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 – although some upside is likely over the coming week, we expect stocks to reach much lower levels by early March.

Gold - A pullback into early March is still a possibility, but both the short and medium-term trends are now UP. Gold stocks should be accumulated on pullbacks.

Inflation and Credit Market Watch

The Clinton Administration has strongly advocated using future budget surpluses to pay down government debt rather than to fund a tax cut. The reason given for this stance is that paying down the federal debt would reduce market interest rates by increasing the amount of money available for private borrowing. In this way the average American family would end up with a cheaper mortgage and more disposable income. Therefore a government debt pay-down, the argument goes, provides a financial benefit to the nation's tax-payers equivalent to that gained through a tax cut. This all sounds quite sensible except for the fact that it is just plain wrong!

In the August 13th 1999 issue of Grant's Interest Rate Observer Jim Grant provides two charts, one displaying the US gross public debt since 1791 and the other displaying the level of long-term interest rates since 1798. Looking at these charts it is clear that there has, over the past 200 years, been no meaningful correlation between the level of market interest rates and the rate of growth in government indebtedness. In fact, the same conclusion can be reached by quickly reviewing the events of the last two decades. During the 1980s, for example, government debt soared whilst interest rates steadily declined. And if we take the more recent past – Oct '98 to Dec '99 – we see that market interest rates rose during a time when the rate of increase in government debt was slowing and budget surpluses / debt pay-downs were the subject of much discussion.

Market interest rates are clearly not solely determined by the absolute amount of government debt or its growth rate. It is our belief that they are, in the main, determined by expectations regarding the future level of inflation. Furthermore, this hypothesis seems to be confirmed by the happenings in the credit market during recent times.

Over the past 16 months long-term interest rates have risen in parallel with (premature) budget surplus celebrations. With oil and other commodity prices rising, high money supply growth rates, and future inflation gauges increasing at their fastest pace in many years, it is not much of a stretch to conclude that the debt market has responded to heightened fears of inflation. Over the past 6 weeks short-term interest rates have increased relative to long-term interest rates because the supply of money has been reduced at a time when the demand for money has remained high. When short-term rates rise this, in itself, tends to support long-term rates by reducing the expected future level of inflation.

So, there is no evidence to suggest that a government debt pay down will result in lower market interest rates and a lot of evidence pointing to inflation as a major determinant of interest rates. Since it is reasonable to assume that the Clinton Administration is in tune with reality, despite public pronouncements indicating the contrary, the question then becomes: what is the true reason for choosing to use future budget surpluses to pay down debt rather than fund a tax cut? We don't know for sure, but hazard the following guesses:

1. Even taking the Government's own figures at face value the debt pay down is very much a 'sleight of hand'. What is actually being proposed is the use of projected Social Security surpluses to affect a transfer of government debt from private hands into the Social Security Trust Fund. Since real operating budget surpluses will either not exist at all or be quite small, a significant tax cut could only be funded with an expansion of government debt. A tax cut could therefore not be implemented without destroying the budget surplus illusion.
   
   
2. The US Government needed to propose a reduction in debt to appease the major foreign holders of the debt, including foreign central banks. A programme to purchase privately-held government debt possibly became necessary to enable foreigners to reduce their holdings of US paper without creating an over-supply in the market.
   
   

Currency Review – The Yen

Massive deficit spending by the Japanese Government has not succeeded in creating a sustainable economic recovery in Japan. It has succeeded in building an enormous federal debt that will reach 130% of GDP during the coming year. However, Japanese public-sector debt, although cumbersome, is dwarfed by the country's private-sector debt. According to research by Goldman Sachs, private debt in Japan totals about 200% of GDP.

With the amounts of public and private sector debt at such dangerously high levels and the economy in its 11th year of stagnation/recession, it seems inevitable that the Japanese Government and Central Bank will embark on an aggressive debt monetisation programme in the near future. This eventuality appears even more likely when we consider that a significant portion of high-yielding time deposits held within Japan's Postal Savings System (PSS) begin to mature in April of this year. The PSS has been a major buyer of Japanese Government Bonds (JGBs) in the past, but may soon be forced to become a net seller of JGBs in order to fund redemptions (the time deposits that mature are unlikely to be re-invested at current interest rates of around 1.75%). We therefore expect to see a dramatic increase in the supply of Yen over the next two years and are thus extremely bearish on the Yen relative to the US Dollar. A significant weakening of the Yen is likely to commence following the repatriation of capital to Japan that always occurs towards the end of their financial year (March 31st).

The US Stock Market

In last week's Update we said: "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." Well, we are now almost (but not quite) ready to rule out the possibility of a near-term upside explosion. Although the NASDAQ continues to make new highs last week's failure of the S&P500 futures (basis March) to break decisively above resistance in the high 1440s, despite market-friendly news on productivity and labour costs, indicates an underlying lack of strength.

The Dow has already broken down and we expect the S&P to do the same over the next three weeks. Money continues to flow into the fewer and fewer stocks that are working (going up), a situation that is tending to support the NASDAQ. However, a serious break in the S&P would certainly spill over into the NASDAQ causing many of the recent high-fliers to fall back to earth.

Although we expect all the major indices to be trading at significantly lower levels by early March, the options expiration scheduled to occur on Friday should give the coming week a positive bias (assuming no negative surprises from the PPI and CPI reports due for release late in the week). The low for the week will therefore most likely occur on Monday with the possibility of a reasonable bounce during the Tue – Thurs sessions.

The bears continue to point out the huge run-ups in NASDAQ stocks and draw the conclusion that a disaster of epic proportions awaits in the near future. We take a different view. The out-performance of tech stocks during the first 6 weeks of this year is a sign of strength and indicates that, once short-term corrective action is complete, the technology sector will again provide investors with the best returns during the remainder of 2000. However, this does not mean that we are unconcerned about the gambling mentality and the contempt for fundamental valuation that pervade today's market. In fact, two events of the past week do a good job of highlighting the current excesses and market psychology. Firstly, an analyst interviewed on CNBC last Wednesday argued with a straight face that Cisco would be a "buy" at any price provided it could maintain its top line growth. Secondly, shares of Indian software services company Infosys soared by 30% during NASDAQ trading on Thursday and Friday of last week, giving the company a market cap of around $40B and putting it at a P/E of more than 700. The really crazy thing is, the shares now trade on the NASDAQ at triple the price that exactly the same shares trade at on the Bombay exchange. Try justifying that with "New Paradigm" logic!

The complacency and downright arrogance of many 'investors' will inevitably be punished, so the leaders of the current NASDAQ surge will probably be market laggards in the not-too-distant future. However, the current pace of technological innovation is breathtaking, thus prompting us to anticipate a steady rotation of leadership within the tech sector rather than a gut-wrenching purge across the entire sector. Stock selection will be critical.

Gold and Gold Stocks

A bear market has always been a prerequisite for the large-scale borrowing of gold, whether the borrowing be for the purpose of hedging future production or to earn a speculative profit via a carry trade. It is now becoming clear, by the actions and words of several large mining companies, that a perception is growing that gold's bear market has ended. This has certainly been our view since last September's upside breakout in the gold price.

Although we are expecting gold to reach much higher prices during the next 12 months, the relative under-performance of gold stocks continues to perplex and concern us. A similar under-performance by the stocks of PGM and oil producers has also been apparent during the recent rallies in the prices of the associated commodities. This leads us to consider the following three possibilities:

1. A near-term drop in commodity prices is about to occur and equity investors are already discounting this drop in the stock prices of commodity producers. A more sustainable rally will then get underway, with the stocks of commodity producers out-performing the underlying commodities as would be expected in a bull market.
   
   
2. Equity investors have misjudged the commodity rallies, mistakenly thinking they will prove to be short-lived.
   
   
3. A tightening of monetary policy and/or a sharp decline in the stock market will bring about a substantial slowdown in global economic growth with a commensurate reduction in the demand for commodities. Equity investors are currently discounting the possibility of such an outcome.
   
   

Possibility #1 appears to us to be the most plausible explanation whereas Possibility #3 seems unlikely in the extreme.

Other nagging concerns at this time are the fact that commercial interests are significantly net short COMEX gold futures, sentiment is quite bullish, and the Australian Dollar has lately been weak. The A$ has ignored the recent bounce in the gold price and was sold off quite heavily last week, ostensibly due to evidence of slower than expected economic growth. In the past the A$ has almost always moved up decisively during the early stages of commodity rallies and has been particularly sensitive to movements in the gold price (gold is Australia's second largest export).

So, our enthusiasm resulting from the very bullish gold price action is being somewhat tempered by the above-mentioned negative factors. We would therefore not be interested in chasing gold stocks at the current time, but do recommend that accumulation be done during pullbacks. Although the immediate-term is uncertain, the events of the past two weeks have increased our confidence that we are in the early stages of a multi-year gold bull market.

Note that a brief interim update is posted by around 3.00am NY time every Thursday at the TSI web site (www.speculative-investor.com).

Steve Saville
Hong Kong
14 February 2000

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