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 Watch

Until things settle down and the monetary authorities stop taking extraordinary measures to promote inflation, we will make "Inflation Watch" part of every Weekly Market Update.

The anticipated "deflation scare" is here

We have warned a number of times over the past several months that a "deflation scare" was probably on the cards, with "deflation scare" being defined by us as a period of accelerating inflation (money supply growth) combined with rising fear of deflation. Accelerating money-supply growth can co-exist with rising fear of deflation because most people wrongly associate falling prices with deflation. Falling prices are, of course, a natural consequence of deflation, but prices can fall for reasons that have nothing to do with deflation. In fact, over the past 70 years there has never been a deflation-related price decline in the US because during this period the US has never experienced genuine deflation. There have, however, been several deflation scares.

Judging by an article published in the Wall Street Journal on 18th October, a deflation scare has arrived. Here are the opening paragraphs of this article:

"Policy makers navigating the U.S. through the global credit crisis may have a new concern on the horizon for 2009: deflation.

The risk of deflation -- generally falling prices across the economy, beyond volatile energy and food costs -- remains slim. But the financial shock and a faltering economy can set the stage for a deflationary environment.

Federal Reserve officials view broad-based deflation as unlikely but possible. Federal Reserve Bank of San Francisco President Janet Yellen said in a speech this week that the plunge in oil prices along with slackening demand for labor and goods should "push inflation down to, and possibly even below, rates that I consider consistent with price stability."

Fed officials generally consider price stability to be an inflation rate between 1.5% and 2%. Their preferred measure of core inflation, which excludes food and energy, stands above 2% now, and is expected to remain above that mark as price increases from earlier this year advance through the product pipeline.

The economic slowdown and declining commodity prices have eased the nation's consumer inflation rate, which surged to 5.6% over the summer. Annual inflation in the U.S. is likely to turn negative for at least several months next year, on declining energy and food prices.

With the unemployment rate rising rapidly and capital markets in turmoil, "pretty much everything points toward deflation," said Paul Ashworth, chief U.S. economist at Capital Economics. "The only thing you can hope is that the prompt action of policy makers can maybe head this off first.""

The comment from the "chief US economist at Capital Economics" is funny because it implies that with the financial markets going haywire the only thing that can save us is more government-sponsored inflation.

Deflation scares always have inflationary consequences -- at least, they have always had inflationary consequences in the past -- because most chief economists and the makers of monetary policy seriously believe that more inflation is the appropriate response to the problems wrought by earlier inflation. This is why the rate of monetary inflation invariably ramps up whenever prices embark on a downward trend, and why the bigger the deflation scare the more bullish the long-term gold price outlook generally becomes.

Some commentators have posited that the amount of new money being created by the government and its central bank is tiny compared to the amount of market value being lost in the equity, real estate and bond markets. This is true, but irrelevant as far as the long-term inflation outlook is concerned because changes in market value don't directly affect the money supply. For example, the rise in the price of a house from $1M to $2M does not create new money and the fall in the price of a house from $2M to $1M does not eliminate any money; all that happens as a result of the up or down move in the house price is a change in the proportion of the EXISTING money supply that will get transferred from buyer to seller upon the sale of the house.

If policy makers attempt to offset asset price declines with new money the end result won't just be inflationary, it will be hyper-inflationary. Note, though, that we are not expecting hyper-inflation to occur within the next few years.

Current Monetary Situation

The Fed expanded its balance sheet by an additional $245B last week, which means that the cumulative increase since 10th September is now $852B. This equates to a 96% increase in just 5 weeks.

As at 6th October, the date of the most recent broad money-supply data, the effect on the total money supply of the aforementioned explosion in reserve bank credit had been significant, but nowhere near as significant as we would have expected (M2 increased by $160B between 8th September and 6th October). There are, we think, two main reasons for this. First, part of the increase in Reserve Bank credit has been associated with the currency swaps that the Fed has arranged with other central banks. These swaps increase the global supply of US dollars, but they don't boost the domestic M2 or TMS monetary aggregates. Second, as at 15th October there were 495 billion dollars sitting in the US Treasury's "Supplementary Financing Account" at the Fed. As we understand it, this money has been earmarked for use in various US Government bailout schemes, such as the scheme to purchase equity in banks and the scheme to purchase the bad debts of banks. However, because it hasn't yet been 'injected' into the economy it doesn't yet figure in the broader money-supply aggregates.

