Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

China in the News

Events in China often make news outside China, but even when we were living in China it was difficult for us to figure out what was really happening. Figuring out what's happening to China's economy is especially difficult, in part because all of the economic statistics put out by the Chinese government are totally bogus. We note, for example, that according to HSBC's survey of China's factory managers September-2012 was the 11th month in a row of deterioration in the manufacturing sector, but even if the manufacturing sector deteriorates every month this year the Chinese government can still be relied on to report annual GDP growth of around 7.5%. And many Western analysts can be relied on to treat the reported 7.5% growth rate as if it reflected reality and use it to justify bullish outlooks for some commodities.

Bogus statistics do not present the biggest challenge to those who want the truth about China's economy. That honour belongs to the combination of widespread corruption and unprecedented mal-investment. As a result of these issues, the superficial signs of China's economic strength are often, on a deeper level, evidence of economic weakness, making it impossible to determine the extent of China's real economic progress. We are referring in particular to the nation-wide building boom that has squandered resources and transferred immense wealth to Party officials, politically-connected property developers and senior managers at State-Owned Enterprises. We've discussed China's monetary-inflation-fueled investment boom in many TSI commentaries over the years. The starring role played by corruption is discussed in "The Macroeconomics of Chinese Kleptocracy".

China recently made the Western news due to violent protests in the streets of major Chinese cities, ostensibly in reaction to the Japanese government's purchase, from a private Japanese citizen, of a group of small uninhabited islands (the Diaoyu Islands in China, the Senkaku Islands in Japan) over which both countries claim sovereignty. We say "ostensibly", because when it comes to China you never really know. A likely explanation is that the widespread and high-profile protests were orchestrated by the Chinese government, either as a way of turning up the heat on the Japanese government or as a way of distracting the Chinese public from economic problems at home. A less likely, but still plausible, explanation is that many of the protestors were actually venting anger at the Chinese government under the cover of a protest against Japan. In China, protests against Japan are usually allowed and are sometimes even encouraged, but protests against the Chinese Communist Party are speedily quashed.

By the way, Taiwan's government also claims sovereignty of the islands at the centre of the China-Japan dispute and attempted to assert its 'ownership rights' earlier this week. In Taiwan the chain of islands is called Tiaoyutai.

Another recent talking point in the Western press was China's official announcement of $160B of spending on new infra-structure projects. The announcement was designed to maintain a veneer of economic strength a while longer -- at least until after next month's Communist Party leadership transition is put to bed. If this spending program goes ahead it will constitute another grand-scale wastage of resources and line the pockets of Party officials and SOE managers with tens of billions more dollars. A large proportion of the looted money will inevitably find its way into the Hong Kong property market, giving the world's most expensive real estate another price-boost and pushing home ownership even further out of the reach of the average Hong Kong resident. That being said, there is considerable scepticism surrounding the latest infra-structure spending binge. For one, it relies on substantial spending by provincial Chinese governments that make the government of Greece look like a picture of financial health. For another, the $160B appears to cover existing as well as new projects.

We now turn our attention to the story about "ghost metal inventories" that made the rounds over the past couple of weeks. The crux of the matter is that many borrowers of money from Chinese banks pledged steel stored in warehouses as collateral for their bank loans. In some of these cases the borrowers defaulted, but when the associated bank tried to take possession of the collateral it discovered that the metal wasn't there, or that the metal was there but not owned by the bank's customer, or that the same pile of metal had been pledged as security to multiple lenders. The story that recently circulated focused on steel inventories, but it's a good bet that the same applies to inventories of copper and other metals. It's also a good bet that the same applies to other collateral used to obtain loans.

The final piece of China-related news that we'll deal with in today's commentary is the decline by the Shanghai Stock Exchange Composite Index (SSEC) to big round-number support at 2000. On Wednesday 26th September the SSEC traded slightly below 2000, which was also its lowest level since January of 2009, before ending the day slightly above 2000.

We aren't inclined to place any bets on the performance of the SSEC, but if we were forced to place a bet it would be a bullish one predicated on the idea that the Chinese government will draw a line at 2000.

T-Bond Update

Treasury Bonds tend to perform relatively well when the stock market is declining and relatively poorly when the stock market is rising. This is mainly because inflation expectations tend to rise and fall with the stock market. At least, that's the way it is today and the way it has been for many years, although at some future time it's likely that rising inflation expectations will cause large parallel declines in the stock and bond markets.

Due to the current tendency of the stock and T-Bond markets to trend in opposite directions, being short-term bearish on both markets is an uncomfortable position. However, this is the position we are in. We can be short-term bearish on both markets because from our perspective individual market analysis trumps inter-market analysis, and both markets appear to have a lot more downside than upside potential.

A couple of weeks ago the T-Bond was a little 'oversold' and within a range of good support (see chart below). It is therefore not surprising that it has since rebounded. A decline in inflation expectations over the past few days in reaction to the stock market's pullback gave the T-Bond an additional boost, but unless the stock market's decline gains momentum (unlikely in the immediate future) the T-Bond market's rebound is probably close to an end.

The Stock Market

The Fed announced "QE3" on 13th September. The S&P500 Index closed at 1437 on 12th September and closed at 1433 on 26th September, meaning that the US stock market is down since the introduction of the Fed's latest inflation program. This simply reflects the fact that a lot of QE anticipation was built into the market prior to the Fed's announcement.

There's a lot of downside risk in the US stock market, but the most likely near-term outcome is that the current correction will be followed by a return to the September high. We suspect that the ultimate high won't be more than 3% from the September high, despite the Fed's helping hand.

Gold and the Dollar

Gold and Silver

Gold tested resistance at around $1800 late last week and then began to 'correct'. This is not the least bit surprising. It traded as low as the $1730s on Wednesday before recouping some of its losses to end the day in the $1750s.

As previously advised, a new short-term buying opportunity would be created by a decline to near the 50-day moving average. This moving average is presently at $1665 and is rising at the rate of about $14/week.

Silver became very 'overbought' during the past fortnight and has begun to roll over to the downside, but the price action hasn't yet signaled that anything more than a 2-3 week top is in place. A new short-term buying opportunity would be created by a decline to $30-$31, but the chart suggests the possibility of a surge to $37-$38 before a significant correction gets underway. This means that we could get a short-term selling opportunity before the next short-term buying opportunity presents itself.



The hard reality is that markets routinely forget to follow the paths that we lay out for them. That's why it's dangerous to rely on forecasts, and, by the same token, why it's much better to rely on real-time analysis. Sometimes we expect to get a selling opportunity at a certain time, but instead the market gives us a buying opportunity. And then an even better buying opportunity. At other times we expect to get a buying opportunity, but the market instead gives us a selling opportunity.

With respect to our own money management, we usually don't attempt to forecast and we never get into the position where we are heavily dependent upon the success of a single forecast. Instead, we try to look at the markets we trade from the following perspective: "If A happens, then we'll do B; if C happens, then we'll do D; if E happens, then we'll do F, etc." One outcome will often be favoured, but we don't assume that our favoured outcome will necessarily be the actual outcome.

Gold Stocks

Current Market Situation

If the HUI had closed lower for a third consecutive day on Wednesday 26th September there would be no doubt that the anticipated short-term correction had begun, but the fact that the HUI managed to close higher on the day despite weakness in both the gold market and the broad stock market leaves a smidgen of doubt. We can therefore only say that a short-term HUI correction has probably begun.

Our view continues to be that support in the 460s defines the maximum short-term downside potential. On this basis and unless advised otherwise, our short-term outlook will return to "bullish" if the HUI drops to the 470s.



A good set-up for a 2-4 month trade could soon emerge

It is common for junior gold mining stocks, as a group, to peak on an intermediate-term basis well after the senior gold mining stocks that are represented by indices such as the HUI and the XAU. Drawing from the historical record to illustrate this point we present, below, a chart comparing the performances of the CDNX and the HUI during 2003-2005. The CDNX isn't an ideal proxy for the junior end of the gold mining sector, but for the period covered by the chart it's the best we have.

The areas on the chart enclosed by the green boxes show the substantial gains made by the CDNX during the months following the December-2003 and November-2004 intermediate-term peaks in the HUI.



There are never any guarantees, but there's a better-than-even-money chance that many junior gold stocks will go on to make new 6-month highs during the first quarter of next year even if the HUI makes an intermediate-term peak during the final quarter of this year (as mentioned in previous commentaries, November of this year is the earliest that we are likely to get an intermediate-term peak in the HUI). This suggests a trading opportunity.

The trade we have in mind is to purchase GLDX, an ETF composed of exploration-stage gold mining stocks (the most speculative stocks in the gold mining universe), in reaction to near-term weakness. A daily GLDX chart is displayed below. For record purposes we will add a GLDX trading position to the TSI Stocks List if the ETF trades at US$8.60 within the next three weeks.



South African mining industry plagued by strikes

Last month, violent protests at Lonmin's Marikana platinum mine in South Africa resulted in 45 deaths. The Marikana mine dispute has since been resolved via an agreement between the company and its workers for pay increases ranging from 11% to 22%, but labour unrest appears to be spreading like wildfire through the SA mining industry. Here are some examples:

1) Workers at the KDC West gold mine of Gold Fields Ltd (GFI) went on strike on 9th September. The strike continues. Furthermore, workers at GFI's Beatrix gold mine have been on strike since 21st September. The KDC West and Beatrix strikes involve up to 24,000 workers.

2) Workers at the Kopanang gold mine of Anglogold Ashanti (AU) went on strike on 20th September and on 24th September were joined by the remainder of AU's Vaal River workers, as well as its workers at the West Wits operations. This strike action could involve as many as 35,000 workers.

3) Workers at Anglo American Platinum’s Rustenberg operations have gone on strike.

We haven't had any interest in owning the shares of SA gold mining stocks over the past two years and continue to have no interest. The risk of strike action is too great. Agreements will be negotiated and the current surge in labour unrest will be followed by a period of relative stability, but the problem is bound to resurface.

Disruptions to South Africa's platinum production can have a big positive effect on the platinum price, but disruptions to South Africa's gold production do not have a significant effect on the gold price. This is because the amount of gold produced in a year by South Africa's mining industry is the equivalent of only about 0.15% of the total aboveground gold supply. Consequently, even though about 40% of SA's gold production is presently halted due to strikes, this is not important as far as the global gold market and the gold price are concerned. It is, however, important for the SA economy and of course for the people directly involved with gold mining in SA.

Currency Market Update

The new inflation-promoting schemes introduced by the ECB and the Fed during the first half of September pushed the Dollar Index to an 'oversold' extreme (more monetary inflation or expectations of more monetary inflation generally leads to US$ selling). It has since rebounded.

The odds are in favour of the Dollar Index dropping to a new multi-month low within the next month, but the downside risk from here is probably no more than three points. However, as is always the case a lot will depend on the performance of the stock market. The US$ generally benefits from stock market weakness, so for the Dollar Index to make a new low next month the S&P500 Index will probably have to return to its September high.

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

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html