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

    - Interim Update 11th February 2015

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.

Japan still has the world's slowest monetary inflation rate

The green line on the following chart shows the annual rate of change of Japan's monetary base (MB). It looks like a brainwave scan of a person experiencing a seizure. The red line on the following chart shows the annual rate of change of Japan's M2, a proxy for the economy-wide money supply. For more than two decades this line has been nearly horizontal within a few percent of zero. It is currently (as at January-2015) at 3.4%. So, why didn't the dramatic increase in the MB during the early 2000s have a significant effect on the money supply and why hasn't the even more dramatic increase in the MB over the past two years had a significant effect on the money supply?


                                                     Chart Source: Bank of Japan

We wish we knew the answer. Here's what we do know:

1) The Bank of Japan (BOJ) is not 'sterilising' its asset monetisation. In other words, the BOJ is not selling assets to negate the effect that its asset purchases would otherwise have on the money supply. Why would it, when the express intention of the asset purchases is to increase the Yen supply?

As an aside, a central bank will sterilise its asset monetisation in the case where it wants to elevate the price of a particular asset without increasing the monetary inflation rate.

2) The mechanics of the BOJ's QE are different to the mechanics of the Fed's QE. For every dollar of QE (asset monetisation) carried out by the Fed, one dollar gets added to the US money supply. Anyone who says otherwise, for example, anyone who says that the Fed's QE adds to bank reserves but not the economy-wide money supply, does not understand the mechanics of QE as practiced in the US.

3) There is widespread belief that the BOJ's massive QE program and the resultant moonshot in Japan's monetary base caused a massive increase in the supply of Yen. Although this belief is unfounded, it has helped bring about a large multi-year decline in the Yen's value on the foreign exchange market.

4) Because the Yen's decline on the foreign exchange market has not been supported by a decline in its domestic purchasing power (the Yen's ability to maintain its domestic purchasing power is not a mystery to anyone who knows the actual money-supply situation), the Yen is now very under-valued relative to the US$ and most other currencies.

The Stock Market

Over the first three days of this week the US stock market managed to do as little as it needed to do to avoid providing any clues as to the likely direction of the next multi-week trend. The situation is interesting, though, because both the S&P500 Large-Cap Index and the Russell2000 Small-Cap Index are just below intermediate-term resistance levels.



Given on our longer-term bearish outlook, two short-term scenarios are equally plausible. One is that the market has already made a major top and will soon begin to trend downward. The other is that the market will make a new high within the next few weeks, but will reverse lower and commence a 1-2 year bearish trend shortly after making the new high. This would be similar to how the NYSE Composite Index peaked during 2000 and how several indices peaked during 2007.


Gold and the Dollar

Gold

In terms of time, gold's correction is probably still closer to the beginning than the end.

In price terms it could be a different story, although the fact that gold has just broken below its 50-day MA during what is probably the initial phase of a multi-phase correction opens up the possibility that the November-2014 bottom will be tested before the correction comes to an end. As outlined in our Yearly Forecast*, this possibility will become the most probable outcome if the senior US stock indices break above last year's highs during the weeks ahead.

The $1250 level has acted as support and resistance at various times over the past 12 months. It has again become resistance and is a likely target for the next rebound, regardless of whether the rebound begins immediately or following some additional weakness.



    *From the "Gold" section of our 2015 Yearly Forecast: "If the S&P500 is in the process of rolling over to the downside on a long-term basis then it's highly probable that gold bottomed last November and will generate the sort of performance in 2015 that we originally expected to happen in 2014. That is, gold will probably work its way higher over the course of this year with a top most likely occurring in the $1400s and with an outside chance of making it as high as $1600. The most plausible alternative is that the S&P500 will make some additional headway over the next few months and gold will drop to test its 2014 bottom during the second quarter of this year prior to a long-term reversal."

Gold Stocks

Why gold-mining stocks are going to outperform gold bullion this year

The gold-mining sector has a reputation for leveraging gold's returns during periods when the gold price is rising. This reputation is undeserved, not only because the gold-mining sector under-performed gold bullion during many multi-quarter periods of gold-price strength over the past 50 years, but also because there is no good reason to expect gold-mining stocks to leverage gains in the gold price unless the gains in the gold price are at least matched by gains in gold-mining profit margins. For this to happen, the dollar price of gold must rise by more than the total dollar cost of gold production.

It therefore shouldn't be assumed that gold-mining stocks will necessarily rise by more than, or even by as much as, the gold price. However, both history and logic tell us that gold-mining stocks should handily outperform gold bullion during periods when the starting gold-stock valuation is relatively low and there is an expansion in gold-mining profit margins due to the gold price rising relative to the total cost of gold production.

Using the gold/oil ratio as a proxy for gold-mining profit margins, the following chart shows how the HUI/gold ratio has responded over the past 15 years to changes in the profitability of gold mining.

Of main interest are the two periods within the boxes drawn on the chart. These boxed periods extend from the start of a large up-move in the gold/oil ratio until two years after the gold/oil ratio reached a major peak. In the first case (2000-2003), the HUI/gold ratio began trending upward as soon as the gold/oil ratio began to rally and didn't peak until two years after the peak in gold/oil. In the second case (2008-2011), the HUI/gold ratio was in crash mode and at a relatively high level when the gold/oil ratio began to rally. It therefore didn't immediately react in a positive way to the gold/oil rally. Instead, it plunged to a low level before starting to trend upward. It peaked about 8 months after the peak in gold/oil, but remained near its high until two years after the peak in gold/oil.



