Overview

Bonds & Oil - Bonds gained further ground last week and may be warning us of a greater-than-expected slowdown in the US economy. A pullback over the next 2 weeks appears likely in order to work off an 'overbought' condition, but the upward trend in bond prices is strong. Oil has once again come to life and could be the catalyst for the above-mentioned short-term correction in bond prices.

Stocks - last week's recovery in the major indices has removed any immediate danger of a technical breakdown, but further downside is likely before a sustainable rally gets underway.

Gold - gold continues to grind lower on a daily basis, but increasingly-positive action in gold stocks keeps us on the bullish side of the fence.

The US Economy and the Current Account Benefit

Bond prices have risen steadily over the past few weeks and it now seems almost certain that bond yields will soon make new lows for the year. This reduction in long-term interest rates begs the question: is the debt market beginning to discount a recession?

It is too early to tell if a recession is on the cards, but the recently-released economic data certainly point towards a slowing economy. Here we are not just referring to the data produced by government agencies such as the BLS, the veracity of which has been widely questioned, but also to privately-funded (and hopefully impartial) information. For example, two important sets of non-government statistics – the National Association of Purchasing Managers (NAPM) survey and the ECRI Future Inflation Gauge (FIG) – were reported last week and lent support to the forecast for a 'cooler' economy.

Last Monday's NAPM release included the following statement: "The past relationship between the PMI [Purchasing Managers' Index] and the overall economy indicates that the average PMI for the months of January through July (54.4%) corresponds to a 4.3% annual increase in real gross domestic product. However, if the PMI for July (51.8%) turned out to be the annual average for 2000, this would correspond to a 3.4% increase in GDP."

The ECRI's FIG for July, reported last Friday, revealed that the FIG hit its high point for the cycle in April and then decreased a small amount in each of May, June and July. The FIG, which looks at a number of leading economic indicators in an attempt to forecast changes in consumer prices 10 months into the future, may therefore be 'rolling over' (although further evidence is required to ascertain whether the recent results are a change of trend or just a blip).

Despite some compelling evidence that the economy is slowing, we know that:

1. Inflation statistics reported by the US Government substantially understate the actual rate of inflation
   
   
2. The understating of the inflation rate leads to an overstating of both the real economic growth rate (GDP growth) and the rate of productivity improvement
   
   

We also know that the popular myth of 'strong productivity-driven growth with low inflation' is supported by the US's massive current account deficit. The current account deficit is the result of an enormous monthly out-pouring of Dollars in exchange for foreign goods and services. In other words, something that is created at zero cost by US banks is exchanged for something that was produced at a real cost (through the expenditure of natural resources and/or human effort) in another country. It is this exchange of nothing for something between the US and other nations that is the foundation of the US economy's seemingly endless expansion.

A country that can run a large current account deficit without seeing its currency depreciate on the foreign exchange markets and without needing to raise its interest rates in order to attract foreign capital, is in an ideal situation. The ability to continually exchange nothing for something means that the 'current account deficit' should more appropriately be referred to as the 'current account benefit'. This benefit can obviously continue until the day foreign investment demand for US-based assets becomes insufficient to offset the net outflow of funds on the current account. When that day comes, the US Dollar's exchange value will begin to slide. The corollary of this is that a stable (or firm) US Dollar indicates that the current account deficit is not an immediate problem and should not be factored into our investment equation.

It is worth noting that the ability of the US to sustain (to date) a large current account deficit has very little to do with the 'reserve' status of the US Dollar. Trade is carried out by private entities, not by governments, with the critical factor being the willingness of private individuals throughout the world to accept the US Dollar in payment for their goods and services (at current exchange rates).

The US Stock Market

Are the Utilities trying to tell us something?

Following are two chart presentations comparing the Dow Utilities Index (DJU) with the S&P500 over the Jan-85 to Dec-94 period and the Jan-95 to present-day period. These charts illustrate that:

1. During the past 15 years whenever the DJU has peaked at a new all-time high, the S&P500 has peaked at a new all-time high at some point during the ensuing 7 months (the S&P high followed the DJU high by a minimum of 1 month and a maximum of 7 months).
   
   
2. During the past 5 years intermediate-term peaks in the DJU (cyclical peaks that did not achieve a new all-time high) were followed by new all-time highs in the S&P within the ensuing 3 months.
   
   

During the past week the DJU surged to a new all-time high. So, unless it is different this time and assuming that the DJU's final peak occurred last Friday, this tells us that:

1. The S&P500 will reach a new all-time high by November this year at the latest.
   
   
2. The ultimate peak for the S&P500 (for this cycle) will occur some time between September of this year and March of next year.
   
   

Note that the clock starts ticking from whenever the DJU reaches its peak, so if the Utilities continue to move up then the above-mentioned time spans will be pushed out. Note also that the recent strength in the DJU tells us nothing about the performance of the S&P500 in the short-term (a near-term S&P decline is not precluded by a surging DJU).

Current Market Situation

From a purely technical perspective the market has done everything it has needed to do, when put to the test, to negate a medium-term bearish outlook. In particular, throughout this year's huge oscillations in both index points and sentiment, the market (the S&P500) has not violated the up-trend dating back to the 1998 low.

Going into the past week we had expected that a rebound would occur, but since the market had not reached an 'oversold' extreme the rebound would likely fail and a test of major support in the 1390-1420 area (basis the Sept S&P) would follow. As it turned out a rebound during the Mon-Wed sessions failed on Thursday morning, but a spectacular reversal immediately followed. The end result was that the S&P500 managed to gain ground every day last week.

Although the market is now positioned comfortably-above major support, we suspect that another probe to the downside will occur over the next 2 weeks (following a push upwards during the early part of the coming week). Our primary concern continues to be sentiment, which is still quite complacent considering the market's recent near-death experience. The following chart shows the TSI Indicator of Bullish Sentiment (TIBS) over the past 3 years. TIBS is an amalgamation of a number of different sentiment indicators. The components of TIBS were selected by graphing a large number of sentiment indicators against the S&P500 over several years and choosing the ones that predicted the market's important turning points with the greatest accuracy. Note that unless the market completely falls apart (something we certainly do not expect) then TIBS should not drop to the level it reached in May during any near-term correction. We would, however, like to see a drop into the low 20s to set the scene for a sustainable rally.

INSERT CHART 3

Despite our thinking that the overall market probably has some more downside ahead of it over the next 2 weeks, there are some stocks that are currently quite attractive on a risk/reward basis. We would be interested in adding to positions in LPTH and GBLX, two optical technology selections, if the stocks pulled back a few dollars from current levels. We also plan to add ADI (Analog Devices) to the TSI Portfolio during any near-term weakness (this stock has recently been hammered during the sector-wide mark-down of semiconductor companies).

This week's important economic/market events

Gold and Gold Stocks

The Gold-Oil Relationship

Several week's ago we discussed the relationship between the oil price and the gold price, noting that a strong oil price is not necessarily bullish for gold price since the prices of the two commodities are driven by different forces. In fact, the only multi-month rally in the gold price over the past 10 years (1993) occurred in parallel with a declining oil price. However, it is clear that the gold/oil ratio has always eventually returned to its long-term average of around 17-20:1, so unless the oil price collapses to $15 or lower the gold price should move up to at least $400. Unfortunately, divergences can persist for a long period of time (the oil-gold divergence has already lasted more than 12 months) before they finally slam shut.

In the short-term a rising oil price is not helpful to the gold price because it does not reduce the investment demand for Dollars (although it will tend to shift the focus of Dollar-denominated investment away from debt). In fact, a rising oil price is a far greater problem for Europe and Japan than it is for the US so a higher oil price could even contribute to Dollar strength.

Current Market Situation

Last week we listed the short-term positives for gold, all of which remain applicable at this time. Almost everything is lined up for a gold rally, but the gold price keeps grinding lower. Give or take a dollar or two, the entire improvement in the gold price since May 25 has now been eliminated.

The problem for gold involves the short-term negatives we outlined last week. A stable or rising Dollar, combined with stable or rising bond prices, creates a powerful barrier to any sizable advance in the gold price. This occurs because the most important driver of the gold price over the long-term is investment demand. In an environment such as we have now, with investment demand clearly focussing on Dollar-denominated debt instruments, the gold price each day is determined by a few thousand COMEX futures contracts.

A correction in both the Dollar and bonds is likely to commence during the coming week, so we expect a bounce in the gold price over the next fortnight. However, the Dollar's up-trend is strong and any decline will probably be short-lived and followed by a push to new highs.

We are pleased and somewhat puzzled by the continued strength in the Australian gold stocks. Despite a $5 fall in the gold price over the past week the Australian Gold Stock Index once again moved higher, with LHG gaining 7% and NDY gaining 5% during the week. It may be that equity investors are anticipating a rise in the gold price, or it could be that one or more of the major Australian gold stocks are being accumulated prior to a takeover offer being made. Time will tell.

We will be unable to do a Market Update next week, but will do a very brief summary at www.speculative-investor.com on Monday August 14 if something noteworthy occurs in the mean time.

Steve Saville
Hong Kong
8 August 2000

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

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