Pushing on a String?

The "pushing on a string" analogy, when applied to monetary policy, refers to the inability of the central bank to stimulate the expansion of credit if borrowers are unwilling/unable to borrow and/or lenders are unwilling/unable to lend. Under certain conditions it doesn't matter how much the central bank cuts official interest rates, the money supply doesn't expand. 

It is obvious that the US Fed is not "pushing on a string", at least not yet. Every significant drop in long-term US interest rates has precipitated another mortgage financing/re-financing binge, causing the money supply to mushroom. Furthermore, the Fed has clearly demonstrated its ability to add liquidity at its whim to meet each new crisis (invariably, a crisis that they helped create). Eventually, prices will react to these monetary injections. The question is when, not if, prices will move higher to account for the increased supply of dollars.

The US Stock Market

Current Market Situation

A pullback in the US stock market did not get very far before stocks once again reversed higher. We think the reason for this is that the level of fear remains high and traders have been very quick to adopt a bearish posture or reinforce an existing bearish posture. This is evidenced by the high put/call ratios in the days leading up to Wednesday's rally (the overall put/call ratio was 0.97 on Tuesday and 0.96 last Friday). Everyone 'knows' that the market is going to drop to test the Sep-21 low and many are trying to position themselves accordingly. However, the market seldom does what everyone knows is going to happen. In this case, even if a test of the previous lows is still in the cards the market must first convince a lot of participants that it is not.

Wednesday's bounce did not achieve very much from a technical standpoint. The S&P500 Index (see chart below) and the NASDAQ Composite Index closed right at the lows reached last March/April (those prior lows now act as resistance) and the December S&P500 Futures were not able to move above the intra-day peak made on October-04. If the market can move decisively above yesterday's closing levels then the likely short-term targets would be the 50-day moving-averages at around 1120 for the S&P500 and 1770 for the NASDAQ. We would be very surprised if the 50-DMAs were exceeded during the current rebound.

The commencement of US military retaliation has had no discernible effect on any of the markets. This is not surprising since it was well known that the retaliation was about to commence and the air attacks to date have achieved no more or no less than most people would have expected. The market environment does, however, remain unusually news-sensitive. An unexpected military success or failure or another terrorist act on US soil would result in a sharp move in the stock market, although we doubt that such news would disrupt the market's trajectory beyond the very short-term. The expected trajectory is a rebound that fails after first giving a large boost to bullish sentiment, a drop to test the Sep-21 low that completely rebuilds the wall of worry, and then a sustainable rally. 

Gold and the Dollar

Mortgaging the Future

Following is an extract from the Interim Update of October-25 last year:

"Hedging has been popular in the gold industry for many years, but nowhere has it been more popular than in Australia. Virtually every Australian gold producer is hedged to some extent, and many producers have already committed more than 50% of their total reserves via forward sales and call options. Therefore, investors in Australian gold stocks have some cause for concern. After all, it is one thing to be losing money on your gold stock investments when the gold price is falling, but it would be much more painful to see your gold stocks decline during a gold price rally. 

Having reviewed the reports of some of Australia's largest 'hedgers' and having spoken to gold stock analysts on the same subject, we doubt that any of the major Australian producers are potential 'Ashantis'. Newcrest is one of the most aggressive hedgers with commitments totaling around 7.0M oz, or about 61% of its reserves (23% of resources). It is not subject to margin calls and the average exercise price on its commitments is well above the current spot price. The exercise prices are, of course, based on assumptions regarding lease rates and would be reduced if gold lease rates moved higher. The problem we see with Newcrest (and several other companies) is not that it will 'blow-up' if the gold price rises sharply (it won't), but simply that the hedging programme has severely limited any upside from a gold price rise. For example, in the case of Newcrest, virtually all production for the next 3-4 years is already committed. Another problem we have with Newcrest is that it continues to hedge and has increased its total commitments by around 800,000 oz over the past 12 months (note: since it delivered almost 1.0M oz of gold into existing hedge contracts over the past year it must have entered into 1.8M oz of new contracts in order to have achieved the net increase). Note that we are only considering commitments, not the total hedge position. Put options are not considered because they provide downside price protection without limiting the upside (the company has the choice of either delivering into the option contract or letting the contract expire)."

Two weeks ago UBS Warburg downgraded their earnings expectations for Newcrest Mining (ASX: NCM). Despite (actually, because of) a substantial increase in the A$ gold price, the actual average sale price achieved by NCM is now likely to fall as a result of the way its hedge book is structured. NCM has some great mining assets, but it is now in the ridiculous position of seeing its profits fall as the A$ gold price rises. Why would any gold stock investor be interested in owning shares in this company? Judging by the performance of the stock price, not many are. 

