Yearly Forecast
...............................-- for the Year 2000

Introduction

1999 was one of the most volatile years ever in the financial markets. We saw the greatest volatility in a generation in the US stock market, large downward moves in bonds, 20% movements in Dollar/Yen and Dollar/Euro, new 20-year lows for the gold price followed by an $80 upward spike, a more than doubling of the oil price, a recovery in most commodity prices and, during the final 3 months of the year, one of the greatest expansions of credit in the history of finance. Unfortunately (or fortunately, depending on your viewpoint), we expect 2000 to give us more of the same.

Excessive and ever-increasing volatility in the financial markets is an inevitable consequence of a financial system in which currency can be created at will by governments and banks. When there is no link between the currency and the physical world then there are no objective limits on the power of the monetary authorities to both increase and reduce the quantity of currency. In such a system the natural tendency is for the supply of currency to grow at a faster pace than the rate at which real goods and services can be produced, thus leading to a reduction in the relative value of the currency (higher prices). If external circumstances such as a capacity glut elsewhere in the world suppress the effect of a burgeoning money supply on a nation's producer and consumer prices, then the swelling quantity of money tends to bloat asset prices. Under these conditions, with the widely-watched inflation indicators revealing no cause for concern, the policy makers may feel constrained in their ability to restrict the supply, or raise the cost, of money. The credit expansion is thus left to continue unfettered, with new loans providing the fuel for further asset price rises which, in turn, provide the collateral for new loans. However, inaction by those who control short-term interest rates (the central bankers) is eventually punished by those who control long-term interest rates (the bond market). Long-term bond prices inevitably adjust to reflect the underlying inflation, that is, to account for the expected depreciation of the currency.

The US is heading down a path that ends with the Dollar becoming worthless. This is not due to a failure of the current US Government or monetary authorities, it is due to an inherent flaw in the monetary system itself. The real failure of the US Government occurred a long time ago when it defaulted on its obligations by removing any official link between the Dollar and gold. Once the Dollar had been freed from its golden shackles policy makers only had it within their power to alter the pace of Dollar destruction, not to change the end result. Unfortunately, under the stewardship of the most popular of US presidents and the most revered of Federal Reserve chairmen, the pace has quickened. (It should be noted that, although we focus on the US Dollar due to its global importance, all of the national currencies are heading down the same path for the same reasons.)

Since 1987 there have been a number of crises that have threatened to bring down the fiat monetary Ponzi scheme, but the scheme has been kept alive in each case by feeding it ever-increasing amounts of money. The latest effort occurred during the final 3 months of 1999 when it wasn't a crisis as such, but merely the possibility that Y2K would create a liquidity shortage that spurred the Fed into action. During last year's fourth quarter the total supply of US Dollars grew at an annualised rate of 17%, growth that was facilitated by a 64% (annualised) increase in the Federal Reserve's balance sheet.

In forecasting the stock, bond and gold markets, we pay very close attention to changes in the supply of US Dollars and the relative strength of the US Dollar on the foreign exchange markets. Our view that the US Dollar is heading inexorably towards a state of worthlessness makes us long-term bullish on both stocks and gold, and long-term bearish on bonds. We are also very bullish on the prospects for technology over the coming few years. As such we will always tend to be long both technology stocks and gold stocks, but will attempt to improve our investment performance by reducing or increasing our exposure within each area based on an analysis of the prevailing psychological, fundamental and technical indicators.

During the first quarter of 2000 the Fed will almost certainly drain off some of the reserves it added to the banking system in the lead-up to the Y2K transition. A small increase in the cost of money (interest rates) became irrelevant during the latter months of last year due to a dramatic increase in the money supply. Similarly, action by the Fed to contract the money supply during the early part of this year will have a great effect on the financial markets regardless of changes in official interest rates. Our forecasts for the financial markets during the Year 2000 are predicated on a belief that the Fed will pursue a restrictive monetary policy for much of the first half (as excess Y2K liquidity is removed) and a very accommodative monetary policy during the second half (to facilitate a robust stock market in the lead-up to the November Presidential elections).

Our forecasts for interest rates, the US Dollar, stocks, gold and commodities are outlined below. We have also included a brief analysis of the Japanese dilemma. These forecasts represent our current `best guess' based on information available at the beginning of January. However, we will never be married to a forecast (because the divorce can be very expensive!) and will change course if events dictate we do so. The important thing is to always remain in synch with the major trends, whatever they may be.

Interest Rates

Yields on US Government securities have been climbing steadily since hitting a major low point in October 1998. We expect interest rates to remain in a primary up-trend throughout 2000 (and for many years to come), but counter-trend down moves will occur as bonds periodically become over-sold. One of these counter-trend moves will likely occur during the first half of this year.

At the time of writing (Jan 00) sentiment regarding interest rates has reached a bearish extreme. Almost every analyst/economist/journalist/commentator expects the Fed to raise rates at its February meeting, with many now forecasting multiple hikes in official interest rates during 2000. Also, bullish sentiment for bonds has declined to a level equivalent to that attained by gold during mid 1999, just prior to its sharp rally. Whenever such unanimity of opinion appears in any market the actual result is usually opposite to the prevailing expectation. As such we anticipate a bond rally during the first few months of 2000 following an initial downward spike in January.

There are also some fundamental factors that support the case for a near-term bond rally. The first of these is that demand for US Government securities is likely to increase as extreme volatility in the stock market causes some investors to switch some funds to the safety of bonds. Secondly, if the stock market undergoes a serious correction during the first quarter, as we suspect it will, then investors' expectations regarding future stock market gains may become somewhat less optimistic. Bond yields of 6.5% may suddenly appear attractive. Thirdly, we believe the Fed will move aggressively during the first few months of the year to mop up the excess liquidity that was introduced during the latter part of 1999 to combat a perceived Y2K risk. Such an action on the part of the Fed would tend to put upward pressure on short-term interest rates as money becomes less readily available, but would provide a boost to long-term bonds as expectations regarding the future rate of inflation are lowered.

With respect to official interest rates, our view differs from the now widely held belief that the Fed will implement several rate hikes during the coming year. We think the Fed will raise rates on only one occasion, most likely at its February meeting. Our reasoning is that a clamp-down on the money supply growth rate will have such a marked and immediate effect on the stock market and on consumer spending that multiple rate hikes will not be required.

Although some upside in bonds can be expected during the first half of the year for the reasons described above, we expect the primary trend to resume during the second half (or a bit earlier, depending on how quickly the markets respond to the Fed's more restrictive monetary policy). In fact it is a political imperative that any necessary financial pain must be out of the way within the first half. The incumbents will certainly desire a strong stock market heading into the November elections, so the money creation machine will need to be oiled up and ready to run at full speed during the second half. Therefore, whatever support bonds are able to muster during the early part of 2000 will fade later in the year amidst an environment of rising prices and renewed stock market speculation.

The US Dollar

The Dollar (trade weighted) Index has been in an up-trend since early 1995. Although we are confident that the value of the Dollar will depreciate relative to physical assets, we are less convinced that the Dollar will depreciate relative to the other fiat currencies of the world.

The bullish case for the Dollar is as follows:

The bearish case revolves around the huge US current account deficit and the high rate of money supply growth during recent years. In particular, the high (and growing) current account deficit means that any reduction in foreign demand for US Dollars would lead to a fall in the Dollar exchange rate, or much higher US interest rates, or both.

Eventually an ever-increasing current account deficit will satiate the foreign appetite for US Dollars and the Dollar's exchange value will decline, but we do not know any way of calculating when this will happen. The best we can do is to respect the trend and assume that the Dollar will remain strong as long as the primary upward trend of the Dollar Index remains in tact.

The US Stock Market

The TSI Stock Market Model issued a SELL signal on the 14th of December, indicating that we had either already reached an intermediate peak in the market or were within several weeks of doing so. Based on a belief that the market would `blow off' to the upside before any substantial drop occurred, we chose not to immediately act on this SELL signal and thus to retain our more speculative technology stocks. At the time of writing the market appears to be very close to a top, with sentiment indicators revealing an overwhelming amount of bullishness. If we haven't already seen the peak of this market we are probably within one week of doing so.

Heading into the new-year we were looking for two conditions to be satisfied to create the environment that would lead to an important top in the stock market. The first was a non-disastrous Y2K outcome, a condition that appears to have been satisfied. The second was a broadening out of the market (an improving advance/decline line). Given the fact that the majority of stocks on both the NYSE and the NASDAQ declined in price during 1999, a broader-based rally was always going to be a good possibility as soon as year-end tax selling was complete. Since important market peaks only occur when the vast majority is bullish, we considered that a temporary improvement in market breadth would eradicate some of the few remaining bears and provide the unanimity of sentiment needed to establish a top. This second condition also appears to have been satisfied, although to only a very limited extent.

Both bulls and bears alike seem to agree that the US stock market is over-valued. The bears think the unprecedented valuations will lead to a crash and a devastating bear market, whereas the bulls find ways to rationalise the current prices. A key to the argument put forward by the permabulls is that we have entered a long period of strong economic growth with low inflation, thus allowing interest rates to remain low and permanently raising the earnings multiples attributed to stocks. Those of an unwaveringly bullish mindset are also wont to speak of an era in which technology continues to create massive cost savings for businesses, generating strong profit growth whilst consumer prices remain stable.

We are neither permanently bullish nor bearish, but simply try to consider all the facts at hand – encompassing monetary policy, market psychology, technical factors and fundamental valuation – when forecasting the financial markets. Although we agree with the bears that valuations are excessive, the stock bull market has survived to this day for two main reasons (neither of which is cited by the permabulls to explain the incredible gains in stock prices):

  1. Low real interest rates. The US has enjoyed negative real interest rates during the past 3 years (the real interest rate is calculated by subtracting the rate of money supply growth from the nominal interest rate). When the real cost of money remains excessively low for such a prolonged period, extraordinarily high asset prices can be achieved and sustained.

  2. Circumstances throughout the rest of the world kept the foreign demand for US Dollars at a high level (despite the low real US interest rates) and provided the US with a flood of low-priced products (thus helping to maintain relatively stable consumer prices in the US).

We are now faced with the question of how much longer the extreme valuations will be supported by these monetary and external factors.

Firstly, as discussed above we expect that the monetary support net will be temporarily removed from the market during the early months of this year. This will have the effect of pushing real US interest rates much higher irrespective of what the Fed does with official interest rates. Secondly, strengthening economic growth overseas has already stopped the decline in import prices that has been so helpful to the US since the Asian crisis of 1997. Thirdly, with many market-participants having taken on large debts in order to increase their stock investments, any significant drop in stock prices will tend to be self-perpetuating. And, as stock prices fall, some of the foreign capital that had been attracted to the perceived safety and consistently strong growth of the US stock market will return home, thus further exacerbating the fall.

If we are correct in our assessment that an important support structure is in the process of being temporarily removed from the stock market, then the next correction will be substantial. The Dow and the S&P500 may escape with falls in the 10-20% range, but many of the high-flying tech stocks will be slaughtered. On the way up many speculative stocks were not hampered by such mundane considerations as price/earnings ratios, since they often had no earnings and no immediate prospects of generating any earnings. However, this also means there is no objective point at which the stocks will become under-valued on the way down. Whereas imagination and greed were the only limiting factors on the upside, fear and the number `zero' will provide the only downside limits.

Enthusiasm regarding the growth prospects of the Internet has created a bubble of “South Sea” proportions in Internet stocks. Although we are long-term bullish on the Internet, we are extremely concerned that companies with very little in the way of revenue have been afforded multi-billion dollar market caps. It is likely that many of today's hottest stocks will not exist in two year's time whilst many others, even if they are able to execute their business plans to perfection, will be trading at small fractions of today's prices. However, we believe there will be great investment opportunities in this sector of the market for many years to come for those who have the foresight to select the right companies and the stomach to buy during the periodic brutal shakeouts that these stocks are subject to. `Net stocks can be considered as call options on the future profits that will potentially stem from one of the greatest inventions in world history.

The speed at which the market now operates suggests that, if an important top is reached in January and a correction then unfolds as forecast, most of the downside will be out of the way by early March. We should then see a recovery lasting a couple of months, another dip around mid-year, and then a powerful rally during the months leading up to the November elections. As well as the likelihood of monetary stimulus as discussed above, a stock market rally during the second half will be supported by an acceleration of earnings growth in the all-important technology sector. We will attempt to use sentiment indicators throughout the year to determine when sentiment has reached bullish or bearish extremes and thus identify important turning points in the market.

Two things we believe will occur prior to a final top being made in the equity bull-market are a multi-month surge in the gold price and a substantial decline in the exchange value of the US Dollar. With the Dollar Index still firmly within a long-term up-trend and gold currently trading within 15% of its 20-year low, it looks to us like the next decline in stock prices (assuming it occurs over the coming 2 months as forecast above) will not violate the primary up-trend. In other words, the market will recover to new highs.

Gold and Gold Stocks

For many years bullion bankers, speculators and even some producers profited from the short selling of gold. Since the price of gold unfailingly retreated to new lows and gold interest rates were always well below US Dollar interest rates, the borrowing and short selling of gold were consistently rewarding activities. The short sellers were not anti-gold from an ideological standpoint, they were simply trying to make money from what they perceived to be a one-way bet. It is important to understand that the phenomenal growth in the volume of gold lending and short selling over the past decade did not cause the bear market in gold, it was a consequence of gold's bear market. Put another way, a bear market is a prerequisite for consistently profitable short selling and a low risk `carry trade'. However, if we are correct in our belief that 1999 saw a reversal in the primary gold price trend, then the greatest opportunity for profit in the gold market will now be on the long side.

No gold price forecast would be complete without a discussion of market manipulation. 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.

We believe that the gold price is heading much higher over the coming few years, with the second stage in the new gold bull market set to unfold during the Year 2000. However, it is likely that the gold price will hit lower levels during the first quarter of the year prior to the commencement of a sustainable rally. At the time of writing in early January bullish sentiment regarding gold is higher than would be expected at an intermediate low point, suggesting that the gold price will decline in the short-term. Also, prior to the start of a rally it is common to see the prices of gold stocks out-perform the bullion price, something that has yet to occur in any meaningful way.

We use a gold momentum model to signal major changes in price momentum. This model requires that any move in the gold price be confirmed by a corresponding move in the XAU, and vice versa, before a change in trend is signaled. To minimise downside risk we will not aggressively purchase gold stocks until either our model gives a BUY signal or we observe capitulation in gold stock prices.

Commodities

We expect ever-increasing worldwide inflation for many years to come as the US monetary authorities are forced to maintain high levels of money supply growth in order to prevent a collapse in their debt bubble. At the same time the other nations of the world will use monetary policy to stimulate their economies and try to prevent any appreciation in the values of their currencies relative to the US Dollar. Against such a backdrop the demand for commodities will surge, leading to much higher prices over the next few years.

In the same way that we expect a sudden (temporary) change in the US monetary environment early in the year to bring about a short-term trough in US bonds (a peak in interest rates) followed by a bond market rally, the same conditions may mean we see a short-term peak in commodity prices during January or February. However, this should result in only a momentary pause in the commodities bull market that began in 1999. The second half of 2000 should see acceleration to the upside in parallel with rising interest rates and gold prices.

Japan

A large component of the Japanese people's enormous savings reside within the Postal Savings System (PSS). The PSS, with its huge store of cash, is relied upon to purchase a major proportion of all new Japanese Government Bond (JGB) issues. However, beginning in April of 2000 the PSS will be getting redemptions and will most likely be forced to become a net seller of JGBs.

Bearing the above in mind, consider that the total debt of the Japanese central government is forecast to reach 130% of GDP by the end of this year. Without the support of the PSS in mopping up the supply of JGBs, the Japanese Government would be forced to offer competitive market interest rates on its debt to attract investors. If Japanese interest rates rose to US levels of around 6% then the Government's annual interest bill on the existing debt would equal 7.8% of GDP. Such a huge interest expense would clearly be unmanageable.

Luckily for Japanese politicians, a government cannot become insolvent in terms of obligations in its own currency – it always has the option of simply printing whatever money it needs. Unless Japan's Government can find buyers willing to take on a huge amount of its debt at an extremely low interest rate, monetisation of the burgeoning federal debt would appear to be the only way out.

In addition to the massive and growing government debt burden, the problem of bad loans within the banking system has yet to be resolved. Despite some signs over the past year that the Japanese economy had started to recover, without a banking system that is willing and able to lend to businesses the recovery is unsustainable. It seems likely that a means of removing the bad loans from the banking system will be found and that this will also involve some form of debt monetisation.

Although Japan's monetary authorities have, to date, done their utmost to avoid the large-scale creation of additional Yen, with deficit spending having failed and no other `easy' solution in sight they will choose the inflationary path. As such, we expect a huge increase in the supply of Yen over the next two years and a consequential fall in the value of the Yen relative to the US Dollar.

Forecast Summary

  1. The worldwide trend during 2000 and for many years to come will be towards higher inflation as all fiat currencies depreciate at varying rates against physical assets.

  2. Interest rates: With an inexorable trend towards higher inflation, nominal interest rates are headed higher over the coming years. During 2000 we expect a spike high at the beginning of the year followed by a down-move lasting a few months. By the second half of the year the primary upward trend will have reasserted itself.

  3. The US Stock Market: We are looking for an important high in January, a sharp correction into March, a 2-3 month rally, a mild correction around mid-year, and then a strong market throughout most of the second half.

  4. Gold: We expect a low during the first quarter followed by a strong rally.

  5. Commodities: We expect commodities to trade in synch with interest rates, that is, lower during the first half following an initial spike high. The second half should see commodity prices moving upwards.

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