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 ended in 2012. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2018-2020. (Last update: 20 January 2014)

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

Setting the stage for the next collapse

When the central bank pumps money into the economy and suppresses interest rates it creates incentives to speculate and invest in ways that would not otherwise be viable. At a superficial level the central bank's strategy will often seem valid, because the increased speculating and investing prompted by the monetary stimulus will temporarily boost economic activity and could lead to lower unemployment. The problem is that the diversion of resources into projects and other investments that are only justified by the stream of new money and artificially low interest rates will destroy wealth at the same time as it is boosting activity. In effect, the central bank's efforts cause the economy to feast on its seed corn, temporarily creating full bellies while setting the stage for severe hunger in the future.

We witnessed a classic example of the above-described phenomenon during 2001-2009, when aggressive monetary stimulus introduced by the US Federal Reserve to mitigate the fallout from the bursting of the NASDAQ bubble and "911" led to booms in US real estate and real-estate-related industries/investments. For a few years, the massive diversion of resources into real-estate projects and debt created the outward appearance of a strong economy, but a reduction in the rate of money-pumping eventually exposed the wastage and left millions of people unemployed or under-employed. The point is that the collapse of 2007-2009 would never have happened if the Fed hadn't subjected the economy to a flood of new money and artificially-low interest rates during 2001-2005.

Rather than learning from prior mistakes, that is, rather than learning from the fact that the use of monetary stimulus to mitigate the effects of the 2000-2002 collapse led to a more serious collapse during 2007-2009 and a "lost decade" for the US economy, the 2007-2009 collapse became the justification for the most aggressive monetary stimulus to date. The damage wrought by previous attempts to artificially stimulate has resulted in the pace of economic activity remaining sluggish despite the aggressive monetary accommodation of the past several years, but it is still not difficult to find examples of the mal-investment that has set the stage for the next collapse. Here are some of them:

1) The suppression of interest rates has prompted a scramble for yield, which has pushed yields on higher-risk bonds down relative to yields on lower-risk bonds. The bonds issued by the governments of Spain and Italy now yield only slightly more than US Treasury Notes, the yields on investment-grade corporate bonds are now roughly the same as the yields on equivalent government bonds, and the yields on junk bonds are generally much lower than normal relative to the yields on investment-grade corporate bonds. This tells us that monetary accommodation has greatly increased the general appetite for risky investments, which is always a prelude to substantial losses.

2) Public companies have been buying back equity at a record pace, despite high equity valuations. One reason is that although equity valuations are high, debt is generally priced even higher. Regardless of how expensive a company's stock happens to be, from a financial-engineering perspective it can make sense for the company to borrow money to repurchase its own stock as long as the interest rate on its debt is lower than its earnings yield. Buying back stock boosts per-share earnings and often increases bonus payments to management, but it does nothing to expand or improve the underlying business.

3) The number of unprofitable IPOs during the first half of this year was the highest since the first half of 2000. What a waste.

4) The latest boom has been so obviously reliant on the Fed's easy money that the real economy's response has been far less vigorous than usual. This at least partly explains the reticence of corporate America to devote money to capital expenditure designed to grow the business and, instead, to focus on financial engineering designed to give per-share earnings a boost. IBM provides us with an excellent example. As David Stockman points out in a recent blog post, since 2004 IBM has generated $131B of net income, spent $124B buying-back its own stock and devoted $45B to capital expenditure. IBM has therefore been channeling almost all of its earnings into stock buy-backs and has bought back almost $3 of its own stock for every $1 of capex. Furthermore, 90% of the capex was to cover depreciation and amortisation. No wonder IBM has just reported declining year-over-year revenue for the 9th quarter in succession.

If interest rates were at more realistic levels there would be less incentive to buy back stock and more incentive to invest in ways to increase productivity.

5) Thanks to the combination of government support, low interest rates and a flood of new money, some large, poorly-run companies are staggering around like zombies, consuming resources that could have been used more productively. General Motors is a prime example.

