Overview

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

Stocks – the battle between bulls and bears is still unresolved. The odds are very slightly in favour of a bullish outcome in the short-term.

Gold - we are approaching a cycle change that should lead to a gold rally. Gold stocks should be accumulated on pullbacks.

Inflation Watch

If you begin a logical thought process from an incorrect premise and then apply flawless logic, any conclusion you reach will be erroneous. Similarly, if you begin any economics discussion using the government-sponsored definition of inflation – that inflation is a rise in the general level of consumer prices – then it is impossible to make sense of the happenings of the past few years. Impossible, that is, unless you make a giant leap of faith into the fantasy-land known as the "New Era" or "New Paradigm", a land where amazing technological advances have changed the laws of economics. If you do not make that leap, but you do accept the proposition that the CPI represents inflation, you will exist in a state of confusion. You will conclude, by subtracting the percentage increase in the CPI from the 10-year bond rate, that real interest rates have been quite high for the past few years. However, you will be unable to reconcile that conclusion with the spectacular gains that have occurred in asset prices (an asset price boom can only occur if the real cost of money remains low for a lengthy period of time). You will be puzzled as to why long-term bond yields have been trending upwards since October '98 while inflation has been, according to your accepted definition, very much under control. You will also probably be looking aghast at a central bank that seems hell-bent on raising interest rates for no better purpose than to stop growth and put people out of work.

But when you correctly define inflation as an increase in the supply of money, it all suddenly makes perfect sense!

The manipulators of the public mindset (the government and their agent – the Federal Reserve) now face a dilemma – they have not only sold the world an invalid definition of inflation, but have also 'massaged' their preferred measures of inflation to the point where these measures bear absolutely no relationship to reality. In doing so they have effectively removed all evidence of inflation from the public eye.

There is no doubt that Greenspan understands the truth – that the level of inflation is already excessive and is trending upwards. However, the snow job has been so successful that those responsible for framing monetary policy find themselves in a state of perplexity – how do you justify raising interest rates to fight an enemy that, as far as the majority are concerned, does not exist? Greenspan has resorted to discussing how aggregate demand within the economy is becoming excessive due to the "wealth effect". He has even made the ridiculous assertion that improved growth in productivity may now be a problem because it causes investors to 'pay up' for stocks, thus contributing to the dangerous wealth effect. All of this because he and his cohorts cannot / will not tell the truth about inflation. Ah, what a tangled web we weave…

In discussing the January PPI in our Feb 21st Update we noted 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." In the case of Proctor and Gamble it was the latter.

The US Stock Market

Technology stocks continued on their winning ways last week. At this stage the up-trends in both the NASDAQ Composite and NASDAQ100 are firmly in tact and show no signs of breaking. Financial support for technology stocks appears to be relentless as dips in the tech-heavy indices seldom last for more than one day before a new wave of buying emerges. However, despite the continued strong price action evidence is building that we are close to a peak in the current leg of the technology bull market.

Sentiment, as far as tech stocks are concerned, has certainly reached levels normally associated with market peaks. Analytical evidence of the rampantly bullish mentality, such as the exceedingly low put/call ratio, is also supported by anecdotal evidence. For example, before the NASDAQ had even reached the 5,000-point milestone many commentators were already talking about the near-term possibility of NASDAQ 6,000.

As far as timing is concerned, it is worth noting that we are approaching a period of the year when technology stocks often reach intermediate tops. For example, the NASDAQ made a significant peak in April of both 1998 and 1999. TheStreet.com Internet Index reached an important top on 13th April 1999 and some of the 'old-line' Internet stocks (Amazon, AOL, eBay) are still trading below their April '99 highs.

Based on the above-mentioned sentiment and seasonal factors we expect a reversal to occur in the NASDAQ at some point during the next 6 weeks, most likely in April.

Many of those who are long-term bearish on the stock market appear to believe that a sharp decline in technology stocks, when it does finally occur, will herald the start of a major bear market. It is our considered opinion, however, that the upcoming correction in tech stocks may signal the final capitulation in a cyclical bear market that began in April 1998 and will be followed by another upwards leg in the on-going secular (long-term) bull market. This conclusion is primarily based on the fact that the majority of stocks have already fallen substantially from their highs and our belief that the expansion of credit (and therefore money) will once again be accelerated during the months leading up to the November elections.

