Reflation and gold loom on the horizon: the equity bears and gold bugs may be moving in to stay in the new fiscal year

Japan, Inc., March, 2003 by Darrel Whitten

DURING THE SECULAR BULL market in the US and similar bull markets in other developed nations jibe major exception being Japan/, bears and gold bugs were an endangered species, as were value investors. Following a monster rally that propelled the price of gold 8.5-fold in a mere four years between 1976 and 1980, gold had been in a major secular bear market, one that took the price of gold down 70 percent over the next 20-plus years from a peak of $850 per ounce to around $2.56.

As the gold market was crashing, a major secular bull market emerged in US equities from 1982. It was a bull market of historical proportions, lasting for the next 18 years to early 2000 despite a short-lived but nasty correction on "Black Tuesday" in 1987 that many erroneously heralded as the end of the bull market.

It takes decades to work off the excesses of bull markets of such historical proportions. Technically, the price of gold has only recently risen after a massive 22-year falling wedge pattern, the breakout point being somewhere above $330 per ounce. Conversely, the Dow Jones industrial average is showing a massive head-and-shoulders secular bear formation. While the market has declined for three consecutive years, the r K bear market is far from over.

The US equity market had logged its third s J straight year of losses at the end of 2002, the t first time this has happened since 1941. Yet market pundits, in delving into the equity market's prospects for 2003, are far from sure that this year will be a slam-dunk in terms of market gains. The last time that the Dow Jones and the S&P 500 recorded four-year declines was 1929-1932. Following the peak in the Dow in early 2000, equity investors have waited in vain for stock markets to come back. While more value-oriented investors had been suggesting that the US particularly Nasdaq and the tech, media and telecom offerings, known as TMT stocks was way over-priced and due for a tumble long before the major secular peak was confirmed, they were much less willing to suggest that once the US market peaked and a bear market began, it would take all major equity markets down with it. However, that is exactly what happened. Over the past three years, the MSCI World index is down by 36 percent, and the level of decline is essentially unchanged even if we factor out the US.

Nikkei blues

Strategists also suggested that Japan would fare better than the US because the Nikkei 225, which had been in the throes of a bear market since 1990, was supposed to have presented less downside risk than the US market, ostensibly because it had fallen so much already in the prior decade. However, the Nikkei 225 actually has fallen more than the S&P 500 during the last three years, according to data compiled by Trust Net.

For most equity investors, 2002 was a year they could not wait to he done with. According to Lipper, a Reuters company, rallies late in the year did little to ameliorate the damage: Science and technology funds had tanked 42.3 percent, telecommunications funds had fallen 40.2 percent, and health/biotechnology funds had lost 29.7 percent. All were on track to exceed the record losses of 2001. Even the so-called "defensive" utility funds had also been hammered 24.2 percent thanks to Enron and other scandals. The utility-fund losses in 2002 were headed for their second-worst year on record--only the 29.9 percent fall in 1973 was worse.

Gold rally not a fluke

Meanwhile, gold funds have been recording record gains. The HSBC Global Gold and the FT Gold Mines indexes both rose more than 50 percent during 2002, while three-year gains were well over 40 percent. Moreover, gold's spot price went beyond the "breakout area" of $325 to $340 per ounce at the turn of 2003. This was an important range in 1991-93 and 1985-86. It also marked the peaks of the October 1999 spike. After starting 2002 at $270 an ounce, gold's price. was up 27 percent well into December, and was trading between $360 and $370 in early February.

Ostensibly, gold's rally is linked to a host of events: a weak stock market, terrorism fears, a looming supply shortage if central banks and commercial banks try to recover the bullion they have lent to third parties, and gold producer efforts to reduce their hedge books. Since the secular bull market in global equities cracked early in 2000 with the Nasdaq crash, global P investors have warily been eyeing the US dollar as an over-priced asset.

With growing signs of deflationary pressures even in China, policy makers around the world are moving to anti-deflation stances, as opposed to their traditional role as inflation fighters. Recent speeches by central bank officials in the US, UK and Japan raise the possibility of global reflation. At the US Federal Reserve, Ben Bernanke was quoted as saying: "The US government has a printing press that allows it to purchase as many dollars as it wishes at essentially no cost." From Alan Greenspan: "There is virtually no meaningful limit to what we could inject were that necessary." Any reflation, ostensibly in the name of global economic revival, strongly implies a structural weakening of the dollar, which also happens to be the world's largest reserve currency.