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

The greatly anticipated ECB bond-buying program

Recent comments by ECB chief Draghi had led to widespread expectations of a new ECB bond-buying program designed to cap the yields on EZ government bonds. These expectations were largely met on Thursday 6th September when the ECB introduced an open-ended (meaning: unlimited) government bond purchasing program for short-term (1-3 year) debt securities to reduce interest rates paid by governments in crisis. It is called the Outright Monetary Transaction (OMT) program.

On Thursday and Friday the financial markets celebrated the new bond-buying program. Of particular relevance, the first of the following charts shows that the yield on the 10-year Spanish government bond plunged to its lowest level since April, and the second of the following charts shows that the yield on the 10-year Italian government bond dropped to its lowest level since March. The 10-year Italian government bond yield is actually now close to a 12-month low. So, no more EZ government debt crisis! Problem solved with just a few words from the ECB.

Lost in the party-like atmosphere late last week were two important details.

First, although many commentators talked as if the ECB had just committed to print euros like crazy, the ECB actually stated that it would sterilise all bond purchases so that these purchases did not result in monetary inflation. To put it more plainly: the ECB specifically stated that it would NOT be printing money as part of this new program.

Second, the ECB stated that the bond purchases would be highly conditional. Importantly, the government in question would have to formally request a bailout, agree to comply with an economic reform package (commonly called "austerity program") approved by the EU and the IMF, and then submit to on-going supervision to ensure compliance. The bond support would end if the government being supported failed to meet its commitments.

So, according to the ECB the new bond-buying program will not result in a higher money supply and will only apply to governments that follow the "austerity" path laid down by supranational organisations. Little wonder there was no push-back from the German government.

Details that weren't overlooked, perhaps because they support the resurgent "risk on" theme, are that the ECB will rank equally with private investors who own the same bonds and that collateral requirements for borrowing from the ECB will be lowered. The latter gives troubled EZ banks greater ability to borrow.

It seems that the financial world is momentarily in a zone where all news that isn't overtly negative is treated as positive. That's why the markets were willing to ignore the word "sterilised" in the ECB's promise to make unlimited sterilised bond purchases. The amount of bonds that the ECB can purchase in a "sterilised" way is actually very limited, because for the ECB to sterilise a bond purchase it must sell an asset of equivalent value (it issues new money to make a bond purchase and then absorbs the equivalent amount of money by selling one of its existing assets). The thing is, a lot of the ECB's existing assets are also the assets it is trying to support via the purchase program. This could mean that the ECB doesn't intend to buy a lot of bonds in the near future. It could also mean that the ECB will eventually be forced to make unsterilised bond purchases (outright bond monetisation, or QE).

The ECB will eventually resort to unsterilised bond purchases, but crisis conditions will probably have to re-emerge before that becomes politically feasible. 

A weak employment report leads to more QE speculation

Debt and Deflation

Deflation is often linked to debt, which on the surface seems reasonable given that the higher the debt level the greater the amount of money that will have to be devoted to debt repayment and the lesser the abilities of borrowers and lenders to increase their commitments. But as is regularly the case in the world of economics, looking beneath the surface leads to a different conclusion. At least, looking deeper suggests the strong possibility of a different conclusion.

Here's the crux of the matter: When a heavily-indebted government is unable to print -- either directly or via its central bank -- the money in which its debt is denominated, the consequences are deflationary. However, when a heavily-indebted government is able to print -- either directly or via its central bank -- the money in which its debt is denominated, the consequences are almost always inflationary. The reason is that inflation (creating money out of nothing) allows politicians to postpone the tough decisions that must be made in order to permanently resolve a debt problem. If postponement can continue for long enough then the debt will become someone else's problem.

With most of today's governments having access (via their central banks) to the printing press, it's a very good bet that the bigger the government's debt problem the greater the amount of inflation -- the monetary kind and the price kind -- there will be, up to the point where more inflation is politically impossible. And more inflation only becomes politically impossible after the voting public begins to see "inflation" as the most important economic threat. To put it another way, in those cases where a government can inflate at will, which is the case in the US and in most countries today, the government will almost certainly attempt to use inflation to put off the really tough decisions for as long as it can get away with doing so.

The Stock Market

The US stock market has decoupled from most other important stock markets in the opposite way to how the true believers in the Asian-growth-miracle-commodity-super-cycle theme expected. We doubt that the US stock market will be a relative strength leader for much longer, but its strength relative to most other stock markets over the past two years has led to divergences between stock market performance and reliable measures of risk aversion. When they are compared to the S&P500 Index these measures of risk aversion appear to have stopped working, but when they are compared to indices representing other important markets around the world they still appear to be valid. Take the HYG/TLT ratio (high-risk bonds relative to low-risk bonds) as an example. The sequence of declining tops in this indicator since early 2011 suggests increasing risk aversion, which is at odds with the performance of the S&P500 Index over the same period. However, the following chart shows that it meshes neatly with the performance of Hong Kong's Hang Seng Index. According to this chart, nothing of a longer-term nature changed as a result of last week's celebrations.



The market action during the final two days of last week proved that the S&P500's preceding downward drift was a routine consolidation. A new multi-year high has been achieved, but we don't have a good reason to anticipate meaningful follow-through to the upside.



The equity rally over the final two days of last week caused the Volatility index (VIX) to quickly fall back to near the 3-year low recorded last month (see chart below). Due to the VIX's unusually low level, a relatively cheap way to insure against a significant (10% or greater) short-term stock market decline would be to purchase $20.00 VIX call options expiring in December. As is the case with most forms of insurance, the premium paid for these options would have to be written off if the insured-against event didn't happen.

This week's important US economic events

Gold and the Dollar

Gold

In the 3rd September Weekly Update, with gold trading at around $1690, we wrote:

"On a short-term basis the gold market is not as extended to the upside as the silver market. Support looks solid at around $1640 (about $50 below the current price), while significant resistance lies more than $100 above the current price. The risk/reward equation therefore still warrants a short-term bullish outlook, but this outlook will almost certainly drop to "neutral" if gold moves up to the mid-$1700s during the first half of September and there is no significant change in the monetary backdrop."

The general misinterpretation of the ECB's new bond-buying program to the contrary, there hasn't been a significant change in the monetary backdrop since we wrote the above. Therefore, with gold having just risen to the mid-$1700s our short-term gold market outlook has shifted from "bullish" to "neutral".

Here's how we see the short-term risk/reward equation: In the absence of a new QE program from the Fed, the best that gold can reasonably be expected to do over the next few weeks is test resistance at around $1800. At the same time, a normal correction could take the price back to around $1650. Furthermore, even if the Fed surprises us and introduces a new QE program this week the gold market probably won't do more than rally to the $1800-$1850 range before commencing a significant correction. The reason is that a lot of QE anticipation has already been built into the market.



As is often the case during the early stages of intermediate-term advances, the euro-denominated gold price (gold/euro) led the US$-denominated gold price to the upside over the past few months. Gold/euro will very likely make a new all-time high within the next three months, but it is now short-term 'overbought' as it approaches resistance defined by last year's high.



Gold Stocks

Current Market Situation

The HUI decisively broke above resistance in the low-460s last week. There's a good chance that its upward progress will temporarily be halted by resistance in the 480-500 range, but last week's price action caused the probability of our "Scenario 3" to plummet (Scenario 3 involved a decline to an October-November test of the May low and was already considered to have the lowest probability of our three scenarios) and therefore boosted the probability that the overall upward trend will continue until at least October-November of this year. 550 remains a reasonable upside target for the final quarter of this year.



Our short-term HUI outlook will shift from "bullish" to "neutral" if the HUI moves up to around 500 this week, because at that level there would be about 50 points of short-term downside potential to counteract the 50 points of remaining short-term upside potential.

Some of the more speculative gold stocks have started to show signs of life. These stocks could continue to do well, in fits and starts, even if the HUI experiences a routine multi-week correction.

What are we doing?

When we wrote the 16th May Interim Update the HUI had just bottomed. However, we didn't know that at the time. What we knew was that the waterfall decline of the preceding few weeks had created such extremes of under-valuation, downward momentum and negative sentiment that it was worth devoting most of the report to the gold sector. After all, it isn't every day that you get the chance to take advantage of the most extreme conditions in 10 years.

We ended our lengthy 16th May gold-sector discussion with a few paragraphs about what we were doing. Here's part of what we wrote:

"In...[the 9th May]...Interim Update, we said:

"With regard to our own money management, we have been steadily buying gold stocks while trying to maintain a substantial cash reserve. This has involved picking away at stocks for which our conviction is highest and raising cash where there is reasonable liquidity and where our conviction is not as high."

This is still the case, although over the past two trading days we bought significantly more than we sold. This has led to a reduction in our cash percentage from around 30% to around 25%."

We now have substantial profits on many of the buys that were made around the middle of May. These stocks are generally still well below their highs of the year, but that's not relevant for anyone following the scale-in/scale-out approach. Having done a considerable amount of buying when the stocks were dramatically 'oversold' and trading at much lower prices, we have begun to re-build our cash reserve. We will still be buying when good opportunities present themselves, but last week we did more selling than buying and will continue to do more selling than buying if prices continue to rise.

Our decisions regarding what to sell will in most cases be dictated by money management considerations. In particular, as a result of the buying we did when prices were languishing during May-July and the recent large percentage gains, our positions in some stocks are now too large. For money/risk management reasons it makes sense for us to trim these positions, regardless of what we expect to happen in the future.

One tactic that we often use at times like this is to take some money off the table in the stocks that have rocketed upward and put some additional money into the ones that haven't yet made meaningful up-moves, with the process involving a net addition to the cash reserve.

Currency Market Update

As we've noted in previous TSI commentaries, the currency market generally takes evidence of increased monetary inflation as bullish for the euro and bearish for the US$. This is regardless of whether the inflation is in the euro supply or the US$ supply. Therefore, when the odds appeared to shift in favour of more euro inflation and more US$ inflation late last week, the euro rose sharply and the Dollar Index fell sharply.

According to the RSI shown at the bottom of the following daily chart and the Dollar Index's position relative to its 200-day moving average, the Dollar Index is now short-term 'oversold' for the first time since late-October of last year. This paves the way for a multi-point Dollar Index rebound to begin immediately or following a final downward spike in reaction-to/anticipation-of this week's Fed news.



Our short-term US$ outlook has shifted from "neutral" to "bullish". As we see it, there is rebound potential to around 83 and additional short-term downside potential to around 79.

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 7th September 2012:

  *Endeavour Mining (EDV.TO, EVR.AX) reported that construction work at its Agbaou mine in Cote d'Ivoire was on track (production is scheduled to commence in Q1-2014) and that the results of new exploration drilling at this project would likely allow for an extension of the mine life. The current estimate for Agbaou's gold resource comprises 1.2M ounces in the M&I category. A new estimate will be done once all assays from the current drilling program are received.

  *Keegan Resources (KGN) issued an update on the status and plans for its Ghana-based Esaase gold project. Much of the information included in this update was also included in the quarterly MD&A issued last month, but KGN's management probably figured that many shareholders and prospective shareholders never get around to reading the quarterly reports, and therefore that a project update should be provided as a separate PR.

KGN reiterated that it is going smaller with the goal of improving the economics and 'financeability' of the Esaase project. Specifically, by opting for a smaller processing plant and selectively mining higher-grade ore, KGN expects to be able to reduce the project's capital cost from above $500M to below $300M and to significantly reduce per-ounce operating costs.

Here is the most important new information in last week's press release:

a) A revised resource estimate is scheduled to be complete during the final quarter of this year. Since the company now plans to selectively mine rather than bulk mine, we expect the revised estimate to have a lower quantity of gold and a higher average grade of gold when compared to the current estimate.

b) Rather than complete a Feasibility Study (FS) during the final quarter of this year as previously planned, KGN's new plan is to issue a revised Pre-FS during the first quarter of next year. This delay to the engineering schedule has obviously been made necessary by the proposed changes to the mine size and mining method.

KGN has rebounded strongly over the past couple of weeks and is up by about 70% from its May low. It is now short-term 'overbought' and is therefore not an ideal candidate for new buying, but the stock is probably not yet close to an intermediate-term peak.

Pretium Resources (TSX and NYSE: PVG). Shares: 94M issued, 101M fully diluted. Recent price: C$13.85

PVG reported the latest in a long line of excellent drilling results last Friday. An intercept in step-out hole SU-526 graded 4195-g/t gold over 1.16m. The current drilling program will continue into the final quarter of this year, so drilling news from PVG should continue to be a weekly or bi-weekly event.

PVG also reported an interim resource update for the Brucejack high-grade deposit. The new estimate for the "Valley of the Kings" zone comprises 5.1M ounces of gold in the Indicated category plus 5.1M ounces of Inferred gold. This amounts to a small increase in the Indicated component (the previous estimate was 4.9M ounces) and a large decrease in the Inferred component (the previous estimate was 10.4M ounces). The total estimated resource has therefore declined by about 5M ounces.

The reason for the lowered estimate is a more stringent interpretation of the geology by Snowden, the third-party consultant responsible for the calculation. The result is a smaller overall estimate with a higher confidence level. As stated in PVG's press release: "The updated Mineral Resource estimate for the Valley of the Kings is significantly higher in confidence than the previous April 2012 estimate as a result of the additional drilling and the higher confidence in the geological interpretation used in the estimation. The additional drilling confirms the location of the high-grade corridors and has allowed a better estimate of the boundaries of these corridors. The updated estimate has tightened the high-grade corridors resulting in a decrease in tonnes; however the additional confidence has allowed the majority of the mineralisation above 1200 mRL to be classified as Indicated."

By the time the current drilling program is completed in October there will be about 50,000m of drilling not included in the current estimate. Snowden will then update the estimate to account for all the non-included results. This update will likely lead to a higher estimate that will be used in the Feasibility Study (FS), which is now scheduled to be completed during the second quarter of next year.

The updated resource estimate may well be higher in confidence than the previous estimate, but it still constitutes a big negative surprise. After all, the previous estimate was also done by Snowden and there was no indication at the time it was announced that it was a low-confidence assessment that would likely be revised downward in the future. Considering the drilling results announced between the April-2012 resource update and the September-2012 re-estimate, most people would have been expecting a significant increase. We certainly were.

PVG's stock price naturally fell sharply in reaction to Friday's news of a surprisingly low resource re-estimate, although not as sharply as it would have fallen if the news had come a few weeks earlier when market participants were collectively less optimistic. As it was, after trading as low as C$12.70 PVG recovered to end the day down by only 5.5% at C$13.85. Support at C$13.00 therefore survived another test.



It usually isn't a good idea to buy a stock in the immediate aftermath of company-specific negative news. Even if the news isn't bad enough to alter an overall bullish trend (as in PVG's case), the first rebound after the news-related plunge is usually followed by a decline to successfully test or breach the initial low. If PVG traces out the typical pattern then Friday's low (C$12.70) will be tested or breached after a rebound runs its course. That being said, a lot will obviously depend on what happens on a sector-wide basis. For example, if the Fed surprises us by introducing a new money-printing program at this week's FOMC meeting then PVG probably won't re-visit Friday's low.

Our suggestion is to wait for the dust to settle before taking any new action with regard to PVG shares.

Mansfield Resources (TSXV: MDR). Shares: 65M issued, 83M fully diluted (including the Sep-2012 financing). Recent price: C$0.75

We've seen a lot of poorly timed and poorly negotiated equity financings from junior mining companies in our time, but the one announced by MDR on Friday is right down there with the worst of them. With the stock price at C$0.75, the company's management has agreed to sell 14M shares at C$0.40. Furthermore, the equity sale has actually been priced at less than C$0.30/share when the value of the 2-year C$0.60 warrant that comes with every new share is accounted for. And as if to rub salt into the wound, the company is paying a finders fee to whoever negotiated this "coyote-ugly" deal. In effect, MDR's management has increased the company's share count by about 50% to raise only $14.3M ($5.75M now and an additional $8.6M when the warrants are exercised). The financing was obviously arranged when the stock price was in the mid-C$0.40s, but still...

MDR has its hands on a very good gold deposit in a bad location (Argentina). It has higher-than-average risk and continues to have a lot of upside potential, although the upside potential has been materially reduced by the latest financing.

Due to the dilution caused by and the management incompetence revealed by last Friday's financing announcement, we are going to remove MDR from the TSI List and record a loss of almost 50% based on our October-2011 entry price of C$1.37. We own shares in the company that we don't plan to sell immediately, but we will be looking for an opportunity to exit over the months ahead.

By the way, MDR's financing wouldn't be a major negative if all existing shareholders were given the chance to participate. The company needs more money to continue the development of its gold project and raising the money at a low price would be fine if all existing shareholders were able to take advantage of the low price. For example, when Copper Fox (CUU.V) needed more money in 2009 to ensure its survival, all shareholders were given the opportunity to buy new shares at the heavily discounted financing price. This meant that any shareholder who wanted to prevent their stake in the company from being diluted by the low-priced financing could do so.

GDXJ Trading Position

For TSI record purposes, we will exit the GDXJ short-term trading position if GDXJ trades at $23.90 this week.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.bloomberg.com/