Overview

Bonds - we believe that bonds have, for all intents and purposes, peaked. The recent surge in bond prices has resulted from 'flight-to-quality' buying that may indicate a simmering derivatives crisis.

Stocks – the NASDAQ has seen its high for the first half of the year, but a new all-time high on the S&P is possible in the near-term.

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

Inflation Watch

Next week we get the greatly-anticipated price indices – the PPI (on Thursday) and the CPI (on Friday). Although the media and the markets tend to agonise over these statistics in an attempt to get a 'heads-up' on the future direction of monetary policy, the chief maker of monetary policy prefers to look at other indicators of inflation. How do we know? Because he has told us so in speeches and in testimony.

An excellent article by Anirvan Banerji entitled "So Much for a Soft Landing" appeared at TheStreet.com on 4th April. Mr Banerji is the director of research for the Economic Cycle Research Institute (ECRI), which publishes the Future Inflation Gauge (FIG) on the first Friday of every month. The FIG's creator, Dr Geoffrey Moore, was Alan Greenspan's statistics professor in college. Unlike the CPI, which is subject to the vagaries of government handling, the FIG is an honest attempt to provide a leading indicator of price changes within the economy. As such it is not surprising that the FIG, unlike the CPI, has proven to be a very accurate predictor of directional shifts in Fed policy during Greenspan's tenure as Fed Chairman.

Below is a graph showing the correlation between the Fed Funds Rate and the FIG during the Greenspan years. Note that the latest figures, released last Friday, reveal that the FIG is currently rising at a year-over-year rate of 12.6%.

The graph highlights a problem for the Fed. In the past the policy makers have waited until there has been a distinct change in the FIG's trend before veering from their current path. However, based on the March 2000 data (not shown on the graph) the FIG is still rising. This creates a quandary because Greenspan, the politician, will want all interest rate hikes out of the way by mid-year (several months prior to the November elections). As such his preferred gradualist approach may need modification in the short-term and we could therefore see a 50 basis point rate increase at one of the next two FOMC meetings.

The Bond Market

US Government bond yields have been falling since hitting a high of around 6.75% in mid January. The rally in bonds was initially driven by the following factors:

1. Sentiment had reached bearish extremes.


2. Bearish sentiment had led to the build-up of a huge speculative short position in bonds, setting the scene for a massive bout of short-covering.


3. In addition to the short positions accumulated by traders, large-scale short-selling of bonds had occurred in order to hedge other debt holdings.


4. A perception began to take hold that the Fed was becoming more aggressive in restricting the supply and increasing the cost of short-term money, thus reducing the expected future level of inflation (and supporting bond prices).


5. The US Treasury confirmed its intention to re-purchase long-term debt instruments.

The above factors alone would likely have taken yields down to the 6.0%-6.2% range. However, as at Friday's close T-Bonds were yielding only 5.7%. The recent plunge in bond yields is probably due to:

1. Flight-to-quality buying, that is, long-term debt without a government guarantee is being sold and replaced with higher quality (government-guaranteed) debt


2. Purchasing of bonds by the Fed as part of its Open Market Operations and on behalf of the Bank of Japan (as part of the BOJ's intervention to support the Dollar versus the Yen).

A mini panic to quality and a Fed that is apparently eager to boost liquidity suggest that there may be a derivatives-related crisis brewing beneath the surface. Another 1998-style bailout may therefore be on the cards.

The US Stock Market

The death of value-investing?

There seems to be a lot of confusion over the term "value investing". True value investors do not necessarily buy stocks with low P/E ratios, nor do they necessarily avoid high-tech stocks. A value investor is someone who buys a company's stock because his/her assessment of the company's value is significantly more than the current stock price. A value-investment decision generally involves buying a stock when, in the opinion of the investor, the market is not correctly discounting the expected future profits and/or cash-flow of the company. As such, a stock selling at a P/E ratio of 70 may represent better value than a stock selling at a P/E ratio of 10 – it all depends on the earnings growth rate. Similarly, a company that is losing money today may represent better value than a highly profitable company since it is the expected future earnings of the company, compared to the current share price, that determines value. That doesn't mean that many of the high-P/E tech stocks in the current market are not grossly over-valued. It does mean that a stock should not be dismissed as being over-valued purely on the basis that it sells at an extremely high multiple of current earnings.

Current Market Situation

We have been anticipating that stocks would reach an intermediate high during April. This may still be the case for the S&P, which has the potential to achieve a new all-time high at some point during the next 2 weeks (particularly if the coming week's inflation statistics do not hold any negative surprises). However, new record highs at this time are unlikely for the Dow and almost out of the question for the NASDAQ.

Over the next 3 months we expect continued high volatility within a generally downwards trending market. Further shakeouts are likely because the majority of market participants seemingly still believe that price doesn't matter when buying high-growth stocks and that new record highs will quickly follow every decline. Until such thinking is dispelled it will be difficult for a sustainable rally to take place.

Selling squalls, such as occurred during the early part of last week, should be used to gradually accumulate technology stocks in preparation for a potentially strong market during the year's second half. We emphasise the word 'gradually' because, when panic selling does occur, there is no way of knowing how far stock prices will fall. This is especially relevant if, as mentioned above, we have a potential derivatives crisis on our hands.

Plunge Protection?

In our latest Interim Update we discussed the rumour that official intervention prompted last Tuesday's turnaround in the stock market. Although the type of action we saw on Tuesday does not necessarily suggest some form of government-sponsored manipulation, we have no doubt that such manipulation has occurred in the past and will occur in the future.

When the world's deepest pockets decide to support a market they will, of course, succeed, at least until the currency buckles and the gold price soars. This is why it makes no sense to base an investment strategy on a cataclysmic end to the equity bull market. Official intervention in the stock market is not a reason to be bearish on stocks. It is, however, a reason to be bearish on the government and its currency.

Gold and Gold Stocks

At this time we see no reason to alter our forecast of a reversal in the gold market by mid April. In fact, the following factors suggest that we are within spitting distance of a bottom:

1. Sentiment towards gold has reached bearish extremes, with Market Vane's bullish percentage having declined to the low 20s and a flood of negatively-skewed news articles having recently appeared in the press.


2. As at 4th April, large speculators were net short 23,000 COMEX gold futures contracts. The speculative net short position will no doubt increase as long as the gold price either stays at current levels or moves lower, thus providing fuel for the initial phase of the next rally.


3. If the stock market remains highly volatile and trends lower over the next few months, as we suspect it will, then gold should benefit from some flight-to-safety buying.


4. Any strong scent of a derivatives-related blow-up would stimulate investment demand for gold (although a downward spike may occur initially as happened in 1998).


5. The drop in the oil price over the past 5 weeks has probably helped quell inflationary fears. We believe the oil price correction will have run its course by mid April, removing a pillar that has recently been supporting a low inflation outlook. Leading indicator data put out by the OECD point to robust global growth going into the year's second half, helping to substantiate the case for firm oil prices (and commodities in general) once speculative long positions have been largely unwound.


6. As we have seen already this year, any slow-down in the rate of credit expansion causes immediate tremors throughout the financial landscape. Not wishing to see any semblance of financial crisis between now and the November elections, the Fed will surely err on the side of excess liquidity at the first sign of trouble. As such, inflation looks set to accelerate – the ideal environment for gold and commodities.

Fundamental, psychological, and even some technical evidence suggests that a gold rally is imminent. However, there are no guarantees and we cannot rule out the possibility of an extended bottom.

Steve Saville
Hong Kong
10 April 2000

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