The Bottom Line:

Top-Down: Gold or Equities, Which is the Real Bull Market?

Until fairly recently, some of the best minds in the financial world were still fretting about deflation, not only in Japan and China, but in the Western world as well. Meanwhile, the CRB index had bottomed in late 2001, and was staging a break-out of a massive bear market that had persisted since the 1980s.

Investors are now only realizing that this break-out means that, instead of fretting about deflation, they need to begin positioning their investments for future inflation and secular outperformance of commodity prices vis-à-vis financial markets, particularly equities. If this supposition is true, the rally in Gold is the real bull market, as a precusor of the next secular rally in commodity prices, the return of inflation, and bond prices that properly discount a level of structural inflation.

Bottom-Up: What Does this Mean for Investments in Japan?

In Japan, individual investors and punters are back, and they now account for more of total trading volume than foreign investors. These are not the old geezers one used to see hanging around the branches of Nomura or Daiwa securities, but a younger "shinjin rui", or new generation of "plugged in" investors, aggressively trading online through their PCs and cell phones. This is giving a big boost to the surviving online brokers in Japan, who at one point at the height of the bear market, were looking increasingly like an endangered species.

As for yen-denominated assets versus commodity prices such as gold, gold and other commodities could well continue to out-perform vis-à-vis there respective US dollar-denominated values. In terms of relative Topix subsector performance, a sustainable rally in commodity prices as represented by the CRB Index could well drive significant outperformance in the oil/coal, non-ferrous metals and other commodity pricing-dependent sectors in the Japanese market, as was seen during the past two big rallies in the CRB Index during the 1973-1980 and the 1992-1996 periods.

Top-Down: Gold or Equities, Which is the Real Bull Market?

Only a few months ago, some of the brightest minds in the world were still fretting about deflation, including Alan Greenspan and the FED.

But the CRB Index, usually a good indicator of inflationary trends, bottomed in late 2001, and by late 2002 had clearly broken up out of a secular bear market from a massive peak in 1980.

Despite the historical inverse correlation between the CRB index and US bond yields, Treasury yields continued declining until midway into 2003. It was the sudden back-up in long bond yields that caused investors to realize that the US wasn't on the verge of falling into a deflationary vortex, as the US economy was actually beginning to show signs of accelerating recovery.

Further evidence was given by the dramatic appreciation of what are considered "resource-based" currencies in the trade-weighted US dollar. Because of the "dirty floats" of other currencies (including Japan) in the trade-weighted dollar index, the more freely floating resource-based currencies such as the Australian dollar and the South African Rand bore a relatively higher burden of the depreciation of the dollar vis-à-vis the currencies of its trading partners.

The recognized consensus now is that inflation, rather than deflation, is the more likely probability going forward. But given the fact that the factors that usually drive gold prices have historically been detrimental to performance of equity prices, the burning investment question is; which is the "real" bull market?

Aside from the temptation to dismiss the suggestions the gold bugs of a gold price substantially above current levels, we believe the bottom line to the discussion is that inflation is back, and that expectations of higher inflation down the road will mean a secular rise in; a) global bond yields (as bonds discount "sustainable" inflation), and b) continued rises in commodity prices. In other words, the next secular bull market will be in commodity prices, not financial asset prices.

Yen Asset Prices and Gold

Everyone, it seems, recognizes the downward risk in the US dollar and US dollar assets. But that is precisely one of the arguments for yen assets, along with the fact that Japanese equities have been the Rip Van Winkle of equity markets for the past 10 years. But if we are indeed at the cusp of a major secular bull market in commodities, how will yen assets fare?

As has been pointed out prior newsletters, the price of gold has been appreciating against ALL major currencies, not just the US dollar. What this implies is that commodities as an asset class are beginning to outperform all financial assets. Thus while the yen could, because of a botched "strong dollar policy" adjustment to get the Chinese yuan and Japanese yen re-aligned vis-à-vis the US dollar, surge beyond ¥100/US$ to challenge the prior high of ¥79/US$, the chart above indicates that commodity prices, of which old is a leading indicator, could well do even better in relative terms.

In terms of relative sector performance, this implies that the long-neglected basic materials sectors in the Japanese market are due for a period of substantial relative outperformance. In the past two instance in recent history when the CRB index staged a large rally, both the oil/coal sectors and the non-ferrous sectors out-performed the Topix. During the 1973-1980 period, aided by two "oil shocks", the Topix oil/coal sector soared 7.3-fold, while the non-ferrous sector jumped 2.3-fold, versus a doubling of the Topix index. During the 1992-1996 rally in the CRB index, the oil/coal sector jumped 56%, while the non-ferrous sector rose 59%, versus a Topix trough-to-peak gain of 54%.

The recent US sector (Dow Jones) performance continues to show a strong preference for mining, metals and basic materials, a trend reminiscent of past rallies in the CRB index. In Japan, the relative performance of the non-ferrous sector has accelerated over the past month, recording relative performance that is about twice that of the Topix.

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