Overview

• Bonds - still bearish (close to a bottom?)
  
  
• Stocks - still bearish (close to a rebound high following the previous sell-off?)
  
  
• Gold - still bullish (consolidating ahead of the next move higher?)
  
  

Inflation Watch

Our current monetary system is not just based on debt, it is based on the premise that debt must continue to expand. If the amount of debt remained constant, then the money supply would effectively decrease due to the need to pay interest on the existing debt. As the amount of money available for spending and investment decreased, the prices of the assets underpinning the debt would fall. As the reduction in money supply continued, the value of the assets would eventually fall below the value of the associated liabilities (debt), leading to financial failures on a grand scale. If the amount of debt (money) in the system ceases to expand, a very lengthy and painful cleansing process would commence. The US government and monetary authorities will try to avoid this process at all costs, the reason we believe that increasing levels of inflation will be seen in years to come.

If debt must continue to expand to prevent a financial crisis, then anything that threatens the ability of the system to create more debt must be swiftly curtailed. As such, last year's Russian debt default and LTCM failure were met with an enormous injection of new money. Similarly, the US Federal Reserve has laid the groundwork for the vigorous addition of money later this year. Beginning on October 1st banks were given access to additional funds, on an 'as-needed no-questions-asked' basis, to circumvent any liquidity constraints in the lead-up to the Y2K transition.

The expectation of further monetary stimuli is one of the main reasons we are only short-term bearish on the stock market.

The US Stock Market

'Fed Fighters' and 'Greater Fool Theorists' dominated the market for most of the past week. They ignore the fact that interest rates are rising (it doesn't matter if interest rates rise from 5% to 6% or even 7% if you expect to make 25% in the stock market) and are prepared to pay ridiculously high prices for stocks on the basis that they will be able to sell to someone else at even more outlandish prices in the future. On Friday the much anticipated Employment Report was released. Ignoring a large increase in hourly earnings, the 'bad news for the economy is good news for stocks' crowd then took centre-stage and celebrated the loss of 8,000 jobs with some fervent buying.

Kidding aside, last week's rally currently falls within the realm of a normal rebound following a sell-off. The fact that there was no significant improvement in the advance/decline line indicates that the buying we have recently seen will not re-establish the former up-trend. There may well be some follow-through buying during the coming week, but we are still expecting the major indexes to reach much lower levels some time over the next 3 weeks. If we are wrong and the market surges to new highs, then we will sit on the sidelines and watch this extraordinary move with detached amusement. The risk/reward ratio is simply way too unattractive right now to encourage any new buying of stocks (except gold stocks).

Our major concern continues to be earnings or, more particularly, earnings growth. Earnings growth is critical to stock prices. This may appear to be stating the obvious, but many investors can't seem to grasp the concept. For example, at the depths of a recession with business conditions at their worst, stock prices will often begin to move up. The stocks are discounting future earnings growth. Similarly, at the height of an economic expansion with company earnings at record levels, stock prices will often begin to decline. This is because some investors recognise that the rate of earnings growth is likely to decelerate so earnings multiples (P/E ratios) must be adjusted downwards. The point of this is that when Q3 earnings are announced they will generally be excellent, but they will already be ancient history. Very strong Q3 earnings are already factored into stock prices, but any slowdown in growth due to the Y2K transition is not. Herein lies the problem for the market.

Another concern right now is the complete lack of fear surrounding Y2K. We were expecting Y2K-related fear to exacerbate the selling that was going to occur anyway due to interest rate worries combined with unsupportable valuations. The fact that Y2K is currently not perceived by the majority of investors as a significant danger to either the economy or the financial markets further increases the risk of buying stocks at this time.

Gold and Gold Stocks

For many years mining companies have gone out of their way to emphasise how they have insulated themselves from the effects of a declining gold price through the forward selling of future production. It is almost unbelievable how quickly the psychology in the gold market has changed, with companies suddenly eager to de-emphasise their hedging and to demonstrate their exposure to the spot gold price.

In the past, a gold price rally was often greeted by a scramble of producers to lock-in better prices through forward sales. The psychology has now changed to such an extent that we are likely to see producers take advantage of any dips in the gold price to close out their forward sales. In other words, in the space of two weeks producer hedging has gone from being an obstacle to a gold price rally to providing a support structure for the gold price.

While gold continued to rally during the past week, climbing 5%, the XAU actually fell by 7%. Such a divergence between the metal and the stocks at such an early stage of a gold bull market is unheard of and can only be explained by the fear of investors surrounding the hedging previously undertaken by mining companies. At the moment it appears that all the major North American and Australian gold producers are being tarred with the same brush, since both the 'heavily' hedged and the 'lightly' hedged were sold off last week. However, if the gold price continues to move up and as information regarding the forward sales and options exposure of the individual companies becomes more widely known, the shares of well-managed gold producers with significant leverage to the spot gold price will rally strongly.

Each investor should do his/her own research to confirm the hedge position of any gold mining company before purchasing shares in that company. Despite the recent rally in their share prices, we still like Harmony Gold and Gold Fields Ltd (both based in SA). These companies have virtually no hedging, were already profitable prior to the bounce in the gold price, and have enormous resources. They are also extremely cheap compared to their North American counterparts. Following some deals over the past week in which their small hedge book was closed out and which will lead to a simplification of their ownership structure, Lihir Gold also looks attractive at less than A$1.40 per share (it trades on the Australian Stock Exchange under the symbol LHG).

Additional fuel for a gold stock rally is likely to be provided as a result of the publicity given to the gold price rise over the past two weeks. As more people become aware of the rising gold price, the money flowing into gold mutual funds will increase markedly. This increased flow of money into gold stocks will be further exaggerated by any general decline in the stock market as investors/speculators/gamblers switch to what is working.

Steve Saville (a.k.a. Milhouse)
Hong Kong
11 October 1999

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