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    - Interim Update 11th June 2003

Will higher money supply growth help?

Gold market commentator and veteran trader Jim Sinclair recently wrote some comments on inflation/deflation that a few of our subscribers asked us to respond to since Mr Sinclair's thoughts differ so markedly from our own. In a nutshell, Mr Sinclair believes that the Fed needs to facilitate much faster money-supply growth in order to prevent a deflationary outcome and 1930s-style depression. To support his view he uses charts of money-supply growth and 'money velocity', where the velocity of money is calculated by dividing the GDP growth rate by the M2 growth rate. Here's our response.

Firstly, dividing the money-supply growth rate into the GDP growth rate tells you nothing about the velocity of money. All it tells you is how much effect money-supply growth is having on GDP growth. For example, M2 money supply has expanded by 16.8% over the past 2 years (an 8%/year compound growth rate), but this high rate of money-supply growth has had only a modest impact on real GDP growth. Hence, the sharp drop in the GDP/M2 ratio that Mr Sinclair is concerned about (see chart below). This doesn't mean that the velocity of money has been low over the past 2 years, but it does indicate that money is being spent in a way that does not give a significant boost to GDP.

Further to the above, rather than interpreting the fall in the GDP/M2 ratio as a signal that we need even higher money-supply growth a more logical line of thinking would be as follows: The 16.8% increase in M2 money-supply over the past 2 years has had only a minimal effect on economic growth, so the problem clearly isn't a lack of money. Higher money-supply growth is therefore not likely to make things better.

By the way, there is a positive correlation between money-supply growth and economic growth, but the correlation is based on real (inflation-adjusted) M2 growth. That is, an increase in the money supply only boosts GDP growth to the extent that it does NOT boost prices. Increases in the money supply that cause goods and services prices to increase are NEGATIVELY correlated with real economic growth.

Secondly, sustainable economic expansions are based on savings and production, not on debt and spending. One of the biggest problems facing the US at this time is that the savings rate is extremely low. Unfortunately, those who advocate monetary stimulation and other measures designed to increase the velocity of money are, in effect, advocating policies that will decrease the savings rate even further and thus DELAY the time when a sustainable economic expansion can begin. The thing that must happen now is that individual balance sheets get repaired. This is always painful in the short-term, but is absolutely necessary.

As an aside, a high savings rate alone is not enough to bring about an economic expansion. For example, the Japanese have had a high savings rate for the past decade, but economic growth has been slow. One of the problems in Japan is that a lot of the public's savings have been loaned to the Government and used unproductively as part of the Government's absurd Keynesian attempts to stimulate growth by spending huge sums on public works projects.

Thirdly and most importantly, Mr Sinclair is making the same mistake that many other commentators are making. Deflation isn't the problem. It wasn't the problem in the 1930s and it is not the problem now. The problem in the 1930s, and the problem now, is that there was a massive asset price bubble fed by an even more massive credit bubble. Once you have allowed a massive credit bubble to form there is no 'inflating your way out of trouble'. The US money supply has expanded at a rapid rate over the past 2 years and all that has been achieved is that an even bigger problem has been pushed into the future. Read the interview with 89 year-old investment legend Seth Glickenhaus in this week's Barrons magazine, because he says it better than we do. To paraphrase Mr Glickenhaus, all the Fed does when it tries to inflate its way out of the mess it helped create is cannibalise the future. It seems as though Mr Sinclair and the others who are clamouring for higher money-supply growth want the Fed to cannibalise the future at an even faster rate.

Lastly, Mr Sinclair warns of the dangers of 'allowing' the US stock market to drop below last October's lows. However, all markets are mean reverting and over the long-term the stock market oscillates between levels of over-valuation and under-valuation. Furthermore, once it reaches one extreme and reverses course it continues in the new direction until the opposite extreme is reached. The greater the level of under- or over-valuation reached during any cycle, the further the market must move in the opposite direction once the mean-reversion process gets underway. There are no instances in history where a government, or anyone else, has been able to prevent an over-valued stock market from following this mean-reversion process through to its logical conclusion, although governments often try. When they try, all that happens is that the bear market turns out to be longer than it would otherwise have been and each hope-rekindling bear-market rally sucks in more of the public's money. As such, the public ultimately loses more money as a result of government attempts to support an over-valued market, including the attempts to indirectly support the market by increasing the supply of money.

The US Stock Market

The VIX

The OEX Volatility Index (VIX), a measure of the expected future volatility of the stock market, has been one of the most reliable indicators of medium-term peaks and troughs in the stock market over the past several years. This doesn't mean it will necessarily stay reliable, but because it is calculated based on what traders are actually doing with their money, rather than what they are saying, it probably will continue to be a useful indicator.

The usefulness of the VIX as an indicator of medium-term market extremes is illustrated in the below chart. The chart compares the VIX with the S&P500 Index since the beginning of 1999, with blue lines on the chart marking the times when the VIX dropped to a cycle low. Note that whenever a downward-trending VIX moved to the low-20s it turned out to be a good, and sometimes great, medium-term selling opportunity in the stock market. In other words, if you had always sold after the VIX fell to around the 21 level you would invariably have been able to buy back at a significantly lower price within the ensuing few months. 

Earlier in today's commentary we mentioned that over the long-term the stock market cycles between levels of under-valuation and over-valuation. The stock market also cycles in the intermediate- and short-terms, but the shorter-term oscillations (weeks or months rather than years or decades) are generally not determined by valuation. They are, instead, determined by such things as market sentiment and how far the market has already moved in one direction. For example, a market that has been rising constantly for several weeks is likely to experience a pullback simply because prices have become high enough to invite profit-taking and discourage new buying. Furthermore, when a market continues in one direction for an extended period it reaches a point where buying or selling becomes exhausted.

The propensity of the market to oscillate in the medium-term is shown quite neatly in the above chart of the VIX. Regardless of whether the major trend in the market is up or down, the VIX will oscillate between extremes as traders first become overly complacent and subsequently become very fearful. When they are overly complacent they will tend to expect relatively low volatility in the future and when they are fearful they will tend to anticipate relatively high volatility in the future. Since the majority is always wrong once it becomes totally convinced of something, a very low value for the VIX usually means that volatility is actually going to be HIGHER in the future.

Right now, the VIX is in the low-20s and it has been in the low-20s for the past few weeks. In fact, when the VIX first fell to 21 a few weeks ago the S&P500 Index was about 60 points lower than where it is today. However, based on the VIX's record over many years it is very likely that someone who sold when the VIX first fell to 21 is going to be able to buy back at a significantly lower level within the next few months.

Current Market Situation

On Wednesday the Dow Industrials became the last of the major stock indices to close above its August-2002 peak (see chart below). This event is certainly going to add to the rampantly bullish sentiment that already exists.

When a market moves in one direction for an extended period sentiment always becomes lopsided, and the current situation is no exception. For instance, the results of the latest Investors' Intelligence sentiment survey show that the percentage of newsletter writers who are currently bearish has just reached its lowest level since 10th April 1987. In 1987 the market continued higher for more than 4 months after the number of bears had shrunk to such a low level, so this extreme reading alone certainly doesn't mean that we are now at a major peak. However, when considered alongside the VIX, put/call ratios and other indicators it strongly suggests that the downside risk in the market is very high.

Given that the NDX/Dow ratio has only just peaked (see discussion in the latest Weekly Update) we think the Dow and the S&P500 probably will move to new recovery highs following a pullback over the next few weeks, but the upside potential from current levels looks minimal.

Gold and the Dollar

Gold

From Market Alert #120, e-mailed to subscribers after the close of trading on Monday: "Monday's market action was slightly bearish for gold and slightly bullish for the US$. In recent commentaries we've mentioned that we would consider a daily close in the gold price below its 18-day moving average to be a preliminary warning sign that gold had reached a short-term peak and that the Dollar Index had reached a short-term bottom. August gold closed below its 18-day moving average on Monday."

Gold followed up Monday's mini breakdown by dropping sharply on Tuesday and then bouncing modestly on Wednesday. If the gold price didn't reach a short-term bottom when it traded down to the low-350s on Tuesday then the most likely place for a bottom to occur would be in the $340-$345 range.

The euro gold price has dropped back to near the bottom of its long-term channel, so strength in gold relative to the euro is likely in the short-term.

Gold Stocks

There is currently no sign that this week's break below short-term support by the gold price has resulted in anything more significant than a pullback within a continuing uptrend. In particular, gold stocks, as represented by the Amex Gold BUGS Index (HUI), remain comfortably above important support in the 137-140 range (see chart below). As long as the HUI doesn't close below 137 it is reasonable to assume that the rallies in gold and gold stocks that began in March and April, respectively, are intact. A move below 137 would, however, suggest to us that the rallies had ended and that what we've described as "scenario b" (gold stocks dropping below their March lows before embarking on a multi-year advance) had become the most likely outcome.

NEM recently bounced off resistance defined by its May-2002 peak and is probably headed back to support (formerly resistance) at around $30. Given NEM's top-class management, recent good results, reasonable valuation and the excellent progress it has made over the past 6 months with regard to eliminating its forward-sales book, we think NEM is an attractive long-term investment at around $30. This is particularly the case for those who are looking for relatively low-risk exposure to the gold sector. However, we probably won't add a position in NEM or in long-dated NEM call options to the Stocks List unless the stock trades down to near the uptrend-line shown on the below chart.

We are currently working on a valuation comparison of 16 major and mid-sized gold producers that will, if all goes according to plan, be included in the next Weekly Market Update.

The Dollar

Freddie Mac (NYSE: FRE), the second largest of the Government Sponsored Enterprises (GSEs) operating in the mortgage market (click HERE for a profile of Freddie Mac http://biz.yahoo.com/p/f/fre.html), has been the centre of attention so far this week. For those who haven't seen or heard any financial market news over the past few days, the three most senior executives of FRE were sacked on Monday due to concerns over the company's accounting. Subsequent to the sackings the Securities and Exchange Commission, the Office of Federal Housing Enterprise Oversight and Federal prosecutors have all opened investigations into possible misconduct at Freddie Mac. As a minimum, it seems likely that Freddie's revenue recognition practices were flawed in that revenue was being recognised each quarter in a way that would smooth results rather than in a way that would accurately reflect what was actually happening with the business.

At this stage Freddie's recent tribulations have only caused a problem for its own shareholders and, to a much lesser extent, the shareholders of other GSEs. The overall stock market and the currency market have not yet been affected to any significant degree. However, this is potentially a much more important issue than the latest market action suggests, partly because the GSEs continue to play a crucial role in perpetuating the US credit bubble. In fact, over the past few years the great US credit expansion has hinged on the ability of the GSEs to borrow money at relatively low rates and to grow their balance sheets ad infinitum. Another reason that this week's news might evolve into a market-moving issue is the large volume of agency securities (the debt issued by Freddie Mac and the other GSEs) owned by foreign investors (foreign investors apparently own about one-third of all US agency debt).

Note that when we discuss the GSEs we are talking about companies that are bigger, in terms of assets and liabilities, than the average country. For example, during the first quarter of this year alone the GSEs issued about $345B of debt, about $70B of which was issued by Freddie Mac. Furthermore, as at the end of April Freddie Mac's total mortgage portfolio (its investment portfolio plus the mortgage-backed securities it guarantees) was valued at 1.3 TRILLION dollars. 

This brings us to our point. One of the big risks for the US is that this week's Freddie Mac troubles will cause foreign investors to lose confidence in agency debt and to therefore reduce the rate at which they purchase this debt. The Federal Reserve could certainly pick up the slack resulting from a reduction in foreign buying, thus preventing mortgage interest rates from rising, but any significant reduction in foreign investment demand for US agency debt would hit the US$. No wonder both President Bush and Treasury Secretary Snow have, over the past 3 days, publicly expressed their support for a strong dollar. 

The latest news might also be viewed by foreign investors as a case of "here we go again", with yet another large-cap high-profile US corporation having been found to be 'cooking the books'. If nothing else, Freddie Mac's situation suggests that there are more skeletons to be found in the US corporate closet.

Current Market Situation

As noted above, the Freddie Mac news hasn't yet had a noticeable effect on the currency market. As the following chart shows, the Swiss Franc was in a short-term downtrend before the 'news' and is still in a short-term downtrend. 

Below is a weekly chart of the silver price. Silver has near-term downside risk to around $4.35, but given the monetary backdrop we expect that this support will hold. 

Update on Stock Selections

Gold Fields (NYSE: GFI) is not one of our current selections, but we thought we'd mention this week's news that GFI and Mvela Resources have done an empowerment deal. Mvela is buying a 15% stake in GFI's South African operations for around US$500M (cash). The price looks a little low, but we think this deal is positive for GFI because it allows the company to comply with black empowerment regulations and removes the need for them to do any other financing (speculation that GFI was going to raise money via an equity issue has been weighing on the stock price for a long time).

Our Desert Sun Mining (TSXV: DSM) has begun trading on the Berlin Stock Exchange under the symbol DRT. DSM has once again dropped back to C$0.82, a good entry level for this stock. 

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/
http://www.economagic.com/

 
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