Overview

Bonds - bond prices are probably close to a short-term peak. We do not, however, foresee any major downside in bonds until the second half of the year.

Stocks – a continuation of the rally is expected following a pullback during the first half of the coming week.

Gold - the short-term trend is down, but a major reversal to the upside should occur by mid April. Gold stocks should be accumulated on pullbacks.

Inflation Watch

Defining the terms

Many people who write on the subject of inflation/deflation are constantly tripping over themselves because they deviate from the correct definitions of the terms. Here are some principles that should never be forgotten during any discussion on inflation/deflation:

1. Inflation is an increase in the supply of currency and deflation is a decrease in the supply of currency.
   
   
2. Rising prices are not "inflation", nor are they necessarily a result of inflation. Falling prices are not "deflation", nor are they necessarily a result of deflation. Do not confuse cause and effect. Inflation/deflation (the cause) usually gives rise to a change in some prices (the effect).
   
   
3. When determining whether we are experiencing inflation or deflation (or neither), the effect of the inflation/deflation is not relevant. For example, inflation will sometimes cause asset prices to rise whilst the prices of everyday goods and services remain stable (such as in the US during the 1996-1999 period). At other times asset prices may actually fall during a period of inflation whilst goods and services prices surge (such as occurred throughout most of SE Asia during 1997 and 1998). Numerous factors including mass psychology (the general level of confidence in government, banks and the currency), currency exchange rates, trade / current-account balances, and foreign economic conditions determine which prices rise and fall.
   
   
4. All currency (except a small float) always remains within the banking system. When people talk of money coming out of one investment and going into another investment, they are technically not correct. Money is simply shuffled around between various accounts within the banking system. It is the net change in the total quantity of money within the banking system that determines whether we have inflation or deflation, not changes in the investment demand for different asset classes.
   
   

Here are some opinions:

1. During the Q&A session of his recent Humphrey Hawkins Testimony, Alan Greenspan admitted that the Fed has given up trying to manage the supply of money because they cannot figure out what constitutes money nowadays. This is extraordinary for two reasons. Firstly, that the Fed Chairman would state, in a public forum, that modern money has become so nebulous that those responsible for framing monetary policy cannot measure its quantity or even define it. Secondly, that the Fed Head could make such an admission without causing members of the mainstream press to voice even the slightest amount of concern.
   
   
2. A debt-based monetary system (such as we currently have) depends on the continuous expansion of the money supply for its survival. When the supply of money is controlled by those with a vested interest in keeping the debt-based monetary system alive (the government, the banks, any enterprise that earns income through the creation of credit), the money supply will be continually expanded.
   
   

Inflation Statistics

The PPI released last Thursday confirmed that crude goods prices have risen 26.1% year-over-year. So far, competition from imported goods has prevented the increases in crude goods prices from flowing through to finished goods prices. However, according to the report on import/export prices released last week, non-petroleum import prices are now rising on a year-over-year basis for the first time since April 1996. So, one of the two major pillars supporting low inflation statistics has been removed. Fortunately, the other major pillar – government manipulation – is still providing solid support.

Credit Expansion

The total supply of US Dollars (M3) grew by $44.7B during the week ended 6th March. This increase did not result from an expansion of Federal Reserve credit. It most likely came about through the process of credit creation explained in Doug Noland's March 10th Commentary at the Prudent Bear site (refer to http://www.prudentbear.com/markcomm/031000.htm).

Credit/money expansion is bullish for stocks and ultimately bullish for gold. It has been, and still is, our view that the world's greatest credit expansion will continue until the Dollar collapses (relative to other major currencies and/or relative to gold).

The US Stock Market

Figures released last week reveal that another large increase in margin debt has occurred, prompting calls for the Fed to raise margin requirements to stem the leveraged gambling that is taking place in tech stocks. It is our view, however, that the Fed should not tinker with margin requirements. In fact, we strongly believe that there should be no Fed-imposed limitations on margin debt. The private organisations that provide margin loans should be free to decide how much they are willing to lend, against stock purchased by their clients, based on their own tolerance for risk.

The debate over whether or not the Fed should increase margin requirements has, to date, skirted the real issue. The real problem with the market, and the reason that uninformed speculation has reached such extremes, is the Fed's well-deserved reputation for intervening to curtail any potentially severe downturn in stock prices. If the Fed had not demonstrated its willingness to do whatever it takes to avoid a rapid decline in equity or debt prices, then those who provide margin loans would not need to be told to lift their margin requirements. As has happened throughout history, the dire consequences of government intervention in the financial markets bring about calls for still more intervention, often from those who rail most vehemently against the imbalances caused by the original government intervention.

In our 15th March Interim Update we said that "if the market can navigate through this potential mine-field of events [the PPI, the CPI and the FOMC meeting] without breaking short-term support (now around 1377 in the June S&P Futures), then a move to new highs could occur by the end of April." As it turned out we were too bearish! So far this year the highest daily close for the nearest S&P futures contract is 1496.5. Last Friday (17th March) the June S&P contract (the nearest futures contract at this time) bounced off this level before closing at 1489.

A pullback in the S&P will most likely occur during the first half of the coming week. If the June contract can hold above 1420 during this pullback then there is a good chance we will see a new closing high (above 1500) by the end of this month.

The NASDAQ also finished the week on a positive note. Both the NASDAQ Composite and the NASDAQ100 (NDX) completed V-bottoms last Thursday in the midst of margin selling and panic unwinding of long NDX / short S&P trades, ending the week 7.7% and 9.6% above the lows hit during Thursday's session. If last Thursday's lows hold during any pullback in the coming week (4455.1 for the Comp and 4049.98 for the NDX) then we should see new all-time highs within the next few weeks. It is worth noting that, with the NASDAQ indices down around 10% at their lowest point last week, many high-flying stocks had fallen by 20-30% from their recent peaks. This is the type of action we expect to see during the next correction (following an April high). The market will not reward uninformed speculation indefinitely and those traders who lack discipline, experience and an understanding of the underlying fundamentals, will suffer large losses.

Some sentiment indicators are currently revealing extraordinary bullishness, whereas others are still showing a healthy amount of negativity. If a move to all-time highs by both the S&P and the NASDAQ does occur over the next few weeks, as speculated above, then we would expect all indicators to show rampantly bullish sentiment at that time. This would set the scene for a more prolonged correction (2 - 4 months) prior to a strong market during much of the year's second half.

Next Wednesday the Fed will almost certainly announce another increase in official interest rates. Whether the rate hike is 0.25% (very likely) or 0.5% (highly unlikely), the stock market should rally thereafter.

Gold and Gold Stocks

Who should invest in gold?

• If you believe that all movements in the price of gold are orchestrated by powerful anti-free market forces (governments, central banks, a cabal of large private banks), then it is illogical for you to invest in gold. To do so would be the equivalent of repeatedly calling "tails" in a coin toss game even though you know the coin to be 'two-headed'.
  
  
• If you think the US is headed for a 1929-1932 style stock market disaster, or even a 1990s Japan scenario, then you should not invest in gold. If you do then you are ignoring both history and logic. Gold was a good investment in the 1930s because it was officially linked to the US Dollar. If this link had not been in place then the gold price would have collapsed along with the price of silver and the prices of all other commodities between 1929 and 1932. When asset prices crash, debt-burdened people do not rush out and buy gold or any other investment. They liquidate everything they can, including gold, in a panic to obtain cash. Such was the case during Japan's financial crisis and during the 97-98 Asian crisis.
  
  
• If you think, as we do, that the supply of US Dollars will continue to be expanded at ever-increasing rates to avoid a catastrophic liquidity crunch, with each monetary injection further depreciating the purchasing power of the Dollar, then you should invest in gold as part of a balanced portfolio.
  
  

Strangely enough, the fact that gold has broken below short-term support at 287 is probably a positive development. With gold hovering around the 290 area, speculators net long and sentiment neutral, it was unlikely that a sustainable rally could commence. We have been looking for a drop into the 275-285 range to build a platform of speculative short positions and bearish sentiment from which a major rally could be launched, and we now seem to be getting just that. A dip below 280, with gold stocks holding at around current levels, would be particularly bullish. We continue to recommend the accumulation of gold stocks on pullbacks and, at this time, expect a reversal in trend by mid April.

Next Tuesday we get another Bank of England fire sale. Based on past experience the successful bid price will be very close to the spot price at the time, whatever that happens to be.

Steve Saville
Hong Kong
20 March 2000

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

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