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Bearish on China

In TSI commentaries over the past couple of years we've devoted a fair amount of space to China's economic negatives and almost no space to China's economic positives. There are two reasons for this. First, the negatives outweigh the positives by a wide margin. Second, many of the financial commentators who have been able to correctly identify and diagnose the flaws in the US economy have been strangely unable to apply the same logic to China. This is especially so for the ones who believe the "commodity supercycle" story. We therefore feel duty-bound to balance the commentary that consistently turns a blind eye to the major economic problems brewing in China.

Our view is that China is now in the late stages of one of the world's greatest-ever credit-fueled booms -- a boom that will inevitably be followed by one of the greatest-ever busts. Given the extraordinary degree of control that China's central government has over the country's banking system and the dominant role that government-directed investment plays in the economy, it's possible that China's boom will linger for another year or even longer. As per the nature of bubbles, it has already gone on for longer than most rational observers would have expected. But while this may be a good a reason not to 'short' the China growth story, it isn't a good reason to bet on its continuation.

A recent piece at Washington's Blog does a reasonable job of covering China's economic negatives. For example, it touches on the country's credit bubble -- the most obvious symptom of which is the real estate construction boom -- and mentions a few other reasons to be bearish, including:

1. Corruption and phony bookkeeping are rife in China at the corporate and government levels. At the corporate level, the types of fraudulent activities that have been uncovered at some US-listed Chinese companies are apparently commonplace within China. At the government level, China's central bank has admitted that from the mid-1990s through to 2008 thousands of Chinese officials stole a combined total of around $120B (http://www.bbc.co.uk/news/world-asia-pacific-13813688) and then fled the country. Also at the government level, the bogus economic statistics put out by US officialdom look plausible in comparison with the economic statistics reported by the government of China.

2. As is the case in the US and Europe, insolvent Chinese banks are being propped up by central bank support. This support ultimately comes at the expense of the rest of the economy.

3. Local governments throughout China have borrowed and spent aggressively to create the illusion of real growth. Consequently, many provinces are now in financial trouble and some are likely in worse shape than Greece. Unfortunately, they will be bailed out by the central government -- at the likely cost of a bigger inflation problem.

The above-linked blog discussion also cites a lack of growth in consumer spending as a reason to be concerned about China's economic prospects, but on this we disagree. Increased consumer spending is an effect of economic growth, not a cause of it. China doesn't need more consumer spending; it needs investment guided by legitimate price signals (price signals that are undistorted by inflation and government intervention).

Lastly, the article linked HERE, which was published back in March of last year, contains Edward Chancellor's list of the ten main characteristics of the speculative manias that lead to financial crises. All of these ten characteristics apply to China today. This doesn't mean that a China financial crisis is imminent. After all, these characteristics have applied since early 2007. It does, however, suggest that a crisis is inevitable.

The Stock Market

At the end of last week we were anticipating a rebound in the senior US stock indices to near their 50-day moving averages, but were allowing for the possibility that they would spike slightly below their recent lows before embarking on such rebounds. The rebounds have since begun, with no preceding spikes to new lows.

The following daily chart shows that the S&P500 Index is already quite close to its 50-day moving average. Note, though, that this moving average constitutes a reasonable MINIMUM target for a counter-trend rebound. It doesn't represent the market's upside potential.

It is not uncommon for intermediate-term and major peaks in the US stock market to be fully tested prior to substantial declines getting underway. For example, the October-2007 peak in the S&P500 Index was actually a test of the July-2007 peak. Therefore, even if we are right to assume that a peak of at least intermediate-term importance was put in place at the beginning of May this year, it would not be out of the ordinary for the market to move back to the vicinity of this peak within the next several weeks.

We aren't forecasting a return to the May peak; we are simply pointing out that there is a realistic possibility of it happening. It was in recognition of this possibility that we upgraded our short-term stock market outlook from "bearish" to "neutral" about two weeks ago.

Gold and the Dollar

Gold, Silver and Platinum

The US$ gold price broke below support late last week, which opened up the possibility that it would decline fast enough to reach its 200-day moving average (in the low-$1400s) within the ensuing three weeks. On the other side of the coin, there were positive divergences late last week in the form of resilience in the gold-stock indices and the silver/gold ratio. At this stage it looks like the positive divergences were significant.

As far as the next few weeks are concerned, gold's downside potential is probably limited by support in the $1460s and its upside potential is probably limited by resistance at $1530-$1550.

Silver began this week in a precarious position -- about $1 above important support defined by its May low. It tested this support on Monday and has since rebounded.

It isn't a fluke that this week's rebound in the silver market from just above important support coincided with a rebound in the stock market from just above an equally important support level. The silver market is generally helped by stock market strength and hurt by stock market weakness, which means that the most dangerous time for the silver market will be when the stock market begins to trend downward in earnest. This is the most likely time for the next leg down in silver's intermediate-term correction.

Silver was still in a precarious position at the close of trading on Wednesday, but with the stock market now showing signs of having commenced a multi-week rebound the odds are in favour of silver remaining in consolidation mode (the mode it has been in since the early-May short-term bottom) for at least a few more weeks.

If support at $33 holds for now (the most likely outcome) then the silver price will probably make its way back to near the top of its $33-$39 consolidation range. However, a daily close below $33 would suggest that the nearest silver futures contract was on its way to the high-$20s.

Over the past 14 months platinum has been by far the weakest of the three main precious metals. Consequently, it could prove useful as an early warning indicator over the months ahead.

The following daily chart shows that platinum has just begun to rebound after testing support defined by its March low. A daily close below this week's low would breach this support and warn of impending short-term trouble in the gold and silver markets, but as long as platinum is managing to hold above support we probably won't get anything more than routine downward fluctuations in the gold and silver markets.

Gold Stocks

Gold bullion's decisive break below a confluence of support during the final two days of the week failed to push the HUI to a new low for the move. This prompted us to state, in the latest Weekly Update, that the HUI appeared to be almost 'sold out' on a short-term basis.

As this trading week got underway it wasn't out of the question that the HUI would soon break below support at 490, but it would probably have taken significant additional weakness in the broad stock market and the precious metals markets to make it happen. With the broad stock market having just reversed upward and with silver having survived a test of its May low, the odds have shifted decidedly in favour of a gold-sector rebound over the coming weeks.

A normal counter-trend rebound would at least take the HUI up to around 540, at which point it would be near its 200-day moving average and would have retraced about half of its preceding decline. At most, a counter-trend rebound would take the HUI up to 580-600.

Currency Market Update

We are tired of seeing the "kicking the can down the road" metaphor used to describe what Europe's political and monetary leadership are doing to avoid a sovereign debt default, so let's simply say that Europe continues to postpone the inevitable. Greece's politicians have just done their part by voting in favour of an "austerity" program, thus paving the way for the creation of more debt that will never be paid off.

Stock markets breathed a collective sigh of relief once it became clear that the Greek government was going to get another injection of credit, and when the stock markets of the world rise the US$ usually falls. The currency market action over the first three days of this week was therefore normal, given what was happening in other markets.

Interestingly, this week's sharp pullback in the Dollar Index is consistent with the April-July 2008 bottoming pattern (refer to the chart in the 27th June Weekly Update for details).

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)

Kinross Gold (NYSE: KGC, TSX: K)

The following chart comparison of KGC and GDX shows that KGC was very weak relative to the average senior gold stock (as represented by GDX) between October of last year and early-May of this year, but that KGC has been relatively strong since the second week of May. Of particular note: whereas GDX dropped to a new for the year during the first half of June, KGC did no worse during June than retrace about half of its May rebound.

We aren't interested in owning KGC shares. However, with the stock at a very depressed level on an intermediate-term basis and showing signs of strength on a short-term basis, we think the time is ripe to take an initial position, or average down on an existing position, in the Kinross D-Series warrants (TSX: K.WT.D). The warrants have an exercise price of US$21.30, an expiry date of September-2014, and a current price (at Wednesday's close) of C$2.35.

Be aware that the market for these warrants is quite illiquid, which means that they can usually only be traded in small parcels.

    Clifton Star Resources (TSXV: CFO). Shares: 36M issued, 40M fully diluted. Recent price: C$2.50

In the process of outlining a rough valuation for CFO in the 20th June Weekly Update, we wrote:

"A 7M-oz resource in Quebec would typically be valued by the market at more than $100/oz, but due to the deposit's complexity we will assume that it attracts a valuation of only $50/oz."

A Mineweb.com article posted on 29th June provides some information on the "deposit's complexity". We are referring, in particular, to the following excerpts:

"It's clear that while Duparquet has an open pit component to it, the underground aspect will increasingly become an important focus for Clifton. Miller says that Clifton will be looking to deep holes targeting depths in the 1,000 metre range in coming phases of drilling."

And:

"Miller speculates there could be four to five open pits on top of underground operations, though whether underground and open-pit operations would proceed simultaneously is a question for engineers to decide in coming studies."

Last year's drilling eliminated the possibility that CFO's Duparquet project would eventually be developed into a single large, straightforward open-pit mining operation. This, we suspect, is why Osisko chose not to continue spending money on the project at the rapid rate it was required to spend money to earn a 50% stake.

The above-linked article also quotes a mining analyst who has an $11.00/share price target for CFO. In our 20th June commentary, we arrived at a valuation range of $6.70 (moderately pessimistic) to $12.20 (moderately optimistic).

    Resolute Mining (ASX: RSG). Shares: 599M issued (incl 151.7M A$0.50 conv. notes), 659M fully diluted. Recent price: A$1.17

Early this week RSG's management issued its production guidance for the 12-month period beginning 1st July 2011. The forecast is for gold production of 410K ounces at a "cash cost" of $730/ounce. This represents substantial production growth, primarily due to the ramp up of the Syama project in Mali.

The above-mentioned production forecast contains significant execution risk, but in the absence of a major accident or natural disaster we expect that the forecast will be achieved. The reason is that RSG has been operating Syama for long enough now to have a good handle on what the mine is capable of.

Our intermediate-term target for RSG is A$2.00-A$2.50. This target range is based on RSG generating cash of $160M-$200M over the next 12 months and getting valued by the market at around 8 times cash flow. Also, it assumes a gold price of US$1400-$1500/oz.

Chart-wise, the stock has resistance at A$1.20 and support at around A$1.00.

We consider RSG to be a good candidate for new buying below A$1.20 and a strong buy in the low-A$1.00 area.

For speculators looking for more 'bang for the buck', the RSG company options (ASX: RSGO) could also be of interest while the stock is trading below A$1.20. The options have an exercise price of A$0.60, expire at the end of this year, and usually trade very close to their intrinsic value (the intrinsic value of a stock option is the market price of the underlying stock minus the exercise price of the option if the option is 'in the money', or zero if the option is 'out of the money').

Chart Sources

Charts appearing in today's commentary are courtesy of:

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