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.

Bonds commenced a secular BEAR market in June of 2003. (Last update: 22 August 2005)

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)

The Dollar commenced a secular BEAR market during the final quarter of 2000. The first major downward leg in this bear market ended during the first quarter of 2005, but a long-term bottom won't occur until 2008-2010. (Last update: 28 March 2005)

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 CRB Index, commenced a secular BULL market in 2001. The first major upward leg in this bull market ended during the second quarter of 2006, but a long-term peak won't occur until at least 2008-2010. (Last update: 08 January 2007)

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Outlook Summary

Inflation Update

True Money Supply (TMS) was roughly unchanged during the one-week period ending 29th September (the latest week for which broad money supply info is available), as was M2. This surprised us given that the Fed aggressively expanded reserve bank credit over the same period. It probably means that it will be another week or two before the broader money supply measures reflect the dramatic money pumping carried out by the Fed during the final week of September, but a less likely alternative is that the steps being taken by the Fed will give a hefty boost to bank reserves while not having much effect on the total amount of money in the economy.

If the additional money provided by the Fed to financial corporations under various new funding facilities does not eventually make its way into the real economy then the new money won't affect prices. This is one of the arguments currently being made by the deflation forecasters. In Japan during the 1990s, for example, the central bank seemed incapable of promoting much monetary inflation. As evidenced by the following chart, Japan's year-over-year M2 growth rate plunged during 1990 and then oscillated between 0% and 4% for the next 15 years. There were times when the Bank of Japan (BOJ) created a lot of bank reserves, but these additional reserves didn't translate into large increases in total money supply.

The Fed has already been far more aggressive on the monetary inflation front than the BOJ ever was. Moreover, the Fed is not leaving anything to chance in its efforts to inflate; that is, it is not relying solely on the collective ability/desire of banks to act as the transmission mechanism for getting new money into the economy. Instead, via the Commercial Paper Funding Facility established last week the Fed will soon start providing new money directly to NON-financial corporations by purchasing the Commercial Paper issued by these corporations. This will be separate from, and in addition to, the money pumped into the system via the other recently established inflation facilities. Also, the US Treasury has decided to follow the UK's lead and directly purchase the shares of banks and other financial corporations, despite the fact that President Hoover tried a similar policy move in 1932 without success. How will the purchase of these bank shares be financed? Most likely, by the Treasury providing bonds to the Fed in exchange for newly created money.

We will be monitoring TMS and M2 more closely than usual over the next few weeks because the current situation is a good test of our theory that a motivated central bank will always be able to increase the money supply (refer to the 29th March 2006 Interim Update for an explanation of why the BOJ was NOT very motivated to inflate). If, for example, the Fed were able to push TMS's year-over-year growth rate into double figures (from its current level of 7%) and keep it there for a few months despite the credit contraction, then deflation forecasts would once again have been proven wrong or premature.

The Stock Market

Panic, or something else?

We sometimes wonder how it is that a market can plunge day after day after day. You'd think, for example, that by the time the Dow had fallen from 14,000 to 10,000 almost everyone who was likely to panic would already have done so, and that the few remaining holdouts would have immediately exited once psychological support at 10,000 was breached. And yet, after closing at around 10,300 on Friday 3rd October with most fear indicators already near historical extremes, the Dow began to drop at the average rate of 500 points per day for 5 days in succession, eventually bottoming out (for now) at 7,883 on Friday morning. When Thursday's session ended with the Dow at 8,579, who could possibly have been left to panic? In other words, who dumped the large quantity of shares that caused the Dow to drop by 700 points from Thursday's close to Friday's low?

The answer is: margin clerks.

It is not so much that people continue to panic day after day after day, it's that after prices drop a long way the decision of some shareholders to sell becomes involuntary. Specifically, people who bought shares using margin will find themselves in the position where continuing to hold is no longer an option. The decision to sell will, in effect, be taken out of their hands and put into the hands of others whose sole concern is that every client always has the requisite margin within their account. It's part and parcel of the global de-leveraging process, and it led to a crescendo of selling in the stock market last week. 

Margin clerks couldn't care less about value, so once margin-related selling begins to dominate there is no telling how far the market price of a company will drop below the fair value of its underlying business. That's how we can end up in the situation where many small companies are being 'valued' by the stock market at less than the amount of cash they have in the bank, and where many large commodity-producing companies with rock-solid balance sheets are trading at less than 5-times earnings.

Natural gas producer Chesapeake Energy (NYSE: CHK) is a good example of a stock whose recent trading has been dominated by margin-related selling. Furthermore, in this case a lot of the selling has been done by the company's CEO (refer to http://biz.yahoo.com/ap/081010/chesapeake_energy_ceo_stock.html?.v=2 for details). It seems that Aubrey McClendon, Chesapeake's CEO, had pledged his 33M-share stake in the company as security for a margin loan and was forced to liquidate the entire position in response to the stock-price decline. There is no doubt that McClendon's selling greatly exacerbated the decline.

In the above-mentioned example, an extremely knowledgeable insider and a rabid bull on the company's prospects was left with no choice other than to sell. He made the mistake of buying/holding shares on margin. Had he been 'unmargined' he could have weathered the storm.

Many similar stories have recently played out across the world of commodity-related equities, leading to valuations that are now extremely low. The stage has therefore been set for spectacular rebounds in the stocks of commodity producers once the broad market reaches a short-term bottom.

Current Market Situation

That was a week for the record books. For example, the VXO moved above 100 on Friday and ended the week at 86. This was almost double the previous high of the past 20 years. Also, the number of NYSE stocks making new 52-week lows on Friday was more than double the highest level ever recorded prior to last week, and the proportion of stocks above their 200-day moving averages dropped to 1%.

At Friday's low of 840 the S&P500 Index was down by 23.6% over the course of the week. It then recovered some lost ground, but still ended with a weekly loss of 18.2%.

At Friday's low the S&P500 Index was down by 45% from its October-2007 peak, which means that the current bear market now ranks with the biggest of the past century.

Taking into account the magnitude of the decline, the length of the decline and the economic backdrop, the closest parallel with the present still appears to be 1937-1938. The 12-month decline from the 1937 peak to the 1938 trough amounted to about 50% and proved to be the first downward leg in a cyclical bear market that wouldn't reach its ultimate bottom until 1942. (Note: the 1942 low was not far below the 1938 low) The 1937-1942 cyclical bear market was, in turn, the second and final downward leg in the secular bear market that began in 1929.

So, did the market bottom on Friday?

We don't know. Over the past two decades there have been some very important turning points between the 9th and the 12th of October, most notably the end of the 1990 bear market, the end of the 2000-2002 bear market, and the end of the 2003-2007 bull market, so this would be a good time for a bottom. However, there is no evidence in the credit and currency markets that the financial situation is about to become less stressed. In particular, the 3-month LIBOR -- the rate at which banks outside the US lend to each other -- ended the week near its high for the move (4.82%) while the 3-month Treasury Bill yield dropped to almost zero, reflecting one of the biggest spreads in history between the short-term borrowing cost of the US Treasury and the short-term borrowing cost of private banks. Also, the following chart shows that HYG/TLT, a ratio measuring the level of confidence in corporate debt, is still in a steep downward trend. Lastly, the Yen and the US$, the currencies that benefit from the global de-leveraging, were strong on Friday while the growth-oriented A$ was again very weak.

There's a good chance that the initial rally following the bottom will be explosive, with the S&P500 Index gaining 15-20% within the space of two weeks. However, there's also a good chance that the bottom will be tested before a multi-month advance gets underway.

Valuations

Despite its recent sharp decline the overall US stock market is still not genuinely cheap, although valuations are now substantially more attractive than they have been at any other time over the past decade.

Throughout the world there are, however, many stock markets that are now genuinely cheap. That is, many markets have reached valuations that are typically associated with the ends of major bear markets. For example, the stock markets of Hong Kong, Singapore, France and Germany now have single-digit P/E ratios and 5%+ dividend yields. At its current valuation of around 10-times earnings, 6-times cash flow and 1-times book value, Japan's stock market is also very cheap right now.

Earnings will probably be lower over the next 12 months than they were over the past 12 months; but just as estimates of future earnings shouldn't be used to justify the high valuations that prevail near the ends of bull markets, estimates of future earnings shouldn't be used to justify low valuations near the ends of bear markets. The fact is that major bear markets end when valuations become low based on historical earnings.

Cause and Effect, Part 2

In the 29th July Interim Update, under the heading "Cause and Effect", we wrote:

"...it's political pragmatism, not economic pragmatism that counts in the minds of those whose overriding goal is victory at the next election; and APPEARING to do something to help millions of voters will almost always be the politically astute path even if the 'helpful' actions are likely to make the economy much weaker in the long run.

Policy-makers generally won't perceive the need to take drastic actions to help during the early stages of a bust, partly because they won't have any idea how bad things are going to get and partly because they will want to create the impression that the initial signs of weakness constitute nothing more than a routine correction to an on-going boom. Usually, therefore, officialdom's initial response to the boom-to-bust transition will be relatively minor -- designed more to re-energise the boom than to alleviate the pain of the bust. However, the further the prices of the former boom-time investments fall and the more obvious it becomes that a major trend reversal has taken place, the more frantic the actions of policy-makers will become.

Like market sentiment, the counter-cyclical actions of policy-makers -- actions taken to counteract the prevailing cyclical economic/financial trends -- almost always follow market prices. For example, in the same way that market sentiment will tend to reach a bearish extreme at an important price low, the actions of policy-makers will tend to reach fever pitch as the price approaches the END of an extended decline. When the price eventually and inevitably reverses upward the illusion is thus created that the bearish sentiment, or the actions of policy-makers, CAUSED the reversal. The intrepid policy-makers can then take a bow for having saved the day, as if the overall market would have gone to zero if not for their courageous actions."

We are currently witnessing the introductions of new policies on almost a daily basis in an effort to stem the stock market's decline and 'unfreeze' the credit markets, and it's a virtual certainty that policy-makers will continue to try new things in an increasingly frantic manner until something appears to work. However, it should now be clear to most rational observers that when the immediate crisis abates and the stock market stabilises it will not be because policy-makers have "pulled a rabbit out of the hat".

This week's important US economic events

Gold and the Dollar

Gold

Current Market Situation

The December gold contract keeps testing, and getting repelled by, resistance at $920. It broke above this resistance early on Friday, but as soon as it became clear that the breakout was not going to 'stick' the price dropped quickly.

It is possible that the gold market will weaken once the immediate financial crisis abates and the stock market stabilises, although a decline in safe-haven-related gold buying could be offset by the effect of a pullback in the US dollar (since the dollar is also likely to weaken once the immediate financial crisis abates). Once the crisis goes into remission the gold sector of the stock market should begin to out-perform gold bullion.

The gold market is in a similar position now to where it was at this time last week, so we'll repeat the following suggestion from the 6th October Weekly Update:

"Our suggestion is that investors use additional weakness over the coming days to add to positions in physical gold. Specifically, we would be buyers in the low-800s and, although we don't expect the price to get that low, in the vicinity of last month's low (around $740)."

The Gold Lease Rate

There has recently been a lot of chatter on the internet about gold lease rates. As evidenced by the following kitco.com chart, gold lease rates have risen sharply over the past month.

The gold lease rate should really be called the gold interest rate, because it is the interest rate charged by central banks for gold loans made to their bullion-bank customers. The recent surge in the gold interest rate almost certainly reflects the reduced willingness of central banks to lend their gold, which, in turn, reflects the reduction in confidence that is plaguing the entire credit market. Private banks aren't keen to lend money to other private banks because they are worried about default risk, and central banks aren't keen to lend gold to private banks for the same reason. Central banks will happily lend huge quantities of fiat currency because they can 'print' as much of the stuff as they want at zero cost, but they are less willing to lend gold because they can't print gold.

The gold lease/interest rate hasn't featured in our gold market outlook in the past because it always seemed to us that it didn't have any predictive ability. The surge in gold interest rates over the past few weeks tells us that the credit markets are 'freezing up', but we already know this by following other interest rates.

Apart from telling us what we already know based on other indicators, what does the recent surge in the gold interest rate mean to us?

First, we don't know what, if anything, it means regarding the likely future price of gold, although we are quite sure that it doesn't have bearish implications.

Second, it suggests that central banks have NOT been attempting to suppress the gold price by increasing physical supply; rather, central banks appear to have boosted the gold price to some extent over the past several weeks by removing physical supply from the market.

We will start to pay more attention to the gold interest rate if it remains near its current elevated level or continues to move higher after LIBOR begins to trend lower, because such an outcome would point to a longer-term bullish change in the structure of the gold market. Specifically, it would suggest that Western central banks were beginning to view their gold reserves as indispensable insurance rather than as remnants of a bygone era or assets that should be mobilised to generate income.

Gold Stocks

Friday was another very disappointing day for those of us who are long gold stocks, with the HUI dropping like a rock and making a new closing low for the move. The only positive is that it remained above Monday's intra-day low.

The price action continues to disappoint while the underlying fundamentals continue to improve. In particular, the determinant of gold-mining profit margins is the difference between the gold price and the cost of mining gold, and this difference is increasing thanks to gold's recent strength relative to gold-mining inputs. For example, one of the two biggest costs for most gold mining operations is the cost of energy, and the following chart of the gold/oil ratio suggests that gold has completed a major 'double bottom' relative to oil. Our guess is that gold will gain another 50-100% relative to oil over the coming year in response to the global slowdown, thus accelerating the upward trend in gold-mining profit margins.

Gold producers should soon begin to see a bottom-line benefit from gold's strength relative to other commodities, forcing the stock market to take notice. We would therefore direct most new buying towards companies with current production. As noted in last week's Interim Update: "...the most obvious candidates for new buying within the ranks of junior and mid-tier gold stocks are New Gold (AMEX: NGD), Northgate Minerals (AMEX: NXG), and Western Goldfields (AMEX: WGW). Each of these stocks is very under-valued and each company has significant unhedged current production and a strong balance sheet."
 
The exploration-stage stocks should also benefit because their gold-in-the-ground will become more valuable, although these stocks might not do much until after the producers have established upward trends.

Currency Market Update

Below is a daily chart of December euro futures.

The euro traded at a new low for the year last Friday, although it managed to end the week slightly above Monday's closing low. A daily close above 1.38 would suggest that a short-term bottom was in place.

On a very short-term basis the euro is being pressured lower by the financial crisis and the rush to 'de-lever' associated with the crisis. It is therefore likely to rebound once the immediate crisis abates. However, we are not optimistic about the euro's intermediate- or long-term prospects. There is considerable political risk associated with both the euro and the US$ due to the actions being taken by monetary authorities in a desperate effort to restore stability, but the euro remains over-valued on a purchasing power basis and encompasses the added risk that some members will decide to break away from the Monetary Union.

In summary, we think the inflation risk is higher in the US, but this is offset by the euro's over-valuation and the distinct possibility that as economic conditions continue to deteriorate the European Monetary Union will fracture.

For information only: Late last week we switched about half of our cash reserve from US dollars to Australian dollars after the AUD/USD rate plunged to the mid-0.60s. Our plan is to shift this cash back to US dollars following a rebound in the A$ to the mid-to-high 0.70s. This is not something we would do in a leveraged way via the futures market because the daily oscillations are too wild to enable appropriate risk management. 

Update on Stock Selections

(Note: To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question)

Resolute Mining (ASX: RSG). Shares: 278M issued, 280M fully diluted (excluding the current rights issue). Recent price: A$0.74

RSG announced on Friday that it was raising about A$50M via a 1-for-3 rights issue at A$0.55/share, with rights to purchase the new shares being issued to shareholders of record at 20th October (shareholders will receive one right for every three shares held).

Although RSG will be raising money at a huge discount to recent market prices for the stock, this method of fund raising does not dilute the interests of existing shareholders who exercise their rights. This is actually the fairest way for the company to raise money because although it reduces the underlying value per share it also allows shareholders to reduce their average purchase cost by the same amount. This compares favourably with the equity financings undertaken by most North American resource companies, which generally involve small groups of 'preferred' investors being offered cheap shares at the expense of all other shareholders.

The only problem with the just-announced RSG offering is that the A$0.55 rights can only be exercised by shareholders with Australian or New Zealand addresses. Other shareholders will have their rights sold and receive the proceeds of the sale.

In our opinion, Friday's very negative market reaction to the rights issue has created another good opportunity to accumulate RSG shares. RSG is on track to produce 400K ounces of gold next year and 500K ounces in 2010.

    Lion Selection (ASX: LST). Shares: 190M issued, 196M fully diluted. Recent price: A$1.34

Instead of returning cash to shareholders via a simple cash return as originally planned, LST's management has decided to return the cash via an off-market buy-back of shares with the purchase price of the shares being set at a small discount (less than 5%) to net asset value (NAV).

The revised method of returning cash to shareholders is a really bad idea. The main problem with this new proposal is that the calculated NAV substantially understates the true value of the company's assets. This is firstly because the accounting value attributed to the Cracow gold mine already understated the true value of this asset prior to the recent huge rise in the A$ gold price and now dramatically understates the true value. Secondly, the current market value of LST's stake in Indophil Resources is less than half the value that should eventually be realised for this asset.

The other problem with the new proposal is that shareholders who want to receive a cash return will not be able to control how much cash they get because the amount returned to each shareholder that participates in the buy-back will be determined by the number of shares offered by other shareholders. How, then, does a shareholder that wants to retain a stake in the company decide how many shares to offer as part of the buy-back plan?

As we said, this is a really bad idea and we will definitely be voting against it. What the company should do is return the cash that it currently has to shareholders via a simple cash return, and then return additional cash in the future as FULL VALUE is realised for its assets.

LST is a buy near its current price (A$1.34) because even though the published NAV understates the true value of the company's assets, the current share price is more than 20% below the published NAV.

Chart Sources

Charts appearing in today's commentary are courtesy of: