The US Stock Market

The stock market continues to experience rapid swings in both directions, but with an overall downward bias. The recent volatility is the continuation of a pattern that has persisted throughout 1999. It is not surprising, therefore, that 1999 has thus far seen the greatest stock market volatility in 25 years, with 40% of trading days ending with the market up or down by 1% or more.

The all time closing high for the S&P was the July 16 level of 1418 (basis cash). It then reached a secondary and lower peak on August 25 at 1381. Rallies have subsequently failed to close above the 1360 area.

With each failing rally, the short-term risk in the market has grown considerably. The next big move in the market will almost certainly be DOWN, and it will probably get underway during the latter part of the coming week or during the week commencing 27th September. For those wishing to profit from the ensuing downside, any rally attempts during the first 3 days of the coming week should be used as an opportunity to accumulate put options. Those who are not inclined to trade the market on a short-term basis should simply remain cashed up awaiting the good buying opportunity we expect to emerge some time over the next 2 months.

Assuming the decline we foresee over the near-term (the next 4 to 6 weeks) does eventuate, it is worth noting at this point the conditions under which we would feel comfortable re-entering the market on the buy side. Our pre-requisites for returning to the bullish side of the fence are as follows:

1. A number of large-cap technology companies have warned of an impending slowdown in earnings growth and a number of earnings downgrades have been issued by Wall St analysts covering the high-flying tech sector. The companies to watch closely on the earnings front are Intel, IBM, Hewlett Packard, Cisco, Dell, Gateway, Motorola, Micron Technology and MCI Worldcom. It is critical that the earnings disappointments that are likely to occur during Q4 99 and Q1 00, due primarily to a cessation of IT spending as companies prepare for and then recover from the Y2K transition, are discounted in stock prices before undertaking any further purchases of technology stocks.
   
   
2. The Fed has reversed course on monetary policy, either switching to an easing bias or cutting official interest rates.
   
   
3. The market has fallen by at least 10% from current levels, but by no more than 25%. A healthy and normal correction would retrace around two-thirds of the move upwards from the October 1998 lows to the July/August 1999 highs. Such a correction on the Dow from its August 25 high point would take us into the 8500 - 9000 region. If the market falls to a level much lower than this it is possible that significant damage will be done to the real economy, perhaps eliminating the potential for a strong rally to commence at year-end.
   
   

We will continue to re-assess this market as the story unfolds over the next 6 weeks.

Gold and Gold Stocks

Gold has barely moved over the past few weeks and remains mired in the mid-250s. We have been expecting a rally to commence in September and are concerned that gold has not yet even approached initial resistance at around 262 (spot).

Time is fast running out for gold as far as 1999 is concerned. The most important event in the gold market over the near-term is the second BoE auction, scheduled for 21st September. Sentiment going into this auction is decidedly negative, creating the potential for a bounce in the gold price if the outcome of the auction is not worse than expected (it is likely that most market participants will be expecting the successful bids to be close to the current spot price).

Gold lease rates remain at historically high levels, indicating continued tightness in the supply of physical gold. With such stress in the bullion market, commodity prices rising, the Dollar under pressure and increasing nervousness in the stock market, it is truly amazing that the gold price has so far failed to move up. It is interesting that silver has also failed to respond positively to numerous fundamentally bullish factors.

As we ponder possible explanations for the listless performance of the gold price in an environment that appears, on the surface, to be overwhelmingly bullish, we must not ignore the market's signals. Whilst we can argue that gold should be on its way to much higher prices, gold's current price action gives us no reason to be optimistic in the short-term. Adding to our concern is that October tends to be a poor month for gold stocks. We therefore suggest a cautious approach to this market and recommend that new buying of gold stocks be only undertaken on strength. Specifically, we suggest the following strategy:

• Maintain a core holding of well-managed, profitable, financially strong gold stocks as insurance against a US Dollar crisis. This core holding should be kept without any stop loss protection. Our suggested gold stocks for this core holding are Normandy Mining (Aust), Delta Gold (Aust), Gold Fields Limited (SA) and Harmony Gold (SA). In the event that a gold rally does not materialise in the near-term, these companies will remain in business and are expected to continue paying dividends.
  
  
• Make additional gold stock purchases (either the above-mentioned 'core' stocks or other profitable producers) after the spot gold price closes above $263, with a stop loss set at $259. That is, the shares purchased on the first spot gold close above $263 should be sold if spot gold subsequently closes below $259
  
  

The US Dollar

Extreme volatility continues to be the norm in the foreign exchange markets. We can only wonder how long it will be before people realise that, without any link between currencies and gold, the volatility will only increase. As long as there are no restrictions on the ability of governments and banks to create and destroy money, the wild swings in relative value to which we have become accustomed will become even more pronounced. Huge amounts of capital will continue to dart from one currency to the next in a frantic search for profits from exchange rate and/or interest rate fluctuations, or simply to seek a safe haven. How many currency crises will it take before the fundamental flaws in our fiat monetary system are addressed?

We now have the Yen surging against the Dollar as speculators unwind their Yen carry trades and buy Yen futures, foreign capital is enticed into the Japanese stock market amidst tentative signs of a Japanese economic recovery, and Japanese capital is repatriated. To counteract these forces, bureaucrats from Japan and the US are rumoured to be meeting to discuss joint intervention in the forex markets. So now that Dollar/Yen has plummeted by 15% over the past 2 months, Japan and the US are going to work together to force it back up.

On Tuesday we get the trade report for July, which is likely to show another terrible US trade deficit. With the US current account deficit running at an annualised rate of $320 billion, the world is being flooded with Dollars. This outpouring of Dollars resulting from the current account deficit will cause the Dollar to drop in terms of other major currencies unless:

1. New investment capital is attracted into the US at a rate at least equal to the current account deficit.
   
   
2. Other governments implement further and more aggressive measures to devalue their own currencies.
   
   

The first possibility mentioned above is highly unlikely in the absence of a financial crisis outside the US that drives capital into the perceived relative safety of the Dollar. The second possibility is very likely and, if successful, would lead to the Dollar becoming the best of a bad bunch.

Milhouse
Hong Kong
21 September 1999

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