The US Stock Market
Despite some further near term upside potential the market holds substantial risk taking a 3 month view. The problem for the market is that the record high price earnings ratios of the major stocks cannot be justified. If we continue to get evidence of pricing pressures then interest rates will rise, making stocks appear even more over-valued. However, even if the US economy begins to show signs of slowing (very unlikely given the recent economic data), thus removing some pressure on the interest rate front, a slowing economy is not the backdrop to generate the earnings growth necessary to justify the sky-high P/E ratios. Whichever way you look at it, stock prices will have to undergo a substantial downward adjustment to bring P/E ratios back to more sensible levels. The question is, will a substantial decline in stock prices between now and year-end signal the death of the bull market?
The short answer to the above question is, in our opinion, no. This conclusion is based on a view that the US economy will not experience any meaningful slowdown until the Year 2001, for the following reasons:
| a) | Presidential elections are scheduled to occur late in the Year 2000 |
| b) | Nominal interest rates in the US are still low relative to the amount of inflation (growth in the supply of money) that has already occurred. The recent quarter point increase in the Discount Rate and the half point increase in the Fed Funds Rate may have a short term psychological effect, but are insignificant on a longer term basis |
| c) | Accommodative monetary policy is likely to continue due to Y2K liquidity concerns and the upcoming Presidential elections (even lately, as the Fed has been talking tough and raising interest rates, they have been adding reserves to the system via coupon passes) |
| d) | Many corporations are curtailing IT spending during the second half of 1999 to allow a total focus on Y2K preparations. This will lead to a spending surge during the first half of next year, giving a huge boost to the earnings of technology companies |
| e) | The release of new chip technologies next year and the on-going integration of the Internet, cable TV, satellite transmission, telecommunications and commerce will have positive fundamental and psychological effects on the economy and the stock market |
With the above picture in mind, the great bull market is not likely to end prior to at least the middle of next year.
Although economic growth should underpin the longer term outlook for the stock market, there are other factors to be considered in the short term. Chief among these is capital repatriation, particularly to Japan. Over the past 12 months foreigners were net sellers of US debt for the first time since records were commenced in 1977. A contraction of foreign participation in the US debt and equity markets is a real problem due to the enormous (and still growing) US current account deficit. If the US is unable to attract capital investment each month that is at least equal to the outflow of money resulting from the current account deficit, then the US Dollar will weaken and US interest rates will rise. A weakening Dollar would encourage further withdrawals of foreign capital and could precipitate a more dramatic decline in US equities than would otherwise occur.
Our short-term recommendation is that investors be "cashed up" awaiting the much more attractive prices that will likely be available around Oct/Nov, whilst maintaining a core holding of gold and technology stocks. A close eye should be kept on the Dollar as its performance relative to other major currencies will indicate the degree of foreign capital repatriation and provide a clue as to the extent of any stock market correction. When a buying opportunity does emerge it will be a very emotionally difficult time to buy because almost everyone will be bearish. The permabulls will be revising their targets downwards and the permabears will be forecasting a complete collapse to a sub-5000 level on the Dow. Those with the stomach to buy technology stocks at this time should enjoy a very profitable start to the next Millennium.
Gold and Gold Stocks
Signs of inflation are everywhere. We have oil approaching $22, the CRB index has broken out of a trading range and recently hit its highest level since Jan 99, the Goldman Sachs Commodity Index has risen 35% since Feb 99 and is now at its highest level since Feb 98, long bond yields have risen by 1.25% since last Oct, the CIBCR Leading Inflation Index recently posted its largest monthly gain in more than 4 years, and increases in employment costs have begun to outstrip productivity growth. Combining this with increasing credit spreads, increasing gold lease rates, nervousness in the stock market and a falling US Dollar, you have an environment in which a gold rally is almost inevitable. Almost, that is, because official sales and lending continue to weigh on this market and strongly influence the near term price action. However, it appears that a revival of investment demand for gold is now occurring in parallel with a contraction in supply, making it increasingly difficult for the bullion banks and hedge funds to prevent a meaningful rally.
The real story in the gold market is physical supply – the rest is just noise. It is reported that the deficit between newly mined supply and demand for physical gold is currently running at over 150 tonnes per month. This means that, in order to maintain the gold price at its current level, at least 150 tonnes of physical gold must flow into the spot market each month from the existing above-ground gold stock. It is not relevant that paper claims to 1,000 tonnes of gold are traded each day in London and that futures/derivatives contracts relating to huge amounts of gold are traded daily in various markets around the world – unless at least 150 tonnes of gold continues to be found each month for physical delivery, the gold price will rise.
The physical gold required to cover the deficit may come from official holdings, or from privately held stocks, or a combination of the two. Wherever it is coming from, the fact that gold interest rates have tripled during the past 2 months indicates that it is becoming more and more difficult to find enough gold to fill the supply/demand gap.
Gold is currently a market that is clearly under stress. The lenders of gold are demanding higher rates of return and this, in turn, reduces the feasibility of mining company forward sales and speculative carry trades. Unless existing holders of large above-ground stocks of gold are willing to sell their holdings aggressively and consistently into the spot market, or lend their gold at rates substantially below the rates provided by US Government debt, then the price of gold will rise.
The scene is set for gold to move much higher going into year-end. The best way to take advantage of this rally is through the purchase of gold stocks since they will increase far more, in percentage terms, than the bullion price. When selecting gold stocks for purchase we would recommend the large producers since they should demonstrate the best returns during the initial stage of a gold price rally and are also more liquid. Investors should check on the hedging arrangements made by any company they intend to purchase, particularly the exposure of the company to changes in gold lease rates. When a company states that their hedging program guarantees them a certain price for their future sales, they are making an assumption about gold lease rates. Should gold lease rates remain at their currently elevated levels then these assumptions will almost certainly be invalid, resulting in a downward revision to the value of the hedge book. Normandy Mining, Australia's largest gold miner and the operator of a substantial hedge book, has taken the prudent step of fixing its lease rate at 1.7% until April 2000.
A word of warning – those who are buying gold and gold shares because they believe the stock market will crash are most likely applying faulty logic. If the stock market does crash it is possible that gold will be dumped with all other readily saleable assets in a scramble for cash (similar to the large scale sale of gold by Asians during 1997 and 1998). Gold did rally in the aftermath of the 1987 crash, but the psychology in the gold market was totally different at that time (gold had been rallying for 2 years) and the effect of the crash on the real economy was far less than it would be today. However, a stock market crash has a very low probability of occurring and in the more likely event of a downward trending, nervous market over the next few months, gold should do well.
Milhouse
Hong Kong
31 August 1999The reader is invited to respond to Milhouse's wisdom via email: sas888@netvigator.com
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