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China and the Anti-Realists

There is much gnashing of teeth by the realists and celebrating by the Keynesians over the possibility that the Fed will soon embark on another round of "quantitative easing". The anticipation of faster inflation of the US$ supply has put downward pressure on interest rates and caused the speculative juices to flow more freely in the commodity and equity markets. The Keynesians, who believe that economic depressions are caused by a mysterious decline in "animal spirits" and that everything would be just fine if we would simply return to borrowing, spending and partying as if it were 2006, are therefore getting their wish. The realists, however, understand that thanks to the excessive borrowing and misdirected spending of the boom years there are now huge imbalances in the economy that must be corrected before a genuine recovery can begin, and that artificially-stimulated borrowing and spending will only add to the imbalances by wasting more valuable resources; in other words, they understand that the problems are real and cannot be made to disappear by conjuring more money out of nothing or by using some other means to foster more of a "devil may care" attitude within the collective mind of the public.

Strangely, though, many people who are realists when it comes to the US are anti-realists when it comes to China. Via the application of sound theory and logic they are able to see that almost all the actions being taken and proposed by US policy-makers will weaken the US economy, and yet they ignore the same theory and logic when forming opinions about China's economic prospects. China, they tell us, is going to go from strength to strength while the US morphs into a shadow of its former self.

A problem with the idea that China will continue its steep upward trend while the US economy shrinks or stagnates is that an important sector of China's economy is almost totally reliant on being able to sell products to the US. The irrepressible China bulls counter that if the US economy goes into an extended funk then domestic Chinese demand will take up the slack, but this makes no sense on a number of levels. For starters, if the Chinese manufacturers that currently export to the US could make a profit by selling their products locally then that's what they would already be doing (why go to the trouble and expense of shipping products across the Pacific Ocean if you can generate a reasonable return by selling them in your backyard?). For seconds, the US market for the sorts of consumer goods that are exported by China is many times larger than the market inside China. The relative sizes of the markets will change over the long term, but in the mean time a lot of manufacturing companies in China will find that they are geared up to make products that cannot be sold. This is an example of the classic "Austrian" mismatch between production and consumption that often arises in response to rapid monetary inflation and artificially low interest rates. It's not that there is insufficient aggregate demand (as the Keynesians like to claim in their misguided efforts to encourage even more inflation and an expanded role for the government); it's that long-term investments were based on consumer spending patterns that prove to be unsustainable because they are artifacts of a credit bubble.

Unfortunately, having a manufacturing sector propped-up by unsustainable consumption trends is not the only major problem facing China's economy. As discussed in previous commentaries and as documented by many other analysts, China is immersed in a fully-fledged real estate investment bubble. There are some interesting facts about China's real estate bubble and the associated mal-investment, including pictures of a completely empty Chinese city (Ordos) that was originally built to cater for 1.5M inhabitants, in the slide presentation delivered by Vitaliy Katsenelson at Casey's Gold and Resource Summit.

One of the indicators that China is an economic accident waiting to happen is the rapid rate at which the country's money supply has been rising. The monetary inflation rate was already at nosebleed levels prior to 2008, but was accelerated by China's monetary authorities in response to the global financial crisis. The total supply of Yuan is now more than 50% higher than it was just two years ago. With the effects of inflation spreading from the asset markets to the markets for basic consumer goods and labour, China's economic commandants became sufficiently concerned earlier this week to push interest rates upward for the first time in three years.

That China's economy continues to maintain the outward appearance of strength, despite a burgeoning inflation problem and mal-investment on an unprecedented scale, is testament to the extraordinary degree of control that China's government exerts over the banking system and the amount of borrowing/lending. Due to this control, insolvent banks continue to lend aggressively to insolvent State-owned companies, which use the borrowed funds to build impressive factories, office buildings and shopping centres, many of which are under-utilised and loss-making.

Eventually, the proverbial chickens will come home to roost (China's bubble will burst). Best to be positioned so as not to get hurt when that happens.

Volatility

The Stock Market

We mentioned, above, that it's a good idea to be positioned in a way that you won't get hurt when the 'China bubble' bursts. This means not being loaded to the gills with investments that will tank when the China growth story unravels. It doesn't mean betting against the China growth story. Betting on the collapse of any bubble is problematic because bubbles always remain inflated for a lot longer than expected, but the danger in trying to time the collapse becomes even greater when non-market forces are as powerful as they are in China.

The big-cap miners of industrial metals are examples of investments that will tank when China's leadership can no longer find ways to postpone a major corrective process. As evidence we cite the following chart comparison of FXI (a proxy for the Chinese stock market) and BHP (the world's largest miner of industrial metals).

The Bank of China's decision to boost interest rates on loans and savings deposits early this week was widely reported as being the cause of Tuesday's sharp downturns in equity and commodity markets. It could well have been a contributing factor, but evidence that trends were about to be interrupted initially appeared last Friday when the Dollar Index experienced an "outside up" day after first dropping to a new low for the year. Also, we find it interesting that China's rate hike supposedly caused a global stock market swoon, and yet it didn't cause any weakness in China's own stock market. In fact, the following chart shows that the Shanghai Stock Exchange Composite Index (SSEC) broke out to the upside on Tuesday!

Many financial journalists labour under the false impression that today's market action is always a response to today's news. Consequently, whenever there's a sharp decline they look for news that can be interpreted as 'bad' to explain it.

The boring reality is that by the end of last week the upward trends in equities and commodities, and the associated downward trend in the US$, had become very stretched. This made the markets acutely vulnerable to near-term reversals of fortune.

Gold and the Dollar

Gold and Silver

Gold and silver have finally begun to correct. This gives the bears some hope, but a 1-3 week correction is all that's likely to happen at this time. Based on strong seasonal patterns, new highs are likely before the end of next month.

One problem with seasonal patterns is that they don't always work. Also, the more times a pattern repeats in a financial market the more confident traders become that it will repeat in the future and, due to the contrary nature of the market, the greater the chance that it WON'T repeat. We suspect that gold's seasonal pattern will 'work' again this year and that an important top won't be in place until December at the earliest, but if it's not going to work we will quickly see the evidence in the price action of silver.

As we've noted in the past, silver doesn't keep you guessing for long after it has reached an important top. Instead, within a few days of the peak it usually suffers a single-day decline of at least 7-10%.

As has been the case in almost all markets, volatility has just picked up in the silver market. However, this week's increase in silver's volatility has been nowhere near as great as it would have been if an important top had just been put in place.

Gold Stocks

From the email sent to subscribers after Tuesday's trading session:

"The expected correction in the gold sector has obviously begun.

As noted in the latest Weekly Update, the HUI has good support in the 490s defined by the 50-day moving average (currently at 493) and the May-June peaks. This support was tested on Tuesday, so even though a downward correction has only just begun it could already be almost complete. However, as also noted in the Weekly Update a spike down to 480 wouldn't surprise us.

Our guess is that the correction will end within two weeks at not far below Tuesday's low."

The following daily chart shows the support we were referring to.

The odds are in favour of the HUI trading to new highs before the end of November.

Currency Market Update

Tuesday should be considered a preview of what will happen to the US$ when commodity and equity prices commence their next intermediate-term declines.

The Dollar Index gave up almost all of Tuesday's gains when commodity and equity prices rebounded on Wednesday. As a result, this week's action hasn't signaled a trend change. It has, however, most likely signaled that the period of ultra-low volatility has ended, and as mentioned earlier in today's report this could be a prelude to some important trend changes.

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)

Crocodile Gold (TSX: CRK). Shares: 203M issued, 237M fully diluted. Recent price: C$1.54

In Stock Selection Update #61, emailed to subscribers after Tuesday's trading session, we advised that we were exiting PEZ.TO for a profit of around 180% in response to the takeover bid for the company, and that we were adding CRK.TO to the TSI Stocks List. CRK's chart is displayed below.

Unfortunately, CRK issued a press release to report a good drilling result prior to the start of trading on Wednesday. When combined with the increase in demand prompted by our write-up and the market-wide rebound, this made it difficult to buy the stock near the price at which we added it to the TSI List. The stock still offers good value after Wednesday's 17% price rise, but to maximise return and minimise risk it is important not to chase any stock. There will always be other buying opportunities.

    Dominion Mining (ASX: DOM). Shares: 104M issued, 111M fully diluted. Recent price: A$3.16

It was announced after the close of trading on Tuesday that Kingsgate Consolidated (ASX: KCN) has made an all-stock offer to acquire DOM (the offer is 0.31 KCN shares for every DOM share). Based on stock prices at the time of the announcement, the offer valued DOM at A$3.63/share. This represented a 33% premium, but half the premium evaporated on Wednesday due to a sharp decline in KCN's stock price.

We aren't thrilled about exiting DOM at its current price, but we don't really have a choice because from now on DOM will trade in synch with KCN and we aren't interested in KCN. We have therefore removed DOM from the TSI List and recorded a small profit of 15% including dividends (based on Wednesday's closing price of A$3.16 and our February-2010 entry at A$2.80).

Of the ASX-listed stocks that we follow, at current prices we think RSG is the best candidate for new buying.

    Batero Gold (TSXV: BAT). Shares: 41M issued, 55M fully diluted. Recent price: C$2.05

BAT is a small Colombia-based gold explorer that we wrote up in the 28th July Interim Update. We are bullish on this company's prospects, but it is too small and too 'early-stage' to be a member of the TSI Stocks List. It is yet to report its first drilling result, but the historical data provided by the previous owner of its flagship project suggest multi-million-ounce potential. In addition, its management is 'top notch'.

The stock has done better than expected since its late-July IPO, despite not reporting any important new developments. There is obviously a good deal of anticipation as to what the company will achieve in the future, and the Colombia location hasn't hurt (Colombia being the 'flavour of the year' in the realm of mining-related speculation).

Even though some bullish future developments are now factored into the stock price, substantial upside potential remains. Furthermore, the recently completed C$1.60/share equity financing was quickly over-subscribed and revealed considerable institutional interest in the stock. This suggests to us that unless something unexpected and untoward happens, the stock won't do any worse from here than drop back to the $1.60s.

A pullback to around C$1.70 would create a new buying opportunity for risk-tolerant speculators.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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