<% 'pass = Request.Form("pass") IF ((Request.Form("pass") = 1) OR (Session("pass") = "pass")) THEN %> Speculative-Investor.com

    - Interim Update 9th April 2008

Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

What is the best measure of money suppy?

It is difficult to discuss a topic as dry as "money supply aggregates" in a stimulating way, so we apologise, in advance, if the following discussion proves to be less captivating than watching grass grow.

As our recent run-in with Gary North clearly demonstrated, there is considerable disagreement about how the supply of money should be measured. This is especially relevant at the moment in that some of the narrowest measures of money supply are revealing no growth in supply, or even outright contraction (deflation), while broader measures are increasing at rapid rates.

We'll start by saying that it's a lot easier to figure out which of the readily available measures of money supply NOT to use than to determine the most appropriate measure (or measures) to use. In particular, it is clear that the Monetary Base (MB) is not a good indicator of monetary conditions, for two reasons:

First, by far the biggest component of the MB is physical currency (notes and coins), but growth in the amount of physical currency appears to be in a long-term decline due to the increasing popularity of electronic methods of payment. This, we think, explains the downward trend in the red line shown on the following chart (the red line represents the year-over-year percentage growth in currency).


Second, the other significant component of the MB is bank reserves, but, as explained in previous commentaries, since 1994 banks have been able to substantially reduce the amount of reserves they hold at the Fed via the practice known as "sweeping". Thanks mostly to the advent of "sweeping", bank reserves are now much lower than they were 20 years ago even though the money supply is vastly bigger today than it was back then. In other words, there is no longer a meaningful link between money supply and bank reserves.

It is also clear that M1 is a poor indicator of monetary conditions. Like the MB, M1 has been substantially altered by "sweeping" (we estimate that M1 would be about 50% higher than its current level if not for the ability of the banking establishment to minimise reserves held at the Fed by "sweeping" money between demand deposits and savings deposits). However, this is not M1's only drawback. It also has the disadvantages of excluding demand deposits held by the US Treasury, which are certainly part of the money supply, and including traveler's checks, which are not part of the money supply.

We can therefore eliminate M1 and the Monetary Base. But what, then, should we use?

Unfortunately, we don't think the answer to that question is 'cut and dried'. Even amongst members of the "Austrian" school of economics there is dissension about what should be included in a money supply estimate. For example, Mike "Mish" Shedlock and Frank Shostak argue against including savings deposits in the money supply on the basis that these deposits are credit transactions (when you put money into a savings deposit you are lending money to the bank). Mish outlines his reasoning at http://globaleconomicanalysis.blogspot.com/2007/01/money-supply-and-recessions.html. However, the great Austrian economist Murray Rothbard argued that savings deposits SHOULD be included in the money supply. Furthermore, the True Money Supply (TMS) charted at the Mises.org web site -- the internet home of Austrian economics -- includes savings deposits.

TMS does not include Money Market Mutual Funds (MMMFs) because to do otherwise would be to double count. By way of explanation, consider the following hypothetical situation: Bill removes $10,000 from his bank and deposits the money into XYZ Money Fund (he purchases units of XYZ). XYZ then uses Bill's money to purchase $10,000 of short-term income-producing securities from Fred, who promptly deposits the proceeds of the sale into his bank account. The net effect of these transactions is that $10,000 has been transferred from Bill's bank account to Fred's bank account, with XYZ acting as an intermediary. But if we now count Bill's MMMF investment as money then the transaction will have added $10,000 to the money supply. This is why, unlike M2 and M3, TMS does not include MMMFs.

Despite the above, a case can be made that retail MMMFs should be included in the money supply. Here's why.

According to Rothbard's 1978 article on money supply, it is the SUBJECTIVE assessment of people that determines whether something should, or should not, be included in the money supply. For example, the fact that people generally believe savings deposits to be redeemable in standard money on demand, and therefore treat them as equivalent to cash, means that these deposits should be included in the money supply.
 
