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No Worries

The yield on the 10-year Spanish government bond has been in a downward trend since last July and is now close to a 52-week low.


                            Chart Source: Bloomberg.com

The Expected CPI (the yield on the 10-year T-Note minus the yield on the 10-year TIPS) moved sharply higher in reaction to the Fed's "QE3" announcement last September, but it held just below the highs of the past 5 years and has stabilised since mid-September. Stabilisation just below the highs suggests a general perception that the Fed is creating significant "inflation", but not problematic "inflation".


                                         Chart Source: Fullermoney.com

The Volatility Index (VIX) just made a new 4-year low.



Spanish government bond yields at 52-week lows plus inflation expectations stable at a moderately high level plus the VIX at a multi-year low equals no worries. The markets are not worried about debt default in the euro-zone or "inflation" or "deflation" or a large stock market decline.

The reason that sentiment is a contrary indicator in the financial markets is that when the crowd becomes convinced that the future is going to unfold in a particular way and bets accordingly, it changes the odds such that betting on the popular outlook becomes a losing proposition.

We don't know what's going to happen over the next few months, but we do know that inflation expectations are unlikely to remain stable at a moderately high level. They are far more likely to either break out to the upside in response to the Fed's money-pumping or fall sharply in response to fear that economic weakness will push prices downward despite the Fed's 'best efforts'. Either of these outcomes would shatter the complacency that currently dominates the financial landscape. We also know that stock market volatility is unlikely to remain at such a low level for much longer.

The Stock Market

The earnings outlook

In mid-2012, the average forecast by equity analysts was for S&P500 earnings to end the year with a 12-month gain of 13%-14%. The final results aren't yet in, but the actual 2012 earnings growth for the S&P500 will probably be less than 2%. Therefore, it is fair to say that in terms of earnings growth the S&P500 did much worse during 2012 than it was generally expected to do as recently as 6 months ago. However, the market gained about 5% over the course of the year's second half.

Anyone who was bullish on the US stock market in mid-2012 or at the beginning of 2012 looks right, but we don't know (or know of) anyone who was bullish on prices AND predicting a plunge in the rate of earnings growth from double digits to only slightly above zero. Everyone we know of who was bullish was expecting at least a moderate rate of earnings growth during 2012.

In the financial markets and in life, dumb luck sometimes beats good analysis. However, it's dangerous to rely on dumb luck.

Why did the US stock market remain firm during 2012 in the face of the almost complete evaporation of earnings growth?

We can come up with two plausible answers. First, during the third quarter of this year it looked like the S&P500 was rolling over into an intermediate-term decline, but then the anticipation of more money-pumping by the Fed began to counteract other considerations. The Fed ended up meeting or exceeding the equity-bulls' expectations, which perhaps created the general impression that although corporate America was doing much worse than originally expected in 2012 it would do much better during 2013. Second, beginning in the third quarter of 2012 there was a strong rebound in Europe. This rebound also had central bank money pumping as its primary driver.

In order to keep the S&P500 in an intermediate-term upward trend the monetary inflation promoted by the world's senior central banks will have to result in significant earnings growth during 2013. This is not impossible, because monetary inflation can bring about artificial strength for a while. That's a large part of why inflation policy remains popular despite its negative long-term effects. However, it isn't the most likely outcome, because US corporate profits are near their highest levels in history as a percentage of GDP and because the profits/GDP ratio is mean-reverting.

As clearly illustrated by the following chart from John Hussman's latest Weekly Letter, high levels of the profits/GDP ratio have always, over the past 65 years, led to a falling rate of profit growth. The present level of the profits/GDP ratio is high enough that it points to a significant decline in corporate earnings over the next few years.



S&P500 profits probably grew by a small single-digit percentage during 2012, versus the double-digit growth of the preceding year. This is the sort of slowdown predicted by the historical record.

The historical record suggests that 2013 will have slower earnings growth than 2012. This means that the most likely outcome is for the S&P500's earnings to be lower during 2013 than they were during 2012. On its own, this isn't necessarily a reason to be bearish. It's only a reason to be bearish, or at least a reason to be concerned about substantial downside risk, because the market appears to be priced for significant earnings growth.

Current Market Situation

The Dow Transportation Average (TRAN) has just edged above resistance defined by its 2011 high. This means that TRAN has just made a new all-time high in nominal dollar terms, although obviously not in real terms.

The TRAN's break to a new all-time high should be viewed as a reward for traders who were smart enough or lucky enough to turn bullish near the lows of the past few months, but it isn't a good reason to turn bullish right now. Actually, it is a good reason to be extra cautious. This is because a) the index is very 'overbought' on a short-term basis, and b) the last three times that the TRAN broke to a new all-time high (July-2007, May-2008 and July-2011) it was close to an intermediate-term peak.



Gold and the Dollar

Gold

Gold's decline from its September-October high went a little deeper and continued for longer than we originally thought it would, but the price action still has the look of a routine correction. Support at around $1630 managed to hold after being tested twice, and the rate of decline from the early-October peak of $1800 to the early-January trough of $1626 averages out to only $12 (0.7%) per week. The total peak-to-trough decline was slightly less than 10%.

When considering the future we are always dealing with probabilities, possibilities and guesses. That is, when considering what will happen there is always uncertainty. We therefore can't rule out the possibility that support at $1630 will be breached and that the decline will transmogrify into something of greater substance. The point is that as things stand today, there doesn't appear to be anything to suggest that the gold market is experiencing anything more than a normal correction, albeit a correction that resulted in the market becoming more 'oversold' than originally seemed likely.



The angst, frustration and disappointment currently evident within the ranks of gold bulls probably has more to do with gold's failure to react in a very positive way to the Fed's actions than with gold's price action in isolation. A slow corrective decline would be easier to handle if not for the increasingly bullish monetary backdrop.

For an explanation of gold's lacklustre performance in the face of the Fed's increasingly absurd attempts to stimulate the US economy by raising the supply of the medium of exchange, look no further than the charts included in the section of today's report entitled "No Worries". The average market participant seems to believe that things are under control.

We don't believe that things are under control.

Gold Stocks

Current Market Situation

The HUI bottomed at 431 on 16th November. It has since had a slight downward bias in that it has made two marginal new lows, but it closed at 431 on Wednesday 16th January. Therefore, if it feels to you as if the gold sector has been going nowhere, it's because the gold sector has gone nowhere.

Something will have to give in the near future. Probably in the next few days. The price action should soon tell us whether the sideways trading of both the HUI and the HUI/gold ratio is a consolidation within a short-term downward trend or a short-term bottoming pattern. Our guess is that it will turn out to be the latter, but we are financially and emotionally prepared for the former.



The following chart of the GDXJ/GDX ratio shows how junior gold mining stocks have performed relative to senior gold mining stocks.

A period of relative strength in the juniors typically begins in late December. This relative strength tends to extend into the second quarter of the year if the overall market is strong and come to an end by early February if the overall market is weak.

The juniors have outperformed over the past few weeks as per the seasonal pattern. Some additional relative strength is likely.



The all-in cost metric adopted by Goldcorp

Last week Goldcorp (GG) announced that from now on it would be reporting an "all-in" per-ounce cost for its gold production. As per the practice of almost all other listed gold miners, GG previously only reported the per-ounce "cash cost" of its gold production. Although it has become an industry standard over the past decade, the popular "cash cost" calculation paints an unrealistic picture of what it costs to mine an ounce of gold. This is because it leaves out some important contributors to the overall cost of production. For example, "cash cost" doesn't include sustaining capital (capital expenditures at existing mines), exploration expenses and G&A expenses.

The difference between the "cash cost" and the "all-in" cost will usually be substantial. Goldcorp, for example, has estimated that for 2013 its by-product "cash cost" will be $525-$575 per ounce and its "all-in" cost will be $1000-$1100 per ounce.

If the new method of cost reporting adopted by Goldcorp is adopted throughout the gold-mining industry it won't make any difference to informed investors. Determining the actual, total per-ounce cost of gold production has always been a straightforward exercise for anyone with basic accounting knowledge and a willingness to take a few minutes to divide the difference between total revenue and net profit by the number of ounces produced. It could, however, influence how government officials think about the taxes imposed on gold-mining companies. As an example, the parliament of the Ivory Coast, a small West African country with the potential to experience rapid growth of its gold-mining industry over the next few years, recently approved a "windfall" profits tax on gold mining. The plan is for the new tax to be calculated assuming a fixed cost of production of $615/ounce. Clearly, the government of the Ivory Coast has looked at the huge difference between the spot price of gold and the "cash costs" reported by most gold producers and jumped to the conclusion that gold miners are veritable cash cows that should be milked more aggressively.

If only the average gold producer really was a "cash cow". The reality is that most of them aren't generating much cash at the current gold price. That's the main reason the stocks haven't done well.

If reporting an "all-in" cash cost results in some influential politicians gaining a better understanding of what it really costs to produce an ounce of gold, it will be a worthwhile thing to do.

Currency Market Update

Market Vane's bullish percentage for the Yen got as low as 17 early this week. This is one of the lowest readings we have ever seen for a major currency. In fact, as far as we are aware this is the second-lowest bullish percentage achieved by any major currency over the past 10 years. The lowest that we know of was the 13% figure achieved by the US$ near the end of a multi-year decline.

We doubt that the Yen has made or is about to make a major bottom, but a substantial bear-market rebound is a definite possibility.

There will be some important Yen-related news over the coming four weeks, starting with the BOJ meeting next week and ending with the appointment of three new BOJ board members (including a new chairman) on 15th February. The news is likely to be bearish for the Yen. For example, the odds are in favour of the BOJ yielding to the government's relentless pressure and announcing a 2% inflation target at the conclusion of its meeting on 22nd January. The question is: how much of this bearish news is already 'in' the market? The answer, in our opinion, is: all of it.

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

Clifton Star Resources (TSXV: CFO). Shares: 38M issued, 41M fully diluted. Recent price: C$0.92

On Tuesday of this week CFO published the results of the Preliminary Economic Analysis (PEA) for its Duparquet gold project in Quebec. We've summarised the salient details in table form below.

So, the project has a PRE-tax NPV(5%) (net present value using a discount rate of 5%) of $382M at a gold price of $1472/oz. The pre-tax NPV(5%) rises to $546M at a gold price of $1619/oz, but it makes sense to use the more conservative gold price assumption -- even though we don't expect that gold will ever again trade below $1500/oz -- in our analysis due to the pre-tax nature of the NPV calculation. Unfortunately, no post-tax NPV figures were provided by CFO.

Our favourite way of quantifying the economic viability of an exploration-stage gold project is the EVCC/NPV ratio shown at the bottom of the above table. The projects that we prefer to invest in have an EVCC/NPV ratio of less than one. At this stage CFO's ratio is therefore higher than we'd like, but CFO remains an interesting speculation for the reasons outlined below.

The main concern we have after going through the PEA is the magnitude of the project's initial capex. $370M is simply too big an obstacle in the current market environment for a project with average annual production of only 132K ounces and a pre-tax NPV of $382M. We doubt that anyone would be keen to finance such a mine development. However, there was a note in the PEA that a substantial reduction in capex and rise in profitability could potentially be achieved by producing a saleable concentrate that was sold to smelters, thereby eliminating the POX (pressure oxidation) part of the milling. Additional testing over the next few months will determine if this is feasible. In other words, it may be possible to substantially reduce the initial capex and improve the EVCC/NPV ratio.

Other points of relevance are:

1) The PEA confirmed a sizeable increase in the Duparquet project's M&I gold resource. The project now has 2.4M ounces in the M&I category and 1.5M ounces in the Inferred category. Of the 3.9M-ounce total resource, 2.9M ounces are 'in pit'.

2) Only the in-pit resources were considered in the PEA, meaning that the project's underground mining potential has not been factored into the estimated economics at this stage.

3) The next major milestone will be the completion of a PFS. The plan is for this to happen in Q1-2014. As for short-term market-moving news, there will hopefully be some resolution within the next few weeks regarding the $22.5M Osisko loan commitment, and we expect to get confirmation during the second quarter of this year regarding the feasibility of the capex-reducing strategy mentioned above.

4) The permitting and construction of the proposed mine is expected to take three years, with permitting beginning in 2014.

5) The Duparquet project's Quebec location increases its attractiveness to large and mid-tier North Amercian gold miners.

6) CFO estimates that it will need $6.7M to fund its operations in 2013. By our calculations, it currently has about $8M in its treasury. It should therefore have enough money to get through the next 12 months without doing an equity financing, although we suspect that a small equity financing will be done at some point during the year.

All things considered, CFO is heading in the right direction. We have some concerns about the size of the initial capex, but there appears to be scope to eliminate this obstacle. And even if the capex can't be meaningfully reduced, this will only be an obstacle for as long as the mine-financing environment remains tough.

CFO is in a similar position to many exploration-stage gold mining stocks. Although it has rebounded from its December-2012 low, it is still a long way below where it was trading 18 months ago. It is definitely a worthwhile speculation near its current price in the low-C$0.90s, but only for the patient and risk-tolerant.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.fullermoney.com/