Overview

Bonds – rallies will occur from time to time, but the major trend is DOWN
Stocks – a major top is likely in January 2000
Gold – heading towards a low in early 2000

Inflation Watch

As pointed out by Jim Grant in the latest issue of Grant's Interest Rate Observer the US Federal Reserve has, during recent months, been adding liquidity at a much faster pace than has either the BOJ or the ECB. Should we therefore conclude that the Y2K computer glitch and its consequences are only a US problem?

The next meeting to decide the level of official US interest rates will occur on 21st December. Although the vast majority of analysts acknowledge that any increase in interest rates prior to the Y2K transition is extremely unlikely, a few have expressed concern that the Fed may revert to a 'tightening bias'. However, judging by the way the Fed has been flooding the banking system with reserves and implementing a rather creative scheme to sell 'liquidity options', this august institution is clearly in no mood to be anything except accommodative ahead of Y2K. As such, the probability of the Fed raising interest rates or changing its bias at the December meeting is somewhere between zero and some number very close to zero.

As discussed in previous Updates, the upward movements in official interest rates over the past five months have painted the false picture of a vigilant and restrictive Federal Reserve. However, the mostly unacknowledged reality has been a debt bubble that has continued to expand due to negative real interest rates resulting from a burgeoning money supply. In our opinion the first half of next year will, from a monetary perspective, be the mirror image of 1999's second half.

Until there is a significant upward movement in the widely watched price indices the Fed is unlikely to meaningfully increase the cost of money. Even this year the Fed initially came under some criticism for raising rates when there was supposedly no evidence of inflation (the criticism dissipated as soon as the rate rises were observed to have no detrimental effect on the stock market). As such, and assuming the CPI does not accelerate upwards, we see a strong likelihood of an outwardly unchanged monetary policy during the first half of next year (official interest rates to remain at, or near, current levels) in parallel with a clamping down on money supply growth. If Y2K does not create a liquidity shortage, the Fed will act to drain reserves from the banking system. For the first time in years, the US may be about to enter a period of positive real interest rates!

The US Stock Market

The US Stock Market is 'managed'. From the timing of interest rate cuts in 1998 to the content of Greenspan speeches, the potential effect on the stock market is always a (or the) major consideration. On occasion, Greenspan has expressed concern regarding the high prices and the lack of appreciation for risk that have characterized the stock market. However, he has presided over a phenomenal increase in the money supply during recent months and would certainly have been aware of the effect that such a liquidity injection would have on the market. In addition, he made a speech on 28th October in which he seemed to embrace 'New Era' beliefs and hint that multiple future interest-rate rises were not on the cards. Once again, he would certainly have known that such talk would pour more fuel on the stock market fire. It is clear that US authorities wanted a fearless and buoyant market heading into year-end.

The current US Stock Market is one of history's greatest bubbles. As reported by Alan Newman (http://www.cross-currents.net/charts.htm), the trading volume on the US stock markets during 1999 will exceed 200% of US GDP. That is, for every dollar that is spent on goods and services each day more than $2 is spent trading stocks. The previous bubble-peak in trading volume, achieved during the 1929 mania, was 130% of GDP. This is why the US monetary authorities and political establishment tread so carefully when it comes to the stock market – rather than being a leading indicator of real economic activity, the stock market now dominates the economy. The 'market managers' are trapped in their own game – the greater their manipulations the bigger the bubble becomes and the more concerted their ensuing manipulations must be.

It does not take a great deal of imagination to figure out that a strong economy (and hence a strong stock market) will be politically desirable heading into the US elections at the end of next year. However, in order to develop the platform from which a buying spree can be launched during the second half of next year, a correction must happen during the first half of next year (there is no way that strong buying can be sustained for another 12 months in a market in which the majority are already fully invested). As such, we expect the Fed to engineer a drying up of liquidity during the early months of 2000 in preparation for yet another monetary flooding during the year's second half. Their success or failure in this high-risk venture will determine whether a market peak in early 2000 is 'a top' or 'THE top'.

Further to the above, we think the market is within several weeks of reaching a (or THE) peak. We are looking for two things to happen during the first half of January to give us the final speculative surge that culminates in a major reversal. The first is a non-disastrous Y2K outcome – making it into Y2K with essential services mostly in tact will generate enormous relief and cause a buying panic. The second is an improvement in market breadth. Some analysts have remained cautious because the advance/decline line has failed to confirm the recent rally. Once tax loss selling is complete it is probable that a sudden improvement will occur in market breadth, causing those analysts to turn bullish very close to the top.

Investors and traders alike should be careful not to get sucked into a New Year rally. For those who already own technology stocks this will be a time to harvest profits. For those who are mostly out of the market it will be a time to sit back and watch the rampant speculation with detached amusement, secure in the knowledge that share prices will be much lower within a few months.

The effect on the stock market of a Y2K outcome that is much worse than expected cannot be known with any certainty, but it may well extend the current up-trend (following a knee-jerk reaction sell-off). The reason is that the Fed would panic, as they have done at regular intervals over the past 12 years, and provide yet another huge injection of money.

Gold and Gold Stocks

Gold performed reasonably well during the past week, dropping only 50c over the course of the week despite a barrage of bad news. In reality the news was not particularly bad (the Dutch gold sale already formed part of the 2,000 tonne limit announced by the ECB on 26th September and the other rumoured sales (from the Russians and the Malaysians), even if true, are small amounts), but was portrayed as such in the mainstream press. However, the continued under-performance of gold stocks suggests that this current corrective phase is not yet complete.

There is a possibility of an upward spike in the gold price over the next 3 weeks since many speculators may be reticent about being short gold as we leap into Y2K. We are concerned, however, that a substantial liquidation of gold long positions (both physical gold and paper claims to gold) will occur in early January. It is likely that people who have made some form of gold investment based purely on Y2K fears will sell in January, thus causing a downward spike in the gold price and potentially setting up the next buying point for gold stocks. As such, we will not buy into any gold rally between now and year-end, even if the short-term reversal points on our gold momentum model (currently 286.75 for spot gold and 69.8 for the XAU) are hit. We will, instead, rely on our existing holdings in two of the companies with the greatest leverage to the spot gold price – DROOY and GOLD – to provide whatever crisis insurance we need.

For those who feel they absolutely must buy gold stocks in the current environment, Anglogold (NASDAQ: AU) looks very attractive on a long-term basis at around $23. Avoid the companies that:

a)  are not profitable at current gold prices
b)  are not generating positive cash flow
c)  have a large amount of debt
d)  have hedge commitments covering more than 2 years
     of future production or more than 25% of reserves
e)  have not exhibited good relative performance
     on the stock market during the past 6 months

Steve Saville (a.k.a. Milhouse)
Hong Kong
14 December 1999

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

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