a long bear market in nominal terms, and relative to gold, would follow. Silver's high was 510.1 on July 15 as the gold/silver ratio set a low at 62.5. The piece concluded with "Rising through 70 would anticipate the next phase of credit distress. Our long term target remains around 110.".

This ratio is not only the oldest price series in history, it also has the characteristics of a credit spread. In rising to 70.9 in early September, it anticipated developing distress. On September 26, it broke 71 and, now at 71.8, bank and financial stocks are very weak.

Energy Prices: Our view in June was that both crude oil and natural gas prices would recover until early October. From a low of 24.12 on June 10, crude recovered 28% to 30.8 on October 1. Natural gas sold off to 2.66 on August 6 and, making up for lost time, zoomed 55% to 4.14 on October 2.

Both have declined a little, but it's enough to break the rising trendline. As we have outlined, U.S. "Gunboat diplomacy" in Iraq will likely start in early January. This would force a brief speculative rally in a much longer downtrend. The money markets are now showing a concerning loss of liquidity that, with the collapse in the junk market, does not auger well for global business conditions into next year (credit distress is global).