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Beware of analysts bearing equations

In general, when an analyst uses an equation to make a point about where the economy is headed and/or what economic policies are required, you should immediately stop reading or listening. By directing your attention away from the equation-happy analyst you will run the risk of being uninformed, but if you continue reading/listening then you will very likely be misinformed. It is usually better to have no information than to have the wrong information.

In the past we've discussed the problems with the famous Equation of Exchange (PT = MV). The equation is of little value outside the classroom and can be dangerous if used to determine the appropriate monetary or fiscal policy. Another of these inherently useless equations that can be dangerous in the wrong hands is called the "National Income Accounting Identity". This equation is typically expressed with lots of variables -- as G - T = (M - X) + (Y - T - (C + I)), for instance -- but it boils down to: net private savings = government balance (government spending minus taxation) + current account balance. For an example of how this equation can be used to come up with wrongheaded conclusions and policy recommendations, refer to pages 5-7 of the report linked HERE. The writer of the afore-linked report tries to use the National Income Accounting Identity to show that higher government deficit-spending (a greater "government balance") is needed to offset the private sector's increasing desire to save.

Analysts who base their economics analyses on mathematical equations usually fail to properly account for cause and effect. They see what's on the surface, such as if one side of an equation rises then the other side must also rise, but they fail to see that cause and effect are inter-connected via such complex feedback mechanisms that their beloved equation is useless in the real world. Considering that the real world involves millions of people interacting to satisfy their myriad individual desires, is it any wonder that the economy can't be properly described by a mathematical equation?

An example of the sort of cause-and-effect feedback mechanism we are referring to stems from the fact that the government can only increase its spending by stealing (directly via taxation or indirectly via inflation) or borrowing more from the private sector. Looking at it in a slightly different way, if taxation is constant then the "government balance" can only increase via the borrowing of more money from the private sector or the central-bank monetisation of government debt (counterfeiting). To argue, then, that the "government balance" needs to grow in order to support the economy is, in effect, to argue that the economy will benefit if the private sector is forced to buy more government bonds or if the central bank counterfeits money on a grander scale. To put it bluntly, increasing the "government balance" MUST have negative consequences for the private sector.

The main cause of Japan's economic malaise (the main reason why the Japanese economy has performed so poorly since 1990) is the massive increase in the "government balance" and the resultant massive non-productive investment of private savings in government bonds. And yet, many analysts (including the writer of the above-linked report) are now advocating that US policy-makers increase the "government balance". If they don't have a viable economic theory to lean on, you'd think they would at least be able to learn from the historical record.

Unfortunately, not only have they not learned from the historical record, they have generally learned exactly the wrong things. A classic example is the common belief that when the Fed tightened monetary policy during 1936-1937 it CAUSED the US economy to plunge back into depression, the implication being that the economy would have been just fine if not for the Fed's 'premature' tightening. The real problem was that the preceding (1933-1936) recovery was an illusion created by monetary and fiscal "stimulus". With the recovery being based on loose money and government spending rather than on profit-seeking investment, it was destined to collapse in a heap as soon as the "stimulus" was wound back. The alternative would have been to keep the "stimulus" going until the currency was destroyed.

Why, we wonder, have no lessons been learned from the economic downturn of the early 1920s? By a number of measures the first year of the 1920-1921 mini depression was worse than the first year of the 1930-1945 great depression. The main reason that the early-1920s depression was over within 2 years and was followed by a lengthy period of real economic progress appears to be that the government of the time did the OPPOSITE of what the Keynesian playbook recommends. Specifically, the government REDUCED its spending and its debt. Had the Keynesians been in control in 1920 then the economics textbooks of today would probably have a chapter devoted to the Great Depression of the 1920s.

In summary, the popular view amongst high-profile pundits is that the economy needs more government spending. Logic and the historical record tell us that the opposite is actually true, but these pundits won't be dissuaded because they have, in their possession, simple one-line equations to 'prove' their case.

The conventional wisdom being what it is and being unlikely to change anytime soon, we can reasonably expect that the trend towards a more expansive (and expensive) government will continue. Consequently, we should continue to put a lot of emphasis on gold-related investments. We can't stop policy-makers from doing stupid things, but at least we can profit from them.

An appropriate quote

The Stock Market

Current Market Situation

The article at http://news.goldseek.com/GoldSeek/1270833600.php makes the case that due to various interventions and inflationary policies, a multi-month correction over the next few months could be followed by a stock market "melt-up". This is clearly not our favoured scenario, but we certainly can't rule it out. It is one of the reasons why the risk/reward of being 'long' gold is much better than the risk/reward of being 'short' the stock market. The stock market's nominal trend can be turned from down to up via monetary inflation, but its real trend cannot be.

Stock market sentiment has become very interesting indeed. For example, the 10-day moving average of the equity put/call ratio just hit its lowest level since September of 2000!

Sentiment is now far more optimistic than we thought it would get, while the fundamental backdrop appears to be no better than expected. This does not mean that the stock market will soon tank. We've previously noted that important tops in the senior US stock indices tend to be gradual processes rather than spikes. If anything, the high level of bullish sentiment makes it even more likely that a gradual topping process will occur, the reason being that a lot of bullish traders will be looking to buy a pullback. Consequently, once a peak is in place there will probably be an initial 5%-10% decline followed by a rebound to 'test' the peak before the market begins to trend downward with conviction.

We won't be surprised if the peak occurs within the next several trading days, especially considering that a peak at this time would line up with the average for the second year of the "Presidential Cycle". If so, a test of the peak would likely occur during May.

Suggested Action

As mentioned in many previous commentaries, our view is that the best way for the vast majority of people to deal with a high-risk market environment is to build up a large cash reserve. This is certainly our preferred approach. At times we will also buy some insurance in the form of put options, but our option positions will always be very small compared to our overall portfolio value. Currently, for example, our total exposure to put options amounts to about 0.5% (half of one percent) of our portfolio value. This exposure will possibly be increased to as much as 2% of portfolio value over the next month or so, depending on price action.

In order to hedge our base metals exposure our initial insurance position is being built in Freeport McMoran (FCX) put options with a January-2011 expiry. Another stock that could be a reasonable candidate for a put-option position is Potash Corp. (NYSE: POT), solely because of its chart pattern (see below). We have no knowledge of and no opinion about the fundamentals of the potash business, but the chart suggests considerable downside potential. The chart also shows that the stock is 'oversold' on a short-term basis, so we would probably only consider POT put options following a rebound to the vicinity of the 50-day moving average.

After we see evidence that a top is in place we may suggest the purchase of an inverse index fund or other bear fund, but at this stage we don't have anything specific in mind.

Gold and the Dollar

Gold

The June gold futures contract (see chart below) is consolidating below resistance in the low-$1160s. The gold price could drop back to around $1130 without doing any damage whatsoever to the 'technical' picture.

There's a good chance, we think, that the gold market will challenge its December-2009 peak within the coming month.

Below is a chart of the BKX/SPX ratio (the banking sector relative to the broad stock market). This has relevance to the gold market because relative weakness in the financial establishment (as represented by the banks) puts upward pressure on the gold price and relative strength in the financial establishment puts downward pressure on the gold price. In other words, one of the many forces that influence the gold price moves inversely to the BKX/SPX ratio.

BKX/SPX has just moved up to near its high of the past 12 months. Considering our gold market outlook it would make sense if the BKX was now at, or very close to, a relative-strength peak.

Gold Stocks

In the email sent to subscribers in response to Tuesday's market action, we wrote:

"On Tuesday the HUI dropped back to test support in the low-430s, and then rebounded. This price action solidifies 430 as an important demarcation level.
 
We have been operating under the assumption that the HUI's short-term upside potential was limited by resistance at 470. While the area around 470 remains the most likely place for the next short-term top, the price action of the past week suggests the potential for a rise to near the December high (520) over the coming month or so. Due to the increased upside potential we are upgrading our short-term HUI outlook from "neutral" to "bullish".
 
The broad stock market is very extended to the upside and could reach an important peak at any time. Consequently, we are concerned about overall stock market risk and the effect that a sharp downturn in the broad market could have on the gold sector. However, individual market analysis should always take precedence over inter-market analysis, and in any case the risk parameters are now defined in such a way that it will only take a small amount of weakness from here to tell us that our short-term bullish view on the HUI is wrong.
 
If the HUI closes below 430 within the next several days it will be a clear sign that we are over-estimating the short-term upside potential. Our short-term bullish stance is therefore predicated on the HUI remaining above 430 on a daily closing basis."

Tuesday's pullback to support in the low-430s and the subsequent rebound was a positive development, but, of course, there is no guarantee that support will continue to hold.

From our perspective, the ideal outcome would be for the HUI to spend another 2-5 trading days 'horsing around' within the 430-450 range and to then resume its advance.

Currency Market Update

The euro gapped higher on Monday in response to news that Europe's monetary union had made a 30-billion-euro loan package available to Greece. This news is unequivocally BEARISH for the euro because it sets a bailout precedent. Furthermore, it is worth noting that the bailout is not for Greece; it is, instead, for the German, French and other banks that would be hurt if the Greek government defaulted on its debt. In other words, this is yet another example of money being transferred from the rest of the economy to cover up the bad investments made by banks.

That the currency market took the bailout news as bullish is additional evidence that the euro's short-term trend has changed from down to up (when the price trend is up, most news is construed in a positive way). Also, the June euro has broken above 1.36, which is the level we said had to be cleared to confirm our suspicion that it had made a short-term bottom late last month.

The following daily chart of the Dollar Index provides more evidence that a short-term trend change has occurred in the currency market.

As mentioned in recent commentaries, 78.0-78.5 is a reasonable short-term downside target for the Dollar Index and 1.42 is a reasonable short-term upside target for the euro.

Update on Stock Selections

(Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html)

Khan Resources (TSX: KRI). Recent price: C$0.47

KRI's share price plunged on 13th-14th of April in response to a company press release announcing that the licenses for its Dornod uranium property had been revoked by a Mongolian Government agency. The full story is contained in KRI's 13th April press release.

Reading between the lines, here's what we think has happened:

ARMZ, a Russian nuclear company, wants control of the assets currently held by KRI. ARMZ tried to secure this control via a C$0.65/share takeover bid, but this bid was trumped by a C$0.96/share offer from CNNC (a Chinese nuclear company). Rather than get into a bidding war with CNNC, ARMZ is now trying to gain control by political means and has enticed the relevant Mongolian officials to invalidate KRI's licenses. The idea is to get KRI and CNNC out of the picture at minimal cost, after which a joint venture between ARMZ and the Mongolian Government could proceed with exploitation of the Dornod resource.

Naturally, KRI is pursuing all legal remedies in an effort to get its licenses revalidated. Also, the C$0.96/share CNNC bid is still on the table, although the market is obviously convinced that it will be withdrawn.

We don't know how this story will 'pan out', but we do think that KRI would be a candidate for new buying if additional panic over the days ahead pushed it down to the mid-C$0.30s. The reason is that the company has about C$0.30/share of cash.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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