| Weekly Market Update for the Week
Commencing 18th September 2000 (Please refer to TSI's Glossary for an explanation of terms used in the Market Update) |
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| Overview Bonds – bonds were due for a correction, but the surprising (to us) strength in the oil price late last week has exacerbated the decline. As expected, short-dated debt securities have been out-performing long-dated securities over the past few weeks as the extent of the yield curve's inversion is gradually reduced. Bonds could see some further near-term weakness, but we do not expect a major downwards move. Stocks – we are probably very close to at least a short-term low, but a sustainable rally at this time is dependant upon the dissipation of currency- and energy-related pressures. Gold – a substantial gold rally will only eventuate if the Dollar breaks important support and embarks on a long-term down-trend (rather than a short-term correction). What are the fund managers thinking?Every month Merrill Lynch (ML) commissions a survey of fund managers from around the world. The most recent survey was completed between 1st and 6th September and covered 240 institutions with funds under management totaling $8.8 trillion dollars. We thought the following three findings of the survey were particularly interesting:
The US Stock MarketToo much of a good thingThe Dow Utilities Index (DJUI) has historically been a good leading indicator for the overall stock market. A breakout to new highs by the DJUI has, over the past 15 years, always been followed within 1-7 months by a new high in the S&P500. This relationship exists because the market tends to `bid-up' the Utilities' stocks in anticipation of lower interest rates and lower interest rates are, of course, beneficial to the entire stock market. When the DJUI made a new all-time high in July it therefore suggested the strong likelihood of a new high in the S&P500 later this year. Since breaking out to the upside in July the rate of increase in the DJUI has accelerated and some of its component stocks have now gone `parabolic'. With long-term interest rates relatively stable over this period and showing no signs of plummeting to much lower levels, this recent move by the `Utes' clearly has very little to do with interest rates and an awful lot to do with something else. That `something else', according to Ed Bugos in his Sept. 12 article at www.safehaven.com ,is speculation on a heightening of the current energy crisis. We think he is right. Rather than being a positive omen, the dramatic out-performance of the DJUI versus bond prices over the past 2 months may be signaling danger ahead for the overall stock market. Included in one of Kevin Klombies' (www.krk-imra.com) recent reports was a chart showing the DJUI divided by the T-Bond price. The chart shows that there was only one other time during the past 2 decades when the DJUI was soaring relative to bonds – the Fall of 1987. We decided to explore the DJUI-Bond relationship in a different way to the ratio used by Mr Klombies. The following chart shows the sum of the DJUI and the the T-Bond yield (multiplied by 20 to give it approximately equal weighting) from January 1985 to September 2000. Since the Utilities stocks tend to reach their peaks at around the time that interest rates are bottoming, and vice versa, the sum of the two would normally be expected to trade within a range (they tend to offset each other). This is, in fact, what happened between 1985 and 1998. In October 1998, not coincidentally at the same time as Mr Greenspan facilitated an enormous injection of liquidity to circumvent a developing debt crisis, the sum of the DJUI and the bond-yield broke out of its long-time trading range. 1998's credit expansion pushed `the sum' into a higher trading range, where it stayed until July 2000. The recent 'blow-off' makes it clear that we are now seeing speculation in the Utilities' stocks that has absolutely nothing to do with interest rates.
The above shouldn't be interpreted as a crash forecast, because it is not. We simply wanted to point out that the nature of the recent up-move in the DJUI is not bullish and is, in fact, another sign of speculative excess in the market. In the same way that some strength in the DJUI was bullish for the stock market whereas excessive strength at this time is not, so it is with the Dollar. The following is taken from our August 21 article entitled “The Dollar, the Euro and Gold”: “Further Dollar strength at this time is not bullish for the US stock market. Capital flooding into the US has certainly boosted US stock prices over the past few years, but there is a trade-off. Many large non-tech multi-national corporations have seen their stock prices stagnate since mid-1998 due to a reduction in foreign-based revenue growth (foreign revenues and earnings are lower when converted to Dollars). Large technology companies such as Microsoft, Oracle, Intel and Cisco have not suffered from a strengthening Dollar because they have little or no foreign competition and are involved in businesses that are growing at rates that are orders of magnitude faster than the rate of global GDP growth. However, the large-cap tech stocks are already fully priced (some would say more than fully priced) and thus cannot be relied upon to drag the overall market to higher levels. A sustainable rally in the major US stock market indices at this time requires a significant contribution from the `old economy' behemoths (a continuation of what we have been seeing over the past few months). A surging US Dollar would prevent, or at least limit, such a contribution. Ideally the US Dollar will remain stable, that is, it will trade within a narrow range.” Unfortunately, further Dollar strength has eventuated and it is most definitely not bullish as confirmed by Colgate, McDonalds, and a number of other large corporations that have warned of currency-related earnings deterioration. In the short-term the rising Dollar, which is linked to the rising oil price, is the single greatest deterrent to any sizable market rally. The strong Dollar is having such a negative influence at the present time because the market's overriding focus has shifted from the economy to company earnings. A moderate near-term decline in the Dollar would not assist the current quarter's earnings for multi-national corporations, but it would allow the stock market to begin discounting a future improvement in foreign-generated earnings. Everyone is worried about the VIX!We've observed a number of technicians worrying over the low value of the Volatility Index (VIX). Even during the correction of the past 2 weeks the VIX has remained in the low 20s, a level that often warns of a sharp impending decline in the stock market. Firstly, a low VIX means that traders do not anticipate much action (up or down) in the short-term. It often works well as a short-term contrary indicator because fear is a more urgent emotion than greed and thus high VIX values tend to occur near the completion of a down-move (when fear is at its peak). However, the VIX is meaningless when looked at in isolation. As stated above a low VIX simply means that traders are expecting low volatility and, since the majority are usually wrong, it tells us to expect an increase in volatility in the near future. It does not tell us which direction the market will be headed (up or down) when that increase in volatility is occurring. To determine this direction it is necessary to look at other short-term indicators such as the equity put/call ratio. Below is a chart showing the VIX and the 5-day moving average of the CBOE equity put/call ratio since the beginning of this year. Currently we have a huge divergence between the put/call ratio and the VIX. The other occasions this year when the VIX was low compared to the put/call ratio were the weeks beginning May 22, July 3 and July 31. These weeks turned out to be important low-points for the stock market and, in each case, were followed by strong rallies. Far from being bearish, the current low VIX value is very bullish because it is occurring in parallel with a high put/call ratio.
We have a number of concerns about the stock market at present, primarily related to Dollar and oil-price strength, but the low VIX is certainly not one of them. Current Market SituationFrom last week's Update: “...any further decline over the next few days should hold in the 1480-1500 range, basis the Dec S&P (Friday's close was 1519). For the NASDAQ, a fall of around 5% from current levels would probably complete the pullback. If the downside can be contained as mentioned above, then the ensuing rally into mid-October could be quite substantial.” As mentioned in the Sept. 13 Interim Update these downside objectives had essentially been achieved during the first three days of last week. Last Wednesday's intra-day low for the NASDAQ Comp. was not penetrated during Friday's drop, but the Dec S&P made a new correction low on Friday and closed at 1483.5. After reaching an overbought extreme prior to the Labor-Day weekend the market is now oversold. Sentiment, which was feverishly-optimistic only 2 weeks ago, is now showing the signs of nervousness that typically precede a reversal to the upside. The blatant worrying over company earnings is a positive as it means that bad news on the earnings front is in the process of being discounted (setting up the potential for an up-move on any good news). However, we doubt that any rally in the short-term will be sustainable unless we see an easing in Dollar strength (which, in turn, probably requires an easing in the oil price). If pressures on the currency and commodity fronts can at least temporarily abate, then a strong rally from near current levels (perhaps following a mini-capitulation in the coming week) is likely. This week's important economic/market events
Gold and Gold Stocks Gold, oil and the currencies On Sept. 14 the ECB announced that it was going to be using the interest income from its foreign currency reserves to purchase Euros in the open market. Although this action on the part of the ECB is not significant in terms of Dollar value, we would have expected such a gesture to at least give the Euro a 2-3 day bounce. However, a surging oil price cut-off the Euro's attempted advance at the knees and left the currency at a new all-time low at week's end. Over the past 2 weeks we have speculated on the reasons for the strong inverse correlation between the European currencies and the oil price. Whatever the real reasons are, the action in the currency markets last Thursday and Friday provided further evidence that the strength in the Dollar (especially relative to the Euro and the SF) is linked to the strength in the oil price. Since the inverse correlation between the Dollar Index and gold is very strong, a meaningful gold rally is unlikely to commence until after the oil price has peaked. In last week's Update we said that Sept.7 might have given us a medium-term closing high for the oil price. This was not to be as a new closing high was achieved on Sept. 15. The extreme volatility in the oil price over the past 2 weeks is reminiscent of the NASDAQ's performance earlier this year and is indicative of an impending top. However, there is no technical evidence that we have, as yet, reached the top. Current Market Situation Although we are disappointed that gold has not managed to rally at any stage over the past 4 months, we are pleased that the gold price has:
On Tuesday we have the next BOE gold auction. The market seems to always make sure that the BOE receives the lowest possible price for its gold, so a bounce in the gold price following the auction is likely. However, a substantial and sustainable rally is highly improbable until the USD embarks on a down-trend. While waiting for that to happen we don't see the potential for major downside in gold stocks (at least not the ones in the TSI Portfolio). We will therefore retain our gold-stock investments and recommend adding to positions during any short-term weakness. Previous Market Updates 11th September |
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Copyright © 2000 Steven A Saville
