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Money-Supply Surge

The following weekly chart shows that the year-over-year growth rate of M2 money supply steadily worked its way higher from early 2010 until two weeks ago, at which point it 'exploded' upward. This money-supply explosion is probably part of the reason that gold futures rose a record-breaking 10 days in succession.

M2 is not a good measure of US money supply because two of its most important components (money-market funds and time deposits) are not money. This is why we don't usually discuss it. Instead, our money-supply discussions usually refer to the monetary aggregate known as TMS (True Money Supply).

We are making an exception in today's report, partly because the "mainstream" pays attention to M2 and is blissfully unaware of TMS. This means that even though TMS is by far the more useful indicator of what's happening on the monetary front, short-term market psychology is more likely to be influenced by large changes in M2. Another reason we don't mind making an exception right now is that the recent surge in M2 was 100% driven by large increases in actual money (as opposed to the non-monetary components of M2 mentioned above), which means that TMS also surged. Specifically, over the two-week period ended 4th July 2011 (the latest period for which data are available at the time of writing) there was an addition of $104B to savings deposits at commercial banks and an addition of $65B to demand deposits.

Of the $169B added to savings and demand deposits, only $27B was directly attributable to the Fed. What, then, was the main cause of the remarkable increase?

$46B of the total increase stems from a draw-down in the federal government's deposits at the Fed. When the Treasury reduces its cash holdings at the Fed, the money is 'spent into the economy' and ends up in commercial-bank savings and demand deposits. Another $23B is due to a net increase in commercial bank credit (lending new money into existence or buying securities with newly created money).

That leaves about $73B of deposit growth ($169B minus $27B (Fed) minus $46B (government) minus $23B (bank credit)) unaccounted for. We don't know where this $73B came from, but one possibility is that it came from overseas (the transfer of US dollars from bank accounts outside the US to bank accounts inside the US). This is a possibility because with the exception of the defunct M3, the US monetary aggregates do not include the large quantity of US dollars held outside the US. Consequently, monetary aggregates such as M2 and TMS get boosted when US dollars are shifted from outside to inside the US, even though the shift does not alter the global supply of US dollars.

If foreign-held US dollars have, indeed, recently been returning home at a rapid rate, the burgeoning problem with PIIGS sovereign debt would explain it. If the governments of Greece, Portugal and Ireland were to default, many European banks would become insolvent. In such a situation the ECB would have the ability to bail out depositors with euro-denominated accounts, but the ECB can't create US dollars.

The Stock Market

Current Market Situation

The S&P500's price action remains non-committal. After reaching some sort of peak in early July, it pulled back to its 50-day moving average and then rebounded.

The two most likely scenarios are:

1) The early-July peak was a successful test of the early-May peak, and a substantial downward trend is now in its infancy. This scenario will take centre-stage if the S&P500 closes below 1295.

2) The pullback from the early-July peak was a routine correction within a continuing short-term upward trend. The market will move to a marginal new high for the year before commencing a substantial downward trend.

This means that both of our favoured scenarios are bearish beyond the next few weeks.

The daily chart displayed below shows that the S&P500/gold ratio is close to breaking out to the downside. Similar breakouts to the downside over the past 10 years have always led to large additional declines within the 6-month period following the breakout.

Natural Gas Equities

Even though the natural gas price hasn't done much, there has been a sharp rebound in the prices of natural gas stocks over the past three weeks. Strength in natural gas equities in parallel with a flat natural gas market is a continuation of the theme of the past 12 months.

Strength in the stocks of natural gas drillers makes some sense because these companies could do well even if the natgas price continued to oscillate at a low level, but some of the large-cap natgas production stocks have also recently sprung to life. Chesapeake Energy, for example (see chart below).

The only exposure to natural gas in the TSI Stocks List is provided by Fairborne Energy (TSX: FEL). FEL tends to have a strong positive correlation with the natural gas price, which will be a good thing when natgas eventually begins to trend upward but has resulted in the stock spending the past two years in a sideways consolidation.

As illustrated below, FEL's trading range is contracting. This means that a breakout should occur within the next few months. More often than not, this type of pattern ends with an upside breakout.

Gold and the Dollar

Gold

Bernanke gets something right

Last week, Ben Bernanke delivered his semi-annual monetary policy report to the US House of Representatives. As usual, the policy report was followed by a Q&A session during which elected representatives were given a few minutes to question the Fed Chairman. Also as usual, the most interesting exchanges occurred during Ron Paul's allotted question time. Unfortunately, in this particular case Ron Paul erred in his efforts to shed light on the economic damage wrought by the Fed.

In this instance, the line of questioning pursued by the heroic Dr. Paul was off track. For example, he questioned Bernanke about gold and asked if gold is money. The Fed Chairman said that gold isn't money; rather, it is an asset that people hold as protection against tail risk -- very bad outcomes.

Bernanke is absolutely correct. Today, gold is not money; it is an asset that people hold to protect themselves against certain bad economic outcomes. As Ed Bugos noted in a recent blog post, if gold were money then we wouldn't be in the current 'pickle'.

With gold having performed so well and with Bernanke having admitted that this performance was likely due to people trying to protect themselves against bad economic outcomes, it would have been nice if Ron Paul had zeroed in on the point that the Fed's actions were contributing to the bad economic outcomes that people were worrying about. However, Dr. Paul was too focused on hammering home the incorrect point that gold is money.

The biggest problem facing the world is that the money we use is totally controlled by the financial establishment (the government, the central banks and the private banks). Naturally, the financial establishment acts in its own best interest, not in the best interest of the broad economy. In the US, for example, the Fed has created a huge amount of new money to help the private banks repair their balance sheets and to help the Federal government spend like a drunken sailor on shore leave. This is what matters. The price of gold doesn't matter, except as an indicator of the damage that the Fed is doing to the dollar and the economy.

When confronted with the accusation that the Fed has been creating a lot of new money, we can imagine Bernanke claiming that this is not so; that the Fed has been boosting bank reserves rather than the money supply. Refuting such a claim would be easy, because commercial bank credit has been flat-to-down over the past two years and yet the total amount of money has increased substantially. A situation like this could only arise due to money-creation by the Fed.

Money is, by definition, the general medium of exchange. Today, unfortunately, the general medium of exchange is something that can be created in unlimited amounts at virtually no cost by central banks and private banks. It isn't helpful to deny this reality and insist that gold is money.

Ron Paul quickly gets back on track

Ron Paul on the debt ceiling drama, courtesy of Zero Hedge:

"Perhaps the most abhorrent bit of chicanery has been the threat that if a deal is not reached to increase the debt by August 2nd, social security checks may not go out.  In reality, the Chief Actuary of Social Security confirmed last week that current Social Security tax receipts are more than enough to cover current outlays.  The only reason those checks would not go out would be if the administration decided to spend those designated funds elsewhere.  It is very telling that the administration would rather frighten seniors dependent on social security checks than alarm their big banking friends, who have already received $5.3 trillion in bailouts, stimulus and quantitative easing.  This instance of trying to blackmail Congress into tax increases by threatening social security demonstrates how scary it is to be completely dependent on government promises and why many young people today would jump at the chance to opt out of Social Security altogether.

We are headed for rough economic times either way, but the longer we put it off, the greater the pain will be when the system implodes.  We need to stop adding more programs and entitlements to the problem.  We need to stop expensive bombing campaigns against people on the other side of the globe and bring our troops home.  We need to stop allowing secretive banking cartels to endlessly enslave us through monetary policy trickery.  And we need to drastically rethink government's role in our lives so we can get it out of the way and get back to work."

YES!!

Current Market Situation

The gold futures market completed a (record breaking?) run of 10 consecutive up-days on Monday and has since bounced around near its high. A normal pullback would take August gold from its current price of around $1600 to just above the 50-day moving average (around $1540).

We usually consider sentiment to be a secondary indicator, because most of the time it simply follows the price. It is only important when it doesn't mesh with the price action, such as when a minor price decline is accompanied by a plunge in optimism. This year, sentiment has taken on greater importance than usual in the gold market because the level of optimism has tended to drop sharply at the first sign of trouble. This has helped to limit price declines.

Further to the above, to get more information regarding gold's short-term outlook we will need to see how market sentiment shifts in response to the next significant pullback in the gold price. For example, if a pullback to the vicinity of the 50-day moving average is accompanied by drops of more than 10% in Market Vane's bullish consensus and the total speculative net-long position in COMEX gold futures, then it will be reasonable to assume that another rally to a new all-time high lies in the near future.

The A$-denominated gold price (gold/A$) has been in consolidation mode since the first quarter of 2009. The following chart shows that it has just moved up to the top of its 2.5-year consolidation pattern.

Gold/A$ will probably break out to the upside within the next few months and start making its way to a much higher level, thus boosting the profit margins of gold producers with operations in Australia.

Gold Stocks

The HUI tested resistance at 580 on both Monday and Tuesday of this week. We won't be surprised if it spikes up to 600 within the next week, but the odds are against it making a sustained move above 580 without experiencing a significant intervening pullback.

A normal pullback would take the HUI back to near its 50-day moving average, which will soon move into the 530s. Depending on the overall market situation and gold-related sentiment indicators at the time, such a pullback could create another good short-term buying opportunity.

Currency Market Update

The euro-zone's debt crisis continues to worsen, with the cost to insure the debt of each of the PIIGS governments hitting a new high earlier this week. In addition, the euro-zone's debt crisis continues to be largely ignored by the currency market.

The Dollar Index has now traded sideways for about 2.5 months. If this sideways move is part of a bottoming pattern (as we suspect), then it should end by mid August at the latest and be followed by a strong upward trend.

A multi-day break below the early-May low would clearly invalidate our opinion that the dollar is bottoming.

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)

Golden Star Resources (NYSE: GSS, TSX: GSC). Shares: 259M issued, 265M fully diluted. Recent price: US$2.85

GSS is hard to like. For the third or fourth time since last November, the company's management has downgraded its own production forecast for 2011.

Unlike a stock that has great expectations built into its price, GSS's stock market performance is now largely immune to a missed production forecast because expectations are depressed. Consequently, this week's announcement of another miss was greeted by only a minor pullback. As things currently stand, the stock has maintained the previous week's upside breakout.

GSS has support at US$2.75 and then at US$2.50. If a drop to the $2.50s occurs, it should be viewed as a short-term buying opportunity.

The next significant resistance level is at US$3.50. A move up to near this resistance within the next few weeks would probably create a short-term selling opportunity.

    Jaguar Mining (NYSE and TSX: JAG). Shares: 84M issued, 88M fully diluted. Recent price: US$5.13

The market was disappointed by JAG's latest quarterly production results, which were announced after the close of trading on Tuesday. The Brazil-based gold mining company produced less gold than expected, and costs were higher than expected. The stock lost 6% in response.

From our perspective, the results were OK. The two operations that caused so much trouble last year are continuing to improve, but the June quarter's production was adversely affected by a temporary mill outage at the company's newest mine. The increase in costs was due mostly to the mill outage, although the strength in the Brazilian currency was also a significant factor.

Importantly, the company is maintaining its 2011 production guidance of around 200K ounces. At this annual production rate, a gold price of $1500/oz and a cost of production near that achieved over the past 6 months, JAG is worth at least US$10/share.

New buying would be appropriate near the 50-day moving average. Resistance lies at US$5.50-$6.00 and then at $7.50-$8.00.

    Andina Minerals warrants (TSXV: ADM.WT)

The ADM warrants have an exercise price of C$2.25 and an expiry date of 2nd June 2012. This means that they are well out of the money (ADM shares closed at C$1.34 on Wednesday) with only about 10 months left to expiry.

We added these warrants to the TSI List back in December of 2009, when they were trading at C$0.48. The speculation obviously hasn't worked to date, because they ended Wednesday's trading session at C$0.12-$0.13. Chances are they will expire worthless, but they could still be of interest to high-risk speculators due to their outsized reward potential.

Here are the three most likely outcomes for these warrants:

1) ADM shares remain below C$1.50 over the next 10 months, causing the warrants to gradually lose all of their value and expire worthless.

2) In response to a large rise in the gold price during the final quarter of this year and the first half of next year, marginal gold projects such as the one owned by ADM are assigned much higher valuations by the stock market. ADM's shares move well above C$3 and the warrants trade at more than 10-times their current price.

3) At some point over the next 6 months, ADM shares rebound to around C$2 before reversing course and returning to the sub-C$1.50 area. The warrants ultimately expire worthless, but the aforementioned rebound creates an opportunity for those who bought at around C$0.13 to exit with a 150%-200% profit.

Be aware that the ADM warrants are illiquid as well as risky. With ADM shares trading below resistance at C$1.40, we advise against paying more than C$0.13 for the warrants.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html