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Cole's Market Insights

February 21, 1997

Economic Data Still Market Friendly

This week's economic data releases continued the theme of low inflation and modest growth that has supported the financial markets for so long. Consumer prices rose just 0.1% in January, well below the consensus expectation of 0.3%. The so-called core rate, excluding food and energy also inched up just 0.1%. Still, the CPI rose 3.3% in 1996, up from 2.5% during 1995.

Housing starts rose a modest 2% last month, coming in below the consensus. A recent commentary from Merrill Lynch proclaimed we now are in "the best of all possible economies". This sums up the feeling of many in the financial community today. Considering the extraordinary performance of bank and broker stocks over the past 2 years, this sentiment is not surprising.

Still, not all is perfect in this the best of all possible economic worlds. Partially reflecting the strong dollar, the nation's trade deficit soared to $10.3 billion in December, up from $7.9 billion during November. For all of 1996, the deficit hit $114.2 billion -- the biggest shortfall since 1988. The huge trade deficit is no problem as long as foreign private investors pour money into our booming financial market and foreign central banks continue purchasing Treasury securities at a rate of several billion dollars a week. What happens when that music stops will be another story entirely.

Stock Market Stalls, Bond Yields Rise

The Dow Jones Industrial average last week again failed to close above 7,000 after earlier moving over that level. Yields on 30-year Treasuries rose from 6.53% to 6.64%. Stocks fell sharply Thursday after Goldman Sachs guru Abby Cohen hinted she was a bit less bullish. However, Forbes columnist Laszlo Birinyi is just as enthusiastic as ever, projecting an 8000 Dow this year, according to an interview in this week's Barron's.

Investors withdrew substantial amounts
of money from mutual funds after
the 1987 crash and during the
milder 1990 bear market.

These two have rightly maintained their bullish convictions through thick and thin. Their pronouncements can move markets as was the case with Henry Kaufman and Joe Granville in the 1970s and Elaine Gazarelli during the 1980s. Interestingly, these gurus eventually fell off their perches and fell hard. Will Cohen and Birinyi share a similar fate?

Forget the pros, the amateurs are as enthusiastic as ever. Stock prices will continue to surge ahead in the short and long run, according to a recent telephone survey of 1000 investors by the National Association of Securities Dealers. Most asserted that a sharp drop in stocks would constitute another buying opportunity; few indicated they would sell if equities turned south.

There is reason to doubt investors will act the way they say they will act when the bear finally starts to bite. Investors withdrew substantial amounts of money from mutual funds after the 1987 crash and during the milder 1990 bear market. Experienced players know how quickly greed can turn to fear when the market begins to tank.

The public is more heavily committed to stocks today than at any time since the late 1960s. Many are depending on a perpetual bull to fund retirement, and most investors have been conditioned to buy on dips with an almost religious fervor. Consequently, the public probably will not start cutting back on their mutual fund holdings until confidence has been shattered by a big decline.

The bulls are correct in one sense -- public withdrawals from mutual funds are not likely to trigger a severe market drop. But they will greatly exacerbate such a falloff once it is firmly established. The public traditionally follows the LILO (last in last out) investment philosophy. There is no reason to believe they will behave differently in the future.

Gold: More Evidence of a New Bull

Gold funds were the
hottest sector last
week, with the better
ones jumping over 5%.

Evidence that a genuine new gold bull has emerged continues to escalate. After lagging the "whites" the previous seven days, the yellow stuff took the lead last week. April gold futures jumped $6.00 to $354.10, while February rose $6.30, also closing at $354.10. Bullion has now broken through the psychologically important $350 level on heavy volume. And gold stocks have started to move again after lagging the overall market for many months. Gold funds were the hottest sector last week, with the better ones jumping over 5%.

Those who argue that rising gold prices primarily reflect short covering - and will collapse again after the shorts have been squeezed - are mistaken. The fact that the February contract closed at the same level as April, tends to confirm reports of severe bullion shortages in Asia. Demand in that part of the world surged when prices dropped below $350 a few weeks ago. Premiums on refined shapes are at or near record levels and there are out and out shortages of some products such as kilobars.

Most significantly, gold now is moving up strongly against all the major currencies -- a necessary precondition for a genuine bull market. The yellow metal has risen much more in yen and marks than in dollars, and has recently penetrated 40-week moving averages in both the Japanese and German currencies.

In the past genuine gold bulls have required South African participation. The failure of South African gold stocks to rally last year when the Americans bounced were a sign that those rallies would fail. The South African gold stocks are participating fully in the current upswing, as gold shares rise around the world.

There has been considerable debate about the reasons behind the sharp 1996-early 1997 plunge in gold prices. A raft of negatives hit the gold market last year. A resurgent dollar made gold costlier for foreigners to buy. European central banks stepped up selling as some central bankers concluded they would need less bullion if a common European currency was established and could earn interest income by investing the proceeds of gold sales. Booming financial markets around the world further reduced the already low level of investor interest in the yellow metal.

Including the current bull market, there have been six great inflations of financial assets since the South Seas bubble of the 1720s. These have all been characterized by declining real gold prices. In each case, real gold prices rallied for three years once the financial markets finally collapsed. There is no reason to believe that it will be any different after the current bull is history. Those in the financial community who have again declared gold to be a "barbarous relic" doomed to languish in the doldrums forever will soon find out how mistaken they are.

The melting point of gold is 1337.33 K (1064.18 °C, 1947.52 °F).
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