Overview

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

Stocks – downside risk over the next 2 weeks is extreme. By the same token, we are probably getting close to the second great buying opportunity of the year (the first was April 14).

Gold - it is possible that 28th April gave us the closing low for gold and a rally has begun. Further evidence is required to confirm this view.

Treasury Bonds and Interest Rates

Bonds: 1998 versus today

Last week we reviewed some of the similarities between the current financial market situation and that of 1998. However, one major difference between then and now is the behaviour of the bond market. During 1998's financial turmoil bond prices rose as stock prices fell, with bonds hitting a major peak (in October) at about the same time as stocks were completing an important bottom. This year bonds peaked in early April, about 2 weeks after the S&P500 reached its highest point, and have since been declining in parallel with stocks. For this reason the downside risk for stocks is potentially greater now than it was at any time during the cyclical bear market of 1998.

Interest Rates

Our view is that there will only be two more hikes in official interest rates, a 50 basis point increase at the May 16 FOMC meeting and a 25 basis point increase at the June 27/28 meeting. Our reasoning is that evidence of an economic slowing will begin to surface by July. During past tightening cycles the Fed has continued to raise rates until it sees the 'whites of a recession's eyes', but with a Presidential election happening in November we expect it to suspend any further tightening at the first sign of a cooling economy.

Last week the Reserve Bank of Australia hiked rates by 25 basis points and confirmed that official interest rates are now on hold for the foreseeable future, assuming no further deterioration in the Australian Dollar.

The Euro Crisis

The continued strength of the Dollar in the face of declining US stocks and bonds shows that a) the US is still perceived to be a relatively safe place to park money and/or b) trend-following speculators are still piling into the long Dollar / short Euro trade. At some point in the near future the Euro will most likely bottom and begin to rise, setting off a sudden and substantial upwards revaluation of the Euro relative to the Dollar as a herd of speculators tries to cover Euro short positions. At this moment, however, there is no evidence that the Euro has bottomed.

The following chart shows the Euro-Dollar exchange rate since January 1995, using the ECU to represent the Euro prior to 1999. It can be seen that the Euro's weakness is not a new phenomenon – it has been declining since 1995 with a steeper downward trend commencing in Oct '98. What we may now be seeing is the final capitulation stage of the Euro's bear market (or perhaps just the capitulation stage in the current leg of an on-going bear market, with an even steeper down-trend commencing after a quick upwards adjustment).

The US Stock Market

Reacting to news

From our May 3 Interim Update: "As far as the very short-term is concerned (the next few trading sessions), a bounce in the stock market seems likely based on the following sentiment indicators. Any rally attempt today (Thursday) may be muted due to a reticence to buy ahead of Friday's Employment Report, but we would certainly expect a rebound to get underway by Friday afternoon at the latest."

Many traders and commentators apparently think that the market should drop on bad news and rise on good news and are always surprised when it does the opposite. Some even assert that a stock market rally following bad economic news is a sign of manipulation. Such thinking demonstrates a complete lack of understanding as to how the market works. A rally was going to occur on Friday regardless of the reported employment situation simply because so many traders had taken a bearish stance going into the report. When more short-selling of the S&P futures occurred in a knee-jerk reaction to the news, the stage was immediately set for a strong bounce.

Current Market Situation

With the market moving lower over the past week the crash sequence we described a few weeks ago is still valid. Although we do not expect a crash, downside risk over the next 2 weeks is extreme.

The impending inflation statistics and the May 16 FOMC meeting create a good deal of uncertainty for the market in the short-term. Until these uncertainties are removed there will probably be very little buying interest, meaning that a small increase in selling has the potential to cause an out-sized drop in the market indices.

The time for selling occurred in March and the time for buying is fast approaching. We suspect that once the dust settles the greatest proportion of new investment will be directed towards tech stocks. The price action over the past few weeks confirms this – when investors have been fearful and most concerned with capital preservation, they have shifted into the large-cap "old economy" stocks or out of equities altogether. When they have been primarily concerned with making a profit, they have shifted into tech stocks.

Our view is that the investment or trade with the best risk/reward potential for the Year 2000 will be the purchase of technology stocks following the completion of panic selling in May. We think this will be the case regardless of whether the current decline turns out to be part of a longer-term bear market or just another correction in the on-going bull market. If we have commenced a long-term bear market then the rally we expect to occur during the second half of this year will not take the S&P500 or the NASDAQ to new highs, but it should still offer a great opportunity to profit on the long side of the market via the right selection of stocks.

Following is a list of tech stocks that we think will provide excellent returns, taking a 6 month view, if they are purchased during any market-wide sell-off during the next 2-3 weeks. We have included, in the list, the prices at which the stocks would represent exceptional value.