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Falling prices are natural

The US government usually admits to "price inflation" of about 2%/year. As far as we can tell, the actual rate is probably at least 5%/year, but no more than 7%/year. Let's say 5%/year for the sake of argument. Considering what the Fed has been doing on the monetary front, 5%/year still seems low. It's certainly a long way from the hyperinflation that some gold and commodity bulls expected to happen by now due to the Fed's profligacy. Why?

In previous commentaries we've discussed the apparent discrepancy between what has been happening to the money supply and what has been happening to "price inflation". We don't want to go back over this ground in today's report, other than to note the following: First, there is plenty of "price inflation" if you know where to look for it. The new all-time nominal price high for the US stock market and the surging demand for junk bonds are two examples. Second, monetary inflation's effects on prices are always non-uniform and can encompass large and variable time lags, making the exact price response impossible to predict and difficult to correctly interpret.

In today's report we want to make the additional point that the central bank's historical effect on the "general price level" is much greater than most people realise, for a reason that never occurs to most people: the natural tendency in a market economy is for prices to trend downward over time.

Most people have been conditioned to believe that rising prices are the natural way of things and that a strengthening economy leads to higher prices. The opposite is actually true. Real economic growth involves producing more via greater productivity and/or population. If more is produced within an economy and the money supply remains constant, then the so-called "general price level" will have a downward bias. In other words, if the supply of money is stable then the increasing production of goods and services will lead to lower prices for most goods and services. The purchasing power of money will increase over time.

An implication of the above is that to bring about a rising trend in consumer and producer prices the central bank must first engineer sufficient monetary inflation to counter the natural downward trend in prices. In the US, for example, increases in production due to productivity improvements and population growth would probably result in an average rate of decline in the "general price level" of about 3%/year, so if prices are rising at 5%/year it effectively means that monetary inflation is adding about 8%/year to the price of the average good/service. It actually isn't that straightforward, but the general point is valid.

If you are having trouble imagining the combination of falling prices and strong growth, just take a look at the computer industry. In this industry the rate of real growth has been so rapid up until now that even the Bernankes of the world have been unable to prevent prices from falling.

The Stock Market

The following daily chart of Japan's Nikkei225 Index illustrates a story that has played out numerous times over the past 14 years. Central-bank efforts to 'reflate' an economy or ameliorate a financial-system problem create an investment bubble, thus sowing the seeds of a collapse and the next major problem that will 'require' a central-bank solution. We know how the story ends, we just don't know when.



Gold and the Dollar

Gold

Last Friday's price action left some doubt as to whether or not gold had broken out to the downside from its 2-week range. This doubt was removed on Monday.

After ending last week in the mid-$1440s, gold traded as low as $1386 on Wednesday 15th May. As we write it is trading at $1390.



A test of the mid-April low has seemed likely, with the main question being whether the test would occur sooner (May) or later (October-November). It's possible that we will get a test of the April low sooner as well as later (that is, a test within the next few days and another test during the final quarter of the year), with the two tests of the low separated by a 1-3 month rally. However, at least one test of the low is highly probable, meaning that if gold reverses upward over the days immediately ahead without first dropping as far as the low-to-mid $1300s then a pullback to this price area will probably happen later in the year.

Gold will probably trade a bit lower, either immediately or a few months from now, but long-term indicators are screaming that purchases made near the current price will end up looking very smart. As evidence we present that following chart of the CEF/gold ratio (the unit price of the Central Fund of Canada divided by the gold price). As discussed in the past, CEF/gold is an effective long-term sentiment indicator because a) CEF holds gold and silver in roughly equal dollar amounts, b) as a closed-end fund CEF will trade at a premium or discount depending on the public's level of enthusiasm for precious metals, c) when the public is very bullish on the PMs the silver/gold ratio will be high and CEF will likely trade at a sizeable premium to its NAV, leading to a high CEF/gold ratio, and d) when the public is bearish or disinterested in PMs the silver/gold ratio will be low and CEF will likely trade at a discount to its NAV, leading to a low CEF/gold ratio.

Including the current signal, over the past 13 years the CEF/gold ratio has generated only 6 clear-cut buy signals. The times when the first 5 signals happened would feature prominently in a list of the best times to buy gold (and silver). It probably won't be different this time.



Gold Stocks

The HUI has just fallen for five days in a row and made a marginal new low for the year on Wednesday 15th May. This creates the ideal set-up due to the tendency for important gold-sector turning points to occur during the month of May. By the way, the 2012 low was on 15th May, so at this stage the 2013 bottom has occurred on the anniversary of the 2012 bottom.

Long-term speculators should be buying this weakness provided that they have sufficient spare financial capacity. Another way of saying this is that long-term speculators should be buying IF they can do so while maintaining a comfortable cash cushion. Nobody should be buying gold stocks on margin.

However, for short-term speculators and for long-term speculators who don't like trying to catch falling knives (most people don't) it would make sense to postpone any buying until after the HUI has its next significant (>3%) up day. Positions could then be purchased in liquid gold-stock ETFs such as GDX, GDXJ or GLDX with risk managed by placing initial sell-stops just below the intra-day low to date.

