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    - Interim Update 8th June 2011

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Financial Repression

In a recent interview at King World News Jim Rickards discusses something called "financial repression", which is the name given by economist Carmen Reinhart to the strategy of using "price inflation" (currency depreciation) to reduce the government's debt. The idea is that if all else remains the same then over a 10-year period the total debt of the government could be cut in half in real terms by reducing the purchasing power of the currency at the rate of 4% per year. Both Reinhart and Rickards point out that in going down this path the government would effectively be reducing the real size of its debt by stealing from savers and investors.

Because it entails theft, "financial repression" is a terrible and unjustifiable strategy. But even if we put aside ethical considerations and look at the situation from the Machiavellian perspective of the typical politician or central banker, it is still an ill-conceived strategy because it has no hope of achieving its objective. One reason is that savers and investors are among the main victims of the theft, which means that the strategy penalises the main drivers of real economic growth and will inevitably lead to a slower economy. Consequently, it will lead to greater dependency on government handouts, larger government deficits, and an increase in the REAL magnitude of the government's debt burden.

You don't need a solid foundation in good economic theory to see that "financial repression" won't reduce the government's indebtedness. This is because "financial repression" has been practised in the US over much of the past 50 years, with one result being a dramatic INCREASE in the size of the government's debt relative to the size of the economy. Another result has been a very long-term upward trend in the price of gold relative to the prices of non-monetary commodities. Gold's long-term upward trend relative to the average commodity stems from the collective attempt by savers and investors to protect themselves from the effects of the deliberate inflation policy.

But just because a policy goes against good economic theory and has been shown in practice to be a complete failure, doesn't mean it won't be tried in the future. In fact, it is obvious to us that what Carmen Reinhart calls "financial repression" reflects the current and likely future approach of the Bernanke-led Federal Reserve. According to the thinking that dominates Fed policy-making, relentless currency depreciation is a prerequisite for a healthy economy.

Relentless currency depreciation requires continuous growth of at least a few percent per year in the money supply, so we can be confident that the Fed will keep doing whatever it takes to keep the money supply growing. We can also be confident that this relentless inflation will curtail the US economy's progress and lead to greater, not lesser, government indebtedness.

Another explanation for why banks aren't lending

In the 30th May Weekly Update we wrote:

"The fact that banks haven't done more with their "excess reserves" up until now suggests that they are being prevented from doing so by a reduction in the private sector's desire to take on debt, or by financial constraints such as large, but as yet unreported, holes in their balance sheets."

Another factor that could be contributing to banks' reticence to make more profitable use of their "excess reserves" is the possibility that they will be forced by the Fed to substantially increase the amount of capital they hold as a percentage of their assets. This possibility is discussed in the WSJ article posted HERE.

If capital requirements were made more stringent it wouldn't necessarily curtail the investing and trading activities of banks, but it would likely make them even more risk averse than they are right now; in which case there would probably be less investing in traditional loans/leases and more investing in Treasury securities.

It is becoming increasingly clear that whether or not the private banking system turns out to be an inflationary or a deflationary force over the coming 12 months will largely depend on the volume of Treasury debt it purchases. To put it another way, it is becoming increasingly likely that the private banking system will continue to reduce its collective loan book over the coming 12 months, which means that to be a net booster of the total money supply it will have to monetise a lot of Treasury debt.

The Stock Market

Current Market Situation

The large-cap US bank stocks, as represented by the BKX, made a new low for the year on Wednesday and have been very week on both an absolute and a relative basis since February. Support at 42.5-45.0 probably defines the BKX's short-term downside risk.

Considering the amount of monetary and regulatory help provided to the banks by the Fed and the Treasury over the past 2.5 years, the relative weakness in the bank stocks is remarkable. Just imagine where these stocks would now be trading if trillions of dollars of direct and indirect support hadn't been channeled from the rest of the economy into the banking industry. Many of them wouldn't be trading at all.

We don't view the relative weakness of the banks as a major problem for the US stock market or the US economy. The real problem is that the Fed and the government won't allow the largest banks to fail, which means that when the financial difficulties of these corporations again become life-threatening they will receive another massive transfusion of wealth, with the productive sectors of the economy being involuntary donors.


Australia's All Ordinaries Index appears to have 'double-topped' in April of 2010 and April of 2011. Support at around 4200 looks like a reasonable downside target for the second half of this year, but right now the market is very 'oversold' on a short-term basis and will probably soon begin to rebound. A routine counter-trend rebound would take it back to around 4800.


The S&P500 Index has just fallen for six days in succession and is now 'oversold' on a short-term basis. If it can drop to important support at 1250 within the next fortnight then the stage will probably be set for a multi-week rebound.

Chinese Stock Frauds

Many North-America-listed Chinese companies have been accused of engaging in fraudulent practices, such as deliberately overstating revenues. This has caused their stocks to plunge in price and in some instances to be suspended from trading or de-listed. A lot of the accusations that are flying around have not yet been substantiated, but sufficient 'accounting shenanigans' have been exposed to date to cause investors to dump their shares at the first scent of something not being quite right.

The most recent example is the Toronto-listed Sino-Forest (TSX: TRE). TRE has internationally-respected people on its board and has the past decade's most successful hedge fund manager (John Paulson) as its major shareholder, but this didn't prevent its stock from being 'trashed' in reaction to a report from "Muddy Waters" claiming that the company is a massive fraud. After trading above $19 just six days ago, TRE traded as low as $3.67 on Tuesday.


"Muddy Waters" (MW), a research and stock-trading firm that takes positions in stocks ahead of publicising its research with the aim of benefiting from the market reaction to the research, has been linked to several North-America-traded Chinese companies accused of fraud. The veracity and thoroughness of MW's research is questionable, but it has garnered credibility because genuine problems have come to light in some of the companies it has targeted.

