Overview
Bonds - bond prices moved up strongly last week and are likely to remain firm in the short-term. The strength in bonds combined with the overwhelmingly bullish sentiment in the oil market suggests that if the oil price has not already peaked it will do so within the next 2 weeks.
Stocks - our view is that the direction of the next major move will be up. However, it looks like a further period of choppy action will be required before this breakout occurs. A decline over the next week is likely.
Gold - gold and the Dollar moved back on trend last week (gold up, Dollar down). The next 1-2 weeks are crucial – if gold is going to break out to the upside it should do so very soon.
Inflation Watch
Here's what the above rather confusing table is saying:
From the above we can glean that the Fed has made a concerted effort, during the first half of this year, to slow the rate of credit growth. It also appears as if the central banking foot was removed from the monetary brake pedal during the latter half of May, although it is too early to be certain of this.
One thing we are sure of is that the Fed is currently faced with performing an extremely delicate balancing act. Several of the widely-watched economic numbers released over the past 2 months have painted a picture of an economy that has begun to slow. However, the veracity of these numbers has been loudly questioned. The May Employment Report, CPI and PPI certainly bore no resemblance to observable reality. The Fed must therefore contend with unreliable data and a perception that the data is being manipulated for political purposes. The thing is, the economy has turned the corner and a slowdown is underway, but the backward-looking economic numbers that fascinate the markets and the press should not yet be reflecting the slowdown to the extent they currently are. However, if the Fed was to continue raising interest rates until it was able to find hard evidence of its desired reduction in the level of growth or employment or inflation or happiness or whatever it is that Greenspan and Co. is trying to control, a severe recession would be the result.
With or without further rate hikes a recession, with a concomitant credit contraction, is a possibility. A second possibility is that the monetary authorities will err on the side of growth and facilitate another large expansion of credit. They would not actually achieve real growth (real growth requires an increase in productivity), but they would achieve the temporary illusion of growth because prices would rise. Based on past experience and the current political environment we assign a high probability to this outcome. A third possibility is that the Fed will engineer a soft landing. Based on the huge imbalances created over the past few years and on our belief that it is not possible to successfully manage an economy (if it was then the Soviet Union would have been one of history's greatest triumphs), we consider such an outcome to have almost zero chance of occurring.
The US Stock Market
Bear market rally or new bull market?
Over the past few months there has not been a single, definitive point that could be deemed 'the low' for the market, primarily because there isn't a single market nor has there been for years. The S&P500 is the best representation of the overall market, the NASDAQ100 and NASDAQ Composite are more heavily weighted towards technology and have thus represented the leadership in the market, and the Dow has been trendless for the past year due to composition changes and the fact that its various components have oscillated out of synch with each other. Each market index, and often the industry sectors that are represented within each index, has bottomed at a different time. This possibly explains why most sentiment indicators have hit market-bottoming levels at different times.
The put/call ratio, the Volatility Index (VIX), a number of sentiment surveys (Market Vane, Consensus Inc. and AAII) and Specialist Short Interest have, since mid April, all hit levels usually seen at market bottoms. In April the put/call ratio and the VIX actually hit their highest levels since the panic conditions of October '98 and, during May, the Consensus Inc. survey (the sentiment survey that we have found to be the most reliable in terms of identifying major highs and lows) yielded one of its 3 lowest bullish percentages since 1995. However, not every indicator signaled that sentiment had reached a bearish extreme. For example, the Investors' Intelligence survey and the ratio of bear funds to bull funds did not indicate substantial pessimism at any time. But then again, the market did not have an Asian financial meltdown, a Russian debt default and a system-threatening hedge fund collapse to deal with.
'Sentiment' is one of the main reasons we believe that a cyclical bear market recently ended and a new bull market has begun.
If we are correct in our conclusion that the move up from the lows is not a bear market rally then the market (as represented by the S&P500) will make a new all-time high at some point over the coming months. As to the life-span of this new bull market, we suspect it will be short. The Utilities Index, a fairly reliable leading indicator for both the stock and bond markets, keeled over during the past week. This suggests that we could see a stock market top as early as the final quarter of this year.
Current Market Situation
In the June 28 Interim Update we exercised our right to modify our forecast. When the market failed to rally in the presence of a number of positive influences during the first 3 days of last week it became clear that a near-term decline was quite likely. Short-term sentiment indicators are also pointing towards too much complacency at the current time, so another drop to test the mettle of those who bought the highs over the past month will probably occur at some point during the coming week. Complicating matters is the fact that the June Employment Report is due to be released on Friday July 7. After the incredible numbers contained within the May report we won't even hazard a guess regarding the contents of the June offering. In any case, provided support around 1420 (basis the Sept S&P500 Futures) holds during any sell-off over the coming week the market will be positioned for what could turn out to be a substantial rally thereafter.
Earnings growth is the major area of concern in the market at the present time as rear-view mirror results show that the second quarter of this year was not particularly good for a number of large companies. However, the market will soon put these historical issues aside and begin to discount the expectations for Q3 and Q4 into current stock prices. The question therefore is, will the market discount a contraction or an expansion?
Gold and Gold Stocks
Gold vs. Oil
Last week we mentioned that different forces drive the gold price and the oil price. Only during periods when these forces are in synch should we expect oil and gold prices to move in the same direction. Two other points regarding the oil/gold relationship are described below.
Firstly, a common misconception is that a rising oil price represents inflation. An equally common misconception is that the gold price always rises in response to higher inflation. These popular beliefs understandably lead many people to conclude that a higher oil price should necessarily give rise to a higher gold price. However, a rising oil price is not 'inflation'. It can be a symptom of inflation, although at the present time it is primarily the result of increased demand due to higher global growth. The oil price has effectively come 'back on trend' following the 97/98 debt-crisis-related demand disruption. Furthermore, higher inflation only leads to a higher gold price when the inflation also precipitates a loss of confidence in the US Dollar.
Secondly, the gold/oil ratio is currently near its lowest level in decades, indicating that gold is extraordinarily cheap relative to oil. We are therefore confident that whatever happens in the energy market, gold prices will outperform oil prices over (at least) the next few months. This could be achieved with both oil and gold prices rising, or with both oil and gold prices falling, or with the gold price rising in parallel with a falling oil price (the most likely scenario).
Gold vs. Equities
As far as longer-term forecasts are concerned, one of our tenets has been (and still is) that gold would make a multi-month, or perhaps even multi-year, up-move prior to the end of the major bull market in equities. The fact that none of the stock market shakeouts over the past few years have been preceded by a substantial gold rally has suggested that the major bull market would resume following each gut-wrenching decline. Taking political factors and global growth probabilities into consideration, an equity market peak between October 2000 and mid 2001 is a distinct possibility. If this turns out to be the case, and if we are correct in our assumption that a shift in confidence (reflected in a higher gold price) would begin to gather pace in the lead-up to the equity market peak, then the recent bounce in the gold price is the beginning of a major trend (or, more accurately, an extension of the trend that began in August 1999).
In addition to a rising US Dollar gold price we have also forecast a decline in the exchange value of the Dollar prior to the eventual stock market peak. We are, however, less confident that the US Dollar will lose value relative to other fiat currencies than we are that it will lose value relative to gold. The reason is that the Euro has eliminated much of the serious competition for the Dollar in the fiat currency world. Whereas the Dmark was a credible alternative to the Dollar, the political and monetary 'hotch-potch' known as the Euro is not. Add to this the apparent desire of the Swiss and the British to have their respective currencies trade in line with the Euro in the forex market and the Dollar's position is further enhanced. As such, as confidence in the US financial system wanes it is possible that the Dollar will remain 'the best of a bad bunch' and capital will be forced to flee to the safety of gold.
Current Market Situation
Over the past few weeks the gold price has moved nicely in accordance with a bullish script, yet the average gold stock remains comatose. It is certainly a concern that gold stocks have, thus far, failed to respond to the rally in the gold price. This may be a negative omen, suggesting that the recent gold rally is doomed to fail. We give more credence, however, to the idea that the current lack of speculation in gold stocks has resulted from the sort of widespread disbelief that usually accompanies the reversal of a long-term trend and that gold stocks will make a violent catch-up move at some point. At least, this is the basis under which we are working until/unless the market proves us wrong.
Last week gold and the Dollar reversed course and moved back in line with the short-term trends that have been in place since May 25 (gold up, Dollar down). The Dollar Index now looks set to test support in the 105.5-106 range, the breaking of which should give a serious boost to the gold price.
With fundamental, technical and psychological factors all currently lined up favourably for gold, an upside breakout in the gold price should/must occur soon. If spot gold has not achieved a daily close above $300 by mid July we may need to re-evaluate our bullish stance.
Gold stocks can still be accumulated at current levels. We recommend that sell-stops be used such that short-term trading positions in gold stocks are exited on a daily close below 56 for the XAU or 280 for spot gold.
By the way, we like the look of this chart:
http://www.the-privateer.com/chart/g-ind.html
Steve Saville
Hong Kong
3 July 2000The reader is invited to respond to Mr. Saville's wisdom via email: sas888@netvigator.com
www.speculative-investor.com