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    - Interim Update 8th December 2010

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The difference between money and debt

In today's monetary system, money and debt are closely related and it is not always easy to tell the difference between the two. For example, money is usually borrowed into existence (new money is created when a bank makes a loan) and some debt securities are so liquid it seems that they are, for all intents and purposes, money. Consequently, some analysts no longer distinguish between money and debt. Unfortunately, this leads to analytical errors.

Before we briefly address two of these errors, let's define our terms. Although today's monetary system blurs the distinction between money and debt, debt is not money (and vice versa). Money is the general medium of exchange, whereas monetary debt is a promise to pay money. This means that money can generally be used to buy things, whereas debt cannot. For example, a 3-month Treasury bill is the most liquid form of debt in the US economy today, but you cannot take a T-bill to the supermarket and use it to buy groceries. This is because a T-bill isn't money. If you want to buy something and all you have is a T-bill, you will first have to sell the T-bill for "money" in order to make your purchase. But what if you hold T-bills indirectly via a money-market fund (MMF) that you can write checks on? If you pay for your groceries by writing a check on your MMF, aren't you using T-bills as if they were money? The answer is no. In this case there is an intermediary (the MMF) that sells the T-bill in order to obtain the money needed to make your purchase. This, by the way, is why MMFs shouldn't be counted in the money supply. MMF accounts don't hold money; they hold highly liquid investments that are sold -- in order to obtain money -- when MMF units are redeemed.

An important ramification of the aforementioned difference between money and debt is that a change in the supply of debt cannot bring about a sustained (meaning: long-term) change in the purchasing power of money unless the change in debt causes a change in the money supply. This doesn't mean that an overall assessment of the financial/economic landscape should ignore changes in debt levels. Clearly, large changes in debt levels will often have important economic effects. What it means is that when assessing whether an economy is experiencing inflation or deflation, we need only consider changes in the money supply.

Having defined our terms, we'll return to the errors stemming from a failure to distinguish between money and debt.

The first error involves interpreting the Fed's purchases of government debt under its QE program as non-inflationary on the basis that it effectively amounts to an exchange of existing money (T-bills, T-notes) for new money (dollars). The reality is that when the Fed uses new money to purchase anything, it either adds to the economy's total money supply or adds to bank reserves. To be more specific, if the Fed uses newly-created money to buy treasury debt directly from the government or from a non-bank entity, the US money supply will immediately be boosted by the dollar value of the transaction. Alternatively, if the Fed buys treasury debt from a bank and the bank keeps the proceeds of the sale in reserve then the money supply won't immediately be affected, but the stage will be set for higher monetary inflation in the future (the additional bank reserves WILL support future money-supply growth). Actually, depending on the mechanics of the process, the latter of the aforementioned scenarios could also result in an immediate boost to the money supply. Consider, for example, the case of a bank using part of its reserves to purchase debt securities from the US government and then selling these securities to the Fed. In this case, money gets transferred from the bank's reserves to the economy via government spending (because the government spends all the money it borrows) and the Fed then replaces the bank's reserves.

In other words, the Fed's QE program either immediately results in monetary inflation or paves the way for future monetary inflation. It is not inflation-neutral by any stretch of the imagination.

The second error involves thinking that a decline in debt can offset, or completely negate, a rise in money supply. Corollaries to this fallacious line of thought are that monetary inflation can be successfully used to counteract the perceived negative effects of an economy-wide reduction in the quantity of debt, and that monetary inflation doesn't matter as long as the quantity of debt is contracting at least as fast as the quantity of money is rising. The fact is that regardless of whether or not the economy-wide quantity of debt happens to be rising or falling, creating money out of nothing will a) promote unproductive investment by distorting relative prices, and b) lead to a reduction in the purchasing power of money. A debt contraction can temporarily mask the bad effects of monetary inflation, but these effects will eventually come out into the open.

Consequently, attempting to offset what is sometimes referred to as "debt deflation" via monetary inflation will only make matters worse.

Can charts be likened to maps?

If charts can be likened to maps, then they are maps that only show you where you have been. In a situation where it isn't possible to go backwards, what use is a map that only shows you how you got to where you are and tells you nothing about where you are going?

Despite what some commentators claim, the price charts used by speculators and analysts are not really akin to maps. They don't indicate what lies ahead or the path to take. They are, purely and simply, a way of displaying historical data. History contains clues about what we can expect to happen in the future, and, therefore, so do charts, but the clues are almost always vague and never amount to anything that could reasonably be construed as a map.

We rely mostly on fundamental analysis in our own speculating, but we use charts to help with timing and the determining of buy/sell levels.

The Stock Market

The US stock market, as represented by the S&P500 Index, made a marginal new high for the year during the first half of this week. At the same time, the Hong Kong stock market, as represented by the Hang Seng Index (HSI), remained well below its early-November peak. The HSI tends to lead at important turning points, so in the HSI's recent relative weakness we could be witnessing the birth of a meaningful bearish divergence. However, it's early days and divergences such as this sometimes develop for months before the lagging market (the US stock market, in this case) reverses course.

Of more immediate significance, the following chart shows that the HYG/TLT ratio made a new 6-month high on Wednesday. A rise in HYG/TLT indicates a contraction in credit spreads, which is generally bullish for risk assets such as equities.

HYG/TLT's new multi-month high suggests that the US stock market's rally is not yet complete. In other words, any pullback from the current level will probably be followed by a rise to a new 52-week high.


Gold and the Dollar

Gold and Silver

The silver/gold ratio remains our primary short-term indicator of the health of the precious metals upward trend. The ratio became extremely extended to the upside in early November, but it has continued to rise and won't signal a problem until it either makes a clear-cut downward reversal or fails to confirm new highs in gold and silver prices.

Silver fell by more than gold on Tuesday, but the resultant drop in the ratio wasn't large enough to signal a trend change, and there was no follow-through to the downside on Wednesday (gold and silver both declined on Wednesday, but the ratio didn't). At this stage, then, the most reasonable expectation is that gold and silver are experiencing routine short-term pullbacks that will be followed by moves to new 52-week highs.


A secondary indicator worth keeping a close eye on right now is the BKX/SPX ratio (the Bank Index divided by the S&P500 Index). Weakness in the banking sector relative to the broad stock market, as indicated by a downward trend in the BKX/SPX ratio, is bullish for gold, which means that the BKX/SPX ratio has been a positive influence on the gold market over the past 5 months. This positive influence could be about to disappear, though, because BKX/SPX recently began to rise and is now testing the top of its downward-sloping channel.


Gold Stocks

In the latest Weekly Update we mentioned that the HUI had just risen for 5 days in a row and that if it rose again on Monday it would stand a good chance of consolidating over the remainder of the week. It did rise again on Monday, extending the unbroken sequence of up-days to 6. It then spiked higher at the start of trading on Tuesday, before reversing course and commencing a consolidation/correction.

Note that when the HUI reversed downward and moved into negative territory on Tuesday morning, both gold and silver bullion were still well into positive territory on the day. Following the extended sequence of up-days, this bearish divergence was a very clear signal that a downward correction had begun or was about to begin.

In the Weekly Update we said that a near-term pullback shouldn't do much more than take the HUI down to around 560. The HUI dropped to around 560 on Wednesday, so does this mean that the correction is already complete?

Our guess is that the correction is close to being complete in terms of price, but that the gold sector might have to spend at least a few more days in 'consolidation mode' before a rally to new highs gets started.


It is unlikely that the gold sector has just made a peak of the intermediate-term variety, because there were no meaningful divergences when the HUI reached its daily closing high on Monday. However, it isn't completely out of the question that an intermediate-term top has just been put in place. If it has then there will be significant additional downside over the next 1-2 weeks, most likely followed by a multi-week rebound to a lower peak.

Whatever the current situation, it's important to understand that when an intermediate-term peak is put in place, nobody will know it for certain in real time. Some people will get lucky and guess correctly, but a good speculating approach doesn't rely on getting lucky. If you methodically build up positions during periods of weakness and scale out into strength, you aren't relying on being able to predict turning points. You aren't even relying on being able to identify them in real time.

Currency Market Update

John Mauldin's latest "Outside the Box" letter includes a short essay by Dylan Grice that's definitely worth reading. Grice explains that policy-makers generally go through three stages of denial during a financial crisis. In the first stage they deny that there is a problem. In the second stage they admit that there is a problem, but deny that it's a big problem (they claim that the situation is "contained"). In the third stage, after it becomes blatantly obvious to every man and his dog that there is a big problem, they deny that the problem has anything to do with them. With regard to the government debt crisis currently bubbling away in Europe, the leaders of the European Union are mostly in the second stage of denial. This is a sign that the crisis is a long way from being over.

The euro zone debt crisis is very likely going to worsen from here and could well be the catalyst for a large decline in the euro over the coming 6-12 months, but we suspect that the euro will rebound to a higher level before resuming its intermediate-term downward trend. 1.37 looks like a reasonable target for a rebound, because lateral resistance and the 50-day moving average coincide at this level.


Of the major currencies, from a short-term perspective the Canadian Dollar's chart pattern looks the most bullish. The chart suggests to us that the C$ has been consolidating over the past 8 months and is almost ready to resume its advance. A solid break above 100 would point to a test of the 2007 major peak.


The next chart shows the Baltic Dry Index (BDI), an index of ocean-going freight rates. We occasionally include a chart of the BDI in the currency section of these reports because important BDI turning points tend to coincide with important currency-market turning points (BDI highs tend to coincide with US$ lows and BDI lows with US$ highs).

As an indicator, the BDI hasn't been useful to us this year because it hasn't trended consistently in either direction. However, we are continuing to track it.

It would be consistent with our overall 6-12 month outlook if the BDI's next consistent trend were to the downside.


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)

Clifton Star Resources (TSXV: CFO). Shares: 33M issued, 39M fully diluted. Recent price: C$4.92

CFO issued two press releases on Monday 6th December. One of these press releases reported some good drilling results and was therefore significant, but the other one was more significant. The other press release advised that Osisko (TSX: OSK), CFO's JV partner, was planning to do 130,000m of drilling and some metallurgical testing on the Duparquet project (the subject of the OSK-CFO JV) in 2011 at a cost of $16.6M.

We can now be sure that OSK plans to proceed with the Duparquet JV, which is important because OSK probably wouldn't be making such plans -- and preparing to spend aggressively in order to earn its 50% share -- unless it perceived strong potential for the project to hold at least 10M ounces of gold and eventually be developed into a profitable mine.

Although it is a gold stock, CFO tends to trade independently of the gold sector. For example, it doubled during the three months following the HUI's December-2009 intermediate-term peak (that is, it doubled while the gold-stock indices were in correction mode) and has pretty much 'sat out' the rally of the past few months. In other words, it shouldn't be bought or sold based on a short-term outlook for the gold-stock indices.

We suspect that CFO will do well over the next 6 months, almost regardless of what happens to the HUI.


    Crocodile Gold (TSX: CRK). Shares: 228M issued, 260M fully diluted. Recent price: C$1.59

CRK has been a laggard over the past couple of months, almost certainly because of the equity financing that was announced on 2nd November. This financing is now complete and there is evidence in the recent price action that demand for the stock is beginning to overwhelm supply.

The stock is challenging resistance at C$1.60. A solid break above this resistance would create a short-term chart-based target of C$2.00-$2.20.


Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html

 
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