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 mid-2010. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 09 February 2009)

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

China, again

A good article

In last week's Interim Update we briefly touched on the burgeoning economic problems in China. For example, we noted that the dramatic expansion of credit engineered by China's government over the past few quarters had led to bad loans being piled on top of bad loans and new mal-investments being piled on top of earlier mal-investments, thus creating distortions within an economy that was already labouring under the distortions created by previous rampant credit expansion.

Shortly after we posted our brief discussion an article covering the same issues, but in far more detail, appeared at http://mises.org/story/3573. Here's an excerpt:

"...at the end of last year, roughly 91 million square meters of apartment space lay empty throughout China. This figure does not include the 587 million square meters of apartment space that has been sold but left vacant over the past five years or the millions more that are built but left off the depressed market. More specifically, since 2006, roughly 152 million square meters of commercial office space has been built in Beijing -- more than all of the office space in Manhattan -- yet 30 million square meters is still vacant. And in Shanghai, the vacancy rate for commercial space is estimated to have hit 25% at the end of last year.

However, as an illustration of unintended consequences, during this new real estate boom several investigations have discovered that real estate developers, desperate to offload nonperforming properties, have dumped mortgages onto state-run banks that are "facing enormous pressure from Beijing to rapidly increase lending to boost the economy."

Thus, while market forces would have reallocated unused property, pushing prices down, the stimulus has catapulted markets such as Beijing and Shanghai into the top 50 most expensive globally, despite that the average resident earns a fraction of their industrialized peers."

Do you have a trade deficit with China, and, if so, is it a problem?

Chances are, most of our readers buy China-made products and don't sell anything to China. If this applies to you then you run a trade deficit with China. Does this trade deficit create an economic problem for you? In particular, do you think that your government should intervene to correct this imbalance of trade by, for example, pushing-up the prices of Chinese products to the point where you will be prompted to buy products made elsewhere? Or is it actually in your own interest to keep buying Chinese products as long as these products offer the best value, regardless of whether or not this results in a larger "trade imbalance" between you and the Chinese manufacturers of the stuff you buy?

The trade deficit that many of us run with China doesn't really seem like a problem, does it? And if it isn't a problem at an individual level then why is it a problem at a group level?

The truth is that a trade deficit or imbalance is never a problem, in and of itself. In fact, the words "deficit" and "imbalance" create a false impression because trade is never really in deficit or imbalanced. What happens is that people trade goods for money and money for goods. The sellers of goods favour the money over the goods whereas the sellers of money favour the goods over the money. As long as people are mostly free to act in their own interest, the trade between people will always be in balance.

But while a "trade deficit" is never a problem per se (read: something that needs to be fixed), it can be symptomatic of a problem that should be addressed. For example, US$ inflation (a huge problem) is one of the main reasons that the US ran such a large trade deficit for so long. Currency manipulation by China's government (another problem, but not in the same league as US$ inflation) is another reason.

Bond Market Update

The Stock Market

Current Market Situation

The US stock market edged a little higher last week. As a result, the market is in roughly the same position now as it was a week ago.

One new development over the past week is illustrated by the following chart of the NASDAQ Composite Index and the NASDAQ's McClellan Oscillator (MO). The chart shows that the NASDAQ rose to a new high for the year last week while its MO declined. This is a bearish divergence because it means that the index's rise was not confirmed by broad-based strength.

The divergence shown above increases the risk that there will be a significant pullback over the coming 1-3 weeks, but this pullback (assuming it occurs) will probably be followed by another rally to new highs for the year.

The Long-Term Trend

The following long-term chart shows the 20-year upward trend in the SPX/gold ratio that ended during 1999-2001 and the subsequent downward trend. Based on the history of secular bear markets, it is reasonable to expect that the downward trend will last 13-20 years.

During its secular bull market the SPX/gold ratio moved back to near its long-term trend line every few years, but notice that there was a blow-off move during 1997-1999. This 3-year blow-off took the ratio a long way above its trend line and completed the bull market.

As was the case with the preceding bull market, the current bear market is likely to end with a blow-off move that takes the ratio a great distance from its trend line. Furthermore, the bear market blow-off is likely to be shorter and sharper than the bull market blow-off because it will be driven by the combination of fear and greed rather than greed alone. Some gold enthusiasts believe that such a move is already underway, but we seriously doubt it because it would mean that the gold bull market was into its final 12 months. This is very unlikely because it would also mean that the bear market in equities was almost complete (the long-term gold bull market and the long-term equity bear market are inextricably linked). A more likely outcome is that the SPX/gold ratio will spend the next 12 months 'chopping' back and forth.

The gold sector of the stock market usually trends in the opposite direction to the SPX/gold ratio, but note that the gold sector still has a lot of catching up to do because the HUI is at roughly the same level now as it was two years ago -- when SPX/gold was twice as high. There is no telling when the gold sector will make its inevitable catch-up move; we are simply making the point that gold stocks, as a group, currently have a lot more upside potential than gold bullion due to their relative under-valuation.

This week's important US economic events

Gold and the Dollar

Gold

The following daily chart of August gold futures shows that the gold market has been consolidating since February of this year. This year's consolidation is part of a longer-term consolidation that began in March of last year.

Last week's back-and-forth action was consistent with this year's pattern. A minor breach of support during Tuesday-Wednesday was quickly retraced and the gold price finished the week within $3 of where it began.

Above the current price there is some resistance at $960 and more important resistance at around $980, whereas support lies at around $920. Our guess is that resistance at $980 will hold if tested over the next two weeks, but a solid break above $980 should be respected because it would suggest that the longer-term consolidation had ended or was about to end.

Gold Stocks

It was an extraordinary week for the gold sector with the first HUI testing resistance in the low-360s and then plunging to the low-330s before quickly returning to the aforementioned resistance.

This is not the time of year when the gold sector normally makes SUSTAINED upside breakouts; rather, this is the time of year when upside breakouts tend to be followed in short order by downward reversals. We would therefore be sceptical of the staying power of any break above 362-365 that occurred over the coming few days.

Seasonality is just one of many considerations and this year could, of course, be different, but if you were under-exposed then the time to have done some buying was last Wednesday-Thursday. If the gold sector follows its seasonal bull-market pattern then there will be some additional back-and-forth consolidation -- including, perhaps, a test of last week's low -- during the first half of August, and then a rally into the first half of September.

Currency Market Update

The Dollar Index plunged on Friday and ended the week at important support defined by its December-2008 and June-2009 lows. The Dollar's precarious situation is illustrated below.

As mentioned earlier in today's report, Friday's sharp decline in the Dollar Index was not confirmed by the bond market. This is one reason to seriously consider the possibility that the US$ will either immediately begin to rebound or that a breach of support during the first half of this week will be quickly negated by an upward reversal. Another reason is that it has taken the Dollar Index almost 5 months to retrace the gains it made during a 2.5-month period earlier this year. This demonstrates resilience. A third reason is that the entire decline from the March-2009 peak to last Friday's low has not yet been confirmed by the gold market (the gold market has been in consolidation mode throughout this period). This is potentially significant because gold has a habit of leading the currency market at important turning points. A fourth reason is that there is a substantial short position in the US$ that will have to be covered at some point.

On a longer-term basis, the euro is now very over-valued relative to the US$ on a purchasing power basis while Europe faces the same major economic problems faced by the US. Specifically, over the years ahead Europe's economy will have to deal with excessive debt, insolvent financial institutions, massive non-funded government liabilities, and the disastrous consequences of bailouts and Keynesian policies.

Having said all that, we've learned the hard way that breakouts through intermediate-term support and resistance levels in the currency market should be respected unless/until they prove to be 'fakeouts'. Many large speculators will pile into a trade based solely on technical considerations, which can result in the market moving contrary to the underlying fundamentals for an inconveniently long time (inconveniently long, that is, if you happen to be betting the other way). We therefore wouldn't take speculative positions based on the assumption that a US$ breakout to the downside will be quickly reversed.

Gold would likely be the main beneficiary of a US$ breakdown that was not quickly reversed. The growth-oriented markets (equities and industrial commodities) have 'enjoyed' US$ weakness up until now, but that's only because the weakness has not been widely perceived as a problem. In other words, in the unlikely (in our opinion) event that the Dollar Index breaks below 78 and begins to accelerate downward we expect that some of the inter-market correlations that have been so strong over the past year will come to an end.

Update on Stock Selections

(Note: 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)

New stock selection: Orvana Minerals (TSX: ORV). Shares: 115M issued, 118M fully diluted. Recent price: C$0.76

ATW Gold has pulled out of the battle for control of Kinbauri Gold (TSXV: KNB), leaving ORV as the likely winner. Assuming that ORV's C$0.75/share bid for KNB proves to be successful it will add the El Valle gold project in Spain to its stable of assets.

ORV was previously discussed in the 15th and 22nd July Interim Updates. As explained in our 15th July commentary:

"El Valle...is scheduled to enter the mine construction phase in the near future and to be in production about 12 months later. Based on a Scoping Study completed earlier this year, El Valle should produce about 100K ounces of gold and 9.3M pounds of copper per year at a cash cost of around US$360/ounce (accounting for copper as a byproduct). The initial capital cost is expected to be less than US$60M and the project has very good economics (at gold and copper prices of $910/ounce and $1.50/pound, resp., the Internal Rate of Return is estimated to be more than 60%).

Once in production at the design parameters a project such as El Valle (100K oz/year gold with relatively low costs in a politically secure location) would be worth at least US$250M."

US$250M, or C$270M at the current exchange rate, equates to around C$2.30 per ORV share. This is ORV's upside potential at current metal prices based only on bringing El Valle into production in accordance with the engineering studies completed by KNB. ORV has other assets, but our primary interest is El Valle. Also, ORV has US$96M of cash, but we are assuming that all of this cash will be used to purchase KNB shares and to construct the El Valle mine.

We were hoping for the opportunity to add ORV to the TSI List at a lower price, but given the stock's large upside potential and that downside risk is mitigated by the company's large stash of cash we will 'bite the bullet' and add it at Friday's closing price of C$0.76. If the overall gold sector remains in consolidation mode (quite likely, in our opinion) then ORV could become available at around 10% lower at some point over the next two weeks, but at the current price the risk/reward is good enough.

The chart displayed below shows that ORV has significant resistance at around C$0.80. Support lies in the high-C$0.60s.

    Golden Queen Mining (TSX: GQM). Shares: 88M issued, 92M fully diluted. Recent price: C$0.58

We last mentioned GQM in late May, after it had just run up to the C$0.70s. At that time we wrote:

"...although GQM remains very under-valued we would not deem it a good candidate for new buying unless it were to pull back to near former resistance (now support) at C$0.50.

GQM's stock price will probably rise to a much higher price level when the company finally receives the remaining permit for its Soledad Mountain gold project in California. The permit could be issued as soon as next month, but we'll believe it when we see it."

The stock subsequently traded as low as C$0.53, providing a reasonable opportunity to do some buying for those with patience. A lot of patience is required here because the permit issue continues to drag on...and on...and on.

It would be OK to accumulate some GQM near the current price (the mid-to-high C$0.50s). As evidenced by the following chart, the stock is nearer the bottom than the top of its multi-month range. Also, it is interesting that the company completed a small non-brokered private placement of shares at C$0.65 last week. The buyers of these shares must be confident that something will happen with the permit in the not-too-distant future.

Chart Sources

Charts appearing in today's commentary are courtesy of: