Gold and Stock Market Update

Overview

Bonds – nearing an intermediate-term low.

Stocks – nearing a major top. A severe correction is likely to commence very soon.

Gold – heading towards a low in early 2000. We expect gold to rally strongly from whatever low it reaches during the first quarter of 2000.

Inflation Watch

On 13th January Alan Greenspan delivered yet another extraordinary speech in which he ruminated on the possibility that today's stock market might one day be retrospectively viewed as "one of the many euphoric speculative bubbles that have dotted human history". Although Greenspan always speaks as if he is just a casual observer, it is crystal clear that we do have a bubble and it is a bubble of Greenspan's making. Without the propellant of an astronomical credit expansion facilitated by an excessively accommodative Federal Reserve, the speculative mania could not have been sustained for such a lengthy period.

Greenspan makes several other interesting comments during the speech, including the assertion that "productivity-driven supply growth has, by raising long-term profit expectations, engendered a huge gain in equity prices". If this is true then increased company earnings and greater earnings growth expectations could mostly explain the surge in share prices over the past few years. However, what we find is that gains in the senior stock market averages have relied mainly on the willingness of investors to pay much higher multiples of earnings relative to expected earnings growth rates. A good example is Intel. As noted by Bill Fleckenstein, the Q4 earnings reported by Intel last week were only 15% higher than its earnings of 2 year's ago. The Intel stock price, however, has risen 150% over the same period. The price/earnings ratio of Intel's stock is now approximately three times its expected earnings growth rate.

The Fed Head can wax lyrical about such phenomena as acceleration of innovation, productivity-driven supply growth and long-term profit expectations, but there is obviously something else at work in today's market. Our contention, and the reason we are only short-term bearish on the US stock market despite the highest valuations in history, is that we are not seeing stocks becoming worth more as much as we are seeing money becoming worth less. The fact that the on-going inflation remains invisible to most economists is due to government inflation statistics that are at best backward-looking and, at worst, a complete joke.

Coming into the year we were anticipating that the Fed would act to mop up the excess liquidity it helped create during the latter months of last year. This 'mopping up' appears to have commenced with Reserve Bank credit having decreased by $47 Billion during the week ended 12th January. By reducing Reserve Bank credit the Fed hopes to restrict new bank lending and thus slow the growth in the supply of money.

The US Stock Market

In last week's Update we said: "Our guess is that whatever upside the market can muster will be complete by the expiration of January options (Friday 21st Jan), after which we will see the start of a process of establishing some real value in the market." And: "If the S&P and NASDAQ are unable to make new highs before declining anew, or just make marginal new highs, then it becomes more likely that we have not yet seen the final peak of this equity bull market. However, if we see a major upside breakout above the highs reached during the morning of 3rd January, then we could very well be in THE final blow-off."

Our short-term view remains unchanged. Option expiration weeks usually have an upward bias, so further upside during the coming week would not be surprising. Both the S&P500 and NASDAQ Composite are still below their all-time closing highs, but are within spitting distance of these marks. With most sentiment indicators showing the market to be extremely over-bought an upside blow-off at the current time seems very unlikely. However, marginal new highs in the above-mentioned indices may be achieved during the next few trading sessions.

We watch the Internet stocks very closely, partly because of our investment interest in a number of these stocks and also because the Internet sector responds very quickly to subtle changes in market psychology (and can therefore be a useful leading indicator). The fact that Internet stocks have tended to under-perform the rest of the tech sector on both the up-side and the down-side over the past two weeks suggests that the market is not about to explode upwards in the near-term.

It should be noted that an upside blow-off at this time is by far the most bearish alternative for the market from a longer-term perspective. An acceleration in stock speculation right now would push market interest rates sharply higher and prompt the Fed to be far more aggressive than it would otherwise be, thus potentially turning the subsequent correction into a crash that breaks the long-term up-trend. However, a failure at or just above current levels leaves open the possibility of a strong stock market during the second half of this year.

Although the Internet sector of the market tends to receive most of the focus whenever excessive valuations are discussed, we are far more concerned with the prices of large cap stocks with proven track records and predictable earnings growth. The Internet stocks of today can be considered as call options on the future profits that will potentially stem from one of the greatest inventions in world history. Like all 'out-of-the-money' call options many will end up becoming worthless, but a few will generate huge returns on investment. However, there is no plausible justification for the earnings multiples at which many large non-Internet companies are trading. Intel was mentioned earlier in this Update, but Intel is downright cheap compared to Oracle (Oracle's P/E is 4.5 times its expected earnings growth rate). Oracle, on the other hand, is positively a bargain compared to Cisco (the P/E of Cisco is more than 6 times its expected earnings growth rate). We even have General Electric, a company that grows its earnings at a very reliable 15% year-in year-out, selling at 50 times earnings. Anyone who thinks that extraordinary earnings growth is the primary driving force behind this bull market is just not paying attention. A reasonably priced stock trades at a multiple of earnings that is approximately equal to its earnings growth rate. Anything extra is due to a breakdown in the connection between the stock price and the underlying business, and when this disconnection happens on a widespread basis it is caused by excessive liquidity.

Gold and Gold Stocks

Last week's Update included the following comment regarding gold price manipulation:

"We do not agree with those who argue that the gold price is low purely as a result of market manipulation. Although the gold market is almost certainly subject to manipulation, it is impossible to manipulate the price lower in the face of strong investment demand with such a limited supply of physical gold. The only explanation is that investment demand for gold is still weak, something we believe will change prior to the final peak in the stock market".

We received a number of e-mails from readers questioning this comment and/or requesting further clarification. Here is an extract from our Year 2000 forecast, the complete text of which can be found at http://www.speculative-investor.com/Y2000fcst.htm

"Although some goldbugs see a conspiracy behind every down-move in the gold price and believe that gold, if left to its own devices, would now be trading several hundred dollars higher than its current price of around $280, such thinking ignores the following facts:

1. The CRB Index hit its lowest level in 20 years during 1999. There is a strong historical correlation between gold and the CRB Index – had the gold price not been trading at low levels at the same time as the CRB Index was reaching its 20-year nadir, this would have been extremely unusual
    
2. US Government bond prices reached the peak of a two-decade long bull market in October 1998. Bonds and gold have a strong negative correlation so it is quite logical that the gold price would hit a major low within several months of a major peak in the bond market
    
3. Although volatility has reached extreme levels, the primary up-trend in the stock market is still very much in tact. Whilst stocks are widely viewed as having an attractive risk/reward balance, investment demand for gold should not be expected to show any substantial increase
    

We are not ignoring all the evidence of gold price manipulation on the part of bullion bankers and governments, we are simply suggesting that the primary reason for a 20-year low in the gold price during 1999 was not market manipulation.

Throughout history governments have certainly attempted to decrease the importance of gold as money in order to promote the currencies that they, themselves, can create in unlimited amounts at no cost. However, history tells us that such attempts are always unsuccessful because confidence in the government-sponsored money inevitably declines and people gravitate towards real, physical money – gold.

In the current world financial environment successful long-term manipulation of the gold market is less feasible than it has ever been. There are literally trillions of dollars sloshing around in the financial markets every day, but there is, at an absolute maximum, only about one hundred billion dollars of gold that could possibly be made available from the official sector to satisfy any increase in demand. As such, a significant rise in the investment demand for gold will lead to a large increase in the gold price, irrespective of any attempts to manipulate the market. Those who believe that paper claims to gold can be used to hold down the price for a long time to come are missing the point – there is a monthly supply/demand deficit in the gold market that can only be satisfied with physical gold. For example, Indian jewelry manufacturers and their customers have no use for paper gold."

During the past week the XAU significantly under-performed the bullion price, suggesting that a sustainable gold rally is not yet close at hand. We will continue to maintain a core holding of gold stocks that are financially strong and are highly leveraged to the spot gold price, but will not do any further accumulation of gold stocks until our Gold Momentum Model gives a BUY signal. (Based on current prices, a BUY signal will be generated with a close above 286.75 for spot gold AND 69.1 for the XAU.) An exception was made during the past week when we added Dome Resources (ASX: DOR) to the TSI Portfolio. Last week Durban Deep made a takeover offer for Dome that values DOR shares at around A$0.35 (the offer was primarily in stock, but with a small cash component). However, following the offer DOR shares have traded consistently at A$0.30. At current exchange rates and assuming the takeover is successfully completed, paying A$0.30 for DOR is equivalent to paying US$1.25 for DROOY (a 19% discount to Friday's closing price).