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    - Interim Update 4th March 2009

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Basic economics: the economy can't get something for nothing

Due to the way economics is generally portrayed in the mainstream press, much of what we say on the subject at TSI probably seems counter-intuitive to our readers. However, our arguments should appear less 'off the beam' if you put aside everything you are continually being told by mainstream pundits and rely solely on common sense. For example, it should be intuitively obvious that the government can't increase wealth or strengthen the economy by creating money out of nothing, and that the only way the government can increase its own spending is to take, by some means or other, more money from the private sector. It should also be intuitively obvious that after way too many resources have been channeled into one part of the economy (housing, in the current situation) and the amount of savings has fallen to a dangerously low level, you can't make things better by channeling even more resources into the over-invested sector and by encouraging people to further reduce their savings.

Most people probably sense that there is something very wrong with the economic remedies that are being proposed and implemented by the governments of today, but just can't put their finger on exactly what it is. After all, the idea that one person's spending is another's income seems correct, so why exactly wouldn't it do any good to bring about an increase in spending? Why wouldn't an increase in spending prompt an increase in production and thus get the whole economy growing at a more normal rate?

In an effort to remove some mud from the water we will now consider two hypothetical situations, the first of which begins with the US Government giving money-printing machines to every adult in the US economy. These machines are designed to create paper dollars that are indistinguishable from the official Federal Reserve Notes, but they are only able to create $20,000 of new money every 12 months and they are given out on the proviso that the recipients spend all the new money. How does this affect the economy?

There is naturally a dramatic increase in spending, but the new money is not spread evenly throughout the economy. As a result, some consumer goods experience large price gains whereas the prices of other consumer goods are initially unaffected. For instance, the residential housing market is largely unaffected because few people use the $20,000 to make a down-payment on a new house, but the prices of restaurant meals, clothing, drugs and education get significant boosts.

Entrepreneurs then react to price signals and begin to increase investment in those parts of the economy that are the greatest initial beneficiaries of the new money. Note, though, that the money-printing machines have not created any additional resources, so the investment prompted by the new money causes resources to be shifted away from some areas and into other areas. This, in a nutshell, is how the market economy continually adjusts itself in response to price information. The problem in this case is that the price information upon which numerous new investments are predicated is not 'real' -- it is solely the result of the new money.

After a while, the effects of the new money are being seen throughout the entire economy and the government starts getting worried about inflation. The government is then faced with a choice -- let the inflation problem grow and potentially risk a hyperinflationary breakdown, or put a stop to the money-printing. It begrudgingly chooses the latter option and takes back its printing machines, thus ending the inflation. The thing is, the money printing caused a huge quantity of savings/resources to be allocated to activities that would only remain viable if the inflation continued. The reduction in the money printing, which was absolutely necessary to avoid a complete monetary breakdown, thus shines a spotlight on the mal-investments that occurred in response to the preceding high-inflation environment. The prices of these mal-investments tank and a severe economic downturn then begins as the economy tries to re-build savings and bring production back into line with sustainable consumption. The government, under the influence of its Keynesian and Fisherian advisors, then tries to curtail the adjustment process and gives out a new bunch of money-printing machines -- this time, machines that are capable of printing $30,000/year of new money.

The result is that boom leads to bust and bust leads to boom, with the economy getting further and further 'out of whack' with each cycle.

In the real world the government doesn't hand out money-printing machines, but the same effects occur when the central bank and the commercial banks create money out of nothing. 

To tie some concepts together let's now consider another hypothetical situation, this time involving a baker who sells bread for $1 per loaf and wants to buy two pairs of shoes, each of which costs $100. To buy the first pair of shoes the baker produces and sells 100 loaves of bread and then gives the proceeds of his bread sales to the shoemaker in exchange for a new pair of shoes. In this case, the baker has paid for his shoes by producing bread. He has taken something out of the economy (a pair of shoes) and has put something of equivalent value back into the economy (100 loaves of bread). In this case, one person's (the baker's) spending is another's (the shoemaker's) income.

Our baker then prepares to produce another 100 loaves of bread to pay for the second pair of shoes, but just as he is about to start work a money-printing machine arrives from the government. There is no longer any need for the baker to go to the trouble of producing 100 loaves of bread because he can now just create $100 out of nothing. He therefore cranks up his new money-printing machine, churns out $100 of new bills, and then gives these new bills to the shoemaker in exchange for a pair of shoes. In this case, the baker has paid for his shoes with NOTHING. In essence, he has taken something out of the economy and put nothing back into the economy. In this case, one person's spending is not another's income because the shoemaker has received no real income; he has, instead, received nothing in exchange for something.

