Cole's Market Insights - March 8, 1997

Stocks Firm, Gold Plunges

Bolstered by reassuring comments from Fed Chairman Greenspan and a modest bond rally after the latest monthly employment report showed little wage inflation despite strong job growth, the Dow Industrials managed to close the week slightly above the key 7000 mark.

April gold, by contrast, plunged from $365 to $350 an ounce, erasing much of the rise from the early February closing low of $340. The excuse for the drop was the announcement that Switzerland would propose selling off 400 tons of gold over the next decade to help holocaust victims allegedly defrauded by Swiss banks. Other factors behind the sell-off included the reported drying up of Asian buying as prices rallied and the denial by the Austrian and German foreign ministers that they were considering postponing the target date for the final implementation of the EMU. On a more positive note, Asian buying is reported to have picked up again after prices fell.

Key Factors Influencing the Gold Market

With the gold bear trying to bottom out what factors will be required to trigger a SUSTAINABLE gold bull market, as opposed to brief sharp rallies followed by equally steep collapses?

Central Bank Gold Sales

The prospect of heavy gold sales by European central banks to meet the strict criteria for the European Union has been a key factor driving down gold prices over the past year. The size and timing of these perspective sales still are very much in doubt. A secular gold bull is unlikely until the markets have a better handle on these issues. A related question is whether recent rumors about heavy gold purchases by the Chinese Central Bank are true. If accurate, this would greatly alleviate market concern about European central bank sales.

Administration Economic Policy

One of the key factors behind the strong rise in gold prices during 1993, was market doubts about President Clinton's economic policies. These doubts have since been alleviated by the President's sharp swing to the right and the Republican takeover of Congress. Such concerns could crop up again. Treasury Secretary Rubin -- the Administration's chief economic and financial strategist -- reportedly opposes broad capital gain tax cuts and the balanced budget amendment, and wants to spend more on social programs. Of course Secretary Rubin is hardly a flaming radical. But the financial markets have such high expectations factored into them, that even modest policy disappointments could send gold up sharply.

Stock Market

The unprecedented bull market in common stocks that has pushed valuations to levels surpassing even 1929 by some measures, has raised concern among some policy-makers (primarily Fed Chairman Greenspan) about a possible stock market crash as in 1987 or a severe bear market such as 1973-75.

The 1987 crash forced the Fed to create an enormous amount of liquidity to prevent the financial system from collapsing. The subsequent soaking up of that liquidity was a key factor behind the 1990-91 recession. This liquidity proved insufficient to support gold prices which then were much higher relative to financial assets than is the case today. If a stock market debacle should again force the Fed to aggressively ease, only enormous gold sales by the world's central banks would have a chance of keeping the yellow metal under $400, and even that might not be sufficient.

The Dollar

The dollar's strong rise over the past 18 months has been perhaps the biggest single factor suppressing the price of gold. The G-7 finance ministers recently issued a communiqué asserting the greenback had risen enough, but have yet to back their words with actions. Indeed the dollar has ascended further against the mark since the G-7 meeting, although it has fallen somewhat against the yen.

Closely related to the strength of the dollar is the continued massive purchases of treasury securities by foreign central banks, especially Japan. Their holdings now total nearly $640 billion, They send us high-quality goods at cheap prices and we give them treasury paper which has increased in value (at least until now). This trade-off has been a key force behind the strong dollar, surging financial markets around the world, and downward pressure on gold prices. It is likely to continue until the European and Japanese economies improve from their current depressed levels, and those nations become more concerned with halting the deterioration of their currencies. Currency depreciation tends to boost economic growth and help financial markets for awhile, but can be very inflationary if carried too far. Too, depressed currencies make it easier for U.S. investors to acquire foreign assets on the cheap.

As long as G-7 support for an end to the dollar bull is not supported by actions, currency and gold traders will not take them seriously. But once the G-7 show they mean business and oppose further increases in the dollar with actions, not just words, the upward impact on gold could surprise all but the most ardent bulls.