The US Stock Market

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.

The above is repeated from last week's update. As it turned out, only on Monday of last week did the market show any strength at all and provide an opportunity for traders to accumulate put options at reasonable prices. For the week, the S&P fell 58 points (4.3%) and the Dow 524 points (4.8%).

Markets tend to behave in a way that traps the greatest number of investors near the top by continually providing hope that the worst of the correction is over. We do not expect today's market to behave any differently and are therefore anticipating further rally attempts before the major part of this decline unfolds. Many market participants, for example, may well consider Friday's action to be bullish. If you were desperately trying to make a bullish case for the market you could convince yourself that Friday was, in fact, a successful re-test of the early August lows. A move up during the early part of the coming week would reinforce such a view and would therefore set the scene for further selling on Thur and Fri (since complacency increases the downside risk).

We also see heightened risk in the latter part of the week due to the scheduled release of a number of closely watched economic indicators. On Wed we get the Durable Goods report, on Thur the GDP and Chicago Purchasing Manager's Index reports, and on Fri the National Association of Purchasing Manager's report. Most, if not all, of these economic numbers are likely to reveal continued economic strength and increased pricing pressures, and could therefore re-ignite concerns that the Fed will raise interest rates at its October 5th meeting.

During the past week there have been several mentions of the Dow Theory and the fact that this theory has now generated a SELL signal (the Dow Theory correlates moves in the Dow Jones Industrial and Transportation averages). This is not true. According to the August 16th issue of the Dow Theory Forecasts letter, "a close below 10,466.93 would represent a negative development, but it would not represent a bear market signal. Under the Dow Theory, the primary trend changes from bullish to bearish when three things happen. First, one or both averages make a failed attempt at new highs. Second, both averages suffer significant corrections, then re-trace part of their corrections. Finally, both averages move below their correction lows." At this stage neither the Industrials nor the Transports have established their initial correction lows and the primary trend under Dow Theory is still bullish. This theory may therefore be useful in predicting the onset of a major bear market, but will most likely fail to warn of a gut-wrenching correction.

We continue to recommend that investors remain cashed-up, awaiting a possible buying opportunity later this year. Traders should already have accumulated put options during the intermittent rallies we have seen over the past few weeks and should now sit back and wait for the market to show its hand.

Gold and Gold Stocks

The fact that almost everyone today talks about inflation in terms of prices - prices going up means inflation, prices going down means deflation - is testament to the success of governments in switching the responsibility for inflation from something over which they have direct control (the money supply) to something they do not directly control (prices). In this way inflation can be blamed on OPEC, or a tight labour market, or over-zealous consumers, or worldwide economic expansion, or militant unions, or a myriad of other factors. However, inflation/deflation is not a matter of opinion to be endlessly discussed, it is a matter of fact. If the money supply is increasing then you have inflation. If the supply of money increases at a greater rate than real economic output, then prices will certainly rise. The only thing we don't know is which prices will rise - goods prices or services prices or asset prices or some combination of the three.

In a recent newsletter James Turk makes an excellent point regarding gold inflation due to the double-counting of leased gold. He points out that although leased gold is almost always sold into the spot market, thus addressing any shortfall between newly mined supply and fabrication demand, this gold is still shown as an asset on the books of the lending Central Bank (CB). In this way, the total aboveground gold stock appears to increase whenever a CB leases its gold. It is this 'apparent gold inflation' that has led to a decline in gold's purchasing power.

The gold price surged by 5% during the past week, an almost perfect mirror image of the Dow's decline. It is still early days, but such a strong rally from a base built around 20-year lows is a very bullish development. However, this is gold we are talking about and there is always the chance of another 'official' announcement at any time. As such, we must always limit the downside using stop losses. In last week's market update we recommended adding to gold stock holdings following a close in the spot gold price above $263, with a stop loss set at $259. Those who followed this advice would have bought gold stocks on Thursday 23rd September. Following gold's strong rally during the past week we will now raise our stop-loss to $262. If we really are at the beginning of a bull market then raising our stop-loss point is something we will be doing often during the weeks and months ahead in order to lock-in profits.

We continue to recommend that investors focus on well-managed, profitable, financially strong gold stocks. We would not be interested in making sizeable purchases of shares in gold mining companies that are not profitable at current gold prices, for two reasons. Firstly, there is no guarantee that the gold price will rise quickly enough to bail out an unprofitable company. Secondly, if a company has remained profitable despite the extremely low gold price then it almost certainly has good management. Well-managed companies will outperform in both bear and bull markets.

The US Dollar

During the past week the US Trade Deficit for July was reported to be $25 billion, another record.

Under a gold standard, a large trade deficit is unsustainable. When gold flows out of the deficit nation as payment for the excess of imports over exports, interest rates rise. Interest rates continue to rise until the deficit-nation's economy slows enough to reduce the appetite for foreign goods and services. The system is self-balancing, with the opposite situation arising in the surplus nation. Currency exchange rates are not a factor since currencies are convertible into gold at fixed rates. However, under our current free-floating fiat currency system, a large trade deficit can be maintained for a long period of time without any adverse effects provided there is sufficient investment demand for the currency of the deficit nation. When this investment demand weakens, market interest rates rise and/or the exchange value of the currency falls.

The Dollar is currently holding its ground against most currencies, although it would not be surprising to see it fall due to the continued increases in the dual deficits (current account and trade) and a heightened perception of US financial market risk by foreign investors. A weakening Dollar would almost certainly encourage the repatriation of capital from the US and exacerbate the on-going decline in equity prices. However, a weaker Dollar would not be bearish for many large US companies. For example, Intel generates more than 50% of its revenue outside the US and would hence benefit from a weaker Dollar.

Despite its many problems, we are not able to bring ourselves to be bearish on the Dollar if it means being bullish on the Euro, the Yen or the Pound. Suffice to say we like the money that is not someone else's liability and cannot be arbitrarily created in unlimited amounts.

Milhouse
Hong Kong
28 September 1999

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