Big Picture View

Here is a summary of our big picture view of the markets. Note that our short-term views may differ from our big picture view.

In nominal dollar terms, the BULL market in US Treasury Bonds that began in the early 1980s will end by 2013. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 23 January 2012)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000, where "secular bear market" is defined as a long-term downward trend in valuations (P/E ratios, etc.) and gold-denominated prices. This secular trend will bottom sometime between 2014 and 2020. (Last update: 22 October 2007)

A secular BEAR market in the Dollar began during the final quarter of 2000 and ended in July of 2008. This secular bear market will be followed by a multi-year period of range trading. (Last update: 09 February 2009)

Gold commenced a secular bull market relative to all fiat currencies, the CRB Index, bonds and most stock market indices during 1999-2001. This secular trend will peak sometime between 2014 and 2020. (Last update: 22 October 2007)

Commodities, as represented by the Continuous Commodity Index (CCI), commenced a secular BULL market in 2001 in nominal dollar terms. The first major upward leg in this bull market ended during the first half of 2008, but a long-term peak won't occur until 2014-2020. In real (gold) terms, commodities commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 09 February 2009)

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Outlook Summary

Don't confuse the monetary base and the money supply

We occasionally see articles where the monetary base is wrongly discussed as if it were akin to the money supply or as if the change in the monetary base indicated the amount of monetary inflation in the economy. We'll now outline the differences between the monetary base and the money supply and explain how these differences are related to the contrasting inflation situations in Japan and the US.

The monetary base (MB) is made up of bank reserves and physical currency (notes and coins). Bank reserves are not counted in the money supply (MS) for the good reasons that a) they are not available for spending and b) they provide 'cover' for money that is available for spending and is counted in the money supply. The physical currency that resides outside the banking system is, of course, available for spending and is naturally counted in the MS as well as in the MB, but these days the combined value of all notes and coins tends to be small relative to the total MS. Also, the total quantity of notes/coins can only increase due to the withdrawal of bank deposits, a process that is always money-supply neutral (every dollar added to the total quantity of physical currency will be offset in the MS calculation by a dollar coming out of a demand or savings deposit). In other words, adding to the supply of physical currency never increases the total money supply.

An implication of the above paragraph is that boosting the monetary base will not boost the money supply. There is an indirect link in that an increase in reserves held at the central bank could prompt commercial banks to lend more money into existence, but the point is that increasing the MB won't immediately put additional money into the economy and won't necessarily even lead to a higher money supply in the future. A related implication is that a large increase in the MB will not necessarily lead to currency depreciation.

The difference between an increase in the MB and an increase in the MS is linked to why the pro-inflation policies of the Bank of Japan (BOJ) have not, over the past 20 years, led to "price inflation" worthy of the name. In Japan, quantitative easing (QE) does not directly expand the money supply; it only expands the monetary base. The BOJ relies on commercial banks and other private financial institutions ramping-up their investing/lending in order to transform a QE-related increase in the MB into a higher MS. As a consequence, the BOJ's QE is not necessarily inflationary.

Up until now the BOJ's QE has not led to much in the way of monetary inflation, which is why it hasn't brought about much in the way of "price inflation". The rate of growth in Japan's money supply has averaged only 2% per year over the past 20 years -- a level of monetary inflation that would be expected to result in no "price inflation" assuming an average annual rate of productivity improvement of at least 2%. In other words, there's no mysterious disconnect between money supply and money purchasing-power at work in Japan. The lack of "price inflation" is exactly what should be expected given the low rate of monetary inflation.

The situation in the US is very different. Whereas the BOJ's QE is not necessarily inflationary, the Fed's QE is always inflationary (meaning: it always increases the money supply, leading to price rises in some parts of the economy, distortions in relative prices, and, eventually, a decline in money purchasing-power). As explained in many previous commentaries, the reason is that when the Fed monetises X$ of assets it adds X$ to bank reserves (part of the MB, but not part of the MS) AND it adds X$ to demand deposits at commercial banks (part of the MS). A consequence is that in the US there is no requirement for commercial banks to expand their lending/investing in order for the money supply to grow, because the Fed is capable of increasing the US money supply by whatever amount it desires regardless of what the commercial banks are doing. It's amazing that very few people understand this.

