Overview

Bonds - bond prices should remain firm over the coming months before they resume their primary down-trend.

Stocks – the recent failure of the stock market to respond positively to friendly economic news is a sign of underlying weakness. We continue to expect stocks to reach significantly lower levels by early March.

Gold - some further consolidation in the gold price is likely over the next few weeks, but both the short and medium-term trends are UP. Gold stocks should be accumulated on pullbacks.

Inflation and Credit Market Watch

The following are extracts from Alan Greenspan's Humphrey Hawkins Testimony delivered last Thursday:

"As would be expected, imbalances between demand and potential supply in markets for goods and services are being mirrored in the financial markets by an excess in the demand for funds. As a consequence, market interest rates are already moving in the direction of containing the excess of demand."

and "…to date, rising business earnings expectations and declining compensation for risk have more than offset the effects of this increase [in market interest rates], propelling equity prices and the wealth effect higher."

and "With foreign economies strengthening and labor markets already tight, how the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process."

Things would be so much simpler if the Fed would just stay out of the way. As it is they have created a debt bubble, they've sustained the bubble by pumping up the money supply whenever anything threatened to burst it, and now, according to the Fed Chairman's latest testimony, they want to gradually deflate it "without destabilizing the economy in the process".

Although the PPI released on Thursday showed only a small increase in finished goods prices, it did confirm that pricing pressures in the pipeline are substantial and growing. The report revealed that finished goods prices are now rising at a year-on-year rate of 0.8%, intermediate goods prices at a 2.4% rate and crude goods prices at a 16.9% rate, all excluding food and energy products (including food and energy bumps up the percentages). This tells us that increases in crude and intermediate goods prices are not flowing through to finished goods prices, meaning that businesses are absorbing the cost increases. Our guess is that a lack of pricing power due to competition from cheap imports (a little thing called the "trade deficit") is preventing cost increases from being passed on. The large and accelerating rise in crude goods prices is particularly worrisome as it will eventually lead to much higher prices for finished goods or significantly reduced corporate profits.

Currency Review - The Euro

If the ECB is really becoming concerned about the on-going slide in the Euro's exchange value (they say they are), the last thing they should do is increase interest rates (as they have suggested they might). Higher interest rates would pose a serious risk to Europe's fragile economic recovery. If the ECB wants a stronger currency in order to attract investment capital into the Euro zone, all they need to do is increase the Euro's gold backing.

Like the Dollar the Euro is a fiat currency and its relative value therefore depends primarily on confidence. Confidence is not something a government can mandate - a bunch of politically and economically disparate nations can't just decide to create a new currency, give it a name, tell people they have to use it and then expect investors to shift their hard-earned wealth into financial assets denominated in it. Confidence can, however, be instilled by backing the currency with the form of money that has been considered a store of value and a hedge against government incompetence for thousands of years.

As well as lifting investor confidence in the new currency, the higher the gold backing of the Euro the closer Euro interest rates would become to gold interest rates. That is, a higher gold backing would simultaneously strengthen the Euro's foreign exchange value and reduce local interest rates, thus promoting economic growth and capital investment.

In the absence of a much higher level of gold backing the Euro will most likely remain in a long-term downward trend versus the Dollar. On a short-term basis it appears to be over-sold and a bounce should therefore be expected.

The US Stock Market

Figures released last week reveal that margin debt among NYSE-member brokerage firms rose 7% in January to a new record high of $243.5B. Margin debt has now increased 36% since last September.

Those who buy shares on margin are the weakest of weak hands because they may become forced sellers during a correction. This is especially pertinent in today's market where we have many inexperienced traders buying on margin based on the ridiculous belief that every pullback in their carefully-chosen stocks will be short-lived and will quickly be followed by new highs.

A common trait of many novice traders and virtually all bad traders is a failure to understand the need to manage risk using stop loss orders. Seasoned and astute traders never suffer large losses because they protect themselves with stop losses and only trade in markets that are sufficiently liquid to enable stop losses to be fully effective.