That being said, MW was not involved with one of the most extraordinary of the Chinese fraud stories. We are referring to Longtop Financial Technologies (LFT), the shares of which tanked and were then suspended from trading in response to a damning letter from the company's auditor (Deloitte). LFT was backed by major hedge funds and investment banks (including Goldman Sachs), and yet it proved to be a fraud. What makes this case so extraordinary is that the company's bank helped perpetrate the fraud by providing false information to the auditor. More details can be found in the article posted HERE.


As most of our readers know, we were directly affected by the above-mentioned Chinese fraud saga thanks to having speculated in the shares of Duoyuan Global Water (DGW). The extent to which DGW overstated the size of its business is yet to be confirmed, but the company's actions (or lack of action in response to serious allegations) over the past several weeks point to significant problems. We don't know how the DGW story will unfold from here, but we see no good reason to be optimistic.

In China, financial fraud is a crime punishable by death. However, it seems that this only applies when the cheating is done in China and the victims are local Chinese.


Gold and the Dollar


Gold and Silver

Gold still has the potential to make a final surge to a new high before commencing an intermediate-term correction, but time is running out. In our opinion, this potential would be eliminated by a daily close below $1520.

In addition to showing the weekly price performance of silver over the past 10 years, the following chart shows silver's 50-week moving average and weekly RSI. Notice that no intermediate-term correction in the silver market over the past 10 years has ended until a) the silver price has traded at or below its 50-week moving average AND b) the weekly RSI has dropped to 45 or lower.

In the current situation the 50-week moving average is rising, which means that it would be possible for silver to reach this moving average by trading sideways over the next three months. However, if silver spends the next three months trading sideways its RSI won't become as 'oversold' as it has during all prior intermediate-term corrections.

In order for both the moving average and RSI requirements to be met, the silver price will probably have to drop back to at least the high-$20s within the coming month or so.


Gold Stocks

Political Risk

As a result of Ollanta Humala's victory in Peru's presidential election, the gold sector of the stock market was weaker over the past three trading days than it otherwise would have been. The market's fear is that the left-leaning Humala will follow in the footsteps of Venezuela's Hugo Chavez, so gold and silver mining companies with important assets in Peru were aggressively marked down. Due to the fact that many gold and silver mining companies -- including gold-mining majors NEM and GFI -- have important assets in Peru, this political development had a significant adverse effect on the overall sector. However, the adverse effect didn't alter the short-term trend (which was already down) or any of our expectations (we were already anticipating a decline to new multi-month lows).

None of the current TSI stock selections have any exposure to Peru, but we aren't opposed to adding some exposure to this country if the price is right. The country risk is now higher, but we don't mind taking risk provided that we get well paid for doing so. Also, we suspect that Humala's 'bark' will turn out to be worse than his 'bite'.

Along more general lines, the political situation in Peru relates to why gold mining stocks have been under-performing gold bullion. As political risk increases, gold bullion stored safely in a vault in Zurich looks increasingly attractive relative to gold stored under the ground in countries where the government has an anti-free-market agenda.

Stock Averages versus Individual Stocks

Price indices are, by definition, averages, and the average of a group of numbers can be very different from most of the numbers in the group. For this reason it is not uncommon for the performance of a stock-price index to be very different from the performances of most of the index's component stocks. Such is the case with the gold-stock indices and their components.

For example, Goldcorp (GG), Barrick Gold (ABX) and Newmont Mining (NEM) have the largest weightings in the HUI and together account for about 40% of this index, so the average of the three stocks should approximate the HUI. However, the following charts show that these stocks have performed very differently from each other over the past 9 months, which means that the chart of at most one of these stocks will resemble the chart of the HUI.

The following charts show that: GG rocketed upward to an all-time high at the end of April-2011 and then plunged, ABX double-topped in early-December of 2010 and late-April of 2011, and NEM has been trending downward since last September. Averaging out these very different performances creates something that looks like the HUI.






Current Market Situation

Displayed below is a weekly chart of the TSX Venture Exchange Composite Index (CDNX). The CDNX is a reasonable proxy for junior resource stocks (the gamut of junior resource stocks, not just junior gold stocks).

The CDNX has been trending downward since late February. Not coincidentally, the CDNX's downward trend has coincided with a widening trend in credit spreads. We say "not coincidentally" because both trends are symptoms of a widespread shift away from risk (increasing risk aversion).

Based on the assumption that the CDNX's performance during the intermediate-term corrections of 2004 and 2006 is an appropriate model for the current correction, we conclude that:

a) The CDNX hasn't yet made its ultimate correction low

b) The CDNX's ultimate correction low will be within 10% of its current level

c) The CDNX will return to the vicinity of its early-2011 high by the first quarter of next year


The HUI broke below its May low on Wednesday, a development that shouldn't have come as a surprise to TSI readers. As is the case with the CDNX, the HUI probably hasn't yet reached its ultimate correction low but is probably within 10% of it. Given that the HUI has just declined for six days in a row and is now 'oversold', the downward trend should soon be interrupted by a multi-day rebound.

Speculators in gold stocks should have low expectations with respect to the next few months. The gold-stock indices could bottom out this month, but seasonal/cyclical influences suggest that the next intermediate-term upward trend won't commence until October-November at the earliest. Also, gold stocks will have to deal with a 10% pullback in the gold price at some point, and the general shift away from risk is likely to weigh on the shares for a while longer.

Our plan is to SLOWLY put cash to work in the gold sector as opportunities arise over the months ahead.

Currency Market Update

Our view continues to be that the Dollar Index is pulling back to 'test' its May low as part of an intermediate-term bottoming process. This view meshes with the idea that the stock market is in the process of forming an intermediate-term top.

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)

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html

 
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