Cole's Market Insights - August 25, 1997

FOMC Stands Pat; Teamster Victory; Credit Demand Surging

To no one's surprise, the Federal Open Market Committee (FOMC) on Tuesday elected to leave the pivotal fed fund rate unchanged at 5.5%.

Reflecting a strong export performance and an unexpected drop in imports, the merchandise trade deficit fell to $8.5 billion in June. Economists are hiking their second quarter GDP estimates to reflect the impact of this better trade performance.

Housing starts held steady in July. Single-family starts eased modestly, but the volatile apartment sector fell sharply.

Although it is too early to tell for sure, the apparent victory of the Teamsters Union in their confrontation with UPS could signal the beginning of a sea change in the in the ant-union tide that has dominated the nation ever since Ronald Reagan was elected president in 981. If so, the "goldilocks economy" idea that has helped drive this stock bull to unheard of heights, may be on the way out as the dominant investment paradigm.

Having lost one on the labor front, big business may soon win another victory on the international front. President Clinton is pressing Congress to grant him fast track authority for a Multinational Agreement Investment (MAI) that would expand the power of transnational capital even beyond the generous limits already set by NAFTA and GATT. This treaty would make it still easier for US. multinationals to transfer jobs to low wage nations in Asia and Latin America.

With the economy expanding at a strong pace, credit demand has taken off. The broad money supply (M3) is expanding at the fastest pace since 1986. Foreign lenders accounted for a third of domestic credit demand over the year ended last March -- the highest proportion in decades.

Despite currency turmoil in Southeast Asia which has undoubtedly triggered some selling of greenbacks, other Asian central banks (probably China and Japan) seem to have taken up the slack. Foreign holdings of treasury debt rose $9 billion to $645 billion during the week ended August 19 after having been flat to down for a number of weeks. How long this renewed foreign buying will persist is another question entirely. Wall Street's smug assurance that foreigners will forever finance our huge trade deficits probably is misplaced to say the least.

Stocks Rebound, Bonds Fall

Perhaps anticipating quick approval of the MAI agreement next month, the "buy the dip" crowd moved back into action last week. The bellwether Dow Jones industrial Average rebounded 2.5% to 7888 despite the unfavorable UPS agreement with the Teamsters. The bond market was more skittish and yields on 30-year treasuries climbed from 6.55% to 6.65%.

The stock market rallied despite a report that equities are 20% overvalued according to a model recently developed for Fed Chairman Alan Greenspan. With Chairman Greenspan having become a contrary indicator, this report plus Friday's impressive rebound from a 175 point drop bodes well for a market rally this week. The writer wouldn't rule out new highs before Labor Day, but the 8300 early August peak probably will hold.

Whether or not the Dow can manage a marginal new high in the near future, the downside risk in most stocks seems far greater than any remaining upside potential. Current extreme valuations implicitly assume today's extraordinarily high returns on sales and equity can persist indefinitely.

Other super optimistic paradigms not likely to pass the test of time include:

No inflation and no recession for the foreseeable future. Foreigners will keep gobbling up treasury paper like drunken sailors. Labor is down for the count. The total domination of the political system by big money is a permanent fact of modern life. Alan Greenspan and Robert Rubin are all knowing geniuses who always will be able to head off any threat to the bubble at the pass.

The swing to the right these past 15 years has benefited investors enormously, but has hurt many Americans via stagnant real wages and loss of job security. To assume this can continue much longer without a massive backlash from those paying the price shows a truly extraordinary degree of arrogance and historic shortsightedness by this generation of investors. The Teamsters victory over UPS may signal that this longawaited backlash has finally begun. Many 1920s investors also thought labor was down for the count, but the 1930s depression triggered a huge resurgence.

Just as the stock bull triggered a self-sustaining upward spiral, so will the looming stock bear. For example, a considerable portion of the current strong growth in corporate profits reflects lower pension contributions as retirement fund investments soar in value. In a bear market, corporations will have to hike contributions as these assets erode in price, depressing profits.

Gold Price Stable, Physical Demand Continues to Climb

Spot gold was little changed last week around $326.50 despite the rebound in US. equities and rumors of additional sales by a European central bank. Gold stocks also showed little change for the most part.

Attracted by the lower prices induced by western CB dispositions and huge speculative short sales, gold demand is surging. Physical demand climbed 11% to a record 723 metric tons in the second quarter, according to the World Gold Council. China and India accounted for much of the gain.

With the stock, bond, and currency markets showing greatly increased volatility, and the prospect of an EMU delay reducing the prospect of additional European sales, the stage is being set for a huge gold bull in the not too distant future. Gold stock action has improved markedly this summer, although still falling short of a technical breakout inmost cases.

But bullion remains in a trading range. A breakout above the resistance point of $330 (spot) would be quite constructive. Even better would be a move above the $336 level -- the 100 day moving average.

Interestingly, the other precious metals -- silver, platinum, and palladium -- have all breached their 100 day moving averages. And these "whites" frequently lead the yellow.