The argument made by Rothbard for the inclusion of savings deposits could also be made regarding retail MMMFs. Rothbard didn't specifically mention MMMFs in the above-linked article, no doubt because they barely existed at the time the article was written, but if we fully understand what he is saying then retail MMMF's should be included because almost everyone who deposits money into a MMMF has the belief that they can withdraw their money at par at any time (most people treat MMMF holdings as if they were cash deposits, even though they are, in actuality, credit transactions).

There is no question that including MMMFs in the money supply calculation results in double-counting, but if almost every individual that holds a money market deposit believes the deposit to be a cash surrogate -- always convertible on demand into cash at par -- then a reasonable argument can be made for including these deposits in the money supply.

On a related matter, Rothbard doesn't mention MMMFs in the above-linked article but he does specifically state that small time deposits SHOULD be included in the money supply (at a discount to reflect the penalty for early withdrawal). In our opinion it would be inconsistent to argue that time deposits, which are clearly credit transactions, should be included in the money supply while MMMFs should not. In fact, we think that a consistent approach to money supply estimation would include savings deposits, small time deposits AND retail MMMFs, or none of them.

As we said, the answer to the money supply question is not cut and dried. Moreover, there may not be a single right answer.

Over the years we've tended to rely most heavily on M2, which includes currency, checkable deposits, savings deposits, small time deposits and retail (non-institutional) money-market mutual funds, but omits government-owned deposits. Thanks to the Mises.org web site we also now have ready access to TMS, which includes government deposits and, rightly or wrongly, excludes all money-market funds and time deposits. Then there is MZM (Money with Zero Maturity), and, of course, M3 (the broadest monetary aggregate).

Our inclination is to pay close attention to TMS, MZM and M2. These three monetary measures will often move together, but will occasionally diverge quite markedly. For example, the following chart shows that there was a large divergence between the yearly rates of change of TMS (the blue line on the chart) and M2 during the first half of the 1990s. In this case, TMS's message appeared to be the more accurate given the strong performance of the US stock market at the time (financial assets such as equities are often initial beneficiaries of money-supply growth). During those periods when the aforementioned monetary measures diverge we will try to uncover the reason(s) and the implications for the markets we follow.


A significant divergence exists at present, with MZM expanding rapidly (around 15%/year), M2 expanding moderately (around 7%/year), and TMS expanding slowly (around 4%/year). In other words, whichever way we look at it we see that inflation is occurring, but different monetary aggregates imply very different rates of inflation.

We plan to say more about the current monetary situation in another commentary within the coming fortnight.

Commodities: the topping process continues

The daily CRB Index chart displayed below reveals an upside blow-off leading to a mid-March peak, followed by a sharp decline and then a rebound. If we are correct to view the March peak as the intermediate-term variety then the current rebound should lead to a secondary (lower) high within the next couple of weeks and then a decline to a new multi-month low.



If the CRB Index completes its topping process over the coming weeks and then takes out its late-March bottom some analysts will undoubtedly claim that the market action is related to deflation (indicating, caused by, or predicting deflation). You should ignore these people. Commodity bull markets invariably experience sharp corrections and when they happen it is not because of, or predictive of, deflation; it is simply due to the market having previously run up too far too fast. Markets routinely overshoot, and after they do it is normal for them to swing back in the opposite direction for a while regardless of the fundamentals.

The CRB's topping process is associated with the US dollar's bottoming process, so as the CRB rebounds to test its March peak the Dollar Index is dropping back to test its March bottom. The following chart shows the Dollar Index's current situation. The pullback by the Dollar Index to test its March low will likely be accompanied by a spike to new highs by the euro, but most of the dollar's competitors should make lower highs.



While on the topic of the inter-relationship between commodities and the US$ it is worth mentioning the Baltic Dry Index (BDI), a measure of ocean-going freight rates. The reason is that there is a loose relationship between freight-rate trends and commodity-price trends, and quite a tight relationship between international freight-rate trends and currency market trends. The second of these relationships has been discussed in several commentaries since last September (to quickly locate these earlier discussions, do a search of "baltic" using the TSI Search function).

