<% 'pass = Request.Form("pass") IF ((Request.Form("pass") = 1) OR (Session("pass") = "pass")) THEN %> Speculative-Investor.com

    - Interim Update 28th January 2009

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.

Debt and other problems

Debt-induced deflationary spiral

Decades of monetary inflation and credit expansion have put the US in the position where the dollar value of debt is way too high relative to the dollar value of assets (many other countries are in similar or even worse positions, but for simplicity we will focus on the US). Furthermore, the situation is likely to worsen over the coming year in that there will very likely be additional declines in asset prices (primarily real estate) and a reduction in the collective ability of borrowers to service their debt, leading to reduced investment, an even weaker economy, and lower prices for everyday goods and services. Consequently, even if the money supply continues to grow at a robust rate the economy could be 'ravaged' by deflation over the coming 12 months, where deflation has the popular -- although incorrect, in our opinion -- meaning of falling prices.

We put quotation marks around "ravaged" in the above paragraph because deflation is not the problem; it is part of the SOLUTION. First, falling prices make things more affordable. Second, although in this case falling prices are associated with economic weakness they are not the CAUSE of the economic weakness. In fact, policies designed to boost prices or prevent them from falling will lead to additional economic weakness, as Presidents Hoover and Roosevelt discovered during the 1930s.

If you have a strong balance sheet and secure income then you should not be at all worried about the prospect of deflation, regardless of how the term is defined, because an increase in the purchasing power of your money is simply not something to fear. Economic weakness could still be a problem for you even if you have a strong balance sheet and a secure income stream, but the economic weakness would not be the result of deflation. As noted above, deflation is part of the cure, not the disease.

For those with strong balance sheets and secure income streams the main source of concern should be the actions that are being taken by governments to counteract the perceived deflation threat. You can protect yourself against deflation -- the monetary kind or the price kind -- by staying out of debt and maintaining a sizeable cash reserve, but it's far more difficult to protect yourself against a government that's doing everything in its power to depreciate the official currency. When governments attempt to stimulate their economies by boosting prices they simultaneously destroy savings and lessen the economy's growth potential. Some protection against government profligacy can be obtained via the ownership of physical gold, but the holders of gold will still be vulnerable to the long-term disastrous effects of inflationary policies if they are employees or run their own businesses.

Because so many people fear deflation and so few people understand the problems caused by creating money out of nothing, governments are likely to step-up their interventionist and inflation-promoting efforts over the next 12 months. What we fear is the loss of freedom and the long-term economic damage that will be done in the name of fighting deflation.

Is excessive debt the main problem?

The amount of debt in the US is either about four times or two times the size of the economy depending on whether you use GDP or a more realistic measure of the economy's size (as explained in an earlier commentary, the US economy is approximately twice as large as the GDP figures suggest). Either way, the amount of debt is far higher today than it has ever been before. And the unusually high debt level is a major economic issue because the process of bringing debt into line with sustainable cash flow will be a drag on the economy for a long time.

The government can't short-circuit the process of bringing debt into line with sustainable economic activity without producing an even bigger economic dilemma because the government can't create real wealth and savings. By increasing its spending the government re-distributes existing savings/wealth inefficiently, and by creating money out of nothing the government de-values existing savings and distorts price signals. The net effect of such action is therefore to further weaken the economy.

Excessive debt isn't the only problem, though. The economy would still be in trouble even if total debt were reduced to a manageable level tomorrow via the waving of a magic wand. The reason is the mismatch between production and sustainable consumption that developed as a result of the inflation-fueled boom.

By way of explanation, consider the hypothetical example of an economy where there was, for many years, a seemingly endless supply of cheap credit. Asset prices were rising rapidly and it was easy to find a high-paying job, so people spent freely and one of the primary targets of their spending was the flat-screen TV. In fact, it became fashionable to have a flat-screen TV in almost every room of the house, and after a while the average house had three such devices. The consumption of flat-screen TVs rose over many years, and so, of course, did the associated production and distribution network. Factories were built to manufacture components for the TVs, other factories were built to assemble the TVs, mines were developed to obtain the necessary raw materials, flat-screen TV wholesalers and retailers set up shop, transportation systems were put in place to get products from one TV production stage to the next, finance companies were established to make it easier for people to buy flat-screen TVs on credit, energy producers geared themselves up to service the rapidly growing flat-screen TV industry and the associated transportation system, and so on. And then, the boom came to an end and the economy entered a recession. Suddenly there was almost no demand for flat-screen TVs and people involved in the industry began losing their jobs in droves. A Nobel Prize-winning economist looked at the situation and exclaimed "we must do something to boost aggregate demand!", failing to realise that low aggregate demand was not the problem. The problem was that a large section of the economy was geared to the production and distribution of flat-screen TVs, but almost every consumer already owned more flat-screen TVs than he/she now needed or wanted. The government decided to help by providing financial assistance to the flat-screen TV industry, but all this achieved was the diversion of valuable resources from other industries to an industry whose existence was no longer justified by economic reality; that is, it hurt other sections of the economy whilst doing nothing about the underlying problem.

The bottom line is that there is no getting around the fact that massive credit expansion is inevitably followed by a lengthy period of economic hardship, not only due to excessive debt but also to a mismatch between production and consumption that takes considerable time to correct.

The Fed's latest blurb

Here's part of what the Fed had to say on Wednesday at the conclusion of its 2-day monetary policy meeting, with our comments/translations interspersed:

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability."

[Ed: The problem is that creating money out of nothing, which is what the Fed always does in response to economic weakness, does NOT promote sustainable economic growth; it promotes mal-investment.]

"The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level."

[Ed: The financial markets could function much more efficiently without the Fed's support].

"The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant."

[Ed: House prices need to fall to create real value in the property market, but the Fed is doing its best to stop this from happening.]

"The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets. The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses."

[Ed: One of the biggest problems facing the US economy is that households have too much debt. The Fed is addressing this problem by encouraging households to take-on more debt.] 

The Stock Market

Current Market Situation

The stock market has begun to rebound from its 'oversold' state, supported by hopes/expectations that the US government will pour enough money into the large banks to not only keep these institutions alive but to ensure that shareholders are left with a significant slice of equity.

The banks have been relative-strength leaders over the past few days after being dramatically weak over much of the preceding few weeks. The belief seems to be taking hold that the government's rescue mission will succeed and that the worst is therefore over. Our belief is that the government will be able to rescue the banks because there is no limit to how much new money it can create, but only at great cost to the overall economy.

We view the on-going efforts to fix the banking system's problems by throwing money at them as a short-term plus for the stock market and a long-term negative for real wealth generators and the broad economy.

Turning to the charts, our bullish short-term outlook is supported by the following picture of the HYG/TLT ratio. The HYG/TLT ratio reflects the performance of high-yield (junk) bonds relative to US Treasury bonds, meaning that this ratio tends to rise when credit spreads are narrowing and fall when credit spreads are widening. HYG/TLT indicates that credit spreads have been narrowing since mid December, which is bullish.


Next, below is a chart of the AMEX Airline Index (XAL). The XAL was very weak during the days prior to Wednesday in response to worse than expected earnings news from a number of airline companies, but on a longer-term basis it may be about to complete a lengthy basing pattern. A solid break above 28 would complete the pattern.

We have exposure to the airline sector via the stocks of two airline companies -- Continental Airlines (CAL) and COPA Holdings (CPA). However, as of this week there is an airline ETF that trades under the symbol FAA. In the future we will probably trade the airline sector using FAA as our vehicle so as to avoid individual company risk.


The Natural Gas Index (XNG) also appears to be building a base. As illustrated by the following chart, the XNG has spent the past several weeks oscillating between 350 and 425. A break above 425 would suggest that it was on its way to 500-550.


Gold and the Dollar

Gold

Below is a daily chart of the February gold futures contract.

Gold spiked up to near intermediate-term resistance on Monday morning and then began to pull back. Intermediate-term resistance extends from $920 up to $940.

A further pullback to as low as the $850s wouldn't do any damage to the bullish chart pattern, but consecutive closes below $850 would suggest that a short-term peak (a peak that holds for 1-3 months) was put in place on 26th January. This is not what we expect. In our opinion, it is more likely that gold will make additional gains before a short-term peak is put in place.


As far as the next couple of months are concerned we are more bullish about copper, silver and most of the other industrial metals, than about gold. Copper's intermediate-term fundamentals are bearish and will remain so if our economic outlook is close to the mark, while gold's intermediate-term fundamentals are bullish. However, copper stands a good chance of out-performing in the short-term because a) the copper/gold ratio crashed late last year and market crashes are always followed by multi-month rebounds, and b) the stock market's rebound will create the impression that an economic recovery is about to begin.

The following daily chart shows that the March copper futures contract has resistance at around US$1.60. A break above this resistance would suggest that copper was on its way back to the low-$2 area.

Note that these three TSI gold stocks receive an immediate bottom-line boost from increases in the copper price: New Gold (NGD), Northgate Minerals (NXG), and Orsu Metals (TSX: OSU).


Gold Stocks

The HUI is in a similar position to February gold. At the end of last week it looked like it was about to break out to the upside, but the following chart shows that it has pulled back over the course of this week after a failed breakout attempt on Monday. It will maintain its short-term bullish posture as long as it remains above 275 on a daily closing basis.


Update on Stock Selections

(Note: 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)

Minefinders Corp. (AMEX: MFN). Shares: 60M issued, 77M fully diluted. Recent price: US$4.19

MFN is ramping up production at its Dolores gold/silver mine in Mexico. According to the company's management, Dolores will be cash flow positive by the end of this quarter and will achieve commercial production next quarter. If this is what actually happens then the stock market will be forced to upwardly re-rate MFN over the next three months.

Due to commissioning delays and cost overruns MFN was forced to do a sizeable equity financing at a very low stock price last December. The share dilution resulting from this financing significantly reduced the company's per-share value, but it is still very easy for us to justify a share price of US$8-US$10 based on either expected cash flow or in-ground reserves. Also, the aforementioned range looks like a reasonable target from a technical perspective. The following chart shows that the stock has resistance at around US$5.50, but the next important resistance level after $5.50 is at $9.50.

We think MFN is a good candidate for new buying near its current price.


    US Silver (TSXV: USA). Shares: 215M issued, 258M fully diluted. Recent price: C$0.11

This is an opportune time to re-visit USA.V. As illustrated by the following chart, the stock broke above resistance at C$0.10 at the beginning of this week and is now pulling back to 'test' the breakout.

USA is a microcap, but unlike most other microcap silver stocks this one has 2M ounces of current silver production in a low-risk location (Idaho). Furthermore, the company should be able to quickly ramp up its production rate to 3M ounces/year once it becomes clear that silver's bull market has resumed.

Based on fundamentals and technicals, USA has the potential to rebound to C$0.25-C$0.30 over the next few months. Risk-tolerant speculators should therefore consider taking a position near C$0.10.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
Copyright 2000-2009 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>