Overview

Bonds – experiencing an upward correction in an on-going bear market
Stocks – overdue for a pullback
Gold - neutral (BoE gold auction will determine near-term action)

Inflation Watch

Despite hiking both the Fed Funds Rate and the Discount Rate at last week's FOMC Meeting, the Fed continues to stoke the money supply. Although it is true that the Fed does not directly create the money and credit that flows through the economy and causes the massive asset inflation that New Era economists are so pleased about, they do have ultimate control of the money creation process. The Federal Reserve, through its open market operations, can increase or reduce bank reserves and thus modulate the ability of banks to expand their balance sheets. If the banking system is restrained in its ability to make new loans due to a contraction in its total reserves (brought about by the Fed's open market operations), then money supply growth will be slowed.

Rather than act to restrict the rapid growth in the money supply, the Fed is currently fueling this growth by adding reserves to the banking system. This is most likely being done to avoid any shortage of liquidity in the lead-up to the Y2K transition. It is also necessary in order to maintain interest rates at an artificially low level. Because interest rates are much lower than the rate at which asset prices are increasing, that is, because the cost of money is too low, the demand for money is surging. In a free market, the cost of money (interest rates) would rise in order to bring money supply and money demand into balance. However, the current money market is not free – it is managed. In effect, the Fed is now working hard to maintain an imbalance. What would we do without them!

Why are interest rates being kept at artificially low levels? Because they can be! Since most of the world looks to changes in consumer prices and labour costs as the measures of inflation, there is no apparent justification for a substantial rise in interest rates until the popular price/cost indices reveal the presence of inflation. At the moment, a Fed that is more aggressive on the interest rate front would create a huge problem for the stock market and possibly a liquidity shortage going into the great unknown of Y2K. And, they would be doing this when there was no evidence of inflation!

We expect the Fed to begin to take action to slow the money supply growth rate as soon as any immediate Y2K problems are out of the way, whilst keeping official interest rates at their current levels (unless increases in consumer prices and/or labour costs reveal the underlying inflation).

The US Stock Market

The Fed has supposedly been vigilant and made three pre-emptive strikes against inflation, yet inflation accelerates. This inflation, which is highlighted by the enormous increases in all measures of money supply growth and credit expansion, occurs in plain view and yet is apparently invisible. Some financial commentators are undoubtedly aware that excess liquidity is driving the stock market to ever-more dangerous levels, but have chosen to close their eyes to the truth. Perhaps they hope that a failure to acknowledge a problem will avoid the necessity of ever having to confront the problem. It is like the entire world is marveling at the record-breaking, but blatantly drug-enhanced, feats of an athlete. As long as no-one forces the athlete to take a drug test then we are all free to go on embracing an illusion.

Having an understanding of the true nature of the market and the much-acclaimed 'New Paradigm' economy should not prevent one from making money from the current excesses. Having such an understanding should, however, cause an intelligent investor or trader to be more than a little circumspect when placing money at risk in this environment. A clear vision of reality should, above all else, help us to avoid the painful consequences of this folly.

In an attempt to profit from the speculative mania engulfing the stock market we have advocated the buying of selected stocks on pullbacks, whilst maintaining substantial cash reserves. We were originally hoping for a large correction in the senior averages during the Sep-Oct period, but will never participate in the money-losing game of trying to tell the market what it should be doing (no matter how irrational the market appears). Had the Dow retreated to the 8500-9000 area, then an investment grade buying opportunity may have presented itself. Under such circumstances a new bull market could have emerged with the capacity to carry us into at least the middle of next year. The fact that a minimal correction of only 10% in the major indices was quickly followed by a speculative frenzy means that the longevity of this current up-trend is very limited. Our guess is that a more substantial correction will begin in late January 2000 in parallel with a Fed-enforced slowing in money supply growth.

Fear is the fuel that drives a bull market higher and hope is the fuel that drives a bear market lower. At the current time there is a complete absence of fear in the stock market, with several of the indicators we watch showing that the level of bullish complacency is similar to that reached at the mid July peak. Therefore, a significant pullback between now and mid December appears certain. However we are anticipating one final speculative surge, probably commencing mid to late December, before the market takes a more sustained downward path.

Marty Zweig said "don't fight the Fed". Once upon a time 'fighting the Fed' meant buying stocks whilst official interest rates were being raised. These days, with a flood of new money entering the economy in parallel with rising official interest rates, it is the short sellers who are fighting the Fed.

Y2K

As mentioned in previous updates, we are watching the oil price for a clue regarding the extent of Y2K-related disruption.

Positive influences on the oil price, such as the on-going compliance of OPEC nations with their supply restrictions, declining inventories and a potentially cold North American winter, are already discounted in the current price. In addition, bullish sentiment in the oil market has reached extraordinarily high levels. Taking all this into account and considering the fact that the oil price often makes a low in the Dec-Jan period, it would seem likely that the oil price should decline between now and the end of the year. If it doesn't and actually rises from here going into year-end, then this would point to a more serious Y2K outcome than most people expect.

Gold and Gold Stocks

The action in the gold market over the past week was decidedly bearish. In parallel with the gold price rising $4 during the week, the XAU actually declined by almost 3%. The continued under-performance of gold shares relative to the bullion price indicates that the correction has not yet run its course. As such, we recommend that no additional purchases of gold stocks be undertaken until the momentum in this market turns positive. We are still looking for a daily close in the gold price of at least $300.50 AND a daily close in the XAU of at least 73.5 to confirm a change in momentum.

Although a good result from the BoE auction may provide the catalyst for some near-term upside, it is now beginning to look like gold's correction/consolidation may continue until Jan or Feb 2000. We will monitor the situation very carefully over the next two weeks to determine whether we should reduce our exposure to gold shares.

During the past week we took profits on the Acacia Resources shares purchased on 26th October and added Durban Deep to the TSI Portfolio. It should be noted that the Durban purchase is not a play on the gold price (since we are not bullish on gold as far as the next three months are concerned), but a play on a stock that looks interesting from both a fundamental and technical perspective.

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

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