We expect that the money currently residing in the "Supplementary Financing Account" will be injected into the economy over the coming weeks/months, thus giving the broader aggregates a hefty boost. Also, on 27th October the Fed will begin to lend money directly to non-financial corporations, thus overcoming the 'problem' of banks accumulating additional reserves but choosing not to increase their lending.

The Stock Market

Although the stock market is still oscillating wildly there is evidence that the financial environment is slowly becoming less stressed. For example, the large gap between the 3-month Treasury Bill yield and 3-month LIBOR narrowed a little last week. Also, the December-2008 3-month eurodollar futures contract broke out to the upside on Friday, signaling a future reduction in the short-term borrowing costs of banks.

Let's now take a quick look at some charts, beginning with a daily chart of the S&P500 Index (SPX). Last Thursday (16th October) the SPX completed a successful test of the 10th October low, although this might not be the final test of the low.

Our view is that the SPX now has more short-term upside potential than downside risk, but for this view to remain valid the SPX should not close below the 899.

Next up is a daily chart of the Bank Index (BKX). The BKX led to the downside prior to July of this year but has shown relative strength over the past three months. This relative strength is evidenced by the fact that while almost every stock market index in the world collapsed to new multi-year lows during the first two weeks of October, the BKX held above its July low. It also held up relatively well during last week's SPX test of the October low.

The BKX appears to have made a major 'double bottom', although this double bottom appears to be the result of government manipulation rather than natural market forces. The US Government has diverted hundreds of billions of taxpayers' dollars to the banks and has promised to divert hundreds of billions more, and any sector of the economy that benefits from government largesse to this extent is bound to show some short-term strength at the expense of other sectors.

We should endeavour to trade and invest based on the way things are, not the way they should be. As such, traders could consider averaging into 'long' positions in one or more of the four major US banks (BAC, C, JPM, WFC), with initial stops set just below last week's lows.

Finally, below is a weekly chart of the Natural Gas Index (XNG) covering the past 10 years. At the recent low the XNG was further below its 50-week moving average than it had ever been and its weekly RSI (shown at the bottom of the chart) was as oversold as it had been at the major low of July-2002.

Either the October-2008 low will prove to be just as important as the July-2002 low, or this year's rapid decline will prove to be only the first leg of a major bear market. We think the former possibility is the more likely, but even if we are wrong there should still be a substantial rebound over the next several months.

This week's important US economic events

Gold and the Dollar

Gold

The Central Fund of Canada (AMEX: CEF) holds gold and silver bullion in approximately equal dollar amounts. It is a closed end fund, which means that its market price can deviate from its net asset value (NAV).

The extent to which CEF's market price deviates from its NAV is an indicator of the public's sentiment, with a large premium to NAV suggesting that the public is very bullish and a small premium, or discount, suggesting a lack of interest in gold and silver bullion on the part of the investing public. The public's sentiment is always a contrary indicator, so a large CEF premium should be considered a bearish omen.

A chart of CEF and the CEF %premium is displayed below. CEF's premium to its NAV had not been a reliable short-term indicator of gold price movements prior to the past few months, but recent peaks and troughs in the gold price have coincided with peaks and troughs in the CEF premium. For example, the rise in the CEF premium to 14% marked the July peak in the gold price, the drop to below 5% in the CEF premium marked the early-September low in the gold price, and the rise in the CEF premium to above 20% marked the late September and early October highs in the gold price. The decline in the gold price from its early-October peak has been accompanied by a drop in the CEF premium to around 10%, which is still a bit on the high side.

A drop in the CEF premium to 5% or lower would signal that gold was close to a short-term bottom. It would also signal a buying opportunity for CEF.

Note: CEF's premium to NAV is reported daily at http://www.centralfund.com/Nav%20Form.htm

It probably wouldn't take much additional weakness in the gold price to push the CEF premium down to 5%. Also, other sentiment indicators, including the Commitments of Traders report, are quickly approaching the levels that would be consistent with a price low.

Last Friday's close below $800 warns that gold could be about to test the support at $725-$735 defined by its September-2008 low and its May-2006 peak. Sentiment indicators suggest that this support will hold if tested.

Gold Stocks

The top section of the following chart shows that the XAU's crash has taken it back to near long-term support at 78-80. We won't be surprised to see a test of this support during the coming week.

The bottom section of the chart shows that the XAU is now lower relative to gold than it has been at any point over the past 10 years. Relative to gold bullion the XAU is actually a lot cheaper now than it was at the major bottom of November-2000.

To show how the current situation stacks up on a longer-term basis we present, below, a weekly chart showing the Barrons Gold Mining Index (BGMI) and the BGMI/gold ratio dating back to 1960. There have obviously been other huge declines in the gold-mining sector over the past 48 years, but the recent episode stands out. For one, the recent decline is the steepest. Also, the BGMI/gold ratio is now lower than it has been at any time since 1960. In other words, the current situation is unprecedented.

The gold sector is now at its most oversold extreme ever, which doesn't mean that it won't fall further. In fact, it will likely fall further during the coming week if gold bullion drops back to test its September low. What it does mean is that this month's low will probably be the major variety (the type that sets the stage for a multi-year bull market) and that the initial rally following the low will be fast.

In last Friday's email alert we said that traders could attempt to play the potential for a fast gold-sector rebound via GDX call options with expiry dates of Jan-2009 or later. Such a trade could be averaged into over the coming days, but should only be attempted by those with plenty of risk capital.

Speculating using options only ever makes sense if the money being put at risk is small in comparison with the speculator's cash reserve. Putting it another way, options trading should only be done using money that could be written off without blinking an eye if things don't go as planned.

Currency Market Update

With regard to the following weekly chart of the Dollar Index, note that:

1. Pullbacks during the intermediate-term upward trend of Jan-2005 through to Nov-2005 ended at, or just below, the 20-week moving average (the blue line on the chart).

2. Rebounds during the intermediate-term downward trend of Nov-2005 through to Mar-2008 ended at, or just above, the 20-week moving average.

3. Pullbacks during the current intermediate-term upward trend have ended near the 20-week moving average.

We don't think the dollar's intermediate-term upward trend is over, but it is overbought and due for a pullback. A reasonable expectation, based on what has happened over the past few years, is that the next pullback will take the Dollar Index down to the vicinity of its 20-week moving average.

Is silver too heavy?

Jim Sinclair (www.jsmineset.com) recently commented that silver is too heavy to ever again be widely used as money. By this we think he means that large purchases would require the transport of such bulky quantities of silver that its use as money would be impractical. According to Mr. Sinclair, the relative ease with which a large monetary value of gold can be transported gives the yellow metal a significant advantage over silver.

In his 16th October discussion at http://silveraxis.com/todayinsilver/, Tom Szabo explains why he thinks Mr. Sinclair is mistaken. We also think Mr. Sinclair's logic is flawed on this particular issue, but not for the reasons given by Mr. Szabo. In our opinion, Messrs. Sinclair and Szabo are overlooking the most important point with regard to silver's transportability. The point is that with today's technology there would seldom be any need to physically transport monetary silver or gold.

We often read that a monetary system based on gold and/or silver would not be flexible enough to meet the needs of today's dynamic economy, but the people who make such claims completely misunderstand the nature of good money and the relationship between money supply and economic growth. The fact is that maximising the economy's long-term growth potential involves making the general medium of exchange (money) as INFLEXIBLE as possible. To paraphrase Shakespeare, money should be as constant as the sun. If the money supply were stable then price signals would always carry accurate information regarding supply/demand fundamentals, leading to a greater proportion of correct business/investment decisions and, consequently, stronger long-term economic growth.

