Overview

Bonds – rising energy prices have taken their toll on bonds and yields have drifted higher over the past two weeks. The fact that bond prices have only moved moderately lower, despite the recent surge in the oil price, suggests that either the oil price is close to a peak or a major downward move in bonds lies ahead of us.

Stocks – stock indices have mostly moved sideways over the past two weeks, with a slight downward bias as expected. A breakout in one direction or the other is likely to occur during the coming fortnight. We think the direction will be up.

Gold – at the end of last week gold and the Dollar Index were still immersed in what we consider to be counter-trend moves. If this view is correct then gold should resume its short-term up-trend and the Dollar its short-term down-trend at some point during the coming week.

Interest Rates

In our June 12 Market Update we mentioned that a sharp upward move in the oil price would put downward pressure on bonds, thus potentially disrupting our optimistic view of the financial markets over the next few months. The oil price has clearly moved appreciably higher over the past week, forcing bond yields higher in the process. However, the effect on bonds has not, thus far, been particularly dramatic. Bonds have simply retraced part of their previous gains with no sign, at this stage, of a major breakdown.

The fact that bond prices have not fallen out of bed, despite the recent surge in energy prices, suggests that either a) oil is nearing an intermediate top and the bond market is, to some extent, discounting an up-coming drop in its price, or b) bonds will eventually succumb to the pressure from rising energy prices and collapse to new lows.

We believe that option a) is correct, if only because believing in option b) involves assuming that the bond market is wrong. In any case, we should know the facts of the situation very soon. A surging oil price and a sanguine bond market cannot co-exist for long, so we expect to see either a reversal in the oil price or a sharp drop in bond prices within the next two weeks.

The Financial News Media Event of the Century

We are, of course, referring to the June 27/28 FOMC Meeting. It seems that each new FOMC Meeting is bigger and better than the last in terms of its importance to the financial markets. At least that is the way it is portrayed in the financial press. This coming week's gathering of US central bankers is drawing extra attention because it may result in the final rate hike in this tightening cycle or, better still, it may not result in a rate hike at all.

According to the Fed Funds Futures, which are almost always right this close to a meeting, there will be no rate hike this week. However, we would be very surprised if the Fed's post-meeting announcement confirmed that it was going to retreat from its 'tightening bias'. After all, they will need to save some good news for the August meeting.

Despite the overwhelming focus on the FOMC meeting that will no doubt occur during the coming week, an important point that will almost certainly receive no mention in the mainstream press is that a committee cannot determine the correct price for money (the interest rate) any more than it could correctly determine what should be charged for a pair of shoes, a new car or television rights to a sporting event. Price is the mechanism by which supply and demand are brought into balance and any official tampering with this mechanism inevitably leads to either a shortage or a glut.

The US Stock Market

Credit Growth

An interesting and informative discussion on the rate of credit growth can be found in the June 20 Market Observations at the Contrary Investor web site (www.contraryinvestor.com). The Contrary Investor points out that there was a marked slowdown in the rate of financial sector debt creation during the first quarter of this year, thus reversing a trend that had been supporting the stock market for several years. Their conclusion is that the game has now changed and it is therefore time to walk away from the table.

While we appreciate the Contrary Investor's analysis, we disagree with the conclusion. A slowdown in the rate of credit growth and in the rate of earnings growth at some tech companies caused the March-May downturn in the stock market. This is now history and was always our expectation for the first half of this year. In fact, had the market fallen in parallel with a continuation of the high rate of credit growth experienced in the final quarter of last year we would not now be bullish regarding the market's prospects.

What is of most interest now is what will happen to credit growth over the next 12-months since it is the perception of the future that determines the present-day pricing of stocks. It is our belief that the scene is now set for a strong second-half market fueled, once again, by an increase in the rate of credit growth.

We are, of course, relying on the assumption that markets will not be left to their own devices in the lead-up to the November elections. Based on the events of the past few years this seems to be a reasonable guess. Adding to our confidence is the fact that the non-seasonally-adjusted numbers show an increase of $64B in the total supply of money (M3) for the week ended June 5.

Another point to note regarding the overall credit equation is that margin debt increased at the average monthly rate of almost $20B between November last year and March this year. It then contracted by $27B in April and $11B in May, for an average contraction of almost $20B per month. At face value the markets have therefore suffered a net reduction of margin-related money in-flow of about $40B per month over the past two months.

The situation is not that simple because a significant part of the total margin debt is associated with short-selling. Whereas rising prices stimulate higher long-side margin borrowing, falling prices no doubt stimulate higher short-side margin borrowing. If this is the case, the reduction in total margin debt probably understates the reduction in the amount borrowed by those on the long-side of the market.

The point is, if stock prices continue to establish up-trends then we could have a potentially significant net addition to stock-buying power due to another turnaround in the accumulation of margin debt.

