About Face on the Market

by | May 17, 2001 | POLITICS

Yesterday I wrote in this column, “So many people are so totally hypnotized by the “don’t fight the Fed” mantra that it wouldn’t surprise me to see a brief rally here, back toward the highs achieved two weeks ago. Maybe a narrow defensive index like the Dow Jones Industrial Average might even make new recovery […]

Yesterday I wrote in this column, “So many people are so totally hypnotized by the “don’t fight the Fed” mantra that it wouldn’t surprise me to see a brief rally here, back toward the highs achieved two weeks ago. Maybe a narrow defensive index like the Dow Jones Industrial Average might even make new recovery highs — briefly. But it won’t last.”

I can’t believe how quickly it came true — or at least part of it. But then again there’s still that stuff about “it won’t last” that has yet to be proven. And now there’s a new development that makes me think it won’t be proven.

That’s right, I’m changing my tune.

It was great to call the April 4 bottom on the NASDAQ. But all the way up I’ve been saying it’s just a bear market rally. A great rally. A profitable rally. But doomed.

By framing my predictions in this way, have I tried to have it both ways? Maybe I’ve set things up so that I can’t be wrong. Or is it that I can’t be right?

What I’ve been trying to convey is that we’ve been fooled before in this awful bear market — I’ve been fooled before. I’m not willing to say that a real bottom has been reached just because the market has gone up, or just because the Fed has cut rates. The world isn’t that simple, nor that riskless.

Now I’m just about ready to change my call that we’re only in a bear market rally. And it’s not just because of yesterday’s big move. In fact, even after yesterday’s surge, the NASDAQ is still below the May 2 highs that I marked as the “bookend” of the move, and the end of the rally.

Something else has happened that makes me think we might be seeing the real thing. I’ve finally gotten the catalyst I’ve been looking for. A definitive breakout in gold.

Yes, gold — — the monetary commodity that the great economist John Maynard Keynes called a “barbaric relic.”

On March 22, the very day the Dow bottomed at 9106, I wrote that we would know when the bottom had arrived the same way we did in August of 1982 — the last time the stock market recovered from a deflationary spiral. The “tell” would be that the price of gold would bottom out and begin to rally. That’s because gold is the most sensitive indicator of the market’s demands for liquidity. When gold starts to rise off its 22-year lows, the markets are getting the liquidity they need and the deflationary spiral is ending. As I put it on March 22, “The markets know more than the economists. And when the Fed finally turns this deflation around, gold will tell us.”

Gold is telling us now. I reported on March 26 that gold was establishing a bottoming pattern, and a mild uptrend. And I reported last week that gold had broken out of its severe long-term downtrend. I was worried that last week’s breakout might just be a technical effect arising from the insolvency of Australia’s Centaur Mining and Exploration, Ltd., and that when that effect subsided, and the Bank of England’s bimonthly gold auction kicked in, the breakout might prove to be illusory. But yesterday’s gold auction went without a hitch, and gold surged to new recovery highs.

If the gold market is right, and the Fed’s rate-cutting campaign is enough to create enough liquidity to end the deflationary spiral, then there are lots of interesting consequences for stock investors.

First and foremost, it means that the Dow’s March 22 bottom and the NASDAQ’s April 4 bottom were it. The bear market ended there. But don’t get cocky. We should still expect all the normal ups and downs from the stock markets, and not kid ourselves about the need for them to digest the huge moves they’ve made in the last six weeks. That means that, at some point — and probably soon — the markets will correct, and that correction will end in a secondary bottom higher than the March/April bottom. The trend that can be projected from the March/April bottom across the coming secondary bottom will define the new bull market.

Second, it means that we should expect some amount of inflation — hopefully, just the right amount. When gold starts rising, it is a long term signal of incipient inflation — just as when it started falling four years ago it was a warning of coming deflation. Don’t let the pundits scare you about this. We should welcome a certain amount of inflation — it is the corrective against four years of deflation. We should expect to see it start appearing first in basic commodities such as raw agricultural products. It may take years to filter into the consumer price index in any noticeable way. There’s still four years of deflation that has to work itself through the economy’s complex price system first.

The best way to play even a small inflationary impulse is with gold stocks. Yesterday, even against the backdrop of the Dow surpassing 11000 and the NASDAQ Composite doing even better, the best performing index of all was — a drum-roll please! — the CBOE Gold Index. But it’s not too late by any means. Yesterday, as adviser, we started positions in Homestake Mining and Newmont Mining. These are two of the best managed gold companies in the world. And their balance sheets and hedge books are structured so that they are levered to the price of gold: their net asset values — and, presumably their stock prices — should move up and down in percentage terms more than the price of gold itself.

Investing in gold stocks is an arcane art. If you’re used to semiconductor and optical networking stocks, you’re going to have to retrain your intuitions a bit if you want to play to win in the gold game. Over the next several days I’ll be writing more about that.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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