Gold and Stock Market Update

Overview

Bonds - still bearish (close to a bottom?) Stocks - still bearish (possible crash) Gold - still bullish (consolidating ahead of the next move higher?)

Inflation Watch

On Friday October 15, the September Producer Price Index (PPI) was reported as being 1.1%. However, the talking heads on TV were quick to point out that excluding food, energy, tobacco and autos, the PPI only rose 0.1%. Good news for those who don't eat, smoke, drive, or use electricity.

During the coming week we get the Consumer Price Index (CPI) for September and the International Trade Report for August. Over the medium to longer term, any improvement in one of these will lead to a deterioration in the other (refer to our October 4 Market Update for an explanation). In the immediate term, the trade report will be another disaster due to higher import prices and the continued strong spending of the American consumer. The CPI, being the most manipulated of all the Government statistics, is anyone's guess (although increasing labour costs and wholesale prices should start having an effect very soon).

The US Stock Market

The Street is in denial, with an almost universal belief that the bull market is still in tact and that we are just undergoing a normal correction. For a long time (actually, since April 1998) the majority of stocks have been declining, but the popular averages (Dow, S&P, NASDAQ) have been shielding the real action from the view of those who refuse to see. Regarding the stock market's great unwashed (all the stocks that fall outside the group of large-cap tech stories that everyone loves), here are some facts:

Note - the above statistics are prior to last week's washout.

Further confirmation of the general weakness in the stock market is provided by the performance of the Transport stocks and the Bank stocks, currently down by 25% and 21% respectively from their early May '99 highs.

Whilst it was true for some time that the major indexes were marching to a different drummer to the overall market, the signs of their impending failure have been obvious for at least 2 months. Since reaching a record high on July 16 and undergoing a correction into an August 10 low, the S&P has made 2 lower highs and 2 lower lows. The Dow hit an all-time high on August 25 that was not confirmed by the S&P. The NASDAQ reached its record high on October 11, a move that was not confirmed by either the Dow or the S&P.

The fact that the NASDAQ Composite and NASDAQ 100 have out-performed the other market indexes can be attributed to the fact that players have been rotating into the stocks with the best 'stories' and also to the influence of day traders. During the first quarter of 1999 day traders accounted for 11% of total trading volume on the NASDAQ. Since that time the proportion of total volume attributed to day trading may have shrunk due to the severe correction experienced by Internet stocks between April and August, but it is likely they still have a significant effect. These traders often operate on margin, which means they are extremely 'weak hands' (they will be forced sellers on any short-term market down-turn). On that note it is interesting that margin debt, as a percentage of personal disposable income, is currently double the high levels reached just prior to the 1987 stock market crash.

During the past week Intel reported its Q3 results. In accordance with GAAP (Generally Accepted Accounting Principles) its earnings were 42c per share compared with 44c in the year-ago period. In accordance with BAP (Bubble Accounting Principles) it earned 55c per share compared with 45c last year (missing expectations by 2c). Intel has not yet come clean regarding any potential slowdown in business during Q4 '99 and Q1 '00, with the CEO saying that they anticipated "seasonally strong business in the fourth quarter". Perhaps he doesn't realise that corporate IT spending will grind to a virtual standstill due to Y2K. (Note – we have nothing against Intel apart from its current valuation. It is certainly one of the world's best companies and, given a sub-$50 share price and some evidence that the overall market had bottomed, we would be interested buyers of the stock).

As an aside, Intel had been expected to exceed expectations. Only on Wall St could something be 'expected' to exceed 'expectations'. It must be like one part of your brain expecting something that, if it eventuated, would be a total surprise to another part of your brain.

The down turn in the market to date has revolved almost entirely around interest rate concerns. The general outlook for earnings growth is still extremely optimistic, leaving room for major disappointments and further liquidation if the current earnings projections are not met.

Are many on the Street continuing to 'fight the Fed'? Further to last Thursday's comments from Alan Greenspan that so unnerved the market, it is worth recalling the remarks made by the Fed Chief on June 17 this year:

"While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. The bursting of the Japanese bubble a decade ago did not lead immediately to sharp contractions in output or a significant rise in unemployment. Arguably, it was the subsequent failure to address the damage to the financial system in a timely manner that caused Japan's current economic problems. Likewise, while the stock market crash of 1929 was destabilizing, most analysts attribute the Great Depression to ensuing failures of policy. And certainly the crash of October 1987 left little lasting imprint on the American economy."

"Someday, of course, the expansion will end; human nature has exhibited a tendency to excess through the generations with the inevitable economic hangover. There is nothing in our economic data series to suggest that this propensity has changed. It is the job of economic policymakers to mitigate the fallout when it occurs, and, hopefully, ease the transition to the next expansion."

In other words, Greenspan believes that the Fed will be able to act quickly and decisively enough to overcome the effects of a bursting bubble. Based on last week's verbiage it appears the Fed is trying to let some air out of the bubble, obviously hoping not to do irreparable damage to the economy in the process. Will they be successful? We don't know. What we do know is that only an idiot, a masochist, or a fully invested fund manager would challenge the Fed to a financial duel.

In our previous Market Update we made the comment that "...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." Despite the recent sell-off we are still expecting more downside before a reasonable buying opportunity emerges. The market is now very oversold on a short-term basis, leading us to put forward two possible scenarios. The first is that the market crashes on Monday or Tuesday of the coming week. The second is that we see a momentary stabilisation and some attempt to rally during the next week, followed thereafter by renewed downside.

Those who purchased put options with the market at much higher levels should be on the lookout for panic selling in order to take profits (we haven't really seen any panic yet). We do not advocate the taking of any new or additional bearish positions (buying puts or short selling) at this time.

Gold and Gold Stocks

Not much to say regarding gold this week (too wrapped up in the unfolding stock market saga). Both gold and gold stocks seem to be undergoing a correction, something you would expect to occur in a normal market after such a large move up. The gold market, however, is not a normal market and a pullback at this time could not have been predicted with any certainty. Due to the potentially explosive upside that could erupt at any moment we recommend that investors not allow themselves to be shaken out of long-term positions in high quality gold stocks. In fact, a significant correction in the stocks of the well-managed, minimally-hedged gold producers would provide an opportunity for further accumulation.

Thus far, the gold rally does not appear to have significantly altered the overall hedging picture within the gold mining industry. Gold Fields announced a plan to close out its small hedge book whereas New Hampton Goldfields in Australia has taken advantage of higher gold prices to expand its hedging. This means that the forward sales previously carried out by gold mining companies continue to underpin the gold price and will one day provide the fuel for an enormous short covering rally.

An easing in gold lease rates over the past week indicates a relaxation in the supply of physical gold (although the rates are still at least double their historical norm) and provides some evidence that we will see a further consolidation/correction in an on-going bull market. If the opportunity presents itself, we would dearly love to purchase more Harmony (HGMCY) below $5.5 and more Gold Fields (GOLD) below $4.75. However, we may not be this lucky.

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

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

Also by Milhouse


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