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Don't fight the Fed?

"Don't fight the Fed" is an adage that's always worth remembering; however, this adage shouldn't be applied to all of the Fed's endeavours because the Fed is powerful in some areas and impotent in others. For example, the Fed can ALWAYS depreciate the US dollar -- that is, it can always cause dollar-denominated prices to rise -- if it chooses to do so, but it can't create real economic growth or sustainable employment (despite the fact that achieving "full employment" is part of the Fed's official mandate). Furthermore, although the Fed can always bring about a rise in prices by inflating the currency supply, it can't control which prices rise the most in response to its monetary inflation. In fact, the price-related effects of the Fed's inflation will often be the opposite of what the Fed intends.

Given that the Fed is always capable of creating inflation (in all meanings of the term), it is important not to bet on deflation at those times when the Fed is going 'full steam ahead' along the inflation path. Putting it another way, it doesn't make sense for investors to worry about deflation as long as the Fed is aggressively trying to promote inflation. By the same token, investors should generally become more concerned about the potential for deflation at those times when the Fed's top priority is to temporarily curtail the inflation.

Whereas it generally won't make sense to bet against the Fed's power to inflate, it will always make sense to bet against the Fed's ability to bring about real economic progress. This is because the Fed's manipulations of interest rates and money supply make the economy less efficient than it would be in the absence of these manipulations. It is also appropriate to bet against the Fed's ability to smooth-out the business cycle, because the central bank is one of the two main causes of large swings in the overall economy (fractional reserve banking being the other).

Summing up, the old adage "don't fight the Fed" always applies when it comes to inflation/deflation and never applies when it comes to real economic progress or economic stability.

The Stock Market

The stock indices that we are watching most closely at the moment are the NASDAQ100 and Russell2000 Indices in the US and the Hang Seng Index in Hong Kong. Unlike the Dow Transportation Average, these indices aren't directly affected by what's happening in the Middle East.

The Hang Seng Index stopped rising last November, but needs to close below 22,500 to signal that the price action of the past few months is more likely a topping pattern than a consolidation pattern. The NASDAQ100 and Russell2000 Indices pulled back to their respective 50-day moving averages in February, which is not sufficient to indicate that tops of even short-term significance are in place. To signal that tops of at least short-term significance were put in place last month these indices need to close below their February lows.

Based on the new high reached this week by the 10-day moving average of the OEX put/call ratio, professional money managers remain far more concerned than usual about the risk of a stock market decline. They have been concerned for a while and nothing bad has happened, but you can also play Russian Roulette for a while without anything bad happening.

The following chart of the HYG/TLT ratio encapsulates the current situation quite well. It reveals a relentless advance since late August -- indicating a general narrowing of credit spreads as the demand for high-risk debt increased relative to the demand for low-risk debt -- with just minor pullbacks along the way. This ratio is likely to peak at the same time as, or prior to, an important peak in the US stock market.

Gold and the Dollar

Gold

The following daily chart shows that the nearest gold futures contract made a marginal new high this week. The breakout will probably become more decisive within the next few weeks, but before that happens there could be a $40-$60 pullback.

Interestingly, Market Vane's bullish percentage for gold was at 78% on Tuesday, which is low for a market on the verge of breaking out to a new all-time high. In other words, sentiment towards gold remains constructive. However, Market Vane's bullish percentage for silver is into the 90s, which is what you'd expect for a commodity market that was approaching a major peak. We wouldn't bet against the silver market at this time, but we doubt that the current speculative fervour surrounding this metal will last longer than a few more weeks.

While gold has just made a new high in US$ terms, relative to other commodities the situation could hardly be more different. Specifically, the following chart shows that relative to the basket of commodities represented by the CCI (the Continuous Commodity Index), gold has just bounced off a 2-year LOW. This indicates that the global growth theme remains dominant and that the goings-on in the Middle East have not yet prompted a meaningful 'flight to safety'.

Gold's weakness relative to silver over the past several months is related to the global growth theme (increasing economic confidence and the general shift away from safety) and the resultant weakness in the US dollar. As evidence we present the following chart, which shows that the gold/silver ratio has trended in the same direction as the Dollar Index over the past three years.

Our expectation is that three major changes will happen at approximately the same time: gold will begin trending upward against most other commodities (including silver), the US$ will begin trending upward against most other currencies, and the the major stock markets of the world will begin trending downward.

Gold Stocks

Gold Stocks versus Gold Bullion

Have gold stocks, as a group, recently been diverging bearishly from gold bullion?

The answer is no. As evidenced by the first of the following charts of the HUI/gold ratio, on a very short-term basis the gold stocks have been strengthening relative to the metal. Also, the HUI/gold ratio bottomed slightly in advance of gold bullion in late January, thus creating a minor bullish divergence.

However, our second HUI/gold chart shows that on a long-term basis the gold stocks have been weakening relative to the metal. Specifically, the HUI/gold ratio peaked near the end of 2003 and has since made a series of declining tops. You'd be hard-pressed to make the case that HUI/gold's post-2003 series of declining tops constituted a bearish divergence, though, given that it occurred in parallel with a 250% increase in the gold price.

If we take an ultra-long-term view, which is what we've done with the following chart of the BGMI/gold ratio (the Barrons Gold Mining Index relative to gold), we see that gold stocks, as a group, have been declining relative to gold bullion since 1968. We don't think that this long-term trend is about to change, although there is some potential for gold stocks to outperform the bullion over the coming 1-2 years.