The Fed has never operated independently of the political process, but during the Greenspan tenure it has dispensed with any pretense of independence. As such, all upward adjustments in official interest rates will be complete by mid-year and we will no doubt witness, during the second half of the year, the type of money supply explosion that has become the hallmark of the current administration.

The three major determinants of stock prices are earnings growth, money flow and investor psychology. Even in the current market any company that fails to meet market expectations regarding earnings growth sees its stock unceremoniously dumped. It is the earnings growth story that should see technology stocks continue to out-perform for years to come as the profits of the "new economy" companies, at least the ones that are able to properly execute their business plans, will probably surprise on the upside. The "old economy" stocks, however, will need to modify their business plans if they are going to thrive in a high-inflation world. The increase in commodity prices seen over the past 12 months is just the beginning of a trend we expect to continue for many years. Until these companies do make the required changes and demonstrate an ability to achieve healthy profit growth, they will trade at low multiples of earnings.

An expanding money supply provides the fuel to lift stock prices and investor psychology determines the focus of investment demand (that is, it determines where the excess money is spent). There is some concern that credit cannot be expanded indefinitely and that the high (and accelerating) level of debt will inevitably lead to a financial collapse. Unfortunately, this is the sickening truth. However, until we see the Dollar Index decisively break its long-term up-trend and the gold price at all-time highs, we can be confident that the end of the world's greatest credit expansion is not close at hand.

It is difficult to even hazard a guess at how steep the NASDAQ's upcoming correction will be. Although bullishness is rampant and valuations are stretched to say the least, we get the feeling that a lot of fund managers will be looking to buy any significant drop. The index itself may therefore not suffer the type of fall that would normally be expected following such a huge run-up. Anyway, we are open-minded regarding the possibilities and will try to identify the buying opportunity that should emerge over the June-August time span. As far as the very short-term is concerned, the market's direction remains unresolved. The pullback in the S&P during Mon and Tue of last week was certainly greater than should have occurred in order to keep the previous week's rally in tact, but Wednesday's $3 drop in the oil price and Thursday's buying spree have kept the short-term bullish case alive. The only thing we can forecast with confidence regarding next week's action is that volatility should remain high as the market reacts to the options/futures expiration and a barrage of economic reports (current account, industrial production, PPI, CPI).

Gold and Gold Stocks

Our stock market strategy is as simple as it is unusual – to always be invested in both technology stocks and gold stocks, changing the weighting of each sector within our portfolio to suit the current market. In this way we hope to achieve good returns under almost all conditions since gold stocks tend to move counter to technology stocks. Because we are always long both sets of stocks and try to scale in/out of positions as a change in the investment cycle approaches, exact timing is not critical.

Based on our expectation that an intermediate-term top in technology stocks is likely during the next 6 weeks, we will take advantage of any near-term strength in our stocks to reduce exposure to this sector (although we don't rule out the possibility of additional purchases if fundamental and technical considerations are favourable). Correspondingly, we have already been accumulating our favourite gold stocks and will add to positions as the short-term outlook for the gold price improves.

The latest Commitment of Traders (COT) Report showed that large speculators are still net long COMEX gold futures. Although we do not place a lot of emphasis on the COT report, it is important for one reason – the initial part of any substantial rally is often propelled by short covering. Once an upside breakout is established a rally will usually take on a life of its own as rising prices stimulate increased buying. With large speculators net long any short covering will be minimal, thus a potential impetus for the commencement of a rally is missing. We would therefore be more confident regarding gold's near-term prospects if the COT report showed large speculators to be net short. It is likely that a drop below 286 in the spot gold price would prompt the close-out of speculative long positions and the establishment of short positions. This, in turn, would probably cause the gold price to fall into the 275-280 range.

The COT is one factor in the gold market, but it is certainly not the most important factor. The single most important influence on the gold price, by a long way, is investment demand. When growth in the investment (monetary) demand for gold begins to accelerate the gold price will rise substantially. The fact that the gold price has twice surged above $300 over the past 6 months, despite a barrage of negative press and high-profile (although fundamentally insignificant) central bank gold sales, is a sign that investment demand for gold is rising.

Steve Saville
Hong Kong
13 March 2000

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

www.speculative-investor.com