Gold and Stock Market Update
Overview
US bonds have been in a bear market since October 1998, but this fact was not widely recognised until the Fed finally acknowledged the obvious and hiked official interest rates in June 1999. US stocks have been in a bear market since July 19th this year, but virtually no-one acknowledges it (at least not in public). Gold has been in a bull market since 21st September. How do we know? Well, there are no guarantees in the investment world (or any other world, for that matter), so anything is possible. However, when the market price of an investment languishes near 20-year lows for several months and then rallies 20% in the space of six days, this is the clearest indication of a major trend change we are ever likely to get.
Inflation Watch
The September 24th edition of Grant's Interest Rate Observer contains a brilliant article on the relationship between the current account deficit and price inflation. The article draws on the work of the late economist Robert Triffin to explain that excess demand (created by excess financing) is the fundamental inflationary cause. An increase in domestic prices is one means of adjusting to this excess demand. Under certain conditions, however, a balance of payments deficit may "constitute the main channel of adjustment to inflationary pressures and reduce correspondingly the extent of domestic price increases".
Grant, quoting Triffin, goes on to explain that "as long as excess demand persisted, any measures which successfully eliminated the foreign deficit would also aggravate domestic inflationary pressures, and any measures which successfully suppressed domestic inflationary pressures would aggravate the foreign deficit. Only the removal of the excess demand itself could provide a valid answer to both problems."
Following on from the above, just imagine the effect on US prices if the flood of cheap foreign imports was suddenly curtailed and tens of billions of dollars of excess money (demand) was let loose on domestic goods and services. No wonder the 'new era nuts' have not a word of caution about the burgeoning current account deficit. After all, it is this deficit that is providing the foundation for their "strong growth with no inflation" assessments of the US economy and allowing them to proclaim that real interest rates are too high.
It is worth noting that the Australian economy has also experienced a long period of strong growth (fueled by an expansion of credit) and low consumer price inflation. Like the US, Australia suffers (benefits?) from a soaring current account deficit. In fact, as a percentage of GDP, the Australian current account deficit is almost twice as large as the US deficit. Australia does not have the advantage of being the provider of the world's reserve currency, but it does have the advantage of being a major commodity exporter. Thus far this year the downward pressure on the Australian Dollar (and upward pressure on interest rates) from the current account deficit has been more than balanced by rising commodity prices. It will be interesting to see the end result of this 'tug-of-war'.
On Friday it was reported that US personal income in August grew at a robust 0.5%, a rate that was outstripped by a 0.9% increase in personal spending. However, if a large part of this spending was directed towards cheap foreign imports then the low inflation facade will be maintained just a little longer.
The US Stock Market
So far during 1999 the Fed has been very careful to prepare the markets for any changes in interest rates. The fact that they have recently been conspicuously silent regarding inflationary concerns strongly suggests that interest rates will not be raised at the October 5th FOMC meeting. This may provide some momentary comfort to those who view interest rates as the 'be-all and end-all' of equity prices and fuel a short-lived rally. However, we have no plans to close-out our short position or undertake any new buying of shares at this time as it is likely the major market averages are still closer to the top than to the bottom.
In our September 20th market update we noted a number of conditions that would have to be met before we would consider taking a more bullish stance. The first of these was that "a number of large-cap technology companies have warned of an impending slowdown in earnings growth and a number of earnings downgrades have been issued by Wall St analysts covering the high-flying tech sector. The companies to watch closely on the earnings front are Intel, IBM, Hewlett Packard, Cisco, Dell, Gateway, Motorola, Micron Technology and MCI Worldcom". (Note - we probably should have included Microsoft in this list, but did not do so on the basis that any warnings by this company would not be believed since they routinely try to lower analysts' expectations). On Friday 1st October, Hewlett Packard confirmed that their revenue growth would not meet analysts' estimates and Dell was downgraded by a high profile Wall St analyst citing a revenue short-fall due to supply issues. This is probably just the tip of the iceberg since the major effect on technology company earnings is likely to come from the curtailment of Information Systems (IS) spending in the months immediately prior to and following the Y2K transition. The evidence of an IS spending slowdown is only anecdotal at this time, but it makes sense that such a slowdown will occur. Apart from anything necessary to specifically address Y2K issues, only a very cavalier IS manager would be carrying out significant system upgrades and replacements ahead of the great unknown of Y2K.
Much has been written about the potential effect on the supply of oil due to Y2K computer glitches. Even a small disruption to oil supply could have a serious effect on the developed economies. The major oil companies have certainly been preparing for Y2K for many years, but have they fixed all the problems? Luckily we don't need to deduce the answer to this question, we simply need to observe the oil price. If there is a likelihood of significant disruptions to oil supply as a result of Y2K, then the oil price will continue to rise between now and the end of the year. In fact, even an unfounded fear of Y2K-related oil shortages can be self-fulfilling, with the hoarding of oil in some areas leading to a shortage in others. The oil price should therefore be a useful indicator in assessing the potential impact of Y2K on the stock market and the economy.
Although the market may get a boost from any non-action by the Fed on the interest rate front, downside risk will re-enter the market later in the week. On Thursday the European Central Bank meets and any tightening of monetary policy by that previously accommodative institution could precipitate a rush out of Dollar-denominated investments by European investors. On Friday we get the Employment Report for September. We expect this report to show a very strong employment picture and therefore scare the myopic crowd who believe that every economic silver lining has an interest rate cloud.
At some point we will see panic selling and that will be the opportunity to sell the put options accumulated at much higher levels. At this time we have seen nothing remotely resembling panic. In fact the general public are unbelievably complacent right now, an unusual situation considering we have already seen the major averages decline by 10% from their highs.
Gold and Gold Stocks
As mentioned in the Overview above, we now believe gold has commenced a new bull market. As such, the gold price can be expected to make higher highs and higher lows, with each correction representing a buying opportunity. It goes without saying, however, that when we get panic buying of gold shares like we saw last Monday and Tuesday, profits on short-term trading positions should be taken. Long-term gold investments should simply be held.
The October 2nd issue of the Australian Financial Review (Australia's equivalent to the Wall St Journal) included a front-page article about gold (refer to: afr.com.au. This article contains nothing new as far as the Gold Eagle readership is concerned, but is mentioned here simply because it provides an accurate overview of what is happening in the gold market. It is thus a refreshing change from the usual nonsense that passes for journalism (where gold is concerned).
Despite the announcement by the European central banks that gold selling and lending will be limited for the next 5 years, the biggest risk to further short-term upside in the gold price still comes from government intervention. As reported at Bill Murphy's Lemetropolecafe web site, the Federal Reserve has apparently been telling some of the firms that are long gold and are expecting delivery not to insist on immediate delivery. Once again the true fundamentals of the gold market are being suppressed.
Government intervention in markets always fails because it distorts the means by which information is transmitted - price. Price is the mechanism by which supply and demand are brought into balance. By attempting to hold prices at a level that is not consistent with the natural supply/demand balance, greater imbalances result. This is certainly the case in the gold market as this past week's action has demonstrated. However, it appears that the US Federal Reserve may be compounding the problem by postponing the day when a true equilibrium price for gold is achieved.
By intervening in markets to create stability, governments make the system less stable. By seeking to moderate the effects of a credit contraction, they create a set of circumstances that eventually leads to far greater hardship than could otherwise have occurred in the absence of their best efforts. In seeking to control the gold price they have created the perception of a risk-free trade that now poses a major threat to the financial system. The greatest risk, for those of us who believe in free markets, is that the financial turmoil that results from the years of massive gold short-selling will be blamed on the greed of hedge funds, bullion banks and producers. The call will then go out for more government regulation of the gold market. Although we have no doubt that many hedge funds, bullion banks and producers are greedy, it was the central banks' removal of risk that allowed the market to be driven to such extremes.
Steve Saville (a.k.a. Milhouse)
Hong Kong
4 October 1999
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