Of course, our hard-working shoemaker doesn't realise that he has been tricked into providing something for nothing because the dollar bills handed to him by the baker look like every other dollar bill. He therefore goes about his business and either spends or saves the $100 received from the baker as if it were real. He is not significantly disadvantaged by the baker's successful attempt to get something for nothing because the money provided by the baker to the shoemaker gets merged with the total money supply. The cost of the baker's fraud is therefore spread over the entire economy, meaning that the baker got something for nothing but the economy became slightly worse-off as a result.

If the only exchange of nothing for something were the $100-exchange between our hypothetical baker and shoemaker then the effect on the overall economy would be negligible, but what if this type of transaction were widespread, with people throughout the economy regularly exchanging money created out of nothing for real goods and services? It takes only a little common sense to realise that if a lot of people within the economy are consuming (taking things out) without producing (putting things back) then there will be a substantial decline in the total amount of wealth.

Once you understand that increased consumption will lead to a LOSS of wealth IF it is not funded by increased production you will see why government stimulus packages not only can't help the economy, they must hurt the economy.

The criticism leveled at the huge stimulus package recently put into place by the Obama Administration has tended to be along the lines of "it is not big enough" or "it won't do much good because it won't result in a large enough boost to spending THIS year". This is terribly flawed logic. The reality is that the greater the amount of the "stimulus" and the faster it gets spent, the more HARM it will do.

The Stock Market

Current Market Situation

Either the post-crash rebound was a lot weaker and shorter than we were expecting, or it hasn't begun yet. We suspect the latter.

Since the end of its secular bull market in March of 2000 the US stock market has had a strong tendency to reach an intermediate-term extreme in March of each year. As recently as two months ago we thought that if March of 2009 was going to provide any sort of extreme it would be a high (the culmination of the post-crash rebound), but it is now clear that if there is going to be an important turning point this March it will be a turn from down to up. In our opinion, this is a likely outcome.

The S&P500 Index broke below its November-2008 low at the end of last week and continued its decline over the first two days of this week before bouncing on Wednesday. It is likely to reach an important bottom this month, but there is no evidence that a bottom is already in place.

Although the S&P500's recent performance suggests that some additional downside will occur prior to the start of a tradable rally, some sectors of the market have potentially just completed successful tests of last year's lows. Examples are the airline and natural gas sectors, which are represented on the following charts by the AMEX Airline Index (XAL) and the AMEX Natural Gas Index (XNG).

The XAL had been making higher lows until mid February, at which point it broke out to the downside and began to accelerate lower. This decline was driven by weakness in the broad market, which, in turn, was driven by fears of dramatic global economic weakness. Airline revenues are obviously going to be a lot lower this year than they were last year, but capacity and costs will also be a lot lower. Furthermore, whether or not the airline stocks continue to decline will be determined to a large extent by what the stock market has already discounted.

By Tuesday of this week the relentless decline of the preceding three weeks had taken the XAL back to its July-2008 low, but support defined by this prior low has initially held.

The XNG is in a similar situation to the XAL in that it broke out to the downside in mid February and plunged to, but not through, its 2008 low earlier this week. The XNG's decline has been driven by the general stock market weakness and fears that the global economic downturn will cause the natural gas price to fall to zero. Interestingly, bearishness about natural gas equities might have reached a crescendo over the past week, just as the natural gas price was showing tentative signs of bottoming.

It is possible that the XAL and the XNG have just bottomed, but if not we expect that important bottoms will be in place before the end of this month.




Gold and the Dollar

Gold

Below is a daily chart of April gold futures.

Tuesday's break below support at $927 indicates that a short-term peak was put in place at around $1000 late last month. However, the gold price has now fallen for eight days in a row, which means that a rebound should begin almost immediately.


Although a rebound should begin within the next day or so it is unlikely that the downward correction has run its course. The reason is that the eight consecutive down-days do not appear to have put a significant dent in bullish sentiment. For example, at the close of trading on Wednesday the Central Gold Trust (GTU) and the Central Fund of Canada (CEF), two funds that invest in bullion, were priced at premiums of 20% and 10% to their respective net asset values. These premiums are quite high and are only about 2% below recent peaks.

In addition, if the long-awaited stock market rebound finally begins later this month then the fears that have been boosting the gold price will abate for a while.

Our thinking is that the gold market will spend a few months consolidating below $1000 before resuming its advance. By the way, this does not represent a change in our thinking in that we have not been anticipating substantial upward progress on gold's part during the first half of this year. For example, in the 9th February Interim Update we speculated that the best gold would do over the coming two months is test its 2008 peak, and when gold rose to the vicinity of its 2008 peak in late February we said that a pullback was very likely.

Things are happening a couple of months later than originally expected, but the strength we have been waiting for in base metals relative to gold appears to be getting underway. Note, for instance, that while gold was falling for an eighth consecutive day on Wednesday the copper futures market was surging to a 3-month high. A daily chart of March copper is included below.


A multi-month consolidation in the gold price within, say, the $800-$1000 range won't necessarily end the rally in the gold sector of the stock market. The reason is that gold stocks, especially the juniors, still have a lot of catching up to do. The gold sector is the only sector of the stock market that will report good earnings results over the next two quarters, and the gold mining business is potentially much more profitable today than it was when the HUI was peaking in March of 2008 or when the average gold stock was peaking in May of 2006.

Gold Stocks

As discussed in last week's Interim Update, the gold sector tends to reach a short-term extreme during the first half of March. With the HUI hitting a 6-week low on Tuesday of this week (3rd March) the stage is now set for a short-term bottom during the first half of March-2009.

It's possible that the HUI reached its correction low on Tuesday when it dropped to 260, but we won't be surprised if it drops a little further over the days ahead and tests the support at 240-250 highlighted on the following chart. Investors who have been waiting for an opportunity to increase their exposure to the gold sector should take advantage of any weakness over the next several days.


The total supply of gold shares has increased substantially over the past three months due to numerous equity financings. This shows that gold mining executives generally don't have much confidence in the upward trend's sustainability, which is not, in itself, a reason for us to be concerned given that most gold mining executives fall into the 'dumb money' category. Like the general public, they tend to be too bullish near important tops and too bearish near important bottoms. However, while it is unlikely that this additional supply will bring the sector's advance to a premature end it will exacerbate the next intermediate-term correction.

Currency Market Update

With the broad stock market seemingly headed for a March low it would make sense if the Dollar Index were headed for a March high considering that there has been an inverse correlation between the two markets over the past seven months.

The following chart comparison illustrates one argument in favour of a March high for the Dollar Index. The chart compares the performance of the Dollar Index during 2007-2008 (the top section of the chart) with its performance during 2008-2009 (the bottom section of the chart) to make the point that its performance from August-2008 through to the present day has been the mirror image of its performance from August-2007 through to March-2008. If this strange relationship continues then the low of March-2008 will correspond with a high in March-2009.

The relationship depicted below is not the sort of thing we would ever risk money on, but we thought it was interesting that the dollar's turning points of the past seven months line up so neatly with the turning points that occurred exactly 12 months earlier. Also, the relationship predicts an outcome that we think is likely based on other considerations.


Update on Stock Selections

(Note: 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)

Lion Selection (ASX: LST). Shares: 82M. Recent price: A$0.85

LST, an Australia-based gold-focused resource investment company, has a net asset value (NAV) of A$1.66/share. This means that at its current price LST is selling at a discount of almost 50% to its NAV. Moreover, the NAV is based on conservative valuations of A$59M for LST's 30% stake in the 100K-oz/year Cracow gold mine and A$12M for its 51% stake in the development-stage Edna May gold project. According to the project's Feasibility Study, Edna May is capable of producing 100K ounces/year of gold at a cash cost of A$636/oz (US$413/oz). Edna May's construction cost is estimated to be A$92M.

LST has a strong balance sheet (no debt, A$29M of cash) and is very under-valued. It offers exposure to gold in a politically secure location (Australia), and to other metals. It is, we think, a reasonable candidate for new buying at this time.

    The NGD-WGW Merger

New Gold (NGD) and Western Goldfields (WGW), both of which are members of the TSI Stocks List, announced a business combination on Wednesday. If it goes ahead as currently proposed, the combination will be effected by NGD buying WGW in an all-stock deal (one new NGD share for every WGW share).

The proposed merger makes some sense from NGD's perspective because WGW's cash plus the cash flow generated by WGW's Mesquite gold mine should, along with NGD's own cash, finance the remainder of the mine construction at NGD's New Afton copper/gold project. However, we fail to see how it makes any sense from the perspective of WGW shareholders. For one thing, there is almost no premium in NGD's offer (whatever small premium there is was created by the 'mysterious' 13% decline in WGW's stock price on the day prior to the merger announcement). For another thing, as one of the few junior gold miners with no significant negative issues -- it has no operational problems, no political/environmental risk concerns, and no need for additional financing -- WGW was ideally positioned to attain a stock market premium and to grow its business by acquiring development-stage gold deposits.

In addition to the apparent lack of any good reason for the merger from a WGW shareholder's perspective, the merger will reduce the number of investment alternatives within the gold mining sector. We'd therefore prefer that it didn't happen, but it almost certainly will happen as currently proposed unless another company makes a better offer for WGW. A better offer is a long shot, but isn't out of the question.

In the absence of a competing bid or speculation regarding a competing bid, NGD and WGW will trade in unison from now on.

As evidenced by the following chart, NGD has broken below its 50-day moving average and short-term support. The chart therefore provides no compelling reason to buy, but the stock is a good candidate for accumulation near its current price based on valuation. Our worst-case NGD valuation of US$3.00-$3.50 won't change as a result of the merger, but the NGD-WGW combination is a lower-risk speculation than NGD on its own.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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