Overview
Bonds - a continuation of the commodity price up-trend will put downward pressure on bond prices.
Stocks - if bond yields continue moving up and/or the May 10 low on the S&P fails to hold on any sell-off during the coming week, a sharp down-move is likely. However, with sentiment already near market-bottoming levels any substantial decline at this time will probably turn out to be the second great buying opportunity of the year (the first being April 14).
Gold - despite downward pressure due to a strengthening Dollar during the past week, gold and gold stocks held their April 13 (the XAU) and April 28 (gold, basis NY spot) closing lows. When the Dollar's short-term up-trend is broken there is likely to be a substantial upwards move in the gold price.
The US Stock Market
Factors influencing the market
The behaviour of the market is influenced by fundamental, psychological, monetary, political and technical factors. We do not believe it is possible to have any real success forecasting the market over the longer-term without taking all of these into account.
In the US the political influence is strong and explains why the 4-year cycle has worked as well as it has. This 4-year (Presidential) cycle suggests that the market will bottom in 2002, so we should be open to the possibility of an extended bear market during 2001/2002.
Current Market Situation
The buying we had expected to occur during the second half of last week eventuated during the first half as traders front-ran the forecast post-FOMC relief rally, thus forcing put-sellers to cover their short positions earlier than anticipated. The major risk factors outlined in last week's Update (a potential fall in bond prices due to pressure from rising commodity prices, an overly-aggressive Fed and the excessive valuations of several large-cap tech stocks) remain very much in play. We do, however, feel quite strongly that if the market has not already bottomed it will do so by the end of this month.
One major positive for the market is that sentiment has reached market-bottoming levels. On Friday 19 May the CBOE Equity Put/Call Ratio was 0.8, indicating extreme fear. Also, the bullish percentages shown in the Consensus Inc. and Market Vane sentiment surveys have recently reached levels consistent with previous important market bottoms. Furthermore, the perennially-bearish Alan Abelson has penned another of his 'the bubble has burst and stocks are about to plunge into the chasm' articles for the latest edition of Barrons, an accurate contrary indicator in the past.
It is not just the fact that sentiment has reached depressed levels that heartens us, it is also that sentiment has actually been deteriorating over the past month even though the major indices have held above their previous lows. In fact, the market has thus far completed a sequence of higher lows as shown below:
| Date of closing low | S&P500 | NASDAQ Comp | NASDAQ100 |
| 25 Feb | 1333 | N/A | N/A |
| 14 Apr | 1356 | 3321 | 3208 |
| 10 May | 1383 | 3385 | 3245 |
| 19 May* | 1407 | 3390 | 3260 |
| * May 19 might not have been a closing low – the events of the coming week will confirm whether it was or not. |
With the NASDAQ having closed last Friday within 2% of its April 14 nadir, there is a definite possibility that a new closing low will occur during the coming week. However, with sentiment as bearish as it is a new low in the NASDAQ at this time would likely punctuate the end of the cyclical bear market in technology stocks that began in mid March.
Our view is that the cyclical bear market of 2000 has either ended already or will end during the next week in a final liquidation wave. As such, we suggest that those who have earmarked funds for investment in technology stocks begin putting some money to work immediately. A reasonable strategy, in our opinion, would be to invest 30% of available funds during any sharp sell-off in the coming week (perhaps on Monday morning if the market drops hard during the first hour or so and then turns around) and possibly another 30% during a pullback next month. Of the stocks we recommended in the May 8 Weekly Update those showing the greatest technical strength are LPTHA, MRVC, SFE, PSIX, and CPQ. Sell stops should be set at the time of purchase to limit losses in case we are wrong.
If our view that the cyclical bear market has ended or is within days of an end proves to be correct it will still probably be a few months before a broad-based up-trend will be established, at least one that is recognised as such by the majority. In fact, the longer the market goes up in a saw-tooth fashion, the longer it will take for the majority to realise that a new up-trend is in force and the higher the market will eventually go. By the time the majority again feels comfortable with the market we will most likely be adopting a more cautious approach.
