Cole's Market Insights - April 20, 1997

Blue Chips Rally, Other Averages Lag

Spurred by a stronger bond market, the Dow Jones industrial Average soared 312 points (nearly 5%) to 6704 last week, thus recovering about half the loss experienced since its early March peak. The S&P 500 climbed 3.9% to 766.

Last week's rally was heavily focused on large blue chips. Smaller stocks continued to lag. The S&P mid cap index rose a modest 1.2%, while the Russell 200 index of small cap stocks climbed just 0.7%. The interest sensitive Dow Utilities index was up only 0.6% despite the stronger bond market.

The lack of broad participation suggests the rally will not last much longer. The primary trend is still down. The Dow might rally another 50-100 points early next week, but the odds favor a renewal of the downtrend shortly. The author still expects the Dow to reach his 5800-6000 target by the end of May. That should be followed by a decent summer rally of 10% or so. The third and most punishing phase of the bear should begin this fall and could last until early 1998. The Dow Industrials may drop to the 5000 area before a new bull market commences.

Gold and Gold Stocks Battered Further

Reflecting reports of continued central bank selling, further heavy hedge fund short-selling, and persistent strength in the dollar, near-term gold COMEX gold futures plunged from $347 to $341.50 after declining from $348.80 to $347 the previous seven days. Gold stocks remained under heavy pressure with the XAU index of large North American producers falling under 100 for the first time since late 1993. This widely followed index has dropped over a third since peaking in February 1996. Continued fallout from the BRE-X fiasco has further soured investors on small gold exploration stocks. Many of these have fallen far more than the majors.

Gold's weakness in the face of a declining stock market really is not that surprising. Gold does best when the future viability of the financial system comes into question, and a modest stock market drop induced by fears of Fed tightening is not going to shake anybody's faith in the system. Investors bailing out of stocks and mutual funds are parking their assets in money funds, not gold or gold funds. And without significant investor demand, the central banks will have little trouble keeping the yellow metal depressed. However, heavy physical buying in Asia whenever the price falls below $350 is making it harder for the western CBs to push the yellow metal much further towards $300.

Why are the Central Banks so Determined to Push Gold Lower?

An interesting question is why have the central banks become so much more aggressive in the their war on gold? For many years they were satisfied to keep the noble metal under $400. Now they seem to want it below $350. Could this reflect fears that the world financial system has become too fragile to sustain even a modest rise in the gold price?

Once investor demand takes off, the CBs will be powerless to stop the rise no matter how heavily they may sell. Huge short positions could propel the yellow metal skyward much faster than most think possible.

From a shorter-term perspective there still is substantial risk in the gold sector. Support at $335 has held so far, but if that is broken, bullion could sink to $325 or lower. The XAU probably would fall another 10-15% if this happened. But with this gold bear now entering its 15th month, a final bottom probably is quite close time wise, if not necessarily price wise. And once the bottom is in, the sky is the limit!