- Interim Update 28th January 2009
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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/
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