Overview

Bonds - we believe that bonds have, for all intents and purposes, peaked. Absent a stock market crash bond prices are likely to move lower from here.

Stocks – the major indices are probably close to a temporary bottom and a rally will most likely commence by Tuesday 18th April.

Gold - we expect a rally at any time.

Inflation Watch

What is the Fed's raison d'ętre?

The Fed has been holding official interest rates at artificially low levels for years. Even after 5 quarter-point rate hikes the Fed Funds Rate and the Discount Rate are still unrealistically low compared to the demand for money.

The correct setting for short-term rates is one that balances the supply and demand for money. This is the rate that would be set by the market, of its own accord, if not for the intervention of the Federal Reserve. In other words, the best the Fed can hope to do is the equivalent of what the market would do in the absence of the Fed. So, what is the real purpose of the Fed?

The Federal Reserve System was created (and is maintained) for the purpose of removing the natural constraints that would otherwise limit the ability of government and banks to expand their respective balance sheets. By eliminating objective limitations on credit expansion it was also hoped that the business cycle could be smoothed. As far as creating an environment within which government spending and bank lending could be dramatically increased, it is clear that the Federal Reserve System has been a resounding success. As far as smoothing the business cycle, the results have been less than stellar.

The productivity miracle

An excellent article from the March 31 issue of Grant's Interest Rate Observer entitled "The Great Productivity Delusion" can be found at http://www.grantspub.com/productivity/. The conclusion of the article is that government statistics have been greatly exaggerating improvements in productivity and that the Q1 Productivity Report, due to be released on May 4, will be a big disappointment.

Although disagreeing with Jim Grant on economic analysis is akin to disagreeing with Michael Jordan on how to win a basketball game, we're going to tentatively do it. While we certainly agree that the real increase in productivity pales in comparison to the reported numbers, we suspect another large increase will be reported on May 4 due to the way in which the calculation is done.

Information released so far this year shows that personal consumption posted huge gains during the first quarter. Since personal consumption accounts for about 68% of GDP, the GDP growth rate for the first quarter is likely to be another big number (the consensus estimate is currently around 6.3%). Productivity growth equals GDP growth minus the growth in hours worked, therefore a high GDP growth number will lead to a high productivity figure unless there is a substantial increase in the total hours worked.

Our view is that the GDP figures are essentially bogus because the effects of inflation are not properly discounted. Bogus GDP figures give you bogus productivity figures.

The CPI

The CPI is a heavily-manipulated, narrowly-defined, backward-looking indicator of prices. The only useful thing about Friday's CPI is that it effectively puts a sock in the mouths of the "New Era" theorists who were, until recently, singing the praises of a 'low-inflation high-growth productivity-driven' economy.

The US Stock Market

Is that a crash on the horizon?

From our April 12 Interim Update: "…sentiment indicators work a lot of the time, but they fail in a crash scenario. Markets only ever crash when the majority of participants are fearful, so automatically buying just because sentiment indicators reveal a high level of fear may have One buying just prior to a crash."

With the market having plummeted over the past week, do we now have a setup for a stock market crash? Probably not, because a setup for a crash invariably involves going through the following process:

1. A major high is reached amidst overwhelming optimism
   
2. The market drops by around 10-20% from the major peak to a preliminary low, causing much consternation but not severely rupturing confidence
   
3. A sharp rebound then ensues, taking the market back up to near its highs and generating a feeling of profound relief
   
4. Another decline then commences, sending the market back to the lows reached during the initial drop
   
5. The market drops below the preliminary lows, causing a sudden loss of confidence and a panic liquidation – the crash
   

The process described above lasts about 2 months – this is the amount of time it seems to take to change market psychology from unthinking bullishness to unbridled fear.

If the market is going to crash, with March 24 giving us the major high on the S&P500, then we are probably just completing step b) in the sequence and should see the market move up over the next two weeks. If it then turns around and begins heading back down towards the current lows (or a lower level reached during any follow-through selling early in the coming week), then a crash becomes possible around May 15-22.

