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

The CPI rose by only 0.1% in November, prompting the following comment at the Briefing.com web site: "For our part, we are calling it case closed – a surge in productivity growth is making it possible to experience 4% growth and stable to lower inflation".

There is certainly no argument from us that strong growth can go hand in hand with low inflation since the two are unrelated. However, the Briefing.com statement (which is typical of the majority view) not only portrays a misunderstanding of the nature of inflation (inflation is an increase in the supply of money, not an increase in consumer prices), it ignores the following:

• the burgeoning current account deficit
  
  
• the fact that leading inflation indices are rising at their fastest pace in over 4 years
  
  
• rising commodity prices, especially oil and base metals
  
  
• the fact that bond prices have been falling steadily for the past 14 months
  
  

For anyone who is old enough and well enough to sit up unsupported it would take just a cursory glance beneath the veil of government price indices to find an explanation for what the 'New Era' nuts refer to as "stable to lower inflation". That explanation is not surging productivity growth or the Internet, it is the current account deficit.

A nation's current account balance is the difference between that nation's income and its expenditure. During the third quarter of this year the current account balance of the US was a deficit of $90B, the majority of which resulted from the purchase of low-priced (by US standards) foreign goods. Had this money been spent on domestically-produced goods instead of flowing overseas, the US CPI would certainly be telling a different story.

The US has, to date, been able to enjoy the benefits of a large current account deficit (lower prices at the consumer level) without suffering the usual ill effects (a falling currency and higher interest rates) because current account outflows are balanced by capital account (investment) inflows. The situation can theoretically continue as long as:

a)  The economies of the major exporting nations remain weak and continue to have excess manufacturing capacity, thus encouraging them to maintain low prices

b)  The US Dollar remains reasonably strong, thus helping to keep import prices at lower levels and encouraging investment in US assets

It should be noted that inflation is not just a US phenomenon as governments and banks throughout the world have been aggressively expanding the supply of their currencies for the past two years. This worldwide inflation should ensure that we see interest rates and commodity prices continue to trend higher over the next two years. As such, the best investments during 2000 and 2001 are likely to be in the natural resources sector.

The US Stock Market

The TSI Stock Market Model uses a combination of monetary, momentum and sentiment indicators to help us identify significant changes in trend. The Model gave a BUY signal on 8 Sep 98 that remained in effect until a SELL signal was generated on 29 Jul 99. A new BUY signal was subsequently issued on 29 Oct 99 and had been maintained, despite deterioration in sentiment indicators, until last week. On 14 Dec 99, a new SELL signal was confirmed.

Last week we postulated that the market was within several weeks of a (or THE) peak. The above-mentioned SELL signal reinforces this belief. We still see a good chance of an explosive (but short-lived) New Year rally and will therefore not do any significant selling at this time. However, we have tightened the stop losses on our Internet stocks and will do no further buying unless we spot a very attractive short-term trading opportunity. If the market surges upward during the final 2 weeks of this year (possibly due to traders front-running the New Year rally) then we may take advantage of this strength to lighten up.

Three weeks ago we highlighted the CBOE Put/Call Ratio as a useful contrary indicator of market sentiment. Since that time the ratio has declined even further (meaning that sentiment has become even more bullish) and now stands at its lowest level in more than 10 years. This provides further evidence that market risk is EXTREME and thus, even though one final surge is expected, investors should now be at least 50% in cash.

In order to continue its historic rise, the stock market needs the on-going creation of debt in ever-increasing amounts. The expanding debt bubble, in turn, relies on the full cooperation of the Federal Reserve for its perpetuation. Should the Fed decide to restrain the growth in the supply of money and credit then market interest rates will rise and stock prices will sink. This is the scenario we expect to unfold during the first half of next year, assuming that the major industrialized nations are able to make a non-disastrous transition into the next Millennium (a big assumption, we know). In fact, there may already be some signs that the Fed is beginning to tighten the screws – the total supply of money in the US actually contracted by a small amount during the two weeks commencing 29 November. On the other hand, perhaps this just indicates a momentary borrowing pause.

We continue to watch the oil price as an early warning signal regarding the extent of Y2K disruption. The oil price has remained quite firm throughout December, but the market has been orderly and there have certainly been no signs of an impending crisis. If, however, an upward spike does occur prior to year-end then we will reduce our exposure to the stock market.

As an aside, several class action suits have been filed against Xerox alleging that "certain senior officers of the company issued a series of false and misleading statements concerning the declining demand for the company's products and services and had engaged in a number of deceptive practices to conceal these trends". Bottom line – Xerox missed Wall St earnings estimates, causing the share price to plummet. Some insiders, however, were 'lucky enough' to sell before the bad news became public.

Compared to the games that many companies are playing to maintain the illusion of strong profit growth, the Xerox situation seems trivial. The main problem with Xerox (the reason they are being sued) is the plunge in the share price. This leads us to forecast that a characteristic of the next bear market will be a plethora of class action law-suits on behalf of shareholders who have lost money. Until now we had considered gold to be the ultimate hedge against a financial crisis, but perhaps a better play would be to own equity in a law firm.

Gold and Gold Stocks

There is nothing inherently wrong with gold leasing. Private owners of gold should be free to lend their gold to anyone they choose at whatever rate of interest is mutually agreed upon. The borrower of the gold should be free to sell the borrowed gold because, after all, gold is just money and one ounce of fine gold is the same as any other ounce of fine gold (meaning that any gold of suitable purity can be used to repay the loan). Like any other lender/borrower arrangement, the lender accepts the risk that the gold loan may never be repaid.

However, there is something inherently wrong with the involvement of central banks (CBs) in the lending of gold. Firstly, the CBs are lending gold they do not own. Secondly, a CB or a government does not have the right to risk the loss of any part of the country's gold reserves, irrespective how small that risk may be considered to be. Thirdly, gold reserves are not held for the purpose of generating interest income – their purpose is to provide some physical backing for the currency. As such, they must remain on hand to support the currency during all circumstances. Fourthly, government involvement in any market distorts the mechanism by which information is transmitted – price. Imbalances therefore develop, initially to the benefit of some market participants and to the detriment of others. If the imbalances continue for long enough then all participants lose because the market ceases to function.

Last week the XAU made a lower low and a higher high, compared to the previous week, and achieved a higher close. The XAU also out-performed the gold price, rising 6.3% over the week compared to a rise of 1.6% for spot gold. These are bullish developments and suggest that a rally into year-end is a good possibility.

Another positive for gold is that large speculators are now net short COMEX gold futures and commercial hedgers are net long. It is doubtful that speculators will want to increase their short position over the next two weeks due to the unknown risks presented by Y2K, so gold has more immediate-term upside than downside.

As discussed in last week's Update, we are concerned that gold may head lower during the early part of 2000 due to the liquidation of long positions and the accumulation of short positions once the extent of Y2K disruption becomes known. As such we plan to remain cautious until we see the behaviour of the gold price during the first half of January. Whatever transpires over the short-term, we expect gold shares to perform very well over the next 2 years in parallel with upward trends in commodity prices and interest rates.

Housekeeping Note

This will be the last Market Update until the week commencing 10th January. Best wishes for a safe and happy holiday season!

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

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

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