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    - Interim Update 29th September 2010

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That's right, there is no "money multiplier". And it's just as well!

This week's issue of John Mauldin's "Outside the Box" letter refers to a recent paper by a couple of Federal Reserve economists that questions whether the fabled "money multiplier" actually exists (the multiplier theory is that for every additional X dollars of reserves, the banking industry will create an additional 10X, or some other multiple of X, dollars of deposits). The Fed economists point out that bank reserves are up by a staggering 2,173% since September-2008, and yet over the same period M2 is up by only 11.4% and bank loans are down by $140.2bn. Their conclusion: "...if the level of reserves is expected to have an impact on the economy, it seems unlikely that a standard multiplier story will explain the effect." Are the Fed economists onto something?

The answer is yes, although they are about 15 years late in recognising that the traditional relationship between bank reserves and money supply no longer applies. It hasn't applied since the early 1990s, when the Fed itself altered some regulations and effectively severed the link between bank reserves and bank deposits. These days, almost any amount of reserves can 'support' almost any amount of money.

The breakdown in the traditional relationship between bank reserves and money supply was blatantly obvious in the data a long time prior to the 2008 financial crisis. Consider, for example, that from January-1990 through to August-2008 a 28% REDUCTION in bank reserves was accompanied by a 215% GAIN in True Money Supply (TMS). If the famous "money multiplier" had been in operation there would have been a large decline in the money supply over this period.

The US economy is actually fortunate that the "money multiplier" no longer 'works' the way it did in the distant past, because if it did still work the way it is typically described in basic economics texts then the Fed's trillion-dollar addition to bank reserves over the past two years would potentially have resulted in the money supply rising by as much as 10 trillion dollars, or about 200% (based on a starting TMS value of around $5.4T in August of 2008). A money-supply increase of this magnitude in such a short time would likely have caused the US dollar to collapse and plunged the US economy into a hyperinflationary depression.

Luckily, the banks haven't yet used their new reserves as the foundation for a tower of new loans, but have, instead, shrunk their loan books to a modest extent. It is important to understand, however, that even without any net lending from the commercial banks the Fed-Treasury combination has managed to engineer a 27% increase in TMS since August of 2008 (note that as far as monetary aggregates go, TMS is vastly superior to M2). By historical standards, that's an unusually large 2-year increase and constitutes definitive evidence that the continuation of inflation does not depend in any way on either the ability or the willingness of private banks to make new loans.

The Stock Market

Thus far it has been a quiet week for the broad US stock market. The market remains 'overbought', but hasn't yet done anything to indicate that a short-term top is in place.

The monthly ISM (Institute of Supply Management) Index will be reported on Friday 1st October. The ISM Index is a measure of how US manufacturing businesses are performing and is more meaningful than the vast majority of economic indicators.

It will be interesting to see the extent of economic softening revealed by the ISM Index.


Gold and the Dollar


Gold

There has been a remarkable lack of volatility in the gold market since the beginning of August. There have not been any meaningful pullbacks or large up-days; gold has just plodded higher.


The bearish divergence between the euro-denominated gold price (gold/euro) and the US$-denominated gold price continues to develop. We note, for example, that the US$ gold price closed at a new all-time high on Wednesday whereas gold/euro closed at a 5-week low. On a slightly longer-term basis, gold peaked in real terms (peaked against most currencies and commodities, that is) more than three months ago. Since then it has been pushed upward in US$ terms by weakness in the US$.

The almost complete absence of volatility means that gold is probably not yet near a top of long-term or even intermediate-term importance, but the extent to which gold is now 'overbought' in US$ terms combined with the divergence mentioned above suggests that a multi-week downturn will soon begin.

Gold Stocks

Current Market Situation

Like the broad stock market, the gold sector of the market was quiet over the first three days of this week. There was a downward spike during the first half of Tuesday's US trading session that helped define the bottom of the channel drawn on the following daily HUI chart, but nothing of real significance happened.

Based on what has happened over the past 10 years, a pullback to the vicinity of the HUI's 50-day moving average is likely during October. This will be the case regardless of whether or not the HUI breaks above major resistance at 515-520 over the next few days.

A daily close below 495 would take the HUI below its short-term channel bottom and signal that the aforementioned pullback was underway.


A note on valuing gold/copper deposits

Some mineral deposits have a combination of gold and copper. A simple way to come up with a valuation for such deposits is to convert the copper part of the resource to a gold-equivalent amount. For example, assume that a deposit contains 1B pounds of copper and 2M ounces of gold. With copper priced at $3.50/pound and gold priced at $1300/oz, it could be said that 1B pounds of copper is the equivalent of 2.7M ounces of gold (1B pounds times $3.50 per pound divided by $1300 equals 2.7M). The deposit could therefore be said to contain 4.7M gold-equivalent ounces and valued as if it were a 4.7M-ounce gold resource.

The above-described method of converting a gold-plus-copper resource into a gold-equivalent amount simplifies the valuation process and is regularly used, but it will typically result in an unrealistically high valuation for the overall deposit and therefore isn't appropriate. The reason this method will tend to yield an unrealistically high valuation is that, all else being equal, the market generally assigns a much lower value to a dollar of in-ground copper (or any other base metal) than to a dollar of in-ground gold. Putting it another way, the market generally values copper resources much more lowly than gold resources. It has always been this way and likely always will be this way, which is why it is inappropriate to convert a copper resource to its gold equivalent.

The difference between the valuations assigned by the market to in-ground gold and in-ground copper isn't an example of market inefficiency or irrationality; it's a logical reflection of the fact that the gold market is dominated by investment-related demand (which encompasses monetary, speculative and store-of-value-related demand), whereas the copper market is dominated by industrial consumption. To be more specific, if a metal's primary purpose is to act as a store of value then it can serve its purpose almost as well below ground as above ground, but if a metal's primary purpose is to be part of a manufacturing or construction process then it can't serve its purpose at all until it is extracted from the ground.

The same applies to silver, and for the same reason. Consequently, converting a silver-lead-zinc resource into a silver-equivalent resource and then valuing this resource as if all the in-ground metal were silver would yield an unrealistically high valuation.

In a nutshell, the only time it makes sense to use gold-equivalent or silver-equivalent calculations when valuing deposits that contain a mixture of metals is when the only metals involved are gold and silver.

Currency Market Update

Much of what comes under the heading of "technical analysis" is based on the idea that price patterns repeat. The reality is that they do repeat, and they do so because regardless of how different the "fundamentals" happen to be at any time, human nature doesn't change. However, there is no way of knowing in real time exactly which pattern is about to repeat. To be more specific, we can be certain that no market will do anything over the next few months that hasn't been done by a market in the past, but until after it happens we won't know for certain which prior pattern is relevant.

Just to be clear: we are sure that historical price patterns contain clues regarding the likely performance of market prices in the future. However, it is important to recognise the limitations of such analysis.

With the above 'disclaimer' in place, we point out that the Dollar Index's performance over the past few months has been almost identical to its performance during the few months leading up to June-2009. Furthermore, the similarities extend to the positions of the 50- and 200-day moving averages and the Relative Strength Index (RSI). Refer to the following chart for details.

If the similarities continue then the Dollar Index will make an interim low within the next few days and rebound to the vicinity of its 50-day moving average over the next few weeks, after which the downward trend will resume.


From a fundamental perspective, the idea that the Dollar Index will move substantially lower over the next several months doesn't make sense. It doesn't make sense because as bad as the dollar's fundamentals appear to be, the euro's appear to be even worse.

Some European countries are beginning to experience "austerity protests". This is evidence that once people become accustomed to 'feeding at the government trough' it is politically difficult for the government to reduce the 'food' supply. We wonder how many of the protestors understand how the government gets its money. Do they realise that every dollar they receive from the government must be borrowed or stolen from someone else? Do they care?

Likely implications of increasing social unrest associated with so-called "austerity programs" are that government cutbacks will be short-lived and there will be more euro inflation -- inflation being the most politically expedient way for over-extended governments to keep voters happy in the short-term -- than most market participants currently expect.

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)

Northgate Minerals (AMEX: NXG, TSX: NGX). Shares: 290M issued, 297M fully diluted. Recent price: US$3.14

NXG announced a $135M convertible-note financing prior to the start of trading on Wednesday. As far as we can tell, the financing is being done in a way that ensures the least favourable rates for the company and the maximum possible short-term weakness in the stock price. In particular, the financing is being arranged by the underwriter on a best efforts basis, with the conversion rate and the interest rate to be determined in the context of the market. The only plus is that NXG will be able to decide whether the notes are paid back in cash or shares. This is potentially a significant plus, however, because if our understanding is correct it could mean that there will be no dilution of the stock as a result of this financing.

We can't comment further at this stage because some of the most important financing terms are still unknown. The stock will probably find support at around US$3.00, but a lot will depend on the yet-to-be-finalised details.

    Andina Minerals (TSXV: ADM). Shares: 108M issued, 129M fully diluted. Recent price: C$1.48

In our 9th August and 25th August commentaries we said that a break above C$1.40 by ADM would probably be followed by a rise to C$1.70-$1.80, where a lot of supply would undoubtedly 'come out of the woodwork', and that good news relating to the PEA (due to be finished early next year) would probably be needed to get the stock above C$1.80. ADM made it to resistance at C$1.80 last week and was then, predictably, overwhelmed by supply.

It quickly dropped back from resistance at C$1.80 to support at C$1.40, so the price action of the past several days created opportunities to do some selling near resistance AND some buying near support. As we keep suggesting: you should scale in during the purges and scale out during the surges, all the while maintaining a core position.


The next time ADM tests resistance at C$1.80 it will have a better chance of breaking through, because some supply will have been absorbed by last week's test. However, the odds still favour the idea that a sustained breakout will require good news relating to the PEA.

    Geovic Mining Corp. (TSX: GMC). Shares: 103M issued, 138M fully diluted. Recent price: C$0.80

Speculative stocks linked to minor metals have 'gone for a run' over the past month, with GMC, a development-stage cobalt miner, joining in to a modest extent over the past fortnight.

The following chart shows that GMC has been basing for the past two years. The top of the base is at C$1.00.


The fact that the market is now rewarding small-cap mining stocks for any bits of good news makes GMC an interesting speculation at this time, especially if it can be purchased at C$0.75 or lower. One reason is that GMC is scheduled to release an updated Feasibility Study (FS) for its Cameroon-based Nkamouna cobalt-nickel project within the next few weeks. If the FS shows robust economics at the current cobalt price, which it probably will, then the market will have something to get enthusiastic about. There could also be news in the not-too-distant future about project financing.

The price of cobalt has oscillated between $19 and $23.50 over the course of this year and is now near the mid point of its range (see chart below). We have no opinion on the likely performance of the cobalt market and wouldn't purchase GMC as a bet on a higher cobalt price. GMC is interesting because the company could potentially make a lot of money at the current cobalt price.


    Energy Fuels Inc. (TSX: EFR). Shares: 97M issued, 106M fully diluted. Recent price: C$0.34

EFR is a high-risk/high-reward play on uranium. The stock has rebounded along with many other exploration/development-stage uranium miners over the past couple of months, and is now testing short-term resistance at C$0.35. With the uranium market showing incipient signs of strength, an EFR pullback to the 50-day moving average would create a new buying opportunity for risk-tolerant speculators.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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