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    - Interim Update 17th December 2014

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TSI Xmas and New Year Schedule

We'll be taking a break over the Christmas/New-Year period, which means that we are going to miss four commentaries. There will be a Weekly Market Update this weekend (published earlier than usual due to our travel schedule) and then no regular reports until the Interim Update on Thursday 8th January. However, between the coming Weekly Update and the 8th January Interim Update we will issue one or two brief market updates via email. Also, there will probably be a least a couple of posts at the TSI Blog.

The Fed

The Fed and Inflation Expectations

The Fed wants the US$ to lose purchasing power at a steady rate. In fact, according to the Fed it is not only important that the US$ lose purchasing power over time at the rate of at least 2% per year, but also important that the public expects the US$ to lose purchasing power. In other words, the Fed wants the public to anticipate generally higher prices. The reason is that people supposedly won't buy anything today if they believe that prices will be lower in the future. This is monumentally stupid, but it is what it is.

Over the long haul the Fed has been incredibly successful when measured against its goals of having the US$ lose purchasing power and maintaining a general expectation of further US$ depreciation. However, due to the massive build-up of debt and the periodic liquidations of the mal-investments fostered by the Fed's perpetual efforts to depreciate the dollar, inflation expectations sometimes plunge. Despite the Fed's inflationary push, once in a while there is a deflation scare.

A mini deflation scare is actually happening right now. As illustrated by the following chart of the 5-year T-Note yield minus the 5-year TIPS yield, a measure of the amount of dollar depreciation the market expects the US government to admit to over the next 5 years, inflation expectations have dropped quite sharply over the past few months and are now at their lowest level since 2009.



We will be surprised if the Fed allows the recent decline in inflation expectations to evolve into a fully-fledged deflation scare.

"Considerable Time"

The financial markets have become so removed from their proper task of efficiently allocating investment that the biggest determinant of asset prices this week was whether or not the Fed would leave the words "considerable time" in its post-FOMC statement. How silly is that!

As it turned out the words remained, but in a slightly different context. The Fed reiterated that the extent to which it interferes with market prices would continue to be data dependent, and that it "can be patient in beginning to normalize the stance of monetary policy." It went on to state that it viewed "this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time".

There was plenty of volatility in the financial markets over the first three days of this week as traders first placed bets on how the Fed's post-FOMC statement would be worded and then reacted to the actual wording. However, one place where there was minimal change in price was the Federal Funds Futures (FFF) market. According to this market there will be two or three 0.25% Fed rate hikes between May and December of next year, with two being the more likely.

The Fed, the US shale-oil industry and policy normalisation

The Fed's money-pumping and suppression of interest rates drastically changed the economics of shale-oil production. It did this by helping to keep the oil price at an unrealistically high level and providing the companies involved in the production of oil from shale deposits with ready access to an abundance of low-cost credit. The relatively high oil price combined with the glut of cheap credit led to a great deal of mal-investment in the oil industry, the extent of which is just starting to become apparent.

The extent of mal-investment stemming from central-bank manipulation of money and credit will usually not be known until the monetary tide goes out. In the US the monetary tide is beginning to go out and the first casualty is shaping up to be the shale-oil industry. If the monetary tide continues to go out then there will be many other casualties over the coming year or two. However, if the Fed does an about-face and resumes its money-pumping, it could create a new burst of activity at the same time as it prompts the wasting of more resources in ill-advised business ventures and other investments.

The problem now faced by the Fed and the economy it constantly meddles with is that the damage has been done. There is no way out. Attempting to withdraw the so-called monetary stimulus will reveal the mal-investments of the past and bring on a crisis, while providing more monetary stimulus will add new mal-investments to the pile and make the eventual crisis even worse.

In other words, the Fed is kidding itself when it talks about a plan to normalise monetary policy. A significant shift in the direction of a more 'normal' monetary policy will bring on a crisis and cause any such plan to be abandoned.

Starting to get bullish on oil

Analysts are competing with each other to see who can come up with the lowest price forecast for oil. This is the opposite of what they were doing during the first half of 2008, when they were competing to see who could come up with the highest price forecast. At the same time, Market Vane's bullish percentage has dropped to 11, which means that about 90% of the traders surveyed by Market Vane are now bearish on oil. Near the major oil price top during the second quarter of 2008, about 90% of traders surveyed by Market Vane were bullish. From a contrarian perspective it therefore makes as much sense to be bullish on oil now as it made to be bearish on oil in Q2-2008.

Based on the path followed by the oil price around previous major lows and the absence of speculative capitulation in the oil futures market, we expect that a significant rebound in the oil market over the weeks ahead will be followed by a decline to a new, and final, low during the first half of 2015. However, we also expect that the oil price will be moderately above its current level by the end of next year and a lot higher than its current level by the end of 2016. This is because the Fed will be quick to shift back into money-pumping mode should there be significant deteriorations in the economic data or the stock market over the months ahead, and because the combination of sentiment and valuation suggests that commodities will be the main beneficiaries of the next round of money pumping.

For the first time in a long time, our intermediate-term oil outlook is bullish.

The Stock Market

The S&P500 Index (SPX) broke below its 50-day MA on Monday, dropped further on Tuesday, and then reversed course on Wednesday. The non-sustained decline below the 50-day MA and a seasonal tailwind suggest that a 2-4 week bottom is in place.

The potential exists for a much larger/longer decline to get underway in January.



Gold and the Dollar

Gold

On Monday of this week the US$ gold price dropped back below $1200 and below its 50-day and 20-day moving averages. This wasn't ideal, but there was no follow-through to the downside and the gold market took the US dollar's strong Wednesday rebound in stride. The price action is neutral.



We plan to take another look at gold's fundamentals in the coming Weekly Update. They remain mixed (neither bullish nor bearish), but will likely turn bullish at around the same time as or just after the US stock market makes a peak of at least intermediate-term importance.

Gold is a beneficiary of the mal-investment wrought by the central bank's money-pumping and interest-rate suppression, but only after the mal-investment starts becoming apparent. There are preliminary signs that this is happening, with the sharp decline in the oil price having shone a light on potential problems in the US shale-oil industry. That explains why gold has separated from oil and the industrial metals over the past 6 weeks.

Gold Stocks

In a short post at the Blog after the close of trading on Tuesday, we wrote that a) the HUI and the XAU had just closed lower for five days in a row and were testing their early-November lows, and b) the next up-day for the HUI, whether it be Wednesday or Thursday or Friday, would probably mark the completion of a successful test of the early-November low and the start of a larger/longer rally than the initial post-crash rebound.

The next up-day turned out to be Wednesday. It's therefore likely that the gold-stock indices have just competed successful tests of their early-November lows. However, this won't be proven until the HUI closes above 180.

The most likely alternative is a decline to slightly below Tuesday's low (within the next three trading days) prior to the start of a rally.



In the latest Weekly Update we said that the gold-mining sector temporarily appeared to be getting influenced in equal amounts by gold bullion and mining equities in general. Prior to this week that involved getting pulled upward by the strength in the gold market and pulled downward by the weakness in diversified mining stocks (as represented by SPTMN), but on Wednesday 17th December a modicum of weakness in the gold market was more than offset by a 7% bounce in SPTMN.



The effects of tax-loss selling were painfully obvious at the junior end of the gold-mining sector during the first two days of this week, with some stocks that were already extremely 'oversold' suffering additional large losses. AKG, PG.TO and PVG are three TSI stocks that were noticeable victims of tax-related selling on Monday and Tuesday. Non-TSI stocks to get hit included Argonaut Gold (AR.TO), which fell 10.3% on Monday and an additional 8.6% on Tuesday, Gabriel Resources (GBU.TO), which fell an incredible 43.8% on Tuesday on no news, and Tanzanian Royalty (TRX), which fell 4% on Monday and an additional 15.5% on Tuesday.

The reckless selling and the associated price action is paving the way for large percentage gains from December lows to January highs.

The Currency Market

The following chart is a different way of displaying a relationship that we've shown many times over the course of this year. It compares the VGK/SPX ratio, a measure of how European equities are performing relative to US equities, with the reciprocal of the Dollar Index, and suggests that almost all of the significant fluctuations in the Dollar Index over the past two years can be explained by the relative performance of the US stock market. When the US stock market is relatively strong, the Dollar Index rises. When the US stock market is relatively weak, the Dollar Index falls. It's as simple as that.



Wednesday's relative strength in the US stock market pushed the Dollar Index up to near its early-December high. It will be interesting to see if it manages to build on Wednesday's gains over the balance of the week and make a new high for the year, or tests the early-December high and then reverses lower. The resilience of the gold market and last week's lower close in the Dollar Index point to the latter outcome.

Updates 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

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://research.stlouisfed.org/

 
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