Current Market Situation

From the June 12 Update: "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."

Over the past two weeks the S&P500 dropped 20 points, the Dow dropped 200 points, the NASDAQ Composite dropped 30 points and the NASDAQ100 dropped 75 points. This certainly qualifies as a modest pullback and the market is now well-positioned to rally.

The next two weeks are shaping up as being critical to the market's medium-term outlook. The over-bought condition of a fortnight ago has been eliminated, sentiment indicators are showing a healthy degree of skepticism, end-of-quarter buying should have a positive effect and the FOMC Meeting will remove some uncertainty on the interest rate front (at least temporarily). These factors should be sufficient to break the market out to the upside. If, on the other hand, a substantial up-move has not occurred by mid July (by substantial we mean a gain of 5% or more in the S&P500 futures), then we may need to re-assess our optimism.

Three stocks that look particularly interesting from both a technical and fundamental viewpoint at this time are Critical Path (CPTH), Alliance Semiconductor (ALSC) and LightPath Technologies (LPTHA). They have already moved up strongly over the past few weeks, but still represent reasonable value at Friday's closing prices.

Amazon

Amazon.com has recently received a lot of press, all of it negative. The stock price plummeted last week as a bond analyst expressed concerns about the company's balance sheet and well-known Internet-stock analysts uttered cautious words (after having previously recommended the stock at much higher prices).

We have never been interested in Amazon.com as an investment. It is not a technology company, it is a retailer and will thus never enjoy high profit margins. However, we have always been interested in Amazon as a test case regarding whether, with the help of extremely accommodative capital markets, a company could sacrifice everything for the sake of market share and customer satisfaction and eventually become an economic success.

As far as whether or not the company will end up as a profitable, cashflow-positive standalone business, the jury is still out. However, the short interest in this stock is huge and, at some point, it is likely to experience the mother of all short-covering rallies. If there is any further pullback during the next week we would be inclined to take a small position in anticipation of such an occurrence. After all, the bad news is now out there for the world to see. Any sliver of good news will therefore have an out-sized effect.

Gold and Gold Stocks

Gold and Oil

Oil prices have rallied strongly since early 1999 whilst the gold price has steadfastly remained below $300. There is a line of thinking that this is anomalous behaviour on the part of the gold market and is evidence that the gold price is being artificially held down. Although we accept that the gold price is manipulated (why should the gold market be any different?) we don't place a great deal of emphasis on such manipulation because the important inter-market relationships still appear to be working. We also believe it is illogical to point to the divergence between oil and gold prices as evidence of manipulation.

The reason that oil and gold prices have gone their separate ways over the past 15 months and during other prior periods is that different forces drive each market. Sometimes these forces co-exist, in which case the oil price and the gold price will move in synch with each other, and at other times they do not. Oil is a commodity that tends to rise in price during periods of increasing global economic growth and during times when the supply of new oil is disrupted. It also does well during times when the US Dollar is weak and the inflation rate is high. Gold is a commodity that is primarily accumulated as a form of money, meaning that the supply of newly-mined gold is not a significant driver of the gold price. The gold price is determined, to the largest extent, by investment demand rather than fabrication demand and thus responds mainly to changes in the level of confidence in fiat currency. Therefore, a period of time during which the Dollar is weak and the inflation rate is high should see oil and gold prices moving up together (for example, much of the 1970s). A period during which the Dollar is strong and global economic growth is increasing should see a rising oil price and a weak gold price (for example, the past 15 months).

The best gold rally of the past decade occurred in 1993 in parallel with a sharp decline in the oil price. The next major gold rally may occur during a period of falling oil prices or rising oil prices, it just depends on the coincident strength of the US Dollar, the rate of global economic growth and the rate of money supply growth.

Current Market Situation

So far, the Dollar Index has held support at 106 and has bounced back to around 108. The Dollar's recovery is likely to continue for a few more days, perhaps reaching a recovery high at around the time of the FOMC meeting. We would then expect a drop to re-test the 106 area.

If the Fed chooses to leave interest rates unchanged on Wednesday then we may get the Dollar weakness and consequential gold price strength that we've been waiting for. It would make sense for the Dollar Index to at least drop to its up-trend line, which is currently positioned at around the 100 level. Even if it stopped at this level such a drop would most likely be enough to propel the gold price comfortably above $300.

As it is with the stock market, the next fortnight is crucial to the gold and currency markets. In particular, the currency market's reaction to the Fed's decision on interest rates will be extremely important. It may turn out that a decision to leave rates alone will be seen as positive for the US economy and therefore positive for the Dollar. We'll just have to wait and see.

Steve Saville
Hong Kong
26 June 2000

The reader is invited to respond to Mr. Saville's wisdom via email: sas888@netvigator.com

www.speculative-investor.com