Overview
Bonds - bonds are likely to remain firm into year-end as further evidence of a slowing economy filters through and increases the prospect of a reduction in official interest rates during the first half of next year. However, the acceleration in the rate of credit growth over the past few months (following the short-lived contraction) will eventually lead to much higher commodity prices and a sharp fall in bond prices. The first half of next year is shaping up as being a bad time to own long-dated debt securities.
Stocks - we expect a strong rally to begin during the next few days.
Gold - the Dollar's trend has not yet reversed to down. Until it does, gold will remain on a tight leash. We expect that gold will be 'unleashed' at some point during the next 4 weeks.
Inflation and Fed Watch
Credit where credit is due
33.4 billion dollars were added to the US money supply during the week ended September 18. Since the expansion of credit has been the primary driving force behind the past 2 years of the stock market's gains, the fact that we have recently seen an acceleration in the rate of credit growth is certainly not bearish for equities. However, the recent re-opening of the monetary floodgates highlights the fine line being walked by the Fed.
The price-fixers at the Fed are faced with 2 immediate problems. Firstly, there is the problem of the Dollar's exchange value. The US Monetary Authorities desire a reasonably-firm Dollar in order to retain/attract foreign investment, but don't want too much strength for 2 reasons:
The quandary for the interventionists at the Fed is that a change in the Dollar's direction could quickly develop momentum and evolve into a major trend reversal. Just as a rising Dollar helped attract foreign investment, the prospect of a falling Dollar would tend to discourage it. There was some doubt expressed by a number of commentators as to whether the recent attempts by Central Banks to support the Euro would be successful. We have no doubt that, with the Fed involved, the Euro's decline can certainly be arrested in the short- to medium-term. Governments and their captive CBs have never had much trouble reducing the value of their currencies, so any concerted attempt by the US to elevate the Euro relative to the Dollar will be a success. The greatest risk is, in our opinion, that it will be too successful.
The second problem faced by the Fed is the difficulty of keeping the financial system liquid for the next several weeks to ensure that any tremors are postponed until after the Presidential elections. This, in itself, is not such an onerous task. The real problem will occur early next year when an increased consumer and corporate debt burden comes face-to-face with both slowing economic growth and rising long-term interest rates.
In the short-term, which is the only term politicians are usually interested in, the stock market is of paramount importance. We should therefore see a continuation of high money-supply growth rates for at least the next 6 weeks, perhaps at the ultimate expense of the much-vaunted "strong Dollar policy". Along these lines we would not be surprised if the Fed announced, following its October 3 meeting, that it was adopting a neutral stance on interest rates (as opposed to its previously-confirmed tightening bias).
The US Stock Market
All predictions eventually come true
Being early is the same as being wrong because any prediction you care to make will come true eventually. At some point in the future the stock market will lose 50%-80% of its value in real terms (in nominal terms the stock market will never again fall to that extent as long as the present monetary system remains in existence). Similarly, forecasts that the Dow will reach 36,000 will also come true, although it may take a few decades to get there. However, in the week-to-week, month-to-month job of making money in the financial markets, grandiose prognostications are of academic interest only (perhaps not even that).
Current Market Situation
There were two potentially-significant technical developments last week. Firstly, the up-trend in the S&P500 Futures dating back to the 1998 low was broken, on a closing basis, for the first time. This does not negate our forecast for a rally into the second half of October, but provides some confirmation that the equity bull-market is 'on its last legs'. Secondly, Friday's action saw positive breadth on the NYSE and only marginally negative breadth on the NASDAQ despite large drops in the major indices. This is a positive divergence. Furthermore, the Dec S&P500 futures contract closed the week right at the up-trend line mentioned above, that is, the up-trend was not broken on a weekly closing basis.
For some time we've been anticipating that the stock market would make an important high in October and presently see no reason to change that forecast. What may in fact eventuate is a high towards the end of October, followed by a short correction, and then another rally into December or January that turns out to be a test of the October peak. As mentioned in the Inflation Watch discussion above, next year is not shaping up as being a bullish one for the stock market. Once political considerations are put aside the Fed will temporarily stop aiding and abetting the credit expansion and may even try to engineer another slowing in the rate of money supply growth. The experience of this year's first half clearly demonstrates how the stock market responds when its 'credit fix' is temporarily removed. The first few months of a new presidency are often accompanied by some stock market strength, but the excesses that have built-up in the financial system (and are yet to be built over the next 2 months) will most likely preclude a 'honeymoon period' for the next president.
If our forecast is 'on the mark' then a rally will get underway almost immediately (some time during the next few days). Friday's positive divergences, the October 3 FOMC meeting and an end to the 'earnings warning season' are helpful in this regard.
This week's important economic/market events
| Date | Description |
| Monday October 2 | NAPM Construction Spending |
| Tuesday October 3 | FOMC Meeting (major event of the week) New Home Sales |
| Friday October 6 | Employment Report Latest COT report released |
Gold and Gold Stocks
Gold versus the Dollar
Below is a chart showing the US$ gold price and the Dollar Index since April this year. The strong inverse correlation between gold and the Dollar is readily apparent from this chart (a correlation between two different markets doesn't get any better than this!).
The major determinant of the gold price is not gold-market manipulation or the fabrication demand for gold or central bank supply. The gold price has always been determined, to the greatest extent, by the investment (or monetary) demand for gold. The investment demand for gold is, in turn, inversely related to the investment demand for the Dollar. With or without market manipulation, the gold price will rise when the US Dollar falls.
So the $64,000 question is, when will the Dollar begin to fall? The Dollar Index has dropped by around 2.5% from its closing high reached on September 20, but is yet to confirm a change in its short-term trend. In other words, the Dollar's trend is still UP. A trend change would be confirmed by a close below 112 in the cash Dollar Index (around 111.8 in the December contract). If this does not happen very soon then the odds will favour a move back up to around the 116 level by mid-October.
Current Market Situation
Until the Dollar's trend reverses to DOWN, gold will have great difficulty mounting any sort of meaningful rally. The good news for the 'gold longs' is that if the Dollar hasn't already commenced a down-trend it will most probably do so within the next 3 weeks, for the following reasons:
- As previously mentioned, the stock market will take precedence over everything else in the lead-up to the elections. Actions taken to support the stock market, such as acceleration in the rate of money supply growth and intervention in the energy and currency markets, will tend to weaken the Dollar.
- Short-term attempts to prolong the credit expansion at the present time will exacerbate the level of economic distress felt over the next 1-2 years. US economic growth is likely to decelerate markedly during the first half of next year, an outcome that the currency markets may begin to discount during the final quarter of this year.
- Considering that a number of cycles converge around mid-October and noting that this year's price-behaviour in several markets has been the opposite of the norm (lows have occurred at times of the year that often produce highs, and vice versa), a mid-October high in the Dollar would not be a surprise.
Early this year we were expecting gold to bottom in April and rally thereafter. Gold made an intermediate bottom on May 25, in parallel with a short-term peak in the Dollar, before embarking on a rally. The May/June rally in the gold price failed during the second half of June when the Dollar commenced a new short-term up-trend that would eventually take it above the earlier peak. Despite the Dollar's extreme strength over the past few months relative to the European currencies and the Australian Dollar, gold has essentially held above its May low (apart from a recent 2-day dip below this level). The relative strength shown by gold since the Dollar began its latest up-move in June this year suggests to us that the next gold rally will be substantial. In particular, we expect gold and gold stocks to dramatically out-perform the S&P500 over the coming 6-12 months.
On a completely different matter, we recommend that you read the Cheryl Strauss Einhorn article "Much Ado About Little" in the latest issue of Barrons. This article is quite extraordinary in that every paragraph contains at least one factual and/or logical error.
On another completely different matter, this will be the last of our Weekly Market Updates that will appear at the Gold Eagle Web Site. The reason is that we have re-launched our own site (www.speculative-investor.com) as a subscription-based service and will be providing our market analysis exclusively to our subscribers. A one-month free trial is available to anyone who wishes to 'check out' our web site. We have very much enjoyed providing our work at the Gold Eagle site and plan to continue the relationship by submitting the occasional (probably about one per month) article for viewing by the Gold Eagle readership.
Steve Saville
Hong Kong
The reader is invited to respond to Mr. Saville's wisdom via email: sas888@netvigator.com
www.speculative-investor.com