Overview

Bonds - absent a boost from flight capital seeking a safe haven, bond prices are likely to move lower from here.

Stocks – last week's rally should continue during the coming week (after some weakness on Monday).

Gold - strength in the US Dollar is turning the short-term outlook negative.

The Euro Crisis

In the 18 months leading up to the 1987 stock market crash, US Government Bonds in terms of the Dmark lost more than 40% of their value. It was the steady erosion of US debt in terms of other major currencies, combined with a panicky attempt by the Fed to stem the decline in the Dollar and quell rising inflationary pressures via the hiking of official interest rates, that precipitated the large-scale liquidation of US assets and an equity market crash.

In the 18 months leading up to the present time, German Government Bunds in terms of the Dollar have lost about 30% of their value.

Whilst the entire world keeps an eagle-eye on the US stock market, pondering when the decisive break will occur, perhaps the collective gaze should be directed towards Europe for the source of a possible global financial shakeout. The Euro has been declining relentlessly since its inception due to a gradual ebbing of confidence. As confidence diminishes investment capital leaves in search of greater stability, thus putting downward pressure on the currency and causing a further reduction in confidence.

A steady downwards trend in the Euro-Dollar exchange rate, low Euro interest rates (compared to Dollar equivalents), and European officialdom who appear to be unwilling to take any firm action to arrest the decline in their currency, are the perfect ingredients for a Euro carry trade. As the Euro's slide progressed over time with no meaningful response from the ECB, it is likely that the speculative short position in the Euro mushroomed. Enormous quantities of Euros have no doubt been borrowed in order to finance higher-yielding Dollar-denominated investments.

So, while much of the world is focussed on the high valuations of US technology stocks we have a potential Euro-crisis in the making. In order to make a guess at how the various markets will be affected, let's summarise what we think we know.

1. There is an interesting parallel between the current time and 1987 in that the European markets of today are, in one important respect, strikingly similar to the US market of 1987.
   
   
2. When huge speculative positions are accumulated based on the belief that a particular trend will continue indefinitely, that is, when a trade is perceived to be a one-way bet, a dramatic reversal is inevitable. The Asian crisis of 1997, the panic unwinding of the Yen carry trade in 1998, and 1999's gold price surge are examples of such reversals.
   
   
3. The fortunes of the world's financial markets are inter-twined. A sudden upheaval in one part of the world will reverberate throughout the globe.
   
   
4. The value of any fiat currency is based purely on confidence. At the moment, confidence in the Euro is low and confidence in the Dollar is high.
   
   
5. As long as confidence in the US Dollar remains relatively high, any crisis that occurs outside the US will likely cause an acceleration of capital flow into the US.
   
   

Our view is that the Euro-crisis has two possible outcomes. The first is that an event occurs that causes the urgent unwinding of the Euro carry trade. The event could be an unexpectedly-large rise in official Euro interest rates, or dislocations in other markets that necessitate an across-the-board de-leveraging. In this case the Euro would probably move lower into 'the event' and then explode upwards as per the Yen in 1998. The effect of such a sudden and extreme reversal in the Euro-Dollar exchange rate would almost certainly be a sharp (and most likely short-lived) sell-off in global equity markets as assets were liquidated in a haphazard manner to cover losses from wrong-way currency bets. US Treasuries would benefit initially from flight-to-safety buying, but would reverse course soon after as central banks add liquidity to the markets at a frantic pace. The second is that the Euro will maintain a downward path towards an eventual demise, punctuated by the occasional sharp short-covering rally. In this case both the US and Japan would continue to be the recipients of large and increasing capital inflows.

It is almost inconceivable that the Euro would be permitted to fall substantially below current levels since such an outcome would not be in the interest of any of the major financial powers. However, an attempt to support the Euro with higher interest rates could potentially backfire (as per the US experience in the 3rd Quarter of 1987). It will be interesting to see if the ECB takes the higher interest rate route (the next ECB meeting is April 27). If they do, then short-term equity market risk will increase on both sides of the Atlantic.

At this stage we are not sure how the Euro-crisis will end, but we suspect it will come to a head soon (within the next 6 weeks). Although we are unsure what the primary effects of this unfolding currency crisis will be (Will the equity markets crash? Will capital seek out the perceived safety of US bonds? Will the gold price drop or rise?), we can quite confidently forecast an important secondary effect. As it always does, the US Fed would react to such a crisis with hyper-stimulative monetary policy.

The US Stock Market

Current Market Situation

The US market reached its peak on March 24. It then began a slide that culminated in a washout on Friday April 14. During the first 2 weeks of this correction bullish sentiment, as indicated by the put/call ratio, was not significantly dented. In fact, as recently as April 10 the CBOE Equity Put/Call Ratio was 0.33 (revealing an extraordinarily high level of bullish complacency considering the market's volatility). This told us that the market would likely fall much further before meaningful support would be found. As downside momentum progressively increased during the week ending April 14, an escalation in the level of fear and a consequential sharp rise in the put/call ratio finally occurred.

The market greeted the first two weeks of the current correction with disbelief that it could be anything other than a blip in an on-going up-trend. Similarly, last week's rally was regarded with complete skepticism. It seems that even the bulls are expecting at least a re-test of the April 14 low before a sustainable rally gets underway. The current uneasiness can be seen in the Equity Put/Call Ratio which, despite an impressive rebound in the major indices over the past week, was a very high 0.68 on Thursday (indicating that traders are anticipating another fall and are seeking to protect themselves through the purchase of put options).

Last week we made the comment that "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". This statement is equally applicable to the week commencing April 24. With Microsoft making some cautionary statements in its conference call after the close of trading last Thursday we will most likely see a weak market on Monday morning. However, with the majority doubting the veracity of the recent rally we expect the market to continue upwards for at least a few more days following the initial MSFT-led sell-off.

Crash Update

Last week we outlined a typical crash sequence. We said: "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 [the initial drop of 10-20%] 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".

Nothing has changed in the past week to negate the possibility for a May crash. However, with so many technical analysts anticipating a re-test of the April 14 lows in order to confirm that a bottom has been put in place, the probability that we will never re-visit those levels becomes greater. We do not think the market will be so accommodating as to put in a successful re-test and thus let everyone know, in no uncertain terms, that a low is in place and it is now safe to buy.

The wildcard in the whole process is the Euro. Whilst we don't completely ignore the possibility that the US market could crash of its own accord at some point this year, the probability of such an event occurring is very small. However, we can see that a financial crisis brought about by an eroding Euro could well be the catalyst for a worldwide equity sell-off.

Further to the above, we see little chance that a successful re-test of the April 14 lows will take place – there will either be no re-test (the market will find support at a higher level during the next downwards move) or there will be an unsuccessful re-test (the market will fall to a much lower level, most likely as a result of a currency crisis centered on Europe).

Gold and Gold Stocks

Last week we noted that the US Dollar requires net investment inflows of more than $30B per month just to offset the current account deficit and thus maintain its relative value. These inflows will not be sustainable if there is a loss of confidence in US financial markets. A diminution in confidence would see the foreign exchange value of the Dollar fall and lead to an increase in the investment demand for the Dollar's major competitor – gold. The corollary of this is that if the US continues to attract sufficient investment to maintain Dollar strength, then the investment demand for gold is unlikely to grow. The pre-requisite for a sustainable gold rally is a loss of confidence in the Dollar and Dollar-denominated assets.

By now we had expected that stock market instability would have taken its toll and slowed the flow of investment capital into the US. However, with the Dollar Index having hit a new high during the past week this is clearly not happening. We must therefore re-examine our premise.

Declining confidence in the Euro is encouraging the mass departure of capital from Europe. Increasingly large net capital outflows are, in turn, putting further downward pressure on the relative value of the Euro. The Dollar is currently being buoyed by this flight capital from Europe.

It seems that gold is being caught in the Euro-Dollar crossfire. As Euro weakness enhances the relative value of the Dollar, the US Dollar gold price falls (or is prevented from rising). As such, a gold rally is not likely to occur until we see a definitive reversal in the Euro-Dollar exchange rate. With speculators having piled into the short-Euro/long-Dollar trade, when a reversal does finally occur it will probably be violent.

Unfortunately, it probably won't be possible to just wait for the Euro to reverse course before going long gold because the re-valuations of both the Euro and gold versus the Dollar will likely take place very quickly. While waiting for the reversal to occur investments in gold stocks should be maintained at a level that satisfies the "sleep test", that is, they should not be so large that sleep is lost worrying about the price of gold.

As discussed earlier in this Update, we suspect the Euro-crisis will come to a head during the next 6 weeks. Unfortunately, there is no telling how far the Euro will fall before the inevitable sharp reversal occurs.

Steve Saville
Hong Kong
24 April 2000

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