Overview

Bonds – appear to have bottomed for the near-term
Stocks – now bullish, but still high risk
Gold - still bullish (consolidating ahead of the next move higher)

Inflation / Greenspan Watch

Last Thursday Chairman Greenspan made one of the most extraordinary speeches we have ever heard. Following is an extract from that speech with our translation (Greenspeak to English) shown in brackets.

"But consumer demand can accelerate so much that total demand could rise above even the productivity-augmented overall growth of potential. This seems to have been happening in recent years, owing to an expanding net worth of households relative to income and perhaps a perception that the recent acceleration in real incomes will continue." (Here Greenspan is saying that the wealth created by surging stock and real estate markets has caused excess consumer demand. He forgets to mention that the soaring asset prices, and hence the excess demand, are a direct result of the Fed's monetary policy.)

"This extra demand can be met only with increased imports or with new domestic output produced by employing additional workers either from drawing down the pool of those seeking work, or from increasing net immigration.

Imports presumably can continue to expand for awhile, since the rising rate of return on U.S. assets has attracted private capital inflows, particularly a major acceleration of direct foreign investment, into the United States. For the recent past, direct foreign investment inflows have almost matched the total current account deficit. But a continued widening of that deficit could eventually raise financing difficulties, ultimately limiting import growth." (In other words, the normal consequence of excess money creation and excess demand – an increase in the general level of prices – has been offset by a burgeoning current account deficit. If US asset prices should ever stop rising at a rapid pace then foreigners may decide to stop financing this deficit)

"Clearly, the growth in gross domestic product cannot exceed the sum of growth in structural productivity and in the working-age population indefinitely. Market pressures must eventually emerge that work to contain such unsustainable growth.

The process of containment may already be significantly advanced. Increasing demand for financing capital goods relative to domestic savings, a reflection of the previously cited imbalances, has apparently been exerting marked upward pressure on real long-term market interest rates, especially as economies abroad strengthen." (The market has taken long term interest rates up high enough)

To recap the above, Greenspan confirms that soaring asset prices have caused excess demand and that consumer price inflation has been suppressed by an escalating current account deficit. He also suggests that the current account deficit is not a problem at the moment because the above-mentioned soaring asset prices have stimulated sufficient foreign investment to generate an offsetting capital account surplus. He warns, however, that should (heaven forbid) foreigners become less willing to continue financing an ever-expanding US current account deficit, then US interest rates would rise. Apparently concerned that the bond market has taken the related problems of excess demand and a disastrous current account deficit to heart, Greenspan's concluding remarks can be freely translated as "Don't worry – you've done more than enough already".

In a nutshell, we interpret the Fed Chief's latest speech as a signal that a concerted attempt will be made to perpetuate the US asset and debt bubbles through the continuation of low real interest rates. What has happened in the past two weeks to alter the stance of the Fed in such a fundamental way? After all, it was only on the 14th of October that Greenspan scared the financial markets by warning banks to be prepared for a sudden drop in asset prices. One possible (and plausible) explanation is that long-term interest rates continued to rise, thus exposing a highly leveraged banking system to massive losses. Another (equally plausible) explanation is that, future (imaginary) budget surpluses notwithstanding, the US Government remains the world's largest debtor and hence a major beneficiary of any reduction in market interest rates.

Attempts by the US Federal Reserve and all other central banks to manipulate the financial markets to suit a particular government agenda and/or to mitigate systemic risk have become standard practice. At any one time the world's central bankers and their cohorts in the private banking community are juggling thousands of balls. Occasionally, one or two of these balls are dropped leading to a frenetic scramble to get them back in the air before anyone in the real world takes notice. Those in the press, even those who have caught-on to some of the manipulation taking place in the financial markets, fail to recognise the root cause of the manipulation. They have not grasped the fact that manipulation of the financial markets is an essential component of a monetary system that is inherently unstable. A system in which currency is convertible into gold has its own in-built protective mechanisms that prevent any isolated failure from bringing down the entire system. Today's 'non-convertible free-floating confidence-based debt-backed CB-bailout Ponzi-scheme' monetary system does not encompass any such controls. As a consequence, the amounts of debt and derivatives are able to grow exponentially during an economic expansion, necessitating intervention/manipulation/management on a daily basis just to prevent (or postpone) a catastrophe. When the expansion finally ends, an even more concerted level of manipulation is required. So, don't complain about manipulation of the stock, debt and gold markets – it is an essential ingredient of our current monetary system. Complain about the system that makes manipulation necessary and truly free markets impossible.

The US Stock Market

For some time we have been on the lookout for panic selling to set up a relatively low risk buying opportunity. A substantial drop in the senior market averages would have reduced the over-valuation risk and allowed us to position ourselves for an expected rally into year-end. However, what we actually saw during the past week was panic buying.

The extraordinary surge in the S&P on Thursday and Friday of last week, combined with an improvement in the market internals, represents a significant upside breakout and has caused our stock market model to generate a BUY signal for the first time since 30th June this year. Although we always try to respect the messages given to us by Mr Market, we have a number of nagging concerns.

Firstly, in terms of the major averages, the market is far more expensive than it has ever been at any time throughout history (although many individual stocks have been declining for more than one year and hence represent reasonable value).

Secondly, the earnings picture for the major technology companies that are so heavily weighted in the S&P and NASDAQ is not particularly rosy. The Y2K-related corporate expense lock-down is underway and is expected to continue until March of next year. The companies that have thus far escaped a share market drubbing due to an earnings growth slowdown associated with Y2k (eg, Intel, Microsoft, Cisco and Sun Microsystems) may not be able to meet their 4th Quarter earnings and revenue targets. This is the single greatest risk since extreme valuations can only be rationalised if strong earnings momentum is sustained.

Thirdly, the monetary picture is unclear. 'Fighting the Fed' is usually a money-losing strategy, but right now it is difficult to ascertain the mood of a seemingly manic-depressive central bank. One day they are raising interest rates and expressing concerns about inflationary pressures, the next day they are talking down interest rates and embracing the 'New Era' hype.

Referring to our earlier discussion, it is possible that last week's stock/bond market rally and Greenspan's speech have signaled a fundamental change in the monetary environment. In our 11th Oct Market Update we said

"…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."

As such, and on the basis of a vastly improved technical picture, we recommend that some cautious buying of selected stocks (refer to the Stocks List for our suggestions) be undertaken over the next two weeks. The market is currently over-bought so buying should be done during pullbacks.

We emphasise that the extreme levels of over-valuation, as far as the major averages are concerned, mean that the market continues to hold substantial risk. Therefore, whilst doing some accumulation investors should continue to maintain a large cash balance. A risk management strategy that we will be using for our own account is the purchasing of protective put options (preferably expiring around Feb 2000) to offset the effects of any sudden and unexpected decline in the market.

The market remains event driven with traders obsessing over every economic report in a desperate search for clues as to the Fed's future interest rates moves. As such, short-term market direction will be greatly influenced by the September Employment Report on 5th Nov and the Q3 Productivity Report on 12th Nov. In addition, a move by the ECB to increase interest rates at their Nov 4th meeting would not be taken well.

Gold and Gold Stocks

One month gold lease rates have contracted to around 1% during the past week, indicating either an increase in the supply of physical gold or a contraction in the borrowing demand of short selling speculators. It is likely a combination of the two, since Central Banks have almost certainly provided short-term liquidity to the market and very few speculators would be eager to borrow gold in the current environment.

It is of concern that the XAU continues to under-perform relative to the bullion price. Such under-performance of the gold stocks suggests that the correction in the gold market is not yet complete. Investors should therefore maintain their holdings of quality gold stocks, but should be in no hurry to add to positions at the present time (with the possible exception of Anglogold – see below).

A Tale of Two Gold Stocks

The problems faced by Ashanti and Cambior have stirred up a great deal of investor nervousness regarding hedging, causing the shares of 'hedged' mining companies to severely under-perform those of 'unhedged' mining companies. This has resulted in a buying opportunity in the shares (and ADRs) of Anglogold (NASDAQ: AU).

As at 30 Sep 99, Anglogold had outstanding hedges covering 13.8M ounces of future production. Although this appears to be a large hedge position, it represents only 11% of reserves, 3% of resources, and less than two years of annual production. The hedge book also contains no credit or margin risk.

AU will earn around US$1.75 per ADR during the year ending Dec 99 (there are 2 ADRs per 1 share) and is forecast by Merrill Lynch to earn US$2.48 per ADR next year assuming an average gold price of US$315 during Y2000. At Friday's closing price for the ADRs of US$28, Anglo is selling at only 11.3 times next year's earnings (assuming virtually no change in the gold price). Anglo also generates a 17.5% return on equity and a 14.8% return on capital.

We also like the fact that the Anglogold management showed good judgement in not expanding their hedge book during the Jul-Sep quarter, recognising that gold prices had reached unsustainably low levels.

If the above wasn't enough, the shares of Anglogold can be purchased at a significant discount (currently around 10%) via Acacia Resources (ASX: AAA). Acacia's board of directors has recommended that shareholders accept Anglo's all-stock bid for the company (3.5 Anglo shares (7 Anglo ADRs) for every 100 shares of Acacia). When we first posted this opportunity at the TSI web site on 26th Oct, AAA shares were trading at $2.46. They subsequently fell as low as $2.40 on 27th Oct before finishing the week at $2.78. Based on the AU offer for AAA, buying AAA at A$2.46 is equivalent to buying AU for US$22.80. Even Friday's price of A$2.78 for AAA gives an entry into AU at only US$25.80.

The other gold stock we wish to highlight is Normandy Mining (ASX: NDY), but for completely different reasons. NDY has been part of our portfolio for some time. We were attracted by its strong balance sheet, prudent hedging and high quality assets. However, a review of its recently issued Q1 Report reveals the following:

1. The total number of ounces hedged has increased by 900,000 during the Jul-Sep quarter (from 12.4M to 13.3M). In other words, the company took advantage of record low gold prices to expand their hedging.
   
   
2. The mark to market value of the NDY hedge book dropped from positive A$669M at 30 Jun 99 to negative A$75M at 30 Sep 99. Part of this A$744M diminution in the value of the hedge book results from a decision to include fees and lease rates in the calculation of exercise prices, but by far the majority of the drop in value is a direct result of the gold price rally.
   
   

Then, at the company's Annual General Meeting on 27th Oct, NDY Chairman Robert de Crespigny made the following comments:

"We would not have a clue where the price of gold is going. We see our job as, first, to produce the cheapest gold possible because that protects the company, and second, that we should not be taking a view on the price of gold. If we don't know where it's going we need to prudently manage our assets. Some companies have taken an extreme view on where gold is going and at this time we are not sure there are any winners among them at all."

Perhaps Mr de Crespigny should try to understand the supply/demand fundamentals of the gold market. We certainly agree that it is difficult, if not impossible, to forecast the short-term direction of the gold price. As such, the hedging of production for the next 12 months may be considered sensible. However, there is a mountain of evidence suggesting that the gold price will be much higher in years to come, so the hedging of 6 years of annual production (as in the case of NDY) is not justifiable.

Further to the above we will be selling NDY immediately and will use Monday's closing price for record purposes in the TSI Portfolio.

Steve Saville (a.k.a. Milhouse)
Hong Kong
1 November 1999

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

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