The hoard of unseasoned traders employing margin debt in an attempt to magnify their winnings poses a risk to the current market. Most sellers in the market are price-sensitive, that is, they endeavour to extract the highest price for their shares. However, when traders receive margin calls (because they have failed to properly manage their risk) and are unable or unwilling to provide additional funds to boost their margin, then price-insensitive sellers enter the market. These price-insensitive sellers are the clerks who work at the margin desks of brokerage houses and when they sell their only objective is to cover the debt owed to their firm.

Since the market has been so narrow for so long, the margin selling that will soon occur may not have a market-wide effect. The vast majority of margin loans taken out by inexperienced day-traders are no doubt centered on a relatively small number stocks. We would therefore steer clear of the popular tech 'stories' that have had parabolic rises over the past few months, even where the long-term outlook for the underlying business is bright.

Evidence that the high-flying stocks can fall quite dramatically without causing severe damage to the overall market was provided in 1999. Between April 13th and August 10th last year the average Internet stock (the primary focus of the heavily-margined day-trading crowd at the time) declined by 44% (as measured by TheStreet.com Internet Index). During this same period the S&P500 fell by only 6%.

Last week began quite positively for the market. Tuesday in particular was a very bullish day with the S&P futures making a lower low, a higher high and a higher close (an "outside up day"). However, the inability of the market to move up in the wake of superficially good news on inflation late in the week and Friday's precipitous decline reinforced our view that we are headed lower into early March.

There is not much to do now except wait to see where the market finds support. Hopefully we will see the S&P500 and the Dow Industrials drop another 5% or so from current levels and the NASDAQ at least 10%, as this would probably be sufficient to engender widespread fear and establish a platform from which the next major rally could be launched. In the very short-term, Friday's mini-capitulation will no doubt lead to attempts on Tuesday and/or Wednesday of the coming week to rally the market. The points at which these attempted rallies fail will give us a clue regarding the ultimate downside over the next few weeks.

In our Feb 16th Interim Update we mentioned that the oil price may be at, or very close to, a peak, and that a drop in the oil price may turn out to be the catalyst for the next stock market rally. It is too early to call a top in the oil price with great confidence, but with Market Vane's bullish consensus at 95% the psychology in this market is now diametrically opposite to that which prevailed at this time last year. In February 1999 oil, as a long side speculation, was universally hated at $12 per barrel. Now, 12 months later, it is loved by all at $30 per barrel. This has always been the way of the investment world, with the majority becoming wildly bullish at the top and desperately bearish at the bottom.

Gold and Gold Stocks

Last week's gold market action was quite positive with the XAU gaining ground over the course of the week despite a $7 drop in the gold price. This is the type of price action we would expect to see for several weeks prior to the commencement of a substantial rally in the gold price.

Although the most likely direction of the gold price over the near-term is down (based on the factors discussed in previous Updates), we are not interested in trying to finesse this market to any degree. With a huge short position in physical gold and derivative problems lurking just beneath the surface, an upside explosion is possible at any time. As such, we continue to recommend the accumulation of high quality gold stocks on pullbacks. The $20 jump in the gold price on Feb 4th was a warning shot that should not be ignored.

The poor performance of the XAU relative to the bullion price has been a concern for some time, but one positive sign has been the strength in the major unhedged South African producers. The stock prices of both Harmony and Gold Fields are in strong up-trends and have generally out-performed the stocks of the major North American gold producers during both advances and declines in the gold price. We expect this out-performance to become even more pronounced as a larger pool of investors grasps the fact that a new gold bull market is underway.

The relative strength evident in the stock prices of Harmony and Gold Fields is not surprising since both companies are essentially hedge-free and highly profitable (a wonderful combination!). Even though Barrick has sought to increase its exposure to the spot gold price through the purchase of call options and Placer Dome has vowed to reduce the size of its hedge book by delivering gold into its forward sales, the hedge positions maintained by these companies are seen as a significant risk. Over the past two weeks they have simply taken their first steps towards mitigating that risk.

Steve Saville
Hong Kong
21 February 2000

The reader is invited to respond to Mr. Saville's wisdom via email:
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Our detailed Year 2000 Forecast has been posted at
www.speculative-investor.com