| Weekly Market Update for the Week
Commencing 21st August 2000 (Please refer to TSI's Glossary for an explanation of terms used in the Market Update) |
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| Overview Bonds – Bonds remain near the top of their recent trading range, despite on-going strength in the oil price. Following a near-term correction to work off their overbought condition bond prices will probably reach new highs for the year (only slightly above current levels) unless commodity prices (especially oil and copper) also make new yearly highs (putting downward pressure on bond prices). Regardless of what happens with yields at the long-end of the curve we expect that the shorter-dated debt instruments will outperform over the next 2-6 months. Stocks – the market looks very healthy from a purely technical perspective, but two of the sentiment indicators we watch are nearing market-topping levels. A pullback during the next week is not only likely, it is necessary if much higher levels are going to be seen over the next month. Gold – responding to bullish traders' commitments and rampantly-negative sentiment, gold has edged higher over the past fortnight. However, a stubbornly-firm US Dollar is keeping a lid on the gold price. Inflation WatchIn our April 10 Market Update we included a chart showing the relationship between the ECRI's Future Inflation Gauge (FIG) and the Federal Funds Rate (the interest rate, set by the Fed, that banks charge each other for overnight money). The chart clearly showed that, during the Greenspan era, every significant change in monetary policy was telegraphed several months in advance by a reversal in the FIG's trend. The chart in the April 10 Update covered the period from January 1988 through to March 2000. Below we include a similar chart covering the period from January 1995 through to July 2000.
In our April 10 analysis we pointed out that the FIG, at that time, showed no signs of reversing its upward trend and that the political need for Greenspan to get all rate hikes out of the way by mid-year would therefore necessitate a 50-point rate increase at one of the next two FOMC meetings. The Fed subsequently hiked rates by 50 basis points at its next meeting (in May) and the FIG appeared to begin `rolling over' during the May-July period. The FIG is designed to predict consumer price changes approximately 10 months in advance, so even if it is correctly forecasting a drop in price pressures we could still see rising consumer prices over the next few months. However, an inverted yield curve and a declining FIG all but guarantee that the Fed's tightening cycle is complete, irrespective of the backward-looking indicators that have the markets and the press spellbound on several occasions every month. Of course if bond yields surge and the FIG once again begins to rise, further rate hikes would be forthcoming. The Dollar, the Euro and Gold Refer to our separate article. The US Stock MarketOverviewThose who are resolutely bearish on the stock market tend to cheer every decline, but really they should be hoping for the market to go up in a straight line. As long as the market keeps advancing in a `two steps forward, one-point-five steps backward' way, there is much more to come on the upside. Only after the market has made a parabolic thrust upwards will the secular bull market end. The NASDAQ indices certainly experienced an explosive up-move during the final quarter of 1999 and the first quarter of 2000, but the NASDAQ is not `the market'. This point is evidenced by the fact that the average tech stock (which typically resides on the NASDAQ) is down by almost 60% from its high, but the S&P500 is positioned within 3% of its all-time closing high. The long-term bull market is unlikely to end until the most important index – the S&P500 – experiences a parabolic up-move. For some considerable time now the market has not been trending, which has meant that those analysts who concoct market-general buy/sell signals based on `confirmation of strength' or `confirmation of weakness' will have been whipsawed many times as every rally has been a selling opportunity and every decline a buying opportunity. Based on the steady enhancement in market breadth since May and the improving monetary environment we believe that when the market stops oscillating and finally breaks out of its trading range, the breakout will be to the upside. Current Market SituationThere are certainly some negatives in the current market, but let's first note the positives:
From the above we can see that the overall market is far more bullish than the senior indices currently suggest. Of course there are always negatives:
The situation with the VIX is quite interesting. The VIX has recently dropped to a level that is generally associated with market tops. It is a widely watched contrary indicator and its low level has, in itself, become a source of worry for traders. Like all sentiment indicators there is little to be gained from looking at the VIX in isolation and a trading strategy will not be successful if it is based purely on the value of a single commonly-known indicator. Below is a chart showing the VIX and the CBOE Equity Put/Call Ratio (5-day MA) since the beginning of this year. Notice how the two track each other quite closely until mid-June (this is what you would expect to see since they both tend to rise as the degree of fear increases), when a divergence begins to unfold. Over the past two months the VIX has trended lower while the put/call ratio has remained at a moderately-high plateau of around 0.48.
Going back over the past 4 years we can only identify one other occasion when such a divergence occurred. For the period spanning Feb-Apr 1997 the VIX was consistently low and the put/call ratio was consistently high. During this period the market oscillated within a 10% range (sound familiar?). However, over the ensuing 3 months the market rallied such that by the end of July the S&P500 was trading 15% above the top of its Feb-Apr range. Further to the above the low VIX value is not a major concern of ours, although it does increase the chance of a pullback in the short-term. On Tuesday we get the next installment of Fed-mania as the FOMC, the world's leading price-fixing authority, gets together to discuss the economy and determine the price of money. There will clearly be no change to official interest rates emanating from this meeting, but there could be a change in policy bias. If the Fed retains its tightening bias as the market expects it will, then any rally following the meeting will be uninspiring. If, on the other hand, the Fed goes `neutral', we could see a sharp rally in stock prices and a sharp drop in the Dollar. In summary, the most likely scenario over the coming week would be pullbacks at the beginning and end of the week and a `pop' in the middle on the Fed news. It would be very bullish and portend new all-time S&P highs by October if the Sept S&P holds 1460 (on a closing basis) during any pullback over the next week. Stock-wise, we will add Copper Mountain (CMTN) to the Portfolio if it becomes available below $60. This week's important economic/market events
Gold and Gold Stocks Investing in gold stocks One of the problems experienced by gold stock investors over the past several years is that rallies have tended to occur with very little warning, they have been sharp and they have all ended quickly (usually within 1-4 weeks). As such it has not been feasible to wait for definitive technical confirmation of a gold rally prior to putting funds at risk. Rather than trying to finesse a buying point the key to making money on the long side of the gold market has been to buy when pessimism is rampant (as it has been since April this year) and then to scale-out into extreme strength. `Buy and hold' is certainly not a suitable strategy to apply to gold stock investment (it is not now and it never has been). The performances of some of the gold stocks in the TSI Portfolio substantiate this point. For example, following the sharp rise in the gold price during Sep '99 we sold two of our Australian gold stocks – LHG and DGD – for $1.88 and $2.92 respectively. These stocks were subsequently re-purchased during the April-July period this year at $0.57 and $1.35 resp. Whatever happens from here a huge draw-down was side-stepped. We clearly took a risk in selling since we had no way of knowing at the time that the gold rally would fail, but the risk was mitigated by the fact that about 50% of the gold stock portfolio was retained (and mostly sold in November after solid evidence became available that the gold rally had run its course). Current Market Situation According to the Merrill Lynch economics team, the US Dollar and the US$ gold price have displayed an 87% inverse correlation since 1993. This doesn't mean that gold and the USD have traded in opposite directions on 87 out of every 100 trading days. However, even looking at daily price changes over the recent past we can see that, of the 56 trading days from June 1 to August 18 this year, the USD gold price and the Dollar Index only traded in the same direction 16 times. Therefore, regardless of what is happening in the world it is highly unlikely that the gold price will rise unless the US Dollar falls. Buoyed by bullish traders' commitments and a dearth of new sellers (everyone who was going to sell has already sold) the gold price rose marginally over the past 2 weeks. However, the Dollar has held its ground (meaning that net investment flows into the US continue to exceed $30B per month) and has thus kept a lid on the gold price. The above-described relationship between the Dollar and gold is now so widely understood that any break of support in the Dollar index (initially 109.8 and then 106.9) would almost certainly cause an immediate upward move in the gold price as trend-following speculators rushed to close-out their gold shorts and `go long'. We'll continue to be patient with gold and gold stocks at this time and manage risk using sell-stops. The downside looks to be very limited as both the stocks and the metal are close to being `sold out'. It is also worth noting that September tends to be one of the best months of the year for gold stocks. Previous Market Updates |
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Copyright © 2000 Steven A Saville
