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Long-term bearish on China and the US

When it comes to their outlooks for China's economy, most analysts fall into one of two groups. The first group is outright bullish on China's prospects over all time frames, while the other is very optimistic on a long-term basis but is concerned about the potential for a painful short- and/or intermediate-term 'correction'. In other words, most analysts are long-term bullish.

As discussed in the past, we fall into neither of these groups. We also can't be counted amongst the naive souls who labour under the delusion that the US is still the "land of the free" and that China is still a Soviet-style basket case.

We are long-term bearish on the economies of both the US and China, primarily because the governments of both countries are now headed down paths that involve using monetary inflation and greater government control of the economy in an absurd effort to counteract the disastrous effects of earlier monetary inflation and controls (China spent much of the past three decades in a bullish trend as far as government involvement in the economy is concerned, but that trend appears to have ended). We are also concerned that there is very little understanding amongst economists, politicians and members of the general public as to what caused the global financial crisis and what should be done to ensure greater stability in the future. In particular, hardly anyone fully understands how monetary inflation affects the economy. Most of the people who appreciate that there is a link between money supply and prices believe that money-supply growth is only a problem to the extent that it brings about an increase in the general price level.

The reality is that an increase in the general price level, which can more aptly be described as a decrease in the purchasing power of money, is just one of the effects of monetary inflation. And of these effects, a decrease in the purchasing power of money is the LEAST important.

Of greater importance is that substantial monetary inflation results in mal-investment on a grand scale, which means that it leads to the economy-wide wastage of resources and reduction of wealth. It does this in two ways, the first being its non-uniform mode of operation (the way that some prices rise earlier and faster than others in response to the increasing money supply). Changes in relative prices are the signals upon which the market economy relies, and when these signals are artificial (meaning: due to additional money rather than due to sustainable changes in consumer demand) the result is a cluster of investing and resource-allocation errors. The errors occur during the inflation-fueled boom, but they don't become apparent until the ensuing bust. The bust is effectively the period when the "chickens come home to roost".

Monetary inflation also leads to mal-investment by creating the impression that there is a greater amount of real savings than is actually the case. It has this effect because it lowers the interest rate.

Here's what is supposed to happen: people reduce their current consumption and save more, with the goal of increasing their wealth and being in a position to consume more in the future. This causes the interest rate to fall, which entices entrepreneurs and other businessmen to invest in long-term projects (property developments, new manufacturing facilities, mines, major expansions and upgrades, etc.). Although most individual entrepreneurs and businessmen won't think of it in this way, they are responding to a signal that the public is saving more today in preparation to spend more in the future.

What happens, though, if the fall in the interest rate is induced by the central bank boosting the money supply? In this case the same signals will initially be sent to the capital markets, but there will have been no reduction in present consumption and no concomitant increase in real savings. Entrepreneurs and businessman will undertake long-term projects based on the assumption that the public will have more real wealth to spend in the future, while the public is REDUCING its future capacity for real spending by consuming aggressively in the present. In other words, a mismatch emerges. This mismatch can continue to develop for years, but the longer it develops the worse the inevitable bust will be when reality strikes.

The effects of the mal-investment wrought by the past decade's monetary inflation in the US are evidenced not only by the dismal state of that country's residential real estate market (the focal point of the boom), but also by the state of the labour market. The following chart from the St Louis Fed's web site shows that total private sector employment in the US today is at around the same level it was at the beginning of 1999. To put it another way, the chart shows that there has been no net-increase in US private-sector employment over the past 12 years. This poor performance has a number of policy-related causes, but in our opinion the mal-investment associated with Greenspan's two inflation-fueled booms is by far the most important.

Unfortunately, Bernanke is now trying to create another inflation-fueled boom.

The problems that stem from many years of monetary inflation and bad government policy are obvious in the US, even if they are usually misdiagnosed. They are obvious because the boom has already turned to bust. They aren't obvious yet in China, though, because the inflation-fueled boom is still going.

Due to many years of mal-investment on an unprecedented scale, China is an economic bust waiting to happen. In itself this wouldn't be a good reason to be long-term bearish, because left to its own devices an economy is capable of recovering from a major misalignment of production and consumption within a couple of years. This would especially be so in the case of China due to the strong work ethic and self-reliance of its population. The reason we are long-term bearish is that there is little chance of China's economy being left to its own devices. Based on the fact that China's policy-makers have made similar mistakes to their Japanese and US counterparts up until now, it's a good bet that they will continue to do so.

The Stock Market

The S&P500 Index plunged below short-term support in the low-1300s during the first half of last week and has since rebounded back to this former support (which is now resistance). This means that the rebound has gone about as far as it should go IF the recent decline is going to evolve into something more serious than a routine short-term correction. To put it another way, if the S&P500 closes above resistance in the low-1300s over the coming days then the downturn that began in mid February was probably just a correction within an on-going intermediate-term advance.

The world is poorer as a result of Japan's recent massive earthquake, the reason being that a lot of real wealth has been destroyed. Furthermore, the government and central-bank responses to Japan's 'economic hit' will add to the existing inflation problem and result in slower long-term economic progress, for the reasons discussed earlier in today's commentary. There will, however, be some winners, such as the companies directly involved in new construction work in the earthquake-ravaged areas and the companies that supply the materials and equipment used in the rebuilding effort.

It seemed that on Wednesday 23rd March the stock market began to discount an increase in the demand for industrial metals that will stem from Japan's coming rebuilding effort. While there is some logic to this, it should be remembered that the prices of these metals are already very high and that the swings in China's economy are going to be far more important, as far as industrial metals markets are concerned, than the reconstruction work associated with Japan's earthquake.

Gold and the Dollar

Gold and Silver

The following three charts sum up the current market situation.

First, we have a daily chart of the gold price in US$ terms, which shows that US$ gold is testing the intra-day highs made earlier this month and has just achieved its highest daily close. It has risen for 6 days in a row and is thus extended to the upside on a very short-term basis, but this only means that there will soon be a 1-3 day pullback. The price action suggests that new highs will be made within the coming fortnight.

Next, we have a weekly chart of the silver/gold ratio. This ratio remains extraordinarily 'overbought' on a short-, medium- and long-term basis, but it hasn't yet signaled a top. This chart suggests that new highs are likely for both gold and silver. It also suggests that traders should be 'dancing close to the exit'.

Lastly, we have a daily chart of the gold price in euro terms (gold/euro). Whereas the US$ gold price looks like it is about to break into new-high territory, gold/euro remains a comfortable distance below its December-2010 peak.

Gold is probably on its way to new highs in US$ terms, but it will be interesting to see if these new highs are confirmed by the euro-denominated gold price. The combination of new highs in the US$ gold price and significantly lower highs in the euro gold price would be a bearish divergence. Assuming no large change in the US$/euro exchange rate, a move to a new high in the euro-denominated gold price would require a move to well above $1500/ounce in the US$ gold price.

Cycle analysis suggests that the rallies in gold and silver could continue until the first half of May. This is certainly possible, but we don't think it is prudent to bet on such an outcome.

As mentioned in a TSI commentary a couple of weeks ago, we are hedging (obtaining insurance) by scaling into SLV July put options as silver ramps upward. We bought some SLV puts when silver traded up to $36 during the first half of March with the aim of buying more with every additional $2-$3 gain. This means that our next insurance purchase will occur at $38-$39.

Gold Stocks

The gold sector, as represented on the following daily chart by the HUI, has rebounded strongly over the past few days. It has just risen for 5 days in succession and is nearing important resistance, which means that it will probably soon have a 1-3 day pullback. However, it is not yet 'overbought' on even a short-term basis.

The gold sector of the stock market is not leading the bullion market. It is most definitely the other way around, in that gold and silver stocks are getting dragged higher by the metals. In fact, it almost seems as if the stocks want to fall, but the metals won't let them. Moreover, the performance of the average gold stock has recently been a lot worse than the performance of the HUI, meaning that most individual gold stocks are lagging the bullion by even more than suggested by the gold-stock indices.

On a short-term basis, weakness in the stocks relative to the bullion is generally bearish. Note, though, that it wouldn't take much additional strength in the stocks from here to push the HUI into new-high territory and eliminate this short-term bearish signal. On a long-term basis, weakness in the stocks relative to the bullion is 'par for the course'. As we've previously explained, gold stocks, as a group, have been weakening relative to gold bullion since 1968.

Regardless of what lies immediately ahead, this week's move in the HUI to near resistance at 580 has created an opportunity to do a modicum of selling. If you have some gold and/or silver stocks that have risen sharply over the past several days and are now at, or close to, new highs, you should consider taking some money off the table.

Currency Market Update

Portugal's Prime Minister has just resigned due to the defeat of his party's so-called "austerity program". This is a reminder that while Europe's sovereign debt problem is not the currency market's present focal point, it hasn't gone away.

Intervention designed to help Japan's exporters has been successful, in that the Yen has been pushed back into its 6-month range (see chart below).

We expect that the success will only be temporary and that the Yen will strengthen against most currencies over the next two months as Japanese capital is repatriated. We also expect that 2-3 months of additional Yen strength will be followed by a Yen bear market. This view is based on the assumption that Japan's monetary authorities will increasingly resort to monetary inflation in their efforts to finance government spending and support export industries.

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)

Minefinders Corp. (AMEX: MFN). Shares: 80M issued, 96M fully diluted. Recent price: US$12.61

The following chart shows that MFN broke above resistance to a new multi-year high during the first half of this week. The breakout creates a measured chart-based objective of $15.50-$16.00. Also of note is the long-term resistance at around US$14.

Based on normal valuation metrics and the company's 135K gold-equivalent production forecast for this year, MFN is now close to being fully valued. It offers good value relative to most silver stocks, but this is because most silver stocks are now very over-valued.

Due to valuation and the fact that the silver rally is now very 'long in the tooth', we think it makes sense to scale out of MFN in the $13-$15 range. For TSI record purposes, we will exit the stock if it trades at US$13.40 within the next few weeks.

    Franco Nevada March-2012 C$32.00 Warrants (TSX: FNV.WT). Recent price: C$6.14

The following chart shows that Franco Nevada, one of the world's two premier gold royalty stocks, hit a new all-time high on Wednesday. This gave our FNV warrants a significant boost.

In the 7th March Weekly Update we wrote:

"...holders of the warrants should plan to scale out of their positions into strength over the next two months. Our previously noted C$10 price target still looks feasible, but in order for this target to be achieved the FNV stock price will have to move up to around C$40."

Due to Wednesday's price action, C$40 for the stock and C$10 for the warrants looks even more feasible. However, we continue to believe that it makes sense to gradually exit into strength.

For TSI record purposes, we will exit the warrants if they trade at C$9.50 within the next few weeks.

    Pretium Resources (TSX: PVG). Shares: 81M issued, 84M fully diluted. Recent price: C$11.38

PVG came under some selling pressure on Wednesday due to the announcement that Silver Standard Resources (SSRI), the owner of 42% of PVG, was planning to exit its stake via a secondary offering. SSRI never intended to be a long-term holder, so Wednesday's news wasn't a surprise.

This development could cause PVG to remain under pressure for the next 1-2 weeks, but it is a longer-term plus because it will improve liquidity and allow some institutions to get positioned in the stock.

    Duoyuan Global Water (NYSE: DGW). Shares: 25M. Recent price: US$7.22

DGW took another stock-market hit on Wednesday in response to the release of its latest quarterly financial report. The report revealed a significant slowdown in the company's growth and reduced gross margins due to increasing costs, but everything with this company is now secondary to the on-going third party audit of its accounts. Even if growth stopped altogether the company is probably worth more than twice its current market capitalisation IF its published accounts can be trusted.

The main reason for Wednesday's high-volume decline was probably the statement, included in the latest quarterly report, that the results of the third party audit would not be available until the end of the second quarter. This means that the audit is taking much longer than most people expected (the original expectation was that the audit would be complete within 4 months, but it now looks like taking 9 months). There is no evidence at this time that there is anything wrong with DGW's accounting, but the audit delays certainly don't instill confidence.

DGW's market cap is now roughly the same as its working capital, which means that its profitable water treatment/purification business is being valued by the stock market at roughly zero. This would make it a low-risk/high-potential-reward situation if we could be confident that the accounts were accurate. As it is, it's a high-risk/high-potential-reward situation.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html