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

Creating money out of nothing

Antal Fekete has recently posted another interesting article dealing with interest rates, depression and deflation. In this latest piece he reiterates some of the arguments about deflation that we addressed in our 1st April commentary, but he also argues that the Fed doesn't create money "out of thin air", as many people believe, because the new money is collateralised. To be more specific, he argues that the Federal Reserve banks are only able to create new money to the extent that they post collateral of equivalent monetary value, which means that the new money has not actually been created out of nothing.

Like Professor Fekete, we are not fond of the Quantity Theory of Money (QTM) and the associated Equation of Exchange (M*V = P*Q). As far as theories go, the Quantity Theory of Money is not particularly useful because it does a poor job of explaining how changes in the money supply affect the economy. However, you don't need to be a QTM devotee to appreciate that banks (the commercial as well as the central variety) effectively create money "out of thin air" when they make loans. Here's why.

First, when a bank lends new money into existence the money is loaned against some form of collateral, but the collateral usually exists prior to the creation of the new money. For example, when a commercial bank lends $1M to Fred Jones for the purchase of a new house, the house exists with or without the loan and the associated new money. But as a result of the bank's action the money supply is now $1M larger.

Second, a non-bank lender makes a loan by transferring part of the EXISTING money supply to the borrower, whereas a bank creates NEW money when it makes a loan. In both cases a repayment obligation is created, but only the bank's loan results in an expansion of the money supply. Has the bank not, in effect, created money out of nothing?

Third, the collateral against which a central bank lends money will not necessarily have any real value because all that's required to balance the central bank's books is an accounting entry. For example, over the past seven months the Fed has issued more than one trillion dollars to various financial corporations in exchange for certain "collateral", but a detailed breakdown of this so-called collateral has never been provided. It is reasonable to assume that the collateral includes securities that are worth less than the amount of new money that was created to purchase them, and it is quite possible that a portion of the collateral is essentially worthless. For all intents and purposes the central bank is above the financial standards that apply to private companies -- it can be as opaque or as transparent as it wants to be at any given time.

Fourth, when the Fed monetises government bonds it really receives nothing in exchange for the new money because the government is a consumer of wealth, not a producer of wealth, and the government's debt will never be repaid. If it chose to do so the US government could, for instance, issue $10T of bonds tomorrow that the Fed purchases with newly created money, resulting in a more-than-doubling of the economy's money supply once the new money is spent. This new money will be 'offset' by $10T of bonds on the asset side of the Fed's balance sheet; but so what? In this hypothetical example the effect on the economy of the 10 trillion new dollars will be the same as if the money had been created by an extremely proficient private counterfeiter.

The main difference between the way the Fed operates and the way a private counterfeiter operates is that the Fed uses double-entry bookkeeping. To be more specific: whereas a private counterfeiter simply prints new money and then spends it, for every new dollar the Fed creates it adds one dollar of "assets" to its balance sheet (the new dollar goes on the liability side and is balanced by something on the asset side). As discussed above, however, the assets will not necessarily have any real value, and in any case the fact that double-entry bookkeeping is used doesn't invalidate the concept that new money is being created "out of thin air". Furthermore, a private counterfeiter could choose to operate the same way as the Fed. Rather than spend his newly-created money the private counterfeiter could introduce it into the economy via collateralised loans. 

China Update

Oil Update

The Stock Market

The senior stock indices remain well below their 200-day moving averages and therefore still have significant short-term upside potential. However, the US stock market and many other markets around the globe have now risen for six weeks in succession, so it is reasonable to expect that a 1-2 week 'pause for breath' will begin either immediately or following another upward surge over the coming days.

The following decisionpoint.com chart shows the S&P500 Index and the percentage of S&P500 stocks that are above their 50-day moving averages. The chart shows that:

a) There is important resistance at 950-1000. Note that the 200-day moving average also lies within this range.

b) The proportion of stocks trading above their 50-day moving averages is now at its highest level in more than two years. This tells us two things. First, it tells that the market is 'overbought', which is a reason to be cautious as far as the next couple of weeks are concerned. Second, it tells us that the current rally is more broad-based than the other rallies of the past two years, which is a reason to anticipate additional upside over the next couple of months.

This week's important US economic events

Gold and the Dollar

Gold

Gold and Economic Confidence

The gold price relative to the general level of commodity prices (as represented by the gold/CCI ratio) can be thought of as the real gold price. In our opinion, few things in the financial world consistently behave as rationally as the real gold price. As a result, we have had far more success over the years at predicting the performance of the real gold price than at predicting the performance of any other market price. For example, in mid-2008 we correctly anticipated a large rise in the real gold price and at the beginning of this year we correctly anticipated a multi-month period of weakness in the real gold price. Unfortunately, being close to 100% right about the real gold price during the second half of last year didn't do us any good from a practical investing/trading perspective because we wrongly thought that the rise in gold-mining profit margins that would stem from the rise in the real gold price would support the prices of gold mining equities.

The real gold price (the gold/CCI ratio) is an indicator of economic confidence in that a rising trend in gold/CCI is usually associated with declining confidence in the economy and/or the financial system, while a falling trend in gold/CCI is usually associated with rising confidence. "Economic confidence" is a fairly vague term, but aside from the gold/commodity ratio its intermediate-term trend can be observed in the performances of the yield curve (the differences between long-term and short-term interest rates) and credit spreads (the differences between the yields on high-risk and low-risk bonds). For example, the following chart of the HYG/TLT ratio shows how high-risk (junk) bonds have performed relative to much lower-risk US Treasury Bonds. The plunge in this ratio during the second half of last year was indicative of a massive widening of credit spreads, which was, in turn, indicative of falling confidence, whereas the ratio's subsequent rebound tells us that confidence has been gradually improving over the past few months.

The recent rebound in economic confidence evidenced by the rise in the HYG/TLT ratio should have been accompanied by weakness in the gold/CCI ratio, which, of course, it has.

If our economic outlook is in the right ballpark then the rebound in economic confidence and the associated decline in the real gold price could continue for another 1-2 months, but not for much longer than that. Furthermore, we perceive more upside potential than downside risk in the gold/CCI ratio, even in the short-term, because the rise in confidence that's propelling equity markets and industrial commodities upward (and gold downward) has fragile underpinnings.

Current Market Situation

The main driver of the recent decline in the gold price has been the growing belief that the worst is over for the economy and the stock market. Also of significance, by late February sentiment towards gold had become overtly optimistic (as revealed by the COT data and the premiums to net asset values of gold-related mutual funds) and it recently became apparent that the IMF is going to move forward with its long-standing plan to sell gold.

The net result of the above-mentioned factors is that the gold price has pulled back to its 200-day moving average. The market is no longer 'overbought', but although sentiment indicators have become more supportive they haven't yet reached the levels that would typically mark the end of a correction. This doesn't mean that the correction is not over; just that there isn't any sentiment-related evidence that it is over.

Our view is that the correction could ultimately take the gold price down to around $800, but not significantly lower than that. In any case, investors should be focused on value, not on trying to pick the ultimate bottom. As mentioned in last week's Interim Update: "If we didn't already have a full position we would be buyers of gold bullion -- for long-term investment purposes -- in the $850s, and aggressive buyers in the low-$800s."

Gold Stocks

Current Market Situation

The AMEX Gold BUGS Index (HUI) is now oversold and, as illustrated by the first of the following charts, has dropped to the bottom of its multi-month channel. This is a likely place for a correction low to occur, but there isn't yet any evidence that the correction has ended or is about to end.

The most important thing missing at this time is a positive divergence between the gold sector of the stock market and the bullion market. In particular, weakness in the gold sector over the past two days was accompanied by weakness in the HUI/gold ratio. The second of the following charts shows the HUI/gold ratio relative to its 40-day moving average.

Positive divergences between the HUI and gold bullion don't always occur near the ends of downward corrections, but when they do occur -- via the HUI falling at a slower pace than gold bullion or via gold making a new low while the HUI makes a higher low -- it increases the probability that a sustainable bottom is being put in place.

Traders could consider taking a long position now on the assumption that last week's decline to the channel bottom completed the downward correction, but a relatively tight stop should be used. For example, a long position in GDX could be established near Friday's closing price with the intention of exiting the position if the HUI subsequently closes below 259. Alternatively, traders that are more risk-averse could reasonably decide to wait for some evidence of a low, such as a daily close above 305 by the HUI or the sort of positive divergence mentioned in the preceding paragraph, before establishing a short-term position.

As far as our own money management is concerned, we aren't interested in taking any short-term gold positions at this time. We have substantial long-term exposure to the gold sector and have begun to place under-the-market buy orders with the aim of further increasing this exposure, but if things go according to plan we will build up some cash by scaling out of non-gold stocks into strength BEFORE we increase our exposure to the gold sector.

Warrants

Our Great Basin Gold warrants (TSX: GBG.WT) trade was a failure as the warrants will expire worthless on Monday. However, over the years we've had considerable success with warrants*. In fact, prior to the GBG.WT debacle we had completed 12 warrant trades and achieved an average profit per trade of around 230%.

We can't say for sure, but the bad result on the most recent warrant trade was probably due to not giving ourselves sufficient time. When we entered the earlier warrant trades the time to expiry was generally at least three years and never less than two years, but when we added the GBG warrants to the TSI List the time to expiry was only 12 months. This was a mistake we won't make again.

If we are correct to assume that the gold sector commenced a multi-year advance last October then carefully-selected warrants on gold stocks should pay-off handsomely over the next 3 years. Unfortunately, there isn't a lot to choose from at the moment in that most of the outstanding warrants that we are aware of have less than two years to expiry and/or are too far out of the money to be of interest (we usually won't be interested in a warrant if its exercise price is more than double the current price of the underlying stock, although there are exceptions) and/or have almost no liquidity and/or are ridiculously over-priced. Here are a few, shown in alphabetical order, that are worth monitoring and potentially worth accumulating on weakness over the coming months:

*ECU Silver Feb-2014 C$0.95 warrants (TSX: ECU.WT, Yahoo Symbol: ECU-WT.TO)
*Endeavour Financial Feb-2014 C$2.50 warrants (TSX: EDV.WT.A, Yahoo Symbol: EDV-WTA.TO)
*Franco Nevada Mar-2012 C$32.00 warrants (TSX: FNV.WT, Yahoo Symbol: FNV-WT.TO)
*Minefinders Corp. Dec-2011 C$5.00 warrants (TSX: MFL.WT, Yahoo Symbol: MFL-WT.TO)
*Silver Wheaton Sep-2013 US$20.00 warrants (TSX: SLW.WT.U, Yahoo Symbol: SLW-WTU.TO)

EDV.WT.A is already in the TSI Stocks List. Of the others, the one that interests us the most at this time is FNV.WT. With reference to the following chart, FNV (Franco Nevada**) looks like it could drop to around C$20 within the next few weeks. If so the warrants would probably drop to C$2.80-C$3.00, in which case we would be buyers.

    *The warrants we trade are long-dated call options issued by companies when they do equity financings.
    **Franco Nevada is a royalty company that owns both gold and oil royalties. By the end of this year about 75% of FNV's revenue-producing royalties are expected to be gold.

Currency Market Update

A daily chart of June euro futures is displayed below.

The euro broke below short-term support on Friday, which projects a drop back to the March low. We suspect that the euro will not only drop back to the March low, but to new multi-year lows later this year. However, significant euro weakness (US$ strength) at this time doesn't mesh with most of our other market views. Additionally, although the euro broke out to the downside on Friday the Dollar Index remains below its 50-day moving average. The bottom line is that we have no opinion on the most likely direction of either the euro or the Dollar Index over the next few weeks.

The following daily chart shows that the A$'s rally from its March low has hesitated at the 200-day moving average, which is normal. We expect the A$ to make additional gains over the weeks ahead and continue to view 0.75-0.80 as a reasonable upside target.

Support at 0.70 should limit the extent of any near-term decline. In fact, this support MUST limit the downside in order for our short-term positive outlook to remain intact. We would therefore exit any long-side A$ trading positions if the June contract closes below 0.70.

 

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)

Natural Gas Stocks

Despite the fact that the natural gas (NG) price is languishing near a multi-year low, natural gas equities have rebounded strongly from their early-March lows. The large-cap NG producers are up by an average of 30% over the past six weeks, while many of the smaller producers are up by 50-100% from their lows. Of course, all of these stocks are still down a long way from last year's highs.

The strong rebound in NG-related equities has been driven by the rebound in the broad stock market and, quite likely, the expectation that the huge reduction in drilling activity will lead to a strong price recovery late this year (the US natural gas rig count has fallen to its lowest level in 6 years and is still in a downward trend).

We suspect that the short-term upward trend in the NG sector of the stock market will remain intact as long as the overall stock market rebound remains intact. This is partly because additional strength in the broad stock market should bolster the emerging (but most likely incorrect) view that a new economic growth phase will begin before year-end.

In our opinion, traders should look for opportunities over the coming month or so to scale out of natural gas and other industrial-commodity stocks on strength and to scale into gold stocks on weakness.

Precision Drilling (NYSE: PDS) is the only NG-related trading position in the TSI List (PDS appears twice in the TSI List -- once as a trading position and once as a longer-term investment position). We are now placing a trailing sell-stop on the trading position. Specifically, we will exit the trade if PDS closes 10% or more below its closing high for the move. The current closing high is Friday's US$4.02, so the sell stop will initially be at US$3.61.

Chart Sources

Charts appearing in today's commentary are courtesy of: