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

Parallels with the 1930s

There are always major differences between the current cycle and any previous cycle, so we should never assume that the financial markets will follow the same path, this time round, that they followed during an apparently-similar period from history. Having said that, the similarities between the current decade and the 1930s are becoming increasingly pronounced. 2008 is looking very much like 1938.

After the US stock market crashed in 1929, the Hoover Administration and then the Roosevelt Administration attempted to rejuvenate the economy by increasing government spending. This was done in a relatively moderate way during 1930-1932 by Hoover, and then extravagantly by Roosevelt beginning in 1933. The Roosevelt spending and regulatory spree appeared to have some positive effects, in that the economy began to recover during 1933-1934 and by early 1937 a fully-fledged boom was underway. This led Roosevelt to believe that he had successfully 'primed the pump' and that the economy had shifted onto a self-sustaining growth path. However, the economic strength of early-1937 proved to be a 'smoke screen' created by rampant inflation.

The 'smoke screen' began to clear during 1937 and the Roosevelt boom began to unravel at warp speed. The turnaround was so fast and so complete that by early 1938 the Great Depression was back in full force. The grand "New Deal" had apparently come to naught and the Administration found itself back where it had started. Actually, it was way behind where it had started because as well as failing to cure the Depression the New Deal had blown-out the federal budget, dramatically increased the federal debt, doubled taxes, reduced the value of the US$ by almost half, and put in place a regulatory quagmire that was severely hindering the productive efforts of private industry.

The Roosevelt Presidency was ultimately saved by the wars in Europe and Asia, as these provided the excuse for an even greater government-sponsored inflation.

Like the 1930s, the current decade began with a collapsing stock market, which, in turn, prompted a massive increase in government deficit-spending and the expansion of the government's regulatory tentacles. And as was the case during the first half of the 1930s, the huge increase in government spending during the first few years of this decade was followed by an economic recovery that eventually transformed into an inflation-fueled boom. The current decade then continued to mimic the experience of the 1930s in that soon after a drop in the rate of monetary inflation the artificial boom unraveled at a phenomenal pace. Just think: it was less than 12 months ago that many analysts were marveling at the unstoppable global bull market.

The 'Bush Boom' of 2003-2007 was like the 'Roosevelt Boom' of 1933-1937 in that both were, in effect, smoke screens created by rapid increases in the supply of money and credit. However, the 2003-2007 boom was more global in nature.

The similarities with the 1930s look set to continue, but whereas the build-up to war and then the outbreak of war provided the justification for an even bigger dose of inflation in 1938 and beyond, the signs are that this time round the primary justification will be financial rather than geopolitical. We certainly aren't ruling out the possibility that war-related 'excuses' for money-supply growth will emerge over the next couple of years. At this stage it just seems that saving the banking system from itself, arresting the decline in home prices and "stabilising the economy" will provide all the justification that's needed to crank-up the monetary printing presses.

Someone who gets it

The Stock Market

The US stock market gained enough ground during the final two days of last week to ensure that the S&P500 Index continued to hold above its July low on a weekly closing basis.

It is very unlikely that the MOAB (Mother Of All Bailouts) and the various other inflationary actions being taken/planned will bring the equity bear market to an end, but they could usher-in a very lengthy (6 months or longer) period of consolidation and thus extend the overall bear market into 2010 or even 2011. We'll talk more about this possibility after the MOAB's details have been confirmed.

Although the stock market has stopped going down, nervousness remains near peak levels. This is evidenced by the way the OEX Volatility Index (VXO) surged to a very high level about two weeks ago and then stayed there. Refer to the following chart for details. This is very unusual behaviour in that moves to such high VXO levels have, in the past, been short-lived spikes.

In addition to indicating that the stock market is still on edge, the ban on short selling could have something to do with the VXO and other volatility indices remaining near their recent extremes. The reason is that the inability to hedge or speculate by selling short could have increased the demand for options, thus boosting option premiums (the popular volatility indices such as the VIX and the VXO aren't measures of actual volatility, they are measures of the volatility implied by option premiums).

Like all the markets, the stock market's performance over the next couple of weeks will largely be dictated by news regarding the MOAB. One plausible scenario is that the stock market will shoot upward as soon as the MOAB deal is finalised, and then give back most of its knee-jerk gains as investors begin to have second thoughts about whether the deal actually fixes anything.

This week's important US economic events

Gold and the Dollar

Gold

Current Market Situation

The latest H.4.1 Report shows that the amount of credit extended by the Fed to banks and other financial corporations grew by $204B during the week ending 24th September. That's a 22% increase in one week! Just to be clear: the Fed extends additional credit -- and grows its balance sheet -- by providing Federal Reserve notes in exchange for some type of security. The security has historically been in the form of Treasuries, but nowadays almost anything can be used as security. In other words, the Fed has just created 204 billion new dollars within the space of only one week.

Now, in last week's Interim Update we said that the Fed's ability to print new money was limited by its own target for the Fed Funds rate (FFR), in that excessive money-creation by the Fed would push the actual FFR to below the target FFR. How, then, did the Fed manage to create such a huge amount of new money last week without pushing the FFR to well below the official target of 2.0%?

The answer is: it didn't. The Fed flooded the banking system with so much new money last week that it drove the FFR down to 1.2%. Refer to http://www.federalreserve.gov/releases/h15/update/ for details. In effect, there was an unofficial 80 basis-point rate cut last week (at least, a temporary one). As far as we can recall, the last time something like this happened was the week of the 9/11 disaster.

From an investment perspective, the upshot of the above is that after being a bearish influence on gold for more than two years the monetary backdrop is now becoming gold-bullish at a frenetic pace.

Gold's intermediate-term prospects are becoming increasingly bullish, but in the here-and-now its price continues to consolidate in the $850-$900 range. For a short while last Friday it looked like the metal was going to break upward from this range, but it wasn't to be. The failure of the gold-stock indices to react strongly to gold's move above $900 on Friday morning proved to be an omen.

The gold market will probably remain volatile this week as it and all the other markets continue to respond to new developments regarding the MOAB. It's possible that final agreement regarding the huge bailout will initially be regarded as overtly bullish for the financial sector and that it will take a short while for the markets to begin discounting the bailout's inflationary implications. If so, the market reaction to the aforementioned agreement could entail a fall in the investment demand for gold and a quick decline in the gold price, followed, a few days later, by the resumption of gold's upward trend. Alternatively, it is possible that the market will immediately 'see' the inflationary implications of the so-called "rescue package".

We don't know what the gold market's initial reaction will be once a bailout agreement is reached, but we strongly believe that a negative reaction would prove to be WRONG. We would therefore view a negative reaction as another good buying opportunity.

Bullionvault.com versus Goldmoney.com

Bullionvault.com and Goldmoney.com are two services that enable their customers to buy/sell gold via the internet and to choose the location of the vault in which the metal is stored. Neither service deals in "electronic gold"; rather, when you buy gold via either of these services you are buying a chunk of physical metal. It just so happens that the change of ownership is transacted electronically.

We've given Bullionvault.com a few positive mentions in TSI commentaries over the years. We have been very satisfied with the Bullionvault service and have therefore had no incentive to sample a competing service such as Goldmoney, but we suspect that Goldmoney.com is just as good. At least, we have no reason to believe that it isn't as good and are not aware of anyone having a bad experience with the company. Furthermore, Goldmoney.com offers its customers the added benefit of being able to trade physical silver.

Gold Stocks

We had identified the mid 350s as a logical place for the HUI's up-trend to pause and, therefore, a place at which it made sense to take a small amount of money off the table. The following daily chart shows that the HUI hit the aforementioned resistance last Monday and then pulled back over the rest of the week.

The 320s became a reasonable downside target after a pullback was set in motion, so the pullback could now be almost complete in terms of both price and time. However, the HUI could continue down to support at around 310 without doing any technical damage whatsoever. A drop to around 310 would constitute a 50% retracing of the preceding advance and would potentially complete the "right shoulder" of a "head and shoulders" bottom.

We suggest adding exposure to senior gold/silver stocks at the current level and especially if the initial market reaction to a bailout agreement leads to some additional near-term weakness. Two likely candidates for new buying are Yamana Gold (AUY) and Silver Wheaton (SLW).

Interestingly, the above-mentioned stocks have similar prices and chart patterns even though they are very different companies (daily charts are displayed below). For example, both stocks bottomed in mid September in the $7-$8 range, rocketed up to their 50-day moving averages at around $11, and then quickly retraced about half of their gains. The $13-$14 range is a reasonable short-term upside target for both stocks.

The CDNX (TSX Venture Composite Index), a proxy for the junior end of the gold sector, did not rebound as strongly as the HUI prior to last week's pullback, but this is to be expected because the demand for the most speculative gold stocks won't increase until it becomes obvious that the senior gold stocks have commenced intermediate-term upward trends. However, we think it will eventually be proven that the CDNX's plunge during the first 11 trading days of September created the ultimate correction low.

With reference to the following daily chart, a close above 1600 would be preliminary evidence that a correction low is in place for the CDNX.

Currency Market Update

Long-Term Outlook

We were long-term bears on the Dollar Index from the 120s down to 80, but when this index fell below 80 in September of 2007 we upgraded our long-term outlook to "neutral". Our thinking, at the time, was that there was only about 10 points of additional downside potential, and on this basis it made no sense to maintain a long-term bearish outlook.

Earlier this year, after the Dollar Index had fallen to the low-70s, we seriously considered upgrading our long-term dollar view to "bullish". Our thinking was that the US$ had become so under-valued relative to the other major fiat currencies -- especially relative to the euro -- that the upside potential over the coming 5 years had become significantly greater than the downside risk over the same period. Also, by March of this year the US$ had fallen far enough in Swiss Franc (SF) terms that it was nearing the bottom of the channel drawn on the following long-term chart. Finally and as mentioned in a number of TSI commentaries over the years, this chart shows that the SF/US$ exchange rate has traced out a post-1970 pattern that can be described as: 8-10 years down followed by 6 years up. So, as well as being close to its long-term channel bottom relative to the SF it seemed that the US$ was into the final 1-3 years of its bear market (assuming that the post-1970 pattern continued).

The main reason we decided against such an upgrade was the enormous US military machine. To be more specific, there's a firmly entrenched perception within the US Government that the US must maintain a strong military presence throughout much of the world and be constantly ready to project massive military force at the President's whim. This, in turn, creates a powerful inflationary bias because funding the military machine leads to far greater federal deficit-spending than would otherwise occur.

In effect, the perceived need to fund a global military presence adds to the US dollar's inflation risk. We cannot quantify this risk because we cannot accurately forecast US military spending, but in our minds the risk is big enough to offset the dollar's long-term upside potential resulting from its current under-valuation.

The US$ has rebounded over the past 2.5 months in response to: a) its attractive valuation relative to the euro, b) the unwinding of a large US$ short position, and c) the realisation that many other parts of the world will be following the US into recession. But at the same time, the US dollar's inflation risk has burgeoned courtesy of the efforts to offset the essential de-leveraging underway in the financial sector by leveraging-up the balance sheets of the Fed and the US Government.

Current Market Situation

The euro's short-term chart looks similar to the HUI's short-term chart, but we don't think the euro has anywhere near the upside potential of the gold sector. At this stage we expect the December euro to test, but not breach, resistance in the low-1.50s.

 

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)

Orsu Metals (TSX: OSU) (Formerly European Minerals). Shares: 457M issued, 621M fully diluted. Recent price: C$0.29

This is what we wrote about OSU in the 23rd July Interim Update, when the stock was trading at C$0.67:

"Half the [company's gold] resource is associated with the Varvarinskoye project, which is currently being ramped up and is expected to be producing gold at 80% of design capacity by year-end. It is expected that full production, comprising 140K ounces/year of gold and 25M pounds/year of copper, will be reached during the first quarter of 2009. If this occurs and costs are roughly as planned then Varvarinskoye will generate sufficient cash flow to justify around C$1.80/share for OSU. The company's earlier-stage projects are probably worth around C$0.20/share at this time, but should increase in value as more work is done. This gives us a rough total valuation of C$2.00/share assuming that current production/cost plans are achieved."

..."Performance is the key. If OSU's new management can simply do what they say they are going to do then the stock market will be forced to price the stock at a much higher level."

OSU's stock price has since plunged to C$0.29, so the Varvarinskoye project must have encountered major problems over the past two months, right? Wrong, the ramp-up to full production appears to be progressing well. For example, according to last Friday's press release the production rate has already reached 80% of design capacity and, as a result of a planned $5M upgrade, is expected to be well ABOVE design capacity by Q2-2009.

With the benefit of hindsight it is clear that we should have exited OSU earlier this year when it became known that delays in the production ramp-up were going to cause financial problems, but the benefit of hindsight is something we never have in real time. The financial and operational problems have since been overcome, but the price is now a lot lower.

Like most companies that have suffered large declines in their stock prices and have had to re-state their financial results, OSU has been served with a claim for damages. We don't think this ambit claim represents a significant risk.

OSU's current stock price exemplifies the irrational valuation evident throughout the world of junior resource stocks. Prices are irrationally low right now, and at some point in the future they will be irrationally high. We prefer to buy when prices are irrationally low, but that's just us.

Chart Sources

Charts appearing in today's commentary are courtesy of: