The following are slightly-modified extracts from recent commentary that appeared at The Speculative Investor web site.

The Dollar versus the Euro

Because fiat currencies are not anchored to anything tangible their relative values can, and often do, fluctuate wildly. The major central banks hold some gold reserves, but the amount of gold is very small relative to the number of currency units. For example, the dollar value of the US' gold reserves amounts to less than 1% of the total supply of US Dollars. The euro zone has more gold than the US, but the total amount of gold still only amounts to a very small percentage of the total money supply (from information available at the ECB web site, it appears that the total amount of gold in the euro system is equivalent to around 2% of the total money supply). So, the amount of 'official sector' gold in the US and in the euro system is not a significant factor in determining the relative values of the Dollar and the euro. (Note that 15% of the euro's currency reserves are required to be gold, but total currency reserves are small in comparison to the total money supply).

Currency market speculation causes many of the day-to-day fluctuations in the relative values of the various currencies, but the major trends are determined by trade and investment capital flows. Despite the huge current-account deficit run by the US over the past several years, the Dollar remained in a strong up-trend versus the euro until late October last year. This strength, in the face of a large and climbing current-account deficit, tells us that current-account outflows were being more than offset by capital-account inflows. Foreign investors were eager to take advantage of the superior performance of the US economy. They bought equities, they bought corporate bonds, they bought real estate and, most importantly of all, they spent enormous sums purchasing entire US corporations. Then, two things happened - the US economy began to slow (removing the economic growth advantage that the US had enjoyed for many years), and the US stock market stopped going up (in the case of the NASDAQ, it began falling at a fast pace). Around October/November last year, due to this change in the investment landscape, the rate at which investment dollars were flowing into the US dropped below the rate at which trade dollars were flowing out of the US. As a result, the Dollar began to trend lower. This new trend will continue until there is a reason for it not to continue, that is, until:

a) The US economy re-establishes a growth advantage over Europe, and/or

b) The US stock market is once again perceived, by foreign investors, to offer a superior risk/reward ratio, and/or

c) The current account deficit shrinks dramatically

A combination of all 3 of the above will most likely be required to reverse the trend.

Note that the downturn in the US economy and stock market began during the first half of 2000 while the Dollar did not peak until the fourth quarter, that is, the Dollar followed the economy and the stock market with a lag of around 6 months. It is probable that a similar lag will occur at the completion of the current cycle, that is, the Dollar will continue to trend lower for several months after the stock market and the economy have bottomed. If this is the case and the stock market bottoms in September 2001 (the earliest time we think a major bottom is possible), then the Dollar's decline will continue until at least the first quarter of 2002. If the US stock market follows the early-90s Nikkei pattern then a major bottom will not occur until October 2002 and the Dollar's downtrend will extend into 2003.

Along the way we'll be paying attention to various technical indicators in an attempt to time the substantial swings in the market (volatility will remain high), but the big picture should always be kept in mind. The big picture is that Oct/Nov 2000 represented a major turning point in the currency market and, as much as we dislike the political concoction called the euro, Europe's new currency looks to be in the early stages of a bull market that should extend for at least another 12 months. This clearly has important implications for gold in that a) the gold-dollar and the euro-dollar exchange rates have a strong positive correlation, and b) gold does not compete with the euro for investment to anywhere near the extent that it competes with the Dollar.

Measuring Market Sentiment

One of the main drawbacks of using sentiment indicators to forecast the market is that, these days, almost everyone uses sentiment indicators to forecast the market. The greater the number of people that use a particular indicator the less likely it is that the indicator will provide useful information.

Market bottoms always occur amidst strongly bearish sentiment and market tops amidst strongly bullish sentiment, the real problem is how that sentiment is measured. The difficulty of measuring sentiment is highlighted by the huge discrepancies in the results of the most popular sentiment surveys. While the Consensus-inc and Market Vane surveys have recently shown bullish percentages in the low- to mid-20s, the Investors' Intelligence survey has been indicating a bullish percentage in the 50-60% range. An inherent problem with the surveys is that many of the respondents use sentiment in determining their forecasts, which means that the results of the surveys affect the results of the surveys (the financial market equivalent of Heisenberg's Uncertainty Principle).

Rather than paying attention to what people are saying in order to determine the prevailing sentiment, it is probably more instructive to look at what they are doing. Here are a few objective measures of sentiment that are based on what people are actually doing with their money:

a) The put/call ratio and the VIX (Volatility Index). The equity put/call ratio has been hovering near market-bottoming levels for several months and the VIX recently spiked up to a level normally seen near intermediate-term lows. However, rather than just looking at the levels reached by these indicators during the periodic sell-offs in the market, it is instructive to watch how they react when the market begins to recover. For example, during the first half of last week a fairly unimpressive rally in the stock market resulted in both the put/call ratio and the VIX dropping sharply, indicating that traders were very quick to exit their bearish bets or hedges at the first sign of any strength. This shows that there is still a longer-term bullish bias in the market.

b) The Rydex Ratio. This ratio indicates where investors are putting their money. When people become more bearish they will allocate a greater proportion of their money to defensive positions such as money-market and bear funds. As the following chart (provided courtesy of www.decisionpoint.com) shows, the Rydex Ratio is presently at its highest level in more than one year (investors are becoming more defensive), but it is still a long way from reaching the levels normally seen at major bottoms.

c) Fund flows. This is similar to the Rydex Ratio, but shows how the net-inflows into mutual funds are split between equity funds, bond/balanced funds and money-market funds. The following chart appeared in an article by Ian McDonald at the realmoney.com site on Mar-05 and contrasts the fund-flows in February 2001 with those of February 2000. In Feb 2000, which was near the top for the stock market and near the bottom for the bond market, money gushed into stock funds and out of bond funds. Feb 2001, however, saw the opposite with money flowing into bond/balanced funds and a net redemption of $13.4B from equity funds. Note that Feb 2001 was the first month of net redemptions from equity funds since August 1998 (the bottom of the 1998 stock market sell-off occurred on 31st August).

d) The gold price. Although any market analyst with at least half a brain would realise that the gold market is manipulated, the gold price is still a good barometer of confidence in the financial system. The fact that the gold price is still near 20-year lows, or the fact that it has been possible to manipulate the gold market such that the gold price is still near 20-year lows, indicates a general lack of fear. It is highly unlikely that we will have reached the level of fear needed to create a lasting bottom in the stock market until the gold price has risen by at least $100.

Sentiment-wise, things are headed in the right direction but we are not yet close to a bottom. That doesn't mean the senior averages will need to fall far below current levels, but it does mean that much more time will be necessary in order to establish the levels of fear and loathing that major equity-market bottoms are made of. We continue to believe that the earliest possible time that a major bottom could occur, allowing for at least one meaningful counter-trend rally, is September 2001.

Steve Saville
Hong Kong

14 March 2001

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