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One person's spending is another person's income??

The concept that one person's spending is another person's income is both misleading and dangerous. While seeming to make sense at a superficial level, it is misleading because it creates the false impression that consumption drives the economy. It is dangerous because an entire school of economics is based on this false impression, and, unfortunately, this school now dominates monetary and fiscal policy-making.

The concept that consumption drives the economy can most easily be seen as a fallacy when money is removed from the equation. For example, without money it would be obvious that a baker spends bread. In order to consume the products of others the baker must first bake bread, and in order to increase his consumption he must first increase his production of bread.

The situation doesn't change when money is introduced. Money is just a medium that facilitates exchange. It's still the case that a baker doesn't really spend money, he spends bread. The difference is that prior to spending he first converts his bread to money, thus giving himself more spending options. (Note: In the absence of money there would have to be a very specific coincidence of wants for a trade to happen. For example, a baker who wanted his teeth fixed would have to locate a dentist who wanted a large quantity of bread).

The point is that production must precede consumption, because production funds consumption. People produce in order to consume, and a person's real income is the stuff he obtains via his production. This was known 200 years ago, but is not widely understood today thanks to the 'great leap backward' taken by the economics profession over the past 80 years.

Now, in a world where money can be conjured out of nothing by the central bank and the private banks, it is possible for an increase in the spending of money to occur without a preceding increase in production. However, this causes problems by setting up exchanges of nothing (money created out of 'thin air') for something. If such exchanges are widespread, prices will be affected in two ways. Firstly, prices will generally be higher than would otherwise be the case. Secondly and more importantly, relative prices will be altered due to the non-uniform way in which new money enters the economy. The changes to relative prices will send wrong signals about the likely future level of consumption, and a lot of investment will be based on these wrong signals. For example, if the price of the average house rises much faster than most other prices, then businesses will respond to this price signal by building a lot more houses. If this price signal is based primarily on the creation of money out of nothing, the increase in demand will prove to be temporary and all industries related to the housing sector will end up being geared to a much higher level of production than justified by sustainable demand. Sound familiar?

The bottom line is that it is more correct to say that one person's PRODUCTION is another person's income. Trying to get around this reality by creating money out of nothing or increasing government spending (government spending is funded by theft or borrowing, not production) will end up weakening the economy.

Default Fear

The Stock Market

The BKX, a proxy for US bank stocks, broke below support at 62 during the first half of this week. This downside breakout boosts the probability that an intermediate-term peak is in place for the US banking sector. It is therefore a bearish omen for the US stock market and a bullish omen for gold.

Ideally, the BKX will drop to the vicinity of its 200-day MA ($59-$60) or lower before rebounding, as its breakdown is marginal at this stage and could be negated by minor strength over the days ahead.



The Dow Industrials is the weakest of the senior US stock indices. As illustrated by the following daily chart, it has just dropped back to its August low and is not far above its June and April lows.

The Dow is very close to confirming a top of at least intermediate-term significance. However, it is also 'oversold' on a short-term momentum basis and right at support defined by its 200-day MA and its August low, making it likely that a rebound will soon get underway even if a cyclical bear market is in its infancy.



We doubt that the recent weakness in the Dow Industrials and some other US stock indices is primarily due to the US government's in-fighting. With or without this in-fighting, there are a lot of reasons to be concerned about downside risk in the US stock market. For example, valuations are high, profit margins look set to contract, earnings growth is almost non-existent, and -- aside from a few minor worries stemming from the "government shutdown" and "debt ceiling" negotiations -- sentiment is generally complacent.

On the bullish side of the ledger there is the Fed's relentless money-pumping. That's pretty much it.

Here's a scenario that appeals to us: A stock market rally soon commences on the back of political deals that ensure full government funding for at least a few more months. This rally takes some stock indices to new highs for the year, but the Dow doesn't come close to its September high before running out of steam. Some indices, including the Dow, then fall to new multi-month lows, leading to general fear that the future might not be as bullish as previously envisaged.

Gold and the Dollar

Gold

The New Fed Chair

President Obama has nominated Janet Yellen, the current vice chair of the Fed, to take over from Ben Bernanke as Fed head next January. Yellen's nomination will almost certainly be confirmed by the Senate.

Based on her public statements and Federal Reserve voting record, Yellen appears to be even more clueless about economics and is likely to be even more reckless on the monetary front than her predecessor. In particular, she appears to strongly believe that a) the Fed can bring about a sustainable increase in employment by creating money out of nothing, and b) it's best for the economy if money loses purchasing power at the rate of at least 2%/year. Yellen's appointment to the Fed's top job is therefore bearish for the US economy and bullish for gold.

On a related matter, the Fed is essentially a dictatorship. Monetary policy is voted on and some dissent is tolerated, but the chairman is never out-voted/over-ruled. The beliefs of the Fed chairman are therefore critical, although in our opinion the times determine the Fed chairman. It is par for the course that at a time when Keynesian claptrap is popular, a deep believer in Keynesian claptrap has risen to the top of the dung-pile.

