Overview
Bonds - bonds have held their recent gains, but are caught in a struggle between countervailing forces. Bond yields are simultaneously being pushed lower by evidence that the US economy is slowing and pulled higher by rising energy prices. The next major move in bonds will most likely be determined by the next major move in the oil price. If the oil price breaks upward out of its recent trading range then bond prices should fall (bond yields rise), and vice versa.
Stocks - the stock market spent the past week digesting the previous week's huge gains. We expect the action to remain choppy over the coming fortnight, with a downward bias. The market's next upwards leg is likely to commence in the days immediately prior to the June 27/28 FOMC Meeting.
Gold - the gold price will probably continue its consolidation over the next few days in parallel with a rebound in the US Dollar. The two-week period commencing 19 June is shaping up as being strong for gold and weak for the Dollar.
Inflation Watch
The 'real' interest rate is generally calculated by subtracting the annualised percentage increase in the CPI from the 'nominal' interest rate. Our view is that this method of determining the real interest rate will lead to an incorrect result because:
- The CPI is adjusted for product quality and type, meaning that its value is partly subjective and does not just reflect changes in price
- Governments have traditionally manipulated the CPI calculation to minimise welfare payments tied to cost-of-living increases and to improve the outward appearance of their own economic stewardship
- Domestic prices are affected by a myriad of factors that have nothing to do with domestic inflation, such as weather conditions and the cost of imported goods
- Even if the CPI was honestly calculated and was not unduly influenced by the external factors mentioned in c) above it would still be, at best, a backward-looking indicator.
The importance of being able to reliably calculate the real interest rate comes about because real interest rates, not nominal interest rates, determine whether money is 'cheap' or 'expensive' and whether the Fed's monetary policy is 'tight' or 'loose'. Using the CPI as the measure of inflation in calculating the real interest rate led many commentators to mistakenly believe (and loudly proclaim) that the Fed was being "too tight" during the second half of last year. The same flawed logic recently had a large number of analysts forecasting a continuation of aggressive interest rate hikes throughout the remainder of this year because real interest rates were supposedly too low to stem inflationary pressures.
We have found that if we calculate the real interest rate by subtracting the percentage increase in the total supply of money from the nominal interest rate, we get a result that closely matches the observed reality. For example, an asset price bubble such as experienced by the US over the past few years can only occur if money is very cheap, that is, if real interest rates are very low (or, in this case, negative). Similarly, sharp downward reversals in asset prices and in various measures of economic strength (such as we have recently seen) tend to occur after money has become considerably more expensive, that is, when real interest rates have risen substantially.
Monetary policy is now tighter than it has been at any time since the early 1990s and if the Fed continues to raise interest rates it will effectively drive the US economy off a cliff. It is important to note that two wrongs don't make a right – you can't correct the imbalances wrought by years of excessively-loose monetary policy via a period of excessively-tight monetary policy.
If the Fed hikes rates at its June meeting it will probably be the last rate increase this year. This is, at least, what the bond market appears to be telling us. Bond yields hit their highs in January and have been trending downward since that time. The Fed tends to follow the bond market, often with about a 6-month lag, so we should be very close to the end of the Fed's tightening cycle (unless bond yields reverse course and soar to new highs, in which case we have a totally different ball game). It is not that the Fed makes a conscious effort to follow the bond market, it is just that they respond to the same stimuli. Bonds react very quickly to significant changes in the economy and the financial markets whereas it usually takes the Fed several months to figure out that something has changed and make the necessary adjustments to its policy.
The potential 'spanner in the works' at the present time is the oil price. If the oil price breaks upward out of its current trading range and surges into the mid-30s, bond prices would almost certainly be forced downward (yields forced upward).
The above ties in with our forecast for a strong stock market over the coming 4-6 months. Our bullish medium-term outlook for stocks is based on a belief that the Fed is almost done, a belief that would be destroyed by a collapse in bond prices. As far as we can tell, the only remotely-feasible catalyst for a sharply lower bond price at this time is a sharply higher oil price. So, our positive view for stocks remains in tact unless oil prices work their way much higher.
The US Stock Market
Current Market Situation
The major risks and uncertainties, as we see them, can be summarised as follows:
- The US economy could potentially slide into a recession
- The Fed might make the mistake of raising interest rates beyond June
- Oil prices might break-out to the upside
- The Dollar might drop low enough to decisively break its long-term up-trend
- Valuations of most large-cap tech stocks are still extremely high by historical standards
The above keep us from being complacent despite a generally optimistic view as far as the next 4-6 months are concerned. However, of more immediate concern is the fact that the presently less-than-ideal backdrop for the stock market is no longer preventing a large number of market participants from becoming complacent. Sentiment is now way too bullish, considering the underlying risks, as indicated by the fact that the 10-day moving-average of the CBOE put/call ratio has dropped to 0.47 (close to its all-time low) and the latest AAII Sentiment Survey shows 61.5% bulls and only 23% bears (a reading that is usually only seen near short-term peaks). For this reason we expect the market to maintain a downward bias over the next two weeks. The cash S&P could potentially drop into the 1390-1420 range without causing us great concern, but should certainly not close below 1380. A decisive break of 1380 on a closing basis would penetrate the up-trend dating back to the Oct '98 low and would have us re-thinking our medium-term bullish outlook.
Assuming we get a modest pullback over the next fortnight (just enough of a decline to create some nervousness and cause the postponement of some new buying), then the market will be well-positioned to rally thereafter.
Discounting the future
Something that most experienced investors and traders know intuitively, but often ignore when it comes to actually buying and selling, is that the stock market is always attempting to discount the future. The bullish view for this year's second half holds that the Fed will be accommodative, money will therefore be cheaper, economic growth will have slowed but not stopped, and technology company earnings growth will be accelerating as new products and a dramatic reduction in inventories lead to a huge increase in demand. If this view garners enough support then the market will begin to discount the final quarter's potentially rosy scenario as early as July. Market participants who prefer to see hard evidence of the improved environment before putting money to work will either find themselves buying near the top (just before the market starts discounting the next slowdown) or not buying at all (because prices have risen too high). Of course, if the bullish view of the market turns out to be flawed then those who bought in anticipation of such an outcome may lose money (although they will never lose a lot of money if they correctly employ sell stops). The point is, great buying opportunities never occur in the market when things look great, only when they look decidedly ordinary or even terrible.
Gold and Gold Stocks
Rallies almost always begin with short-covering. Short-covering causes the initial rebound in prices and the rising prices, in turn, stimulate new buying and the rally gathers momentum. So far in this budding gold rally there appears to have been very little new buying (as indicated by the substantial contraction in COMEX open interest), thus leading to a failure at the very first significant resistance level of 290. This is not surprising when it is considered that seven years have passed since the gold market experienced something more meaningful than a short-lived bounce. The market is now conditioned to believe that every rally will quickly fail.
'Disbelief' currently dominates the gold and currency markets. The majority is not convinced that gold and the Euro have bottomed and that the Dollar has peaked. Such skepticism is typical during the first stages of a major move following the reversal of a long-term trend.
The US Dollar continues to be the key to the gold market. According to a recent report by Merrill Lynch, since 1993 the US Dollar and the US$ gold price have displayed an 87% negative correlation.
Regarding the interplay between the major currencies and gold, the following comments from our June 7 Interim Update are still applicable: "The US Dollar Index has now fallen during 8 of the past 9 trading sessions and is testing support at around 106. With the Dollar now over-sold and with sentiment having recently plummeted, a rebound is likely over the next 5-7 trading days. It would be reasonable to expect the Dollar to move back to around the 109 level before resuming its down-trend.
Assuming the Dollar does experience an upwards correction and the Euro a downwards correction between now and the end of next week, gold is unlikely to advance much further during this time frame. We will probably need to wait for the final 2 weeks of June for a decisive break above $300."
The US Dollar will most likely continue its recovery for a few more days before resuming its short-term down-trend. The Dollar Index can fall to around 100 without doing any damage to its major up-trend, so 100 is a reasonable target for the Dollar over the next month. As the Dollar moves down and assuming it is not 'different this time', the US Dollar gold price should rise.
In our May 29 Weekly Update we mentioned that "gold's risk/reward ratio is now as good as it gets". However, it is now probably even better because we have since been provided with further technical evidence that the Dollar has peaked and the gold price has bottomed, but very few market participants seem to have acted on this evidence. Any weakness in the early part of the coming week could be used to add to holdings in profitable, lightly-hedged gold producers.
Please note that there will be no Weekly Market Update next week.
Steve Saville
Hong Kong
12 June 2000The reader is invited to respond to Mr. Saville's wisdom via email:
sas888@netvigator.com
Also by Steve Saville
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