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China's Boom-Bust Cycle

Once there has been sufficient monetary inflation to create an economic boom, a bust is inevitable. The only question then facing the central bank is: do we stop the inflation immediately and therefore experience a bust sooner, or do we keep the inflation going for a while and experience a more severe bust later? In other words, there is simply no way to avoid a bust once an inflation-fueled boom has been fomented. You either deal with the consequences of the inflation in the short-term or you postpone the pain at the cost of greater damage to the economy. The greatest long-term damage would be done by attempting to maintain a high-enough rate of monetary inflation to postpone the bust indefinitely. This path leads to the complete destruction of the currency and an economic bust of biblical proportions, which is why it is seldom followed. Seldom, but unfortunately not never.

An inflation-fueled boom began in China in 2004-2005. Consequently, China is headed for an economic bust. No ifs, buts or maybes. The only question relates to timing. There is evidence to indicate that a bust commenced about 18 months ago, but the evidence is not yet conclusive. Aside from the signs that China's economy has almost ground to a halt, evidence pointing to a bust having already begun is found in the following chart.

The chart shows that the year-over-year (YOY) growth rate of China's M1 money supply has been trending downward since peaking at 35%-40% in early 2010. By early 2012 it had fallen to a 12-year low of around 3% and in August of 2012 (the latest month for which there is money-supply data) it was hovering just above its 12-year low. The chart suggests that China's monetary authorities have decided to 'bite the bullet' and suffer a bust now rather than do even more damage and suffer a far more severe bust later. However, the chart also suggests that China's monetary authorities decided to 'bite the bullet' and suffer a bust during 2008 (note the downward trend in the M1 growth rate during 2008), but then chickened out and breathed new life into the boom via a huge injection of money. It is therefore fair to say that the verdict isn't yet in. It looks like China's inflation-fueled boom-bust cycle has entered the bust phase, but there is still a chance that the old boom's life will be prolonged by another large and damaging injection of monetary heroin. After all, we are talking about a country where the annual money-supply growth rate can be quickly increased from 5% to 20% via a command from the central government to the banking system. There was an unusually large increase in new loans outstanding within China's banking system in August, so perhaps the command has already gone out.



It makes sense to be long-term bearish on China's economy based on the reality that if the boom hasn't already turned to bust, it is living on borrowed time. It also makes sense not to under-estimate the ability of China's government to temporarily re-energise the boom via money pumping and directed bank lending.

Deflating the emerging markets bubble

Hindsight Bias

The Stock Market

Q3 earnings season is about to begin. So far, more than 80% of Q3 earnings pre-announcements for S&P500 companies have been negative, which is more than double the normal rate. From a "glass half full" perspective this could mean that a poor quarterly earnings situation is factored into current stock prices, thus insulating the market from near-term bad news on the earnings front. While this is certainly possible, the market's price action and valuation don't suggest that bad news has been discounted to a meaningful degree.

The Dow Jones World Stock Index (DJW) made a new high for the year on 14th September, the day after the Fed's QE3 announcement. It has since pulled back, but at this stage there is nothing in the price action to suggest that the decline from the 14th September peak is anything more than a minor correction.

We don't think there's much additional upside potential, but our guess is that the DJW will make another move to a new high for the year before starting an intermediate-term decline.



Gold and the Dollar

Gold

The US$ gold price made a marginal new intra-day high for the move early this week, but there was no follow-through. It has essentially traded sideways since the day of the "QE3" surge.



A pullback to near the 50-day moving average is needed to create a new short-term buying opportunity, but before this happens there could be a break above resistance at $1800 and a jump to as high as $1850. A lot will depend on the monthly US employment report scheduled to be released on Friday morning. If this report reflects further deterioration of the labour market then the QE beneficiaries will probably get another boost, sending gold, the chief beneficiary of the Fed's QE, to a new multi-month high.

Gold Stocks

Two of the things that short-term HUI corrections almost always accomplish before they come to an end, are:

1) A price decline to near the 50-day moving average

2) A decline by the daily RSI(14), a short-term momentum indicator, to between 40 and 50.

The following chart therefore suggests that if a short-term correction has begun, it is not yet close to being complete. The 50-day MA continues to rise and is now in the low-460s, but this is still about 8% below Wednesday's closing price. And while the daily RSI(14) has dropped back from the extreme high reached 2-3 weeks ago and is no longer registering 'overbought', it is still well above the 40-50 range that will likely be probed prior to the correction's end.



If the HUI reverses upward and breaks out to a new multi-month high over the days immediately ahead (not likely, but possible), it won't mean that the correction has ended earlier than expected. It will mean that it hasn't yet started. In this case the expected correction would likely get underway after the HUI had tested resistance at 550.

Currency Market Update

The Dollar Index continues to consolidate with an upward bias after reaching an 'oversold' extreme about three weeks ago. We suspect that the current rebound will be followed by a decline to a new multi-month low.



The big news of the past week was the collapse in Iran's currency, known as the rial. In early 2011 it took 10,000 rials to buy one US$. Last week it took 24,000 rials to buy one US$, meaning that the rial had lost about 58% of its value relative to the US$ over the space of only 18 months. However, on Tuesday of this week it took 35,500 rials to buy one US$, meaning that the rial had lost an additional one-third of its value in just one week.

The totally unethical economic sanctions imposed on Iran by the US government and its partners in crime are partly to blame for the currency collapse and the violent protests that have begun to erupt in the streets of Tehran in reaction to skyrocketing prices, but in order for Iran's money to behave in this way its own government must have massively inflated the money supply. We doubt that there are any reliable records regarding the extent to which the supply of rials has expanded, but it's crystal clear that dramatic expansion has occurred.

Iran is going to experience a great deal of economic and political instability over the months ahead. Whether this leads to regime change is anyone's guess. Moreover, if major political change does occur it won't necessarily be positive from the perspective of Western governments. The change could, for example, involve the elimination of any semblance of democracy (Iran currently has a democratically elected president) and the assertion of stricter control by the country's religious leadership.

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

Midway Gold (NYSE and TSXV: MDW). Shares: 128M issued, 143M fully diluted. Recent price: US$1.58

MDW has stakes in three Nevada-based development-stage gold projects: the Pan and Gold Rock projects, which MDW owns and operates, and the Spring Valley project, which is a joint venture with Barrick Gold (Barrick is the operator and has the option to earn 70%).

We were prompted to check out MDW by the fact that Golden Predator (GPD.TO), a recent addition to the TSI Stocks List, owns 4% gross production royalties on the Pan and Gold Rock projects. In our efforts to determine the value of these royalties it occurred to us that MDW would be a reasonable speculation in its own right. At this stage we prefer to gain indirect exposure to MDW's projects via GPD, but MDW offers good value and the advantage of an NYSE listing.

Of MDW's projects, Pan is the most advanced. First production is scheduled for 2014 and the average production rate is currently designed to be 81K-ounces/year, although there is potential to increase the rate to 150K-ounces/year. The mine plan is simple, in that we are dealing with an oxide gold deposit that can be mined via open pit and heap leach. At a gold price of $1725/oz the project's NPV(5%) is estimated to be $290M, or about $2.00 per fully diluted MDW share.

Assuming a gold price of $1700/oz, at Pan's design production rate of 81K-oz/yr the 4% gross production royalty owned by GPD would generate annual revenue of $5.5M. This implies a value for the royalty of about $55M (using a 10-times revenue multiple, which is lower than the revenue multiple that most gold royalty companies now trade at) after production begins in 2014, assuming a gold price of $1700 and not allowing for any future expansion.

Gold Rock is similar to Pan, although it is at an earlier stage of development (initial production is scheduled for 2016) and could end up being slightly larger. Annual gold production is expected to be 80K-100K ounces.

If we take the bottom of the above-mentioned range and make the same assumptions we made when assessing the future value of the Pan royalty, we arrive at the same potential value of $55M for GPD's Gold Rock royalty.

Further to the above, if MDW is successful in its endeavours then at a gold price of $1700/oz the value of GPD's royalties on MDW's projects will likely be worth at least $110M within three years. This equates to about $0.76 per GPD share, or roughly double the current GPD stock price. None of this potential value appears to be factored in at this time, which means that success by MDW could translate into a 200% gain in GPD's stock price within three years. Note that success, here, is simply defined as bringing the projects into production roughly in accordance with the present schedule. Any cost blow-outs suffered by MDW won't affect GPD because GPD's royalties are based on gross production. Alternatively, if MDW turns out to be a total failure then GPD's shareholders will lose a lot of upside potential but could still do OK as a result of GPD's Yukon-based projects. This is why we prefer to gain exposure to MDW via GPD.

It is worth mentioning that in addition to the Pan and Gold Rock projects, MDW has a stake in the Spring Valley project. MDW's stake will probably end up at either 30% or 25%, with Barrick Gold owning the rest. However, due to Spring Valley's size (the total in-ground resource is presently 4.2M ounces of gold) this 25%-30% stake could generate similar production for MDW as its 100% stakes in the Pan and Gold Rock projects.

MDW's current market cap is around $200M and the company has about $15M of working capital to fund its development activities over the next several months. It has three solid projects in a good location (Nevada), two of which are 100%-owned and one of which is a JV with the world's largest gold mining company. While we don't intend to add it to the TSI List in the near future (for the reason stated above), it would be a reasonable addition to a gold stock portfolio. A good place for new buying would be within a few cents of the 50-day moving average (around US$1.40).

    Keegan Resources (TSX: KGN, NYSE: KGN). Shares: 76M issued, 83M fully diluted. Recent price: US$3.20

Our most recent mention of KGN was in the 10th September Weekly Update. At that time it was priced at US$4.15 and was short-term 'overbought'. It has since pulled back a long way, for no fundamental reason we are aware of. It is now short-term 'oversold'.

KGN's current market cap is around $250M. This is moderately high considering the size, location (Ghana) and development stage of its flagship Esaase project, but it is offset by the company's $185M of cash. Due to its large cash position KGN's enterprise value is only about $65M, which is low.

KGN is a good candidate for new buying in the low-US$3 area.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html