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Cole's Market Insights - March 14, 1997

March 14, 1997

Economy Strong, Wholesale Prices Decline

Economic data released this week show robust economic growth and contained inflation. Retail sales were strong in February, while January was upward revised sharply. Industrial production posted a sharp 0.5% rise last month. Many forecasters are hiking their first quarter GDP estimates. Primarily reflecting lower energy costs, February producer prices fell 0.4% . Wholesale prices excluding food and energy eased 0.1% - much better than expected.

Dow Drops After Reaching Record High; Gold up Slightly

The Dow Jones Industrial Average plunged 160 points Thursday after approaching 7100 earlier in the week. The Dow rebounded over 50 points Friday, but still closed the week considerably below the 7000 mark. This weakness reflected a jump in interest rates on news of strong retail sales. President Clinton's backtracking on CPI revision added to the market's woes. The prospect of magically cutting the deficit without taking any political heat -- never very realistic -- has plunged to almost zero, giving the bond bulls a slap in the face.

The Dow Jones Industrial Average -- the world's most widely followed stock index -- was revised significantly last week. Texaco, Woolworth, Bethlehem Steel and Westinghouse were deleted from the index. They were replaced by Travelers, Wal-Mart, Hewlett-Packard, and Johnson & Johnson. If these changes had been made in 1991, the Dow would be nearly a thousand points higher today. Many in the financial community feel this revision makes the index more vulnerable on the downside than was previously the case.

April gold rebounded slightly to $353 last week. Gold stocks and gold mutual funds rose modestly. Bullion's failure to rally sharply when the stock market plunged on Thursday signals that more base building will be necessary before a sustainable upmove can develop.

Have Stocks Peaked?

After Thursday's steep drop investors must again ask if it is finally time to abandon this aging bull. During 1996, many gurus mistakenly called for the bull to end only to switch their views as prices moved relentlessly higher.

This time, it may really be different. The Dow Utility Index -- a good leading indicator of interest rates and the broader market -- has retreated materially over the past few months. Yields on 30-year Treasury bonds seem poised to break above 7% before long. The Dow Industrials made a new high last week, but most other market indexes didn't. The three groups that have led the 1990s bull -- financial services, technology, and health care -- all seem to have peaked. Investors remain very optimistic despite Thursday's selloff which is seen by many as another buying opportunity.

The preponderance of evidence signals that the market has peaked or, at least, is close to peaking. This writer doubts that a big break is imminent, but does expect the Dow Industrials to be closer to 6000 than 7000 before many weeks have elapsed.

Gold and Gold Stock Behavior During Stock Market Declines

With the bond market already in full retreat and stocks vulnerable to a substantial falloff, what can gold investors expect? In recent years, gold has generally moved in tandem with the stock market. Gold stocks fell together with the market in 1987, 1990, and 1994. Bullion held for a few months after the 1987 crash, but fell sharply in 1988 as world central banks moved to rescue the battered dollar.

Earlier cycles were sometimes quite different. Anticipating the 1934 hike in the official gold price from $20 an ounce to $35 an ounce, gold stocks soared during the 1929-32 bear market -- the worst ever. Gold and gold stocks also surged during the 1973-75 bear -- the second worst of this century. -- as inflation took off and a sitting President was forced to resign.

Note that gold soared during both the deflationary 1929-32 depression and the inflationary 1970s. Both of these periods were characterized by extreme economic and political turbulence that triggered great uncertainty about the future of the nation's economic, financial, and political institutions. Gold does best when the economic and financial powers that be seem to be losing control. That is why the yellow metal can be expected to fare much better during a serious and sustained crisis than during a modest stock market correction engendered by expectations of Fed tightening.


Interestingly, bullion was exceedingly cheap relative to financial assets at the beginning of the last two secular gold bull markets. The Dow Jones Industrial Average was approximately 20 times the price of bullion in both 1929 and 1971.. By contrast, the Dow was just six times the price of bullion when the market crashed in 1987 and a modest eight times at the beginning of the 1990 slide. Significantly, the ratio is now back to the 20 to one level that prevailed in 1929 and 1971.


History teaches that the 1000 point drop in the Dow Industrials anticipated by this writer will not in itself trigger a sustained rise in gold prices, although sharp trading rallies cannot be ruled out. On a more positive note for gold investors, gold and mining stocks now are so cheap that the kinds of steep declines experienced during and shortly after the 1987 and 1990 equity bear markets are extremely unlikely. The most probable scenario is for the gold complex to continue forming a base in the months ahead as the stock market corrects.

Major Gold Bull Coming

If the rebound from the anticipated 1000 point stock market decline fails to go above recent peaks, then the stage will be set for a much worse drop later this year or in 1998, as the buy and hold philosophy comes under increasing challenge. With the public now having a larger share of its assets in stocks than at any time in history, and many counting on the stock market for a secure retirement, a severe decline to say 5000 on the Dow Industrials not followed by a quick recovery is bound to trigger widespread discontent with far reaching consequences. That is the kind of environment which could lift the noble metal and the mining stocks into the stratosphere.

Gold's special properties mean that it has a greater variety of uses than almost any metal.
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