The Reflation Trade

Here is an extract from a recent commentary entitled "The Reflation Trade" by Morgan Stanley's Stephen Roach:

"All this begs the critical question as to whether the policies of reflation will ultimately work. For what it's worth, I continue to have my doubts. Policy traction is an art, not a science. And I continue to fear that the artistes have lost sight of the canvas -- a dangerously US-centric world that still finds its principal growth engine in the throes of a wrenching post-bubble shakeout. Policy traction in America typically falls to three sectors -- consumer durables, homebuilding, and business capital spending. With all three sectors having gone to extreme excess in recent years, I still fear the impact of policy stimulus could be surprisingly muted. And barring the emergence of a new engine of global growth, the world would flounder in response to the inevitable next relapse in America's post-bubble workout. 

But I concede that the financial markets probably won't see it that way -- at least for a while. The fix is on, and this is the medicine that has always worked in the past. It brings back all the glories of investor jingoism -- don't fight the Fed and, above all, don't have the audacity to believe that this time is different. The great bear market of our lifetime has dished out enough punishment. The recent pullback in equity markets after an eight-week surge off the early October lows has the appeal of an intriguing entry point. I suspect we're about to enjoy a long overdue respite -- albeit a temporary one at that. If that qualifies me as bullish, so be it. It's a good trade." [Emphasis added]

Stephen Roach's views on the economy have generally been 'on the mark' over the past two years, but he has not been anywhere near the mark when it comes to inflation/deflation. He has spent a lot of time this year explaining why the US was facing a major deflation problem (he defines deflation as a decline in the general price level), but due to the Fed's stated intention to "reflate" at all costs he now perceives a more bullish equity environment. Actually, he's not sure that the Fed will be successful in its attempts to reflate. Rather, he thinks the markets will believe in the Fed's ability to reflate and, therefore, that it's worth turning bullish for a trade.

Roach's recent semi-back-flip highlights the trouble that people can get themselves into when their argument is based on an incorrect premise. If Roach knew what deflation was then he would realise that the US has faced, and continues to face, a major inflation problem. Quite simply, there are way too many dollars in the world. The effects of this excess dollar supply can't be seen by looking at the current price-behaviour of the things that were bid-up to stratospheric heights during the mania of the 1990s, but they can be seen by looking at the prices of the things that did not benefit from the 1990s mania. These things include gold, commodities, and the other major fiat currencies. An effect of the excess supply of dollars can also be seen in the monthly US trade numbers (the huge trade deficits are an indirect result of US$ inflation).

Someone who understood the true nature of the problem facing the US would not need to contemplate whether it was possible for the US monetary authorities to "reflate" their way out of the current mess. It's as simple as this: If the problem is too many dollars, then how can creating more dollars possibly do anything other than make the problem even worse? If the problem really is too few dollars, then why is the US$ falling against gold, commodities and other currencies?

If you start with the incorrect premise that falling prices are THE problem, then you might seriously entertain the absurd notion that 'reflation' could be a viable solution. If, however, you understand that the current predicament was created by the excessive expansion of credit (that is, by a high rate of inflation) then you will realise that more of the same can't possibly be a solution. In fact, you will realise that deflation isn't the problem, it's the only viable solution. In order to cleanse the system of the enormous excesses resulting from the great US credit bubble, a lengthy and painful period of deflation will be necessary. Hyper-inflation is also a solution, but not a viable one if the US$ is to maintain its utility as a medium of exchange.

Deflation is the solution, but it's not going to happen prior to the 2004 presidential election. In the mean time, those investments that benefit from the US$ inflation problem should continue to do well. It's not the "reflation trade", Stephen, it's the "inflation trade", and it's been working really well for about 2 years now.

The US Stock Market

The chips are down

According to Fred Hickey, one of the world's best technology analysts, 40% of total semiconductor output ends up in PCs and another 20% ends up in mobile phones. Based on what the major sellers of PCs have been saying over the past few weeks, we know that the demand for PCs is now well below expectations. As such, we can be confident that the upward guidance to revenue estimates recently provided by Intel and Advanced Micro Devices is purely associated with an inventory build and, therefore, that revenue/earnings estimates for these two manufacturers of microprocessors will have to be lowered at some point over the coming 2-3 months.

Based on information from Nokia we also know that the demand for new mobile phones has not lived up to expectations, meaning that the suppliers of chips for mobile phones are going to have to reduce their revenue/earnings estimates over the coming few months.

Last week Cirrus Logic, a supplier of chips for electronic consumer-entertainment devices such as DVDs, announced that this quarter's sales were going to be about 20% lower than previously expected due to order cancellations. So, another significant part of the chip business is looking weak.

