Overview

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

Inflation Watch

Many commentators still insist that interest rates are too high and assert that the Fed is wrong to raise rates when there is no evidence of inflation. Putting aside the obvious flaws in the argument that there is no evidence of inflation, these commentators fail to mention that long-term interest rates have been rising since October '98 whereas the Fed has only been tightening since June '99. The bond market has, for the past year, been signaling that official interest rates are too low (unrealistically low short-term interest rates increase the risk of higher inflation in the future which, in turn, puts downward pressure on bond prices (upward pressure on bond yields)). So these "the Fed is too tight" complainers are, in effect, saying the market is wrong (always a losing supposition). Rather than saying, "the Fed is too tight", the market is screaming "the Fed is too loose!"

Last week the stock market cheered one of the highest CPIs of the past two years and another disastrous trade deficit because neither was quite as bad as many traders had feared. Next week we get the Employment Cost Index (Thursday) and the Chicago Purchasing Management Index (Friday). If these reports reflect reality then the ECI should confirm a continuation of the trend towards higher labour costs and the Chicago PMI should highlight the on-going rise in prices paid.

The US Stock Market

Along the way in a bull market you get the occasional sell-off that looks very much like the end of the bull market. Some people get 'spooked' on these drops and get shaken out of the market at what turns out to be a correction low. It is the same story in a bear market, where each rebound can look like the start of a new bull market. Additional money is hence drawn into the market at what turns out to be a correction high.

In last week's update we said the following:

"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."

Clearly the market did not crash and we got the obligatory bounce from dramatically over-sold levels. This 'bounce' appears to us to be a correction in an on-going bear market and may well have already run its course. One important reason for this opinion is that, even though last week's rebound in stocks followed the worst week for the markets in a decade, it has changed the mass psychology from fear of being trapped in a 'gut-wrenching' decline to fear of missing the next great rally.

Bear markets end when the majority view the rally in total disbelief. When a rally is greeted with cautionary words from most mainstream analysts and financial commentators, it may well be the start of something sustainable. When it is widely hailed as the start of a surge to new all-time highs, it is probably not.

The most volatile market index over the past two weeks has been the Volatility Index itself. The Volatility Index (VIX) measures the average volatility of a sample of eight index options. A low reading (in the 17-22 range) indicates complacency whereas a high reading (above 30) indicates fearfulness. On 8th Oct the VIX bottomed at 21, indicating widespread complacency. Then, only seven days later, the VIX peaked at 35.5 intra-day (indicating a high level of fear). On Friday 22nd Oct the VIX closed at 22.8, back in the complacency/bullishness camp. In other words, in the space of only two weeks sentiment has gone from being extremely bullish to being extremely bearish and back to being extremely bullish. With the amplitude and frequency of oscillations in the major market indices become higher and higher, this market is flashing DANGER signals. A continuation of this pattern would see Dow 10,000 decisively taken out during the latter part of the coming week.

What would make us more bullish on the stock market? If the Dow, S&P and NASDAQ could stabilise around current levels whilst the level of complacency declined, we would be less concerned about the short-term downside risk.

Even in a mania, earnings growth (or, at least, the perception of future earnings growth) is the major determinant of stock prices. As such, it is difficult not to be impressed at the resiliency of the US stock market in the face of some rather negative news regarding future earnings prospects (particularly for technology companies). We confess to being in awe of the fact that even though Xerox, IBM, Hewlett Packard, Coke, Gillette, Intel, Unisys, Lexmark and a host of other large companies have announced disappointing results and/or expressed concerns about future growth, the major market averages remain within 10% of their record highs. However, it is likely that the earnings picture will deteriorate further before we see any improvement and, therefore, that the huge companies that are keeping the averages at their elevated levels will soon feel the effects of the Y2K-induced growth slowdown. The following is from the Wall St Journal:

"Many companies say they are instituting computer-purchase freezes until they see whether fixes they have made in anticipation of Y2K will really work. Others have ordered developers to stop attaching new software applications to existing systems until after the first of the year, which also promises to slow down sales."

And "Things may get worse. Most of the freezes that companies are discussing don't start until Nov. 1. And some last until March 1, because of concerns about how computers will handle the leap year."

Our recommendation is that investors remain cashed-up awaiting a buying opportunity that will hopefully emerge during the next month. Those who purchased put options with the market at much higher levels should continue to hold and be on the lookout for panic selling to take profits. We do not recommend that new or additional bearish positions be undertaken at this time.

Gold and Gold Stocks

Those who are bearish on gold tend to fall into two camps. The first group are those who believe that gold no longer has monetary (or investment) qualities and does not, therefore, provide an adequate hedge against inflation. The second group believes that the gold price does reflect inflationary and deflationary trends and has been indicative of a dis-inflationary environment for many years.

The fact that 100% of official sector gold and around 75% of private sector gold is held for monetary/investment purposes debunks the argument of the first group. During the past several years a portion of the private monetary stock of gold has simply shifted location, moving from the Western World to the Indian sub-continent and the Middle East. As the price of gold continues to rise, a gradual shift in the other direction will most likely take place as the momentum investors of the West increase their purchases relative to the value investors of the East.

The argument put forward by the second group is closer to the truth, but with one important flaw. The gold price does not rise as a result of inflation, it rises as a result of declining confidence in government and government-sponsored money. Usually inflation leads to the erosion of confidence as people witness the deterioration of their currency's purchasing power, thus prompting increased investment demand for gold and a consequential rise in the gold price. However, when the signs of inflation are hidden from view by a burgeoning current account deficit and a heavily-manipulated consumer price index, confidence in the national currency can be maintained for some considerable time whilst inflation rages in the background. The second group's argument also fails to account for the effect on the gold price of the massive lending of gold over recent years, although we believe the extraordinary growth in gold lending/short selling to be both a cause and an effect of gold's bear market. Without the cooperation of government inflation statistics and a set of conditions that enabled the US to run-up an enormous current account deficit, manipulation of the gold price by an army of short sellers would not have been possible.

During the past week gold interest rates continued to ease, indicating that the gold price may continue its normal correction in the near future. Investors should take advantage of any pullbacks in the stock prices of profitable, well-managed, minimally-hedged gold producers to accumulate further positions. Our preferred stocks and target buy prices can be found at the www.speculative-investor.com web site.

Finally, in last week's Market Update we mentioned that Durban Deep had expanded its hedge book during the recent gold rally. According to the Company this is not correct, with Durban's net hedge exposure being 850,000 ounces (forward sales plus call options sold less call options bought) - less than one year of production (1.2 million ounces).

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

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