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The Stock Market, Gold and Interest Rates

Steve Saville
May 11, 2004

Below are extracts from a commentary posted at www.speculative-investor.com on 9th May 2004.

The Stock Market - Overview

Our big picture view is that the stock market will test its October-2002 low during 2005, but we don't have a firm opinion on the path it will take to get down there. What we can be sure of, though, is that barring a 911-style shock it is not going to get there in a straight line. In other words, even if we are right to expect the market to re-visit its 2002 lows during the coming year there will almost certainly be multi-week and perhaps even multi-month periods during which the market will rise. In fact, one of the greatest challenges of profiting from a market decline -- and one of the reasons why most people would be well advised to just sit in cash while the market makes its way towards a bottom -- is that even during a bear market the stock market usually only trends strongly lower for relatively short periods of time.

The way the technical situation is shaping up there appears to be a good chance of a steep decline within the coming three months. However, with the market already hitting oversold extremes and still being relatively close to its 52-week high we'd be very surprised if this decline took the stock indices anywhere near their 2002 lows (once again, barring a 911-style shock to the system). A more likely outcome is that we'll get a drop of 10%-15% from current levels over the next 1-3 months, followed by a multi-month rebound.

If the aforementioned outcome did eventuate it would be both ironic and appropriate because the consensus expectation at the start of this year was for the market to continue trending higher during the first half of the year and to then start weakening. So wouldn't it be just like the stock market to put a low in place by July and then move higher into year-end?

Reasons to be bearish

In no particular order, here are the fundamental reasons we expect the stock market to trade well below current levels within the next several months:

1. Year-over-year M2 growth peaked last August and trended sharply lower until January of this year. It has since turned higher, but given the average 2-3 quarter lead between changes in the inflation-adjusted M2 growth trend and changes in the GDP growth trend a substantial slowdown in the US economy has likely begun and should continue over the coming 6 months.

2. The US inflation problem has become more widely recognised, meaning that interest rates will probably move higher over the coming months. Higher interest rates, in turn, negate the main argument put forward by stock market bulls to justify today's high stock-market valuations.

3. Although it may not be the most likely outcome, there is a significant chance that the oil price will surge above $40. If this happened it would be a big psychological blow to the stock market.

4. The Iraq occupation is not going well and terrorists are becoming increasingly active throughout the world. These things might not have a direct effect on corporate earnings, but anything that makes people feel less optimistic about the world can be a big problem for the stock market when the stock market is priced for perfection (as it is now).

5. Despite the problems, volatility is still near its lowest levels since 1996 (refer to the below chart of the Volatility Index). This means that although the market might be near an oversold extreme on a very short-term basis, most market participants are presently not very fearful. In other words, there is still a lot of scope for the pendulum to swing away from greed and towards fear.

6. There are clear signs of increasing risk aversion throughout the financial markets. Examples include the topping action in the NDX/Dow ratio (the NDX tends to under-perform the Dow when people are becoming more risk averse) and the recent pronounced weakness in emerging market debt. A shift away from riskier investments is something that tends to happen in the early stages of a major stock market decline.

Gold and Interest Rates

The reactions to the strong US employment data on Friday were a rise in interest rates across the curve, a surge in the US$ and a plunge in the gold price. The superficial explanation for this would be that a strengthening US economy was causing an increase in the demand for dollars and reducing the desirability of gold as an investment, but when we look deeper we find big flaws in this explanation. For one thing, if the US economy is set to power ahead over the next 6-12 months then why is the US stock market beginning to unravel? For another thing, if the markets are factoring in REAL growth for the US economy then why does the below chart reveal that inflation expectations -- as measured by the performance of inflation-protected securities relative to the performance of the non-inflation-protected T-Bond -- have just surged to a new multi-year high?

The challenge, at this time, is to reconcile the upside breakout in inflation expectations shown on the above chart with the below chart of the gold price. Gold, as you can see, rebounded back to its breakdown point (390-395) before plummeting back to near its 6-month low at the end of last week.

It could be said that the dollar is strong and gold is weak because the market is expecting the Fed to hike short-term interest rates enough to flatten the yield-curve (a flatter yield-curve is bullish for the US$ and, therefore, bearish for gold). The idea is that when the Fed pushes up short-term rates relative to long-term rates the effect is to reduce the future level of inflation.

We know that the market is expecting the Fed to start hiking rates soon because the Fed Fund Futures now indicate an 88% chance of a rate hike at the 30th June FOMC Meeting. Also, the yield on the 3-month T-Bill has just moved above the Fed Funds Rate for the first time in more than two years and shorter-term interest rates have risen sharply relative to longer-term rates over the past 5 weeks (as illustrated by the below chart of the 30-year/5-year yield-spread). However, if the market really was expecting the Fed to squash the burgeoning inflation problem, as the drop in the gold price would seem to suggest, then why are the inflation-protected securities continuing to out-perform the non-inflation-protected securities? After all, who needs inflation protection if the Fed is 'on the ball'?

The only explanation that makes sense to us is that gold, gold stocks and all the other investments that are perceived to benefit from higher inflation got caught up in the leveraged trades that were entered on the basis that short-term interest rates were going to remain at generational lows for a long time to come. In other words, large amounts of US Dollars were borrowed at very low short-term rates and used to buy things -- including gold -- that were likely to appreciate as a result of the Fed's pro-inflation stance. The Fed's pro-inflation stance hasn't changed, but when it became clear that short-term rates were headed higher with or without the Fed the trades had to be unwound even though the inflation problem wasn't likely to diminish in the foreseeable future.

Further to the above, we doubt that gold is weak because it is being manipulated lower. Rather, the weakness is most likely the result of a lot of highly-leveraged speculators desperately trying to squeeze through a narrow doorway at the same time.

Steve Saville
Hong Kong

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