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 ended in 2012. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2018-2020. (Last update: 20 January 2014)

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 Update

As part of his introduction to a very good Michael Pettis article titled "What does a good Chinese adjustment look like?", John Mauldin wrote: "China is the number one risk, in my opinion, to global financial economic stability, more so than Europe or Japan, which are also ticking time bombs." To this, we say: Hogwash! The US government-Federal Reserve combo is by far the biggest threat to global economic stability. Then comes the euro-zone's political and monetary leadership. China is well down the list and is likely to remain so for a long time to come.

China certainly has major economic problems courtesy of mal-investment on an unprecedented scale. In fact, we've previously described China's economy as a slow-motion disaster in progress. However, China isn't economically important enough to be the number one risk to global stability. Furthermore, we reiterate that its economic disaster is happening in slow motion. Due to the extent to which its central government controls credit, banking and investment, China's much-needed economic adjustment is likely to unfold over many years, perhaps even decades, such that from the outside it will look a lot more like a never-ending stagnation than a collapse. This is essentially the "long landing" option described in the above-linked Pettis article.

The alternative option described in the Pettis article involves a collapse, but this option only comes into play if China's leadership throws caution to the wind and tries to maintain a fast pace of economic activity -- via a fast pace of credit growth. Attempting to maintain a fast pace of destabilising economic activity would probably set the stage for a collapse in a few years' time, but for the coming year or two would create the impression that everything was fine.

We don't have an opinion about which option will be selected by China's political leaders. They would undoubtedly prefer the "long landing", but they might be forced to choose the option that leads to a more bullish short-term outcome. The stock market could be discounting the more bullish short-term outcome.

Natural Gas (NG) Update

From the 11th August 2014 Weekly Update:

"The US natural gas (NG) futures market has a seasonal low during August-September. ...During those years when the NG market respects the seasonal pattern and trends downward into August-September it sets up a good opportunity to 'go long' for a 2-4 month trade. 2013 was one of those years (as pointed out in TSI commentaries at the time), and ...so is 2014. The idea is to buy weakness in NG or UNG (the US Natural Gas Fund) from late-July through to early-September and to set an initial 'stop' just below whatever price low is put in place during this period. Profits would then be taken during December."

If the NG market is going to continue following its seasonal pattern, then a seasonal low should be in place by the end of this week. Therefore, anyone interested in trading the seasonal pattern by averaging into a natgas position during August-September weakness should place an initial sell stop just below whatever low is in place at the end of this week.

The Stock Market

China

As mentioned in last week's Interim Update, with the recent upward reversal in the EURO STOXX50 Index (a proxy for large-cap European stocks) relative to the S&P500 Index there are signs that the US stock market is now underperforming on a global basis. One example: Now trending higher relative to the US stock market is China's stock market, as represented by the Shanghai Stock Exchange Composite Index (SSEC).

We noted in July that the SSEC was close to signaling the end of its cyclical bear market and that despite the country's economic problems the SSEC's intermediate-term risk/reward was skewed towards reward. Later the same month we noted that the SSEC had broken out to the upside from an 18-month basing pattern, a confirming signal that an intermediate-term upward trend had begun.

The first of the following daily charts shows that the SSEC has built on its July-2014 upside breakout, while the second chart reveals evidence that the SSEC has reversed course relative to the SPX.

Earlier in today's report we wrote that China's stock market could be discounting the resumption of rapid credit expansion as China's leadership opts for a more bullish short-term outcome at the cost of a far more bearish long-term outcome. However, this is probably just part of the story. Another likely part of the story was described as follows in a recent WSJ article:

"Starting in October, overseas money managers will be able to buy Chinese companies listed in Shanghai via Hong Kong's stock exchange. Investors have poured money into funds that track these so-called A-shares in anticipation of the rule change, while some brokerage firms that operate in the region say they are hiring new staff to handle added trading."

That is, Chinese stocks are probably being boosted by some investors buying in anticipation of the buying that other investors will do after a rule change comes into effect in October.

It's also possible that the domestic demand for Chinese stocks is getting a boost from reduced demand for real estate investments. In other words, due to recent poor returns in the property market, Chinese investment demand might be shifting from the property to the stock market.

