Overview

Bonds - Bonds remain near the top of their recent trading range, despite on-going strength in the oil price. Regardless of what happens with yields at the long-end of the curve we expect that the shorter-dated debt instruments will outperform over the next 2-6 months.

Stocks - the market has become increasingly 'overbought' during the past two weeks. However, the coming week will probably see further attempts to move higher before a correction gets underway following the Labor Day Weekend.

Gold - the Dollar looks to have made at least a temporary peak during the past week, suggesting that gold will move higher in the short-term. A substantial up-move in the gold price is unlikely to occur unless the Dollar breaks below important support.

Inflation Watch

The secular bull market in stocks will not end until there is a prolonged slowdown in the rate of credit expansion. During the first half of this year the Fed engineered a small increase in the cost of money and a modest reduction in the monetary base, thus bringing about a 4-5 month slowdown in the credit growth rate. However, as we pointed out numerous times during the first and second quarters of this year, the political calendar dictated that the pace of credit growth would pick up in the year's second half. It therefore did not make any sense to be bearish on the stock market beyond May. As the following chart of MZM (money of zero maturity) shows, a definite up-tick in the rate of money supply growth is occurring.

Euro Update

An understandable confidence problem

The market's confidence in the Dollar appears to be at, or near, an all-time high. Some may argue that this confidence is misplaced, but that is beside the point. Whether or not the market's view of the Dollar or, more particularly, Dollar denominated investments is right or wrong, it is certainly understandable given:

1. The relative strength of the US economy


2. The political, monetary and fiscal unity of the US


3. A worldwide acceptance of the Dollar by individuals (not governments) that has been established over generations

We are certainly negative on the Euro, but that negativity stems more from disdain for fiat currency in general than a particular bias against Europe's new currency. The Euro just happens to have a greater reliance on government fiat than does the Dollar (billions of people outside the US freely choose to accept the Dollar in payment for their goods and services). We have no allegiance to the US, Europe or Japan, and are thus in a position to objectively assess the merits of the major currencies. As such, and regardless of whether or not the Euro has just bottomed versus the Dollar, we recommend against holding Euros or Euro-denominated debt instruments (Euro-denominated assets such as stocks and real estate are another matter and should be evaluated on a case-by-case basis). The reason is that even if the Euro-Dollar exchange rate rises from current levels there will still be a significant inflation (purchasing power) risk involved in holding Euros (or Euro-denominated debt) as the Euro supply is expanded.

In summary, we see no viable alternative to the Dollar in the fiat currency world. We cannot emphasise strongly enough that those who have a negative view on the Dollar should buy gold or the stocks of gold mining companies.

An important ECB meeting

At its August 31 meeting the ECB has a chance to change the perception of traders and investors via a 50bp interest rate hike. However, modest growth and falling business confidence in Germany might prevent them from acting. This quandary is central to whole EMU saga – how does the ECB concoct a 'one size fits all' monetary policy when there are large divergences between the economies of the participating countries?

If the ECB does hike rates on Thursday, as the market anticipates it will, there is no guarantee that the Euro's exchange rate will improve. The vast majority of the investment capital that has moved from Europe to the US over the past 2 years has been channeled into equity, not into debt. That is, interest rate differentials have not been the primary motivator of capital flows between Europe and the US. Just as rising interest rates did not stem the outflow of capital from the US in 1987, they may not lead to a sustainable rally in the Euro in 2000.

Current Market Situation

During the past week the Euro managed to hold above its May low and an all-out crisis in confidence was averted, at least temporarily. In 1997, 1998 and 1999 the Dollar topped in the July/August period and then embarked on a 2-3 month correction, bottoming in October. There is currently no evidence that last Wednesday's reversal lower in the Dollar and higher in the major European currencies is anything more than a blip in an on-going Dollar up-trend, but the fact that it has occurred at a time of year when the Dollar has often made medium-term peaks is encouraging for anyone who doesn't have the bulk of their net-worth invested in cash Dollars or US Treasuries.

The US Stock Market

Medium-Term Forecast

In our July 24 Market Update we speculated that October, a month that often provides an important low for the stock market, may this year give us a major high. The Presidential election and the monetary environment were the two factors that we thought could bring about such an outcome. However, although an October high is still on the cards the following points suggest that it may not be a high of major long-term significance:

1. The steady improvement in market breadth on the NYSE over the past 3 months.
   
2. The upwards surge in the Dow Utilities Index over the past several weeks (the Utilities may have peaked last week, presaging an S&P500 peak some time during the next 1-7 months).
   
3. New all-time highs being registered by some of the broad-based stock market indices such as the NYSE Composite.
   
4. Some tentative (early) signs of a bottoming and turnaround in the NASDAQ 'internals' (for example, last Friday's breadth on the NASDAQ was positive and new highs exceeded new lows despite a small drop in the NASDAQ Composite Index).
   
5. Continued strength in the Dollar (we expect capital to retreat from US investments for a period of many months prior to the final stock market peak occurring).
   

At this stage we still expect a peak of some significance in October. If/when it occurs we will try to assess if it represents THE top or just another high in an on-going sequence of highs.

Current Market Situation

This market is stubbornly refusing to go down. Pullbacks were initiated during all five trading sessions last week, but every time the market dropped a few points new buying emerged to boost the major indices into positive territory (except for a small loss on Friday). This type of performance shows underlying strength, but also limits the near-term upside by preventing an overbought condition from being worked-off.

Further to a theme we touched on last week, stock market bulls tend to cheer a market that moves straight up whereas bears tend to revel in every small decline as though it was the beginning of some catastrophe. In reality the two groups should be hoping for exactly the opposite. A market that regularly pauses on the way up is healthy and is almost certainly headed higher, whereas a market that goes up in a straight line is doomed to fall sharply. Since bottoming in late May the market has behaved in a healthy manner, edging higher over time whilst keeping a lot of investors guessing as to its true intentions. However, too many are now gravitating to the bullish side of the fence making another nerve-raking decline a necessity if much higher numbers are going to be seen over the coming months. We doubt that anything significant will happen on the downside during the coming week, but the two weeks following the Labor Day long-weekend hold the potential for a sizable decline (traders will be returning from Summer vacations with the market at or near an overbought extreme).

One thing worth noting is that, as at August 22, the commercials were still holding a net short position in S&P500 futures that is close to an all-time high. A large bet against a market by the commercials is generally considered to be a bearish omen. However, another way to view the current situation is that it has taken substantial and concerted short-selling by the commercials over the past 3 months to prevent this market from breaking out to the upside. If the market can navigate through the next 3 weeks without any collapse, as we suspect it will, then an explosive up-move could unfold as commercial interests cover their S&P shorts in parallel with a surge in speculative buying.

In terms of stock purchases we will continue to nibble at any special situations that occasionally arise. Last week we suggested buying Copper Mountain (CMTN) on a decline below $60. CMTN didn't drop into our buy zone until Friday afternoon and we will watch the action at the beginning of this week before pulling the trigger on this stock. We'd like to see a selling climax prior to buying. Another stock we are interested in is PSINet (PSIX). This company is absolutely hated by Wall St to the extent that it is growing at 100% per year but sells for only slightly more than two times this year's revenue (current market cap is around $3B). The company has high debt (> $2.5B), but has $1.5B in cash. We will look to add it to the Portfolio at $16-$17 with a tight sell-stop at $14.

This week's important economic/market events

Gold and Gold Stocks

Current Market Situation

With September often being a good month for gold stocks and with a reversal lower in the Dollar having possibly just occurred, we continue to recommend that gold stock investments be held (or accumulated on pullbacks).

We have no way of knowing, at this time, if the Dollar's reversal lower last Wednesday is anything more than a pause in its up-trend. However, the Commitments of Traders (COT) report released on Friday gives us a reason to expect a significant drop in the Dollar over the next month or so. In particular, the COT indicates that 'non-commercials' are extremely bearish on both the Swiss Franc and the Yen. On the Chicago Mercantile Exchange the 'non-commercials' were long only 17 SF futures contracts compared to a short position in excess of 21,000 contracts. Similarly, they were long only 140 Yen contracts compared to a short position of around 28,000. Such lopsided commitments suggest the likelihood of near-term rallies in both the Swiss Franc and the Yen. The Swiss Franc, in particular, has a high positive correlation with the USD gold price.

Silver

As part of our integrated approach to the financial markets we factor cycle analysis into the overall equation. We do not, however, analyse cycles ourselves, preferring to leave this complex and time-consuming pursuit to those who do it on a full-time basis.

According to Eric Hadik, editor of the INSIIDE Track newsletter and a specialist in cycle analysis, the most bullish thing silver could do this year is spike below 482 and then close the year above 545.3. This would give a yearly "2-close reversal" buy signal. Last week silver did spike below 482 and then reversed higher, setting up the potential for an extremely bullish yearly signal.

With volatility currently at low levels, the purchase of long-dated silver call options is now a reasonable trade for those who appreciate the risks involved in buying options.

Steve Saville
Hong Kong
28 August 2000

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

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