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Inflating away the debt

Under the current monetary system almost all money gets borrowed into existence. For example, commercial banks generally make loans by creating new money out of nothing, not by transferring part of the existing money supply to the borrower. Also, when the Fed purchases the Government's bonds it does so with newly created money. Consequently, adding a dollar to the money supply usually entails adding a dollar of debt. How, then, can the total debt burden ever be 'inflated away'?

If the central bank follows its traditional procedures then the total debt burden can't be inflated away, but monetary inflation can help alter the distribution of debt. For example, in the US over the past 18 months there has been a significant reduction in private-sector debt alongside a huge increase in government debt*. Also, central banks in general and the Fed in particular have recently demonstrated a willingness to deviate from their traditional modus operandi in order to pump more money into their respective economies. The Fed, for example, has chosen to monetise existing debt securities, thus adding new money without adding new debt. Furthermore, there is no good reason to believe that the Fed's monetisation will stop at debt securities (if the Fed is willing to monetise mortgage-backed bonds then at some point in the future it may be willing to monetise shares and houses).

The deflationists argue that monetary inflation can't help, to which we respond: yes, we know; we've been explaining in our commentaries for the past 10 years that monetary inflation can only make things worse. By distorting relative prices and sending false signals regarding the amount of savings within the economy, monetary inflation leads to widespread mal-investment and the destruction of wealth. As a result, most debtors don't benefit in the long run from the currency depreciation that always, eventually, stems from a large increase in the money supply. Instead, they either become unemployed or suffer substantial declines in their REAL incomes.

That inflation doesn't "work" or "help" goes without saying as far as we are concerned. The problem is that the 'ignorami' that populate the upper echelons of most central banks and governments either don't know that, or believe that they can use monetary inflation to buy some time. It therefore remains a good bet that the weaker the economy gets, the more inflation there will be.

    *As mentioned in previous commentaries, hyperinflationary episodes of the past century have generally been set in motion by a rapid expansion of government debt combined with the monetisation of the government debt by the central bank. In other words, hyperinflation has generally occurred via explosions in the quantities of money AND debt. Deflation forecasters who believe that the current high debt levels preclude the evolution of a major inflation problem therefore don't have a sufficient appreciation of monetary history. We reiterate, though, that while we think hyperinflation is almost inevitable on a long-term basis, we do not believe there is a significant risk of it occurring within the next two years.

The Stock Market

In the latest Weekly Update we said: "The market's 'overbought' condition points to a near-term pullback, but it's very likely that a move to new 52-week highs will follow the next pullback. The reason is that most indicators and market internals have confirmed the recent strength."

A pullback hasn't yet occurred. Instead, the market has become more 'overbought', with the VIX moving to its lowest level since May of 2008 and the 10-day moving average of the equity put/call ratio reaching its lowest level since July of 2005. This means that a pullback remains likely. Most indicators and market internals have again confirmed the latest strength, so it also remains likely that a move to new 52-week highs will follow the next pullback.

The one important indicator that continues to diverge bearishly is the HYG/TLT ratio (a measure of credit spreads). This bearish divergence and other considerations (the Presidential Cycle, for example) suggest that the stock market will peak on an intermediate-term basis by mid April.

In the hope of gaining an advantage we try to look at things that every man and his dog are NOT looking at. The following chart comparison of the S&P500 Index (SPX) and the WMT/SPX ratio (the stock price of Wal-Mart relative to the broad stock market) is an example. The idea behind this chart is that 'investors' gravitate towards relatively safe stocks such as WMT during periods when risk is generally perceived to be increasing, resulting in WMT/SPX trending inversely to the SPX.

The WMT/SPX ratio could provide timely confirmation that an intermediate-term decline has begun. The confirmation would be in the form of a solid break above 0.05.

Gold and the Dollar

Gold

Long-term speculators, people who use gold as a long-term store of value and people who hold gold for insurance purposes shouldn't care whether the next $50 move in the gold price is to the upside or the downside. Regardless of whether gold's next $50 move is to the upside or the downside, the gold price will still be within the consolidation range bounded by its December-2009 high and its February-2010 low.

Oscillations within the consolidation range can create trading opportunities, but the biggest and easiest money will be made by maintaining substantial exposure to gold-related investments until gold becomes over-valued. And how will we know when gold has become over-valued? The answer is that we won't know for certain, but one thing to keep in mind is that the last two secular bear markets in US equities didn't end until after the gold price had traded at roughly the same level as the Dow Industrials Index.

As noted in the email alert sent earlier this week, the Fed confirmed on Tuesday that it is planning to keep the real short-term interest rate in negative territory for many more months and that it is prepared to resume "quantitative easing" at a moment's notice if deemed necessary. The Fed is therefore committing to do what it can to keep the monetary backdrop gold-bullish. As also noted in the email alert, it would be reasonable for short-term holders of gold futures to manage risk by placing a stop just below last week's low ($1097 in the April contract).

Gold Stocks

Current Market Situation

In the email alert sent in response to Tuesday's market action, we wrote:

"After peaking on 3rd March the HUI completed a picture-perfect pullback. What we mean is that pullbacks within continuing short-term upward trends typically last 5-8 trading days, and the pullback from the 3rd March peak bottomed on the 8th trading day (Monday 15th March) after retracing only half of the preceding 5-day surge. Furthermore, the low on the 8th trading day was immediately followed by a definitive upward reversal.
 
This doesn't guarantee any particular future outcome, but it does mean that the risk-management parameters are now clearly defined. Specifically, traders could operate under the assumption that short-term upward trends have resumed for the gold-stock indices and gold bullion unless the lows of the past three trading days are breached on a daily closing basis. The relevant lows are 409 for the HUI and $1097 for April gold."

And in the latest Weekly Update, we wrote:

"As far as the coming three weeks are concerned, we think two very different potential outcomes have roughly equal chances of occurring. One possibility is that the gold sector is consolidating in bullish fashion and will soon resume its short-term advance, with the XAU and the HUI moving quickly up to around 185 and 470, respectively. The other possibility is that the gold-stock indices are now headed back to test their February lows."

The action during the first half of this week clearly shifted the odds in favour of the first potential outcome; that is, it appears that we are more likely to get a rise to resistance at 470 than a return to the February low over the next 2-3 weeks. 

Unless something unexpected happened, we would view a rise to 470 (or thereabouts) by early April as a short-term selling opportunity. An example of "something unexpected" would be a break below 78 by the Dollar Index.

The Juniors

Almost all junior gold/silver stocks rebounded strongly from their Q4-2008 lows, but only a select few are now well above their levels of 2 years ago. Most are either flat or down on a 2-year basis, despite gold bullion having made considerable headway in the mean time. The juniors that have provided the best returns on a 2-year and a 1-year basis generally have profitable production of more than 100K ounces/year, or, in the case of exploration-stage companies, have at least one of the following:

1) A mineral deposit that will likely be the target of a mid-tier or major mining company within the next 12 months

2) A financially-strong partner

3) A high-quality mineral deposit in a secure location AND access to sufficient financing to take the project through to production

Of the exploration-stage stocks in the TSI List, CKG.V and KGN are in category 1); CFO.V fits into categories 1) and 2); and FVI.TO and ORV.TO have some current production but can be put into category 3) because their main projects are under development.

Something we haven't seen since 2006-2007 (the last two years of the inflation-fueled boom) is broad-based speculation at the junior end of the gold/silver universe. The reality is that with a few exceptions, the stock market is not giving exploration-stage stocks any credit for their upside potential. To put it another way, there is almost no option value being factored into the current prices of these stocks. That it is still easy to find in-ground gold resources on sale for less than $30/ounce is evidence of this.

Now, the future is not a simple extrapolation of the past so the fact that the market has fixated on a certain type of stock and ignored other types of stock over the past 12 months doesn't mean it will do the same over the next 12 months. Cycles change, if for no other reason than strong demand for a particular investment will increase the valuation of that investment relative to the alternatives.

We expect to see a dramatic upward revaluation of in-ground gold and silver resources over the next two years, but we can't confidently predict when this revaluation will begin in earnest. As noted in previous TSI commentaries, in the interim it will be important to spread one's junior gold-stock exposure across the gamut -- from companies with >200K ounces of current profitable production to companies that are years away from having any production. Also, with regard to the explorers we would be inclined to steer clear of companies that haven't yet proven-up a resource of at least 1M gold ounces.

Currency Market Update

The following daily chart shows that the Dollar Index touched support at 79.5 on Wednesday. It has therefore achieved what we have thought to be the minimum objective for its downward correction. The maximum objective is 78.0.

Not surprisingly, the euro's daily chart (see below) looks like the inverse of the dollar's chart. Support for the Dollar Index at 79.5 corresponds with resistance for the June euro at 1.38.

The present association between the currency market and the general perception of the financial world can be expressed as follows:

1) The Dollar Index between 78.5 and 80.5 signifies that most things are perceived to be right with the world (the proverbial "Goldilocks" scenario).

2) The Dollar Index dropping below 78 would signify the general perception of an increasing US inflation problem and would likely be associated with the US$ gold price surging to a new all-time high.

3) The Dollar Index moving above 81 would signify the general perception that deflation was again becoming a clear and present danger and would likely be associated with pronounced weakness in stocks and commodities.

We expect the Dollar Index to break out of its "Goldilocks" range to the upside, but not over the next few weeks.

Update on Stock Selections

(Note: 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)

Catalpa Resource (ASX: CAH). Shares: 161M issued, 171M fully diluted. Recent price: A$1.50

CAH announced on Tuesday 16th March that it is raising A$20M -- A$10M by issuing new shares at A$1.32/share to a couple of large investors and an additional A$10M via a rights issue. Under the rights issue, eligible CAH shareholders (those with registered addresses in Australia or New Zealand) will be able to purchase 1 new CAH share at A$1.25 for every 19 shares they own. Shareholders with registered addresses outside Aust/NZ will have their rights sold on their behalf by a nominee company and will have the proceeds of the sale sent to them (assuming that there is a viable market in the rights and a premium over the expenses of sale can be obtained).

Associated with the above-mentioned equity financing, CAH's debt is being restructured to slightly reduce the interest rate and 6M options held by Macquarie Bank are being cancelled.

All things considered, the financing/debt-restructuring is a minor plus in that the company's fully diluted share count will only increase by 10M (16M new shares less the 6M cancelled options) and its balance sheet will be strengthened.

We suggest that eligible shareholders participate in the rights issue.

Our intermediate-term valuation-based price target for CAH is A$2.50/share.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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