The US

The S&P500 Index made a marginal new closing high last Friday, but the downside risk keeps growing. New index highs continue to be unconfirmed by the number of individual stocks making new highs, and sentiment is as complacent as it ever gets. We point out, in particular, that according to Investors Intelligence the percentage of investment advisors who are bearish on the US stock market has fallen to 13.3%. This is the lowest bearish percentage since August-1987.

A multi-week upside blow-off remains a realistic possibility, but the risk/reward is skewed heavily towards risk over every timeframe.

Stock Market Manipulation

ZeroHedge.com is at it again -- taking a small piece of interesting information and blowing it out of all proportion via one or two giant 'logical' leaps that do not follow from the original information. Recent examples are "It's Settled: Central Banks Trade S&P500 Futures" and "What's The Point Of Hiding It Any Longer?".

The above-linked articles contain a giant leap from factual information that the CME (one of the largest futures and options exchanges) offers discounts to non-US central banks and, by extension, that the CME counts central banks among its customers, to: central banks are rigging the US stock market on a daily basis. We can't prove that the conclusion is wrong, but the information provided to support the conclusion does not contain a single shred of evidence that central banks trade S&P500 futures. Moreover, the first of the above-linked articles does contain evidence that the US Fed is NOT involved in trading futures.

Central banks are continually affecting all prices via their gross manipulations of money and interest rates. Furthermore, bubbles in major financial markets can only be caused by manipulating money and interest rates. They cannot be caused or prolonged by the manipulative trading of futures. The amount of direct manipulation carried out by the senior central banks (the ones that matter on a global basis) is insignificant, which is why market prices often don't do what the central banks want them to do and why central banks temporarily look powerless whenever a major investment bubble bursts.

This week's significant US economic events (The most important events are shown in bold)

Gold and the Dollar

Gold

The gold price remains within the small downward-sloping channel that has defined its progress over the past 2 months. In this respect, last week's price action wasn't significant. However, gold's downward drift finally took a toll on the gold-mining sector last Thursday, with the HUI and GDXJ breaking below the bottoms of their 2-month ranges.

The TSI commentaries from late-June and early-July show that we were anticipating some corrective activity. At that time, the gold market, the silver market and the silver/gold ratio were clearly extended to the upside. That being said, we obviously got more corrective activity than we were expecting in terms of both price and time.



Prior to last week's price action we thought it was important to give the 'imminent rally' scenario the benefit of the doubt, mainly because the gold-mining indices were strong relative to gold bullion and also because we were entering a time of year when gold often rallies. But with Thursday's downside breakouts in the gold-mining indices and Friday's failure to immediately negate the breakouts, that's no longer the case. On a short-term basis, uncertainty now reigns.

It's possible that our short-term outlook will get 'whipsawed' again within the next few days, because some related markets appear to be near extremes and it wouldn't take much strength from here to counteract last week's deterioration. The key, we think, is the GDXJ/GDX ratio, as it proved to be the most reliable short-term indicator by NOT generating any bullish signals over the past few weeks.

Gold Stocks

Current Market Situation

The following chart shows the HUI's long-term basing pattern. On a couple of occasions over the past month it looked like the HUI was about to complete the basing process, but it wasn't to be. The basing process continues.



Last week's break below the bottom of the 233-250 trading range created a chart-based downside target of 215-220. However, there is also some support defined by the 200-day MA. The HUI began to rebound after coming within 0.06 points of this moving average last Friday.

The next chart shows GDXJ and the GDXJ/GDX ratio. Like the HUI, GDXJ broke below short-term support on Thursday and then began to rebound from close to its 200-day MA on Friday. $34 is the downside target created by Thursday's break below support.

GDXJ was materially stronger than GDX on Friday, leading to the best single-day bounce in the GDXJ/GDX ratio since July. However, the GDXJ/GDX ratio made a new multi-month low on Thursday and Friday's bounce was not big enough to signal a reversal.



Checking progress against the 1970s Model

The gold sector's price action of the past three years continues to have a lot in common with its price action during the mid-1970s cyclical bear market and the first part of the late-1970s cyclical bull market. The similarities are evident on the following weekly chart, which shows the percentage change of the Barrons Gold Mining Index (BGMI) from June-1974 in green and the HUI's percentage change from September-2011 in blue. In direction terms the HUI has tracked the late-1970s BGMI quite closely since its December-2013 bottom, but its rallies have been weaker.



The BGMI's performance following both its 1970 bottom and its 1976 bottom suggested an upside target of around 300 for the HUI this year. That's why 300 has been our upside target for 2014. We originally expected that this target would be reached by mid-year and then by the end of September.

As a result of last week's price action there is no longer a realistic chance of the HUI reaching our 2014 upside target by the end of September. That's the bad news. The good news is that the overall pattern continues to match the early part of the late-1970s bull market.

A literal interpretation of the HUI-BGMI comparison shown above is that the HUI will decline into late-September and then rally into mid-November.

The Currency Market

The ECB's cunning new plan

Last Thursday (4th September) the ECB introduced a cunning new plan to spur growth in the euro-zone, the first part of which involves cutting official interest-rate targets by 0.1%. The benchmark refinancing rate has been reduced to 0.05%, because 0.15% was obviously too high, and the deposit rate has gone further into negative territory, because it obviously wasn't negative enough. The actions have been taken due to "inflation" and inflation expectations being too low.

Inflation of any kind is the last thing that Europe needs, but from the Keynesian perspective, which is the perspective of all central bankers, it is critical that both inflation and inflation expectations are well above zero. The reason is that in the back-to-front world in which Keynesians are mired, consumption spending comes first and is the driving force of the economy. Furthermore, according to Keynesian logic if people believe that prices are going to be lower in the future they will put off their spending, which will set in motion a vicious deflationary spiral of price declines leading to reduced spending, leading to additional price declines, and so on.

Keynesian logic explains why the computer and smartphone manufacturers never sell anything. Everyone knows that if they wait a year they will be able to buy a better smartphone and a better computer at a lower price, so nobody ever buys these products. As a consequence, the entire computer and smartphone industries have zero sales year after year.

Getting back to the ECB, a goal of reducing the cost of credit to zero is to generate some "price inflation", which, according to the theories that inform the decisions of central bankers, will boost immediate consumption and cause the economy to grow faster. But if a faster rate of price inflation is what they want, then what they will have to do is increase the rate of monetary inflation. In this regard, taking an overnight interest rate down from 0.15% to 0.05% is probably not going to do much. If the ECB is serious about generating "inflation" then what it really needs to do is implement a Fed-style QE program.

Which brings us to the second part of the ECB's cunning new plan. The ECB announced that it would begin monetising covered bonds and asset-backed securities (ABS)*, including real-estate-backed securities, next month, with the details to be announced at next month's ECB meeting. Depending on its size and mechanics, this asset monetisation program could certainly cause prices to rise. To the extent that it does cause prices to rise it will benefit banks and speculators at the expense of savers, productive businesses and wage earners.

Fortunately or unfortunately, depending on your perspective, due to the limited availability of eligible collateral the QE program announced by the ECB last week might be restricted in size to about 200B euros. This means that it might not be large enough to have much effect on the euro-zone money supply.

    *Banks create asset-backed securities by pooling mortgages and other loans. Covered bonds are similar, but the underlying assets are 'ring-fenced' on the bank's balance sheet, which means that the assets are still there if the bank goes bust.

Current Market Situation

Despite the initial market reaction, to the extent that the ECB's new scheme boosts asset prices it will be short-term and intermediate-term bullish for the euro's exchange rate. This is because it will draw investment into the euro-zone and temporarily reduce the risk of major economic weakness (while increasing long-term risk). In particular, if the scheme leads to significant additional strength in European bank stocks and European equities relative to US equities, it should lead to strength in the euro relative to the US$.

As things now stand, there is a sizeable divergence between the currency and equity markets that points to future strength in the euro.

For the past four years, the euro and the EURO STOXX Banks Index (SX7E) have been moving up and down together. However, over the past two weeks the SX7E has reversed course and moved sharply higher while the euro has continued its decline, resulting in the divergence indicated on the following chart.

By the way, the euro's upward reversal in July-August of 2012 coincided with Mario Draghi's promise that the ECB would do whatever it takes to support Europe's monetary union. Interestingly, the speculative net-short position in euro futures is almost as big now as it was at the time of the 2012 reversal.



The following weekly chart shows the extent to which the Dollar Index is now extended to the upside on both a short-term basis and an intermediate-term basis. The price touched long-term resistance late last week and the weekly RSI is now as high as it has been at any time over the past 10 years.

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

Company news/developments for the week ended Friday 5th September 2014:

[Note: AISC = All-In Sustaining Cost, 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]

  *Almaden Minerals (AAU) released the results of an updated PEA for its Tuligtic gold-silver project in Mexico. This is a very positive development and is discussed later in today's report.

  *Evolution Mining (EVN.AX) published its financial statements for the Financial Year ending 30th June 2014.

The company achieved a bottom-line profit of A$50M, or A$0.07/share. Also, it declared a 1c/share dividend, payable to shareholders of record at 9th September.

The bulk of the important information in the annual financial report had been provided in earlier press releases. From our perspective, the most interesting new information was the change in the overall financial position as reflected in the published balance sheet. Based on the reported production results we were expecting to see a significant improvement in the financial position, but it didn't happen. The company's net debt (long-term debt minus working capital) was lower at 30th June 2014 than at 31st December 2013, but only by a relatively small $7M (it was $123M at 31st December 2013 and $116M at 30th June 2014).

This is a disappointing performance. Despite the healthy profit margin suggested by its reported per-ounce production costs, it is clear from the change in its balance sheet that EVN is only marginally profitable at the current gold price (the change in the balance sheet during a period is the best indicator of performance, because it cuts through the accounting adjustments that affect the reported net earnings). Being marginally profitable at the current gold price puts EVN ahead of the average gold producer, but it will need a materially higher gold price to have a good business in absolute terms.

Timmins Gold (TGD, TMM.TO) is one of a small number of gold producers that does appear to have a decent business at the current gold price. This is one of the reasons we recently added it to the TSI Stocks List and consider it to be a top candidate for new buying. RIO Alto (RIOM), a former TSI stock, also has a decent business at the current gold price, although it is now a very expensive stock due to roughly doubling its share count in exchange for Sulliden Gold's development-stage Shahuindo project.

  *Pilot Gold (PLG.TO) released the results of recent step-out drilling at the Valley porphyry discovery at the TV Tower project (Turkey). The highlight was 0.63 g/t gold and 0.27% copper over 134.7 metres. Although these results extend copper and gold mineralization at the Valley porphyry, this is not the sort of news that will increase demand for the stock in the current sombre market for gold-related investments.

  *Ramelius Resources (RMS.AX) published its financial statements for the Financial Year ending 30th June 2014.

The company's financial position can no longer be described as solid. Due to a further consumption of cash over the latest half-year, its working capital fell from $16M at 31st December to $8M at 30th June. This means that in the absence of a quick and substantial rebound in the gold price, RMS probably only has sufficient financial resources on hand to fund its business until December of this year. It could obviously raise more money by issuing more shares, but a large issue of new shares near the current market price would greatly reduce the per-share value.

RMS also published updated resource and reserve estimates. Due primarily to a lower gold price assumption, the total resource has fallen by 320K ounces over the past 12 months to 2.3M ounces (1.3M in the M&I category plus 0.8M in the Inferred category). P&P reserves fell by about 170K ounces to 427K ounces.

  *Rio Alto Mining (RIOM, RIO.TO) was removed from the TSI Stocks List in May in response to the company's agreement to pay a very high price for Sulliden Gold (SUE.TO). This turned out to be a badly timed move on our part, as RIO has since been one of the best-performing gold stocks.

Also, at the time of its removal from the TSI List and in subsequent notes in TSI commentaries during May-July, we advised that we were retaining substantial exposure to RIO in our own accounts with a plan to be out by the end of September. This plan was based on a) our expectation that the gold-mining sector would be strong during August-September, which is something that obviously hasn't happened, and b) RIO likely getting a significantly higher weighting in GDXJ due to the SUE takeover, leading to increased demand for RIO shares and a good selling opportunity during the weeks following the August completion of the merger.

The purpose of this note is to advise that our money-management plan is unchanged. We've exited about half of our position and intend to exit the balance by the end of this month.

RIO now has a market cap of around $1B, which constitutes a very high valuation considering its assets and the valuations of many other gold miners.

    List of candidates for new buying

After last week's price action many of the stocks we follow are both under-valued and close to chart-based support levels. This means that there are many good candidates for new buying. However, to make this list more useful we limit it to 5 stocks.

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

1) AAU in the US$1.40s (last Friday's closing price: US$1.51).

2) EDV.TO (last Friday's closing price: C$0.84).

3) EVN.AX (last Friday's closing price: A$0.68).

4) PVG (last Friday's closing price: US$6.66).

5) TGD (last Friday's closing price: US$1.54).

    Almaden Minerals (AAU). Shares: 69M issued, 77M fully diluted. Recent price: US$1.51

AAU published the results of a revised PEA for the Ixtaca Zone at its Tuligtic project in Mexico. The Ixtaca Zone contains gold and silver in roughly equal dollar amounts (using a gold/silver ratio of 60).

Here's what we wrote about the original PEA, which was issued in April of this year:

"The PEA is based on an open-pit mine with average annual production of 260K gold-equivalent ounces (130K ounces of gold plus 7.8M ounces of silver) and a mine life of 12.1 years. It is estimated that the mine would cost about $500M to build and would operate at a cash cost of around $600/oz.

At gold and silver prices of $1320/oz and $21/oz, resp., the after-tax NPV(5%) is estimated to be $437M and the IRR is estimated to be 22.2%. These figures suggest that the project would be economically viable at these metal prices, but we doubt that anyone would spend $500M building a gold mine with an NPV of $437M. At metal prices of $1530 and $29 the after-tax NPV(5%) increases to $875M and the IRR increases to 34.1%. These are robust economics."

And:

"...the cost to build a mine at the Tuligtic project is probably high enough that a decision to build would not be made at the current gold price [of around $1300/oz] even though it is estimated that the mine would have a cash operating margin of almost $700/oz. However, according to the PEA the project's economics are good enough that it would only require a moderately higher gold price to shift the balance in favour of mine development."

The revised PEA considers two cases: An updated base case and a ramp-up case.

For the updated base case, almost everything is the same except for the initial capex. By coming up with a more efficient way of doing the pre-stripping, AAU has managed to reduce the initial capex by about $100M. This makes a big difference to the economics and the potential viability of the project. Specifically, at gold and silver prices of $1320/oz and $21/oz, resp., the estimated after-tax NPV(5%) rises from $437M to $515M and the estimated IRR rises from 22% to 28%. Most importantly, the bottom row of the following table shows that the reduction in the initial capex causes the EVCC/NPV ratio (the Enterprise Value of the company plus the initial Capital Cost of the company's flagship exploration-stage project divided by the project's NPV) to fall from 1.34 to 0.95 at the current stock price and a gold price of $1320/oz. The updated base case therefore suggests that the project would be economically viable and that AAU would be a reasonable takeover target with gold in the low-$1300s, whereas the original base case suggested that a gold price of around $1450/oz would be needed.

The base case uses a 30,000-tonne/day mining operation from Year 1. For the ramp-up case, the mining rate begins at 7,000-tonnes/day and is increased to 30,000-tonnes/day in Year 6. This enables the initial capex to be slashed to $244M.

At the same metal prices noted above, the ramp-up case has the disadvantage of a lower NPV and IRR ($427M and 23% for the ramp-up case versus $515M and 28% for the updated base case). However, the bottom row of the following table's final column shows that the large reduction in the initial capex enabled by the ramp-up plan pushes the EVCC/NPV ratio down to only 0.78.

An EVCC/NPV ratio of 1.00 or lower is good (the lower the better). An EVCC/NPV ratio of only 0.78 points to the Tuligtic project being very under-valued at the current AAU stock price.

Both of the cases considered in AAU's revised PEA indicate that the economics of the Tuligtic project are significantly better than previously thought. This means that AAU offers even better value than previously thought. We suspect that the ramp-up case would be preferred in a difficult market for financing, but that the updated base case would be preferred -- due to its higher NPV and IRR -- in a market environment where reasonable-cost financing was readily available.

Lastly, remember that PEA stands from PRELIMINARY Economic Assessment. It's a first pass, with detailed engineering to follow as part of the PFS and then the FS. AAU's PEA constitutes a good start, but it's just a start.

The stock market's reaction to AAU's PEA news was strange. There was no market reaction at all on the day of the press release, but there was a high-volume appropriately-positive reaction the next day. It seemed as if nobody got around to reading the press release until 24 hours after it was issued.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://bigcharts.marketwatch.com/