Overview

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

Stocks – the low point for the current correction has probably not yet occurred. Further downside is expected following an attempted rebound during the next week.

Gold - the recent drop in the gold price has not altered our view. We continue to expect a rally to commence from a low that is likely to occur during the next month. Gold stocks should be accumulated on pullbacks.

The US Stock Market

Alan Greenspan is worried that soaring technology-stock prices are making people feel wealthy, thus causing them to increase their spending relative to their incomes. He complains that this 'wealth effect' is leading to excessive demand within the economy, a recipe for higher prices if we are not careful. By the end of last year he had tried everything to cool off the rampant speculation in the stock market. Everything, that is, except restricting the growth in the money supply and raising margin requirements. Then, during the first two months of this year, he upped the ante by taking steps to rein-in the money supply growth rate and by speaking with uncommon clarity of the need for further interest rate hikes for the specific purpose of containing the wealth effect. And yet, despite his best efforts (or perhaps because of them), highly speculative issues on the NASDAQ have risen at an even more frenetic pace. At the same time the majority of stocks, including many that were not over-priced to begin with, have been sold down to bear market levels.

In his insightful book about mass psychology Jim Dines describes the nature of paradox thusly: "Over-efforting for the wrong thing produces countervailing forces. The things that we pursue the most strenuously are the ones most likely to recede from us, and what we fear most tends to pursue us. Irony is the punishment of paradox." Greenspan's dilemma is an example of what happens when a Fed Chairman with obviously no understanding of market psychology tries desperately to engineer a particular market outcome, only to achieve the opposite result to that which was intended. Attempts by the Fed to cool-off speculation by raising interest rates and by leading the market to believe that multiple future interest rate rises are in the cards has caused money to concentrate in those stocks that are perceived to be the least sensitive to higher interest rates - the high-flying tech stories with no earnings and prospective growth rates that are only limited by the imaginations of day-traders. Ironic, isn't it?

In our 31st January Update we said "when a few more high-profile support levels are taken out (eg, Dow 10,000) and pessimism is running rampant, another buying opportunity will be upon us." Well, Dow 10,000 was taken out decisively on Friday, but pessimism certainly does not appear to be running rampant. Quite the contrary - the low volume of put options traded relative to call options over the past few days indicates that complacency prevails (a low put/call ratio tells us that very few market participants are concerned enough about a further decline to protect themselves through the purchase of put options). This means that a rebound from near current levels is unlikely to be successful. Widespread bearish sentiment provides a platform from which a major rally can be launched. Until that platform is built all rallies are suspect.

In the face of a sharp 16% drop in the Dow the current low put/call ratio is not just unusual, it may be unprecedented. One possible explanation for this extraordinary situation is that traders in today's market are willing to take on more risk due to a perceived safety net provided by the Fed. In a recent article in the Financial Times, Jim Grant draws on research by Merrill Lynch in discussing this new-found confidence that the Fed will never let anything really bad happen to the stock market. According to the aforementioned article, "members of the Merrill Lynch equity-derivatives strategy department suggest that the chairman [Greenspan] has written a form of global investment insurance policy. [The authors of the Merrill Lynch analysis], who are fluent in the language of derivatives, have named this insurance policy "the Greenspan put". "Using a derivatives framework," say the authors, "the Fed's consistent pattern of providing liquidity during financial crises seems to be conditioning investors to believe that the Fed is writing them free, out-of-the-money 'put' protection on the market (and on other asset classes)." In the spirit of scientific inquiry the authors do not assert absolutely that such an option exists, only that investors have begun to behave as if they believe it does." In other words, why spend money buying put options when Uncle Alan doles them out for free?

In reality, if things do get quite nasty for the stock market over the coming months then the Fed will have no choice other than to play the knight in shining armour. The stock market's influence on consumer spending and hence the economy is simply too great to allow a severe bear market to occur.

