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)

Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

Outlook Summary

Long-term bearish on China

Excluding the people who labour under the delusion that the US is still the "land of the free" and China is still a Soviet-style basket case, most people fall into one of two groups when it comes to their views on China's economic prospects. The first group is outright bullish on China's prospects over all time periods, while the other is very optimistic on a long-term basis but is concerned about the potential for a painful 'correction' within the next couple of years. In other words, most people are long-term bullish. We, however, are not.

Our view is that China's economy looks strong right now only because its credit bubble hasn't yet burst. In terms of the way it is widely perceived, the current situation of China's economy can, we think, be likened to the situation of the US economy in 1999-2000. Recall that the US economy was thought by most pundits to be in wonderful shape at the end of the last millennium, and that phrases such as "productivity-driven growth miracle" and "King Dollar" were waved about with abandon. Recall, as well, that intelligent observers argued in all seriousness that 50-times earnings made sense for leading technology stocks and that 36,000 was fair value for the Dow Industrials Index. Interestingly, arguments of a similar flavour are being made today to justify the absurd valuations in China's stock and property markets. Even more interestingly, in some cases people who correctly diagnosed the flaws and non-sustainability of the "US growth miracle" are now failing to apply the same logic to China's "economic miracle".

There is no requirement for China's banks to mark their investments "to market" or accurately report non-performing loans, so China's credit bubble could go on longer and grow much bigger than its US counterpart. For example, China's economy began to shrink during the second half of 2008 (not according to the official stats, but according to more objective data such as power usage), which must have caused many bank loans to become "non-performing" by Western standards, and yet China's banking industry expanded its collective loan portfolio by 32% during the course of 2009. Economy-wide loan growth of this rapidity is unheard of in the US, and we reiterate that this spectacular surge in new bank lending began when the economy was shrinking. How did it happen? Simple: the government instructed the banks to make the Yuan-equivalent of 1.5 trillion US dollars of new loans within the space of 12 months, so that's what they did. Furthermore, most of these new loans must have involved the creation of new money, because China's M2 money supply and total deposits at Chinese financial institutions were both up by around 28% in 2009.

With China's banking system being slightly less transparent than the average house brick, there is no telling how big the bubble will get before it bursts. As discussed in a previous commentary, if the government doesn't deliberately deflate the bubble it could continue until the effects of the massive monetary inflation become evident in food prices. Once this happens, the political cost of not stopping the inflation will, we think, be greater than the political cost of continuing it.

It is not possible to know, in advance, when a great credit bubble will burst. Also, it is dangerous to bet against a bubble because the nature of these things is to go on for much longer than a rational observer would expect. What we do know is that when they burst the result always includes a severe economic downturn and the wiping out of much of the 'wealth' that was created during the bubble years.

But although the bursting of a credit bubble always leads to a severe economic downturn, it doesn't have to cause long-term weakness. The key to whether it does lead to long-term weakness is the government's response to the initial downturn. History and logic tell us that if the government gets out of the way and allows the economy to move back into line with reality (as opposed to the distorted perception of reality created by the preceding credit growth and inflation), the adjustment will be painful but will likely be complete within 1-3 years; however, if the government tries to soften the blow by, for example, propping up prices and supporting failed enterprises, then the adjustment process could take decades.

We think it's a good bet that China's government will make the same mistakes that were made by the US government during the 1930s, Japan's government post-1990 and the current US government, thus setting the stage for a long-term decline once the bubble eventually bursts. This is the main reason we are long-term bearish on China's economy.

As things now stand, we are inclined to give China's bubble the benefit of the doubt; meaning that we are disinclined to bet on falling Chinese asset prices at this time. It looks like China's stock market, as represented on the following chart by the Shanghai Stock Exchange Composite Index (SSEC), made a major peak in 2007 and is in the midst of a post-crash rebound, but the post-crash rebound may not be complete. A signal as to whether or not it is complete will be the direction of the breakout from the triangular pattern that the SSEC has traced out since last August. A downside breakout from this pattern could be interpreted as a warning that the credit bubble is in trouble, although it should be noted that the epicentre of China's boom is the property market, not the stock market.

The Stock Market

Put/Calls and Probabilities

The 10-day moving average of the equity put/call ratio ended last week at 0.50. The last time it was this low was July-2005, and the time before that was January-2004. In other words, there were only two previous occasions over the past 6 years when traders of equity options were as optimistic as they are right now (a low put/call ratio suggests optimism). Let's take a look at what happened on these two previous occasions.

The following DecisionPoint.com chart shows the S&P100 Index and the equity put/call's 10-day MA during 2004-2006. Note that the scale on the put/call section of the chart is inverted, meaning that a falling put/call ratio is represented by a rising line on the chart. The vertical red lines mark the two occasions when the 10-day MA of the equity put/call ratio (P/C) dropped to 0.50.

After the P/C dropped to 0.50 in January of 2004, the market traded sideways near its high for about six weeks and then embarked on an intermediate-term correction. The peak-to-trough decline in the S&P100 was about 10% over 5-6 months. Soon after the P/C dropped to 0.50 in July of 2005 the market commenced a short-term correction. In this case the peak-to-trough decline in the S&P100 was about 5% over 3 months.

What does the above tell us about the future? Unfortunately, not a lot. We know that important market tops almost always coincide with low put/call ratios, but a low put/call ratio doesn't guarantee that an important market top is at hand. Also, we don't know that the put/call ratio won't continue to decline over the weeks ahead as market participants become even more optimistic. Lastly, a multi-year low in the P/C doesn't tell us the extent of the decline that will ensue over the coming months even if the general level of optimism has just peaked. All we can say is that when added to other information, today's unusually low P/C suggests minimal additional upside potential over the next few months.

We'll now segue to a related point about probability, which is that in the realms of financial markets and economics the historical data will never enable you to quantify the probability of a future occurrence. For example, if the P/C had just dropped to 0.50 and if the stock market had fallen by 10% during the ensuing three months on eight of the past ten occasions when the P/C had dropped to 0.50, this information would not mean that there was an 80% probability of a 10% decline within the next three months. One reason has to do with insufficient data, which we will explain by considering the hypothetical example of someone randomly tossing an unbiased coin. We know that the probability of the coin coming up "heads" is 50%, but in our example the coin is tossed 10 times and comes up "heads" 7 times. Based on the historical data just gathered, our coin tosser arrives at the false conclusion that the probability of the coin coming up "heads" on the 11th toss is 70%.

Our hypothetical coin tosser drew an incorrect conclusion primarily because his conclusion was based on insufficient data. Had he tossed the coin a million times then he would almost certainly have arrived at the correct probability.

In the financial markets and in economics, we are generally dealing with a data set that is too small to accurately estimate probability. These days, for example, we regularly see analysts drawing conclusions about the future strength of the US economy based on what happened during the years following previous recessions, but this means that they are basing their conclusions on a very small sample size.

The other reason that the historical data relating to the financial markets and the economy will never tell you the probability of a future outcome is that the conditions are always different. To be more specific, the current set of conditions will never be exactly the same as any prior set of conditions. There will be important similarities from time to time that can be QUALITATIVELY incorporated into our analysis, but there will always be significant differences.

It is important to know what you don't know and can never know. Otherwise you could end up deluding yourself and betting too aggressively on a particular outcome.

Current Market Situation

The slow upward grind continues in the US stock market, with the S&P500 Index having now risen for six weeks in succession and on eight of the past nine weeks. The gains of the past several weeks will probably be given back in quick time once a peak is in place, but with the senior stock indices making new 52-week highs as recently as last Friday there is no evidence, yet, that a peak is in place.

The chart pattern of the AMEX Oil Index (XOI) continues to evolve in a way that points to additional gains over the coming 1-2 months. As depicted below, the XOI has moved up to test the 'double top' of October-2009 and January-2010. 'Triple tops' are rare, meaning that they are typically followed by upside breakouts.

If the XOI were to break above its October and January highs then resistance at 1300 would become a logical short-term target.

The XOI's chances of making it to 1300 within the next couple of months would be enhanced if it were to pull back to the mid-1000s before breaking above resistance in the 1120s. Traders could therefore buy an oil-stock proxy such as XLE following a near-term pullback to around 1050, employing a tight trailing stop of, say, 5%.

Our plan is to use any strength in the oil sector over the coming month or so to further reduce exposure to oil and gas stocks. As previously noted, natural gas stocks have tended to trade with oil stocks over the past year rather than with the price of natural gas.

This week's important US economic events

Gold and the Dollar

Gold

Current Market Situation

June gold futures ended last week at lateral resistance (see chart below) after having risen on six of the past seven trading days. This doesn't mean that a pullback is about to begin, but the gold price is now at a level at which a pullback lasting at least a few days would be a normal occurrence.

Although gold is now at a level where a $15-$30 pullback would be 'par for the course', we are upgrading our short-term outlook from "neutral" to "bullish". The reason is that it is looking increasingly likely that the current rally will end up taking the US$ gold price into new-high territory.

The euro gold price (gold/euro) remains in a very consistent upward trend and at no stage over the past six months has its short-term outlook been anything other than "bullish". The consistency of this short-term upward trend is useful because it means that gold/euro's first solid break below its 50-day moving average will probably be a timely signal of a trend reversal.

To illustrate what we mean we have included, below, a chart of gold/euro along with its 50-day moving average. Notice that since the beginning of 2005, once gold/euro established a consistent upward trend the first solid break below the 50-day moving average marked the start of an intermediate-term consolidation. The sample size is only three, but it does give us something to work with.

Gold versus other commodities

One thing we've learned to expect is for sentiment towards gold and gold stocks to move with the nominal gold price rather than the real gold price, even though it's the real performance of an investment that determines its merit and the change in the real gold price that determines whether gold mining profit margins rise or fall. The market action of the past two years has been a wonderful example of the aforementioned tendency, in that the share prices of gold-mining stocks plummeted while the real gold price was rocketing upward during 2008 and then rallied strongly over the past 13 months while the real gold price was in a downward trend.

When we talk about the "real" gold price we mean the price of gold relative to the prices of other commodities. The real gold price generally does very well during major economic declines and quite poorly during economic booms, as evidenced by the following chart of the gold/GYX ratio (gold relative to a basket of industrial metals). Relative to the industrial metals complex, gold hit a new 12-month LOW last week.

Our view is that the downturn in gold/GYX that began in February-March of 2009 will prove to be an intermediate-term correction within a long-term bull market.

Gold Stocks

As mentioned in previous commentaries, a logical target for the HUI's current rally is resistance at 470. This resistance is drawn on the following daily chart. We have also mentioned that May is the most likely time for the next short-term peak.

The HUI ended last week at 450. This means that it will have to pull back or consolidate over the next week or so IF it is going to do no better than reach 470 during May. Another possibility is that it will continue to move upward over the next several days and reach 470 before commencing a pullback/consolidation. If this were to happen then we would begin to anticipate a test of the December-2009 high during May.

We are operating under the assumption that a rally into May would be followed by a decline to an ultimate correction low during October-November (most likely October). This scenario meshes with our views on other markets (we expect the US$ to resume its advance following several weeks of consolidation and we think the broad stock market is close to an intermediate-term peak). It also meshes with the gold sector's very strong tendency over the past decade to make important turning points during October-November and the fact that intermediate-term corrections in the gold sector generally last at least 6 months (the current correction low was only two months after the peak).

For traders, the risk management parameters remain clear. Specifically, between now and when a short-term peak is put in place the HUI should not close below 430, so a daily close below 430 could be used as a stop for short-term trading positions. Also, traders could reasonably buy a near-term pullback to the mid-430s and then employ a very tight stop.

Currency Market Update

There is not yet much in the way of price-related evidence to confirm this view, but we think the Dollar Index made a short-term peak in late March and will consolidate/correct for several weeks before resuming its intermediate-term advance. At the same time, we do not believe that the dollar's downside risk from here is substantial. If a correction is underway it will probably end up being of greater magnitude than the previous two, but the downside is probably limited by lateral support and the 200-day moving average at 78.0-78.5.

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)

Golden Queen Mining (TSX: GQM). Shares: 88M issued, 93M fully diluted. Recent price: C$1.20

GQM's Soledad Mountain project in California has a gold-equivalent (gold + silver) M&I resource of 2.7M ounces. According to the Feasibility Study (FS) completed in December of 2007, it could be developed into a mine with annual gold-equivalent production of about 90K ounces and an initial capital cost of US$60M.

A press release put out by GQM on Friday morning stated:

"On April 8, 2010, the Kern County Planning Commission formally considered Golden Queen Mining Co. Ltd.'s Soledad Mountain project following a review and comment period for the supplemental environmental impact report (SEIR). At the meeting, the commission, consisting of a panel of three commissioners, unanimously approved the project."

The long-awaited approval of the SEIR means that the project can now proceed to the mine financing and construction phase, and that a significant risk/uncertainty has been eliminated.

GQM gained 26% on Friday in response to the SEIR approval news, but at the current price of $1.20 it still looks very under-valued. Specifically, in the 17th December 2007 Weekly Update we outlined why Soledad Mountain was probably worth more than $2 per GQM share at a gold price of around $800/ounce (the gold price at the time). At the current gold price the valuation would be significantly higher.

It is possible that the stock price will pull back to the low-C$1 area to 'test' Friday's breakout. If it does, it will be a good opportunity for new buying.

    Copper Fox (TSXV: CUU). Shares: 257M issued, 375M fully diluted. Recent price: C$0.33

CUU was up another 26% on Friday and gained about 75% over the course of last week. We don't know what caused the sudden surge in the demand for CUU shares, but this sort of thing is not uncommon in the world of junior resource stocks. Such stocks will sometimes lie dormant for an agonisingly long period and then quickly double for no obvious reason.

At Friday's closing price of C$0.33 CUU remains under-valued. Furthermore, it is a good candidate for a takeover, with Teck and NovaGold being the most likely bidders. Having said that, it is generally a good idea to take some money off the table after the price of a stock has rocketed upward, especially if the large price rise causes the stock in question to attain an excessive weighting within one's portfolio.

Back in June of 2009 CUU issued a huge number of new shares at a very low price in order to dig itself out of a financial hole. At the time we suggested that existing CUU shareholders mitigate the extent to which their stakes were being diluted by participating in the equity financing. Shareholders who did participate now have a gain of more than 900%, including the intrinsic value of the warrants received with the new shares. It could make sense for these shareholders to sell the shares they obtained via the financing and to maintain their position in the stock by exercising the warrants. In any case, the warrants should be exercised prior to their July-2010 expiry.

    Red Hill Energy (TSXV: RH). Recent price: C$0.79

In the 22nd March Weekly Update we noted that since the announcement of the merger between RH and Prophecy Resource (TSXV: PCY) in late January, RH had traded at a substantial discount to the implied market price of the post-merger shares. We said that we were less than thrilled with the proposed merger, but that we would not consider selling at a large discount to a legitimate offer currently 'on the table'.

As at the close of trading on Friday the discount had narrowed to only a few cents, so we are going to take the opportunity to exit RH. The current price is about 2% below our November-2006 entry, but it is well above the average price of the past 18 months.

We will continue to keep an eye on the progress of RH-PCY and may add it to the TSI Small Stocks Watch List in the future.

Chart Sources

Charts appearing in today's commentary are courtesy of: