Overview

Bonds - bond prices are likely to remain within their 95-99 trading range over the next few weeks.

Stocks - the market should continue working higher in a 'saw-tooth' fashion.

Gold - the Dollar Index has remained safely above critical support and gold has come under selling pressure. Unless/until the Dollar breaks lower gold is unlikely to surmount $300.

Bonds and Oil

Over the past few weeks concern has been expressed in a number of quarters that OPEC may not be able to expand its production much further due to physical limitations and that demand would therefore exceed supply for the foreseeable future. There has even been talk of oil prices surging to over $40 per barrel in order to bring the market into balance.

Stories that OPEC is capacity-constrained may well be true, but when such information appears in the press after an already large increase in price it is often a sign that an important peak is close at hand. Most people don't seem to realise that by the time they read something in the newspaper or on the Internet, or when something is discussed on TV, the market has probably already attempted to discount the effect of the news.

Last week's drop in the oil price provided some technical evidence (although nothing conclusive as yet) that the price-peak is behind us. Our view is that the oil price will drift lower for the next few months as further evidence of a US economic slowdown becomes available, but we do not foresee a sustainable drop below $25. The oil bull market most likely has years to run and much higher prices will be seen after the upcoming consolidation is complete. We suspect that a return to sub-$20 oil prices would only be possible if the US economy entered a prolonged credit contraction, something to which we assign an extremely low probability.

For the past several weeks the bond market has been telling us that a) the Fed is done for the year and b) the oil price is close to a peak. Bonds may rally some more in the near-term and could even make new highs for the year, but we do not think this is the early stage of a new bond bull market. Our take is that the entire move up from the January low is a bear market rally that will be curtailed by the fear of rising inflation once the credit expansion gets back into full swing.

The US Stock Market

The Dow

Anyone drawing conclusions about the 'the market' based on the performance of the Dow Jones Industrial Index (DJI) is making a mistake. The market is best represented by the S&P500 and the leadership in the market, at the present time, is best represented by the NASDAQ100. The price-weighted average of the 30 stocks that comprise the DJI may be of interest for reasons of historical comparison, but it is of little value as far as market forecasting is concerned.

Those who view 'the market' as being represented by the DJI would understandably be concerned right now. For the past several months the Dow's chart pattern has been forming what some technicians have described as a "broadening top" and others as a "diamond". Either way, these are chart formations that generally occur at major peaks. Putting aside the point that the DJI in no way represents 'the market' we question whether a chart pattern that everyone can see, in one of the worlds most watched indices, is really worth seeing. Is it likely to tell us anything about the future? Our experience has been that the best returns come from identifying something ahead of the pack, that is, seeing something that is not obvious to the majority of market participants.

Another point worth noting regarding the Dow's supposedly ominous chart pattern is that it would never have occurred without the changes that were made to the Dow's composition last October. Without these changes the Dow would not have made a new all-time high in January this year (it would not have surpassed its August '99 high) and it would have traded down to around 9,000 at the end of February. In other words, the chart pattern that a number of technicians are concerned about was 'manufactured' by last year's composition changes.

Current Market Situation

In last week's Update we said "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". We got the expected drop during the Wednesday and Thursday sessions, but the market held support (in fact, important support was not even tested) and finished the week on a strong note. Friday's Employment Report was taken positively, although the bounce during Thursday afternoon's trading indicated that we were going to have a strong market on Friday regardless of what the BLS reported. So far the market is doing just enough to maintain our confidence that a new bull market commenced on May 24, but it hasn't yet done enough to completely eliminate the 'bear market rally' argument. When/if it does finally do enough to convince the majority that an important cyclical low is in place (possibly after the SPU (Sept S&P futures contract) breaks decisively above 1520), then those who like to buy after 'confirmation of strength' will no doubt pile-in on the long side and we will see a sharp upwards move.

We would be surprised if a major upside breakout occurred during the coming week. With the Volatility Index (VIX) in the low 20s and Friday's CBOE equity put/call ratio hitting a level usually seen near short-term peaks, any follow-through buying in the early part of the week will probably be sold into. At this stage we think that a rally attempt following the next pullback has a reasonable chance of breaking the market out to the upside.

We don't believe there is such a thing as a "New Economy", but because the terms "New Economy" and "Old Economy" are now widely used and understood they have become convenient tools when discussing the stock market. We said some time ago that the "old economy" stocks tend to out-perform when 'capital preservation' is the primary focus of investors, whereas the "new economy" stocks will do better when the desire for 'capital gain' dominates. This change in investment focus has been demonstrated by the vast out-performance of the NASDAQ indices, compared to the S&P500 and the Dow Industrials, since the May 24 low. We think the out-performance of the "new economy" stocks will continue for the next few months with the major winners being companies involved in optical communications technology, internet infrastructure and semiconductors (despite Salomon Smith Barney's recent downgrade). At this stage we are not interested in the traditional 'dot.com' leaders such as Yahoo and CMGI, but may be in the future if they take a further beating.

An Overbought/Oversold Indicator

Another technical indicator worth noting at this time is the TRIN. The TRIN attempts to measure whether a market is overbought or oversold by comparing the ratio of advancing stocks to declining stocks with the ratio of advancing volume to declining volume. If the proportion of advancing stocks is high but the level of advancing volume is low (relative to the level of declining volume), the TRIN will indicate that the market is oversold. Similarly, if market breadth is poor (the A/D ratio is low) but advancing volume is high relative to declining volume, the TRIN will indicate that the market is overbought. It sounds a bit convoluted, but the TRIN's record of pinpointing extremes (major highs or major lows) is quite good.

Below is a chart showing the NYSE TRIN, provided courtesy of DecisionPoint.com. As you can see the NYSE very recently became more oversold than at any time since Sep/Oct '98. (The NASDAQ TRIN reached a similar extreme in mid April and is still marginally oversold.)

The TRIN is one more indicator that has now hit a market-bottoming level during this year's roller-coaster ride. As discussed in previous Updates, different sectors/indices have bottomed at different times over the past 3 months. There hasn't been a single point in time when the overall market and the associated technical indicators have achieved the type of climactic low and reversal that technicians like to see in order to be convinced that a bottom is in place.

Gold and Gold Stocks

China

Hong Kong property developer Cheung Kong Holdings recently purchased a large stake in the parent of Singapore-based gold trading company RNA holdings. The stated purpose of Cheung Kong's investment was to position itself to be a major player in the Chinese gold industry when the market opens up. According to a report in the South China Morning Post the People's Bank of China controls most aspects of the gold industry and retail supply in China, but a phased deregulation is likely in the coming 12 to 18 months.

Cheung Kong is the flagship company of Li Ka Shing's financial empire. Mr Li is not only the richest man in Asia, in a recent AsiaWeek survey he was voted the most powerful man in Asia (ahead of China's President Jiang Zemin). If Mr Li is positioning himself to take advantage of the opening up of the gold market in China then this 'opening up' is not only likely, it is a certainty.

The future opening up of China's gold market will not be a factor in the short-term, but it will eventually provide a huge boost to the demand for physical gold. Just something else to be considered by those who are short physical gold.

Current Market Situation

Our analysis of the gold market is probably less objective than our stock market analysis. One of the hazards of having a fairly good understanding of the 'Ponzi Scheme' nature of the monetary system we've been lumbered with is that we tend to have a bias in favour of gold. However, any ingrained bias is a hindrance when it comes to financial market forecasting.

Having noted our possibly clouded view when it comes to the gold market, we can't help thinking that the recent drop in the gold price is just a short-lived pullback prior to a more substantial rally. Of greatest concern at the moment is not the gold price itself (the bullion price has done nothing to negate the bullish case), it is the dismal performance of the XAU. As per last week's Update, Wednesday's close below 56 in the XAU triggered our sell-stop for short-term long positions in gold stocks.

At the same time as the XAU was breaking out to the downside last week the XGO (Australian Gold Stock Index) was breaking out to the upside. We have no way of knowing whether the recent bullish action in the XGO is predicting a rise in the gold price or if it is simply the result of takeover speculation. All we can say is that the divergence between the XAU and the XGO is an anomaly that will be corrected, one way or the other.

A negative influence on the gold price over the past week was the steady rise in the Dollar Index, thanks mainly to a falling Yen. If the Yen continues to slide, and it is certainly showing signs of doing just that, there will be two major implications for global financial markets. Firstly, in the latest issue of Barrons it is reported that Japanese Government Bonds (JGBs) returned 17.9%, in US Dollar terms, over the last year. An extended decline in the Yen/Dollar rate would make JGBs less attractive and encourage the flow of investment funds from JGBs into US Treasuries, thus exacerbating the Yen's decline. Secondly, a falling Yen may resurrect the carry trade that was so popular prior to October 1998. The bottom line is that if the perception takes hold that the Yen has entered a prolonged decline versus the Dollar, huge capital flows into the US (and an even stronger Dollar) are the likely result. This is a potential positive for the US stock market and a potential negative for the US Dollar gold price.

At this time we are continuing to give the bullish case the benefit of the doubt, primarily because the potential upside in gold stocks is so much greater than the potential downside. As such we would not disturb long-term gold stock positions and would re-purchase short-term trading positions if the XAU spikes below 50 or closes above 60.

Steve Saville
Hong Kong
10 July 2000

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

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