Overview

Bonds - we believe that bonds have, for all intents and purposes, peaked. However, we do not foresee any significant downside in bond prices (upside in bond yields) until the second half of the year (in parallel with rising inflationary expectations)

Stocks – if the S&P and the NASDAQ have not already peaked, they should do so during the next 2 weeks.

Gold - sentiment indicators suggest that gold is close to a bottom. Gold stocks should be accumulated on pullbacks.

Inflation Watch

Alan Greenspan may not be a great Fed Chairman, but he is a very astute politician. He is also someone who, by his own admission, enjoys exploring reams of statistics in the hope of improving his economic stewardship. As a political animal who believes that the central bank, given enough data, can coax an economy into performing in a pre-determined way, here's how we think his mental road map for the US economy would have looked at the beginning of April 1997:

Phase 1: Although inflationary pressures are building, hold off raising interest rates and pursue an accommodative monetary policy during the 1996 election year. Status – COMPLETE.

Phase 2: Begin tightening monetary policy by March 1997. It is likely that 7 or 8 quarter point rate rises over a 15 month period will be necessary to slow the growth in credit, cool-off an over-heated stock market and cure the growing habit of Americans to spend more than they earn. This can hopefully be accomplished without causing a large decline in stock prices (the Dow would most likely stagnate for 18 months, allowing P/E multiples to contract). Status – first rate rise COMPLETE. Remainder of Phase 2 – PENDING.

Phase 3: Beginning in the final quarter of 1998 gradually begin to loosen monetary policy, ensuring that both the economy and the stock market will be strong by the middle of the 2000 election year. Status – PENDING.

Unfortunately, the Asian financial crisis occurred in mid 1997 and continued through the first half of 1998, eliminating (in the collective mind of the US monetary authorities) the possibility of higher official interest rates during that period. Then the Russian debt default and the LTCM fiasco arrived on the scene during the 3rd quarter of 1998, prompting a panicky Fed to cut interest rates and facilitate an explosion in credit growth. Then, after the world had been saved a second time (the first "saving of the world" actually helped create the crisis that necessitated the second "saving of the world", but that's another story) and the first steps toward tighter money were being taken, the Y2K issue suddenly sprang out of nowhere and we were off to the money-printing races again.

So we now have a credit bubble of unprecedented and unmanageable proportions, leaving those in power with 2 options – let the bubble implode and suffer the painful consequences (since gradual deflation is not possible), or keep expanding the supply of credit/money at ever-increasing rates. We're pretty sure which option they will choose, especially in an election year.

The US Stock Market

Don Wolanchuk has made the point that increased buying does not cause higher stock prices. It is, in fact, higher prices that bring about an increase in buying. This phenomenon is seen in the investment world time and time again, as the majority only become interested in an investment after prices have risen substantially. The same logic applies to changes in the total amount of margin debt. According to a report prepared by the Federal Reserve Bank of San Francisco, a Granger-causality test applied to the relationship between stock market valuation and margin debt showed that "the growth in stock market capitalization precedes the growth in margin credit, not vice versa. Specifically, both the one- and two-month lagged growth rates in stock market value are significant in explaining the growth in margin credit; the lagged growth rates in margin credit have no explanatory power for the growth in stock market value. While the Granger-causality test does not identify economic causation and only depicts a statistical association, the data do not suggest that, in general, the growth in margin credit fuels the stock market gains. Rather, the data are consistent with investors reacting to a rise in stock prices by borrowing more against stocks and, likewise, reacting to a fall in stock prices by borrowing less".

The report also points out that the published margin credit data reflect both short and long positions. "Since short positions are marked to market daily, any positions showing a loss would automatically result in an extension of margin credit to the customer. Thus, a portion of the growth in margin credit could be associated with mark-to-market losses on short positions as equity prices rose…"

Margin clerks have certainly been busy issuing 'sell instructions' over the past few weeks, leading to highly-leveraged under-capitalised traders becoming forcibly separated from their previously soaring tech stocks. As a result of the margin selling that has apparently taken place it is probable that the margin debt figures for March, scheduled to be released in a couple of week's time, will reveal a reduction in the total amount of outstanding margin debt.

As mentioned in the 29th March Interim Update we were not particularly concerned with the cautious words coming from some high-profile investment gurus during the first half of last week, but were very concerned that the market failed to respond positively to some good news (the falling oil price). The inability of a bull market to rise on good news is a sign of exhaustion.

The next two weeks should see a continuation of the volatile action in both directions, with the coming week likely to have a positive bias (particularly for the tech stocks). There is still a possibility of marginal new all-time highs in both the NASDAQ and the S&P during the first half of April, but any rallying in the near-term should be considered as a selling opportunity (a time for shifting funds from tech stocks to gold stocks).

Our longer-term view remains unchanged, that is, a correction during the April – July time period is expected to precede a very strong market during the second half of the year. As advised in last week's Update we do not anticipate a move below 1325 on the cash S&P (the 28th Feb intra-day low) during any correction that unfolds over the next few months. With respect to the NASDAQ Composite, last week's drop below the 16th March intra-day bottom has weakened the 3-month outlook. We expect to see the NASDAQ drop below 4,000 by the end of May (after some rallying from its currently over-sold condition during the next 2 weeks).

The greatest risk to the medium-term bullish case would be a near-term upside explosion. Although such an eventuality is extremely unlikely, a sharp move up from current levels (to over 1700 on the S&P and 6000 on the NASDAQ) would have us re-thinking our optimism regarding the year's second half.

Gold and Gold Stocks

Sentiment in the gold market has reached bearish extremes and it is likely that large speculators are now significantly net short COMEX gold futures. These are very positive developments. A negative aspect is that the XAU has not been consistently out-performing the gold price and many prominent gold stocks are not yet displaying definitive evidence of having bottomed.

It appears as though we may be close to a bottom in the gold market in terms of price, but not necessarily in terms of time. On 31st August 1998 gold and gold stocks spiked downwards, creating a bottom that was immediately followed by a rally. However, during 1999 we saw the gold price grind out a bottom over a 4-month period in parallel with a slight firming in gold stock prices. What is unknowable at this time is whether we are headed for a 1998-style bottom or a 1999-style bottom. We are currently leaning towards a 1998-style spike (probably into the low 270s) because gold typically moves counter to other financial assets and we anticipate volatile, downwards-sloping stock markets over the next few months. Either way, if we are correct in assuming that the gold price is now close to its correction low then gold stock prices should begin to rise in the very near future.

We will not be entirely confident that a bottom is in place until our gold model gives a new BUY signal. However, due to the explosive upside potential in the market (and hence the risk of being left behind should a gold rally suddenly erupt), we continue to recommend that the shares of profitable, lightly-hedged gold mining companies be accumulated during pullbacks.

Steve Saville
Hong Kong
3 April 2000

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