- Interim Update 20th August 2008
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Bonds and the coming deflation scare
Deflation Fear
The big run-ups in the prices of some commodities during the first half
of this year created the general impression that the inflation threat
was rising. However, as we noted in a number of TSI commentaries the
FEAR of inflation was rising at a time when the ACTUAL rate of
inflation (the rate of money supply growth) was low. Our interpretation
was outlined as follows in the 19th May Weekly Update:
"...the year-over-year
(YOY) growth rate of TMS is presently about 3.5%. To put it another
way, TMS tells us that the inflation (money-supply growth) rate is
presently in the bottom quartile of its 10-year range.
Our statement that the US
inflation rate is presently in the bottom quartile of its 10-year range
may appear to be absurd given that the prices for various commodities
and everyday goods/services are rocketing upward, but today's rising
prices are largely due to the massive inflation that occurred years
ago; specifically, the massive inflation in the US during 1998-2004 and
outside the US during 2003-2006. There is often a multi-year lag
between the cause (money-supply growth) and the effect (rising prices),
which is one reason why so few people are able to see the link between
money-supply changes and purchasing power changes.
During any long-term
inflation cycle the major beneficiaries of the inflation will be the
sectors of the economy where the supply/demand fundamentals are the
most bullish, that is, those sectors where there is relative scarcity.
Commodities should continue to be the major beneficiaries during the
current inflation cycle -- a cycle that's probably nowhere near an end
-- because that's where the relative scarcity now lies, but the
downward correction in the money-supply growth rate over the past few
years creates an intermediate-term hazard for commodity investors.
We expect that wider
recognition of the inflation problem will eventually bring about a
major decline in Treasury bond prices (a major rise in bond yields),
but the temporarily SLOW rate of US money-supply growth over the past
2-3 years could support US T-Bond prices over the coming 6 months by
putting irresistible downward pressure on the prices of industrial
commodities."
Of course, anyone who thought that M3 was a good measure of money
supply would not have perceived this glaring mismatch between the
inflationary evidence being generated by the commodity markets and what
was actually happening on the monetary front (since M3 was expanding at
a rapid clip at the time). As it has done at a number of important
turning points over the decades, M3 recently generated a 'major league'
false signal*.
What appears to be underway right now is a process whereby commodity
prices move back into line with the monetary backdrop. In addition,
there is a self-reinforcing aspect to this process in that most people
wrongly think that rising prices are synonymous with inflation and that
falling prices are synonymous with deflation, the result being that
falling prices lead to lowered inflation expectations, which, in turn,
lead to a fall in the speculative demand for commodities and other
items that are widely perceived to be inflation hedges. It is quite
possible, in fact, that the expectations of market participants will
end up doing a 180-degree turn, meaning that at some point over the
coming year the financial world may be dominated by the fear of
DEFLATION.
It is important to understand that there can be a big difference, from
both a theoretical perspective and a practical investment perspective,
between a deflation scare and a genuine deflation threat. Deflation
scares occur because prices fall, but falling prices are only related
to deflation if they are caused by a contraction in the money supply.
And as things currently stand, the year-over-year growth rate of "True
Money Supply" appears to have bottomed during the final quarter of 2006
and to now be in the early stages of a new upward trend. This means
that if the FEAR of deflation rises over the coming year in response to
falling prices it will probably be doing so as the stage is being set
for the next round of inflation-fueled price INCREASES.
In previous commentaries over the years we've argued that from the
perspective of policymakers the occasional deflation scare can be
useful because it provides the justification for the next round of
government-sponsored inflation. It is a virtual certainty that as the
fear of deflation rises there will be loud calls for the government and
the central bank to "reflate", and that policymakers will heed these
calls. Moreover, the only practical limit on how much new money the
government can borrow into existence and how much new money the central
bank can create (by monetising assets and debt) is imposed by the bond
market, but government bond yields will remain low and policymakers
will be free to inflate to their hearts' contents as long as inflation
is not widely perceived to be a problem.
*Note: After
deceptively signaling very strong money-supply growth over the past
couple of years, recent data suggests that M3 is now moving into line
with TMS. Money-supply figures can be quite volatile on a
month-to-month basis so it is too early to be confident that the recent
data is indicative of a new trend, but it would make sense, given the
performance of TMS, if the recent M3 data did turn out to be indicative
of a new trend. Also, bear in mind that although M3's 3-month rate of
change appears to have dropped to almost zero, it still has a
double-digit gain on a year-over-year basis. Due to the monthly
volatility we generally focus on year-over-year changes.
Implications for bonds and gold
The money-supply growth rate is relatively slow, an equity bear market
is in progress, the economic situation looks set to deteriorate
further, an intermediate-term decline is underway in the commodity
world, the US$ appears to be in the early stages of a multi-month
rally, and the fear of deflation is beginning to grow. This is NOT the
right time to be short US Treasury Bonds. However, ETFs that invest in
high-yield (junk) bonds are reasonable short-sale candidates at this
time because the default rates on these bonds should surge over the
coming year if, as we expect, the economy continues to slow and credit
remains hard to obtain for all bar the most financially-strong
corporations.
Although we suspect that Treasury Bonds will maintain an upward bias
into at least the final quarter of this year, for valuation reasons we
aren't bullish on this market.
With the exception of the money-supply backdrop (as discussed in the
latest Weekly Update), the current situation is bullish for gold. We
don't think that genuine deflation is a serious threat, and both gold
and gold stocks performed well during the deflation scare of 2001-2003.
So, after the over-leveraged euro bulls have been washed out of the
gold futures market there will be a decent chance of gold commencing
its next intermediate-term advance, even while industrial commodities
remain in intermediate-term downward trends.
The Consumer Price Index (CPI)
"Inflation Climbs to 17-Year High" was the headline in a Washington Post article last Friday. Many other newspapers and web sites displayed similar headlines.
When defined properly -- as an increase in the supply of money -- the
US inflation rate has actually been relatively low over the past couple
of years, but a common misconception is that the CPI reported by the
government tells us what's happening on the inflation front. Therefore,
when the US Government reported last Thursday that the CPI's
year-over-year rate of growth had just reached its highest level since
1991 the news was widely interpreted as: "inflation at a 17-year high!"
The official CPI is a bogus number, as is the much higher CPI reported at http://www.shadowstats.com/.
It is simply not possible to calculate an average price within the
economy, so there's no point pretending otherwise. No point, that is,
unless the main reason for doing the calculation is to come up with a
number that can be used to manage inflation expectations.
Most people who regularly buy 'stuff' would have a feel for how fast
their money is losing purchasing power and have probably figured out
that the cost-of-living statistics reported by their government don't
reflect reality. For example, the US dollar has certainly lost a lot
more purchasing power over the past few years than indicated by the US
Government's statistics.
The financial markets are more concerned about what will happen in the
future than what has happened in the past, and recently the markets
have been acting as if they expect the US dollar to lose purchasing
power at a REDUCED rate over the next 12 months. In our opinion, such
an expectation is reasonable.
The Stock Market
Current Market Situation
We don't think the US stock market's rebound from its 15th July interim
bottom is complete, but if our overall market view is correct then the
rebound in the Bank Index (BKX) relative to the broad market is
complete. Putting it another way, new rebound highs in the broad stock
market over the coming 1-2 months should be accompanied by lower highs
in the BKX/SPX ratio.
Oil Stocks
If the historical tendency of the AMEX Oil Index (XOI) to lag the oil
price by several months at major peaks is still applicable then the XOI
will make new highs at some point over the next 6 months even if oil is
now in a cyclical bear market. But even if this historical tendency
were destined to be overridden by other factors this time round, we've
thought that a tradable multi-week rebound in the XOI would follow a
test of support at 1250. Such a rebound appears to be underway.
Japan
We are surprised and disappointed by the poor performance of Japan's
stock market. The top section of the following chart shows that iShares
Japan (EWJ) recently dropped to a new multi-year low, reflecting
weakness in the Yen combined with a lacklustre Japanese stock market.
EWJ is now at the bottom of a long-term channel and stands a good
chance of rebounding from around this level, but of greater concern to
us is the recent performance of the EWJ/SPX ratio. EWJ/SPX trended
upward during the first half of this year, but has since plunged to a
new 2-year low.
Our plan, at this stage, is to look for an opportunity to exit our exposure to Japan over the next two months.
Gold and
the Dollar
Currency Market Update
In an article posted HERE,
Antonio Sousa argues that the main driver of the dollar's recent
resurgence was a change in interest rate expectations in the dollar's
favour. This is the simplest explanation and, we think, the right one,
although we doubt that the increases in official US interest rates
currently being discounted by the financial markets will actually
occur. We suspect that it will be a long time (more than 12 months)
before the Fed begins its next rate-hiking campaign, but in the mean
time the ECB's target rate (currently at 4.25%) will probably drop back
to near the Fed's target rate (currently at 2.00%). The closing of the
interest rate gap should, in turn, allow the euro to fall under the
weight of its own over-valuation.
One reason that interest rate expectations have recently moved in the
dollar's favour is the emergence of evidence that economic conditions
throughout much of Europe are just as bad as they are in the US. Also,
the sharp declines in commodity prices have played important roles in
that the former strength in commodity prices was the primary basis for
the ECB's seemingly relentless 'hawkishness'.
The following weekly chart shows that the Dollar Index has broken
decisively above its 50-week moving average (the red line) and the top
of the downward-sloping channel that has defined its trend over the
past three years. The intermediate-term trend has clearly reversed
upward and additional gains are likely over the coming months, but it's
reasonable to expect that long-term resistance near 78 (the 1998 low)
will temporarily halt the advance.
Gold and Gold Stocks
Gold and the AMEX Gold BUGS Index (HUI) are rebounding, but the
rebounds haven't been impressive to date. This leaves open the
possibility that there will be another plunge over the coming week or
so prior to a sustainable low being put in place.
With reference to the following daily chart of the HUI, a daily close
above last week's high (344) would constitute preliminary evidence that
a low is in place.
Gold is still tending
to trade up and down with oil, which means that a lot of speculators
are still treating gold as if it were nothing more than one component
of a general commodity play. However, there's a good chance that gold's
safe-haven role will start to dominate once credit market conditions
resume their deterioration (as indicated by widening credit spreads)
and financial market liquidity resumes its contraction (as indicated by
a steepening of the US yield curve).
As noted in the latest Weekly Update and reiterated earlier in today's
report, the money-supply backdrop is bearish for gold and could remain
so for some time. We expect that other factors will soon begin to
override the loose relationship between gold and the money supply, but
even if we are wrong about this there should still be a tradable rally
in both gold and gold stocks from current levels or from whatever new
lows are put in place before the end of this month. Whether it proves
to be the first upward leg in a new intermediate-term advance or a
counter-trend move within a continuing intermediate-term decline, it is
reasonable to expect that the coming rebound will take the HUI back to
its 50-day moving average.
The shortage of physical gold and silver
A lot has been written at internet sites over the past few weeks about
the difficulty of obtaining certain gold and silver coins. It seems
that the public's demand for gold/silver coins, which was already well
above average, has risen further of late even though the prices of
these metals have plunged. This discrepancy between the supply/demand
situation for some forms of physical metal and the overall
supply/demand situation is quite unusual.
As far as we can tell, there is no shortage of physical metal; only a
shortage of metal in the form in which the retail investing public
currently wants to buy it. For example, someone whose only goal is to
secure ownership of physical gold at close to the spot gold price can
do so by purchasing futures contracts and taking delivery, or by
purchasing gold through a service such as bullionvault.com. We also
note that more than 20M ounces of physical gold -- the equivalent of
more than 200,000 COMEX futures contracts -- change ownership every day
via the LBMA. However, if you want to buy certain types of gold coin
you may not be able to do so without paying an absurdly large premium
because mints and dealers have not been able to keep up with the demand
for some coins.
The discrepancy between the rising demand for gold/silver coins on the
part of the investing public and the falling gold price has been
portrayed by some analysts as a bullish omen, but we fail to see the
logic in such a portrayal. Increasing optimism on the part of the
public towards a particular investment at a time when the investment is
falling in price is, if anything, a BEARISH divergence.
We suspect that the public's demand for gold has risen in response to
superficial signs of inflation becoming more prominent, but superficial
signs of inflation tend to be lagging indicators. The actual inflation
rate (the rate of monetary expansion) has moderated over the past few
years, potentially setting the stage for a DE-flation scare even as the
public frets about the IN-flation threat. In other words, the public
appears to be reacting vigorously to yesterday's news at a time when
tomorrow's news could paint a very different picture.
If the recent surge in the public's demand for physical gold and silver
reflects increasing concern about inflation and increasing demand for
inflation hedges, then we think it represents more of a risk than an
opportunity as far as our gold-related investments are concerned.
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)
Even
though the best value can be found amongst the juniors, over the past
few weeks we've suggested that new buying in the gold/silver sector of
the stock market be focused on major and mid-tier miners -- stocks such
as RGLD, SLW, HL, NGD and GFI -- because these are the sorts of stocks
that will rebound the fastest once the sector-wide trend reverses.
However, we'd be remiss not to highlight some of the best buys amongst
our juniors because the prices that some of these stocks have sunk to
defy all logic.
When the speculative juices are flowing freely at the small-cap end of
the gold/silver universe the small mining companies that need to
finance themselves by issuing more shares are able to do so at
attractive prices. In such an environment it is not a big comparative
advantage to have a substantial cash reserve. In the current
environment, however, any junior mining company that needs to raise
money by issuing more equity will almost certainly be forced to do so
at a very low price, meaning that the financing will seriously dilute
the interests of existing shareholders (equity financings only ever
dilute existing shareholders to the extent that the price at which the
new shares are issued is below the company's underlying value). In
other words, in the current environment it's a big advantage for a
junior to be in the position of being able to fund its
exploration/development work without the need to issue more shares.
Here are four extremely under-valued companies that are in such a
position:
1. Andina Minerals (TSXV: ADM). Recent price: C$2.21. Cash in the bank: C$25M
ADM recently reported a substantial increase in the gold resource at
its Volcan project in Chile, but the way the stock has acted you'd be
forgiven for thinking that it had reported a substantial decrease.
ADM's Volcan project now has a total resource of 9.4M ounces, 6.6M of
which are in the measured-and-indicated (M&I) category. This means
that at Wednesday's closing share price of C$2.21 it is being valued by
the stock market at only C$14.50 per total in-ground gold ounce and
$20.50 per M&I gold ounce.
2. Fortuna Silver (TSXV: FVI). Recent price: C$1.13. Cash in the bank: C$47M
FVI's current market cap is about C$104M, so almost half its market cap
is accounted for by its cash reserve. It owns the profitable Caylloma
silver/zinc/lead mine in Peru (current sales revenue of around
$32M/year) and the very interesting exploration-stage San Jose
gold/silver project in Mexico. Much of the stock's upside potential
lies with the San Jose project, but the market has recently been
disappointed by news that a new San Jose resource estimate will be
postponed to early 2009 to allow for the conversion of resources from
inferred to M&I status.
3. Keegan Resources (TSXV: KGN). Recent price: C$2.25. Cash in the bank: C$15M
KGN's Esaase gold project in Ghana currently has a total estimated
resource of 1.67M ounces, but the revised estimate due before year-end
should be much greater.
4. Sabina Silver (TSXV: SBB). Recent price: C$0.81. Cash in the bank: C$42M
SBB's Hackett River project in the northern part of Canada has 206M
ounces of silver and 4.4B pounds of zinc in the M&I category. A
preliminary economic assessment completed in March of 2007 estimated
that near today's metal prices this project would have an IRR of around
32% and a net present value of around US$700M.
How much is such a project worth?
According to the stock market it is worth almost nothing, since SBB's
current market cap is only marginally above the amount of cash it has
in the bank. If you meet someone who claims that the stock market is
efficient, ask them to explain SBB's valuation.
Chart Sources
Charts appearing in today's commentary
are courtesy of:
http://stockcharts.com/index.html
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