The US$-BDI relationship can be described as follows: Over the past 20 years, important turning points in the BDI have usually coincided with important turning points in the currency market, with peaks in freight rates coinciding with bottoms in the Dollar Index and bottoms in freight rates coinciding with peaks in the Dollar Index.

The following chart of the BDI reveals an intermediate-term topping process (a peak last November followed by an initial sharp decline and then the obligatory rebound) and therefore supports our view that the US$ is bottoming. This, in turn, supports our view that the commodity world is in the early stages of an intermediate-term correction (a multi-month downturn within a bull market).

It is clear that the November-2007 peak in the BDI did not coincide with the ultimate low for the Dollar Index, but it did mark intermediate-term bottoms for the US$ relative to the Canadian Dollar and the British Pound.



If it turns out that we are (still) too bullish about the US dollar's short-term prospects then the biggest beneficiary will most likely be the gold sector. In our opinion, if the Dollar Index makes a SUSTAINED break to a new low then the gold price will quickly move to new highs and the price of the average gold stock, which is currently very depressed relative to the price of gold bullion, will explode upward.

The Stock Market

Current Market Situation

Below is a chart comparison we've shown many times in commentaries over the past 9 months. The comparison is between the S&P500 Index and the HYG/LQD ratio, a measure of how high-yield debt is performing relative to investment-grade debt. In effect, HYG/LQD is a proxy for the amount of stress in the credit markets, with the ratio rising as stress decreases and falling as stress increases. Note that the charts have been offset by about three weeks to show that HYG/LQD has been leading the US stock market at significant turning points.

There is almost no chance that the problems inflicting the credit markets have been solved or will be solved in the near future, so we are certainly not expecting HYG/LQD to move back to near last year's highs. However, it is clear that credit-related tensions became temporarily 'overdone' during the first quarter of this year and that these tensions have begun to abate. This has alleviated the downward pressure on the stock market.


We continue to believe that the US stock market and most other stock markets around the globe are in the early stages of multi-month rebounds. Credit-related concerns most likely peaked with the Bear Stearns fiasco in mid March, and even if the US stock market is in the midst of a cyclical decline (we think it is) a rally is needed to create more of a balance between bulls and bears. There are simply way too many bears right now.

Some analysts have opined that the "double bottom" hypothesis (the view that the January and March lows constitute a double bottom) is too popular, but if most market participants really do believe that a double bottom is in place then why do sentiment indicators continue to reveal such negativity? Even the fairly minor declines of the past two days provoked sufficient concern to push the equity put/call ratio to around 0.9.

As we noted in last week's Interim Update, the biggest near-term risk is the potential for a sustained break to new highs by the oil price.

Gold and the Dollar

Gold Stocks

As a result of the market action over the past few weeks, support at 420 for the HUI has become very important. This support is evident on the following daily chart.

The chart also shows that the HUI/gold ratio remains near the bottom of its range, which means that the HUI would probably provide good leverage to gains in the gold price IF the gold price rallied to new highs over the next few weeks. The risk is that gold is now rebounding within the context of a downward trend and that the HUI is currently forming the right shoulder of a head-and-shoulders top. If this were the case then some additional strength over the coming week or so would be followed by a sharp decline to a May-June correction low. The stage would then be set for a major multi-month advance.


The present situation is very interesting because there will very likely be a sharp move in one direction or the other over the next 6 weeks. A sharp decline in gold-related investments would mesh with our short-term views on the US stock market and the US dollar, but with oil and the euro having just moved back to their March highs there is clearly the potential for a fast move in the opposite direction.

The plan we have with respect to our own portfolio is to do a small amount of selling and/or buy some insurance in the form of GDX put options if the HUI trades up to around 480 at some point over the coming 2 weeks. We would then get rid of the insurance if the HUI continued its rally to new highs.

Silver and Silver Stocks

We've been told that there's a shortage of silver at coin dealers in North America. This is obviously not bearish, but neither is it necessarily bullish. One reason is that the current price factors in everything that's known about the supply/demand situation. In other words, if there is a shortage then the market has already done its best to discount the effects of the shortage in the current price. Another reason is that a physical shortage of a commodity such as silver will most often occur in the vicinity of a price top and will never occur in the vicinity of a price bottom. A shortage of physical silver at coin and bullion dealers would imply that the public had been buying aggressively, something it usually only does after price has already moved up substantially.