6) On an economy-wide basis there has been no deleveraging in the US. This is evidenced by the following chart. Instead, the Fed's promotion of leveraged speculation and the government's deficit-spending maintained the steep upward trend in economy-wide credit. Consequently, in terms of total debt the US economy is in a more precarious position today than it was in 2007. It will therefore not be possible for interest rates to normalise without precipitating an economic collapse.



7) The abundance of cheap credit prompted hedge funds and private equity firms to buy more than 200,000 US houses, which in many cases are now being rented to people who lost their homes when the previous Fed-promoted boom turned to bust. This has boosted house prices and created the false impression that the residential real-estate market is immersed in a sustainable recovery, prompting new (mal-) investments in this market.

8) The strength in auto sales is linked to the ready availability of subprime credit, which, in turn, is an effect of central-banking largesse, making it likely that auto sales will tank within the next two years. This will not only affect the assemblers of cars and the manufacturers of the components that go into cars, but will also affect all the industries that are involved in the shipping, storage, selling and financing of new cars.

9) While there is no doubt that the shale oil-and-gas industry would have been a great success story without the flood of cheap credit engineered by the Fed, the flood of cheap credit has led to a massive increase in the industry's debt-to-revenue ratio that has probably made the economics of shale-oil production look better than is actually the case and made the industry acutely vulnerable to tighter monetary conditions. Consequently, despite its solid economic foundation there will probably be many bankruptcies within this industry over the next few years.

A final point is that just as you never really know who has been swimming naked until after the tide goes out, you will never be able to identify all the mal-investments until after the monetary stimulus comes to an end. 

The Stock Market

The US

The S&P500 Index (SPX) has essentially traded sideways since 10th June, which, not coincidentally, was the day that GDXJ confirmed the beginning of a tradable rally in gold-related investments by breaking above the top of its short-term channel. It is also worth pointing out that various indicators, most notably credit spreads and the RUT/SPX ratio, are sending bearish signals, and that the first half of July is a time of the year when the SPX regularly reverses direction on a short-term basis. However, the SPX hasn't yet shown any signs of weakness.

A daily close below 1950 would be a preliminary sign of weakness. It would suggest that the SPX was at least on its way back to the low-1900s and was possibly on its way back to its 200-day MA in the mid-1800s. The SPX hasn't visited its 200-day MA since the final quarter of 2012, so a decline of this magnitude is overdue regardless of whether or not the cyclical bull market is in trouble.



There was a short-lived burst of fear in the stock market last Thursday in reaction to news that a passenger jet had been shot down in Ukraine. This caused the Volatility Index (VIX) to break upward from its recent range, but the fear completely subsided within a few hours and the VIX was unable to sustain its breakout.



As an aside, we have some VIX August-$15 call options in our account that will be sold if the VIX spikes up to around 20 within the next four weeks. In the absence of a near-term volatility surge, these options will expire worthless.

Russia

Due to last week's news it is time to take another look at Russian equities, as represented on the following daily chart by the Market Vectors Russia ETF (RSX). The historical record suggests that Russian equities will be good performers over the coming 12 months if commodity prices trend upward, almost regardless of political and geopolitical considerations/risks. Our intermediate-term bullish outlook for commodities therefore piques our interest in owning RSX, especially since the Russian stock market's average valuation is very low.

RSX plunged last Thursday in reaction to the Ukraine news and only retraced a small portion of its Thursday losses on Friday. This price action means that a new opportunity to buy RSX could arrive within the next few weeks.

We'll try to identify the opportunity when it arrives.

This week's important US economic events

Gold and the Dollar

Gold

Goldman's Gold Forecast

Last week, a Goldman Sachs analyst reiterated his forecast for the gold price to drop to $1050/oz by the end of this year.

The Goldman Sachs gold-market analysis is much better than the gold-market analysis of Eric Sprott and many other high-profile gold bulls, because at least Goldman is looking in the right direction for clues as to what the future holds in store for gold. Many gold bulls, on the other hand, haven't the foggiest idea about gold's fundamental drivers.

