The US Stock Market

Over the past two weeks the US stock market has traded from one economic report to the next, with an overwhelming focus on any data that may influence the Fed's next move. Even fundamentally important issues such as Y2K and the relative strength of the US Dollar are only discussed in terms of how they will affect monetary policy.

Most of the recent economic reports have contained something for everyone. If you want to find evidence of a slowing economy, you can find it. If you want to see a trend towards higher prices, you can see it. Friday's Producer Price Index was a classic example – it showed that the core (excluding food and energy) finished-goods index fell by 0.1% during August whereas the core crude-goods index rose by 1.8%. The stock market bulls liked the reduction in the finished-goods index and decided to buy technology stocks. The fact that current brisk rises in crude-goods prices suggest future upward pressure on finished-goods prices was ignored, as was the considerable jump in food and energy prices.

The bulls continue to grab hold of any evidence that indicates a slowing of the economy to argue that the Fed will not need to raise rates again this year, but fail to explain how a slowing economy helps justify the stratospheric price/earnings ratios of most large-cap stocks.

Medium-term the market continues to hold great risk. Although there may be some further efforts to rally over the next week, we expect the market will be trading at much lower levels by mid to late October. We see two likely scenarios for this market. The first is that stocks are able to hold their ground through to the end of September, in which case the Fed would tighten again on 5th October (or move to a tightening bias) thus precipitating a serious decline. The second is that the market undergoes a correction during the second half of September, thus encouraging the Fed to hold fire at its October 5th meeting. The first of these scenarios would probably result in a drop of greater magnitude.

Investors should remain cashed up awaiting the buying opportunity we expect to emerge during Oct/Nov, whilst maintaining a core holding of technology stocks (bought at much lower prices) and gold stocks. Longer-term we remain tentatively bullish and anticipate that a strong rally will commence late this year and continue during the first half of next year. However, we will re-assess the situation based on how the story unfolds over the next 2 months.

The main reason we are not excessively bearish regarding stocks, despite the current over-valuation, is the nature of modern money. The US stock market has never been as highly priced as it is today, but the US Dollar has never been as worthless as it is today.

There are many similarities between the stock market mania of the late 1920s and that of the late 1990s, but the critical difference is the unit of measurement itself. At the time of the 1929 crash and subsequent depression, stocks were priced in terms of a rock solid currency. They are now priced in terms of something that can be created in unlimited amounts at the whim of bureaucrats and politicians. When the US debt bubble begins to unravel, the Federal Reserve will provide whatever amount of money is necessary to prevent a sharp decline in asset prices and a severe recession. They can do this by monetising bank assets.

Following the massive injection of liquidity during the latter part of 1998 and recent speeches by Alan Greenspan confirming the intention of the Fed to "respond to quickly declining asset prices", no-one should doubt that attempts will be made to expand the money supply during any debt or liquidity-based crisis. The only question is, will such measures succeed? After all, Japan is still mired in recession a decade after their debt bubble collapsed. Perhaps the "pushing on a string" analogy would apply?

The Japanese, for political reasons, took a different path. The 'money-supply solution' described above comes at the price of a rapid depreciation of the currency, something that is politically feasible only if the majority of voters do not have substantial savings. In Japan it was therefore decided to implement huge deficit-spending programmes, a policy that was doomed to failure because it did not address the problem of non-performing loans in the banking system.

In our opinion, based on the complete absence of any restrictions on money creation, the US monetary authorities have the power to support asset prices and maintain liquidity. They have already demonstrated their willingness to use this power. Longer-term, the costs of excessive money creation come in the form of higher interest rates, reduced real economic growth, and increased unemployment. Short-term, a crisis can be avoided.

In summary, today's monetary system is diametrically opposite to that which existed during the 1920s and 1930s, leading us to believe that this bull market will end in inflation, not deflation.

Gold and Gold Stocks

The 'New Era' adherents continue to proclaim that there are no signs of inflation, demonstrating both a complete misunderstanding of the nature of inflation (it is an increase in the money supply) and a refusal to acknowledge reality. Until recently they could argue that increases in productivity would continue to offset higher wages, but the economic numbers released over the past two months show that increases in productivity are being outstripped by compensation growth. Until a few months ago they could point to falling commodity prices as indicating a lack of inflation, but that is clearly no longer the case. They are now left with the argument that a gold price of $250 proves that there is no inflation. Would someone who knows Larry Kudlow please take him aside and explain to him that more than four years of future mine production have been borrowed from central banks and dumped into the spot market. Ask him to consider what the gold price would be if so much of the aboveground gold stock had not been 'mobilized'.

The past two weeks have seen very little action in the gold market. It is worth noting, however, that gold investments have tended to move up on the days when the stock market has exhibited the greatest nervousness, and vice versa. For example, both gold and gold stocks (as measured by the XAU) moved up strongly during the 2nd September sell-off in the US stock market. In fact, with the S&P down 2% during that day's early trading, the XAU was up 2%. This is encouraging as it demonstrates willingness by investors to buy gold stocks as insurance against an overall market decline.

Although movements in the gold price have been somewhat muted of late, this market remains under considerable stress. Gold lease rates continue at historically high levels, indicating tightness in the supply of physical metal. As we move closer to the great unknown of Y2K the lenders of gold will likely become more risk averse, withdrawing supply from the market and demanding even higher returns. At some point something must give – either one or more central banks will part with a substantial amount of their gold reserves, or the price of gold will rise appreciably in order to draw additional supply into the market.

We expect a gold rally to begin this month, although further patience may be required in the lead-up to the next Bank of England auction on 21st September. Due to the disappointing result of the first gold auction on 6th July (for the bulls, that is), there is unlikely to be any great enthusiasm in the market prior to completion of the next auction. If a gold rally has failed to commence by the end of September, we may re-assess our short-term optimism. Long-term, based on our view that fiat currencies will be depreciated at ever-increasing rates, we could not be more bullish on gold.

We continue to recommend that investors accumulate the shares of major gold producers in anticipation of a rally into year-end, with particular emphasis on companies that are already profitable and have strong balance sheets. Since bottom fishing in the stock market can often be a money-losing venture, stop losses should be used at all times.

Milhouse
Hong Kong
14 September 1999

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