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Something we didn't know

In his "Up and Down Wall Street" column in the 29th September edition of Barrons magazine, Randall Forsyth discusses Bill Gross's resignation from PIMCO, the gargantuan asset management firm founded by Gross more than four decades ago. In the course of this discussion Forsyth stated a fact that stunned us. Here's the relevant excerpt from the Barrons article:

"Gross' exit roiled the prices of Pimco closed-end funds, especially those that trade at egregious premiums to their net asset values (which Barron's has pointed out several times over the past couple of years).

Prominent among those hit was Pimco High Income (PHK), which plunged 6% Friday. Prior to that, it had closed at a massive 46.1% premium to NAV, according to cefconnect.com. Shareholders' willingness to pay $146 for $100 in assets may relate to their being managed by one William H. Gross or to the fund's 11.75% distribution rate. Similarly, Pimco Corporate & Income Opportunity (PTY) fell 6.6% Friday; as of Thursday, it had commanded a 17.2% premium while yielding 8.48%."

A fund that invests in high-yield (meaning: high-risk) corporate bonds trading at a 46% premium to net asset value (NAV)? That's a mindboggling fact that we were not aware of.

Even after its recent drubbing, PHK still trades at a premium to NAV of around 40%. This is both absurd and symptomatic of the desperate chase for yield in a world where central banks have eliminated any opportunity for bond and other fixed-income investors to make a real return by investing prudently.

We can't claim that PHK's ridiculous premium is a bell-ringing sign of a top, because the following chart from cefconnect.com shows that the premium has been ridiculous for years. However, it's worth noting that near the crescendo of the 2008 financial crisis PHK traded at a discount to its NAV. Assuming the fund survives there's a good chance that at some point in the future it will again trade at a discount. That future point will be near the end of the next crisis or equity bear market.

The Stock Market

Prior to the past few days, Hong Kong's Hang Seng Index (HSI) appeared to be immersed in a routine correction. As part of this correction it was testing July's break above long-term resistance, which was all perfectly normal. However, it has just accelerated downward and has fallen far enough to suggest that the July breakout was false.



The HSI's downward acceleration was largely a reaction to increasing political instability in Hong Kong, with police using tear gas and pepper spray as part of the government's efforts to end a peaceful street protest.

Tens of thousands of HK residents have taken to the streets with the goal of reversing a trend towards more rigid control of HK by China's Communist Party. In particular, the protestors want the resignation of the current Communist-Party-appointed chief executive and for the people of HK to have a say in the Region's future political leadership.

There's a risk that the HK protests will escalate and prompt a heavy-handed response from China. The stock market is trying to discount this risk.

That being said, the recent weakness in HK's stock market is not solely related to HK's political situation. It is also part of a global stock market trend. As illustrated by the following daily chart, this global trend in equities has just pushed the Dow Jones World Index below significant support to its lowest level in more than four months.



In the US, the Russell2000 SmallCap Index (RUT), the weakest of the high-profile US stock indices, made a new daily-closing low for the year on Wednesday 1st October, although the following chart shows that a decisive downside breakout hasn't yet happened. The RUT is now short-term 'oversold', but it's a good bet that a decisive downside breakout will happen during the first half of October.



It's lastly worth pointing out that, like many other commodity-related equity sectors, the coal sector tanked over the past month. As a result, the Market Vectors Coal ETF (KOL) is extremely 'oversold' and is testing major support defined by last year's low.

Incredibly, just six weeks ago KOL appeared to be preparing to break out to the upside from its 15-month range.



Gold and the Dollar

Precious Metals

Considering the goings-on in the commodity and currency markets, the gold market continues to demonstrate remarkable resilience. The gold market hasn't yet signaled a short-term bottom, but it has managed to remain above last week's low ($1206) on a daily closing basis.



While gold was refusing to buckle under the pressure over the past two trading days, silver closed at a new multi-year low and the waterfall decline in the platinum market became even steeper. Platinum ended last week at major support and at a rare 'oversold' extreme, paving the way for a rebound to soon begin. However, support gave way and set in motion another wave of speculative selling. Needless to say, platinum is now even more 'oversold'.

The panic selling evident in the price action of platinum and several other commodities creates the potential for strong rebounds, most likely in parallel with a downward correction in the Dollar Index. The question is: Will the commodities that have recently been clobbered in response to strength in the US$ be able to manage anything more than 1-2 month counter-trend rebounds if the US$ is still in the early part of a major advance? The answer is: Probably not.



Gold Stocks

The following daily chart shows that the HUI made a new multi-month low during the first half of this week, while the GDXJ/GDX ratio remains above its early-September and mid-September lows. This divergence makes the recent market action look more like what happened to the gold-mining sector during April-May of this year than what happened during any part of last year, although the HUI's decline since the early-September beginning of the current bullish divergence is greater than its decline during the April-May bullish divergence.

Divergences never matter until they do, and the gold sector's bullish divergence obviously hasn't done anything for us yet. It is important, though, because it increases the probability that the current decline is part of a drawn-out basing pattern.



The Currency Market

The ECB's Monetary Machinations

The ECB recently launched a two-pronged attack aimed at boosting bank lending to the private sector. The first prong was the TLTRO (Targeted Longer Term Refinancing Operation), which got underway on 18th September. The second prong was the ABS (Asset Backed Security) and Covered Bond Purchase Program, the details of which will be announced a few hours after this commentary is published. Will these schemes be successful?

That depends on what constitutes success. The schemes cannot possibly foster economic progress, because creating money and credit out of nothing distorts price signals, redistributes wealth from savers to speculators and generally makes the economy less efficient. So, if success is defined as bringing about a stronger economy then failure is guaranteed. However, if success is defined as increasing the size of the ECB's balance sheet by 1 trillion euros and adding 1 trillion euros to the money supply, then the schemes will probably, but not necessarily, be successful.

The challenge faced by the ECB as it tries to prod the commercial banks into lending more money to the private sector is the dearth of lending opportunities open to the banks. Due to the after-effects of the credit bubble that blew-up in 2008 and the ensuing years during which wealth was siphoned out of the real economy to prevent the holders of government bonds from suffering any losses (part of what we referred to back in 2010 as "the no bondholder left behind policy"), the euro-zone's pool of willing and qualified private-sector borrowers has experienced severe shrinkage.

The new ABS purchase program is supposed to encourage the commercial banks to be more aggressive in their search for lending opportunities, in that the ECB is effectively saying "if you securitise it, we will buy it". In other words, the ECB is effectively saying to the banks: "If you make new loans and package the loans into a security that can be sold, then you will definitely have a buyer for the security at an attractive price. You will therefore be able to shift the risk from your balance sheet to our balance sheet." The extent to which the commercial banks will take advantage of this 'generous' offer is unknown.

The new ABS purchase program appears to have a better chance than the TLTRO of promoting increased bank lending to the private sector. The reason is that the ABS program enables banks to shift the risk of loan default to someone else (to the ECB and ultimately to tax-payers throughout the euro-zone), whereas the TLTRO is supposed to encourage banks to add risk to their own balance sheets. The TLTRO could still work, though, because the senior managements of banks are often guided by the same type of short-term focus as most politicians. Just like the average politician is focused on doing/saying whatever it takes to win the next election, we get the impression that the average bank CEO is focused on doing whatever it takes to make the next quarterly and annual earnings reports look good.

Some analysts and commentators are concerned that the ECB's new money-and-credit creation schemes won't do enough to bring about the "inflation" that -- according to their crackpot theories -- the euro-zone needs. Therefore, they believe that the ECB should resort to Fed-style QE (outright large-scale monetisation of government bonds). This prompts us to address the question: Why hasn't the ECB resorted to Fed-style QE? After all, it is blatantly obvious that Mario Draghi is as ignorant about economics as his Federal Reserve counterpart.

It's first worth noting that the ECB does not appear to be facing a legal obstacle to the sort of QE programs implemented by the Fed. The ECB is legally prohibited from buying government bonds directly from any euro-zone government, but it is able to buy government bonds in the secondary market. In this respect it is in the same boat as the Fed. Like the ECB, the Fed is legally prohibited from buying US Treasury bonds directly from the US government, but it can buy as many Treasury bonds as it wants from Primary Dealers.

Rather than being legally constrained, the ECB appears to be politically constrained. Whereas some euro-zone governments and national central banks would be in favour of a full-blown QE program, other euro-zone governments and central banks, most notably the German government and the Bundesbank, would be very much against it. That's why the ECB is coming up with half-measures. At this stage Draghi and Co. can't get approval for the large-scale monetisation of government bonds, but they can get approval for a monetisation program that will supposedly result in additional credit to private businesses.

Lastly, if the ECB is determined to add 1 trillion euros to its balance sheet and the money supply over the coming 12 months then it will almost certainly find a way of doing so. If the ABS purchase program and the TLTRO don't do the trick, then some other method will be concocted.

Current Market Situation

The Dollar Index confirmed its breakout on the monthly chart by holding its ground over the first two trading days of this week (the last two days of the month and the quarter). The implication of this breakout is that substantial additional gains are likely over the coming 12 months, but the following paragraph from our latest Weekly Update remains applicable:

"Even if the Dollar Index is in the early part of a major rally that will extend well into next year, it is probably not far from the highest level it will reach this year. By the same token, the euro is probably not far from its ultimate 2014 low. In other words, the recent short-term trends probably won't extend much further. Instead, 1-2 month trends in the opposite directions should soon begin."

Updates 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

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html