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US Mortgage Mess Update

John Mauldin's latest Weekly Letter contains an explanation of why US banks could collectively be facing additional unplanned losses of more than 100 billion dollars as a result of the way they put together Mortgage Backed Securities (MBS's). It seems that banks deliberately and knowingly inserted many flawed mortgages into the MBS's that they sold to investors, which could mean that the banks will be forced to buy back hundreds of billions of dollars of these products at the original sale value. The securities are now worth a lot less than the original sale value, hence the additional loss potential mentioned above.

The US mortgage market has evolved into the crisis that keeps on giving. Just when it seems that every cockroach has been exterminated (usually at taxpayer expense), a bunch more crawl out of the woodwork.

Since the start of the financial crisis the US government and the Fed have teamed up to provide the US banking industry with direct support of around 2 trillion dollars. There has also been indirect support measured in the trillions. The alternative to providing this taxpayer-funded support would have been to let some large and poorly managed banks go bust, which would have resulted in the banks' bondholders suffering massive losses. In other words, the choice was to let bondholders suffer the consequences of their ill-conceived investments or to shield the bondholders by effectively spreading the losses across the entire economy. The latter option was chosen.

With more large losses now looming for the banking sector, the Treasury-Fed combo faces a dilemma. Its loyalties clearly lie with the large banks and their bondholders, but with public resentment already at a troublesome level due to high unemployment and the earlier bailouts it is probably not politically feasible to provide beleaguered banks with more direct financial support. Fortunately for these banks and their investors, there is almost no limit to the amount of indirect support that can surreptitiously be provided by the Fed.

The next round of "quantitative easing", for example, will benefit commercial banks because all the new money created by the Fed will eventually end up in the private banking system (with the exception of a small float (notes and coins in wallets, cash registers, etc.), all the money in the economy is held in bank accounts). Perhaps more importantly, the Fed is capable of supporting banks by maintaining a steep yield curve indefinitely. An artificially steep yield curve effects a transfer of wealth from a bank's depositors to the bank itself (because the bank pays its depositors a below-market rate of interest thanks to the Fed's efforts), but it has the political advantage of being a wealth transfer that few people recognise. After all, most people have been conditioned to believe that the central bank helps the OVERALL economy by reducing interest rates, which effectively means that they have been conditioned to believe that the Fed, via its manipulation of interest rates, is able to provide the proverbial "free lunch".

So, expect the banking industry to be handed more financial assistance at the expense of the overall economy. Just don't expect the assistance to be the overt kind.

Are you ready for QE2?

The Stock Market

The S&P500 Index (SPX) has closed within a 12-point range (1174-1186) on each of the past 11 trading days, and over the past 4 trading days its daily closing range has narrowed to only 3 points (1183-1186). In other words, on a daily closing basis the US stock market has done almost nothing over the past two weeks.

The recent loss of upward momentum could mean that the market is about to roll over to the downside, but it's more likely to be a pause within a continuing short-term upward trend. Our guess is that the SPX will test its April high at some point over the next month, but this doesn't imply interesting upside potential because the April high is only about 3% above the current level.

The following daily SPX chart shows intermediate-term resistance defined by the April high and short-term resistance/support levels (support lies in the low-1160s). It also indicates the early-July "death cross" (the 50-day MA's cross from above to below the 200-day MA) and the recent "golden cross".

When the moving averages crossed over in early July, we wrote:

"The stock market's recent weakness has allowed the S&P500's 50-day moving average to cross below its 200-day moving average, an event that technical analysts commonly call a "death cross". The term "death cross" sounds ominous, but such crossovers have no statistical significance in that they are only followed by meaningful additional losses about 50% of the time. Rather than being an indication of what lies in store, we consider the S&P500's "death cross" to be one of several milestones that had to be reached if we were correct to assume that an intermediate-term decline began in April."

As it turned out, the so-called "death cross" coincided with an important price low. This is actually not uncommon. It is also not uncommon for a "golden cross" to occur at around the time of an important price high. Why, then, do some technical analysts place a lot of emphasis on these moving average crossovers, with "death crosses" considered to be reliable bearish signals and "golden crosses" considered to be reliable bullish signals? We don't know -- you'd have to ask them.

It is now apparent that an intermediate-term decline began in April, but as we first realised at the beginning of September it most likely ended about three months sooner than originally expected. A test or marginal breach of the April high could mark the next intermediate-term turning point, but we'll cross that bridge when we come to it.

Gold and the Dollar

Gold

Our view continues to be that gold is immersed in a routine short-term correction within a continuing upward trend. Counter-trend moves such as this often take the price down to the 50-day moving average or a little lower. As indicated by the following daily chart, this moving average is now at $1295 (basis the December futures contract).

Below the 50-day moving average there is lateral support at around $1260-$1270, which could come into play within the next several days.

Sentiment indicators suggest that gold's correction will extend no further than the lateral support mentioned above. For example, Market Vane's survey shows that the percentage of bullish traders has dropped from 85 to 70 since the October price peak. This is as much of a reduction in bullish sentiment as we'd expect from a short-term correction. Also, Central Gold Trust (GTU) ended Wednesday's session at a premium to net asset value (NAV) of only 1.4% and traded at a small discount to NAV late last week. Last week was the first time since September of 2008 that GTU traded at a discount to its NAV.

With gold most likely within a few percent of a correction low, we are upgrading our short-term outlook from "neutral" to "bullish".

Speculators wanting to 'get long' or add to existing long positions in gold should consider the following scaling-in plan:
  - do some buying in the US$1320s
  - do some more buying if the price drops to the US$1290s
  - do some more buying if the price drops to the US$1270s

Gold Stocks

The HUI has tested support in the low-490s on 4 of the past 6 trading days. The more times a support level is tested, the higher the probability that it will be breached before a sustainable low is in place.

A breach of support could lead to nothing more than an intra-day spike to around 480, but the chart pattern is evolving in a way that suggests the potential for a decline to as low as the mid-450s. Many gold-stock holders would no doubt be worried by a decline to the 450s, but we would welcome it with open arms because it would lower the risk of new buying.

Based on the gold sector's performance over the past decade, the most likely time for a correction low is this week or next week.

Currency Market Update

Hong Kong's Hang Seng Index (HSI) is a good proxy for the global stock market situation. This is perhaps because Hong Kong is an interface between the developing world's most important economy and the economies of the developed world. As a result of this interface role, HK's stock market probably acts like a barometer of global economic growth.

The following chart compares the aforementioned proxy for the global stock market situation with the Dollar Index. Clearly, the strong inverse relationship between the Dollar Index and global equities that began in July of 2008 is still very much in effect.

The turning points in the HSI and the Dollar Index match up so closely that it is impossible to tell, by looking at the chart, which market is leading and which is lagging, or if there is any sort of lead-lag relationship at work. We suspect that traders are simultaneously buying equities and short-selling the US$, or selling equities and closing-out US$ shorts, in response to swings in economic growth expectations.

As an aside, there is also an inverse correlation between the global stock market situation and the gold/silver ratio, the gold/GYX ratio (GYX is the Industrial Metals Index), and the gold/CRB ratio. This means that gold has generally been doing better than other commodities when the US$ has been strengthening and worse than other commodities when the US$ has been weakening.

As we mentioned at the time, there's a possibility that the Dollar Index's "outside up-day" on Friday 15th October could have marked an intermediate-term turning point. However, arguing against this possibility is the absence, to date, of any evidence that an intermediate-term stock market peak is at hand. It's therefore more likely that the Dollar's current rebound will be followed by a decline to at least a marginal new low.

As noted on the following chart, a counter-trend rebound should end at, or below, 80.

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)

In Stock Selection Update #62, sent to subscribers following Tuesday's trading session, we advised that we were exiting Fortuna Silver (TSX: FVI) at a profit of 76%. The main reason was that at Tuesday's closing price of C$3.79 FVI was within 5% of being fully valued. It is also worth noting that FVI is technically 'overbought' (it is about 50% above its 200-day moving average) and -- as illustrated by the following chart -- at long-term resistance.

    Franco Nevada $32.00 warrants (TSX: FNV.WT). Recent price: C$6.25

FNV appears to have acquired the 'leading indicator' status that Royal Gold (RGLD) once held. If so, its move to a new all-time high on Tuesday is a bullish omen for the overall gold sector.

Our main interest is with the FNV C$32 warrants (FNV.WT). Our chart-based target for FNV is C$40, and if the stock moves up to around this target over the next couple of months then fair value for FNV.WT at that time will be $11-$12. However, the stock market has consistently priced these warrants at a sizeable discount to their fair value*, so it is quite possible that a rise to C$40 in the stock price would only bring about a rise to around C$10 in the warrant price. We have therefore decided to exit the warrants if they trade near C$10.

    *For example, at Wednesday's closing price of C$34.72 for FNV, the fair value for FNV.WT is about C$7.80; however, FNV.WT ended Wednesday's session at only C$6.25.

    Jaguar Mining (NYSE and TSX: JAG). Shares: 84M issued, 88M fully diluted. Recent price: US$6.24

In the realm of gold mining companies that are expected to produce more than 200K ounces of gold next year, at current prices JAG is one of the two most under-valued (ASX-listed RSG being the other). Disappointment earlier this year relating to production problems and the consequent failure of the company to achieve its growth plans eventually led to what we view as a stock market over-reaction and an excellent buying opportunity. The most recent production guidance announced by JAG again disappointed the market and provided news-related justification for a sharp pullback from the stock's channel top (see chart below). However, the company's updated forecast for the current quarter was not far from what we had expected and the updated forecast for 2011 was exactly in line with what we had factored into our valuation analysis.

In our opinion, JAG is a strong buy at around US$6.00. Assuming no significant change in the gold price, we think it has the potential to rebound to US$9.50 over the coming 9 months based solely on the achievement of a valuation closer to the industry average for a producer of its size. Also, it is worth mentioning that the technical (chart-based) objective following a break above resistance at US$7.00-$7.50 would be $10.00-$10.50.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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