It is during the period between a selling climax that ends a cyclical bear market in stocks and the point when it starts to dawn on investors that the worst is over, that gold stocks often provide excellent returns. In addition to using sell stops with any tech stock purchases, holding a sizeable position in the right gold stocks at the current time should ensure that losses are contained even in the (unlikely?) event that we are wrong about the stock market.
Gold and Gold Stocks
Gold = Money
The gold market cannot be analysed as though gold was like any other commodity. Some analysts have tended to focus on the fact that the amount of newly mined gold has, for several years, been substantially less than the amount of gold required for fabrication purposes. However, this apparent deficit has little relevance since the supply of gold is not the 2,500 tonnes per year of new mine production, it is the total aboveground gold stock of 130,000 tonnes (or thereabouts). For this reason and the fact that gold is accumulated as a store of value throughout much of the world, gold has more in common with money than it does with other commodities. This is why the gold price has not responded over the past 12 months to the strong rally in the prices of other commodities. It has, instead, responded to the strength of the US Dollar.
Taking the above argument one step further, it is possible that there is no direct correlation between gold and other commodities. Looking at charts of the gold price and the CRB Index over the past 20 years it is clear that the prices of gold (in US Dollars) and commodities have almost always moved in the same direction, thus leading to the conclusion that gold and commodities are linked. However, it may just be that the forces that lead to higher commodity prices almost always exist in parallel with the forces that lead to a higher gold price. Although we may appear to be splitting hairs, this concept helps explain why gold has stagnated while commodities have rallied over the past year.
Commodity prices react primarily to global economic growth, with higher worldwide growth leading to an increase in the demand for commodities and hence higher prices. The US Dollar gold price, on the other hand, responds to the relative strength of (and confidence in) the US Dollar and expectations regarding inflation. Since an increase in global economic growth has often occurred in parallel with heightened fears of inflation and a weakening US Dollar, it has looked like there was a strong direct link between gold and commodities.
Although there may be no direct link between gold and commodities, there is an indirect link that could be very important at the present time. An extended upward move by commodity prices will, eventually, breed fears of inflation. As expectations regarding the future level of inflation are ramped up, yield-only investments such as bonds become less appealing. As capital shifts away from yield-based investments into physical assets and other well-recognised inflation hedges, gold and commodities will once again move in lock-step.
If gold trades as money, what is a reasonable gold price at the current time? Over the past 20 years gold has tended to trade with the German Mark and the Swiss Franc, that is, the gold price usually rises and falls in parallel with corresponding moves by these European currencies relative to the Dollar. In the past when the DM and the SF were trading near their current levels gold was in the $350-$370 range, suggesting that gold is currently under-valued by $80-$100. If the US Dollar weakens from today's elevated level then this rough calculation will obviously yield a higher reasonable value for gold. It is interesting that if we compare gold to the CRB Index a similar gold price range is indicated (that is, with the CRB Index at 223 gold has typically been in the $350-$370 range).
There are a number of possible explanations for the fact that gold is trading far below our calculated reasonable range, including:
- Our calculations are wrong
- The gold price has been depressed by excessive hedging by mining companies (strangely enough, Barrick does not account for the effect that its forward sales programme has on the gold price when it calculates the extra money it has earned over the years through hedging)
- Gold price manipulation
Current Market Situation
Last week we speculated that the US Dollar may have already peaked and was possibly in the early stages of a correction. It turned out that we were early (or, in other words, wrong) in making this statement as the Dollar hit new highs during the past week. However, the fact that the Dollar hit a new closing high whilst gold did not make a new closing low (basis NY spot) meant that a positive divergence was created (for gold).
The current gold market must be frustrating to bulls and bears alike since it is steadfastly refusing to break in either direction. All the evidence we can find, and we are not just looking for confirmation of the bullish case, suggests to us that the next big move in the gold market will be up. All the ducks except one – a weakening US Dollar – are perfectly lined up. We don't expect the final duck to keep us waiting much longer.
Steve Saville
Hong Kong
22 May 2000The reader is invited to respond to Mr. Saville's wisdom via email:
sas888@netvigator.com
Also by Steve Saville
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