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Gross Output

For those desiring a measure of total economic activity, there is an alternative to Gross Domestic Product (GDP). It's called Gross Output (GO).

An alternative measure of total economic activity could be worthy of consideration, because as an economic indicator GDP is worse than useless. This is firstly because it measures spending without differentiating between productive and unproductive spending, which means that an increase in GDP doesn't necessarily indicate economic progress (although that is exactly what almost everyone thinks it indicates). Secondly, GDP doesn't cover all spending; instead, it is primarily a measure of final sales to consumers and government spending. Consumer spending is therefore a much larger percentage of GDP than of the overall economy, which is not a problem in itself but becomes a problem when almost everyone believes that GDP measures the overall economy. Thirdly, the spending omitted by the GDP calculation (the spending of all businesses involved in the intermediate stages of production) is the spending carried out in the parts of the economy where most people are employed.

GO is a more useful statistic than GDP, because it includes the intermediate stages of production. Consumer spending is therefore not over-weighted by anywhere near as much in GO as it is in GDP. Specifically, consumer spending is almost 70% of GDP and less than 40% of GO.

Also, because GO is not dominated by the most stable component of total spending (consumer spending varies less than the other macroeconomic spending categories), it is better than GDP at reflecting the economic cycles. For example, whereas US GDP never contracted by more than 2% in response to the 2008-2009 financial crisis and global recession, the chart displayed below shows that the year-over-year rate of change in GO plunged from +5% in 2007 to -8% in 2009. This is clearly a better reflection of what actually happened to the US economy.

Unfortunately, GO, like GDP, fails to differentiate between productive and unproductive spending and is therefore not a good measure of real economic progress.



By the way, GO is not a new concoction. We first mentioned it about 5.5 years ago (in the 7th January 2009 Interim Update) and it has been around for much longer than that. What's new is that until recently GO was only updated annually with a lag of more than 12 months, but it is now being updated quarterly with a lag of about 4 months. The quarterly figures are posted HERE.

As a practical tool for speculating or investing, GO is just as irrelevant as GDP. We therefore won't be spending a lot of time analysing GO data. However, the GO numbers provide a more accurate historical tally of monetary spending throughout the economy, so the fact that these numbers are now being published in a more timely manner and becoming more widely known is a small step in the right direction.

The Stock Market

The "Emerging Markets"

The emergence of our positive outlook for "Emerging Market" equities

We began this year thinking that "Emerging Market" equities, as represented by EEM, were close to the end of a cyclical bear market, but that there could be a final wash-out decline in 2014 to end the bear. Due to the potential for this wash-out decline, during the first two months of the year we were interested in making short-term bets against emerging-market equities.

For example, in the 24th February Weekly Update, we wrote:

"The potential exists for a sharp decline in EEM to the low-$30s. That's the reason for our short-term bearish speculation. On a longer-term basis, the trend that entails relative weakness in the emerging markets is now very old and is probably going to end within the next several months. It seems that almost everyone is now bearish on the emerging markets. While such a sentiment backdrop doesn't preclude a final washout, it sets the stage for the emerging markets to become leaders to the upside during the next global equity-market advance."

By late March, however, EEM's performance relative to the SPX was signaling that the risk of EEM experiencing a final wash-out decline had receded. For example, this is from the 26th March Interim Update:

"...over the past two trading days the EEM/SPX ratio broke out to the upside from the well-defined channel that had limited its movements since October-2013. We take this as an early warning that even if EEM's bear market is not complete, it could be about to strengthen relative to the US stock market for at least a couple of months."

A few days later (in the 31st March Weekly Update), we wrote:

"As is the case with commodity-related equities, signs are beginning to appear that emerging-market equities are shifting from relative weakness to relative strength. Last week, for instance, EEM broke above well-defined resistance at $40 and the EEM/SPX ratio had its best week since the third quarter of last year. From a fundamental perspective the recent strength in EEM makes less sense than the recent strength in CRX [the Commodity-Related Equities Index], but it isn't uncommon for the obvious fundamentals to lag at important turning points for market prices."

After two more weeks went by there was additional evidence that an important trend change was in the works, prompting us to write:

"While a large and sharp decline to end EEM's bear market remains a realistic possibility, EEM's resilience in the face of the recent weakness in the US stock market suggests that it isn't the most likely scenario.

We currently aren't inclined to bet on any particular short- or intermediate-term outcome for the emerging markets, but if we were forced to state a conclusion it would be: the emerging-market bear is dead and a decline by EEM to around $39 is the worst that will happen over the months ahead."

Finally, in the 14th May Interim Update we reviewed the positive long-term correlation between emerging-market equities and commodities, concluding that:

"...EEM should perform well over the next couple of years if we are right to believe that commodities, as a group, are in the process of turning higher on a long-term basis. We are well aware that the economic fundamentals do not suggest that the recent relative strength in emerging-market equities will be sustained beyond the very short-term, but if the upward trend in commodity prices is set to continue then additional relative strength in emerging-market equities is a high-probability bet."

In the 14th May Interim Update we also discussed the Russian stock market's tendency to act like a leveraged play on the emerging-market and commodity themes. This tendency suggested that short-term downward pressure put on Russian equities by Ukraine-related fear, including economic sanctions, would create good opportunities to average into the Market Vectors Russia ETF (RSX) for an intermediate-term (6-18 month) trade.

EEM, China and Coal

The following chart compares EEM with the EEM/SPX ratio. Notice that EEM spent a few years oscillating within a wide range while the EEM/SPX ratio trended relentlessly lower. EEM's wide trading range could be part of a major topping pattern, but it now looks more like a long-term consolidation.



SSEC, a proxy for China's stock market, has broken out to the upside from an 18-month basing pattern. This suggests that an intermediate-term upward trend is now in progress.



This week's upside breakout in China's stock market was accompanied by an upside breakout in the Market Vectors Coal ETF (KOL). However, KOL's upside breakout is marginal at this time. A weekly close above $20.00 is needed to confirm the reversal.



The US

With regard to the US stock market's performance over the past three days, the only development worth noting is that the Volatility Index (VIX) appears to have reversed upward. This confirms the potential for a quick move in the VIX to around 20, which could only happen in response to a sharp pullback in the S&P500 Index.



Gold and the Dollar

Gold

Gold, the Ukraine and Russia

It is still not known how MH-17 was shot down, or by whom. As far as we can tell, the weight of evidence currently points to the Ukraine military having caused the event, either accidentally or as a "false flag" designed to increase international pressure on Russia and Russian separatists. If it was a "false flag" then it has been very successful, because despite a complete lack of credible evidence to support claims of Russian involvement, the event has led to more stringent economic sanctions against Russia.

Regardless of where the truth lies, continuing to ramp-up the pressure on Russia via economic sanctions will have negative economic consequences for "the West" as well as for Russia. This could mean that cooler heads will prevail before too long, but there is definitely a risk that the efforts to put pressure on Russia will undermine Western economies that are already in weakened states due to many years of destructive central bank policy. If so, the fundamental backdrop will become more bullish for gold.

Current Market Situation

We suspect that gold made its correction low when it traded at $1287 on 24th July, but it hasn't moved high enough to provide definitive evidence that this is, indeed, the case. As previously advised, it needs to achieve a daily close above $1325 to clearly signal an end to the correction that began about three weeks ago. The fact that it hasn't yet done this leaves the door open to a final downward spike to a new multi-week low.

Gold's upward trend will probably resume within the next few days, with or without a final downward spike to a new multi-week low.



Gold Stocks

There is still a risk that the HUI will spike down to around 225 before the gold-mining sector's correction comes to an end. As illustrated by the following chart, 225 is roughly mid-way between the 200-day and 50-day moving averages. However, with or without such a downward spike the correction will probably end within the next few days.



There are both fundamental and technical (price/chart related) reasons to believe that the price weakness in the gold-mining sector over the past three weeks is nothing more than a routine 2-4 week consolidation. From a fundamental perspective, the backdrop for gold became definitively bullish in April of this year for the first time since August of 2011. From a technical perspective, notice the difference on the chart displayed above between the recent price action and the price action immediately following the March top. Following the March top the HUI quickly fell below its 50-day MA, whereas the HUI is currently struggling to make it down as far as this MA. This tells us that prices are well supported, with price weakness quickly attracting new buying.

The Currency Market

This is where it gets interesting. The Dollar Index is right at an intermediate-term demarcation level. It is also now very 'overbought' on a short-term basis and likely to soon reach a multi-week peak.

If the Dollar Index can end this week above resistance at 81.5 it will suggest that an intermediate-term advance is underway. It would still likely be close to a peak that holds for a few weeks, but a weekly close above 81.5 would mean that the ensuing pullback was likely to retrace only part of the May-July rally and be followed by a rally to new 18-month highs.

Alternatively, if the Dollar Index fails to end this week above 81.5, and especially if it fails to end this week above 81.5 after spiking higher in a knee-jerk reaction to 'bullish' employment news on Friday, it will maintain the potential for an eventual decline to the low-70s.

Updates 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

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html