We can explain (and have explained) why the long-term bull markets in gold and gold stocks are almost certainly not over, but right now these bullish long-term views don't matter. They don't matter because even if gold and gold stocks commenced long-term bear markets in 2011 there would now be an uncommonly good opportunity to make money by scaling into the gold-mining sector. Long-term bull market or long-term bear market, extremes such as we have right now usually lead to strong multi-month rallies.

Currency Market Update

The Australian Dollar (A$) has been grossly over-valued for years, but prior to the past two weeks it refused to buckle. It has just buckled, having fallen for 8 days in a row and on 10 of the past 11 days. It is now within spitting distance of support at 98. Support actually extends from 98 down to 96.



The A$'s recent weakness is consistent with its relative over-valuation, but it has occurred at a strange time. Our expectation was that the A$ would become very weak during the next intermediate-term stock market decline, but the A$'s recent breakdown occurred in parallel with stock market strength.

The A$'s recent divergence from the stock market could be part of a broader change in the relationship between the stock and currency markets (the US$ has usually trended in the opposite direction to the stock market over the past several years), but at this time we aren't prepared to make that call. Until proven otherwise we are going to assume that the positive correlation of the past 3.5 months between the stock market and the US$ is a temporary divergence.

The following chart comparison of the euro and the SPX illustrates why we don't think that a change in the currency-equity relationship has been confirmed at this time and what would be required to confirm such a change. The chart shows that although the euro has pulled back quite sharply since early February while the SPX has continued to trend upward, the euro is still well above its July-2012 low and hasn't yet breached important support. There is some support near Wednesday's low (128.5), but the key support lies at 127. A solid break below 127 in parallel with the combination of continued strength in the stock market and rising economic optimism would mean that our currency-market outlook was right for the wrong reason. We expect the euro to eventually break below 127 on its way to a much lower level, but we expect it to do so in response to stock market weakness and/or the resumption of the euro-zone's debt/banking crisis.

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

Asanko Gold (NYSE & TSX: AKG). Shares: 85M issued, 102M fully diluted. Recent price: US$2.33

AKG reported the results of the PFS for its Esaase project in Ghana. The PFS indicates good economics, although not quite as good as we expected. The initial capex was 10% higher than we were expecting and the net present value (NPV) was less than we thought it would be. However, as discussed below there is scope to improve the NPV.

The salient PFS details are set out in the following table.

As discussed in the past, an EVCC/NPV ratio (the last row of the table) of 1 or lower suggests an economically-robust project being offered at an attractive price. At AKG's current stock price the ratio is 0.90, so this requirement is met. Furthermore, there is a good chance that the project's NPV can be significantly increased while leaving the initial capital cost (CC) the same, thus reducing the EVCC/NPV ratio to an even more attractive level and providing more scope for share price appreciation.

Lengthening the life of the mine is the key to boosting the NPV, and the key to lengthening the life of the mine is incorporating more of the M&I resource into the mine plan. Currently, only 2.4M ounces of the 4.4M-ounce M&I resource are included in the mine plan. AKG and its consultants believe that there is an opportunity to include more of the resource. This opportunity will be investigated as part of the FS, which is scheduled to be completed in Q4-2013.

AKG is one of the top candidates for new buying in the gold sector. It is currently trading at only slightly more than the value of its cash.

    Revamping the Small Stocks Watch List (SSWL)

The SSWL was created as a way of highlighting stocks that were too small and/or too illiquid to be included in the TSI Stocks List, but appeared to have substantial upside potential and could be of interest to risk-tolerant speculators capable of doing their own company research. Unfortunately, it was created at the worst possible time -- in early-2011, at the start of a 2-3 year bear market in the types of stocks it was designed to contain.

As long as the cyclical bear market in highly speculative resource stocks continues, most of these stocks that would ordinarily have speculative merit are going to struggle. We are therefore going to officially put the SSWL on the backburner (it has unofficially been on the backburner since October-2012, which is when it was last updated) until early signs emerge of a new cyclical bull market. Also, we have scaled down the SSWL from its previous five stocks to just two stocks, by removing four stocks and adding one stock. Specifically, we have a) removed First Mexican Gold (FMG.V), Geomega Resources (GMA.V), Prophecy Coal (PCY.V) and Tigris Uranium (TU.V), each of which is interesting in its own way but unlikely to do much until well after the overall market environment improves, b) retained Frontier Rare Earths (FRO.TO) due to its potential to do well even if the market environment remains difficult, and c) added Roxgold (ROG.V) for the same reason.

ROG.V came to our attention two weeks ago due to a mention of the company by Brent Cook in his Exploration Insights newsletter. It has 158M shares outstanding and about $15M of cash in the bank, giving it an enterprise value of around $67M at Wednesday's closing price of C$0.52. This is not cheap considering that the company's flagship Yaramoka project in Burkina Faso has an Indicated resource of only 680K ounces. What makes ROG an interesting speculation is the combination of the grade, depth and metallurgy of the resource. The average grade is very high (15.7-g/t), metallurgical testing has achieved an excellent gold recovery of 98% via a conventional gravity/CIL circuit, and the bulk of the resource is close enough to the surface to be extracted via an open pit. This means that despite the small size of the resource, there is a better-than-average chance that it will be developed into a lucrative mining operation.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html