Overview
Bonds – close to an intermediate-term low. We expect a rally in the near future.
Stocks – nearing a major top. A severe correction is likely to commence very soon.
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
The Fed's 'mopping up' exercise is well underway. Following the $47B contraction in Reserve Bank credit during the week ended 12th Jan, a further reduction of $18B occurred during the latest week. This action by the Fed may already be having a wider effect with M3, the broadest measure of money supply, having decreased by $57B during the week ended 10th Jan.
A contraction in the total quantity of money, or even just a slowdown in its growth rate, is far more significant than any minor upward adjustments in official interest rates. The US asset bubble requires the expansion of credit at ever-increasing rates for its survival. Although we believe that the acceleration in credit and money creation probably has several years to run before its inevitable implosion, even the current Fed-engineered pause in credit growth will have a quick and severe impact on the debt market, the stock market and the economy.
The impact on the debt market is already being seen with yields on shorter-dated government securities rising at a faster pace than yields on their longer-dated cousins. The yields on 5-year notes through to 30-year bonds are now almost identical, with even a slight inversion at the long end (10-year rates are now higher than 30-year rates). However, those who see this flattening/inversion of the yield curve as a sign that the US is about to plunge into recession should stop worrying – this will only be a temporary phenomenon. By the middle of this year, or possibly even earlier, the Fed will once again firmly plant its foot on the monetary gas pedal in an attempt to stimulate growth in the lead-up to the elections. This re-acceleration in the rate of credit/money expansion will rekindle the inflationary expectations that are now in the process of being suppressed, thus making for a steeper yield curve. This does not mean that we expect short-term interest rates to decline during the course of the year, but that we expect long-term interest rates to increase at a comparatively faster pace once the current tightening is complete. In the near-term, bonds look extremely over-sold and are likely to rally over the next two months. The Fed becoming more outwardly assertive in trying to contain the current excesses, such as hiking official rates by 50 basis points at its Feb 1/2 meeting, may actually enthuse the bond market and bring about a reasonable bounce in bond prices.
The impact on the real economy stems primarily from the current size of the stock market and its substantial influence on consumer spending. A result of the 'wealth effect' is that changes in monetary policy can now very rapidly affect the economy provided those changes have a significant and immediate effect on the stock market. This is a major divergence from the past when many months would elapse before changes in monetary policy would begin to alter consumer-spending patterns. Aggressive tightening by the Fed now has the capacity to quickly bring about a recession by precipitating a sharp fall in the stock market. This is one reason why the Fed, although desirous of a slowdown in aggregate demand, will continue to err on the side of inflation. They have no choice because many years of excessive credit expansion have removed any margin for error on the side of 'tighter money'.
The US Stock Market
The first two weeks of the year saw a rotation out of tech stocks into cyclicals and the large multi-nationals that populate the Dow Jones Industrial Average. However, the past week saw tech stocks resume their leadership role with the NASDAQ Composite gaining ground during every trading session and achieving new all-time highs.
We are still expecting a sharp decline in stock prices to occur between now and March, but are somewhat concerned that many other analysts are also anticipating a near-term correction. In order to restore widespread complacency within the Wall St community and thus set the stage for a shakeout, we probably need a further rally that takes the S&P500 to a new record high over the next week or two. An upside breakout that generates great excitement and then fails would set the scene quite nicely. If the early January lows in the S&P are then taken out you have a real chance that panic selling would ensue. If the January lows hold during any downturn over the next 6 – 8 weeks (around 1390 on the March S&P contract), then the market would probably surprise on the upside for the remainder of 2000.
Right now, holding the January lows on any correction is not the most likely outcome. For the first time in many years all the ducks are lined up in such a way as to bring about a severe correction in stock prices, including the biggest duck of them all – a Fed that is finally acting to restrict the growth in the money supply. High valuations, a doubling in oil prices, rising long-term interest rates and even a few upward adjustments in official interest rates have not been sufficient to make a lasting dent in the equity bull market. However, with the monetary authorities now making their first serious attempt to restrain the rate at which new money is brought into existence it is difficult to imagine a more risky market environment. Although we believe the current vigilance on the part of the Fed will be short-lived and Greenspan's wondrous credit expansion will be back in full swing by mid-year, there is a distinct danger that the market could collapse. This market is simply so richly valued and so heavily reliant on debt that any normal correction could prompt a rush for the exits. As such, and despite the fact that our long-term outlook remains bullish, we cannot over-stress the need to exercise extreme caution at the current time. Under no circumstances should stocks be held on margin and a substantial cash balance should be maintained.
Gold and Gold Stocks
The following is taken from Harry Bingham's January 18th Weekly Gold Market Update:
"The primary determinant of gold's value is the perceived value of credit instruments, particularly when that perception becomes reality. The two great gold bull markets of the twentieth century occurred when either only the most credit worthy entities could borrow at all or when all debtors could obtain credit only on the most punishing terms. Lesser gold bull markets occurred under similar though less severe credit conditions. Since the brief but sharp gold bull market of 1995-1996 confidence in credit and credit uses in most major countries has been supreme. Even a rise in interest rates usually has been ascribed to the prudence of inflation fighting central banks. Stock markets have soared partly on the grounds that central banks could contain every crisis, almost regardless of the extremes of speculation in the preceding boom."
We are in total agreement with this analysis. Gold competes for investment with fiat currency and fiat currency denominated credit instruments. Increased investment demand for gold always occurs as a result of declining confidence in credit instruments and government-sponsored money. In the absence of reduced demand for the investments with which gold competes, there can be no gold bull market.
Historically, a rise in the gold price has tended to precede a general rise in commodity prices, prompting many people to believe that the gold price is a leading indicator of the overall direction of commodity prices. However, although there is often a strong correlation between the gold price and other commodity prices, the gold price has never actually been a predictor of general commodity price movements. As discussed above, gold moves counter to the changes that occur in the general level of confidence in fiat currency and credit instruments. One of the most common reasons for a decline in such confidence is inflation, something that also has the effect of pushing up commodity prices. When inflation occurs whilst a high level of confidence is somehow maintained, as has happened during the past two years, it is not at all strange that gold prices have yet to fully respond. The question is, therefore, when will the on-going inflation cause a shift in confidence that leads to increased investment demand for gold?
The answer is, the shift probably began last year. When the gold price broke out of a multi-year down-trend in September 1999 the catalyst was the now-famous announcement by the European central banks. However, prior to this announcement gold had already moved up $16 from its low and gold interest rates had reached unusually high levels. It is likely that a trend change was about to occur – the European announcement just provided a kick-start.
The shift in investment demand that commenced in 1999 will probably continue for many years as confidence in fiat currency, central banks and governments gradually erodes. It will go unnoticed by the majority until the price of gold has risen substantially.
Whilst we expect the second leg in gold's bull market to get underway some time during the next 2 months, we remain cautious in the very short-term. Gold stocks once again under-performed the bullion price during the past week, a sign that further patience is required. We expect the XAU to outperform the bullion price for several weeks prior to the commencement of a sustainable gold rally.
There is no law that says gold stocks must necessarily lead every major gold rally, this is just the way it usually happens. If, for some reason, it is different this time, then we will buy on strength based on a BUY signal from our Gold Momentum Model. We also maintain a core holding of highly-leveraged and financially sound gold stocks at all times in case an unforeseen event causes a sudden leap in the gold price.
Steve Saville (a.k.a. Milhouse)
Hong Kong
24 January 2000The reader is invited to respond to Mr. Saville's wisdom via email:
sas888@netvigator.com
Our detailed Year 2000 Forecast has been posted at
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