Gold and Stock Market Update

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 / Fed Watch

One year ago the Producer Price Index (PPI) for finished goods was falling at a year-on-year rate of 0.6% and the PPI for crude goods was falling at a year-on-year rate of 18.4%. They are now rising at year-on-year rates of 2.7% and 11.6% respectively.

The indicators of future inflation issued by the ECRI and the CIBCR are rising at rates between 6% and 9%, their highest levels in more than four years.

But, according to New Era hype, there are no signs of inflation.

As expected the fear of deflation that prevailed in 1998 caused central banks throughout the world to crank the monetary spigots wide open, with the US Federal Reserve leading by example. The resultant flood of new money is now beginning to have an effect on some of the popular indicators of inflation.

The reason we have never considered deflation to be a realistic possibility is that its consequences, in a monetary system that relies on the continuous expansion of credit for its very survival, would be so dire that central banks would always err on the side of excess money. If the burden of debt within the economy becomes so great that it threatens the life of the financial system, the burden could be lightened (or removed altogether) by the central bank through its power to monetise the assets (loans) of the banks. When this fraudulent monetary system eventually does collapse it will be amidst a sea of money (hyper-inflation), not a lack thereof (deflation).

Since early September this year, the total quantity of US Dollars has been growing at an annualised rate of 13.7%. Having presided over this inflation, the Fed meets on 16 Nov to decide whether or not to raise official interest rates. If they do raise rates the stock and bond market participants will cheer the Fed's vigilance (except for a few New Era types who will be outraged that interest rates are being increased when there is no evidence of inflation). If they don't raise rates the stock market will no doubt celebrate, but the bond market may carry out a rate hike of its own.

Will the Fed use interest rates to target the excessive speculation in the stock market? According to Greenspan's public pronouncements, asset prices must be taken into account when framing monetary policy. However, what the Fed Head says and what the Fed Head does do not necessarily correspond. If interest rates are not increased on the 16th, then we can be quite sure that stock prices are not being targeted by Fed policy.

The US Stock Market

In last week's Market Update we said:

"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 pullback we were looking for has, thus far, failed to materialise. However, our thinking is unchanged in that we are still expecting a retracing of some of the recent gains prior to a final upward surge into mid January.

The Internet stocks provide the best means of participating in this year-end rally. Many Internet stocks can be likened to fiat currency in that their stock prices are supported solely by confidence. US Dollars remain useful as long as most people do not comprehend the fraudulent 'Ponzi-Scheme' nature of the monetary system. By the same token, the valuations of many Internet stocks rely on the continued willingness of buyers to ignore the traditional need for a business to generate positive cash-flow or to at least have a clearly defined plan as to how it will become cash-flow positive (vague promises to somehow monetise 'eyeballs' in the undefined future does not count as a plan). In selecting Internet stocks we therefore focus on finding businesses that have multiple revenue streams and a competitive advantage, characteristics that should eventually lead to profitability. Currently, our favourite companies in the Internet sector are Mediconsult.com (MCNS), Liberty Digital (LDIG) and Sportsline USA (SPLN).

MCNS provides the premier on-line health resource for patients and physicians. It is in the process of acquiring Physician's Online (POL), a private company that has built up an on-line customer base comprising 80,000 doctors. This is important because, of the (current) total of 10 billion dollars spent each year by pharmaceutical companies in promoting their products, $8B is targeted at physicians. MCNS is therefore cementing, via the purchase of POL, its competitive advantage in an area that offers the greatest potential rewards. Despite being uniquely positioned to benefit from the growing importance of the Internet to the health-care industry MCNS has, to date, gone largely unnoticed by Wall Street. It was purchased for the TSI Portfolio at $5.25 on 21 Oct 99 and has quietly moved up to $7.75. At this price it is still a strong buy (with a stop loss set at $5.50).

Both LDIG and SPLN have moved up strongly over the past two months to around the $40 area. Any pullback into the low 30s over the next three weeks would be a buying opportunity for these stocks.

As an aside, it is noteworthy that John Meriwether of Long Term Capital Management (LTCM) fame has raised capital for a new hedge fund that is scheduled to commence operations on 1 Dec 99. Somewhat chastened by the LTCM experience, the new fund (JWM Partners) will employ more modest leverage than the 20:1 ratio used by LTCM ($20 of leverage for every $1 of capital). JWM Partners plans to only use leverage of $12 to $18 for every dollar of capital.

J Meriwether and his LTCM colleagues were/are bad traders. We can make this statement without qualification simply because they 'blew-up', that is, lost a substantial portion of their capital in a short time. Good traders never blow-up because:

a) they always manage their risk using protective stops, and

b) they only operate in markets that are sufficiently liquid to enable protective stops to work effectively.

Gold and Gold Stocks

These days in the financial markets, much is made of imaginary lines in the sand called "resistance" and "support". Technical analysts determine resistance and support by looking at charts showing historical prices. Resistance is generally seen as the price at which a prior advance was terminated (or a future advance is likely to terminate) and support is the price at which a prior decline stopped (or a future decline is likely to stop). We confess to being unsure of the importance of resistance and support to market behaviour. We are convinced, however, that a recognition of the overall trend of the market is extremely important to both a trader and an investor. We have also observed that points of resistance are irrelevant in a bull market and points of support are irrelevant in a bear market. For example, during the past few years the Dow has paused only momentarily (or not at all) at supposed resistance levels before bolting to new highs. On the other hand, every gold rally has failed to sustain a break of important resistance levels. This is just another way of saying that bull markets continue to make higher highs until they stop being bull markets, and bear markets continue to make lower lows until they stop being bear markets.

It is our belief that gold is now in the early stages of a bull market. If this is correct then the much talked of resistance at 300, 325, 340, etc is irrelevant – these prices will be surpassed with the greatest of ease during the next rally.

Although the price action in the gold stocks was marginally more positive during last week than it was during the previous week, there is no evidence at this time that the correction has run its course. As such, we would still 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 (refer to the Stocks List at www.speculative-investor.com for our gold stock suggestions). However, aggressive traders may wish to purchase a long position now to take advantage of a possible short-term rally as described below.

The next Bank of England gold auction is scheduled for Nov 29. There is a reasonable chance that the successful bids at the auction will be above the spot price, providing a catalyst for a quick move up in the gold price. A second possibility is that a good auction result will be anticipated by the market and the gold price will move up during the days prior to the auction.

If a long position is established now, we would close it as follows:

Y2K

The effect of the Y2K computer glitch remains an unknown quantity. As stated in a previous update, we will be watching the oil price as a signal regarding the extent of Y2K-related problems. If the Y2K glitch is going to be a serious problem, then it will certainly disrupt the supply of oil. If an oil supply shortage is on the cards for the first few months of 2000, then the market will discount this situation prior to year-end. As such, a strengthening in the oil price to around the $30 level in December will indicate serious Y2K problems ahead. If on the other hand the oil price is still at current levels (around $25) or below by mid December, then we will be confident that Y2K will not pose a major threat to the developed economies.

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

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

www.speculative-investor.com

Also by Milhouse


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