Cole's Market Insights - April 9, 1997

Fed Hikes Rates, Bonds and Stocks Slide

Ending months of speculation in the financial community, the Federal Open Market Committee (FOMC) hiked the federal funds rate from 5.25% to 5.5% at its late March meeting. Fed Chairman Alan Greenspan's repeated statements that the CPI overstates inflation suddenly stopped. This argument was strictly for public consumption so politicians would (hopefully) be able to cut entitlement spending without taking much political heat. But now that President Clinton has rejected the "easy road" of CPI revision, Fed officials may no longer have to worry about the contradiction between arguing the CPI vastly overstates inflation while at the same time hiking interest rates in a "preemptive" strike against the Dracula-like enemy that always threatens to rise again, no matter how many times it is slain.

History shows that the FOMC rarely boosts rates just once. So the odds are that rates will be hiked further in the months ahead unless the economy and financial markets cool considerably. Responding to this expectation, 30-year Treasury bond yields have breached the 7% level, the stock market has corrected sharply, and the dollar has rallied markedly. The author's recent forecast that the Dow Jones Industrial Average would soon be closer to 6000 than 7000 now is accepted by many in the financial community. After topping 7000 early in March the Dow Industrials fell to an intra day low of 6405 on April 3 before rallying modestly to the 6600 area. The decline resumed on April 9. The relatively small number of new lows to date and the continued optimism of index option traders augurs against a reversal anytime soon. The Dow Industrials is forecast to drop to the 5800-6000 area by late May before a meaningful rally develops.

Gold Bullion Continues Basing, Gold Stocks Smacked by BRE-X Debacle

Gold bullion has retreated a bit over the past few weeks, but at the current level of $347-$348, has held up quite well in the face of a host of negatives. These include the stronger dollar, rising interest rates, rumors of further central bank selling, and progress in negotiations between the President and Congress towards balancing budget by the year 2002.

Gold stocks, by contrast, have plunged further, reflecting investor disenchantment in the wake of revelations that the "huge" BRE-X Indonesian gold strike was vastly exaggerated and may in fact be completely fraudulent. Junior Canadian mining shares were hit especially hard, but the major North American gold producers represented in the XAU index also fell steeply. Established South African producers -- much cheaper relative to earnings and reserves than most North American gold miners -- held up considerably better.

The BRE-X debacle is bullish for bullion and established producers longer term because it will significantly reduce the ability of small exploration companies to finance aggressive exploration and development efforts in third world countries. But the fallout from the BRE-X debacle likely will cast a pall over the entire gold mining sector for months to come.

New Gold Bull Coming

But the North American majors still are considerably higher compared with bullion than they were at the beginning of the 1993 bull which saw many gold equities double or triple in a matter of months. And with the stock market poised to drop further, there still is some downside risk in the gold sector. But having been in a bear market for over a year, the gold sector probably is a lot closer to a major bottom both price wise and time wise than almost any other industry.

The relative valuation building blocks for a new gold bull market are falling into place, but some sort of catalyst probably will be required to touch it off. Any number of possibilities come to mind -- a crisis of confidence in the dollar, serious pressure on President Clinton to resign as the sandals surrounding his administration grow, hostilities in the Middle East, EMU problems, a stock market meltdown more severe than the drop to 5800-6000 projected here, problems in the balanced budget negotiations, etc.

Nobody can be sure exactly when such a catalyst will occur, but the writer's best guess is sometime in the second half of 1997. And when gold can again breach $400, however unlikely that now seems, it will astound on the upside.