The bottom line is that the monetary base is not necessarily a good indicator of the monetary inflation situation. The main focus of analysts should therefore be on the change in the money supply, not the change in the monetary base. Unfortunately, not many analysts know how to correctly measure the money supply. 

The Stock Market

The iShares Home Construction ETF (ITB) made an intermediate-term peak in May and made a new daily-closing low for the year last week. This ETF's price action runs counter to the widespread view that the US housing market is continuing to recover.



The weakness in the home-building sector is a bearish omen for the broad US stock market, but the market's overall price action is mixed. For example:

1) The RUT/SPX ratio (small-cap US stocks relative to large-cap US stocks) made a new high for the year last week. This is a sign of strength.



2) The HYG/TLT ratio (high-risk bonds relative to low-risk bonds) has declined over the past two weeks, but hasn't yet shown significant weakness. This suggests that a meaningful shift away from risk has not yet begun, which is a sign of underlying strength.



3) The GYX/gold ratio (industrial metals relative to gold) broke to a 3-month low last week. This should be viewed as a warning of economic and stock market weakness to come.



We remain very concerned about downside risk on a short-term and a longer-term basis. In our opinion, we are dealing with either an incomplete downward correction within an aging bull market or the first downward leg of a new bear market. There isn't yet any solid evidence to support the latter possibility, but by the time such evidence emerges the senior stock indices will likely be trading at much lower levels.

This week's important US economic events

Gold and the Dollar

Gold

Gold and the Fed

There's a lot of discussion/debate in the financial press about who will replace Bernanke as Fed Chairman early next year. However, as far as the US economy's prospects and gold's prospects are concerned, it doesn't matter.

The times make the Fed Chairman, not the other way around. If there is a general belief that aggressive monetary inflation and downward manipulation of interest rates are what's needed, then the Fed will deliver aggressive monetary inflation and downward manipulation of interest rates regardless of the identity of its chief. By the same token, if there is a general belief that solving an inflation problem is the top priority, then the Fed will deliver genuinely tight monetary policy regardless of the identity of its chief.

Presently there is an almost total absence of political will to end the pro-inflation policy, so more 'money-printing' is on the cards. But as discussed in previous commentaries, more money-printing over the next few quarters will not be required for gold to embark on the next leg of its long-term bull market. This is because there has already been more than enough money-printing to set the stage for such an outcome. What's needed, now, is evidence that the Fed's QE has either not helped or done greater harm than good. The evidence could come in the form of blatant "price inflation", but is more likely to come in the form of data that indicates economic weakness.

This week we get the most important monthly US economic data, beginning with the ISM Manufacturing report on Tuesday and ending with the employment numbers on Friday. The Manufacturing report will be particularly interesting because the same report a month ago suggested that the US economy was doing much better than expected. The report scheduled for this Tuesday will tell the financial markets if last month's strong data constituted a fluke or a true indication.

Current Market Situation

The gold market quickly gave back its small Syria premium during the final two days of last week.

As noted in last week's Interim Update, a normal short-term correction could take the gold price down as far as the $1350s, but shouldn't result in a daily close below $1350. This means that to keep alive the chance of new multi-month highs during September, gold must remain above $1350 during the days immediately ahead.



Regardless of whether the current pullback turns out to be a minor interruption to a continuing short-term upward trend or the start of a short-term downward trend, the gold market has done enough over the past two months to confirm that a major low was put in place in June. Aside from gold's ability to break above important resistance levels in both US$ and euro terms, the pronounced upward reversal in the CEF/gold ratio from its extreme low (see chart below) is a clear sign of a major trend change. This doesn't preclude the possibility of a test of the June low during October-November, but it does mean that a successful test of the June low is probably now the worst-case scenario.



Gold Stocks

HUI Scenarios

Over the past 15 years, October-November has been by far the most consistent timeframe for important (intermediate-term or long-term) turning points in the gold sector. May has been the second most consistent time for such turning points. When the HUI broke to a new low for the year in June of 2013, the gold sector's cyclical tendency suggested that a sustained turn to the upside would wait until October-November of 2013.

A final low during October-November of 2013 is still one of the two most likely HUI scenarios.

The second of the two highest-probability scenarios is based on the fact that of all the major gold-sector corrections of the past 50 years, the major correction of 2011-2013 most resembles the 1968-1970 episode. Of particular significance and interest, the following chart comparison of the Barrons Gold Mining Index (BGMI) from its 1968 peak and the HUI from its 2011 peak reveals that the HUI's performance over the past 12 months has been remarkably similar to the BGMI's performance during the final 10 months of its 1968-1970 cyclical bear market and the first two months of its 1970-1974 cyclical bull market.

Under this scenario, the HUI made a major correction low towards the end of June and is now in the early part of a new multi-year bull market. Continuing to track the 1968-1970 model would entail a rally over the next two weeks followed by about two months of choppy sideways movement.



These are obviously two very different short-term scenarios. Which one should you bet on?

The answer is that there is no good reason to bet heavily on any single short-term scenario. The possibility that the more bearish scenario will play out can be taken into account by maintaining a substantial cash reserve and ensuring that any new buying is done gradually on weakness. The possibility that the more bullish scenario will play out can be taken into account by maintaining core exposure to the gold sector and not being afraid to do some buying of high-potential gold stocks as opportunities (pullbacks to support) arise.

Note that under either scenario a major low will be in place by November of this year.

Current Market Situation

The following daily chart of the HUI could be interpreted bullishly or bearishly. The obvious bullish interpretation is that last week's pullback is part of the right shoulder of a head-and-shoulders bottoming pattern. The bearish interpretation is that the HUI's recent inability to get above lateral resistance is a sign of weakness that portends a test of the June low, and possibly new multi-year lows, within the next two months.



For the more bullish of our two short-term scenarios to remain in play the HUI must soon close above 285.

South African gold stocks

South Africa (SA) has a big inflation problem. The inflation problem is reflected in the performance of gold in South African Rand (ZAR) terms (see chart below), but SA gold miners aren't benefiting from the situation because the inflation problem has also led to persistent labour unrest and rapid cost increases.



A 30th August article at Mineweb.com discussed the labour unrest that is plaguing the SA economy in general and SA's mining industry in particular. Here's an excerpt:

"Weeks of strikes and violence led Harmony to suspend output at its biggest mine for two months this year. A precondition to reopening the operation was that employees sign a code promising to respect the rule of law. The AMCU is the majority union at the mine.

A wave of mining strikes cut about 15 billion rand in output last year. Stoppages in the industry have already shaved 0.3 percent off growth in 2012, President Jacob Zuma said June 13.

Should gold miners down tools, they would join 30,000 operators at car manufacturers including the local unit of Toyota Motor Corp., who have been on strike since Aug. 19. Another 90,000 construction employees and 72,000 workers at gas stations and car dealerships may walk out after talks failed.

The six-member FTSE/JSE Africa Gold Mining Index has fallen 45 percent this year compared with an 8.1 percent increase in the FTSE/JSE Africa All-Share Index."

Unless a last-minute deal is reached, a new round of strikes will hit SA's gold-mining industry this Tuesday.

Almost regardless of how cheap they get, our intention is to avoid SA gold stocks. They aren't worth the trouble.

Currency Market Update

Last week's currency-market action was a little puzzling, in that the Dollar Index did almost nothing in reaction to the news that the US was laying the groundwork for some sort of military assault against Syria (heightened risk of international conflict in the Middle East would normally boost the US$) and then strengthened late in the week after the financial world became less worried about the Syria situation. However, the net effect of this price action wasn't significant. As illustrated by the following daily chart, the Dollar Index moved back above its 200-day MA but was unable to break above its 50-day MA.

Price action is neutral, as is sentiment and momentum. Consequently, as far as the Dollar Index is concerned, on a short-term basis we see no good reason to lean to the bullish side or the bearish side.



The Yen is more interesting, because although it has done very little over the past few weeks the following daily chart suggests that it is poised to break sharply in one direction or the other within the next two weeks.

We continue to believe that on a short-term basis the Yen has more upside potential than downside potential, largely because currency speculators, as a group, are positioned for Yen weakness. This positioning on the part of speculators means that signs of strength would probably lead to a wave of short covering.

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

Company news/developments for the week ended Friday 30th August 2013:

[Note: FS = Feasibility Study, IRR = Internal Rate of Return, MD&A = Management Discussion and Analysis, M&I = Measured and Indicated, NAV = Net Asset Value, NPV(X%) = Net Present Value using a discount rate of X%, P&P = Proven and Probable, PEA = Preliminary Economic Assessment, PFS = Pre-Feasibility Study]

  *Dragon Mining (DRA.AX) issued its financial statements for the half-year ended 30th June 2013. The statements indicate that there was a small improvement in the company's financial position during the first half of this year. Specifically, working capital edged up from $14M to $16.5M with no long-term debt and no change in non-current liabilities.

There should be additional improvement in DRA's financial position during the second half of this year IF the improved production performance achieved in the June quarter is repeated.

  *Energold Drilling (EGD.V) issued its financial results for the June-2013 quarter last Thursday.

Due to the seasonal nature of its energy-drilling business, EGD's operational performance during the June quarter is dominated by its Minerals Division. Revenue generated by the Minerals Division during the June quarter of this year was $16M, which is $6M less than the same quarter last year. Furthermore, the bulk of the revenue decline was in the higher-margin drilling conducted on behalf of junior miners, so the profit decline was greater than the revenue decline.

The decline in EGD's revenue and earnings was not surprising and was fully discounted by the stock market some time ago. That's why EGD's stock price didn't move by much after the sub-par financial results were published.

EGD's financial performance is also likely to be sub-par over the remainder of this year, but, again, the stock's valuation suggests that such an outcome has been fully discounted by the stock market. As evidence we cite the fact that even after the recent rebound in its stock price, EGD's market cap is only about $10M higher than its working capital. In effect, this means that the stock market is valuing a $130M/year drilling business with excellent long-term prospects at only $10M.

EGD's stock price appears to be building a base, with resistance at C$2.15-$2.25. FWIW, C$3.00 would be the technical objective following a break above this resistance.



  *Evolution Mining (EVN.AX) issued its annual report for the financial year ended 30th June 2013. Most of the useful information in the annual report had previously been provided in quarterly reports.

The balance sheet is the most important new information. It shows that at 30th June the company had $13.7M of cash and $12M of working capital. The company also had $73M of unused credit. This means that EVN's liquidity situation has deteriorated substantially over the past 12 months, although it is still OK. Anyhow, EVN should be a net generator of cash from now on.

A large reduction in capital expenditure is the main reason that EVN should go from being a substantial cash consumer in FY-2013 to a substantial cash generator in FY-2014. Capex was very high at $375M in FY-2013, but is expected to fall to about $175M in FY-2014.

  *Pretium Resources (PVG) arranged another small equity financing last week. The latest financing involves the purchase by Liberty Metals and Mining of about 1.1M new shares at $9.35/share, for proceeds to PVG of around $10M. This means that PVG has added a total of $25M to its treasury over the past two weeks.

Candidates for new buying

From within the ranks of TSI stock selections, the best candidates for new buying at this time are:

1) EDV.TO at around C$0.70 (last Friday's closing price: C$0.82).

2) EGD.V below C$2.00 and preferably near the 50-day MA in the mid-C$1.80s (last Friday's closing price: C$1.96).

3) GFI shares or GFI Jan-2015 US$7.00 call options. GFI is being treated/valued by the stock market as if it were still a South African producer, but after the recent deal with Barrick is consummated 42% of its production will come from Australia and only 11% of its production will come from South Africa. GFI is well positioned to benefit from the Australian Dollar's bear market.



4) GSS in the low-US$0.50s (last Friday's closing price: US$0.55). Use a tight stop if buying for a short-term trade.

5) RIO.TO at around C$2.35 (last Friday's closing price: C$2.64) or RIOM at around US$2.25 (last Friday's closing price: US$2.52).

6) SBB.TO at C$1.15-C$1.20 (last Friday's closing price: C$1.24).

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html