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

An Appropriate Quote

The great H.L. Mencken wrote:

"As democracy is perfected, the office of president represents, more and more closely, the inner soul of the people. On some great and glorious day the plain folks of the land will reach their heart's desire at last and the White House will be adorned by a downright moron."

Democracy in the US clearly reached Mencken's "perfection" with George W Bush's rise to the presidency and has since remained perfect. However, it occurred to us late last week that with a few minor tweaks the above quote could apply just as well to central banking. Specifically:

"As central banking is perfected, the office of Fed chairman represents, more and more closely, the inner soul of the people. On some great and glorious day the plain folks of the land will reach their heart's desire at last and the Federal Reserve will be adorned by a downright moron."

There is no longer any doubt that central banking achieved Mencken's "perfection" with the ascent of Ben Bernanke to the role of Fed chairman. 

Fed Up

So, the Fed has done what we thought it would have enough sense not to do at this time. The US now has "QE3". The Fed has said it will purchase $40B per month of mortgage-backed securities, indefinitely. This is being done to "put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative." Interest rates are at generational lows, but the Fed believes that what the US economy really needs right now are lower interest rates.

Suppressing interest rates to below their market level hurts savers and helps debtors. At least, it helps the debtors that are able to borrow at the artificially low rates. The federal government is by far the biggest debtor capable of taking advantage of the artificially low rates, so the government is clearly the biggest beneficiary of the policy. It is therefore fair to say that the Fed's policy brings about a transfer of wealth from private savers to the federal government. No good economist would view such a wealth transfer as a net benefit to the economy. It is also unethical. Bad economics and bad ethics -- that's what the Fed is all about.

In the good old days (prior to this year, that is), the Fed would wait for a deflation scare before opening the monetary spigots. This latest inflation program therefore marks a huge change in strategy. This change in strategy, as opposed to the dollar value of the new inflation program, is the most important aspect of last week's decision by the Fed. More specifically, $40B per month of debt monetisation is not a big deal in the grand scheme of things (as many deflationists will probably point out), but it is a big deal that the Fed has introduced a new inflation program at a time when there is no sign of any price deflation and when the rate of monetary inflation is already high.

To help illustrate the difference between the latest "QE" and the earlier programs, we present two charts. The first chart is from Fullermoney.com and shows the spread between the yields on standard 10-year T-Notes and "inflation-protected" 10-year T-Notes (10-year TIPS). We call this yield spread the "Expected CPI" because it reflects the market's expectations of how the CPI will change over the years ahead. In a nutshell, it is an indicator of inflation expectations. Notice that when the earlier QE programs were initiated the Expected CPI had either just fallen to a 12-month low (in the case of QE2) or just plummeted to a multi-year low (in the cases of QE1.1 and QE1.2), but that the latest program is kicking off with the Expected CPI having just risen to near a multi-year high. The second chart shows that when the earlier programs were initiated the S&P500 Index was 'oversold' and either near a 12-month low or long-term low.

This is so extraordinary that we have to ask, in all seriousness: what were they smoking at last week's FOMC meeting?

They probably weren't smoking anything. It's clear that Ben Bernanke and most other members of the FOMC truly believe that the economy can be strengthened, and a sustainable improvement in the labour market brought about, by counterfeiting money and manipulating interest rates. The root of the problem is unwavering commitment to bad economic theory, so that when the economy doesn't respond as expected to a certain dosage a higher dosage is automatically considered appropriate. It never occurs to the good doctors that they have their diagnosis completely wrong. How could it when they are, in effect, astronomers trying to make sense of the planetary movements based on the theory that everything revolves around the Earth.

The bottom line is that when this latest program doesn't achieve the intended results, it won't be perceived by the Fed as a failure of "monetary accommodation". It will, instead, be perceived as a failure due to insufficient monetary accommodation and therefore as a reason for an even higher dose of the same bogus remedy. This process is likely to continue until price inflation is widely perceived as a major problem.

The process outlined above was well underway prior to last week, but last week's Fed decision marks a material acceleration. This is bullish for gold and very bearish for the US economy.

The Stock Market

Although we didn't think it was the most likely outcome, the recent extension of the US stock market's short-term upward trend helps with the inter-market puzzle. As stated in the 20th August Weekly Update:

"If the stock market were able to hold up (avoid falling out of bed) for another 2-3 months it would allow the pieces of the inter-market puzzle to fit more neatly than they do right now. For starters, 2-3 months of additional stock market stability would pave the way for a strong euro rebound and the unwinding of the huge net-short position in euro futures, thus creating a set-up for the next US$ rally. For seconds, 2-3 months of additional stock market stability would enable T-Bond futures to fall far enough to become 'oversold' on an intermediate-term basis, thus setting the stage for T-Bonds to subsequently benefit from a 'flight to safety' as stocks trended downward."

The monetary change that occurred last week has altered the short-term probabilities such that the US stock market is likely to do no worse than experience a routine (no more than 5%) pullback over the next couple of weeks and generally be stable or firm for another 1-2 months. That being said, one of the difficulties in assessing the stock market's short-term risk/reward in the wake of the Fed's new bout of stupidity is that previous "QEs" were initiated when the stock market was very 'oversold' and at or near a 12-month low. As discussed above, the latest QE is unprecedented in that it is commencing with the stock market 'overbought' and near a multi-year high. This not only makes the short-term price direction even more unpredictable than usual, it means that we have no history to draw upon when assessing risk versus reward. Whereas previous QEs were followed by multi-month advances, there's a decent chance that the latest QE will do no more than prolong the market's topping process. That's why we have left our short-term stock market outlook as "bearish".

To further explain our stance, the probability of substantial short-term downside has certainly been reduced by the Fed's new inflation program. This is because stock prices are quoted in currency units that the central bank appears to be in a hurry to depreciate. But while a sizeable short-term decline now has a lower probability, the risk hasn't been eliminated. Due to this risk we think it makes sense to remain hedged and/or to add some hedges. We are currently hedged via a 30% cash reserve and a small position in VIX call options. We will be looking for opportunities over the weeks ahead to increase our cash reserve.

Moving on, here's something to file in the "interesting but of unknown significance" file. The Dow Transportation Average (TRAN) has lagged the Dow Industrials Index by a widening margin over the past several months, leading to a definitive "Dow Theory" non-confirmation. The non-confirmation was in place prior to last week, but is now more pronounced due to last week's rise by the Industrials to a new 52-week high and the on-going sideways drift in the Transports. A daily chart of TRAN is shown below.

According to "Dow Theory", the non-confirmation is a bearish warning signal. We don't view it as bearish, because we've seen no evidence that "Dow Theory" signals provide reliable information about the future. We do find it interesting, however, that the Transportation sector of the stock market continues to show few signs of life. We could cite the lacklustre performance of the TRAN as proof that the economy is deteriorating even as the senior stock indices rally on the back of monetary inflation, but that would be self-serving given that TRAN proved itself to be a poor economic indicator during 2007-2008.

This week's important US economic events

Gold and the Dollar

Gold

Considering what the Fed did last week, the reaction of the US$ gold price was small. The gold price gained 2% over the course of the week, which isn't to be sneezed at but at the same time isn't particularly impressive in light of the monetary development. This shows that even though we weren't expecting the Fed to do anything immediately, most traders were. Obviously there was a lot of QE anticipation built into the market prior to last week.

The QE anticipation is evident in the Commitments of Traders (COT) data that were released on Friday. The latest COT numbers reveal that the total speculative net-long position in COMEX gold futures was 237K contracts as of Tuesday 11th September. This reflects an increase of almost 100K contracts over the preceding 5 weeks. The next set of COT data won't be published until this coming Friday, but it is reasonable to assume that the speculative net-long position is now at least 250K contracts (close to the 12-month high reached at the end of February). This simply means that there are now a lot more short-term traders involved in the gold market on the 'long' side than there were a few weeks ago. Many of these new short-term bulls will be shaken out of the market during the next correction.

Resistance at $1800 still appears to be a reasonable near-term target, but we doubt that gold will do much better than that before commencing a multi-week correction. The 50-day moving average (MA) is the most plausible downside target for this correction. This MA is currently at $1635, but it is rising rapidly and could easily be in the high-$1600s by the time it meets the market price.



Silver is in a similar position to gold, except that it is more 'overbought'.



The next short-term buying opportunities in gold and silver will be created by pullbacks to near the respective 50-day moving averages.

Could gold and silver do better than we expect over the next several weeks as a consequence of the Fed's monetary profligacy? Yes, but that possibility is not a concern. It is never a concern to us when a market that we have substantial exposure to does better than we expect. We are only concerned when the market we happen to be 'long' does worse than expected. We therefore spend a lot more time pondering what could go wrong than what could go right.

Gold Stocks

HUI Scenarios Update

When the HUI was near its bottom during May and when it was testing its bottom during July we said there was a good chance of a recovery to 550 by October, which seemed farfetched at the time considering that 550 was 47% above the May low and 43% above the July low. However, 550 by October no longer seems farfetched given that it is only 7% above last Friday's closing price.

"550 by October" wasn't a forecast, and if the HUI makes it up to 550 within the next few weeks it won't indicate any prescience on our part. We never pretend to know what's going to happen in the future. Our point was simply that if the HUI did what it did the last two times it became dramatically oversold during the month of May then it would be back at 550 by October.

As a result of the price action of the past two weeks we are left with two plausible scenarios with regard to the HUI's likely performance over the next 12 months. There are actually many other possible outcomes, but the two possibilities that we are now going to mention have by far the highest probabilities assuming that past is prologue. These scenarios were also considered to have the highest probabilities in early June when we first outlined them. They are:

1. The intermediate-term upward trend that began in May of 2012 won't end prior to May of next year, but there will be multi-week corrections of as much as 20% along the way.

2. The intermediate-term upward trend that began in May of 2012 will end during October-November of this year. The gold sector will then trend downward to an intermediate-term bottom in the second quarter of next year.

Scenario 1 was originally thought to have the higher probability. That's still the case. In fact, last week's decision by the Fed increased the probability of Scenario 1 relative to Scenario 2.

Current Market Situation

The bullion market's reaction to the Fed's new inflation program was muted, but the reaction of the gold-stock indices was far more impressive. The HUI cut through resistance at 480-500 like a sharp knife through soft butter and ended the week at a 6-month high. The HUI/gold ratio also ended the week at a 6-month high.



The HUI is likely to make significant additional gains before an intermediate-term peak is in place, but the short-term downside potential is now almost as large as the remaining short-term upside potential. That's why we've shifted our short-term HUI outlook from "bullish" to "neutral".

Regardless of whether it begins immediately or three weeks from now (it will almost certainly begin within three weeks), the gold sector's next downward correction will likely take the HUI back to its 50-day moving average (MA). This MA is currently way down at 431, but it has begun to rise and its rate of ascent should accelerate over the next few weeks. It's probable that by the time the HUI next meets up with its 50-day MA, the MA will be in the 460s.

Buying and selling opportunities will emerge in individual gold stocks independently of the HUI and the other gold-stock indices, but the next sector-wide buying opportunity will occur when the HUI drops to the vicinity of its 50-day MA.

Some junior gold/silver mining stocks have made large gains since their May-July bottoms, but many others have only made small gains or haven't even begun to recover. It should be remembered that the juniors are called late-stage stocks for a reason: they tend to achieve the bulk of their gains during the second halves of intermediate-term advances. As an upward trend matures, market participants become more confident in its sustainability and gravitate towards riskier stocks.

Currency Market Update

Our short-term US$ outlook shifted to "bullish" last week on the basis that there was the potential for an 'oversold' bounce to as high as 83 (about 3 points of upside potential) and that there was downside risk to around 79 (about 1 point of downside risk). As a result of last week's action the Dollar Index is now even more 'oversold'. In fact, according to the RSI displayed at the bottom of the following daily chart it is now more 'oversold' than it has been at any time since September-October of 2010. However, the Fed news has changed the risk/reward equation. There is a good chance of a US$ bounce within the next couple of weeks, but the downside risk is now greater (although still not substantial) and the next bounce will likely be followed by a decline to new lows for the year. Our short-term US$ outlook has therefore shifted back to "neutral".

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 14th September 2012:

  *Batero Gold (BAT.V) reported the results from seven infill drill holes. Six of the seven holes contained good intercepts, with the best results being 96.6m of 1.14-g/t gold starting from 3.4m below the surface, 97.4m of 1.00-g/t gold starting from 2.6m below the surface, and 167m of 0.91-g/t gold starting from 3.2m below the surface.

In the wake of the disappointing resource estimate published early this year, BAT changed plans and set about defining a smaller and shallower pit than originally envisaged. The primary focus is now on a piece of land roughly 600m long by 200m wide by 200m deep, containing oxide ore (from surface to a depth of about 70m) and transition ore.

The plan change makes sense for a number of reasons. First, financing a larger operation in the current market environment would be somewhere between difficult and impossible. Second, the best grades at Batero's La Cumbre deposit tend to be in the top 150m of the deposit. Third, metallurgical testing yielded gold recoveries of 93%-94% for mineralization in the Oxide Zone and recoveries of 82%-86% in the Transition Zone, whereas initial recoveries for the deeper Sulfide Zone were much lower. Fourth, a smaller/shallower operation could be brought into production more quickly. In a nutshell, it became clear that the company's best chance of generating good returns for shareholders was to focus on the top 200m of the deposit.

While BAT's exploration and engineering work is now focused on a shallower hole, the stock price is still near the bottom of a deep hole (see chart below). This is bad for existing shareholders, but means that there is a lot of upside potential for buyers near the current low price.

Our main concern at this time is that BAT will need to do another financing within the next few months. Due mainly to this financing risk, we would only put a small amount of new money into BAT shares at this time.



  *Clifton Star Resources (CFO.V) announced that the option payments it is obligated to make to the current owners of its Duparquet project (CFO has the option to earn 100% of the project by making certain payments) have been renegotiated to substantially reduce this year's obligation and spread the balance more evenly over the next five years. Previously, CFO was required to make option payments of $22M on 1st Dec 2012 and $30M on 1st Dec 2017. The new payment schedule, which CFO can choose to accelerate, is:

-$2-million and 250,000 shares on Dec. 1, 2012
-$10-million on Dec. 1, 2014
-$10-million on Dec. 1, 2015
-$15-million on Dec. 1, 2016
-$15.2-million on Dec. 1, 2017

This new payment schedule enhances CFO's financial flexibility, but we understand that CFO still has the right to borrow $22M from Osisko (OSK) to cover option payments. The right to borrow $22M from OSK was part of an earlier joint-venture agreement between the two companies and remained applicable after the JV was ended. Furthermore, the $22M could be repaid by issuing shares to OSK at a deemed price of C$3.12/share. That is, our understanding is that CFO is entitled to $22M of funding from OSK at C$3.12/share, with the money to be used to make option payments.

So, there are two important events coming up for CFO over the next four months. The first -- unless OSK is able to wriggle out of its commitment -- is the receipt of a $22M financing effectively priced at $3.12/share. The second is the completion of a Preliminary Economic Assessment (PEA).

If you currently don't own any CFO shares and you can tolerate the stock's risk and lack of liquidity, then you should consider taking a small position ahead of the upcoming news.

  *Golden Star Resources (GSS) announced that it had redeemed $6M of the convertible notes that were due to be repaid on 30th November 2012, leaving a balance of $44M. The remaining $44M is expected to be repaid using the company's existing cash.



  *Jaguar Mining (JAG) appointed David Petroff as its new CEO. Mr. Petroff has a good C.V. and probably wouldn't have trouble finding a top-level job in the junior mining realm, so the fact that he has chosen to work for JAG is a plus for the company.

If JAG's management successfully completes its three-stage cost reduction program by early next year (as currently scheduled) and substantially reduces debt by making an asset sale then JAG's share price could rebound to at least US$3.50 even with no additional gain in the gold price. That's the upside potential, but there is also considerable risk due mainly to the present weak state of the company's balance sheet.

  *Pinetree Capital (PNP.TO) reported that its per-share net asset value was C$1.74 as at 31st August. Due to price changes since then it would probably now be C$1.85-$1.90.

  *Pretium Resources (PVG) has followed the typical 'bad-news-plunge' price pattern despite the sector-wide rally and the Fed's yeoman-like efforts to increase the wealth of gold investors. The bad news in this case was the surprisingly-low resource re-estimate reported on Friday 7th September.

As explained in our 10th September commentary: "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."

We just got the test of the 7th September low. It's too soon to tell if the test will be successful, but this is a reasonable time/price to buy some PVG shares if you currently don't own any.



  *Ramelius Resources (RMS.AX) reported very good drilling results from below one of the historical open pits at its Mt Magnet gold-mining operation. The results included 11m of 10.85-g/t gold and 12m of 12.14-g/t gold. We don't yet know the significance of these results. In particular, we don't know the extent to which they expand the mineable gold resource.

The same press release confirmed that the Mt Magnet mine was on track to reach its targeted 80K-oz/yr production rate in December.

  *Rio Novo Gold (RN.TO) reported the resignation of its CEO. We don't know why the stock market reacted negatively to this news, as the just-resigned CEO was sub-par (based on performance) and his replacement (Julio Carvalho) has the potential to be much better. The new CEO certainly has a wealth of experience, having previously been CEO of Peak Gold Limited (now New Gold), Executive Vice President of South and Central America of Goldcorp, President and CEO of Mineracao Onca Puma Ltda. (the Brazilian subsidiary of Canico Resource Corp.), and Chief Financial Officer and Executive Director for Rio Tinto Brasil.

  *Volta Resources (VTR.TO) reported another -- and likely final for this year -- round of drilling results for its Kiaka South prospect. The results were generally positive, with best gold intercepts of 6.95m @ 11.59g/t, 32.00m @ 4.44g/t and 15.00m @ 3.87g/t. The first resource estimate for Kiaka South will now be done.

Reducing exposure to West Africa

There are a lot of interesting gold-mining companies operating in West Africa. This part of the world still seems to have an abundance of untapped exploration potential and in many cases the stocks of West-Africa-based gold miners appear to be very under-valued. That's why the TSI Stocks List now contains several West-Africa-focused gold mining companies. We are referring to Endeavour Mining (EDV.TO, EVR.AX), Golden Star Resources (GSS), Keegan Resources (KGN), Resolute Mining (RSG.AX) and Volta Resources (VTR.TO). There are good reasons to be bullish on each of these stocks at their current prices, but it's not good that our list of stock selections has so much exposure to a single moderately-risky region that appears to be headed in the wrong direction on the risk scale.

There are two main reasons for our view that West Africa is headed in the wrong direction on the risk scale. First, this year's events in Mali (a military coup, a civil war, inroads being made by well-armed Islamic fundamentalists) suggest that democratically elected governments in that part of the world have a tenuous hold on power. After all, prior to this year Mali was generally thought to be one of the most politically stable of West Africa's nation states. Second, governments in West Africa are becoming increasingly aggressive in their efforts to take a bigger share of the profits earned by gold mining companies. For one example, in its 2012 budget the government of Ghana increased the corporate tax rate on miners from 25% to 35% and introduced a 10% windfall profits tax. The windfall tax has since been delayed and could ultimately be abandoned, but it is clear that tax policy in Ghana, which is reputedly the best country in West Africa to operate a gold mining business, is being driven by the belief that the miners are rolling in money and that "the people" deserve more of this money. If only the miners really were rolling in money. For a second example, a spokesman for the Cote d'Ivoire government said last week that a windfall profits tax on gold miners would be put in place "to ensure the country benefits from higher world prices for the precious metal". These governments don't understand that if they implement windfall profit taxes then investment in the mining industry will dry-up and overall tax revenues will end up declining. Mining is a very cyclical business. If the opportunity to earn a lot of money near the peak of the cycle is taken away then so is the incentive to invest.

At this stage we plan to maintain significant exposure to West Africa via gold stocks that have attractive risk/reward ratios (taking into account the increasing political risk), but our short-term goal is to reduce the number of West-Africa-focused stocks in the TSI List from 5 to 3. We are going to start immediately by exiting Resolute Mining (RSX.AX), a long-time inclusion in the TSI List. We have made numerous suggestions to buy RSG shares and numerous suggestions to take partial profits on RSG shares over the years, but this one will go into the books as a profit of 106% based on its price when it first appeared in the TSI List (March of 2005) and last Friday's closing price of A$1.88.

We have chosen to exit RSG because its flagship Syama project is in Mali, which has turned out to be one of the riskiest countries in the region. EDV.TO will also have significant exposure to Mali after it completes its takeover of Avion Gold, but with EDV's current production coming from three separate West-African countries it is less vulnerable to a major problem in any one country. In a market and political environment in which everything went well for RSG, EDV would also do very well. And in terms of valuation and growth potential, RSG and EDV look quite similar.

The bottom line is that with EDV picking up significant Mali exposure via its Avion purchase, it doesn't make sense for us to have both EDV and RSG in the TSI List. RSG is the one to go because its stable of assets is less diverse and riskier.

Short-term GDXJ trade closed out

In the 10th September Weekly Update we wrote that for TSI record purposes we would exit the short-term GDXJ trading position if GDXJ traded at $23.90. This price was achieved on Thursday 13th September, so the trade has been closed at a profit of 22.9% (based on the 25th June entry price of $19.45).

Index changes to be aware of

At the end of last week Standard and Poors (S&P) announced changes to various Canadian (S&P/TSX) equity indices that become effective after the close of trading on 21st September. Here's how members of the TSI Stocks List will be affected:

1. Endeavour Mining (EDV.TO) will be added to the S&P/TSX Global Gold Index and will therefore have to be purchased by some index-tracking funds late this week, which could give the stock price a boost.

2. GPD.TO, JAG.TO, ORV.TO, PNP.TO and VTR.TO will be deleted from the S&P/TSX SmallCap Index, which could put some downward pressure on these stocks late this week. One way to take advantage of this situation would be to place an under-the-market buy order for an affected stock prior to the start of trading on Friday 21st September with the aim of catching a downward spike caused by the selling of index trackers. Upward and downward spikes caused by index changes are often retraced in full during the ensuing trading day.

Previously it was announced that Ramelius Resources (RMS.AX) would be removed from one of the S&P/ASX indices at the close of trading on 21st September, which could result in some downward pressure on RMS's stock price late this week.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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