Overview

Bonds – an intermediate-term low is likely in early 2000. We then expect a rally lasting several months (taking long-bond yields back to around 6%), followed by a resumption of the down trend (higher interest rates) during the second half of the year.

Stocks – a major top is likely in January 2000, followed by a severe correction into March. The up-trend should then resume and continue, although with high volatility, until year-end.

Gold – heading towards a low in early 2000. We expect gold to rally strongly from whatever low it reaches during the first quarter of 2000.

Inflation Watch

We have said for some time that the major effect of the Y2K transition would be monetary, that is, an acceleration in the money supply growth rate going into year-end followed by a slowdown (enforced by the Fed) during the early months of the new year. The acceleration has certainly occurred, with M3 growing at an annualised rate of 17% during the final 3 months of 1999. We now await the slowdown and its impact on a stock market that needs an ever-increasing rate of credit expansion to sustain its upward path.

The Leading Inflation Index calculated by the Foundation for International Business and Economic Research (FIBER) rose by 1.2% in December, giving a year-over-year increase of 9.1%. With forward-looking inflation indicators rising at near double-digit rates and with money supply having expanded at a rapid pace for the past 3 years, we must be very close to seeing acceleration in the growth rate of the backward-looking inflation indicators (such as the CPI). On the other hand, perhaps the method of calculation of the CPI will be revised (as it has been many times in the past) to more 'accurately' reflect the New Economy (the New Economy is the one where the price of a PC is important but the prices of food, energy and shelter are not).

The US Stock Market

Borrowing from Oscar Wilde's definition of a cynic, a typical modern-day tech-stock investor is someone who knows the price of everything and the value of nothing. The problem is, when stock ownership is not supported by the confidence that comes from knowing that the underlying business fundamentals justify the price paid for the stock then any significant price decline can lead to panic selling. We almost saw panic selling during the past week as eagerness by some investors to lock-in the large paper profits achieved during 1999, combined with a lack of new buying and interest rate jitters, led to a 10% downward adjustment in the NASDAQ over just 3 trading sessions. The low points reached last week now represent critical psychological support for the market. Take out these lows and panic selling will certainly occur.

Despite a SELL signal being issued by our Stock Market Model on 14th December, we had been expecting an explosive rally to occur during the final 2 weeks of December and the first half of January before any substantial downward action unfolded. As such we had decided to not immediately act on this SELL signal, but to use strength during the early part of 2000 for profit taking. Although the first week of the New Year provided some huge downward moves and extreme volatility, we are still expecting a final upward surge prior to a more sustainable decline. The American investing public has been conditioned to buy every dip and this latest hiccup will be no different. After all, stocks that were selling at 100 times next year's sales are now available at the bargain price of only 80 times sales!

Our guess is that whatever upside the market can muster will be complete by the expiration of January options (Friday 21st Jan), after which we will see the start of a process of establishing some real value in the market. Some time during March or April we may find ourselves presented with another buying opportunity, but that will need to be assessed at the time. We certainly expect markets to be strong during the second half of this year, in the lead-up to the Presidential elections, in parallel with yet another Fed-facilitated monetary stimulus. Whether or not we reach new highs towards the end of this year largely depends on the action over the remainder of January. If the S&P and NASDAQ are unable to make new highs before declining anew, or just make marginal new highs, then it becomes more likely that we have not yet seen the final peak of this equity bull market. However, if we see a major upside breakout above the highs reached during the morning of 3rd January, then we could very well be in THE final blow-off.

Two things we have been looking for to indicate that we are approaching the end of the bull market in stocks are a surge in the price of gold and a drop in the exchange value of the US Dollar. With gold trading within 15% of its 20-year low and the Dollar Index firmly within an up-trend dating back to early 1995, these indicators are currently telling us that the upcoming decline will simply be another correction in the bull market. (Note – we do not agree with those who argue that the gold price is low purely as a result of market manipulation. Although the gold market is almost certainly subject to manipulation, it is impossible to manipulate the price lower in the face of strong investment demand with such a limited supply of physical gold. The only explanation is that investment demand for gold is still weak, something we believe will change prior to the final peak in the stock market). It is our expectation that gold will be trading somewhere north of $500 when the equity bull market finally reaches its zenith.

The bottom line is that we may head higher over the next 2 weeks, but market risk is as extreme as it gets. Not only do we have the excessive valuations, we will now surely see a far less market-friendly central bank. In addition, the market still has to deal with the problem of a near-term earnings growth slowdown for the large-cap tech stocks (a problem that began during Oct 99 and has yet to be discounted in stock prices). As such, our expectation is for much lower stock prices by March.

Y2K

With no major disruptions having occurred during the days following the Y2K transition, some commentators have questioned the prudence of the large Y2K-related expenditures. This is like taking a drive in a car, not having an accident, and then questioning the wisdom of having spent all that money to repair the brakes.

It was always our belief that the oil price would provide us with the most reliable leading indication as to the extent of Y2K disruption. There is a mountain of information available regarding the potential effects of Y2K, but, to paraphrase Jim Dines, sometimes it is better to look rather than to think. As such, we will continue to look at the oil price to ascertain whether or not any on-going Y2K failures will cause significant problems.

Gold and Gold Stocks

A long-term chart of the Market Vane bullish % for gold indicates that sentiment towards gold has been in a down-trend since early 1995. Prior to 1997, the bullish % would bottom out at around 30% at important lows for the gold price. However, as gold's bear market became more severe during 1997, 1998 and 1999, bullish sentiment continued to make lower lows until we saw the bullish % remain under 20 for several weeks during June, July and August of last year. Bullish sentiment then spiked up to about 60% during Oct '99, before falling back in parallel with the Oct-Nov-Dec decline in the gold price.

If we have seen the lows for the gold price and the Sep/Oct '99 rally was the first leg in a new bull market, then we will also have seen the lows for bullish sentiment. As such, bullish sentiment is unlikely to drop below 20% again. If we return to a more normal gold market then bullish sentiment readings in the 25-30% range should indicate that we are close to an intermediate bottom.

A more normal gold market is probably what we now have, courtesy of the decision of the European CBs to limit their sales and lending. The past 3 years have been an aberration, with the price continuing to decline even as sentiment was plumbing new depths. There always seemed to be an endless line of sellers who were willing to sell irrespective of price.

If we now have a market in which the major participants are price sensitive, there will still be attempts to manipulate. In this respect the gold market is no different from the other financial markets. We can rail against this manipulation, but it is often not smart to bet against it. There is no satisfaction to be gained by buying something that is cheap only to see it become even cheaper. This is where the typical gold stock investor can learn something from the momentum crowd. Momentum investors know the price of everything and the value of nothing – they simply buy stocks that are in strong up-trends. An investor who takes the hybrid approach of buying stocks that represent good value and are in up-trends can potentially get the best of both worlds – the satisfaction of quick gains and the security of owning part of a profitable business at a reasonable price.

During our last Update (for the week commencing 20th Dec) we made the following comments:

"…we are concerned that gold may head lower during the early part of 2000 due to the liquidation of long positions and the accumulation of short positions once the extent of Y2K disruption becomes known. As such we plan to remain cautious until we see the behaviour of the gold price during the first half of January. Whatever transpires over the short-term, we expect gold shares to perform very well over the next 2 years in parallel with upward trends in commodity prices and interest rates."

Our short and long-term views remain unchanged. We are looking for gold to make a low during the first quarter of this year and to then commence a strong rally. In order to create the platform from which a sustainable rally can be launched we will probably need a decline in the bullish % to around 25 (it is currently 33) and an increase in the net short position of large speculators. Prior to a rally commencing we should also see the XAU consistently out-performing the gold price.

Our detailed Year 2000 Forecast will be posted at www.speculative-investor.com on 17th January.

Steve Saville (a.k.a. Milhouse)
Hong Kong
10 January 2000

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