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Inflation and nothing but inflation

Last week's surprise interest rate cut by the ECB changed nothing at a fundamental level. It was purely symbolic. The ECB was, in our opinion, making the point that there are no limits to how far it will go along the inflation path, a point that had already been made by the US Federal Reserve.

Anyone who has been bearish on gold over the past two years due to a belief that deflation was about to happen has been on the right side of the gold market while being as wrong as they could be in their reasoning. They got lucky, because the gold price has fallen in parallel with considerable inflation. In essence, they got lucky because the Fed got lucky.

The Fed got lucky over the past two years due to the fact that its money-pumping boosted the 'right' prices, where the right prices are equities, bonds and real-estate investments. It was primarily luck, because the Fed doesn't have much control over the paths taken by the new money it creates. We note, for example, that similar bouts of money pumping from late-2008 through to mid-2011 gave the biggest boosts to the 'wrong' prices, most notably gold and commodities.

Now, when we say that the Fed got lucky we aren't saying that gold bulls, including ourselves, got unlucky. We missed some signs that the markets had entered a multi-year period during which the pendulum would swing in favour of the central planners and the inflation policy would appear to work. Of equal importance, the simple fact that the 'wrong' prices had risen so far so fast during 2009-2011 created the potential for a substantial swing in a different direction.

In any case, that the "QE" programs and the other extraordinary measures implemented by the senior central banks have appeared to work over the past two years will encourage more of the same and therefore greatly reduce the probability of monetary policy becoming prudent anytime soon. In order to get a positive change in policy, the problems caused by previous actions will have to become blatantly obvious. Also, from the collective view of policy-makers, influential economists and the financial press, deflation will have to be eliminated from contention.

Looking at it another way, there will be no limit to what central banks will do to devalue their currencies as long as the problems caused by earlier attempts to devalue are not blatantly obvious and as long as deflation is generally perceived to be a realistic possibility, so afraid are most central bankers, economists and journalists of your money being able to buy more in the future than it does today. Consequently, the more correct the deflation forecasters appear to be in the short-term, the more incorrect they will end up being.

Copper Update

In last week's Interim Update, we wrote:

"We don't have a strong opinion about the copper market's short-term direction, but there are hints that the price is rolling over to the downside. A daily close below $3.20 would break copper out of its recent narrow range and point to another test of major support at $3.00 (the following chart shows the 'technical precipice' at $3.00), while a daily close below $3.00 would suggest that a multi-month decline to as low as $2.00 could be in store. In recognition of this downside potential, our short-term industrial metals outlook has shifted from "neutral" to "bearish"."

The copper price closed below $3.20 on Wednesday 13th November and has therefore broken out to the downside from its recent narrow range. This suggests that the more important support at $3.00 will soon be tested.

Our short-term industrial metals outlook shifted to "bearish" last week. With downside copper-price risk to as low as $2.00 over the next several months, our intermediate-term outlook is also now "bearish".



Although the copper price is breaking down and looks set to test major support at $3.00 over the weeks ahead, the following daily chart shows that the stock price of the world's largest listed copper producer (FCX) is still in the top quartile of its 18-month range. This suggests to us that the downside risk in FCX is much greater than the downside risk in copper.

A bearish FCX speculation (FCX put options, for example) is tempting with the stock trading in the $36-$39 range, as such a speculation could benefit from copper weakness or stock market weakness.

The Stock Market

The US

The senior US stock indices made marginal new highs on Wednesday. This isn't a big surprise and doesn't change anything.

The Emerging Markets

Evidence that the 'emerging markets' rally has ended continues to build. As illustrated by the top section of the following chart, EEM (the Emerging Markets ETF) has moved below its 50-day and 200-day moving averages. Of greater significance, the bottom section of the following chart shows that the EEM/SPX ratio (emerging-market equities relative to large-cap US equities) has dropped back to the multi-year low hit during the third quarter of this year.

The bear market in the EEM/SPX ratio is now three years old and is therefore 'long in the tooth'. We doubt that this trend will continue for a lot longer, but it doesn't yet appear to be over.

Note that although the EEM/SPX is ratio is very 'oversold', there are two reasons to expect that EEM will fall faster than the SPX during the next intermediate-term stock market decline. One is that monetary policy is more stock-market-friendly in the US. The other is that the emerging markets will be hurt by a shift away from risk.



Gold and the Dollar

Gold

The Fundamentals

Gold doesn't require more "QE" to start a new cyclical bull market. It also doesn't need obvious evidence of rampant "price inflation" (leading indicators suggest that such evidence won't appear until at least 2015). Instead, gold needs evidence that "QE" has failed to bring about a self-sustaining economic recovery.

It is more than a little surprising that QE isn't already widely seen as having failed to cause a sustained turn for the better, but perhaps many analysts and market participants are giving the policy the benefit of the doubt simply because the stock market keeps going up.

Which brings us to the point that very few people appreciate just how over-valued the US stock market is at present. The market looks moderately expensive based on the earnings of the past 12 months, but these earnings are the result of extremely elevated profit margins. Consequently, the valuation is actually much higher than indicated by the P/E ratio. The inevitability of the average profit margin returning to its historical mean creates the potential for a substantial earnings decline within the next few years and for a cyclical bear market in US stocks that in real terms matches the severity of the 2000-2002 and 2007-2009 episodes.

No prizes for guessing how the Yellen-led Fed will respond to the next substantial stock market decline.

The Price Action

Gold has important daily-closing support at $1270 (the green line on the following chart). On a daily closing basis, gold successfully tested this support during August and October.

Some data services showed a daily close just below $1270 on Tuesday whereas others showed a daily close just above $1270 on Tuesday. In any case, gold was clearly above $1270 at the close of trading on Wednesday 13th November.



Support at $1270 for gold is similar to support at $21.00 for silver. Silver clearly breached $21.00 on both Tuesday and Wednesday of this week, so silver has broken out to the downside. However, this downside breakout needs to be confirmed by an equivalent breakout in the larger and more important gold market.

We would take a daily close below $1270 as a signal that gold and silver were headed down to test their June lows, while a daily close above $1362 by gold would definitively signal that THE bottom was in.

A test of the June low remains a realistic possibility. Furthermore, if such a test is going to happen it will most likely do so within the next few weeks. At the same time, sentiment indicators continue to point to a major bottom in the making. We note, as evidence, that despite gold and silver prices being well above their June lows, the Market Vane bullish percentages for these markets are at or below the extraordinarily depressed levels reached at the June nadir. Specifically, on Tuesday 12th November the Market Vane bullish percentages for gold and silver were 35% and 27%, respectively, which compares with June lows of 34% (for gold) and 29% (for silver).

The following chart shows that the silver/gold ratio rocketed upward in August and has trended downward since late-August. This tells us that silver has been weakening relative to gold since the late-August price peaks for both metals. This is typical.

It is reasonable to expect that silver will keep trending lower relative to gold until after gold's short-term price trend turns up.



Gold Stocks

The HUI spent the first three days of this week trading back and forth within last Friday's price range. This price action provides us with no additional clues.



Currency Market Update

The Dollar Index broke above resistance at 80.5-81.0 last week and has since pulled back. If this pullback is a routine consolidation within a new short-term upward trend then it should hold above 80.5 on a daily closing basis.

We remain neutral on the Dollar Index. It is very likely that the Dollar Index will hold above its October low over the remainder of this year, but we are uncertain about the upside potential.

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

Sandspring Resources (SSP.V). Shares: 132M. Recent price: C$0.24

SSP is a former TSI stock selection that we are discussing today due to a very interesting deal that was announced earlier this week. We are referring to the "gold stream" agreement that SSP has entered into with Silver Wheaton (SLW). SLW calls it an "early deposit gold stream agreement" to reflect the fact that it is linked to a deposit (the Toroparu gold project in Guyana) that is a long way from production and may never go into production.

The deal involves SLW making upfront payments totaling of $148M for the right to purchase 10% of Toroparu's gold production at $400/oz. SSP will be entitled to an initial drawdown of $13.5M in the near future to help with funding of the project's Feasibility Study, with the balance of the $148M being subject to SLW's election to proceed. The balance would be payable in instalments during construction of the Toroparu project once all necessary mining licences have been obtained and conditions pertaining to final feasibility, the availability of project capital finance, the granting of security to Silver Wheaton and other customary conditions are satisfied. If SLW elects not to proceed, then SSP can keep the initial $13.5M payment in exchange for a stream percentage of 0.774%.

What makes this deal so interesting is that SSP gets the money it needs to fund itself over the coming 12 months with almost no dilution of existing shareholders. To get the same amount of money via an equity placement at C$0.20/share (the stock price at the time the deal was announced) it would have been necessary for SSP to increase its total share count by about 50%. That is, raising the same money by issuing new equity would have effectively diluted the interests of existing shareholders by about 33%. Under the SLW deal, existing SSP shareholders only have to give up 0.77% of potential future production in order to get the initial $13.5M payment.

Whether or not SLW ends up proceeding with the full $148M funding commitment, this is a good deal for SSP. It means that this exploration-stage company will most likely survive the current ultra-difficult market environment. It is also a good deal for SLW, as that company gets an option covering 25K-ounces/year of future production for what is, for a company of SLW's size, a small initial outlay.

Due to its win-win nature, perhaps this deal will become a template.

We aren't going to return SSP to the TSI List, at least not yet. Its Toroparu project is probably not economic at the current gold price (the Pre-Feasibility Study indicated that the project would be viable above $1400/oz), its news flow probably won't be exciting while the Feasibility-level engineering work proceeds behind the scenes, and in the current lousy market for gold-mining shares we are spoiled for choice. However, it will certainly be worth keeping a close eye on and has been added to the TSI Small Stocks Watch List.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html