For those who are skeptical of the Fed's ability to rescue the stock market should it begin to slide into economy-threatening bear market territory, ask yourself this question: If you had the power to create an unlimited amount of money, do you think you could support the stock market? The real challenge for the Fed is to prevent an overly serious decline in the stock market without, in the process, causing a major loss of confidence in the Dollar and Dollar-denominated credit instruments. In the long run it is a game they cannot win, but between now and the November 2000 elections we give them every chance of success.

Following is a list of some of the major US stock market indices and the changes from their 52-week highs to Friday's closing levels:

• Dow Industrials - down 16%
• S&P500 - down 10%
• Dow Transports - down 39%
• Dow Utilities - down 17%
• Philadelphia Bank Index - down 31%

It should also be noted that:

1. The Dow, which closed at 9,862 on Friday, would be about 750 points lower if the changes to its composition had not been made late last year. That is, without the addition of Microsoft, Intel, SBC and Home Depot to the Dow Industrials and the removal of four comparatively weaker stocks, the Dow would now be trading at a new 52-week low.
2. The majority of stocks have been declining since April 1998

So, should the above information cause us to become bearish on the market? Absolutely not! What we can garner from the above is that the market is nowhere near a short-term peak and may, in fact, be closer to a bottom. That doesn't mean we are short-term bullish (we're not), but it does mean that buying Dow or S&P put options right now is probably not a sensible strategy (although it is certainly more sensible than holding shares on margin).

In summary, the absence of strongly bearish sentiment leads us to believe that rally attempts in the near-term will be unsuccessful. However, much of the total potential downside in the majority of stocks has probably already occurred. Regarding the NASDAQ high-fliers, at some point over the next few weeks or months they will no doubt come back to earth in spite of Mr Greenspan's unintentional attempts at keeping them airborne.

Gold and Gold Stocks

As previously stated, we were somewhat concerned that the upside breakout in gold on 4th Feb that resulted in a new BUY signal from our Gold Momentum Model occurred without sentiment having dropped to a bearish extreme and without the accumulation of a large speculative short position on COMEX. These conditions increased the risk of being 'whipsawed' due to an absence of new buying following the initial upwards spurt. Our concerns turned out to be well-founded as the BUY signal was reversed last Friday (25th Feb).

As advised in our Feb 23rd Interim Update, we would not be surprised to see the gold price pullback to the 275-285 range over the next few weeks before a substantial rally gets underway. Such a drop would no doubt dishearten many investors and would have a good chance of creating the platform of bearish sentiment from which a sustainable rally could be launched. Under normal circumstances we would be inclined to step back and watch for evidence that corrective behaviour is complete before considering further purchases. However, the potentially explosive upside in the gold price increases the risk of trying to time the market. We therefore continue to recommend that the shares of profitable, lightly-hedged gold mining companies be accumulated during pullbacks.

One of the best ways of minimising short-term downside risk is to only buy stocks that are in up-trends. When a stock within an unloved sector of the market is in a strong up-trend there is usually a very good fundamental basis for such a trend. Such is the case with Gabriel Resources (GBU), a stock we have just added to the TSI Portfolio.

Deviating from our goal of only buying stocks that are in up-trends, we re-purchased Lihir Gold (ASX: LHG) for the Portfolio last Friday at A$0.75. This stock has now fallen by 40% since we sold it immediately following the negative outcome of the November 29th BOE gold auction and now represents such compelling value that we are no longer able to restrain ourselves. At current prices LHG's total market cap (fully diluted) is only US$520M. It has a 42M ounce resource in the one location, most of which will eventually be converted into reserves. The current mining operation produces 600,000 ounces per annum at a cash cost of about US$200 per ounce and could be expanded to achieve 1M ounces per year with the expenditure of US$200M. There is no technical evidence that the share price has bottomed, so it could become even cheaper, but at current prices it must be an extremely attractive takeover proposition for a major producer.

One final point of interest - James Turk, in his latest newsletter, provides a long-term chart showing the Swiss Franc price of gold. As expected, the chart reveals that gold has been in a down-trend since hitting a major high in 1980. It also reveals that this down-trend was recently broken for the first time in 20 years. This is a very bullish technical development for gold and a very bearish development for the Swiss Franc.

Steve Saville
Hong Kong
28 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