Overview
Bonds - further equity market volatility will potentially extend the recent rebound in the short-term. However, a continuation of the commodity price up-trend will put downward pressure on bond prices over the medium-term.
Stocks - panic selling did not occur at any stage over the past week, so the door has been left open for a final liquidation wave during the next 2 weeks.
Gold - the Dollar's short-term trend has reversed downward and the Euro's short-term trend has reversed upward. All conditions are now in place for a gold rally.
Monetary Policy
The following is from our 20 Dec '99 Market Update: "In order to continue its historic rise, the stock market needs the on-going creation of debt in ever-increasing amounts. The expanding debt bubble, in turn, relies on the full cooperation of the Federal Reserve for its perpetuation. Should the Fed decide to restrain the growth in the supply of money and credit then market interest rates will rise and stock prices will sink. This is the scenario we expect to unfold during the first half of next year, assuming that the major industrialized nations are able to make a non-disastrous transition into the next Millennium."
It was not difficult to forecast, towards the end of last year, that the Fed would engineer a slowdown in the money supply growth rate during the first half of 2000. It should also have been obvious to anyone with any common sense that the stock market was being powered higher by the excessive expansion of credit and that any significant slowing in the rate of new credit creation would have a major adverse effect on stock prices. Unfortunately, most market participants and analysts always seem to extrapolate the present set of circumstances way into the future and are therefore surprised when things change. For example, for much of this year's first quarter the majority was behaving as though the monetary conditions that led to the speculative frenzy in the stock market would continue indefinitely. It was a battle royal between the ingrained psychology and the new fundamental backdrop.
Now that the herd has realised that the brakes have been applied and that the investment climate has changed, the current conditions (tight monetary policy) are expected to continue throughout the remainder of this year.
We suspect that an extrapolation error is once again being made and, as a result, a mismatch now exists between what the majority thinks the Fed will do and what the Fed will actually do.
The major risk, as we see it, is that the US economy falls into a severe recession. Under normal circumstances the Fed, which tends to react 'after the fact' and has an abysmal economic forecasting record, would make the mistake of tightening monetary policy too much and for too long. They would thus increase the amplitude of an economic downturn in the same way that they stayed too loose for too long during the expansion phase, thus magnifying the excesses. However, the close proximity of the elections may force the Fed's hand, prompting what many of the Fed governors will consider at the time to be a premature relaxation of policy. However, in retrospect they will be thought to have acted prudently because an economic slowdown is coming, with or without further interest rate hikes. The only question at this time is whether the Fed adds to, or detracts from, the severity of the slowdown.
The Euro Crisis
The Euro has once again benefited in the foreign exchange markets from an ECB decision to leave interest rates unchanged. The market's reaction to the ECB decision is not a surprise since raising rates to support a currency is both senseless and futile. Such an action would potentially dampen economic growth and would have no positive effect on the currency's exchange value since a small increase in interest rates will never compensate investors for the currency depreciation risk.
The Euro's recovery during the latter part of last week looks, at this time, like a change in at least the short-term trend. As the trend change becomes more widely recognised we expect to see a large jump in the Euro-Dollar rate as speculators rush to unwind their Euro short positions. Gold, which has been a victim of the weak Euro / strong Dollar environment, should benefit greatly from this reversal.
The US Stock Market
Current Market Situation
With sentiment having hit a low ebb on Friday May 19 we were looking for panic selling – a final liquidation wave – to occur during the past week to punctuate an end to the cyclical bear market. Unfortunately, we didn't get it. There were three sharp sell-offs last week and two short-lived rallies, but there were no signs of panic. In our Interim Update we called the action irresolute and that remains the case as we write the Weekly Update.
The absence of a selling climax last week leaves the door open for another sharp down-move during the coming week. The fact that we get the May Employment Report on Friday (June 2) may help things along since new buying interest will be limited until the contents of this report are known. With the mood of the market as it is, an unpleasant surprise in this widely-watched report may bring about the final capitulation of those who remain staunchly bullish (assuming the capitulation hasn't already occurred by that time).
One concern regarding the above analysis (the market situation is rarely clear-cut) is that many pundits seem to be on the lookout for a large-volume decline and reversal to confirm that a bottom is in place. However, there is no particular reason for the market to be so accommodative. The market may never provide us with an obvious signal that the bottom has been reached. It may, instead, just drift sideways for a couple of months with occasional nervous plunges and failing rallies.
We came into this year expecting a gut-wrenching shakeout during the first half amidst a less than favourable monetary environment, followed by a strong second half as Fed policy became more stimulative in the lead-up to the elections. At this stage we see no reason to change course and will continue to use sharp declines for the purpose of accumulating fundamentally-sound tech stocks. On the contrary, we would have been far more concerned if the bull market in tech stocks had persisted into mid year.
Nearing the end of a 2-year bear market?
A broad-based up-trend in the US stock market has not existed since April '98. During the past 2 years the majority of stocks have experienced a bear market camouflaged by strength in the technology sector and a few huge-cap stocks that dominate the capitalisation-weighted indices. Most large-cap "old economy" stocks peaked in either July '98 or May '99 and bottomed in Feb '00. The most speculative tech stocks peaked early this year and are in the process of bottoming now. The super-techs (Cisco, Microsoft, Oracle, Intel, Sun, Dell, etc.) peaked near the end of March and have not yet bottomed. After 2 years of deteriorating market internals (advance/decline line, ratio of new highs to new lows) it is not inconceivable that a sharp near-term decline in the stock prices of the 'super-techs' will herald the end of the broad-based down-trend.
The biggest risk to our forecast for a strong market during the second half of this year, as mentioned above under "Monetary Policy", is that the US is about to experience a severe recession. There are already a few signs of a slowdown, yet some high-profile Wall St firms have recently ramped up their estimates for official interest rates. This indicates that, far from seriously considering the possibility of a recession, the analysts are anticipating a continuation of the boom times.
Is Wall St trying to talk down the market?
Last Wednesday the market suffered a sharp sell-off only to end the day with substantial gains in the major indices. Such a reversal would normally lead to at least a two or three day rally, but follow-through buying on Thursday was cut short by a slew of negative comments from Wall St analysts. This is what the market had to contend with on Thursday morning:
- Bearish comments by Goldman Sachs on Microsoft that knocked the wind out of tech stocks
- Bearish comments by Merrill Lynch on Goldman Sachs and bearish comments by Goldman Sachs on Goldman Sachs, prompting a general sell-off in financial stocks
- A general downgrade of airline stocks by a gaggle of analysts just 24 hours after the proposed UAL/US Airways merger ignited a rally in that sector
It is possible that the out-pouring of negative statements, just as the market looked like pulling itself out of a hole, was pure coincidence. However, we couldn't help thinking that the major Wall St financial houses may be trying to make life easier for the Fed by stifling a rally at this time. Unlike the fund managers who must demonstrate performance on a monthly basis and therefore tend to take every opportunity to make their portfolios look as good as possible, the major brokerages and investment banks are probably more concerned with the longer-term health of the market. This is, of course, pure speculation on our part.
Gold and Gold Stocks
Last week we said: "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."
The final duck – a weakening US Dollar – only kept us waiting another 3 days before falling into line. On Thurs May 25 the Dollar reversed lower and the Euro reversed higher, with Friday's price action confirming these reversals. All the prerequisites for a gold rally are therefore now in place. This doesn't mean that the gold price will immediately start moving higher (although it may just do that). It does mean that gold's risk/reward ratio is now as good as it gets.
Further to the above, for those who do not already own their full complement of gold stocks now would be a good time to add to positions. As usual we recommend the profitable, unhedged producers such as HGMCY and GOLD. Other stocks that will respond quickly and vigorously to a rise in the spot gold price are LHG (Lihir Gold), DROOY and AEM. Although it has substantial hedging we also like NDY (Normandy Mining) at current prices.
Provided the US Dollar trend remains down, any further short-term weakness in the gold price would not concern us. We would, however, be very concerned if the Dollar Index reversed upward and exceeded its May 18 high (this would probably only happen if a financial crisis outside the US resulted in capital flight into the US). We would also be concerned if the XAU broke below its April 13 low. As such and on the basis that we should always be prepared to cut our losses if the market proves us wrong, we recommend lightening up on gold stock investments in the event that the Dollar Index closes above 112.15 or the XAU closes below 54.5.
Steve Saville
Hong Kong
29 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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