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The Fed-induced downward spiral

The following text and chart are from John Hussman's latest weekly commentary:

"...the poor performance of the U.S. economy from an employment standpoint cannot be separated from the Fed's attempts, for more than a decade, to make easy monetary policy a substitute for the accumulation of real savings and investment. ...Speculating and consuming off of cheap credit may feel better than saving, but the long-term results are profoundly different."

It could be argued that factors other than the policies of the Fed and the US federal government have contributed to the multi-decade downward spiral in US employment growth illustrated above, but discussing these other factors only clouds the issue. The reason is that the reduction over time in the US economy's ability to create productive jobs is consistent with what Austrian economics (good economic theory, that is) predicts would be the result of the market distortions introduced by the Fed and the government. Looking beyond Fed-sponsored inflation and the government's meddling in the economy to explain the economic deterioration would be akin to someone sitting in a sauna, with the temperature control cranked up to the max, looking for reasons unrelated to the sauna for why he/she is uncomfortably warm.

Unfortunately, very few people are looking in the right direction in their efforts to diagnose the cause of the decline and come up with solutions. As discussed last week, that's why we are long-term bears on the US economy. There will be no hope as long as the causes of the problem are misdiagnosed, because the proposed solutions will almost certainly be wrong if the true causes of the problem are unknown. In fact, if past is prologue then the proposed solutions will be exactly the opposite of what is required and will make things worse. For example, bad economists will recommend, and ignorant and/or unprincipled policy-makers will bring about, more inflation of the money and credit supplies in an effort to combat the problems caused by earlier inflation of the money and credit supplies.

Successful Indoctrination

The Stock Market

Presidential Cycle Update

2011 is the third year of the Presidential Cycle. As evidenced by the following chart, the S&P500's average third-year performance entails a strong upward trend through to July and then 'choppiness' over the remainder of the year. In other words, the chart shows that the market not only tends to be strong during the third year, but also tends to make all of its upward progress during the first 7 months of the year.

The "Presidential Cycle Model" (PCM) is not, by itself, a good reason to be bullish (or a good reason not to be bearish). It is just one piece of the puzzle, and should be taken into account along with all the other pieces (monetary policy, valuation, sentiment, price action, geopolitical developments, etc.).

With regard to the PCM, the points we wanted to make today are:

1) Despite some dramatic and potentially disruptive events (popular uprisings in an important oil-producing region, a massive earthquake in Japan, the worsening of Europe's sovereign debt problem and tightening monetary policy in the "BRICs"), the US stock market has held up remarkably well over the first four months of this year. Consequently, it is fair to say that the market is roughly tracking the PCM.

2) The PCM suggests that the market will be very strong over the next 5 weeks.

3) Taking out the March low would be a significant departure from the PCM.

Current Market Situation

Here are some of the stock market indicators and indexes that we are paying close attention to:

1. Hong Kong's Hang Seng Index (HSI). As illustrated below, the HSI has rebounded strongly over the past two weeks but is now approaching an important test in the form of the downward-sloping trend line that dates back to early November of last year. Failure by the HSI to confirm new 52-week highs in the senior US stock indices would be a significant bearish divergence.

2. The Russell2000 Small Cap Index (RUT). Weakness in the RUT relative to large-cap indices such as the S&P500 should generally be considered bearish, and relative strength in the RUT should generally be considered bullish. The RUT closed at a new multi-year high on Wednesday while the S&P500 remained below its February high. This is a bullish divergence.

3. The HYG/TLT ratio. This indicator of credit conditions has partially retraced its February-March decline, but remains well below the high reached earlier this year. New highs in the senior stock indices alongside lower highs in HYG/TLT would be a bearish divergence.

4. Gold relative to silver and the base metals. When gold begins to strengthen relative to silver and the base metals it will probably mean that the stock market's intermediate-term advance is at, or nearing, its end.

5. The OEX put/call ratio. The 10-day moving average of the OEX put/call ratio began to flash a warning signal at the beginning of this year, and continues to do so. This indicator suggests that the 'smart money' is presently a lot more worried than the 'dumb money' about downside risk.

Our overall assessment is that the US stock market is probably going to work its way higher over the next several weeks, but downside risk remains worrisome.

Gold and the Dollar

Gold

In the email alert sent during the Asian trading session on Wednesday, we wrote:

"There's a reasonable chance that gold will break out to the upside within the coming week or so, leading to a similar breakout in the HUI. The rally that followed such a breakout would probably last only 4-6 weeks, but the rally's magnitude could be significant (>10%). Also of note is that the risk management parameters are currently clear, in that for this short-term bullish scenario to remain plausible the gold price should not close below $1380 during any additional 'corrective' action over the days ahead.

Further to the above, we are upgrading our short-term outlooks for gold and gold stocks from "neutral" to "bullish". Unless advised otherwise, this short-term bullish view will be 'stopped out' if gold closes below $1380."

In addition to gold's price action and the absence of any weakness in the silver/gold ratio, the decision to upgrade our short-term outlook was influenced by sentiment. Specifically, with Market Vane's latest survey showing that only 75% of traders were bullish on gold and with the latest COT Report showing that the total speculative net-long position in COMEX gold futures was about 80,000 contracts shy of last December's peak, there appears to be plenty of scope for the recruitment of more bulls.

In this week's email alert we emphasised that for a move to new highs to remain the most likely near-term scenario, the gold price should not close below $1380. We want to point out, though, that while a break below $1380 would almost rule out a near-term move to new highs, it wouldn't suggest to us that a large decline had begun. In our opinion, a break below $1380 within the next couple of weeks would result in gold doing no worse than dropping back to the low-$1300s.

The extraordinarily 'overbought' condition of the silver market remains our biggest concern. Ideally, silver will remain extraordinarily overbought for at least a few more weeks before succumbing to 'market gravity', but in the mean time we continue to like the strategy of hedging our precious metals exposure by scaling into SLV July put options as silver rises.

Gold Stocks

If gold breaks out to the upside in the near future, the HUI will probably do the same. As noted in the latest Weekly Update, a break above resistance at 580 would create a short-term chart-based target of around 670 for the HUI.

Nearby support extends from 550 down to 540, but if this support were breached over the days ahead it wouldn't mean that a major decline had begun. Instead, it would probably mean that the HUI was on its way back to the low-500s.

Our view is that the HUI is more likely to break above resistance at 580 than below support at 540-550. If it does break out to the upside and move sharply higher then we will take advantage by doing some selling.

Currency Market Update

The deluge of new money created out of 'thin air' by the Bank of Japan (BOJ) has had the desired effect and pushed the Yen down to the bottom third of its 6-month trading range against the US$.

Will the BOJ continue to inflate by enough to offset the upward pressure on the Yen's exchange value stemming from the capital repatriation that will take place to finance earthquake-related insurance payments and reconstruction?

Nobody knows. Given its unlimited ability to create new Yen, the BOJ certainly has the ability to prevent Japan's currency from rising in response to market forces. The question is whether it will choose to make full use of this ability over the months ahead.

In the past the BOJ was one of the most cautious of the world's central banks when it came to inflating the money supply, but we doubt that this was due to the BOJ decision-makers having a superior understanding of the negative effects of monetary inflation. There has been no evidence of such intellectual superiority in the official statements put out by the BOJ over the years. Instead, like their counterparts at the Fed the central planners at the BOJ appear to be labouring under a hotchpotch of ill-conceived Keynesian and Monetarist theories.

One possible explanation for the BOJ's relative prudence on the monetary inflation front is that the Japanese government has, up until now, been able to finance its aggressive spending at low interest rates using the population's existing monetary savings. But that method of financing the deficit appears to have gone about as far as it can go, so perhaps we'll see the BOJ becoming more Bernanke-like in the future. This would be bad for Japanese Government Bonds, but good for the Yen-denominated prices of Japanese equities.

We'll see. We are long-term bearish on the Yen because Japan's government will have to resort to rampant monetary inflation within the next few years to avoid directly defaulting on its debts, but we haven't given up on the idea that there will be a final Yen rally spurred by earthquake-related capital repatriation.

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)

Endeavour Mining (TSX: EDV). Shares: about 125M. Recent price: C$2.63

We removed EDV from the TSI Stocks List some time ago, but retained some exposure to this company via the warrants (TSX: EDV.WT.A).

Whether or not EDV makes its way back into the TSI Stocks List in the future will depend on what the company does with its $200M cash hoard. It is currently under-valued and offers exposure to gold via its 80K-oz/yr Youga mine in Burkina Faso, but because cash constitutes about half of its net asset value it doesn't offer as much leverage to gold as we'd like.

As we've mentioned in the past, we think it would make sense for EDV to use its cash to make a stock-plus-cash bid for Resolute Mining (ASX: RSG). RSG is under-valued and would make a good fit with EDV's West African assets. Following a successful bid, RSG's non-African assets could be sold off or spun off to make the expanded EDV an Africa-focused mid-tier producer with a strong balance sheet. This would likely lead to a substantial upward re-rating in the stock market that would benefit all shareholders.

Although we aren't going to return EDV to the List at this time, we wanted to point out that it is a relatively low-risk buy near the current price. This is not only due to the low valuation and strong balance sheet, but also due to the stock chart.

The chart (see below) shows that EDV has trended upward over the past two years via a "two steps forward followed by one-and-one-half steps backward" process. The rallies have generated trough-to-peak gains of 83%, 78% and 52%, while the intervening downward corrections have taken the stock price to just below its 200-day moving average. There's a good chance that the stock's most recent correction ended in the C$2.30s earlier this month.

Consecutive daily closes above the 50-day moving average (currently C$2.72) would suggest that the next "two steps forward" rally had begun. If the next rally results in a trough-to-peak gain of 52%-83% then it will end at C$3.50-C$4.30.

    With a market cap of only $12M at Wednesday's closing price of C$0.37 and average daily turnover in its shares of only $30K, First Mexican Gold (TSXV: FMG) is way too small and illiquid to be considered for the TSI Stocks List. However, it is an interesting little company and is included in the TSI Small Stocks Watch List (SSWL). It is interesting due to the drilling results achieved to date at its project in Mexico.

It doesn't take much selling or buying to move the price of a stock such as FMG. Consequently, a lack of news can push the price down -- and thus create a buying opportunity -- by causing small traders to get bored and dump their holdings onto the market.

For speculators who are comfortable with small, early-stage resource stocks, the recent lack of any new drilling results has created an opportunity to accumulate FMG shares 'on the cheap'. Drilling work has recommenced and results should trickle in over the coming 2 months.

    A company called Norton Gold Fields, which trades in Australia under the symbol NGF and operates gold mines and a mill in the Kalgoorlie region of Western Australia, came to our attention earlier this week. We haven't had a chance to take a detailed look at it yet, but our preliminary investigation suggests that it has speculative merit. In fact, in terms of enterprise value relative to annual gold production it is by far the cheapest 100K+ oz/yr gold miner that we know of.

NGF is currently producing gold at the rate of about 155K ounces per year. This production is unhedged, profitable, and at the 31st March closing price of A$0.17/share is being valued by the market at only $1175/oz (taking into account net debt of $64M). By way of comparison, we aren't aware of any other gold mining stock with more than 100K ounces/year of current production that is being valued by the market at less than $2000 per ounce of production.

A possible explanation for the incredibly low valuation is that the market expects the production rate to fall. NGF appears to have enough in-ground resources in the vicinity of its mill to produce 150K ounces/year for at least the next 10 years, but maintaining this production rate will involve bringing new mines on line.

At this stage we are presenting NGF as a speculating idea that you might want to check out. Also, if you know why this stock is so cheap, we'd greatly appreciate it if you could fill us in.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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