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

Money is a performance-enhancing drug to the stock market

The combination of aggressive rate-cutting by the Fed and sustained rapid growth in the money supply have never failed to produce a multi-month stock market rally, so why would this time be any different? Some analysts have pointed to the failure of central bank rate cuts to boost the US stock market in the early-1930s or to boost the Japanese stock market during the early-1990s, but they are missing a critical point. During early-1930s US and early-1990s Japan, the money supply growth rate plunged. Therefore, comparisons between those past times and the current US market environment are irrelevant.

The obstacle that the US stock market will face later this year, and the reason that the current bull market will most likely have a short life-span, is that the positive monetary conditions (the entire basis for this bull market) will disappear. Without the support of a rising liquidity tide, valuation levels will become all-important.

The friendly monetary conditions are likely to disappear later this year as a result of the inflation threat becoming more widely recognised. A growing recognition of the inflation threat will lead to higher long-term interest rates and reduce the ability of the US financial sector to expand the money supply.

Current Stock Market Sentiment

We know people who have an emotional commitment to the bearish view and even more who are emotionally committed to a bullish view of the stock market. When someone is emotionally committed to a particular view they tend to seek-out information that supports that view and dismiss any information that supports an alternative view.

One of our goals is to never be emotionally attached to any view on the financial markets. Our only concern is to be as accurate as possible - whether this entails being bullish or bearish, it really doesn't matter to us. This doesn't mean we are always going to be right (we are certainly not always right), but if we can remain objective we stand a better chance of being right. In order to be right at important turning points it is usually necessary to move in the opposite direction to 'the herd', which is why we pay attention to sentiment indicators. We give more weight to what we call the objective indicators of sentiment (the ones that tell us what people are actually doing with their money) than to the subjective indicators (the ones that are based on what people are saying).

The recent correction has been quite extraordinary from a sentiment perspective. In terms of points trimmed from the major stock market indices it has been a normal bull market pullback. However, someone looking at the Arms Index and put/call ratios (objective indicators of sentiment) could be forgiven for concluding that the world must be coming to an end. We discussed the oversold extremes being registered by the Arms Index in our Jun-06 commentary. Below is a chart showing the 5-day moving-average of the equity put/call ratio, which has also moved well into 'oversold territory'.

Extremely negative sentiment, by itself, will not lead to a major rally. Negative sentiment can be considered to be a build-up of pressure under the market that has the potential to push stocks much higher if a few other things go right (or, in this case, don't go disastrously wrong).

Gold versus the Stock Market

Below is a chart of the S&P500/gold ratio (the number of ounces of gold it takes to buy the S&P500 Index). This ratio has been in a downtrend since August last year, meaning that the gold price has been out-performing the S&P500 for the past 10 months. However, owners of gold bullion only recently started seeing a positive absolute return on their investment (as opposed to a positive relative return). This is because, between August 2000 and April 2001, the S&P500/gold ratio was driven lower by a falling S&P500 rather than a rising gold price.

We expect the S&P500/gold ratio to continue trending lower for at least the remainder of this year and probably for much longer. The downtrend can continue with gold remaining flat, or even with the gold price falling provided that the S&P500 falls by a greater percentage. We are, however, much more interested in good absolute returns than in good relative returns. One of the reasons we are very bullish on gold and gold stocks is that we expect the downtrend in the S&P500/gold ratio to remain in force and we expect the S&P500 to move higher. The reason we expect gold and the S&P500 to rally in parallel over the coming months is that both markets are being pushed higher by a rising tide of money, with gold likely to out-perform because the excess money is fueling fears of inflation. Take away that monetary support and gold would probably still out-perform due to its safe-haven status, but the absolute returns on gold investments would not be as good.

Gold versus Gold Stocks

Below is a chart of the gold/XAU ratio that we previously included in our May-30 commentary. In gold bull markets gold stocks out-perform the bullion price whereas in gold bear markets they under-perform. The chart provides strong evidence that a bull market began last November.

Steve Saville
Hong Kong

20 June 2001

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