Bonds - bond prices should remain firm over the coming months before they resume their primary down-trend.
Stocks – the battle between bulls and bears remains unresolved, but the bulls now have the upper hand.
Gold - 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.
"It is clear…that the US Federal Reserve will act to head off an impending financial crisis before it becomes a crisis and that their most potent weapon is money supply. In particular, note that the Fed has the ability to purchase loans from private banks with newly created dollars. A down turn in the US share market which resulted in leveraged investors defaulting on their loans could be handled via the purchase of these loans by the Fed at some arbitrary discount. The first ramification of this is that we effectively have only two options for the medium term: inflation or hyperinflation (the possibility of deflation caused by debt defaults has been eliminated). The second and more insidious ramification is that all risks associated with the making of loans have been transferred from the banking system to US citizens who save money and/or pay taxes. Banks are free to lend whatever they want to whomever they want without fear of non-repayment.
It will be interesting to watch the reaction of the US monetary agents to any significant down turn in the US stock and bond markets. These markets began a correction in early August and during the first half of this month approximately 50 billion dollars were added to the US money supply. As Mr Greenspan stressed in his speech, the Fed can create money without limit. Put another way, there is no limit to the amount by which the purchasing power of the dollar can be eroded."
The above was taken from an article we penned for Gold Eagle in September 1997 entitled "US Money Supply and the Demand for Gold".
From the same article:
"However, the prevailing high rates of money supply growth cannot be sustained without substantially diminishing the purchasing power of the US dollar. When this reduction in purchasing power begins to be recognised, it is almost certain that many people will seek to protect their wealth from being confiscated through inflation by converting some of their financial assets into gold. Due to the relative size of the markets concerned, a small percentage shift out of financial assets (debt, currencies, shares) into gold would cause a large percentage increase in the gold price."
2.5 years and 1.3 trillion dollars later, the extracts shown above are just as applicable. However, we must confess to having under-estimated the ability of US officialdom to conceal, and the inability of the vast majority of people to recognise, the on-going debasement of the US Dollar.
At the time the above-quoted article was written many economists and financial commentators feared we might be heading for a deflationary collapse. In fact, some still cling to this belief. This view of a deflationary future has never made sense to us because:
Such a setup makes the possibility of deflation (a contraction in the money supply) so low as to be not worth considering.
- The current monetary system gives a political entity (the central bank) the power to arbitrarily create an unlimited amount of currency, and
- The central bank has shown itself to be ready and willing to use this power to resolve/preempt any liquidity crisis
What we should reasonably expect in the future is progressively higher inflation as each 'liquidity problem' prompts the creation of new money in ever-increasing amounts.
The US Stock Market
In last week's Market Update we pointed out that the Dow, minus the changes to its composition that were made late last year, would have been trading at a new 52-week low (it would have been below 9,200). We did not think it was sensible to become bearish in the face of such pronounced weakness (outside the hot tech sector) and suggested that a rebound was likely. We were, however, skeptical that a rally would be successful beyond the short-term due to the absence of the extreme pessimism that usually accompanies important market bottoms.
One week, 500 Dow points and 80 S&P points later, the short-term downside risk in the market is now more worrisome. One area of particular concern is the CBOE Volatility Index (VIX), which fell from around 29 on Friday 25th Feb (indicating a fairly high level of nervousness) to close at about 21 on Friday 3rd Mar (one of the lowest readings of recent months, indicating a high level of complacency). During the past few years the VIX has always dropped into the teens at important market peaks. However, taking a look at a long-term chart of the VIX we can see that it has been in an up-trend since the beginning of 1994, telling us two things. Firstly, it is clear that volatility has been steadily increasing during the past 6 years. This is not surprising considering that stock prices, over this period, have been determined progressively less by underlying business fundamentals and progressively more by the expansion of credit. Secondly, it is quite likely that the next major bottom in the VIX (indicating a major top in the market) will not necessarily see the VIX dropping below 20 (if the upwards trend in volatility remains in tact then each drop should make a higher low). As such, the VIX at 21 is a cause for some concern.
Two other negatives for the market at the current time are the continuing low put/call ratio (indicating that traders are more worried about missing a rally than they are of being trapped by a large fall) and, as mentioned in our 1st March Interim Update, the continuing strength in the oil price. If the oil price does not pullback soon it will cause major problems for the economy (both the 'new economy' and the 'old economy') and the stock market.
On the positive side of the ledger there remains a veritable army of people who are deeply concerned about the extremely high valuations within the technology sector. Even many long-term bulls have become worried about the unrelenting surge in the NASDAQ and have partially withdrawn from the market in anticipation of a near-term shakeout. This possibly explains the fact that the Consensus Inc., Market Vane and American Association of Individual Investors sentiment surveys are still showing a healthy amount of bearish sentiment. However, when there are a significant number of investors waiting on the sidelines for a substantial correction prior to putting more money at risk, the market does not usually accommodate them. Mr Market prefers to have everyone fully invested before taking a big slide.
As usual there are forces in the market that are tugging in opposite directions. Some sentiment indicators show overwhelming complacency, others are mixed. Valuation risk in the technology sector remains enormous, but markets and stocks almost never go down just because they are over-priced. The monetary environment is not helpful at the current time, with growth in the money supply having been minimal so far this year and short-term interest rates at their highest levels in many years. The high oil price also looms large as a negative factor for both the stock market and the economy. Set against the negatives we have the 'old economy' stocks possibly in the early stages of recovery following a sell-off that has been gathering steam since last May for the blue-chips and since April 98 for the majority of stocks. We also have a market that, despite the obvious negatives, has so far met every challenge and appears ready to move higher.
We went into last week expecting a rally that would, after a few days, fail. What we got was a rally that has yet to fail and has, in fact, already taken the S&P500 to a higher level than would generally occur if this was simply a temporary rebound within an on-going downtrend. The visual evidence (the price action) at the moment is thus suggesting a continuation of the up-move that began last Monday. Our guess, therefore, is that the market will ignore some adverse fundamentals over the next few weeks and move higher, provided:
Take out 1380 and the S&P would probably fall quickly to around 1330.
- The March S&P does not drop below 1380 during the pullback that will almost certainly occur some time in the next few days
- The oil price does not move appreciably higher
Gold and Gold Stocks
During the above "Inflation Watch" discussion we summarised our reasons for excluding the possibility of deflation occurring at any time in the foreseeable future. The same thinking that leads us to expect ever-increasing levels of inflation also spurs our interest in gold as both an attractive investment for the next few years and as a hedge against the coming inflation.
Gold was not always a hedge against inflation. In fact, until 1971 it was a hedge against deflation. Pre-1971, with the Dollar and gold officially linked at a fixed rate, the purchasing power of gold rose and fell with the purchasing power of the Dollar. As such, gold's purchasing power increased during the 1930s deflation and decreased during the inflation of the '50s and '60s. However, when the official link was severed the Dollar and gold became competitors (on some level they were always competitors, even when paper money was convertible into gold, because governments usually found themselves unable to resist the temptation to excessively expand the supply of paper money). This competitive relationship means that a loss of confidence in the Dollar leads to, and is a prerequisite for, a rise in the investment demand for gold.
With the inflation that has already taken place and the inflation that will be necessary in the future to maintain liquidity in our debt-burdened financial system, confidence in the Dollar will decay and investment demand for gold will correspondingly grow. This is as inevitable as day following night, although many gold investors may be feeling like they are in the midst of an Antarctic night.
On Friday the XAU closed at its lowest level since July 19th of last year, suggesting that gold is not yet ready for prime time. However, we still recommend that gold stocks be accumulated on pullbacks due to the difficulty of accurately timing a market that could spring upwards like a released 'jack-in-the-box' at any time.
Our favourite South African gold stocks – HGMCY, GOLD, and to a lesser extent DROOY, are holding up quite well. The strongest stocks in a down market tend to be the best performers when the market turns up. Don't make the novice's mistake of buying the stocks that have gone down the most just because they appear cheap.
6 March 2000
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