Goldman's gold forecast has little chance of being correct, though, because it is predicated on a strengthening US economy and because gold's true fundamentals are trending in a bullish direction. Of particular importance, we note that:

a) The BKX/SPX ratio, a measure of how the banking sector is performing relative to the broad US stock market, gradually began to turn gold-bullish (meaning: bank stocks gradually started to weaken relative to the overall market) in early-July of last year and turned decisively gold-bullish in April of this year. This influential ratio will remain supportive for gold as long as it is making lower highs and lower lows.

Here's a daily chart comparing gold and the BKX/SPX ratio over the past four years.



b) The HYG/TLT ratio, a measure of US credit spreads, began to move in gold's favour (meaning: credit spreads began to widen, causing the HYG/TLT ratio to decline) at the end of last year and made a new 52-week extreme last week. As is the case with the BKX/SPX ratio, the HYG/TLT ratio will remain supportive for gold as long as it is making lower highs and lower lows.

Here's a daily chart comparing gold and the HYG/TLT ratio over the past four years.



Our guess is that the gold price will end this year in the $1400-$1500 range.

Another geopolitical drama disrupts the gold market

Ukraine is again the source of an increase in international tension due to the shooting down, either by Russia-backed Ukrainian rebels or the Ukrainian military, of a Malaysian Airlines passenger plane traveling in Ukrainian airspace last Thursday. This news caused the gold price to jump $20/oz, which prompts us to reiterate the following guideline:

All price gains made by gold on the back of international military-risk events will be given back.

It was therefore never likely that last Thursday's news would result in the resumption of gold's upward trend. In fact, it's possible that last Thursday's news has prolonged the correction that got underway following the 11th July spike to the high-$1340s by causing a premature surge in speculative buying.

The speculative gold buying that often occurs in reaction to news suggesting heightened geopolitical risk is uninformed. This is because heightened geopolitical risk is not a fundamental driver of gold's value.

Current Market Situation

In the 14th July Weekly Update, when discussing the likelihood that the gold market would 'correct' its recent gains before resuming its advance, we wrote:

"...a substantial correction is unlikely at this time. The 65-week moving average should now provide strong support, which suggests that gold should remain above $1310 on a weekly closing basis. The shorter-term moving averages of importance (the 50-day, 150-day and 200-day moving averages) are now either into the $1290s or should move into the $1290s within the next three weeks, which suggests that the $1290s is probably now the worst case for an intra-day downward spike."

Last week the gold price traded as low as $1292, but ended the week marginally above $1310. Last week's price action was therefore not out of the ordinary. Having said that, the fast pace of the decline during the first two days of the week and the news-related surge on Thursday could lead to a small extension of the correction in terms of both price and time. Furthermore, the speculative net-long position in COMEX gold futures hasn't yet fallen by enough to suggest that the correction is complete.

As mentioned in last week's Interim Update, it is now likely that the $1280s will be visited before a rise to new multi-month highs gets underway. However, regardless of anything else we would now view a daily close above the 17th July intra-day high of $1325.90 as an early warning sign that the correction is over.



Gold Stocks

The gold-mining sector held up quite well in the face of last week's $28 decline in the gold price. The HUI only lost 1.7% and the GDXJ/GDX ratio is not far below its high of the past two months.



As is the case with gold bullion, the market reaction to the latest Ukraine drama will potentially extend the gold sector's correction in terms of both price and time. We still think that moving-average support at around 225 defines the near-term downside risk for the HUI, but there is now a higher probability that this support will be tested before the upward trend resumes.

Traders and investors should use near-term price weakness to add to positions in gold-mining stocks in preparation for another strong 1-2 month rally. Our guess is that the next tradable rally will begin in early August.

The Currency Market

The euro is very close to breaking out to the downside. This means that it is now either very close to a short-term bottom or about to breach important support and project significant additional weakness.

A daily close below 134.9 would constitute a downside breakout and suggest that the currency was on its way to 130.



The recent weakness in euro-zone bank stocks is the most important bearish influence on the euro at this time. If this weakness persists then the euro will probably breach support, indicating that the decline is more than just a routine correction within a continuing intermediate-term advance.

In the euro's favour is the fact that speculators have already built-up a large bearish position in the futures market. However, although the speculative net-short position in euro futures is near an 18-month high, there is no theoretical limit to how high it could go. Furthermore, the speculative net-short position was more than double its current level when concerns about the euro's prospects were peaking in mid-2012. It is therefore possible that breaking below support at 134.9-135.0 will set in motion another wave of speculative selling, especially if the breakdown is accompanied by more threats of default within the euro-zone's banking industry.

Note that a breakdown in the euro in reaction to heightened fears about the solvency of Europe's banks would be fundamentally bullish for gold and would probably lead to a higher US$ gold price, even though it would result in a higher Dollar Index. However, the gold market's initial knee-jerk reaction could be to decline along with the euro.

Updates 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 18th July 2014:

[Note: AISC = All-In Sustaining Cost, FS = Feasibility Study, IRR = Internal Rate of Return, MD&A = Management Discussion and Analysis, M&I = Measured and Indicated, NAV = Net Asset Value, NPV(X%) = Net Present Value using a discount rate of X%, P&P = Proven and Probable, PEA = Preliminary Economic Assessment, PFS = Pre-Feasibility Study]

  *Almaden Minerals (AAU) has arranged a C$6M financing at C$1.50/share. This is a reasonable move by the company's management and was not unexpected (on 19th May we wrote that a small equity financing would probably be done during the second half of this year to top-up the treasury).

We estimate that AAU will have about US$15M in the bank when the aforementioned financing is completed. This should be enough to fully fund its business for the coming 12 months.

  *Asanko Gold (AKG) advised that the budget for building Phase 1 of the Asanko Gold Mine (Ghana) is $295M. This is almost identical to the figure contained in the 2012 FS arranged by PMI Gold, the previous owner of what is now Phase 1 of the Asanko project and what was previously known as the Obotan project. Phase 1 is expected to result in gold production of 200K ounces per year beginning in Q1-2016. Phase 2 will incorporate the Esaase deposit and will probably enable production to be increased to around 400K ounces/year.

In addition to confirming that PMI Gold's 2012 estimate for the Phase 1 capital cost remains valid, AKG's detailed engineering has also confirmed that other important components of the 2012 FS are still applicable. Consequently, AKG's Definitive Project Plan for Phase 1, which is scheduled to be complete in Q4-2014, shouldn't be materially different from the 2012 FS. This suggests that Phase 1 of the Asanko mine will be economically robust at $1300/oz.

AKG currently has $150M of undrawn credit and about $230M of cash, so Phase 1 is fully funded through to production.

  *Endeavour Mining (EDV.TO, EVR.AX) reported gold production of 122.5K ounces during the June quarter. This is well above plan and makes it likely that the company will exceed the top end of its 400K-440K-oz 2014 production guidance. This is simply an excellent result.

We suspect that EDV will break above major resistance at C$1.00 (the top of its long-term base) within the next month.



  *Pretium Resources (PVG) has filed a final short-form base-shelf prospectus with the relevant securities commissions in Canada and the US that will allow it to offer up to US$600M of new securities from time to time over the next 2 years. PVG's management is therefore paving the way for the additional equity financing that will be needed to build the proposed $750M underground mine at the Brucejack project.

This news is neither surprising nor significant. However, if PVG goes ahead and raises the money needed to build the mine it will be significant. Given that a sale of the project to a senior or mid-tier gold producer is the preferred exit strategy, it will indicate that the company has been unable to attract a buyer and has therefore been forced to 'go it alone'.

List of candidates for new buying

From within the ranks of TSI stock selections, the best candidates for new buying at this time are:

1) AAU (last Friday's closing price: US$1.47).

2) EDV.TO in the low-C$0.90s (last Friday's closing price: C$0.95).

3) EVN.AX (last Friday's closing price: A$0.82).

4) RSG.AX (last Friday's closing price: A$0.63).

5) SBB.TO (last Friday's closing price: C$0.81).

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://research.stlouisfed.org/