Having said all that it should be noted that a crash is an extremely low probability event and is not something we expect to happen.

Current Market Situation

In last week's Update we said we expected continued high volatility within a generally downwards-trending market. What an understatement that turned out to be!

Although fear does not yet appear to have reached extreme levels, sentiment is certainly bearish enough at this time to suggest that a strong rebound will commence on either Monday or Tuesday of the coming week. For example, last Friday's closing values for the CBOE equity and overall put/call ratios were 0.77 and 0.91 respectively. Also, the CBOE Volatility Index (VIX) hit a high of 41 on Friday before closing at 39. Levels such as these have not been seen since October 1998. In addition to these statistical indicators of sentiment, bearish commentary and dire prognostications have become more prevalent over the past few days. Furthermore, evidence that we are close to at least a short-term bottom was potentially provided in the latest edition of Barrons – when the unswervingly-bearish Alan Abelson begins to sound cheered by the market's performance, a near-term rally is almost guaranteed.

We had been expecting the market to make an important intermediate top in April. It now seems clear that the top for the S&P occurred on March 24 and the top for the NASDAQ on March 10 (with a marginally lower peak on March 24). While we can never be complacent when it comes to a market that has so recently exhibited the greatest excesses in stock market history (and, to a certain extent, still does), a severe correction at this time fits perfectly into the political and monetary backdrop. We are therefore still confident that whatever low is reached over the next 4-6 weeks will prove to be a great buying opportunity.

At the margin

To our surprise, the total amount of outstanding margin debt increased by 5% in March. This means that the margin calls sent out by brokerage houses during March's high-tech selling squalls were, by and large, satisfied through the deposit of additional cash and/or security. It also helps explain the severity of the NASDAQ's decline during the first half of April as leveraged-traders were clearly betting heavily on a resumption of the tech-led rally.

Gold and Gold Stocks

Since bonds didn't catch much of a bid last week and the Dollar has not weakened to any significant degree, it appears as though foreign investors who recently sold US stocks have left the proceeds in cash US Dollars. However, continued volatility in the US stock market will likely prompt the repatriation of some Dollar-denominated funds and lead to a drop in the exchange value of the Dollar. If the Dollar Index falls enough to break levels perceived as important technical support then speculative selling would no doubt ensue, thus exacerbating the fall. A declining Dollar would also reduce the appeal of US assets, leading to a further outflow of capital.

The US needs to attract at least $30B per month of net foreign investment just to offset the current account deficit. Even if all the existing US Dollar investments remain in tact (very unlikely), the Dollar will fall unless a large amount of new investment flows into the US every month. In order to attract this new investment and to ensure that existing investments remain parked in the US, confidence in US financial markets must be maintained.

Higher interest rates will not support the US Dollar. To an investor seeking to preserve his/her capital, an additional one or two percent annual return is an irrelevance. Confidence is built on a strong currency, a strong currency requires more than $30B per month of net capital inflows, and large capital inflows will only occur if US markets are perceived to be stable and in long-term up-trends.

As we do not see stability or anything resembling a consistent up-trend returning to the US stock market for at least the next 2-3 months, a near-term decline in the Dollar seems highly probable. If the investment demand for Dollar-denominated investments does diminish over the coming few months as we suspect it will, then the investment demand for gold should get a serious boost.

During the wild oscillations on the world's financial markets over the past week gold was conspicuous for its stability, with a few attempted rallies being quickly snuffed-out. To the suspicious-minded it probably seemed as though gold was being held in check (it certainly did to us!). However, should confidence in the US Dollar begin to slide then the consequential increase in the investment demand for gold will overwhelm any games being played in the futures markets.

We remain bullish on gold and feel very comfortable holding gold shares in these turbulent times.

Steve Saville
Hong Kong
17 April 2000

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

www.speculative-investor.com