Overview

Bonds - the major part of the expected rally is likely over, although bonds should remain strong over the coming months before they resume their primary down-trend.

Stocks - after last week's forecast rally the downward correction should resume shortly. Our longer-term outlook remains bullish.

Gold - an upside breakout on 4th Feb has altered the short-term picture. A pullback into early March is still a possibility, but both the short and medium-term trends are now UP.

Inflation and Credit Market Watch

Much has been made of the US Treasury Secretary's recent announcement that the Treasury is going to use part of the budget surplus to buy back $30B of long-maturity government debt over the coming months. This has supposedly caused yields on long bonds to drop from 6.75% to their current level of around 6.2% in the space of only two weeks.

$30B is not a substantial sum compared to the Government's total debt of around $5.7 trillion dollars, so this level of debt reduction should not have had such a dramatic effect on the market. Clearly, what we have just witnessed is the panicked unwinding of highly-leveraged 'wrong-way' bets in the credit market that follows on the heels of the Oct '98 collapse in bond yields and the Sep '99 surge in the gold price. (The gold market, due to the enormous influence of gold loans and interest rates on gold's supply/demand relationship, is now more aptly considered to be a credit market than a commodity market.) On Friday 4th Feb this bond market panic surrendered centre stage (at least momentarily) to yet another panic in the gold market.

The majority of players in any market always assume the current trend will remain in effect for the foreseeable future. This is why the consensus view is almost always wrong and why an understanding of market psychology can be quite useful - when sentiment becomes extremely lopsided it takes very little to create a change in trend, thus trapping the complacent herd and accentuating the reversal.

One unhappy consequence of the increasing frequency and severity of credit market panics is likely to be a call for greater regulation. The argument will no doubt be that the invisible hand of capitalism has failed to provide the necessary safeguards so let's bring in the visible hand of government bureaucracy. It is unfortunate that virtually no-one is prepared to broach the root cause of the problem.

The root cause of the problem, and the reason that financial crises will tend to occur more regularly with or without the granting of greater powers to petty bureaucrats, is the nature of our fiat currency system itself. Any monetary system that does not impose objective physical limitations on the ability of banks to create money, that doles out the greatest rewards to those banks that are able to grow their assets (create new money) at the fastest pace, that creates a liability in excess of one dollar for every new dollar brought into existence (due to the obligation to pay interest), that relies on the vast majority of currency remaining within the banking system at all times to ensure the public stays blissfully unaware that more than 90% of their money does not exist outside the memory banks of computers, and that requires the continuous expansion of debt for its very survival, is inherently unstable. With such an innately dysfunctional monetary system the biggest surprise is that so many people continue to be surprised at the ever-growing price volatility and the increasing frequency of crises. In reality, the fact that we have come this far is testament to the dexterity of the US Federal Reserve and the other monetary authorities. After all, such a system necessitates manipulation on an ever-increasing scale in order to sustain confidence and postpone the crisis that will eventually bring down the system. It is an endless task for the Greenspans of the world as each circumvention of free market forces leads to an even greater imbalance and sows the seeds of the next crisis.

Returning to the government debt pay-down that has been blamed for the recent panic-buying of T-Bonds, there are two important issues that have not received much attention elsewhere. Firstly, with the US Government's debt having increased by $100B during the past 12 months there is currently no surplus. Furthermore, the figures put out by the Congressional Budget Office forecast a total operating budget surplus over the next 10 years of about $800B, that is, less than 15% of today's Federal Government debt. The bottom line is, when Bill Clinton talks about paying off the national debt he really means that a small component ($800B) of the privately-held government debt might possibly be paid off with the balance (the vast majority) being transferred to the Social Security Trust Fund. Secondly, bearing in mind that today's monetary system needs an ever-expanding supply of credit (money) to avoid an implosion (it is a 'Ponzi scheme', pure and simple) begs the question: Even assuming a budget surplus does eventuate, is a government debt pay-down really a good idea? After all, any slack in the issue of new government debt will have to be taken up by the private sector to ensure that the money supply growth rate does not reach a dangerously-low level. However, a problem faced by non-government borrowers is that they do not have a license to print money - their capacity to take-on debt is finite!

Not to worry, this whole government debt pay-down issue will almost certainly turn out to be a storm in a teacup. Real budget surpluses will never materialise and the Treasury will retain its ability to expand the money supply.

The US Stock Market

In last week's Update we said "…with a lot of trepidation now in the market due to the recent sharp drops in the major indices and the upcoming FOMC Meeting, a strong rebound should occur very shortly. Whatever low point is reached on Monday or Tuesday (or Friday's 1362 level if this is not taken out during any further sell-off early in the coming week) will then provide the next line in the sand, penetration of which will probably set off another round of liquidation. " A low of 1357 was hit on Mon, after which a strong rebound ensued as expected.

The trepidation that was evident at the beginning of last week has now been replaced with bullish complacency. As they have done for the past few years investors and traders are currently ignoring a number of negative developments in the belief that stock prices will always quickly recover to new highs following any sell-off. An important difference right now is that the Federal Reserve is attempting to simultaneously raise the cost and reduce the supply of money (last year's rate hikes were accompanied by an expansion of Federal Reserve Bank credit and thus did not constitute a real tightening of monetary policy). This is a monetary environment that, if it continues for long, will have a very deleterious effect on a stock market that is priced for perfection and is supported primarily by excessive liquidity.

There are a number of factors currently playing out in the financial markets. We have falling long-term interest rates, an inverted yield curve that is becoming more inverted by the day, surging oil and gold prices, and a stock market containing numerous divergences (the NASDAQ Comp at a new closing high, the S&P500 delicately poised a few percent below its all-time high, an under-performing Dow, strength in the Utilities sector, and a complete breakdown in the transportation stocks). Although our initial reaction is to draw an extremely bearish conclusion from all this as far as the short-term direction of the major stock market indices are concerned, another possible outcome is an upside blow-off. It is not out of the question, based on the experience of the past 13 years, that the Fed will suddenly reverse course and once again flood the system with money. It all boils down to what they have to do to avoid a collapse and this, in turn, will be determined by the extent of problems within the banking system that would result from an 'unplanned' unwinding of leveraged positions. The Fed would surely not like to see an upward surge in stock prices at a time when they are trying to eliminate excess demand within the economy, but they may simply have no alternative other than to provide more fuel for the speculative fire. So, whilst expecting and hoping for a significant near-term decline in stock prices (negative action in the short-term increases the prospect of longer-term positive action), we are not ruling out the possibility of an upside explosion.

Gold and Gold Stocks

During Sep and Oct '99 we were short-term bearish on the stock market. However, an upside breakout on Oct 28th caused us to jump to the bullish side of the fence. Although we could not see any value in the market at that time and a veritable mountain of logic pointed towards the continuation of the correction, it suddenly became clear that stock prices were headed higher.

Upside breakouts should never be ignored. Often the real reason for a breakout does not become known for some considerable time and by then it may be too late to take advantage of the directional change. For example, the abrupt turnaround in the stock market last year resulted from the Fed's decision to flood the banking system with additional reserves to preempt any potential shortage of liquidity in the lead-up to the Y2K transition. However, empirical evidence confirming this action on the part of the Fed did not surface until after the stock market had experienced a huge rally.

In last week's Update we said: "We will only be confident that a bottom has been established in the gold market when we see the following:

a) Much lower levels of bullish sentiment
b) The commercial interests net long gold futures
c) A BUY signal from our gold momentum model (currently, a BUY would be signaled with a daily close of 286.75 or above for spot gold AND 65 or above for the XAU)."

Although points a) and b) have not yet come to pass, point c) most definitely has. The upside breakout in the gold price and the XAU on 4th Feb has caused the TSI Gold Momentum Model to give a BUY signal. Although a pullback over the next few weeks is still possible, Friday's action provides further resounding confirmation that a new bull market began in Sep '99 and that the gold price is headed much higher. As discussed above, upside breakouts should be respected and the real reason for their occurrence may not be known for some time (in gold's case, the breakout was probably not due to PDG's announcement regarding its hedging plans).

The behaviour of the gold price in the very short-term will depend on the reaction, to Friday's price rise, of the heavily-hedged gold mining companies and the speculators who have short-sold a large quantity of physical gold. If the short sellers do not panic and if gold mining companies continue their usual hedging practices, the gold price would probably retreat for a few weeks prior to the commencement of a more sustainable up-move. This, however, is a very big "if". A more likely outcome would be a continuation of last week's move, punctuated with the occasional consolidation. After all, with many speculators and producers having been caught on the wrong side of the gold market twice in the space of 5 months they will be less likely to bet against gold in the future. The explosive upside potential in the gold market has been revealed - TWICE!

Despite last week's pop in the gold price, many gold stocks are still extremely cheap. Gold Fields Limited, one of our favourites, last week reported a profit of US$35M for the Dec quarter. This company is unhedged, debt free, and will earn an additional $40M pre-tax for every $10 increase in the spot gold price. It provides a low-risk means of gaining leveraged exposure to an improvement in the gold price. We also like Durban Deep at around US$2 and are pleased that this stock did what it was supposed to do on Friday, rising by 30% in one day.

Further to our Feb 2 Interim Update, we took advantage of Wednesday's selling climax in Franco Nevada and purchased it for the Portfolio on Thursday at C$18.80. This stock is still a strong buy at its current price of around C$22.

Housekeeping Note

Due to technical problems The Speculative Investor web site (www.speculative-investor.com) will not be updated until at least 9th Feb.

Steve Saville
Hong Kong
8 February 2000

The reader is invited to respond to Mr. Saville's wisdom via email:
sas888@netvigator.com

Our detailed Year 2000 Forecast has been posted at
www.speculative-investor.com