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)

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Outlook Summary

Inflation Update

Differences between now and the 1930s

As most of our readers would be well aware, there has been explosive growth in the Fed's balance sheet and Federal Reserve credit since last September. This dramatic increase in Federal Reserve credit has led to a far less dramatic, but still very meaningful, increase in monetary aggregates including M2 and TMS (M2 and TMS are up about 10% year-over-year).

The following charts were copied from a presentation by John Kemp entitled "A Distant Mirror: Credit contraction, monetary policy and commodity prices during the Great Depression" and together make the point that the current monetary situation could hardly be more different to the monetary situation of the early 1930s. The first chart shows that there was no significant increase in the Fed's balance sheet prior to 1934-1935, the second chart shows that Federal Reserve credit was almost unchanged throughout the 1930s, and the third chart shows that M2 fell quite sharply during the early 1930s.

Regardless of the direction of the change, large changes in the money supply always cause problems. However, we doubt that the Fed could have created a more friendly economic environment during the early 1930s by counteracting the decline in the money supply. The root problem during the 1930s was that the ultra-easy monetary conditions of the preceding decade had led to the excessive expansion of debt and to mal-investment on a grand scale. Borrowing more money into existence could not have ameliorated the situation or even helped smooth the transition to the next phase of economic growth, although, like the many other official efforts to prevent the economy from completing a necessary re-adjustment, it could have made things worse. The point is that the money-supply contraction of the early 1930s was not the problem; it was a SYMPTOM of the problem. A disease can never be cured by covering up a symptom, but covering up a symptom can prevent the appropriate corrective measures from being taken. For example, if insufficient savings are part of the problem then the road to recovery involves the accumulation of savings, which means that policies designed to increase consumer spending (bring about a further reduction in savings) can only make things worse.

Despite the large contraction in the money supply during the early 1930s the depression would probably have ended in 1932 if not for government intervention. The "New Deal"* policies of Franklin Roosevelt were the main reason why the depression lasted 15 years and came to be known as the Great Depression.

Unfortunately, today's policymakers seem intent on making the same mistakes that were made during the 1930s and adding the mistake of monetary inflation to the mix.

    *There were actually three New Deals. The first New Deal was the name given to the set of policies espoused by Roosevelt during the 1932 election campaign, but it proved to be nothing more than a bunch of lies and propaganda designed to garner votes. The second New Deal was, in many ways, the opposite of the first New Deal, and constituted the set of policies that were actually implemented by Roosevelt on taking office. Many of these policies had to be abandoned because they were total disasters or because they were declared unconstitutional by the Supreme Court, thus paving the way for other policies (the third New Deal) that were introduced on an ad hoc basis over the years. In general, policies were selected based on their vote-getting potential with no regard to broad or long-term economic consequences.

Current Situation

The Fed has paused to take a breath. The total amount of Fed credit is now $970B higher (a bit more than 100% higher) than it was 12 months ago, but $420B lower than it was at the beginning of this year. In other words, there has been a 30% reduction in Reserve Bank credit over the past 5-6 weeks. As far as we can tell, about half of this reduction is due to the closing out of currency swaps between the Fed and other central banks. Under these swap arrangements the Fed provided US dollars to other central banks in exchange for the other banks' currencies in order to address a temporary spike in US$ demand. The unwinding of the swaps suggests that the short-term demand for US dollars outside the US is subsiding to more normal levels.

It is not surprising that the Fed has calmed down a little given that signs of financial stress have dissipated over the past two months. In particular, the TED Spread has plunged, credit spreads have been narrowing, the T-Bill yield has bounced, the Yen has been rolling over, the T-Bond price has fallen (indicating reduced flight-to-safety buying), the currency market has been a lot less volatile, and it has been almost three months since the stock market made a new low.

When the next bout of instability begins -- quite likely during the second or third quarter of this year -- you can be sure that the Fed will swing back into full pump-priming mode because it operates under the mistaken belief that economic problems can be solved, or lessened, by creating money out of nothing. 

Bonds

The Stock Market

The Big Picture

Below is a chart that we show once or twice per year, every year. We don't show it more often than that because it presents a very long-term picture that doesn't usually change significantly from month to month or even from year to year, but we like to show it at least once per year because it is, in our opinion, the most important chart in the world for long-term equity investors. The importance of this chart is that it takes currency fluctuations out of the equation and reveals the US stock market's REAL long-term trend.

The stock market's real long-term trend can be defined by its performance in gold terms or, just as appropriately, by the trend in its average valuation (price/earnings ratio, dividend yield, etc.). It doesn't matter which of these two measures is used because, as evidenced by our chart, the long-term trends in the stock market's performance relative to gold (as measured by the Dow/Gold ratio) and the S&P500's valuation (as measured by the price/peak-earnings ratio developed by John Hussman) are always in synch with each other.

When we take variations in the purchasing power of money out of the equation -- as we've done in the following chart -- the stock market's trend becomes crystal clear. In particular, it is clear that a long-term bear market began during 1999-2001 and that the 2003-2007 rally -- a rally that led to a new all-time high for the Dow Industrials Index in nominal dollar terms -- was just a rebound within a secular bear market.

Note that while we can categorically state that a bear market was in progress throughout the past eight years, we can't state with absolute certainty that a bear market is still in progress today. This is because it is possible that the bear market ended last Thursday (the day of the most recent new multi-year low in the Dow/Gold ratio). Extremely unlikely, but possible. Putting it another way, in real time the direction of the market's long-term trend is always a matter of opinion because there will always be a possibility that the trend has just changed, but it's a matter of fact that a secular bear trend in the US stock market was still in force as of last Thursday.

On a related matter, gold's long-term trend is always the opposite of the stock market's long-term trend. This relationship is due to gold's historical role as money, and it hasn't been materially altered by the changes to the monetary system that have occurred over the generations. Consequently, it's a very good bet that gold's secular bull market will last as long as, but no longer than, the secular bear market in equities.

Current Market Situation

In the short-term, the broad stock market continues to struggle. It doesn't look like it is about to break down, but at the same time it seems incapable of making any real upward progress.

The banking sector remains weak on both an absolute and relative basis. To be specific, the Bank Index (BKX) ended last week near its bear market low in nominal terms and relative to the S&P500 Index (SPX). The following chart shows the BKX/SPX ratio.

It's unlikely that the stock market will manage a tradable rally until the general belief begins to take hold that the worst is over for the banks. By the way, we don't think the worst is over for the banks, but sentiment is at such a low ebb right now that it won't take much of a sentiment shift to ignite a 1-3 month rebound.

One area of the market that should do well once a short-term upward trend gets underway -- assuming that a short-term upward trend will get underway in the not-too-distant future -- is energy. With reference to the following daily chart, a sustained break above 1000 by the AMEX Oil Index (XOI) would create an upside objective of 1200-1250.

Gold has been the only sector of the market that has recently been working, but when the broad market eventually begins to move upward with some conviction our non-gold stocks will probably begin to out-perform our gold stocks. However, we would continue to maintain a much higher weighting in gold than anything else because whereas most other sectors stand a good chance of experiencing a tradable 1-3 month rebound, the gold sector is probably in the early part of a new cyclical bull market that will last at least three years.

This week's important US economic events

Gold and the Dollar

Gold

Over the past few weeks gold has been responding more to economic data and the performance of the broad stock market than to changes in the US dollars' foreign exchange value. Specifically, gold has tended to advance in response to dismal economic data and stock market weakness, and to ease back in response to signs of hope. This has created a near-term positive correlation between gold and the Dollar Index because the US dollar's foreign exchange value has also tended to rise in response to bad economic news and stock market weakness.

We expect that both gold and the Dollar Index will go into 'consolidation mode' after the stock market eventually begins to rally in earnest, but in our opinion neither has a lot of downside risk. It is more a case of the upside potential being limited in the short-term if, as we assume, a stock market rebound lies in store.

Gold Stocks

The AMEX Gold BUGS Index (HUI) broke out to the upside last Wednesday. It pulled back on Thursday and Friday, but maintained its breakout. Additional gains are likely over the coming month.

A couple of potentially significant bearish divergences are developing in the gold sector. The first is the failure of the HUI/gold ratio to confirm last week's upside breakout by the HUI, which was discussed in the latest Interim Update. The second is discussed below.

Royal Gold (NYSE: RGLD) has a tendency to reach intermediate-term peaks and troughs well in advance of the HUI. For example:

a) RGLD peaked in January of 2006 -- about 4 months in advance of the HUI

b) RGLD bottomed in June of 2007 -- about 1.5 months in advance of the HUI

c) RGLD peaked in November of 2007 -- about 4 months in advance of the HUI

Significantly, RGLD's most recent peak occurred on the first trading day of 2009, and when the HUI surged to a new multi-month high last Wednesday RGLD was 10% below its early-January high. This divergence between the HUI and RGLD is readily apparent on the following chart.

RGLD's decisive break above long-term resistance at $40 created a technical objective of around $58. The January high was well short of this objective, so it wouldn't surprise us if the divergence between RGLD and the HUI were eliminated over the weeks ahead by RGLD moving to a new high.

Considering the amount of time by which the 2006 and 2007 intermediate-term peaks in RGLD led the corresponding peaks in the HUI, it also wouldn't surprise us if RGLD's January peak proved to be the intermediate-term variety. The reason is that one of the most likely times for an intermediate-term peak in the gold sector, based on this sector's cyclical tendencies and intermediate-term rally durations, is April. If RGLD peaked in January and the HUI peaks in April then the time between the two peaks will be about 4 months (the same as 2006 and 2007).

The bottom line is that if RGLD fails to make a new high over the weeks ahead then the probability will increase that a HUI peak will be in place by the end of April.

Currency Market Update

Indecisiveness in the currency market since mid January has paralleled indecisiveness in the stock market. This is not a coincidence. As evidenced by the following chart, there has been a close relationship between the currency and stock markets for the past several months. To be more specific, the chart shows that a large decline in the S&P500 Index last year went hand-in-hand with a large rise in the Dollar Index, with both moves culminating in the second half of November. It also shows that the stock market's initial rally from its November low was accompanied by a sharp decline in the Dollar Index, and that stock market weakness from mid-December through to mid-January occurred alongside US$ strength. Triangular patterns, indicating a general lack of conviction, then began to develop in both the S&P500 and the Dollar Index.

For both the Dollar Index and the SPX, taking out the extremes of the past month would establish the direction of the short-term trend.

We expect the SPX to break out to the upside from its multi-week consolidation, and, as a result, we expect the Dollar Index to head lower. However, our view is that the Dollar Index's short-term downside potential is only 5-6 points, versus upside potential of 3-4 points. In other words, our short-term bearish outlook for the Dollar Index is marginal.

We continue to believe that the currencies with the potential to make the biggest moves in the short-term are the Australian Dollar and the Yen (up for the A$, down for the Yen), but this potential will only be realised if the stock market rallies.

With regard to the intermediate-term, it is becoming increasing difficult to justify a bearish view on the Dollar Index because euro-related risks are growing. As outlined in last week's Interim Update and in Ambrose Evans-Pritchard's 14th February article in the Telegraph, European banks have huge exposure to 'dodgy' emerging-market loans. Also, the euro remains over-valued against the US$ on a purchasing-power-parity basis and the interest rate advantage currently enjoyed by the euro is likely to disappear over the months ahead. Lastly, there's the ever-present risk that Europe's monetary union will begin to break apart as the member countries with the weakest economies decide that they need the freedom to inflate at will. The USD/EUR exchange rate constitutes more than 50% of the Dollar Index, so euro weakness will almost always boost the Dollar Index even though this index includes several other currencies.

We turned intermediate-term bearish on the Dollar Index last November, but since that time the euro's downside potential has increased relative to the US dollar's downside potential. As a result, we are now upgrading our intermediate-term Dollar Index view to "neutral". If nothing else changes in the mean time, a decline by the Dollar Index to the low-80s within the coming 2 months would cause us to further upgrade our intermediate-term Dollar Index view (to "bullish"). 

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)

ATW Gold (TSXV: ATW). Shares: 60M issued, 92M fully diluted. Recent price: C$0.75

ATW owns two gold projects in Western Australia, the Burnakura Project and the Gullewa Project. The projects are about 300km apart and have total combined NI 43-101 resources of roughly 1M ounces.

The size of ATW's gold resource will almost certainly grow, but ATW has never really been an exploration play; rather, from our perspective it has always been a play on the potential for near-term production and cash flow from gold mines in a politically secure location. As we wrote when we added the stock to the TSI List in June of last year:

"There should be plenty of drilling news from ATW over the next few months, but the key to the stock's upside potential lies with getting Burnakura into production. Bringing Burnakura into production at 40K oz/year would justify a stock price of at least C$1.00/share at current metal prices, allowing nothing for Gullewa or Burnakura's expansion potential. However, if ATW's management is able to establish credibility by successfully bringing Burnakura into production over the coming four months then the market will almost certainly begin to discount success with the Gullewa project, leading to a much higher stock price."

It has taken a little longer than originally envisaged, but according to a recent ATW press release the Burnakura project is now within three weeks of going into production at the rate of 35K ounces/year. This is 5K oz/yr less than the mine plan at the time of our June-2008 write-up, but the A$-denominated gold price is now more than 40% higher than it was then. Depending on the cost at which ATW is able to produce its gold, at the current gold price Burnakura's 35K ounces/year production could be worth a lot more than C$1.00/share. And then there is Burnakura's expansion potential and the value of the Gullewa project to consider (we expect that Gullewa will be developed into a mine that produces about 60K ounces per year of gold).

Until ATW proves that the Burnakura mine operates as planned the risk will remain high. At the same time, the potential rewards are high and the rewards could come within the next two months.

The following chart shows that ATW is extended on a short-term basis and has significant resistance at C$0.90-C$1.00. Consequently, we wouldn't do any new buying unless the stock pulled back to the low-C$0.60s. Alternatively, those who currently have no exposure to ATW could consider taking a small initial position near the current price with the aim of buying more following a pullback.

    Precision Drilling Trust (NYSE: PDS, TSX: PD.UN). Shares: 206M (incl. recent financing). Recent price: US$3.22

Last week PDS, a natural gas drilling company with operations in Canada and the US, announced financing arrangements comprising an offering of new trust units (46M units at US$3.75 to raise US$172M) and a US$250M offering of senior notes. These arrangements will strengthen the company's balance sheet and reduce risk, but they have put additional short-term downward pressure on the stock price. Once the stock market has digested the new offerings the stock price should recover.

PDS also announced its Q4-2008 financial results last week. The company had net earnings of US$0.58 per unit in Q4, which equates to US$2.33/unit annualised. At a price/earnings ratio of 10 the Q4 earnings would imply a unit price of US$23. The number of units has since increased by almost 30%, but the Q4 results include only one week of earnings related to the Grey Wolf acquisition.

This year's earnings will almost certainly be a lot lower than last year's due to the reduction in drilling activity in both the US and Canada stemming from the decline in the natural gas price. However, the Q4 results show what PDS is capable of achieving when drilling activity returns to a more normal level.

PDS's current low price reflects an excessively pessimistic (in our opinion) outlook for natural gas, the short-term effects of the recent financing, and the company's decision to eliminate its monthly distribution in order to accelerate the pace of debt repayment. Like almost all companies involved in the natural-gas production business its future profitability hinges on the gas price, but it provides more upside leverage than most other companies because its market value has been pushed to such a low level.

Chart Sources

Charts appearing in today's commentary are courtesy of: