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    - Interim Update 8th April 2009

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No Weekly Update this coming Sunday

We will be traveling over the Easter weekend and the following week. As a result we won't be publishing our usual report on Sunday 12th April. If things go according to plan we will, however, be able to publish the Interim Update at around the normal time on Thursday 16th April.

Replacing private debt with public debt

Total private debt in the US is around $50T (50 trillion dollars). To date, in its attempts to 'fight' the emerging economic depression, the US government and the Federal Reserve have spent, lent or committed $US12.8T (as reported by Bloomberg). Almost all of the new spending and lending has occurred or been committed over the past seven months, which means that the government-Fed tag team has been increasing its monetary obligations at the annualised rate of around $20T. If this rate continues then by the end of 2010 the government's 'depression-fighting' monetary commitment will amount to almost 100% of the current total private-sector debt burden. And yet, some people continue to claim that the government's attempts to inflate will be overwhelmed by the contraction in private sector debt. To these people we respectfully say: wake up!

Analysing Inflation/Deflation

Economics is all about human action and must therefore be treated as a logical science, not an empirical one. To put it another way, in the realm of economics you generally can't, or at least you shouldn't, use data to develop a theory. Instead, to have a good chance of understanding real-world economic outcomes you must BEGIN with a sound theory. Otherwise you will likely confuse cause and effect, perceive cause-effect relationships that don't exist, or wrongly interpret the data in some other way.

The above is as true with regard to inflation/deflation as it is with any other macro-economic issue. In particular, because inflation (money-supply growth) affects the prices of different things in different ways at different times, and because the effects of inflation go well beyond price increases, you can't possibly understand inflationary effects by simply monitoring the price performance of any one thing or any group of things.

Here's an example of what we mean: It is widely believed that a rising T-Bond price (a falling T-Bond yield) signals a falling inflation threat. But what if the Fed decided to buy T-Bonds with newly-created money in a deliberate attempt to reduce the T-Bond yield? In this case the bond market would be the main initial beneficiary of the monetary inflation and a rising T-Bond price (a falling T-Bond yield) would be a symptom of a RISING inflation threat.

The above example is obviously not hypothetical given that the Fed has promised to create new money to buy T-Bonds and the initial market reaction to this heightened inflation threat encompassed LOWER bond yields.

By logical deduction we know that there are conditions under which the relationship between bond yields and inflation will be the opposite of what is commonly believed. We also know that a central bank policy that involves creating new money to suppress interest rates will eventually become counter-productive because the new money that initially BOOSTS the demand for bonds will eventually work its way through the economy and create effects that REDUCE the demand for bonds.

Greenspan's Mistake

Former Fed Chief Alan Greenspan has stridently argued that his decision to lower the Fed Funds Rate (FFR) from 6.5% to 1.0% during 2001-2003 was NOT the cause of the housing bubble.

In our opinion it is overly simplistic to argue that the Fed's interest rate manipulations during the early years of this decade caused the housing bubble, meaning that Greenspan is at least partly right to argue that there were other powerful forces at work. Rather than pointing the finger of blame at any single Fed action, we think it is more appropriate to view the Fed as the 'great enabler' of the range of monetary excesses that led to the bubble and the subsequent bust.

Having said that, we strongly believe that the Fed erred badly when setting its interest rate target during the first half of this decade. Specifically, it is clear to us that the Fed held its official target rate too low for too long during much of 2001-2005. To support our claim we present, below, a chart comparing the FFR target with something called the Future Inflation Gauge (FIG). The Future Inflation Gauge is calculated by the Economic Cycle Research Institute (ECRI) and is an attempt to quantify that future EFFECTS of inflation.

Our chart begins in 1994, but note that the FFR had been trending up and down with the FIG from the time Greenspan took the helm of the Fed in 1987. Towards the end of 2001, however, the two began to head in opposite directions. The chart's message is that the Fed continued to lower the FFR during 2002-2003 even though the inflation threat was growing, and then held the FFR at an unreasonably low level throughout 2004 and the first half of 2005.



The FIG-FFR comparison suggests that the Fed should have ended its rate cutting in October of 2001, when the FFR was 2.5%, and should have begun to hike rates during the first half of 2002. However, there is a far bigger issue here. The Greenspan Fed may well have erred in a major way when determining its interest rate target during the first half of this decade, but the more important point is that it will never be possible for the Fed or any other agency to determine the correct interest rate. This is because the correct interest rate is the one that would be set by the market in the absence of the Fed. We've always thought it strange that people who clearly understand why it would make no sense for a government agency to set the price of eggs (or any other good/service) fool themselves into believing that a government agency should have the power to set the price of credit.

Alan Greenspan has a unique opportunity right now, which, unfortunately, he will almost certainly let pass. Regardless of how aggressively he argues to the contrary, he will go down in history as the Fed chairman who blundered so badly that he set the scene for the second Great Depression. There is nothing he can do about that now. What he can do is to not only admit the mistakes that were made under his stewardship, but to explain that, regardless of how many resources are brought to bear and the intelligence of the people involved, such mistakes will inevitably occur when you give a person or a group of people the power to override the market. If he did that he would make up for decades of wrongheadedness.

The Stock Market

Current Market Situation

The following daily chart makes the point that the S&P500 Index (SPX) has important resistance at 850. It is now consolidating after testing this resistance late last week.


Our view is that the stock market is immersed in a counter-trend rally that will, at a minimum, take the SPX up to the vicinity of its 200-day moving average.

Japan

Here's an interesting quote from an interview with money manager Jean-Marie Eveillard:

"Japan is on the opposite side of the world, both literally and figuratively.  It is an island in more ways than one.  From a top-down perspective, Japan is in much better shape than the US and Germany.  Its companies have massively over-capitalized balance sheets.  The value of the Nikkei index is at the same level as it was in 1984.  Japan has experienced 20 years of a bear market and 25 years of no returns.

Approximately 22% of Japanese companies trade for less than net-net working capital (NNWC).  [Ed. Note: NNWC is current assets - current liabilities - long-term debt]   Between 10% and 15% of companies trade for less than net cash value, and between 75% and 80% of non-financial companies trade for less than their book value.  These companies have high quality assets -- cash, receivables, and depreciated fixed assets. 

The Japanese market is priced at Great Depression levels, but there are many high quality companies."

We turned long-term bullish on the Japanese stock market during the second quarter of 2003, which looked like a smart decision for a while but doesn't look so smart now. Our reasoning was that equity valuations were low in Japan and that 13 years was a normal duration for a secular bear market (the Nikkei's secular bear market began at the end of 1989).

Japanese equity valuations are now even lower (at "Great Depression levels", according to Mr. Eveillard), so even though the intermediate-term outlook for Japan's economy is dismal this appears to be a good time for investors to build up some exposure to the Japanese stock market.

The biggest risk in Japan is the government. Japan's economy would have moved onto a sustainable growth path long ago if not for the many attempts to stimulate it via increased government spending. Unfortunately, in Japan and throughout much of the world bad economic theory ("Keynesianism") continues to prompt bad economic policy, which, in turn, undermines the economy's attempts to heal itself.

Gold and the Dollar

Gold

April gold futures broke below support at $890 on Monday. This breakdown creates a measured objective of around $800, but another possibility is that the gold price is consolidating within a channel (as indicated on the following daily chart) and will bottom-out in the mid-$800s.

At the moment, movements in the US dollar's foreign exchange value seem to be almost irrelevant to the gold market. A lot of gold buying was prompted over the past few months by fears about what was happening to the financial system and what governments/central-banks were doing to their currencies and economies. The result was a sharp rise in the gold price from $700 to $1000 at the same time as the price of just about every other asset was falling. These fears were rational and will almost certainly re-emerge later this year, but they are temporarily abating in response to the global stock market rebound.


Gold's decline from its February peak is good news for anyone who doesn't have a full position. For those wanting to increase their bullion exposure our suggestion is to begin buying in the $850s.

Regardless of what vehicle you choose to obtain your gold (or silver) bullion exposure, make sure that the price you pay is close to (within a few percent of) the spot price. In other words, never pay large premiums to the spot price. For example, do not consider buying the Central Fund of Canada (CEF) or Central Gold Trust (GTU) unless their premiums to net asset value are 5% or less. At the close of trading on Wednesday these two funds were trading at premiums of 11.8% and 28.5%, respectively.

Gold Stocks

The AMEX Gold BUGS Index (HUI) moved sharply higher between late October and mid December of last year, but has since been drifting back and forth within a slightly upward-tilted channel. This is a rarely seen chart pattern. Usually, a consolidation within an upward trend will be either downward sloping or flat.

The HUI's chart pattern could be interpreted in a bullish way in that the sequence of rising lows and rising highs suggests that new buying is coming in at progressively higher levels, as is profit taking. This is our interpretation.


If the pattern of the past four months continues then the HUI will drop to the low-270s within the coming two weeks and then commence its next multi-week advance. Of course, the pattern will not continue indefinitely -- the HUI will eventually break out of its multi-month channel in one direction or the other. Our expectation is that the eventual breakout will be to the upside.

A daily close above 305 within the next few days would be a sign that something more bullish than a near-term drop to the channel bottom is on the cards, whereas a daily close below 260 at any time would indicate that a multi-month high was put in place at the beginning of April.

Currency Market Update

A daily chart of June euro futures is displayed below.

The euro dropped below its 18-day moving average (the green line on the following chart) earlier this week, which is a short-term negative for this currency. However, the short-term outlook for both the euro and the Dollar Index can best be described as muddy. As far as the next few weeks are concerned, the one thing that makes us favour a modest amount of strength in the euro (and a modest amount of weakness in the US$) is the fact that since July of last year there has been an inverse correlation between the stock market and the Dollar Index. We are anticipating some additional strength in the stock market, so if the currency-equity relationship of the past 9 months persists then this should go with some weakness in the US$.


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)

Continental Airlines (NYSE: CAL). Recent price: US$11.70

During the second week of March, with CAL trading near its recent low, we wrote: "...once this stock bottoms the ensuing up-move tends to be explosive. In addition to 2008, this was the case following intermediate-term bottoms in 2002, 2003 and 2005. CAL is an interesting speculation at this time, but only for those who can handle high volatility."

At this stage CAL is following a similar path to the previous 'V bottoms' of the past 7 years. The current and the previous four 'V bottoms' are identified on the chart displayed herewith.


CAL tends to make impressive V-bottoms because concerns periodically arise that the company is headed for bankruptcy, prompting a vicious sell-off that takes the stock's market capitalisation down to a small fraction of its annual revenue. These fears then dissipate, prompting a powerful rebound. In one way this makes CAL a terrific trading stock, but it also makes risk management difficult and can result in small timing errors being costly.

If CAL continues to follow a similar path to its previous four V-bottoms then it will move back to $20-$25 within the next three months. However, there is no guarantee that it will continue to follow this path. Therefore, buyers of CAL near the recent low should, we think, make at least a partial exit if the stock rises to $13-$14 over the coming fortnight.

    Resolute Mining (ASX: RSG). Shares: 407M issued, 486M fully diluted. Recent price: A$0.71

In the 30th March Weekly Update we said that new buying of Australia-based gold producer RSG would be appropriate following a pullback to A$0.70-A$0.75. The stock has dropped into our 'buy zone'. In fact, it traded as low as A$0.66 in Australian trading earlier today.

RSG is suitable for new buying in the low-A$0.70s (or lower) and would be a partial sell at around A$1.00.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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