Overview

Bonds – experiencing an upward correction in an on-going bear market
Stocks – neutral to bullish over the short-term (2 months)
Gold - still bullish (consolidating ahead of the next move higher)

Inflation / Interest Rate Watch

The monetary environment in the US remains confused. A schizophrenic Fed is ostensibly on a tightening path whilst, at the same time, the total stock of money has recently begun to grow at an accelerated pace. In addition, the financial sector has been actively expanding its borrowing over the past two months. As reported by David Tice, "the financial sector began borrowing aggressively in September and this continued last month. In fact, financial sector commercial paper borrowings increased $29.9 billion in September and $19.4 billion in October. This two-month $49.3 billion increase in borrowings compares to total commercial paper borrowings of $8.2 billion during the previous five months". So, while the financial markets focus on the possibility of another increase in official interest rates, money is actually anything but tight.

What we are now witnessing is a continuation of a policy maintained by the Fed throughout the tenure of its current chairman, that is, any and all threats to liquidity in the financial markets are met with increased credit creation and, consequently, an increase in the money supply. Eventually, this policy will lead to much higher consumer and producer prices, higher nominal interest rates, and a collapse in the exchange value of the US Dollar. In the short-term (between now and year-end) it may once again support an extremely over-valued stock market.

The next major event on the monetary calendar is the FOMC meeting on 16 Nov. Recent economic data and 'non-hawkish' remarks from Greenspan have convinced many commentators that the Fed will not increase rates at this meeting. Our guess is that rates will be raised at this meeting by 25 basis points, particularly in light of last week's 50 basis point rate hike by the ECB. If such an increase in official interest rates does eventuate at the November meeting it may be the last one prior to the year 2001. This is because a slowdown in economic growth (partly induced by Y2K) will likely become evident over the coming months, obviating the need for higher interest rates during the first half of 2000. Towards the end of 2000 Americans will be going to the polls and only an independent central bank would dare raise interest rates during the months leading up to a Presidential election.

The US Stock Market

The upside breakout on 28 and 29 Oct caused us to become cautiously bullish on the stock market, with an emphasis on the word 'cautiously'. The good news is that market breadth has improved substantially of late, with advancing stocks outnumbering declining stocks on the NYSE every day last week. The bad news is that the market continues to contain the greatest valuation risk in its history and various indicators show that it is over-bought on a short-term basis.

Our thinking is that the market will drop over the next week or so, possibly taking the S&P Dec futures into the 1320s. We would then expect a rally into mid January before the risk of major downside re-emerges. However, even in a best case scenario for the market we do not envisage much upside potential from current levels for the major indices. The main reason is that the earnings growth picture for the large-cap tech stocks that have powered the averages for so long continues to deteriorate. In fact, the market now appears to be approaching a blow-off phase in which only the most speculative stocks achieve significant gains.

The adverse ruling against Microsoft in its anti-trust case, announced after the bell last Friday, is a major negative for the company and for the market. In the short-term many bulls on the market and Microsoft will no doubt put a positive spin on this news, saying it removes uncertainty. We do not agree. The judge's ruling amounts to a realisation of the worst case fears and leaves uncertainty regarding the remedies to be applied. After a knee-jerk sell-off and subsequent rebound, the unknown extent of any punishment and/or settlement is likely to weigh heavily on MSFT stock for many months – another limiting factor on the widely-watched indices.

Between July 19 and Oct 27, the trend in the market was clearly down. Despite having broken this down-trend on 28 Oct the market is now almost directionless, with only a slight upward bias. It therefore remains high risk and unsuitable for most investors. As such, we recommend that investors continue to maintain a substantial portion of their investment funds in cash. If we get a pullback over the next 5-7 trading sessions that does not violate support in the 1320s (basis the Dec S&P), then a reasonable short-term trading opportunity may emerge in selected Internet stocks. Stay tuned.

Gold and Gold Stocks

On Friday 5 Nov the XAU had its lowest daily close since 20 Sep, the day prior to the last Bank of England gold auction, whereas the gold price is still 13% above its 20 Sep level. The continued under-performance of gold stocks relative to the bullion price is a signal that the recent correction in the gold market is not yet complete. We therefore recommend that investors maintain a core holding of the stocks of profitable, minimally-hedged gold mining companies, but do not do any further buying until we see some evidence that the pullback has run its course and a new rally has commenced (for those who do not already have a core holding of gold stocks, please refer to our Stocks List for suggestions). Based on last week's price action, we would need to see a daily close in the gold price of at least $300.50 AND a daily close in the XAU of at least 73.5 prior to undertaking additional purchases.

A note to the managers and directors of listed gold mining companies:

The majority of those who have invested in gold stocks have not done so with the goal of obtaining a consistent income stream or steady growth. Consistency and steadiness are attributes that can be found in well-managed consumer products, industrial and technology companies without the risks inherent in a mining operation. It is our opinion that most gold stock investors have a positive view on the future price of gold and have bought gold stocks to take advantage of the supposed leverage offered by the stocks. They are seeking exposure to the explosive upside in gold stocks that has always, in the past, accompanied a substantial rise in the gold price. For some reason, however, many gold mining company directors seem unaware of the objectives of their shareholders. Instead of working to maximise the rewards that a gold rally should provide, they are mortgaging future profitability and share price upside in order to manufacture a more stable earnings profile. The senior executives of companies that have forward-sold the equivalent of several years of future production tell their shareholders that their company will still benefit from higher gold prices due to an increase in the value of non-hedged in-ground reserves. However, such statements will be small consolation to any investor whose gold stock holdings fail to appreciate in the face of a gold bull market. The performance of gold stocks over the past two months has demonstrated that the market will not reward those companies that have significantly reduced their exposure to a higher gold price.

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

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

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