Gold and Stock Market Update

Overview

Bonds - bonds may attract some buying in the aftermath of the May 16 FOMC meeting, but a continuation of the commodity price up-trend will put downward pressure on bond prices.

Stocks - the rally on May 11 has markedly improved the short-term picture. A further rally is likely in the days following the FOMC meeting.

Gold - it is likely that April 13 gave us the closing low for the XAU and there is some chance that April 28 gave us the closing low for gold. If this is the case then a rally has begun. However, further evidence is still required to confirm this view.

Treasury Bonds and Interest Rates

Wall St firms are busy raising their estimates for official interest rates. For example, Salomon Smith Barney recently upped its target for the Fed Funds Rate from 6.75% to 7.5% (the rate currently sits at 6%). In fact, the consensus expectation amongst Wall St analysts now seems to be for the Fed to continue raising rates throughout this year's second half, despite the elections, adding 150 basis points to the Fed Funds Rate by January 2001. In many cases these are the same people who proclaimed, in mid 1999, that the absence of inflation meant that we would see, at most, two small upward adjustments in official interest rates. Having been wrong at the beginning of the tightening cycle they are now about to be just as wrong at the end of the cycle.

With long-term interest rates having risen steadily since Oct '98, commodity prices having been trending upwards since early '99, the ECRI Future Inflation Gauge having moved up sharply over the past 15 months and the total supply of money growing at double-digit rates for the past two years, the analyst community is now suddenly focussing on pricing pressures. Interest rate forecasts are hence being ramped up to reflect this newfound appreciation of the real world just as evidence of a slowdown is beginning to emerge.

As speculated in last week's Update, the Fed will probably raise rates at its May 16 and June 27/28 meetings. By the time the August meeting comes around we suspect there will be enough evidence of an economic slowdown (note: some evidence is already appearing) that the Fed, not wishing to be a factor in the November elections, will put rates on hold for the remainder of the year.

The Euro Crisis

From last week's Update: "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." With the Euro having risen back above US$0.91 on Friday despite the ECB's decision to leave interest rates unchanged (or perhaps because of that decision – see below), and with the financial markets having already discounted a 50 basis point rate increase at the May 16 FOMC meeting, it is possible that the Euro has bottomed. A rush to cover short positions and a consequential surge in the Euro-Dollar exchange rate will occur when a sufficient number of speculators conclude that the trend is reversing.

In our letter to the ECB (refer to the May 1 Update) we suggested that "raising official interest rates would potentially jeopardise Europe's economic recovery and may actually have the opposite effect on exchange rates – the Euro may decline further relative to the Dollar as investment capital exited European debt and stock markets". The Euro is not weak because of an interest rate differential, it is weak because of a confidence and growth differential.

The US Stock Market

Current Market Situation

From last week's Update: "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."

Although the bounce that occurred late last week has not totally removed downside risk from the market, the crash sequence has been negated.

While the Thursday/Friday rebound was not particularly convincing in that volume was light, breadth was not impressive and no important technical levels were surmounted, there was one major positive – the reversal was greeted with widespread disbelief. On Thursday, despite the 5% surge in the NASDAQ and the 2% move in the S&P500, the CBOE equity put/call ratio was 0.65. Such a high reading suggests the majority of traders were still expecting the market's next major move to be down. Commentary in the mainstream financial press confirmed this sentiment, with the consensus being that we were simply witnessing a snap-back prior to further downside.

There is still likely to be minimal buying interest ahead of the FOMC meeting and the release of the April CPI on May 16, but the prevailing sentiment and the upcoming Options Expiration (Friday May 19) set up the possibility of a strong rally during Wednesday through Friday of the coming week. In particular, the large volume of put options purchased over the past month has the potential to magnify any up-move as we head into Options Expiration, for the following reason. Large-scale sellers of put options often seek to hedge their exposure to the market by shorting the underlying stocks or index futures (if they do not short the underlying stocks or index then their loss, in the case of a market downturn, will substantially outweigh any benefit gained from receiving the put option premiums). In this way they cover themselves in case of a sudden drop in the market and hope to simply pocket the put premiums following expiration of the options. The problem occurs if the market suddenly turns upward, thus creating a loss on the short position that was entered to hedge the puts. In this situation, to avoid giving back the profits gained through the sale of the put options or to minimise the loss on the trade, put-sellers are forced to close-out their short positions. The prices of the shorted stocks or index are thus propelled upwards.

Although the coming week has the potential to be quite positive for the bulls, the following major risk factors are hanging over the market and may precipitate another down-move in the weeks ahead:

  1. If commodity prices continue their rally then bond prices will almost certainly fall, putting downward pressure on stocks.

  2. If the Fed is not as politically sensitive as we think they are then they may continue raising rates even after the first signs of an economic slowing appear, thus bringing about a severe recession.

  3. Several large-cap tech stocks, Cisco and Oracle being prime examples, remain grossly over-priced even assuming the continuation of strong earnings growth. Although these stocks are a minority they have an outsized influence on the NASDAQ100 and the S&P500 due to their enormous market capitalisations.

We see point 1 above as the greatest single risk over the next two months. In an environment where the Fed is obviously going to remain restrictive (relatively speaking) for the time being and expectations regarding stock market gains are in the process of being adjusted downwards, an increase in long-term interest rates will act like a giant lead weight on stock prices.

Is the stock market rational?

The stock market attempts to discount the future and, in this respect, it can be considered as an economic forecaster. Its forecasting record is by no means perfect, but it is better than that of any other forecaster we know of.

Although the stock market often appears irrational in real time, in hindsight it usually appears to have acted with rationality when all factors are taken into account. For example, the stock market surged upwards late last year in the face of higher official interest rates and a potential Y2K disaster. As it turned out, the market was right – Y2K was mostly a non-event and the higher official interest rates belied the fact that the supply of money was being expanded at a frenetic pace. The market was responding in a rational way to the irrational actions of the monetary authorities.

If we are correct that monetary policy will be 'loose' during the months leading up to the elections then the market, in its mysterious way, should begin to discount this eventuality well before it becomes common knowledge. In fact, when the next sustainable rally does commence it will no doubt be greeted with total disbelief and comments such as "this is a selling opportunity" and "the market cannot possibly move much higher in the face of such a restrictive Federal Reserve". Several months later everyone will know why the market did what it did.

Gold and Gold Stocks

There is a strong inverse correlation between gold stocks and the general stock market. In fact, gold stocks only move in synch with the S&P500 10% of the time. This inverse correlation broke down during 1985 to 1987 due to US Dollar weakness.

There is usually a strong positive correlation between gold and commodities, however this relationship has broken down over the past year. This may be due to manipulation of the gold price or it may simply be due to the use of gold as money. Gold is a form of money that no longer circulates as currency, but is accumulated for investment purposes. As such, it competes for investment with the fiat currencies of the world. With investment demand for the US Dollar having increased markedly over the past year the gold-USD exchange rate has remained suppressed. Gold has, however, fared much better than most government-issued money over this period.

So, combining the above we get the following:

Therefore, if we are correct in our forecast for a strong stock market during the second half of this year then gold and gold stocks will perform poorly after mid-year unless the anticipated stock market rally occurs in parallel with Dollar weakness.

The Dollar looks to have peaked on May 4 (maybe) and is now in the early stages of a correction. If this correction proves to be a short-term adjustment prior to making new highs later this year then gold stocks, which appear to have bottomed on April 13, will probably hit their highs between late June and mid July. If, however, we are at the beginning of a major trend change that will see the Dollar weakening relative to the European currencies for years to come, then we are also probably about to witness a multi-year up-move in gold.

The difficulty in drawing any conclusions at the current time arises because we are in a transition period. We are seeing back and forth action in stocks, bonds and gold as the markets try to figure out which way they should break. The Dollar is still in a strong up-trend and the Euro in a strong down-trend, but these trends are old and are showing signs of reversing (at least temporarily).

With the Dollar and the Euro seemingly embarking on at least short-term corrections (Dollar down, Euro up) and with commodities moving higher, gold stocks look like a good bet based on fundamental considerations. A short-term BUY signal would be generated by our Gold Momentum Model with a daily close above 283.40 for spot gold, provided that the XAU does not close below 56.

Steve Saville
Hong Kong
15 May 2000

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Also by Steve Saville


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