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The end of "QE2"

The Fed's "QE2" program is complete. The Fed has stated that it will continue to purchase Treasury debt using the proceeds from interest and principal payments on its holdings of mortgage-backed securities, but note that this doesn't involve the creation of new money and is therefore not inflationary (it is not "quantitative easing"). Consequently, we expect that the rate of money-supply growth will decline over the next few months.

It looks like the financial markets have been discounting reduced monetary inflation since the beginning of May. In so doing, however, some markets recently became sufficiently 'oversold' to enable multi-week rebounds to get underway just as "QE2" was officially ending. We are referring in particular to the broad stock market and the gold sector of the stock market.

Rebounds in the 'oversold' markets will potentially continue for a few weeks, but it should be kept in mind that the monetary backdrop will likely become less accommodative from here on unless the Fed does an unexpected 'about-face'. This could pave the way for significant additional price weakness during August-October.

The Stock Market

A stock market divorced from the real economy

China's stock market, as represented by the Shanghai Stock Exchange Composite Index (SSEC), is presently about 20% higher than it was 10 years ago. This means that it has achieved a compound growth rate of only 1.8%/year over the past 10 years. Given that the Yuan has lost a lot of purchasing power over the same period, anyone who bought the basket of stocks represented by the SSEC in mid-2001 and held until now would have suffered a significant loss in real terms.

Over the same 10-year period, China's economy grew by more than 10% per year in nominal currency terms (how much it grew in real terms is unknowable). So, nominal economic growth of more than 10% per year was accompanied by a nominal stock market return of less than 2% per year. This prompts the question: why has there been such a large performance difference between China's stock market and China's economy?

First, it should be understood that there generally isn't a strong correlation between economic performance and stock market performance. This is the case everywhere, not just in China. However, the divergence between China's economy and its stock market is uncommonly large and is probably due to the following factors:

a) The enormous influence exerted by China's government on the country's financial markets.

b) The general lack of accounting reliability and transparency, which makes it extremely difficult for serious outside investors (meaning: investors who aren't company insiders) to value companies.

c) The fact that the retail investing public in China treats the stock market like a casino.

The influence of the government and the casino-like nature of China's stock market can be seen in the way the SSEC achieved its small nominal 10-year return. As illustrated by the following chart, all the gains (and then some) over this 10-year period occurred between December of 2005 and October of 2007. We don't recall the exact details, but we do recall that by the second half of 2005 the dismal performance of China's stock market had become a source of embarrassment for the political elite and so policy changes were made with the aim of boosting the investment demand for equities. The result was an upward trend, which, thanks to an abundance of monetary fuel, quickly became self-reinforcing and turned the stock market into the most popular game in town. Prices rose at such a frenetic pace that by 2007 the political elite had become concerned that a dangerous investment bubble was forming, the bursting of which would potentially have dire consequences for the overall economy. The government therefore intervened again, this time with the aim slowly letting the air out of the bubble. Naturally, that plan didn't work.

China's stock market crashed during 2007-2008 and then experienced a routine post-crash rebound that peaked in August of 2009. Since August of 2009 the SSEC has made a sequence of lower highs, despite the fact that the stock markets of most other "emerging" economies maintained their upward trends until November of 2010.

The only conclusion that can reasonably be drawn from the SSEC's 'sloppiness' over the past two years is that the stock market has not come close to regaining the popularity it had during 2006-2007. We don't think it says anything about China's economy, although we are bearish on China's economy for other reasons.

It would be nice if China's stock market evolved into something like the US stock market used to be. But unfortunately, the evolution that appears to be taking place is the US stock market becoming increasingly like that of China.

Current Market Situation

The S&P500 Large-Cap Index (SPX) and the Russell2000 Small-Cap Index (RUT) have intermediate-term support at 1250 and 775, respectively. These support levels are drawn on the daily charts displayed below.

It looks like the aforementioned support levels have held for now, and that multi-week rebounds have begun. The 50-day moving averages (the blue lines on the charts) are reasonable targets for these rebounds.

To confirm that intermediate-term tops were put in place at the beginning of May, the SPX and the RUT will have to achieve weekly closes below 1250 and 775. Our guess is that this will happen within the next few months, but not within the next few weeks.

Gold and the Dollar

Gold

Perspective

The best way to put gold's performance into perspective is to look at charts showing gold relative to other asset classes. For example, here is some of the information that can be gleaned from the following long-term chart of gold's performance relative to the Dow Industrials Index (Gold/Dow):

1. For the Gold/Dow ratio to reach its 1980 peak it would have to rise by more than 500% from its current level.

2. Since bottoming in 1999 the Gold/Dow ratio has been moving upward in a way than can aptly be described as "a few steps forward followed by a few steps sideways". To put it another way, the chart pattern since the 1999 bottom involves a repeating surge-consolidate sequence. This is similar to the pattern that occurred from 1980 through to 1994, except in the opposite direction.

3. There was a downside blow-off during the final 5 years of Gold/Dow's 1980-1999 secular bear market. During this period the Gold/Dow ratio declined in almost straight-line fashion.

4. The current bull market has not yet commenced an upside blow-off.

There are no guarantees, but it would be very strange if gold's long-term bull market were to end before the Gold/Dow ratio had experienced an upside blow-off. Furthermore, due to the differing natures of the gold and stock markets there's a good chance that the upside blow-off in Gold/Dow's long-term bull market will be steeper and shorter than the downside blow-off in its preceding long-term bear market.

The chart displayed below zooms in on Gold/Dow's performance over the past three years. During much of this period Gold/Dow has been in the "few steps sideways" part of its repeating sequence.

At this stage there is no definitive evidence that the consolidation that began in Q1-2009 is complete, although we suspect that it is. This suspicion is based on the fact that in February of this year two important indicators of economic confidence began to trend in a direction that indicates falling confidence. We are referring to credit spreads, which began to widen, and the CCI/gold ratio, which began to decline.
 
It should be noted that similar trend changes appeared to be underway at this time last year but were ultimately prevented from gaining traction by the Fed's "QE2" program. There is a possibility that the Fed will again find a way to extend the consolidations that began in Q1 2009, although the spreading recognition that "QE2" didn't help the real economy makes it likely that a new inflation-promoting program won't be introduced until after the backward-looking economic numbers paint a much bleaker picture and/or the stock market drops to a much lower level.

Current Market Situation

In the latest Weekly Update we wrote:

"If gold and silver futures can continue to hold above support ($1520 for gold, $33 for silver) this week then the risk of a sharp near-term decline will subside. As mentioned in the last two TSI commentaries, the most likely alternative to a sharp near-term decline is several more weeks of 'choppy' range trading. We suspect that this extended period of range trading would be followed by declines to below the May lows for both gold and silver."

Based on the action over the first three days of this week it looks like we are in for "several more weeks of 'choppy' range trading".

Since closing slightly below support at $1520 on Monday 13th June, the nearest gold futures contract has risen for seven days in succession. This probably means that a multi-day pullback or consolidation will soon commence.

The most important nearby support remains at $1520. Resistance is at $1560-$1580.

Gold Stocks

The extent to which the HUI was 'oversold' at the end of last week made it likely that a significant rebound would soon begin. The only question was whether there would be a spike below support at 490-500 before the rebound began. Based on the price action over the past three trading days, it looks like support at 490-500 is going to hold for now and that a multi-week rebound has begun.

The following daily chart shows that the HUI's 50-day and 200-day moving averages are converging at 540. This makes 540 a reasonable near-term upside target.

There is some chance that the HUI's ultimate correction low was put in place late last week, but this is not the most likely scenario. The reason is that the intermediate-term correction that began last December has not yet resulted in the HUI falling as far, relative to its 50-day moving average, as it has during every other intermediate-term correction of the past 10 years.

Short- and intermediate-term corrections in bull markets often have nothing to do with fundamental changes, but if you desire a fundamental justification for additional weakness in the gold sector you need look no further than the temporary end of the Fed's money pumping.

Currency Market Update

Things are generally quiet on the currency front, although the British Pound is showing signs of breaking down.

The US$ will be boosted if the euro-zone's leadership fails to quickly apply another "bandaid" to the gaping hole in the Greek government's balance sheet, but substantial strength in the US$ will probably require substantial weakness in the broad stock market. Therefore, the Dollar Index probably won't do much if the stock market rebounds or consolidates over the next few weeks.

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)

Mansfield Minerals (TSXV: MDR). Shares: 51M issued, 54M fully diluted. Recent price: C$1.84

MDR is developing the Lindero gold project in Salta Province, Argentina. Lindero's 3M-ounce deposit has the potential to be developed into a mine that produces 150K ounces of gold per year.

A Feasibility Study (FS) should soon be complete. Based on the results of the earlier Pre-FS, the FS is likely to show positive economics at a gold price of $1000/oz or higher.

The FS should give a boost to MDR's downward-trending stock (see chart below), but our main concern is whether the company will get the permits it needs to construct a mine. MDR has a very low valuation despite the strong potential for the Lindero project to be developed into a profitable mining operation, but we won't be totally comfortable with the stock until the mine permits are in place.

MDR is presently a member of the TSI Small Stocks Watch List. Depending on the stock price at the time, we may decide to transfer it to the TSI Stocks List -- that is, make it a formal TSI stock selection -- once a mine permit is received, because in addition to removing some risk the receipt of the mine permit would probably make the stock more liquid.

    International Tower Hill Mines (AMEX: THM, TSX: ITH). Shares: 85M issued, 90M fully diluted. Recent price: US$7.01

A common misconception is that large moves in market prices are driven by changes in the so-called "fundamentals", the implication being that large declines shouldn't occur if the fundamentals are bullish and large rises shouldn't occur if the fundamentals are bearish. The reality, however, is that financial markets routinely make large moves that turn out to have had absolutely nothing to do with changing "fundamentals". To paraphrase Warren Buffett, on a long-term basis the markets are weighing machines, but over shorter timeframes they are voting machines.

The performance of THM's stock price over the past three months provides a good example of what we are talking about. As far as exploration-stage gold-mining stocks go, THM is relatively low risk. It has 100% ownership of a large deposit in a good location (in Alaska, close to power and transport infrastructure); it has a strong balance sheet (more than $100M in the bank); it has a supportive major mining company (Anglogold) as its largest shareholder; and it is in what we refer to as the "sweet spot" of the mine development sequence (the stage where there is minimal scope for disappointing news).

THM offered reasonable value at C$10.50/share in early April, but despite this and the positives mentioned above it then began to trend downward to a low of C$6.50 early this week. During this downward trend there was no deterioration in the "fundamentals". In fact, the most important fundamental (the gold price) improved.

In general, when markets make large moves that are counter to the fundamentals they create money-making opportunities. In THM's case, the recent decline created a better buying opportunity than we expected would arise (we previously thought the stock was a buy after it fell to around C$8.00).

Chart Sources

Charts appearing in today's commentary are courtesy of:

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