In our opinion, the only thing that anecdotal evidence of shortage tells you is that we are nowhere near a price low.

The top section of the following chart shows the performance of Pan American Silver (NASDAQ: PAAS), one of the largest primary silver producers, and the bottom section shows the PAAS/silver ratio.

PAAS/silver can be a useful leading indicator because it tends to peak and begin trending lower well in advance of peaks in the prices of either PAAS or silver bullion. It was the sharp downturn in this ratio from its early-January peak that prompted us to write, in the 27th February Interim Update, that "if the pattern of the past several years repeats then silver is within 6 weeks of an intermediate-term peak." As things turned out, silver probably reached an intermediate-term peak in mid March (three weeks later).

We used the word "probably" in the above sentence because PAAS hasn't yet confirmed an intermediate-term peak by breaking below its channel bottom. A daily close below $36 would be confirmation.


Despite the market risk, many junior silver stocks are currently at levels where they should be bought rather than sold. However, it is reasonable to expect that they will get even cheaper if larger-cap silver stocks such as PAAS breakout to the downside.

Those who feel the need to hedge their exposure to the juniors should consider buying some PAAS put options into strength over the coming week.

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)

Andina Minerals (TSXV: ADM). Shares: 64M issued, 81M fully diluted. Recent price: C$3.39

Like Keegan Resources (TSXV: KGN), ADM is an exploration-stage gold stock that has the right attributes to be a core holding. In particular, the company has its hands around a large high-quality gold deposit in a reasonable location and is making rapid progress. Also like KGN, it is currently in what we refer to as the "sweet spot" -- the time when almost all news on the exploration front will be good news. But unlike KGN, ADM's shares haven't performed well over the past few months. It was this poor performance that gave us the opportunity to introduce the stock last month at the bargain-basement price of C$3.66. The stock has since fallen to an even lower price and therefore now offers even better value.

Apart from the general lethargy in the market for exploration-stage resource stocks, the reason for the weakness in ADM's stock price is probably the downward pressure exerted by this month's expiration of about 8M low-priced warrants. We anticipated this when we wrote the following in our 12th March commentary: "Our suggestion is that investors with a 1-2 year time horizon use the current warrant-related weakness, and any additional such weakness over the next month, to average into a position in ADM."

The worst that we could envisage happening to ADM in the short-term would be a drop to support at C$2.50 (see chart below) due to the combination of a sector-wide downturn and the above-mentioned warrant-related selling. However, we certainly wouldn't rely on being able to buy the stock that cheaply. It would be a gift if it occurred, but a more likely outcome is that the stock bottoms not far from its current price.


    New Selection: Great Basin Gold warrants (TSX: GBG.WT). Recent price: C$0.72

Due to our uncertain short-term outlook for gold we almost decided not to add the GBG warrants to the TSI Stocks List. However, regardless of our overall sector view these warrants appear to be a good speculation near their current price, because:

a) Great Basin Gold (TSX: GBG, AMEX: GBN) looks attractive from both fundamental and technical perspectives. In particular, at current metal prices we can easily justify a valuation of $5/share. Also, the following chart shows that although the stock has been quite strong, it is not overbought (it has recently been consolidating above former resistance at C$3.40-3.50).

b) At Wednesday's closing prices, the warrants are slightly under-valued relative to the stock.

c) If the gold sector were to move sharply higher over the next several weeks then GBG would probably be a relative strength leader and the warrants would take-off. On the other hand, if the sector were to reverse lower in the near future and head down to a May-June correction low then the warrants would initially fare poorly, but even in this case we expect that they would ultimately yield a good return as long as GBG's management executed its business plan.

The GBG warrants have an exercise price of C$3.50 and an expiry date of 20th April 2009.


Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.decisionpoint.com/
http://www.bloomberg.com/
http://www.economagic.com/

 
Copyright 2000-2008 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>