Over the past several months we've had a huge rise in the gold/oil ratio and an up-turn in the HUI/gold ratio from a very low level about two months after the start of gold/oil's accelerated rise. Based on the tendency for HUI/gold rallies to continue for a "considerable period" after a major peak in the gold/oil ratio and the tendency for the cost of gold mining to follow the gold price with a lag of 1-2 years, as long as the gold price does no worse than hold its ground we can reasonably expect gold-mining profit margins to trend upward over the coming 1-2 years and for gold-mining stocks to outperform gold bullion over the course of this year. They are also likely to outperform next year, but there's no point looking that far ahead.

Current Market Situation

The HUI remains in correction mode and is probably headed for support at around 180.



The HUI has held up relatively well during the course of gold's 2-3 week decline. For example, whereas gold bullion broke below its 50-day MA on Wednesday 11th February, the HUI is still comfortably above its 50-day MA. Due to improving gold-mining profit margins, the relatively good performance should continue.

The Currency Market

During the first half of January we said that the days around the 22nd January ECB meeting (the date when the ECB's new QE program was due to be introduced) made a likely time-window for short-term trend reversals. The two markets that trended most strongly into that window were the currency market (in particular, the euro and the Dollar Index) and the gold market.

The gold market made its intra-day high for the year of $1307.80 on 22nd January and has since done enough to confirm that a short-term trend reversal occurred at that time. The euro made its intra-day low for the year of 111.6 on 23rd January but has not yet done enough to confirm that a short-term trend reversal occurred at that time. A daily close above 115 would signal a short-term trend change.



Downward pressure is being maintained on the euro, preventing it from signaling an upward reversal of its short-term trend, by the debt/bailout negotiations between the government of Greece and the other euro-zone governments. Although 28th February is supposed to be a deadline for something to be resolved, we won't be surprised if these negotiations drag on for months in true EU tradition.

The reality is that the Greek government should have defaulted on its debt years ago, resulting in large losses for the holders of Greek government bonds and a vastly reduced debt burden. Instead, the short-term cost of the debt was reduced while the size of the burden was greatly increased in what has come to be called "extend and pretend".

According to the new Greek government, the time for pretending is over. It's time for the EU's senior politicians and central bankers to come to terms with the reality that the Greek government is insolvent.

Updates 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

McEwen Mining (MUX). Shares: 300M issued, 305M fully diluted. Recent price: US$1.03

We added MUX, a junior miner with gold, silver and copper assets, to the TSI Stocks List via the email sent to subscribers after the close of trading on 10th February. The price at the time was the same as the current price.

The following chart shows how the stock has performed over the past three years. Despite being over-priced relative to its assets, the stock held up quite well and was still trading above US$3 in the middle of last year. However, it collapsed from a high of $3.19 last July to a low of only US$0.90 last December. It then rebounded to US$1.40 before pulling back to its current level of US$1.03. A test of the December low is certainly possible over the weeks immediately ahead, but, as discussed in our 10th February email, its current value and its growth potential make it a good candidate for new buying in the low-US$1 area.



In 2015 MUX is expected to have gold-equivalent (gold plus silver) production of 140K ounces from its operating mines in Mexico (El Gallo 1) and Argentina (San Jose). In the current market this production is probably worth somewhere between $1000 and $1500 per ounce, or between $140M and $210M.

MUX also has some potentially valuable exploration-stage assets, chief among them being:

  1) The El Gallo 2 silver project in Mexico

It is estimated that at a cost of $150M this project could be developed into a mine that produces 5.2M ounces of silver per year. However, it probably won't make economic sense to build the mine until silver moves up to $24/oz. In the mean time we assign this project's 64M-oz M&I silver resource an option value of $25M.

  2) The Gold Bar project in Nevada

A PFS completed in November-2011 estimated that this project's 500K-oz gold deposit could be developed into a 50K-oz/year mine at a cost of $53M. At $1300/oz the project's NPV(8%) and IRR were calculated to be $45M and 34%, respectively.

Considering that operating costs should be lower now than they were in November-2011, we suspect that this project will be developed into a mine during 2016-2017 (the permitting process is scheduled to be complete in 2016).

Our valuation at this time is $23M (half of the calculated NPV).

  3) The Los Azules copper project in Argentina

This project contains a massive, low-grade copper deposit. The total copper resource (all categories) is 19.7 BILLION pounds.

A PEA completed in November-2013 estimated that at an assumed copper price of US$3.00 the project would have an NPV(8%) and IRR of $1.7B and 14.3%, respectively. The problem is that the PEA also estimated an initial capex of $3.9B.

The potential value of Los Azules probably explains why MUX was such an expensive stock for so long. The thing is, nobody is going to spend $3.9B to build a mine in Argentina with an IRR of 14.3%, so even at a copper price of $3.00/pound this project would have no chance of progressing to the construction phase or attracting a substantial offer from a large mining company.

However, Los Azules does have some option value at the current copper price and will probably be assigned significant value by the stock market when the copper price moves back above $3/pound. In our opinion, right now Los Azules is only worth about $30M, but, based on the price that was paid for Lumina Copper's Argentina-based copper deposit last year, will be worth $300M when the copper price recovers to $3.00-$3.20.

So, at current metal prices and in the current depressed market environment, we think that fair value for MUX is: $140M-$210M for the producing assets + $25M for El Gallo 2 plus $23M for Gold Bar + $30M for Los Azules = US$218M-$288M. The stock's current enterprise value is US$280M, which means that MUX is currently not a bargain. However, our estimate of fair value will rise quickly when metal prices begin to trend upward.

At today's price MUX offers substantial leverage to upside in gold, silver and copper prices, with downside limited by a portfolio of conservatively-valued assets.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html

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