Below are 12-month charts of NCM and Lihir Gold (LHG). This is an interesting contrast since, of all the medium and large Australian gold producers, LHG provides the greatest leverage to the spot gold price. This leverage was the main reason we added it to the Portfolio in March of this year. 

One thing we've never really been able to figure out is why they do it - why do some gold company managements all but eliminate their companies' exposure to the spot gold price? After all, the stock prices of the heavily-hedged companies fare just as poorly as the stock prices of the lightly-hedged companies when the gold price is trending lower, then dramatically under-perform when the gold price rises. It is blatantly obvious that the shareholders of a gold mining company are severely disadvantaged if that company commits a substantial portion of its future production at a fixed price. Buyer beware!

Current Market Situation

In the October-01 WMU we warned that the current phase in gold's bull market appeared to be nearing its end and recommended against doing any further buying of gold stocks. Then, in Market Alert #54 e-mailed to subscribers after the close of trading on Tuesday, we said that we planned to immediately sell our short-term trading positions in gold stocks (while retaining our core investment position). In the e-mail we noted the break of the short-term up-trend as illustrated on the below chart.

We placed greater emphasis on gold's recent short-term technical failure than we might normally do, for a number of reasons. Firstly, the Commercial net-short position and the corresponding speculative net-long position in COMEX gold futures had become substantial. This would not have been a problem in itself since the speculators tend to be on the right side of the market most of the time, but it meant that a rally failure would probably be met with a rush of long-covering by speculators. Secondly, as strong as the gold price appeared to be over the past few weeks the rally (basis the December gold contract) had not exceeded the intra-day peak reached back in May. This was a subtle sign of weakness. Thirdly, bullish sentiment amongst traders in the gold market had reached a level normally associated with a short-term peak. This was not only evidenced by the build-up of speculative long positions and the results of sentiment surveys, but also by the conversion of a very high-profile gold bear (Andy Smith of Mitsui) from bear to bull. We don't consider Andy Smith to be a contrary indicator, but his 'conversion' added to the market's optimistic sentiment. Fourthly, interest in gold had clearly increased as a result of the terrorist acts and the associated on-going tensions. We don't, however, consider that the recent events provide a firm basis for a sustainable gold rally. Our emphasis has been, and continues to be, on the deteriorating quality/relative-value of the US$ as a result of massive inflation. We expect the gold price to move much higher as the effects of Dollar inflation start to be more widely recognised, with any shocking events potentially providing short-term spikes along the way.

So, where to now? So far, what we have is overly bullish sentiment and a downside break in the short-term trend. The longer-term trends in all the financial markets remain very supportive of higher gold and gold stock prices. As such, what we are most likely seeing is a correction within an on-going bullish trend.

As far as how long this correction will last, our thinking is anywhere from 3 weeks to 3 months. The key will be how long it takes to inject a healthy level of pessimism back into the gold market. A signal that bullish sentiment has been sufficiently curtailed to enable the start of another rally will be a large reduction in the speculative net-long and commercial net-short positions. Until this happens we will remain on the sidelines as far as gold stock trading positions are concerned, but will retain exposure to any event-related gold rally via our core investment position. We emphasise that it will be important to be patient and wait for the risk/reward ratio to swing decisively in our favour before re-establishing long trading positions. 

The following charts of several popular gold stocks are provided to give some indication of the probable extent of this correction (the charts do not include yesterday's trading action). Beside each chart we've noted the approximate support levels - levels that should hold assuming the continuation of an overall bullish trend. Some of the trendlines and support levels shown on the charts are well-defined and the ability, or otherwise, of the stocks to hold above these levels over the coming weeks will give us clues regarding the sustainability of the gold market's overall up-trend. Note that gold stock prices have dropped quite sharply over the past few days and are probably already close to short-term lows. Also, during today's trading in Asia the spot gold price dropped to around $280, an area that should provide some short-term support.

In Market Alert #54 we mentioned that the breakdown in the gold price had not yet been confirmed by an upside breakout in the Dollar Index. This is still the case. However, the following chart indicates that the Dollar is very close to breaking out of its 4-month downtrend. Any further strength in the Dollar over the remainder of this week would suggest that we have seen at least a short-term trend reversal in the currency market. 

Changes to the TSI Portfolio

As per Market Alert #54, gold stock trading positions were sold. LHG was sold at $1.17 (for a profit of 89%) and the NDY Nov $1.25 calls were sold for 16c (for a profit of 255%).