Gold and Stock Market Update

Overview

Bonds – currently over-sold, but the major trend is DOWN
Stocks – a short, sharp pullback followed by a Xmas rally?
Gold – close to a short-term bottom?

Inflation Watch

The Nov 29 issue of Barrons contains an article by Joseph Carson, chief economist at Warburg Dillon Read. In the article Mr Carson explains that Warburg, in an attempt to find a way of measuring the true rate of inflation within the US economy, has developed a broad transaction-based price index. Their broad-based price index comprises the CPI (given a 67% weighting), the PPI (given a 13% weighting), real asset prices (given a 15% weighting), and financial asset prices (given a 5% weighting). According to Mr Carson:

"In the past three years, sizable increases in real and financial-asset prices have contributed to a large and persistent rise in the broad transaction-based price index. Year-on-year changes have hovered around 6%, a change in price that consistently has been above the official target for the federal-funds rate. Perhaps even more troubling, the uptrend in prices appears to be accelerating again.

To be sure, there is no specific numerical level of price change that compels the Fed to tighten policy. But with aggregate prices growing at a faster pace than the current 5 1/2 % target level for the fed-funds rate, the real funds rate actually is negative after adjusting for this gauge of inflation. That would indicate that the current stance of monetary policy is too accommodative. Indeed, by this measure, Fed policy is even easier than when it held the nominal fed-funds rate at a low 3% in 1993."

That is, using an index that provides a more broadly-based measurement of price changes than the widely-watched CPI, Warburg Dillon Read have shown that the US has enjoyed negative real interest rates for the past three years.

The above-mentioned article confirms what we have been saying for years, although we arrived at the same conclusion via a different path. It seems axiomatic to us that the rate of change in the general price level within an economy can be determined by subtracting the real economic growth rate from the money supply growth rate. After all if the supply of money is increasing at a greater rate than the supply of the things for which money is exchanged, then more money will, on average, be used in each exchange. The assumption here is that newly created money is spent (not saved), an assumption that is validated by a declining personal savings rate.

The US asset bubble, like many bubbles before it, continues to be propelled by negative real interest rates. In fact, although official US interest rates were recently hiked by 25 basis points, real interest rates have plummeted (become even more negative) during the past three months courtesy of a surge in the money supply growth rate. The Fed is facilitating this continued extraordinary growth in the total supply of money by adding reserves to the banking system.

Under the Fractional Reserve Banking system that operates in all developed nations, the total amount of deposit currency that can be created by the private banks is limited to a multiple of bank reserves. With the Fed having pumped up bank reserves over the past 3 months at an annualized rate of around 50% due to Y2K liquidity concerns, the banks are simply doing what they do best – using the additional reserves to support more lending and hence the creation of more deposit currency. During the most recent week for which data is available (the week commencing 22 Nov 99), the total quantity of US Dollars increased by $35.8B!

If the world is able to navigate into the next Millennium without a major disaster, the Fed will act immediately to restrict the rate of money supply growth. This is the key problem for the exuberant stock market – the more uneventful the Y2K transition, the less money will be available to support a continued surge in stock prices. Any New Year celebrations are therefore likely to be short-lived, with a major reversal likely to occur during the second half of January.

The US Stock Market

Those who are long stocks tend to look for bullish arguments to justify their position. They grasp at any means of rationalizing the extraordinary valuations, such as the popular myth of unending strong productivity-driven growth with no inflation. Correspondingly, those who are short stocks or out of the market look for negatives to justify their bearish stance. Some are reduced to hoping for a calamity, such as a disastrous Y2K transition, in order to validate their investment position.

It is impossible to be totally unemotional regarding the cauldron of emotions that is the stock market, but those who achieve the greatest level of objectivity are the most successful over the long run. Our goal is therefore not to be unswervingly bullish or bearish, but to position ourselves in synch with the major trend.

Similar psychology applies to the Y2K computer glitch, where one particular group has embraced a worst case outcome and is not prepared to consider any evidence to the contrary. By the same token a much larger group believes that the Y2K issue is a total irrelevance. We honestly don't know whether Y2K will be a disaster or a non-event or something in between, and we doubt that anyone else does either. We are confident, however, that Y2K will continue to have a major effect on the availability of money. A smooth transition into the next year would be positive for the markets in the immediate-term, but would most likely result in a much more restrictive monetary policy from the Fed.

For the past 3 weeks we have been expecting a short, sharp pullback in the stock market to commence at any time, primarily due to an absence of fear. During the early part of last week the market began to decline, but then promptly reversed and bounded to new highs. The reason this market stubbornly refuses to drop to any significant extent is that many professionals realize the historic level of over-valuation and short the market at every opportunity. The short sellers, who have been burned on numerous occasions by this unrelenting stock market mania, are now easily panicked and rush to cover at the first sign of an advance. Our statement regarding a lack of fear is therefore not entirely accurate – there is no fear of a substantial decline, but there is great fear that the market will explode upwards without warning.

It should be noted that the extreme level of over-valuation is not market-wide. In fact, the majority of stocks have not participated in the last 18 months of this bull market. Even last week, a period during which the S&P and NASDAQ indices surged to new all-time highs, the number of declining stocks was far greater than the number of advancing stocks.

Although the time is running out for a correction prior to a Xmas/New Year rally, we still anticipate a pull back during the next two weeks. We do, however, recommend that all investors have some exposure to the technology sector going into January. The New Year rally may be short-lived for the reasons described earlier in this Update, but it has the potential to be explosive. In order to limit the downside risk, new buying at this time should be focused on stocks that have not yet had parabolic rises. The following stocks represent reasonable value at their current prices and have the potential to move up strongly over the next 2 months:

We will provide some additional recommendations next week. In the mean time some of the current 'frothiness' will hopefully be removed from the market.

Gold and Gold Stocks

The relative performance of individual gold stocks during the Sep/Oct rally has provided investors with important information to assist with future stock selection. Assuming there are no significant fundamental changes to the underlying businesses, we now know the stocks to own (and the stocks not to own) to make the most of any future gold rally.

Firstly, the stocks to own. Of the companies we follow closely Harmony, Goldfields and Agnico Eagle were the star performers. Our goal is therefore to be long the shares of these companies prior to the next gold rally. Our second-line favourites in the sector are Lihir, Anglogold and Durban Deep.

Secondly, the stocks not to own. The under-performance of Barrick is indicative of investor concerns over large hedge positions. We do not think such concerns are irrational. The size of Barrick's hedge position reveals a less than optimistic view of the future gold price by that company's senior management (or, perhaps, the absence of any view). During a gold bull market the 'mark-to-market' value of Barrick's hedge position will become progressively lower. Irrespective of the fact that ABX are able to defer delivery into forward contracts for many years, a burgeoning unrealized loss on the hedge book will cause the share price to under-perform during any future gold rally. Pressure from shareholders would likely result in the eventual close-out of forward sales at much higher gold prices. We believe ABX would not appreciate substantially during a gold price rally and would depreciate (although at a slower rate than the unhedged miners) with the rest of the gold sector during a gold price decline. As such, we see Barrick as a 'no win' situation. Another stock we will avoid is Normandy Mining. Relative to gold reserves, Normandy's hedge book is even larger than Barrick's. Normandy has confirmed that it will continue to hedge a substantial portion of its future production regardless of the gold price. Since we are only interested in gold stocks as a leveraged play on the gold price, we see no reason to own NDY.

Further to last week's Market Update, we reduced our exposure to gold stocks as soon as the negative outcome from the BoE auction was confirmed. We will retain a core holding of gold stocks for insurance purposes whilst awaiting the next rally. What are we insuring against? A US Dollar crisis or a large and sudden increase in the widely-watched inflation indicators (primarily the CPI). Either event has the capability of causing a panic out of financial assets, with gold historically being the investment of choice at such times.

Although companies with large hedge positions offer less downside risk during a gold price decline, the core (insurance) position must offer explosive upside potential to be effective. As such, we have retained our Durban shares and 50% of our Goldfields shares in the TSI Portfolio. We will look for an opportunity to re-purchase Harmony at lower prices and would also be interested in acquiring a holding in Stillwater Mining at the right price (< $20).

In order to turn short-term bullish on gold we would need to see a daily close in the spot gold price of at least $290.50 AND a daily close in the XAU of at least 71.3. Long-term we could not be more bullish on gold.

Steve Saville (a.k.a. Milhouse)
Hong Kong
7 December 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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