As we've explained many times in TSI commentaries over the years, despite popular opinion to the contrary the stocks of major gold producers do NOT provide leveraged exposure to gains in the gold price over the long term. There are a number of reasons for this, the main one being mine depletion. In effect, gold producers have to invest a lot of money every year just to stand still (that is, just to prevent their in-ground resources from shrinking). Over the long haul the cumulative cost of this continual investment usually offsets any benefit achieved from a higher gold price.

The upshot is that the best way to obtain long-term exposure to gold is to buy...gold. The major gold stocks make good intermediate-term trades when they become extremely depressed relative to gold bullion, as was the case in Q4-2008, but in general they shouldn't be held as long-term investments.

Other than those times when the major gold stocks are extremely depressed relative to gold bullion, speculators looking for gold-related leverage should be able to find it at the junior end of the gold sector.

Current Market Situation

The HUI has broken above resistance at 555-560 and is now approaching its all-time high. Support during a routine 'retracement' of the recent rally would likely be found in the vicinity of the 50-day moving average. This moving average is presently at 538, but it has begun to rise and will probably move into the 540s over the days ahead.

As we noted at the time, the HUI's decline to around 500 in late January created a good short-term buying opportunity. At that time the short-term risk/reward was very attractive because the downside risk was minimal and the situation was such that even a counter-trend rebound would result in decent gains over the ensuing weeks. The short-term risk/reward still looks OK, but it is nowhere near as attractive as it was in late January. This is mainly because the downside risk is significantly greater now than it was back then.

Some individual gold stocks are at levels where new buying could be appropriate, but on a very short-term sector-wide basis the current situation should be viewed as a selling opportunity. In our opinion, the most dependable way to outperform the market involves scaling in on weakness and scaling out on strength.

Currency Market Update

The Dollar Index has broken below its early-February low. Also, it has either broken below its 3-year trend line or is very close to doing so.

It will be interesting to see if the (potential) break below the 3-year trend line is confirmed on a weekly closing basis. If it is, it won't necessarily mean that there is a lot of additional downside in store for the US$, but it will probably mean that a new multi-month bottoming process will occur before the US$ begins its next intermediate-term rally.

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)

Crocodile Gold (TSX: CRK). Shares: 321M issued, 400M fully diluted (incl 93M-share Mar-2011 financing). Recent price: C$0.97

CRK, a junior gold producer that operates mines in Australia's Northern Territory, became the latest in a rather long line of gold producers to disappoint on the operational front when it announced on Monday that its 2011 production will be around 90K ounces. This compares to the 120K ounces that we were anticipating.

Record-high rainfall over the past two months is the main reason that CRK's 2011 production will be lower than previously forecast. Other mining companies in the region have been similarly affected by the extraordinarily wet conditions.

Although the market's reaction to the lowered 2011 production forecast was predictably negative, we don't see it as a big issue. CRK's management obviously can't control the weather, and the plan to ramp up to a production rate of 200K ounces in 2012 still appears to be achievable. Monday's news therefore didn't have a significant adverse effect on our valuation of the stock.

As far as the stock's valuation is concerned, Tuesday's news was more negative than Monday's. On Tuesday the company announced a 93M-share financing at the extremely low price of C$1.05/share. And as if to rub salt into the wounds of existing shareholders, the company announced that participants in the equity financing will receive half of a 5-year C$2.25 warrant with each new share they buy.

When a company issues new equity at a large discount to the underlying value of the existing equity, the existing equity is de-valued. By way of explanation, consider the hypothetical case of a company that has $200M of assets and 100M shares on issue, meaning that each share is worth $2.00. If this company raises $50M by issuing 50M new shares at $1.00/share, the total value of assets will rise to $250M and the total share count will rise to 150M. Therefore, as a result of this financing the value of our hypothetical company's shares will fall from $2.00 ($200M/100M) to $1.67 ($250M/150M).

Note that it will sometimes make sense for a company to issue new equity at a large discount to full value. One example is when there is a feasible plan to use the money to fund an expansion that should ultimately add more value per share than is subtracted by the stock dilution. Another example is when the additional equity reduces risk by enough to offset the reduction in the per-share upside potential.

The proceeds of CRK's equity financing will be used to fund production growth, but it couldn't have been timed worse. In our opinion, it has reduced the current per-share valuation by about 15%. Moreover, the warrants could effectively put a long-term cap on the stock at C$2.25-C$2.50.

It probably doesn't make sense to exit CRK right now because the market's reaction to the bad news has pushed the stock price a long way below our reduced estimate of current value (our per-share valuation has dropped from $2.00-$2.20 to around $1.70 due to this week's developments). However, we wouldn't do any new buying at this time, unless we could do so via the private placement (and thus get the free 5-year warrants). The reason we wouldn't be eager to buy this weakness is that the combination of the production news and the large equity financing makes it likely that CRK will be 'dead money' for at least the next 6 months.

    General

Exploration-stage gold stocks have historically had more upside potential and more downside risk than the stocks of gold producers, but based on what has happened over the past 12 months -- producers have been regularly missing their own production forecasts and getting clobbered by the stock market in response -- it seems that the explorers now have more upside potential and LESS downside risk than the producers. We are referring, in particular, to the exploration-stage miners that have already discovered substantial in-ground resources but are still a long way from entering the mine construction phase -- stocks such as BAT.V, CFO.V, KGN, PVG.TO, SBB.TO and THM. At some point the market will begin to reward current production, but at the moment it is a lot easier to make money amongst the pure explorers.

Of the stocks mentioned above, CFO.V and KGN are probably the best candidates for new buying at this time. THM would be suitable for new buying at around US$9.00 and would be a strong buy if it were to drop back to the low-US$8 area. BAT.V, PVG.TO and SBB.TO are too 'overbought' for new buying right now, although they are obviously in demand and could therefore become even more 'overbought' before substantial corrections get underway.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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