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    - Interim Update 4th November 2009

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Money, Credit, and Deflation

Frank Shostak, one of the most levelheaded contributors to the inflation-deflation debate, recently posted an article that discusses the difference between money and credit and explains why a decline in credit does not, in and of itself, imply or cause deflation. Here is the article's conclusion:

"Contrary to popular thinking, it is not a fall in credit as such that is the key to deflation, but a fall specifically in credit created out of thin air. It is this type of credit, which commercial banks have created through fractional-reserve lending, that causes the decline in money supply, i.e., deflation. A fall in normal credit (i.e., credit that has an original lender) doesn't alter the money supply, and hence has nothing to do with deflation.

Despite the likely current fall in commercial-bank lending out of thin air, as long as the rate of growth of the money supply remains positive, one should talk about inflation rather than deflation.

However, as the pace of monetary pumping by the US central bank is starting to fall sharply, there is a growing likelihood that the fall in commercial-bank lending out of thin air will cause actual deflation."

This meshes with a point we have made a number of times over the past 12 months, which is that a decline in the supply of credit is only "deflationary" to the extent that it brings about a decline in the supply of money. A related point is that if the total supply of money is growing -- and especially if it is growing at an accelerating rate -- then regardless of what is happening on the 'credit front' the economy is experiencing inflation, not deflation.

We again emphasise that the main problem with monetary inflation isn't that it causes the average price level to rise (although the "Consumer Price Index" will eventually rise in response to a large increase in the money supply); it's that it distorts relative prices, resulting in mal-investment and an undeserving transfer of wealth.

Note the final sentence in Frank Shostak's article. Up until now the Fed's monetary pumping has more than offset deflationary forces such as the decline in "commercial-bank lending out of thin air", but if the pace at which the Fed creates new money -- by, for example, monetising government debt and mortgage-backed securities -- slows over the months ahead, then the US economy could experience actual deflation.

Our view is that the Fed will re-accelerate its monetary pumping well before the money-supply growth rate goes negative, with the Federal Government providing whatever borrowing power is required. After all, Bernanke is labouring under the misapprehension that a decline in the money supply caused the Great Depression.

We would be wrong, though, to state that deflation is impossible. It's not impossible, just very unlikely within the current political/monetary framework.

The Stock Market

A Typical Recovery?

In his 2nd November Weekly Comment, John Hussman writes that we currently face two data sets characterising two very different possibilities for the true state of the world. In Dr. Hussman's words:

"One possibility, which is clearly the one that Wall Street has subscribed to, is that the recent downturn was a standard, if somewhat more severe than normal, post-war recession; that the market's recent strength is an indication that it is looking forward to a full "V-shaped" recovery, and that the positive print for third-quarter GDP is a signal that the recession is officially over. Applying the post-war norms for stock market performance following the end of a recession, the implications are for further market strength and the elongation of the recent advance into a multi-year bull market.

The alternate possibility, which is the one that I personally subscribe to, is that the recent downturn was the initial phase of a more prolonged deleveraging cycle; that the advance we've observed in recent months most likely represents mean-reversion -- qualitatively and quantitatively similar to the large and often abruptly terminated "clearing rallies" of past post-crash markets; that major credit losses are continuing quietly but are going unreported thanks to changes in accounting rules by the FASB this past spring, which allowed for "substantial discretion" in accounting for loan losses and deterioration in the value of securitized mortgages; that a huge second-wave of mortgage losses can be expected from a reset schedule on Alt-A and Option-ARMs that has just started (following a lull in the reset schedule since March) and will continue into 2010 and 2011; that intrinsic economic activity remains abysmal; that recent GDP growth is an artifact of massive fiscal stimulus that is unlikely to have sustained follow-through; and that recent market valuations are not representative of those observed at the end of most post-war recessions, but are instead similar to those observed at major market peaks prior to the mid-1990's."

Like Dr. Hussman, we subscribe to the "alternate possibility". It is very much a minority view, as evidenced by the generally high level of optimism reflected over recent months by indicators of stock market sentiment. Furthermore, the view is not only contrary to that of most 'run-of-the-mill' analysts, investors and commentators, it is also contrary to that of a few 'top-notch' analysts and investors (including James Grant, who expects the uncommonly sharp downturn of 2007-2008 to be followed by an uncommonly sharp upturn, and Warren Buffett, who just paid US$34B to buy a rail transportation company in what he describes as a bullish bet on the US economy). However, we think it is by far the most logical view, given that the economy is trying to recover from the collapse of the world's greatest-ever credit bubble but is being prevented from doing so by aggressive government intervention.

As we've been saying over the past year or so, the governments of today are making the same mistakes that were made by the Hoover and Roosevelt Administrations during the 1930s (propping up prices, transferring wealth to failed businesses, increasing "regime uncertainty" via more regulations and taxes, discouraging saving, ramping up government spending, and trying to replace a private-sector credit bubble with a government credit bubble), but on a much grander scale.

In the aftermath of a multi-generational credit bubble and with governments seemingly making every conceivable error, how could we possibly forecast a typical post-WWII recovery?

Current Market Situation

The following daily chart shows that the Dow Industrials Index has good support at 8750-9000. In our opinion, this support defines the short-term downside risk and is also a reasonable short-term target.


We continue to expect that a short-term bottom will be in place by mid November, but this is based on the assumption that the market will continue to work its way downward in the interim. If, instead, the market rebounds over the coming 1-2 weeks then either the short-term correction is going to last longer than expected or the October peak was less significant than we currently believe.

Gold and the Dollar

Gold

Current Market Situation

As everyone is undoubtedly aware, it was announced on Tuesday that the Indian Government bought 200 of the 403 tonnes of gold recently put up for sale by the IMF. Neither 200 tonnes nor 403 tonnes are substantial amounts in the context of the overall gold market (an average of about 650 tonnes of physical gold changes hands every day via the London Bullion Market Association), but India's purchase was potentially significant because it may be indicating that the "official sector" -- the current holder of about 30,000 tonnes of aboveground gold -- has shifted from being a net seller to a net buyer of gold. That, we think, goes a long way towards explaining this week's surge in the gold price. The Fed's pledge to hold its targeted short-term interest rate at close to zero for an extended period also helped.

The gold price is now challenging the next psychological obstacle, which is $1100. Also, it is near the top of what is now a well-defined channel, meaning that it will soon have to experience another pullback or that the slope of its upward trend will have to become steeper.

Our view is that a short-term top won't be in place before December. Why? Because when gold makes a new high for the year during October the rally almost always continues until at least December.


Gold is 'overbought' by some measures, but you should ignore claims that there is a gold bubble. Gold will almost certainly enter 'bubble territory' at some point over the next several years, but at this stage of the bull market we are yet to see the sort of upward acceleration in the gold price that was seen during either the first half or the second half of the 1970s. Also, the gold price has not yet accelerated upward the way the prices of many industrial commodities did at various times over the past 4 years.

To further explain what we mean we have included, below, a monthly chart showing the year-over-year (YOY) percentage change in the gold price. The chart shows that gold's YOY % change peaked at 100% during the first half of the 1970s and at 200% during the second half of the 1970s, but has not managed to exceed 45% over the past 2 years. Recall, as well, that the oil price doubled during the final 12 months of its multi-year run-up.


It will be reasonable to start talking about a gold bubble if the gold price rockets up to around $2000 within the next few months, but our view is that the gold market won't enter bubble territory anytime soon. We think the gold bull market has years to run, and that the next peak -- which is likely to occur before year-end -- will be followed by another normal (10%-20%) correction.

Gold versus Silver

Many people believe that silver offers very good value relative to gold on the basis that the gold/silver is presently very high by historical standards. In particular, an ultra-long-term (multi-century) view of the ratio reveals that silver has tended to trade at around one-fifteenth the price of gold (a gold/silver ratio of 15:1), compared to its current level of around one-sixtieth (a gold/silver ratio of 60:1).

This line of thinking doesn't appeal to us. The fact is that long-term relationships sometimes change, especially when the monetary system undergoes dramatic change. The gold/silver ratio is not similar to a stock market valuation such as a price/earnings ratio, where there will always be good reason to expect an eventual return to the long-term average regardless of what happens over shorter time periods.

If we focus on what has happened over the past 11 years we see that the silver/gold ratio has generally trended with the US stock market (as evidenced by the following chart), and that the current level of the ratio is about right considering the current level of the S&P500 Index. Furthermore, the market action of the past 11 years suggests that it only makes sense to be bullish on silver relative to gold at this time if you also expect that the US stock market will maintain its intermediate-term upward trend.


Gold Stocks

Current Market Situation

A chart comparing the HUI and the HUI/gold ratio is displayed below. The chart shows that the HUI has substantial resistance at 450-460 and that the HUI/gold ratio has been declining since mid-September.

In our opinion, the most likely near-term outcome is that the HUI will test the aforementioned resistance within the next three weeks and then resume its intermediate-term correction. The next most likely outcome is that the HUI will make a new high for the year before the end of this month, but the new high will only be marginal (no more than 5% above the October high) and won't be confirmed by the HUI/gold ratio. An intermediate-term correction would then begin. The third most likely outcome is that the HUI has just commenced a new multi-month advance.

The third most likely outcome will shift to being the most likely outcome if the HUI makes a new 52-week high after the first week of December.


Suggested Actions

The actions that are appropriate for an investor at any time will be determined, to a substantial degree, by his/her current positioning. For example, an investor who is very overweight gold shares should respond differently to the current market action than one who has minimal exposure to this sector of the market. In particular, whereas the investor with large exposure to gold shares should be looking for opportunities to lock-in gains and generally mitigate the impact of the next downward correction, the investor with very little current exposure and a reasonably high tolerance for risk should still be looking for opportunities to buy under-valued junior gold stocks. The following suggested actions apply to the former (someone with large exposure).

1. Use strength over the next three weeks to lighten-up on gold/silver stocks that have made very sharp upward moves or that you don't plan to hold over the long-term.

2. Partially hedge your exposure to the gold/silver sector by scaling into SLV and/or GDX put options that have at least three months of time before expiry.

Remember that risk management always costs you money, except when it turns out that you need it (in which case it pays large dividends). Unfortunately, you never know in advance exactly when you are going to need it, and by the time you do know for sure it will usually be too late to do anything about it. For example, you can't wait until your house begins to burn down before buying fire insurance. The point is that you have to do the risk management before you can be certain that you will actually need it.

Currency Market Update

The following chart shows that the Dollar Index spiked up to its channel top and its 50-day moving average on Tuesday, and then reversed lower. From our perspective, therefore, the situation is unchanged. We think the Dollar Index is close to a bottom, but there is presently no meaningful price-related evidence that a bottom is in place.


Some market participants/observers are always bearish on the US$, whereas others seem to be bullish all the time. Both the always-bearish and always-bullish camps lack objectivity. Of those who maintain an open mind, most appear to be anticipating a significant US$ rebound. This suggests that the outcome that would leave the greatest number of objective analysts leaning the wrong way would be substantial additional weakness in the US$.

We are not stepping away from our view that the Dollar Index is close to an intermediate-term bottom. We are saying that sentiment is probably not as lopsidedly anti-US$ (that is, supportive of a US$ rebound) as many 'contrarians' believe.

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)

Gold-Ore Resources (TSXV: GOZ). Shares: 82M issued, 89M fully diluted. Recent price: C$0.50

The stock price of Gold-Ore Resources, a small-scale gold producer based in Sweden, was hit hard on Monday in reaction to the quarterly production and financial results reported after the close of trading last Friday. The magnitude of the sell-off surprised us, because we don't understand why anyone would dump such an under-valued stock in response to a single quarter's numbers. The nature of GOZ's business is that the quarter-to-quarter progress will be lumpy; and it wasn't as if great expectations had been built into the stock price prior to the news. Also, the company advised that gold production reached a monthly record during the first month of the current quarter.

In the absence of immediate and sizeable additional upside in the gold price, it is reasonable to expect that GOZ will have to spend at least 1-2 months basing in the C$0.45-C$0.60 range before commencing its next short-term upward trend. This is because there is probably now a lot of supply near former support in the low-C$0.60s that will have to be absorbed, while bargain hunting will probably create a floor in the mid-C$0.40s.

If you don't already have a full position then it would make sense to accumulate GOZ in the C$0.45-C$0.52 range.


    Andina Minerals (TSXV: ADM). Shares: 105M issued, 119M fully diluted. Recent price: C$1.81

Gold explorer ADM sold off on Tuesday in response to Monday's post-close announcement of a C$25M equity financing (12.5M shares at C$2.00/share).

We don't know why ADM's management is diluting the stock at this time given that the company already has more than enough cash in the bank to fund its activities over the next 12 months. Perhaps this just confirms what we've said before, which is that most managers of small gold mining companies seem to be embedded with a gene that prevents them from saying "no thanks" when presented with the opportunity to raise money by issuing more shares.

On the positive side of the ledger, the financing is a "bought deal" and the new shares are being issued at a 10% premium to the market price at the time the deal was done. This shows that some well-heeled investors believe that ADM is worth a lot more than C$2/share.

ADM is a good candidate for new buying near the current price.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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