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

US Economic Numbers Update

The monthly numbers on US manufacturing released last Monday and the monthly US employment numbers released last Friday were slightly better than expected, but the overall picture hasn't changed. There's a high probability that the current period will eventually be recognised as being recessionary, but the recognition might not happen until the second quarter of next year.

Due to words uttered by Ben Bernanke and other senior Fed officials over the past two months, the financial markets now fixate more than ever on the monthly employment numbers. If last Friday's serving of August employment data had shown greater weakness than expected, there probably would have been another price-surge in the assets that are considered to be the main beneficiaries of QE. Alternatively, these assets would probably have sold off sharply if the data had been strong enough to suggest a turnaround. The data turned out to be just a little better than expected, so most markets consolidated. Consolidation has actually been the name of the game in the financial world since the day after the QE3 announcement.

Despite the Fed having promised a new QE program on 13th September and despite the financial markets having reacted to the Fed's promise, a new QE program hasn't yet begun. In fact, the very gradual contraction of the Fed's balance sheet that began in July of 2011 continued over the past three weeks. Of particular relevance, between 12th September and 3rd October (the date of the latest data) the Fed's holdings of Mortgage-Backed Securities CONTRACTED by $9B, the total amount of securities held outright by the Fed CONTRACTED by $16B, and total reserve bank credit CONTRACTED by $21B. To put it bluntly, since announcing a new inflation program the Fed has taken actions that are modestly deflationary. 

Natural Gas Update

We speculated in the 14th May Weekly Update that the natural gas price had just made a major (meaning multi-year) low. Subsequent price action has removed most of the doubt that such a low is in place. The question is: with the natgas price having rebounded from below $2.00 to around $3.50, how much additional upside is it reasonable to expect over the coming several months? The answer is: not a lot.

There is a supply-related and a demand-related reason to believe that a sustained rise in the natgas price to above $4.00 is not going to happen anytime soon. On the supply side, US natgas production was never significantly reduced in response to this year's low prices, but it will probably be quickly increased in response to higher prices. We suspect that producers will rush to take advantage of a natgas price of $4 or more by ramping up current production and hedging future production. On the demand side, it is now a lot cheaper in the US to generate electricity using coal than to do so using natgas. Many power plants can be easily switched between coal and natgas, so additional gains in the natgas price should lead to a meaningful reduction in electricity-generation-related natgas demand unless the price of thermal coal moves sharply higher.

The Stock Market

As is the case with most of the QE beneficiaries, the S&P500 Index (SPX) has essentially gone nowhere since its immediate upward reaction to the Fed's new inflation program. We won't be surprised if the SPX spikes above its September high to a new multi-year high this week, but we will be surprised if there is a sustained upside breakout.

Important lateral support is in the 1420s. A routine short-term correction would bottom near this support, which means that a decisive break below the 1420s would be the first sign that something more serious than a routine short-term correction had commenced.

This week's important US economic events

Gold and the Dollar

Gold and Silver

A weak US employment report on Friday could have temporarily broken gold above resistance at $1800 by stirring up hopes/expectations of more Fed monetisation. As it was, gold held up well in reaction to employment numbers that weren't as weak as they could have been.

Gold remains below resistance at $1800 and has essentially moved sideways since the immediate reaction to "QE3". A spike above $1800 wouldn't surprise us, but a sustained move above $1800 is unlikely at this time. The gold market is now very 'overbought' on a short-term basis, as evidenced by the new 12-month high just registered by the total speculative net-long position in COMEX gold futures and the new all-time high just registered by the net-long position of small traders in COMEX gold futures.

$1700 is a reasonable target for a pullback.

Silver is in a similar position, having traded sideways since "QE3" day and being very 'overbought' on a short-term basis. The difference is that silver never reached intermediate-term resistance ($37.00-$37.50 for silver is the equivalent of $1800 for gold) and has greater short-term downside risk.

With or without a spike above the September high, silver's next correction will probably take it back to $30-$32.



Gold Stocks

Current Market Situation

To make a change from the same old HUI chart, below is a daily chart of the XAU. HUI resistance at 550 and HUI support at 460 are equivalent to XAU resistance at 205 and XAU support at 170. Our view is that support at 170 defines the short-term downside risk and that a correction to just above this support commenced in mid-September.

In the unlikely event that the XAU breaks above its September high within the next few days, the upside will likely be limited by resistance at 205.



SA mining on strike

26th September was when we last wrote about the labour unrest disrupting South Africa's mining industry. It was bad then, but it is worse now. According to the latest report we've seen, 100,000 workers (about 20% of the country's total mining workforce) are now on strike and the strikes are becoming increasingly violent.

Major strike action (actual or threatened) is something the SA mining industry has to deal with every two years at around the time that labour contracts are renegotiated. It is par for the course, so to speak. However, the current round of strikes is happening more than 6 months ahead of schedule, in that labour contracts aren't due to be renegotiated en masse until mid-2013. SA was a difficult place to operate a mining business when you had to deal with a production-disrupting strike every two years. If the current unrest marks a change such that from now on production-disrupting strikes will be more frequent and less predictable, it will make no sense to own/operate a mining business in SA.

We presently have no desire to own the shares of any mining company that does most of its business in SA, but a potentially interesting trade is setting up in the long-dated call options of Harmony Gold (HMY). HMY produces about 1.3M ounces of gold per year, all of it from mines in SA. Thanks to the strikes that have spread through SA's mining industry over the past several weeks, HMY's stock price ended last week at a 3-year low. Furthermore, over the past 6 years it only traded lower than it is today during the second half of 2008 -- around the crescendo of the 2007-2009 global financial crisis.



HMY earned US$0.71/share during the year ended June-2012, which means that it is currently trading at around 11-times last year's earnings. Its earnings are highly leveraged to the gold price, which means that it should earn a lot more during the current financial year than it did during the preceding year provided that a) the average gold price is significantly higher and b) its annual production is not adversely affected in a big way by the strikes.

The risk that HMY's annual production will be affected in a big way by the strikes is too great to justify buying the shares, but the risk/reward of the January-2014 $10 call options looks attractive to us. The risk is 100%, but the potential reward is a few hundred percent. It could be worth scaling into a position in these options over the next couple of weeks, especially if the HMY stock price falls further in reaction to the strikes and a sector-wide correction.

Currency Market Update

Japan's Unintentional Strong Yen Policy

Over the years we have read many times that the Bank of Japan (BOJ) has rapidly inflated the supply of Yen. The 'pundits' who made such statements were obviously swayed by the numerous announcements of QE programs emanating from Japanese officialdom, but they should have done a little research rather than blindly assume that these QE programs led to large increases in the economy-wide Yen supply. If they had done the appropriate research they would have discovered that over the past 20 years the annual rate of growth in the Yen supply (Japan's monetary inflation rate) has oscillated in a narrow range around an average of only 2%, and that it is presently near this long-term average. This is illustrated by the following chart. The fact is that of the major currencies, the Yen has had by far the slowest rate of supply growth over the past two decades. That's why the Yen has maintained its purchasing power and why it has been a relatively strong currency on a long-term basis despite the many blatant short-term negatives.

On a side note, the following chart shows that Japan's money supply grew at an average rate of around 10%/year during the boom years of the 1980s and that the money-supply growth rate collapsed during 1990-1991. The monetary transition from the bubble world to the post-bubble world is where comparisons between the US and Japan break down. Whereas Japan's monetary inflation rate tanked after its credit bubble burst, the US's monetary inflation rate moved sharply higher. This is an important part of the explanation for why things never got that bad in Japan and why the much-maligned Japanese economy had stronger real growth over the past 10 years than the US economy. The reality is that monetary inflation damages the economy. The more 'success' that the Fed enjoys in its efforts to maintain a high rate of US$ inflation, the worse things will inevitably get for the US economy.

On another side note, it's too bad that Japan's government went on one Keynesian spending binge after another following the bursting of the credit bubble. If it hadn't gone down this path, wasting resources on a grand scale and racking up an enormous debt in the process, Japan's economy would probably now be in very good shape.



As far as currency exchange rates are concerned, the relative monetary inflation rate is the tide. Interest rate differentials, trade balances, equity and commodity price trends, government debt/deficit levels and differences in economic growth rates are waves. The waves can dominate for periods of up to a few years, but the tide will eventually have its way.

As mentioned in our opening paragraph, the tide has been in the Yen's favour for a long time. One result is illustrated by the following weekly chart. Despite the US dollar's interest rate advantage over the Yen during the entire 15-year period covered by the chart, the Yen has been in a long-term bull market relative to the US$.



The US$ has done poorly relative to most major currencies over the past 10-15 years, so let's check the Yen's performance against a strong currency: the Australian Dollar (A$). The following weekly chart shows that there have been some big multi-year swings in the Yen/A$ exchange rate over the past 15 years, but the current level of this rate is the same as it was in 2003 and the same as it was in 1998. During the period covered by this chart the A$ apparently had everything going for it. In particular, the A$ had a large interest rate advantage throughout, the Australian economy was consistently stronger than the Japanese economy, there was a secular bull market in commodities that attracted considerable foreign investment into Australia, and the Australian government ran budget surpluses or small deficits whereas the Japanese government relentlessly ran huge deficits. All of these 'waves' added together constituted a powerful force, but they were counteracted by the tide (Australia's average money-supply growth rate was much higher than Japan's over the period in question).



The past has been characterised by relatively slow growth in the Yen supply and long-term strength in the Yen, but the future could look very different. Japan's government has racked up so much debt that at some point within the next few years it will have to either directly default on a substantial portion of its debt or enlist the help of the central bank (the BOJ). Either way, savers will be hurt. A lot of Japanese savers are invested in government bonds, so a direct default would result in large nominal losses for many members of the voting public. It would be blatantly obvious that the government was to blame for the losses, so the government that took this action would effectively be committing political hara-kiri. That's why it is more likely that the government will enlist the help of the BOJ.

The BOJ could monetise a large slice of the debt. While this wouldn't reduce the total size of the debt burden, it would effect a transfer from the balance sheets of voting investors to the balance sheet of the central bank. The debt could then be defaulted on, with the BOJ taking the loss. Due to the Yen's loss of purchasing power, the cost to savers would be just as great as it would be in the case of a direct default. Moreover, the cost to the overall economy would be greater if the monetisation route were taken due to the distortion of price signals and the mal-investment caused by creating a lot of money out of nothing. However, it would have the political advantage of making it more difficult for the average person to correctly assign blame.

Large-scale debt monetisation will very likely occur in Japan, leading to the Yen becoming a relatively weak currency. The difficult question is: when will the large-scale monetisation begin? We don't know the answer. A year ago we thought it would have begun by now, but clearly it hasn't.

Current Market Situation

The Yen made an all-time high against the US$ at around this time last year. It lost 10% over the ensuing 5 months and then recouped about two-thirds of its losses. The 70-week moving average generally does a good job of defining the Yen's intermediate-term trend. As illustrated by the following chart, this moving average (the blue line on the chart) is flattening out and almost exactly coincides with last Friday's closing price.



This year's performance by the Yen has been out of the ordinary. Based on what had happened over the preceding 15 years, the rebound from the 'oversold' extreme reached in March should have peaked at around the 70-week moving average, with perhaps a 1-2 week overshoot. The rebound has therefore been stronger than a typical countertrend rally. This means that the chart is even less helpful than usual in our effort to guess the direction of the Yen's next 10% move.

The tide is still in the Yen's favour, but the direction of the next 10% move will be determined to a greater extent by the waves than the tide. The most important waves over the next few months are likely to be global stock market performance and sentiment, with sentiment influenced to a substantial degree by the words and actions of both the BOJ and the Fed. The Yen would be boosted by a global stock market decline, whereas it would be pushed downward by a continuing upward bias in equities and/or evidence that the BOJ was prepared to do a lot more on the monetary inflation front.

Our guess is that the Yen's next 10% move will be to the downside. However, its long-term bull market appears to be intact.

The plunge in the purchasing power and exchange rate of the Iranian rial continues to be the biggest currency-related story of the day. From our perspective, one of the strangest aspects of this currency crisis is that nobody on the ground in Iran or commenting in the mainstream Western press appears to have any clue as to the major role that must have been played by monetary inflation. As evidenced by the New York Times article posted HERE and several other articles and commentaries that we've read on the topic, the finger of blame is either being pointed at economic sanctions instigated by the US government or economic mismanagement by the Iranian government. The sanctions are inexcusable (an absolute disgrace, actually) and there is no doubt that the policies of Iran's own government have been harmful, but neither of these factors could possibly be the primary cause of the currency collapse and associated moon-shot in the general price level. The hyperinflation that Iran is now experiencing would not be possible in the absence of a huge increase in the country's money supply.

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 5th October 2012:

  *Carpathian Gold (CPN.TO) announced that the construction of its 100K-oz/year RDM gold mine in Brazil was on track and on budget ($160M) for production commencement during the second half of next year. Despite stating that the mine construction was on budget, the company also implied that the budget would have to be increased due to some scope changes to do with environmental requirements.

Assuming no major changes to the RDM construction budget, CPN says that it will be fully funded through to production once it finalises a $90M debt facility with Macquarie Bank. The debt facility is expected to be finalised very soon.

CPN would not be near the top of our shopping list if we were looking to add long-term exposure to the junior gold mining sector, but at around C$0.30/share we like it as a 6-month trade. The stock price appears to be basing, the valuation is low, and there will probably be positive news flow from both of its gold projects (the RDM project in Brazil and the Rovina Valley project in Romania) over the next several months.



  *Endeavour Mining (EDV.TO, EVR.AX) announced that two independent proxy firms have recommended that Endeavour shareholders vote for the resolution approving the issuance of Endeavour shares in connection with the acquisition of Avion Gold (AVR.TO). A special meeting of EDV shareholders to consider/approve the AVR takeover has been scheduled for Friday October 12.

As previously explained, we don't view the AVR takeover as a bad deal. We wouldn't vote against it, although we would prefer that it hadn't happened. We think the deal increases the stock's risk by more than it increases the potential upside.

At the current stock price EDV's risk/reward is attractive, although its value isn't quite as good now as it was 5 weeks ago when it was trading below $2 and was described in these pages as one of the best buys in the gold sector.

  *Energy Fuels (EFR.TO) announced in August that it had arranged to buy-out its 50/50 joint venture partner in a small exploration-stage uranium project in Utah (the Sage Plain properties), thus adding about 1.4M pounds of uranium and 9M pounds of vanadium to its in-ground resource at a total cost in cash plus shares of about $2M. This deal has been completed. It is a plus, but not a significant one.

  *Fairborne Energy (FEL.TO) closed its previously-announced asset sale. The $188M sale proceeds were used to eliminate all of FEL's bank debt. As a result, the company is now debt free with an undrawn $80M credit facility.

The asset sale has substantially reduced FEL's downside risk as well as its upside potential. Our current intention is to exit the stock if it rebounds to around C$2.

  *Golden Predator (GPD.TO) reported drilling results from the Fosters Zone at its Brewery Creek gold project in Canada's Yukon. None of the reported intercepts were impressive, but they were all close to the surface and when taken together they improve the odds that the Fosters Zone will be developed into a profitable open-pit mine.

  *Jaguar Mining (JAG) announced that it was once again in full compliance with the NYSE's minimum price standard for continued listing (the minimum price standard requires that a company's shares trade at an average price of at least $1.00 over a 30 day period). That's nice, but we are a lot more interested in how the company's cost reduction program is going. With the cost reductions that have been implemented to date and the recent rise in the gold price, JAG should now be in a healthy cash-flow situation.

  *Pretium Resources (PVG) reported another round of drilling results that included another batch of ultra-high-grade gold intercepts. Of particular note, Hole SU-542 had separate intersections of 2,258 grams per tonne over 2.30 meters, 8,912 grams per tonne over 0.50 meters, 1,780 grams per tonne over 0.5 meters and 2,420 grams per tonne over 0.5 meters.

This year's exploration program is almost complete, with final drilling results expected over the next few weeks and an updated resource estimate scheduled for December-January. The updated resource estimate is the next important milestone for PVG.

  *Sabina Gold and Silver (SBB.TO) reported some excellent gold intercepts within its latest bunch of drilling results, including 10.31 g/t Au over 39.85m, 18.18 g/t Au over 25.7 m and 12.84 g/t over 23.00m. These intercepts should help convert existing resources from the Inferred to the Indicated categories, but they probably won't add to the size of the overall resource.

SBB's 2012 drilling program is either complete or will be completed within the next few days, but additional drilling results will be reported over the coming month or so. After that, the next piece of significant company-specific news is likely to be an updated resource estimate that we expect to be published early next year.

Golden Star Resources (NYSE: GSS, TSX: GSC). Shares: 259M issued, 318M fully diluted as at Sep 2012 (counting 47M $1.65 CNs as equity). Recent price: US$1.99

After the close of trading on Friday GSS announced its Q3 gold production and updated 2012 guidance. As is almost always the case with this company, its production over the latest quarter came in below its own forecast and guidance for the full year was reduced. This could, but won't necessarily, cause the stock to sell off this week. It won't necessarily cause a significant decline in the stock price because a) the reduction in 2012 guidance was fairly small (338K ounces down to 333K ounces), and b) if the company achieves its reduced Q4 guidance of 87K ounces it should generate a lot of cash due to the likelihood of gold averaging a much higher price in Q4 than in the previous two quarters.

Here are some back-of-the-envelope specifics. An average gold price of $1750/oz during Q4 should result in a gross margin of at least $700/oz for GSS, which should, in turn, enable the company to generate at least $36M of cash assuming production of 87K ounces. If we use a fully diluted share count of 312M and apply an 8 multiple to the annualised quarterly cash flow, we find that a quarterly cash flow rate of $36M justifies a GSS share price of about $3.70 (85% above last Friday's closing price). Therefore, if the market focuses on the underlying value and the potential cash flow generation rather than the reduced guidance, the stock won't sell off. It could even rally.

In the 24th September Weekly Update, with the stock price at US$2.04, we noted that GSS was 'overbought' and a potential candidate for partial selling. Note that IF the reduced production guidance prompts a sell-off this week, a short-term buying opportunity would be created by a decline to the US$1.60s.

Short-term trading idea: Rye Patch Gold (TSXV: RPM). Shares: 146M issued, 155M fully diluted. Recent price: C$0.56

RPM is a gold junior with three exploration-stage projects in Nevada (the Wilco, Lincoln Hill and Jessup projects). All told, these projects currently have 1.9M ounces of gold in the M&I category and 0.8M ounces of gold in the Inferred category as laid out in the table posted at http://www.ryepatchgold.com/i/pdf/Rye_Patch_Resource_Table_Sept_2012.pdf. This in-ground resource gives the company some option value and underpins its market capitalisation, but the very low average grade of the resource (around 0.36-g/t) suggests that it couldn't be economically mined. We therefore wouldn't be interested in owning RPM shares if the aforementioned projects were all the company had going for it.

RPM only interests us at this time as a play on the outcome of a legal case scheduled to go to trial next month. To cut a long story short, Coeur d'Alene Mines (CDE) failed to pay the maintenance fees on unpatented mineral claims around its Rochester silver/gold mine in Nevada by the due date of 31st August 2011. By late October of 2011 CDE still hadn't made the required payments to the BLM (Bureau of Land Management). The mining claims were therefore forfeited and became open to the location of new mining claims by any third party. Rye Patch identified the open ground and located unpatented mining claims during October and November 2011. RPM completed the monumentation of its mining claims in November 2011, informed the senior management of CDE of the location of the mining claims on November 28, 2011, and issued a press release on December 5, 2011, informing the world of the situation. The market's reaction was to immediately raise RPM's stock price from the low-C$0.40s to the low-C$0.80s. CDE then initiated legal proceedings in an effort to get their forfeited claims returned. As the months went by the market gradually lost interest, causing RPM's stock price to drift downward to not far above its level just prior to the Rochester news. However, interest should begin to increase as the November court date approaches.



According to CDE, the disputed claims cover about 20% of the Rochester Mine's reserves and a substantial portion of the Rochester Mine's resources. At this time the mine is producing at the rate of about 4M Ag-eq (silver-equivalent) ounces per year. Its reserves total 42M Ag-eq ounces and its resources total 185M Ag-eq ounces (155M M&I plus 30M Inferred). This makes it an important asset for CDE.

We aren't knowledgeable about the legalities of unpatented US mineral claims, but everyone we know who is knowledgeable believes that RPM will win the court case. A legal victory would, in our opinion, push RPM's stock price up to at least C$0.80 and probably as high as C$1.00. There's also a possibility that CDE will try to resolve the issue by making a takeover bid for RPM prior to the start of the trial. In the unlikely event that RPM loses in court, RPM's other projects should prevent the stock from falling below the C$0.30s. This sets up an attractive risk/reward for a short-term trade. The plan would be to take a position in the low-to-mid-C$0.50s with the aim of either exiting at a profit of 60%-100% following a legal victory or takeover bid or exiting at a loss of up to 40% following a legal defeat.

We aren't adding RPM to the TSI Stocks List at this time, but will do so if it becomes available at C$0.52 within the next two weeks.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html