After the close of trading on Tuesday Micron Technology (MU) reported that its first quarter revenue was way below expectations. The Micron stock price fell 23% on Wednesday in response to this news, but the fact that the news could have been a surprise shows how little attention is being paid to underlying business health and valuation in the tech sector. MU closed on Wednesday at its lowest price since 1996. Technically, the stock is sitting right at long-term support so a bounce from near current levels is likely, but since MU is still selling at a hefty 3-times sales it will drop much lower after the obligatory bounce.

The rally since the 10th October low was led by the chip stocks, which is evidence, in itself, that the buying that powered the rally was not based on an educated view of fundamental business prospects or on any sort of objective valuation analysis. In fact, the entire rally appears to have been driven by fund managers who put the fundamentals to one side and tried to generate short-term performance by wagering other peoples' money on high-beta stocks (stocks that are highly sensitive to movements in the overall market). The problem for the performance-chasers comes, of course, when they try to 'lock in' the profits on the high-beta stocks that they've all piled into in their efforts to generate short-term performance.

Below is a 6-month chart of the Semiconductor Index (SOX). The SOX is starting to break down and closed below its 50-day MA on Wednesday, but the technical damage is not yet terminal. However, a close below 281 would create a 'lower low' and also complete a head-and-shoulders top formation. If this happens then a reasonable target over the ensuing 3 months would be 170 (about 43% below Wednesday's close).

Current Market Situation

The recent relative weakness of the SOX has increased our confidence that the bear-market rally has ended, but we are still looking for the major indices to close below their November pullback lows to provide definitive technical evidence that the major downtrend has resumed. The levels to watch are 872 for the S&P500, 8298 for the Dow Industrials, 1319 for the NASDAQ Composite, and 972 for the NASDAQ100.

Gold and the Dollar

The Inflation Trade

There are plenty of economists and commentators on the economy, Lawrence Kudlow being a high-profile example, who simply don't have a clue what is happening. They are "new economy" cheerleaders who think that everything was just fine until the Fed raised interest rates in 1999. According to them the Fed has been 'too tight' over the past 2 years, regardless of the fact that last year's money-supply growth rate was the highest since the early-1970s and despite the Fed having implemented the most aggressive rate-reduction cycle in its history. If only the Fed would lubricate the economy with a lot more money the wonders of technology-induced productivity improvements would result in another lengthy economic expansion and another stock bull market, or so the story goes. 

Then there are those who recognise that the whole "new economy" concept was a fantasy concocted to justify absurd stock prices and that the US economy is facing major problems as a result of the excesses of the 1990s, but who also think that inflation might possibly be a solution to the problem. John Mauldin and PIMCO's Paul McCulley are in this group, as is Richard Russell (Mr Russell, someone who has been right about most things over the past few years, says that the Fed must "inflate or die"). But, as discussed earlier in today's commentary, how could more money and credit ever, even in our wildest dreams, be a solution to a problem caused by too much money and credit? The problem, as also discussed earlier, is that this group is fixating on falling prices. If you think falling prices are the problem, or even just part of the problem, then of course you will think that anything that causes prices to move higher is at least a partial solution.

Lastly, there is Doug Noland and a small group of "Austrians" who understand that there is simply no easy way out and that more inflation at this time will just make a very bad situation even worse.

Now, assume there are only 3 economists in the world and their names are Larry, John and Ludwig. When asked for their opinions on how to 'fix' the US economy this is how they respond. Larry says "the only thing necessary to create a sustainably-vibrant economy is for the Fed to create lots of money. Technology and entrepreneurial spirit will take care of the rest." John says "umm...arr...you probably should try to create some inflation, perhaps by weakening the dollar, although I doubt that such an action will allow the economy to do anything more than just muddle through". And Ludwig says "there is no easy fix here. Way too much debt has been created and a sustainable economic expansion cannot possibly begin until debt levels have been substantially reduced. The debt reduction process will be extremely painful, but that is the price you must pay for permitting one of the greatest credit bubbles in history to occur."

It's not hard to figure out which of the above-mentioned economists will be the most popular and which one will be shunned by policy-makers and anyone wanting to get re-elected in two year's time. Ludwig will eventually be proven right, but those with the power to implement and influence monetary policy will follow the course set by Larry, a course that will receive the reluctant approval of John. 

Don't let the daily fluctuations in the various markets cause you to lose sight of the bigger trend. Even though the US has a major inflation problem, powerful forces have been galvanised to create even more inflation. Given that one of these forces is an institution with an unlimited ability to create dollars, they will appear to be victorious for a while. This is why the inflation trade - going long those things that benefit from higher inflation and a weaker dollar - is probably going to be a winner for another couple of years at least. 

