1994 Revisited

Two days ago, your New York editor guessed that Villanova
might win the NCAA championships and that gold might soon
resume its rally. The good news is that Villanova still has
a chance…

The bad news is that Alan Greenspan thrust a semantic stake
through the heart of the gold market…or so it has seemed
since last Tuesday.

The chairman’s quarter-point rate hike – and his
accompanying verbiage – stunned the gold market, while also
rocking most other financial markets. But despite gold’s
near-death experience this week, we suspect it will rise
again…along with most other commodity markets.

The commodity bull market might be out of breath, but we
doubt it will suffocate.

Last Tuesday, around 2:15 Eastern Time, the benign American
financial environment suddenly assumed a very menacing
demeanor. At that very moment, Chairman Greenspan hiked
short-term interest rates one-quarter point to 2.75%.
Within minutes, investors rushed to sell stocks, bonds,
oil, gold and every other financial asset that wasn’t
bolted to the floor. By day’s end, the Dow had dropped
nearly 100 points, crude oil had slipped nearly two dollars
from its high and gold had tumbled nearly 10 dollars.

The Fed’s itty-bitty adjustment to its itty-bitty interest
rate should not have produced such a mess. After all,
nearly every economist and investor in the land had
anticipated this exact move. Apparently, however, all these
economists and investors were not prepared to learn that
the chairman considered inflation to be a problem.

"Though longer-term inflation expectations remain well
contained," declared the Fed’s statement accompanying its
rate hike, "pressures on inflation have picked up in recent
months and pricing power is more evident."

This simple phrase erased billions of dollars of paper
wealth in the span of a couple hours.

It is true, of course, that rising rates are not usually a
great thing for asset prices. But they are not always
disastrous. To generalize, FALLING interests rates tend to
encourage speculation in all manner of financial assets.
Conversely, rising rates tend to reacquaint investors with
the concept of risk-aversion. And a risk-averse investor is
usually a seller of speculative of financial assets like
emerging market stocks and bonds, as well as U.S. junk
bonds and small cap stocks. In short, the riskier the
asset, the more damaging the effects of rising rates…at
least that’s the conventional wisdom.

If this wisdom proves true during this particular interest
rate cycle, the red-hot emerging market stocks and U.S.
small caps depicted below might be due for a lengthy
cooling off period.

However, commodities and resource stocks are somewhat more
difficult to handicap. That’s because they are very
schizophrenic creatures in a rising rate environment. They
are speculative, to be sure. But they are also inflation
hedges, which tend to excel during cycles of rising
interest rates.

Therefore, this week’s steep sell-off in nearly every
financial asset – including gold – compels us to ask
ourselves two questions: 1) Is this the beginning of a
serious correction in financial asset prices? 2) Once this
correction of uncertain duration runs its course, which
financial assets are most likely to reassert themselves.

To preview our conclusion: Financial assets that melt
slowly when exposed to extreme heat are likely to perform
better than those that burst into flames.

As a guide to the future, let’s examine a small slice of
recent history: 1994.

The most recent example of a "shocking" rate hike by the
Fed occurred 11 years ago, on February 4, 1994. On that
fateful day, recalls Matein Khalid of the Khaleej Times,
"Chairman Greenspan dropped a bombshell on Wall Street. The
Fed raised overnight Funds Rate from 3 to 3.25 percent. To
the world, this was no big deal, a routine monetary
tightening response to a slight up tick in inflation and
GDP growth. However, on Wall Street, it was pure panic, a
Black Death in the capital markets. Within two months, an
estimated $1.5 trillion was wiped out in the bond
markets…Orange County, the wealthiest in the United
States, went bankrupt.  David Askin, one of world’s leading
mortgage derivates managers, blew up his entire $600
million hedge fund. Dozens of supposedly ‘safe’ U.S.
Treasury and money market funds lost 10-30 per cent of
their capital whose beneficiaries were literally widows and
orphans. Proctor and Gamble, which is supposed to make
money selling pampers, needed pampers itself as its
structured Libor notes went ballistic."

90 days after Greenspan’s February 1994 shocker, every
major financial market had fallen, especially the bond
market. 10-year bond yields soared from 5.87% to 7.11%. The
commodity markets shared the bond market’s pain, as the
rising rate trend threatened to slow the world economy and
curtail demand for natural resources.

However, one year after Greenspan’s infamous rate hike, the
S&P 500 and the CRB Index had both recouped their losses.
Crude oil was up 20% and copper – the commodity with a PhD
in economics – had gained 50%. In other words, Greenspan’s
"shocking" rate hike of February 1994 jolted the commodity
markets, but did not electrocute them.

We expect history to repeat itself. In other words, the
commodity bull market is merely resting, not retiring. In
the "oil glut" days of 1994, the supply of oil swamped
demand. What’s more, China consumed less than half the oil
per day that it does now…and still crude oil jumped 20%
in the face of rising interest rates. Oil possesses a much
more bullish profile today than it did in 1994, and so do
most other commodities. Whether rates are falling or
rising, supplies struggle to keep pace with demand.

"China’s long-run rise is inevitable," observes Justice
Little, co-editor of Outstanding Investments. "Long-term
erosion of the dollar is equally sure. For both of these
reasons, I agree with Jim Rogers’ assertions that we are in
the early stages of a commodity bull market that could last
another decade or more."

Even so, Justice admits, "China may have gotten ahead of
itself and the dollar still has the ability to confound in
the near term…We have to be prepared for potentially
rough waters in the latter half of 2005…China is a
compelling long-run story, but in the short run, the dragon
may be close to overheating; Shanghai, for example, is
experiencing a real estate bubble every bit as over-the-top
as Southern California’s, and the fidgety nature of ‘hot
money’ being pumped into China’s infrastructure development
is making even the most aggressive money managers nervous.

"In addition, the Federal Reserve is finally admitting what
everyone else saw a long time ago: that inflation is taking
hold and the interest rate hikes may need to accelerate.
The Fed slamming on the brakes could temporarily put the
brakes on U.S. consumption as well, and an ensuing slump in
demand could temporarily take the wind out of crude oil’s

"This is not an alarm signal as much as a watch signal,"
Justice warns. "Crude may yet break through $70 without a
hitch. Given that possibility, however, it’s crucial to
recognize that we are entering a delicate stage of the
game. Multiple trends that have been intact for the past
year, if not longer, are showing signs of fraying… and
clear potential for unraveling is at hand."

We acknowledge this potential. But we also acknowledge the
potential for the Federal Reserve to fail in its efforts to
quell inflation, and the potential for global demand trends
to drive commodity prices much higher and the potential for
investors to prefer holding gold to dollars.

In short, we suspect the commodity bull market is more
powerful than Alan Greenspan’s lexicon.

Outstanding Investments

Did You Notice…?
By Jay Shartsis

There is a good probability that the market has just made
an important trough. Evidence for such a conclusion is

The 21-day equity put/call ratio is at 0.67, which is near
the level it attained at the market bottom in late January.
The dollar-weighted 21-day put/call ratio, however, is
still below the level it hit at the January bottom, now at
about 63 cents (63 cents in puts traded for every $1.00 in
calls) versus about 73 cents in late January. A high
put/call ratio indicates fear in the market place, so goes
the theory, and often marks an excellent time to buy.

Last Thursday, Nasdaq volume was just 11% greater than the
volume on the NYSE. It’s normally much higher. This
indicates a low level of speculative sentiment among
investors – a phenomenon commonly seen at market lows.

Finally, the option premium ratio fell to 0.61. Looking at
the data from the past few months, this is a low reading
and suggests a rally may be on the cards.

In sum, today or tomorrow looks like a good time to cover
shorts and try the long side.

Rendered Predictable

And the Markets…



This week

















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JPY 106.07

JPY 105.54



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Dollar (USD/GBP)