Current Market Situation

In US$ terms, gold is around the same price now as it was on 13th September. It has therefore spent almost four weeks going nowhere, although the price chart (see below) suggests that the short-term bias is to the downside. As previously advised, a daily close above $1376 would confirm an upward trend reversal. A daily close above the 50-day MA (currently at $1345) would be an early warning that the short-term trend was reversing from down to up.

In the absence of the aforementioned evidence of a trend reversal it will make sense to anticipate moderate additional weakness and a traditional October-November turning point.



Gold Stocks

On Wednesday 9th October the HUI traded below its early-August low and to within a few points of its late-June low. The price action therefore continues to set the stage for a traditional October-November reversal. Considering the extent to which the market is 'oversold', our guess is that the reversal will happen before the end of this month.



GDXJ, a proxy for junior gold-mining stocks, will usually rise by more than GDX (a proxy for large and mid-size gold miners) during sector-wide rallies and fall by more than GDX during sector-wide declines. That explains why the GDXJ/GDX ratio has been falling since late August. However, over the past few days GDXJ has been materially weaker than would normally be expected, causing the GDXJ/GDX ratio to drop like a rock. Refer to the bottom half of the following chart for details.



For those who are wondering, the sudden downward acceleration in GDXJ relative to GDX was due to the performance of a single stock. We are referring to LionGold Corp., a company that trades on the Singapore stock exchange under the symbol A78 (see chart below). Over the three trading days from Friday of last week through to Tuesday of this week, LionGold went from $1.50/share to $0.18/share. The sudden near-90% decline in LionGold's stock price had a significant effect on GDXJ because at 30th September this stock was 5.2% of the ETF's portfolio. In fact, it was GDXJ's largest holding.

As far as we can tell, LionGold's price collapse was mostly due to the bursting of a speculative bubble in Singapore-traded small-cap stocks rather than company-specific developments.



This goes to show that traders who buy equity ETFs are not totally immune to individual stock risk, but those who had some indirect exposure to LionGold via GDXJ obviously fared much better than those who owned LionGold directly.

We like GDXJ as a short-term trading vehicle, but, despite the additional risk and volatility, for long-term trades we prefer individual junior gold-mining stocks.

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

Pretium Resources (TSX and NYSE: PVG). Shares: 105M issued, 114M fully diluted. Recent price: US$4.70

PVG issued a press release prior to the start of trading on Wednesday 9th October. We would normally cover this news in the Weekly Update on Sunday 13th October, but due to the dramatic stock market reaction to the news (the stock price fell 30%) we will deal with it now.

Prior to this week there were two independent consultants, also known as Qualified Persons (QPs), working on PVG's Bulk Sample Program (BSP). Snowden Mining was responsible for the review and sign-off of the milling and processing component of the program. Strathcona Mineral Services was responsible for overseeing and reporting on the overall program. Note that in addition to milling and processing a 10,000-tonne bulk sample in Montana, the overall program involves on-site sampling and underground drilling.

The news that shocked the market was that Strathcona had resigned from the project. There was no information in PVG's press release to explain the resignation, but PVG's management subsequently advised that it was due to a disagreement between the two consultants. According to the Mineweb article linked HERE, "Snowden, which produced Pretium's latest resource estimate on the Valley of the Kings, wants results from the whole bulk sample to be used as validation, Ovsenek [PVG's Chief Development Officer] said, whereas Strathcona prefers a series of smaller, representative "tower" samples."

What we understand is that there are no indications at this stage of any problems with the resource. The underground drilling results* have been consistent with the resource model and the first results of the sampling of the bulk material are not yet in. What we don't understand is exactly why Strathcona resigned. It doesn't make sense to us that the method of validating the resource was not fully defined prior to the start of the BSP and that a disagreement over methodology could not be sorted out. It also doesn't make sense to us that Strathcona would insist on using representative samples of the extracted material when all of the material was being analysed. After all, the main point of sending 10,000 tonnes of material hundreds of miles to a special-purpose mill is to confirm that the total amount of gold produced matches the assumptions used in the resource model and Feasibility Study.

PVG expects the milling of the 10,000-tonne bulk sample to yield about 4,000 ounces of gold. Taking into account a recovery rate of 90%, this is the amount of gold that should be produced if the average grade of the resource is around 13.6 g/t, which is the reserve grade assumed in the FS. If the bulk sample actually does yield 4,000 ounces it would be clear-cut evidence that the resource model is correct.

As per the current schedule, the total amount of gold extracted from the bulk sample will be known and reported by year-end.

PVG's stock price is now a lot lower than it was and at a fundamental level nothing appears to have changed, so a good argument can be made that new buying would be appropriate. However, we generally avoid buying in the immediate aftermath of a sharp sell-off prompted by unexpected company-specific bad news, especially when -- as is the case with PVG right now -- we aren't sure that we have the full story. Even when the market dramatically over-reacts to bad news, as it has probably just done with PVG, it will usually take at least a few weeks for a new upward trend to begin.

    *As we were putting today's Interim Update to bed, PVG issued a press release reporting more bonanza-grade intercepts from underground drilling associated with the BSP and from exploration drilling.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html