Gold Stocks

Below is a 3-year chart showing the HMY/GG ratio (the Harmony Gold stock price divided by the Goldcorp stock price). Two major differences between Harmony and Goldcorp are:

a) Harmony has substantial leverage to the spot gold price whereas Goldcorp has minimal leverage (Goldcorp is unhedged, but its low production costs and sky-high stock market valuation mean that its leverage is low)
b) Harmony is based in South Africa whereas Goldcorp is based in Canada.

These differences would be expected to result in HMY out-performing GG when the gold price is strong and under-performing GG when the gold price is weak. In fact, this is what has generally happened over the past year. However, the recent action has been inconsistent with what we would expect because the HMY/GG ratio has remained within its 6-month consolidation range (GG out-performing HMY) even though the gold price has shown considerable strength.

One possible explanation for HMY's failure to out-perform during the recent gold rally is that the market is concerned about the adverse effect of a strong Rand on HMY's earnings. The SA Rand has been trending higher against the US$ since the beginning of this year and has been particularly strong over the past 2 months (see chart below). Because Harmony's costs are denominated in Rand and its revenues are denominated in US Dollars, the immediate impact of an increase in the US$/Rand exchange rate is a decrease in HMY's profit margin.

Another possible explanation is that gold stock investors are still 'playing defense'. That is, because they are not confident that the increase in the gold price is sustainable they are focusing on the major stocks that appear to be the safest rather than the ones that offer the most leverage. If this is the case and the gold price continues to push higher then the Harmony stock price will soon surge relative to the Goldcorp stock price.

We think the second of the above explanations is more plausible, for two reasons. Firstly, there has been a strong correlation between the HMY/GG ratio and the gold price over the past 18 months, but no meaningful correlation between the US$/Rand exchange rate and the Harmony stock price. Secondly, the greatest leverage to the gold price can be found amongst the junior gold stocks, but there has been very little speculation in the juniors over the past 2 weeks. 

Current Market Situation

Below is a daily chart of gold futures. On Wednesday the gold price closed above $340, thus bettering resistance defined by the intra-day 'spike peak' during October of 1999. The best case, if you are long (and the worst case if you are short), is that gold will accelerate higher from here and that any subsequent pullbacks will hold at, or above, $340. However, gold could drop all the way back to its former downtrend-line (currently around $326) without doing major damage to the bullish argument.

It's amazing how often a market that breaks through an intermediate-term trend-line, as gold did last week, will move back to test that trend-line before resuming its new trend. For example, in late-November we mentioned that the Swiss Franc had done exactly that (pulled back to its former downtrend-line). As the following chart shows, the SF subsequently moved sharply higher and has broken decisively above its July peak.

Note that we don't expect the gold price to drop all the way back to the mid-320s in the near future, but just wanted to point out the maximum decline that could occur at this time without negating the short-term bullish argument.

The Dollar Index has not yet broken down (see chart below), but since gold, the euro and the SF have all broken out to the upside the probability is high that the Dollar Index will soon move decisively below its July bottom. As mentioned in the latest Weekly Update, 97 becomes a reasonable target for the Dollar Index once we get a close below 103.50.

The gold bull market probably has years to run, but an important intermediate-term peak (a peak that will be followed by at least a 6-month correction) is likely at some stage over the coming 3 months. Such a peak could actually occur within the next 2-3 weeks if we get sufficient blow-offs in the gold and currency markets. We'll monitor various indicators, including the performances of gold stock prices relative to the gold price as discussed in the Weekly Update, in an effort to identify a good selling opportunity.

Although we don't yet have any evidence that gold stocks are near a peak or that the downside risk substantially outweighs the upside potential, it might be appropriate to take some profits now. We say "might" because the decision will be different for each person depending on their level of exposure and the stocks they own. For example, someone who has made a large (relative to the size of their total investment portfolio) commitment to gold stocks should probably start taking some profits now, whereas someone with a relatively small exposure should not. Also, some stocks, such as the over-priced North American favourites (GG, MDG, AEM and GLG) are sale candidates right now whereas other stocks, such as the major SA producers and most of the junior gold companies, are not. Lastly, if at any time you have a gain of a few hundred percent in any stock or option it always makes sense to at least retrieve your initial investment even if the trend remains bullish.

Our plan is to take profits on call options first, then to take profits on the major gold stocks, and finally to take profits on our junior gold stocks. 

Update on Stock Selections

Desert Sun Mining (TSXV: DSM) has gained 57% so far this week. It has the potential to move much higher and can still be bought if we get a decent pullback (a drop to C$0.65-$0.70 would represent a buying opportunity). 

Chart Sources

Charts used in today's commentary were taken from the following web sites:

http://stockcharts.com/index.html
http://www.futuresource.com/
http://finance.yahoo.com/