Only a naturally occurring element can be sufficiently inflexible/stable to be good money, and over the centuries gold and silver have proven to be the elements best suited to perform the monetary role. Moreover, never before in world history have gold and silver been better suited to perform the monetary role than they are right now. The reason is that current technology makes it possible to use gold and silver as money without ever having to physically shift the metal. To be more specific, the metal could remain securely stored in a vault anywhere in the world, with computers and internet-related technology used to transfer ownership. As a result, there would never be a need to carry a bag of gold and silver coins to your local shopping centre. Instead, you could make purchases using a 'gold card' or 'silver card' in the same way that you currently use a credit card, the difference being that a purchase would result in the ownership of a certain quantity of metal being transferred from yourself to the shop owner. Similarly, companies could pay salaries by electronically transferring the ownership of gold or silver to their employees' accounts.

Having said that, we actually agree with Mr. Sinclair's conclusion that gold will eventually regain its monetary role while silver will not. The reason is that for a commodity to adequately perform the role of money its aboveground supply must dwarf the amount of the commodity used in industrial applications. This is the case for gold, but is no longer the case for silver.

Silver bulls claim that the ever-expanding industrial usage of silver could lead to silver being a better investment than gold over the years ahead, which is possibly true. However, that's a different issue altogether. The point is that the more silver is used in industrial applications, the less chance of it ever again being widely used as money. 

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)

Risk

Over the past several months we have suggested focusing on gold stocks in general and on junior gold stocks in particular (for longer-term positions, as the juniors are not good trading vehicles). Furthermore, within the ranks of gold juniors we've suggested focusing on those that were relatively low risk. Unfortunately, our suggested approach hasn't worked. Despite sufficient strength in the gold price to lay the foundation for higher gold-mining profit margins, the gold sector of the stock market has been hit as hard as, or harder than, any other sector, and the lower-risk gold juniors have often fared just as poorly as the higher-risk ones.

But in the face of adversity comes opportunity, and an opportunity created by the current market environment was described as follows in the 6th October Weekly Update:

"Due to the fact that the prices of almost all junior resource stocks have been hammered regardless of their risk, the opportunity now exists -- and will probably continue to exist for 3 more months -- to improve the quality of one's portfolio by shifting out of the most risky juniors and into those that offer more safety. ...The point is that the market has downgraded stocks indiscriminately, thus creating an opportunity to reduce overall portfolio risk without reducing upside potential."

We don't expect any of the junior gold/silver stocks in the TSI Stocks List to go out of business. If we did we would remove them from the List. However, some stocks are obviously less risky than others, and the opportunity to shift from the relatively high-risk to the relatively low-risk stocks without paying significant safety premiums still exists.

With the aim of reducing risk we are going to make one specific change to the TSI Stocks List at this time (as detailed below), but the general idea is to shift from early-stage explorers to miners that have, or are close to having, current PROFITABLE production; and amongst the early-stage explorers to shift from those that are cash-poor to those that are cash-rich. Stocks that have, or are close to having, current profitable production are allocated a risk rating of 3 or less (the risk rating is the second last column of the TSI Stocks List). Cash-rich early-stage explorers include ADM.V, CKG.V, KGN.V and SBB.V.

ATW.V (ATW Ventures), CGR (Claude Resources) and NSU (Nevsun Resources) are special situations in that they warrant a relatively high risk rating (4 or 5) even though they aren't early-stage explorers. ATW has about $10M of cash and is expected to advance its Burnakura project into production within the next few months, but we will leave the risk rating at '4' until there is a clearer indication from the company as to the project's completion schedule and economics. CGR has about 50K ounces/year of current production at its Seabee project, but has never been able to turn a profit from this production. Due to Seabee's marginal nature we have always considered that the bulk of CGR's upside potential lay with its early-stage Madsen project. NSU has moved into the development phase and has plenty of cash, but has high political and execution risk.

    New stock Selection: Capital Gold Corporation (OTC: CGLD, TSX: CGC). Shares: 193M issued, 198M fully diluted. Recent price: US$0.305

The change to the TSI Stocks List referred to above is the removal of Claude Resources (AMEX: CGR) and the addition of Capital Gold (OTC: CGLD). It would make no sense to exit CGR near its current ultra-depressed price unless it was possible to replace it with a stock that had a more attractive risk/reward ratio.

Thanks to the indiscriminate selling that has occurred in the stock market over the past few months, the lower-risk CGLD has been hit just as hard as the higher-risk CGR. This creates the opportunity to substantially reduce risk without sacrificing much upside potential (CGLD has a lot less risk than CGR and only slightly less upside potential).

Both CGR and CGLD have plenty of cash and about 50K ounces/year of current production. The most important difference is that CGLD's cash cost of production is about $225/ounce whereas CGR's cash cost is around $700/ounce. When other costs are factored in, at the current gold price this means that CGLD's production is very profitable whereas CGR's production is barely break-even. Other factors in CGLD's favour are its greater proven gold resource and its greater intermediate-term growth potential (CGLD's production is expected to be 70K ounces/year in 2009).

But not everything favours CGLD. For example, while CGLD has good exploration-related upside it doesn't have anything with as much "blue sky" as CGR's Madsen project. Also, CGR has an AMEX listing and a cleaner share structure. CGLD's management is considering an AMEX listing, but in order to qualify for the AMEX the company would have to do a reverse split.

Due mainly to CGR's Madsen-related upside we agonised over whether to make this change to the TSI List. In the end, the deciding factor was current profitability. The level of speculation amongst junior resource stocks will probably remain subdued over the coming months, meaning that the upside potential of the Madsen project will probably remain under-appreciated. At the same time, it will be difficult for the market to continue ignoring current profitability and strong earnings growth.

The CGLD story is quite an unusual one, for all the right reasons. In an environment where cost overruns and construction delays were the norm, the company brought its Chanate gold mine in Mexico into production late last year on time and below budget. Furthermore, the mine's performance during its first three quarters of operation was better than Feasibility Study projections. Such positive surprises are rare because almost every new mine has teething problems.

The Chanate project has a measured-and-indicated resource of 1.7M ounces, including 832K ounces in the P&P reserve category. A new resource estimate should be released early next year.

If the gold price averages at least $800/ounce then CGLD should generate cash flow of at least $30M next year. Assuming a conservative cash-flow multiple of 8 we therefore arrive at a rough valuation of $240M for the company. However, from this $240M we must subtract $18M for the royalties on the Chanate project owned by Royal Gold (RGLD), leaving us with a royalty-adjusted value of $222M. Based on the fully diluted share count of 198M, this equates to US$1.12/share.

    Chesapeake Gold (TSXV: CKG). Shares: 38M issued, 43.5M fully diluted. Recent price: C$4.11

CKG released its Phase 1 report on the Metates project last Friday. The report contained less information than we were expecting, but the information provided was very encouraging. In particular, initial indications are that the project is economically viable.

The Metates project has a historical (non-NI 43-101 compliant) resource estimate of 15.7M gold-equivalent (gold + silver) ounces. This calculation was done by Cambior, a former owner of the project, and much of CKG's work over the past several months has been directed towards confirming the drilling results achieved by Cambior with the aim of coming up with a NI 43-101 compliant resource estimate. CKG has also been drilling with the aim of expanding the overall resource.

CKG's drilling campaign has been successful to date and should provide the basis for a very large NI 43-101 compliant resource estimate. However, the company has not yet advised the likely timing of this updated estimate.

CKG has more than enough cash to fund its activities over the coming year and is, we think, a good core holding for long-term gold bulls. It is suitable for new buying near the current price, but note that care must be taken when buying/selling because it is a tightly held and illiquid stock.

Chart Sources

Charts appearing in today's commentary are courtesy of: