Overview

Bonds – may have resumed their downward trend
Stocks – a short, sharp pullback followed by a Xmas rally?
Gold - neutral (BoE gold auction will determine near-term action)

Inflation Watch

A veritable flood of credit (money) within the US economy has created excess demand. This excess demand is evident in the prices of stocks and real estate, with the resulting 'wealth effect' continuing to propel a consumer-spending binge. It is also evident in GDP growth (the revised Q3 GDP growth rate came in at a very strong 5.5%, fueled by increased consumer spending and business investment) and in the burgeoning current account deficit. Eventually, one of the following will happen:

1. The continued strong demand for imports will cause import prices to rise, thus leading to an increase in the CPI (the CPI is, apparently, the only indicator of inflation that is visible to many analysts). With the cover of a benign CPI having been removed, the necessity for tighter monetary policy will become obvious to even the 'New Era' adherents.
   
   
2. Asset prices will experience a substantial and prolonged decline, eliminating the 'wealth effect' (perhaps precipitating a 'negative wealth effect') and hence alleviating the excess demand.
   
   
3. The Fed will be truly pre-emptive and take forceful measures to restrict the supply of money
   
   

We hope that, once the Y2K issue is largely out of the way, option 3) will come about. Although there is great risk involved in the tightening of monetary policy when the major stock market averages are so extremely over-priced, such action is the only way of limiting the eventual damage. If the Fed does take a responsibility pill in January and seriously attempts to curb the current excesses, then a strong stock market is possible during the second half of 2000.

The US Stock Market

In last week's Market Update we said that fear is the fuel that drives a bull market higher and hope is the fuel that drives a bear market lower. This counter-intuitive statement is an important piece of the stock market puzzle and deserves further explanation.

When there is no fear in the market and bullish sentiment is widespread, almost all potential buyers have already bought. There are, therefore, few buyers left to push stock prices higher. At such times the level of fear in the market must rise in order to create future buying power. The sequence typically goes as follows:

• Near the peak of an advance some smart operators take profits. Since there are very few new buyers at this time to absorb the selling, a small decline in stock prices results
  
  
• The decline generates apprehension amongst other investors, who are thus prompted to reduce their exposure to the market
  
  
• The process is self-perpetuating as selling begets fear which begets selling
  
  
• Recognizing an opportunity, those investors/traders who were first to take profits re-enter the market at the lower price levels
  
  
• At this point fear has shaken many 'weak hands' out of the market. A small amount of buying is therefore enough to stop the decline and cause prices to begin to rise
  
  
• Rising prices stimulate more buying and the process becomes self-perpetuating on the up-side
  
  

Just as fear provides the fuel for a bull market by keeping some people on the sidelines (or under-invested) and causing others to sell too early, hope keeps people invested during a bear market (thus providing the fuel for a future decline). Once all hope is lost (when the 'buy and hold' investors have finally given up and sold everything) a bear market can end and a new bull market can commence.

There are a large number of technical indicators that can be used to ascertain the prevailing sentiment (mood) of the market, one of the most popular being the put/call ratio. When the number of equity put options being traded is low relative to the number of equity call options, this tends to indicate a high degree of bullishness. That is, few people are concerned enough about a possible decline to seek protection through the purchase of put options. A chart showing the 10-day moving average of the CBOE put/call ratio can be found at http://www.decisionpoint.com/DailyCharts/CurrentPC.html. According to this chart, bullish sentiment is more prevalent now than at any other time during the past few years. In other words, the level of fear is at a minimum.

In order to make effective use of contrary indicators such as the put/call ratio to time the market, an investor must also understand the overall trend of the market. Sentiment can remain extremely positive for long periods of time in a bull market and extremely negative for long periods of time in a bear market. Also, looking at sentiment indicators in isolation may lead to incorrect conclusions during a transition from bull to bear or from bear to bull.

There is no 100% reliable means of market timing (if there was it would be self-defeating), but using a combination of psychological, technical and fundamental analysis gives an investor the best chance of success.

In addition to the put/call ratio, many of the other sentiment indicators we watch reveal that the level of fear in the current market is minimal, meaning that a correction in the very near term is highly likely. We anticipate a short, sharp pullback over the next 3 weeks, perhaps dropping the S&P500 by around 5% and the NASDAQ100 by 7-10%. This short-term sell-off, which should reduce the level of bullish sentiment, will most likely be followed by another speculative surge through the Christmas period and well into January.

Internet stocks should continue to be the best performers in this extraordinary market. As previously advised, our favourite stocks in this sector are Liberty Digital (LDIG), SportsLine.com (SPLN) and Mediconsult.com (MCNS).

Y2K

We are still watching for continued oil price strength going into year-end to provide us with advance information regarding the extent of Y2K-related disruption. However, irrespective of how serious a problem the Y2K computer glitch turns out to be, we do not expect it to bring about the end of the equity bull market.

Gold and Gold Stocks

In last week's Market Update we said:

"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."

Nothing has occurred during the past week to change our view of the gold market. We expect that any rally that is precipitated by a good auction result will be short-lived, with the gold price reaching a low during the first quarter of next year. The second upward leg in the new gold bull market should then commence.

If the auction result is not positive for the gold price, that is, if the successful bids are at or below the spot price, we may decide to immediately reduce our exposure to gold stocks. More important than the actual auction result will be the market's reaction to the news. As such if gold stock prices fall in the wake of the announcement of the auction results, we will sell 100% of our Harmony Gold shares, 100% of our Lihir Gold shares and 50% of our Goldfields Ltd shares.

Housekeeping Note

We have added a glossary at http://www.speculative-investor.com/glossary.htm to explain many of the terms used in the Weekly Market Updates. If there are other terms you think should be included in the Glossary, please e-mail us your suggestions and we will do our best to include them.

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

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

www.speculative-investor.com