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PIVOTAL EVENTS
THURSDAY, JUNE 29, 2000
Credit Spreads and The Curve:
Fortunately, a possible recovery in the general stock market coming out of late May has been working out. With rising asset pricing reducing the motivation of margin clerks, some relief in distressed credit markets has been possible. Junk spreads narrowed from 655 bp to 610 last Friday. On the same move, those for medium-grade corps narrowed from 265 bp to 243 bp as swaps went from 135 to 121 bp. These have been widening since Friday.
The corporate curve, as determined by the yield ratio from 30-year AAA bonds to commercial paper backed off from .9136 to .8883 last Friday. As with spreads, the curve reversed that day to .9018 on Wednesday. Traditionally, for the past 140 years it has been appropriate to lighten up on most equities as the ratio went through .90. Of course, arithmetically speaking, 1.01 indicates full inversion and the consequence has been a recession. Some occurred with the curve only approaching inversion.
The curve and spreads, even at recently relieved levels, are at distressed conditions and the next extension of the trend would be very concerning. Our model expected these to reverse to unfavourable trends in January.
On The DJIA the possible "spring" pattern has prompted only a modest rally instead of a stronger move. The so far brief increase in credit pressures could be inhibiting the usual
vigour.
Powerful Forces Could Trump Complacency:
This has been one of the most powerful gathering of speculative financial forces in history. We should never lose respect for these forces by considering that the brilliant results are due to equally brilliant policy. Central banks, as with their counterparts in five previous examples since the start of central banking, are merely along for the ride. The other point is that many value investors are hoping that as the speculative fringe burns out the bulls will then turn to traditional equities. The problem is statistics. Every new financial era ended with a speculative climax and the consequent credit contraction induced a broad bear market and a global recession.
Biotechs:
This group has been phenomenal, both in its parabolic rise to early March as well as in its recovery to date. However, it's a market mania and very similar to previous examples. Whether the conviction is in a commodity or stock, the signposts of emotional excess have been reliable.
In extreme markets, one of our reliable tools has been the ADX, which measures the extension of the trend. For example, at the end of September/98 it locked in our call for an immediate reversal in that powerful bond rally. In another mania through February, we pointed out that some leading biotechs were registering 70+ on the ADX. To indicate the risks upon conclusion of the move, we noted (frequently) that Bre-X in 1996 and gold in 1980 were two rare examples. The action turned to distribution in early March and Tom's list of brief short selections was made on March 8. The high was on March 6.
Ross Clark's chart on the "Sell" also considered that the 50-week moving average would indicate major support and the "Buy". That came in at 380. We like to stress that impartial determinations are important in an increasingly volatile world. We also thought the failure in biotechs would lead and be greater than in semis or telecoms.
The attached charts document the remarkable correlations that suggest a mania is a mania is a mania. The main difference is the label, or the name of the game. In the biotech label, all that is needed to suggest a "Trader's Sell" would be a few technical indications. Investors should be reducing exposure.
The potential magnitude of the next decline can be analyzed. Our December article on "The Internet - New Technology" (see website) reviewed major technological advances since turnpike roads in the 1670s. Each was over-celebrated by the stock crowd and particularly so since the development of great financial bubbles shortly after the advent of central banking in 1694.
One observation important to today is that each was a celebration of a great vision well ahead of commercial success. This is already seen in many internet concepts and will likely be seen in the biotech frenzy.
Also illustrative is the history of mining exploration plays as seen in Toronto, Vancouver, or some years ago in Melbourne. These, when actually successful geologically, include a huge celebration of a relatively fast realization of an economic asset. Then it takes some years to put the asset into production and realize positive cash flow. Typically, the stock has decayed to about one-quarter of its visionary high.
Biotechs, particularly in mapping the human genome, have been accomplishing wonders. Much of this is likely in the market and commercial success could take longer than speculative patience or margin clerks can handle. Recently as high as 700, technical support at 570 is critical.
Banks: The attempt to stabilize and rally may have run its course. The Bank Trading Guide, after relaxing from an important decline to June 21, extended its decline quite noticeably this week. This likely overrides some other technical improvement and patience should be endured until something more constructive comes along.
The Guide is impartial and last provided a distinctive "Buy" on March 14. Then the "Investor's Sell" (usually 2 to 3 weeks before the high) came in the week ending May 26. Typically, within 5 days of the high, the "Trader's Sell" was on June 2. This was coincidental with the high for U.S. banks and 5 days before that in Toronto. The gain on the BKX from "Buy" to "Sell" was 37%.
The Guide is also indicating a downturn in A/Ds.
Base Metals:
Our index (less nickel) had a high of 240 on January 21 and declined to 207 in mid-April, and has ranged between 209 and 224 since. Recently, the 224 is a 50% retracement and, considering the trend in the credit markets, most base metal prices are vulnerable. Nickel got caught up with the speculation in high techs and peaked (4.81) with the Nasdaq on March 10. The unique play has failed from the rebound to 4.79 on May 19 and plunged 26% to 3.56 on June 21. It has had a recovery to 3.65 recently.
Our November study was looking for a cyclical high around January-February and this seems to be the case. Our Boom Indicators are indicating that a recession is possible.
The Gold Corner:
Gold is recovering nicely from an "isolated low" on the chart as well as a low in sentiment and remains within a constructive pattern that has led to extended recoveries. The last one failed in breaking below 302 in February.
On the big picture, gold has fit the historical model in declining through a new era. This unique approach to the decline in investment demand is anticipating a dramatic change to increasing investment demand once this climax of a new era concludes. Quite likely, the best monitor of the transition is our list of Boom Indicators. This is a reliable supplement to even the most thorough of traditional supply-demand studies.
On Wednesday, South Africa's central bank announced that it was increasing its gold reserve. While we are pleased that a central bank is following our May 19 advice, they are not subscribers and we can't claim any influence.
Although in official financial policy common sense is rare, there is no monopoly on it.
Energy Groups:
As emphasized in May, some energy stocks and indexes were impetuously replicating the action that completed the top in the Nasdaq in early March. Last week it was noted that the best they could do as crude approached the 34.13 high of March 7 was to churn around below their previous highs.
Representative stocks and indexes have rolled over and the divergence provided by disappointing action in the equities threatens the enthusiasm for the products.
Our view has been that, while the Coppock gave a cyclical buy on The Economist Commodity Index in December, 1998, the incredible coordination by OPEC Ministers could only happen in the context of a financial bubble. A triple in price suggests, as with the artificial shortages in nickel, that in a mania anything can be believed or even done - for a while.
The link between this and the lively "home run" baseball will be discussed in another issue. In the meantime, most commodity prices are vulnerable.
Bond Future: The attached chart brings the action up to date. For new readers, the lower chart is the model for forecasting significant trend changes. This was laid out in 1997 when lesser exchanges began to fail in Asia. On October, 1, 1998, Ross noticed the comparison to the violence centered around 1987, which gave considerable confidence that the pattern would prevail for a few years.
Also on that fateful (as it turned out) October 1, price targets were introduced. Despite the contract soaring to 135 on October 5, our initial target was 117 with a projection to 110. Other technical work suggested that the reversal was imminent. We have run the models with the updated current chart at least a dozen times and the validity of the concept has been confirmed.
Using this, our investment position was moved to the 3-4 year maturities on April 14 when the long bond yield was 5.78%. Traders were short at 98-1/2 (high 99-1/4), then long at 93-1/4 support (low 92^28) and flat at 98 on June 8.
Risks to investors make the 3-4 year term ideal. Short-dated treasuries could decline on a flight to quality. Also, diminishing overall liquidity could reveal term risk.
A modest bond rally on weakening commodities is possible.
Boom Indicators:
In addition to the notes on the attached page, it is worth pointing out some recent developments.
When the spring selling panic in techs concluded on March 14, the Indicators were at +5. Instead of showing some relief, they have continued to deteriorate down to -2, with the last downgrade made on June 22.
This is unhealthy for a financial boom and, if they don't immediately reverse to more positive trends, the latest high flyers are vulnerable. Concerningly, if they stay near these levels for a few months, a recession would be probable.
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