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 December of 2008. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 4 April 2011)

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

Will private banks take over where the Fed leaves off?

For the purpose of this discussion, let's assume that the Fed ends its current QE program as scheduled within the next few weeks. This means that we will soon reach the point where the Fed is no longer directly ramping up the money supply*. However, the private banking industry in the US has around $1.5 trillion in excess reserves (the banks are collectively holding 1.5 trillion more dollars in reserve than they need to 'back up' the dollars in demand deposits), which means that the private banks theoretically have enough reserves to grow the US money supply by many trillions of dollars without any further assistance from the Fed. The question is: will they do it?

The short answer is: probably not. The huge volume of "excess" bank reserves constitutes an inflation risk, but it's a risk that probably won't materialise during the next 12 months. Instead, it's likely that the private banks will continue to do what they have been doing over the past 2.5 years and what they did throughout the 1930s, which is 'sit' on their excess reserves. Now for the longer answer.

The risk, or the opportunity if you think that more money creation out of thin air is just what the US economy needs, is that the commercial banks will attempt to generate greater profits by putting their excess reserves to work. These reserves presently generate only 0.25%/year of interest income, so it should certainly be possible for the banks to earn a better return by making loans to credit-worthy borrowers. However, government statistics tell us that the US economy has now been in recovery mode for about two years, and yet the bottom section of the following chart tells us that the year-over-year (YOY) percentage change in "Total Loans and Leases in Bank Credit at Commercial Banks" has spent the bulk of this 'recovery' in negative territory and recently moved back into negative territory after turning positive for a few months. This prompts the question: If the banks didn't use their "excess reserves" to support additional lending during the statistical recovery of the past two years, then why should they start to ramp up their lending now that the statistical recovery has pretty much run its course?

Perhaps our economic outlook is too pessimistic and a period of much stronger growth lies immediately ahead, in which case conditions could soon become more conducive to bank lending. We doubt it, though. It looks, to us, like the economic rebound from the 2007-2009 collapse has seen its best days and that the banking trend is towards less, not more, lending.

Now, even when banks aren't expanding their loan books they can still increase the economy-wide supply of money by monetising securities such as Treasury bonds. The middle section of the following chart ("Investment Securities in Bank Credit at Commercial Banks") shows that this has, in fact, been happening to a significant degree since early 2009. Rather than making new loans, commercial banks have been generating profits by using the money they create out of nothing to purchase interest-bearing securities such as the debt securities issued by the US government.

The monetisation of debt securities by the commercial banks partly offset the deflationary effect of the post-financial-crisis contraction in the banking industry's collective loan book, but the YOY percentage change in overall bank credit (refer to the top section of the following chart) tells us that it wasn't sufficient to enable the private banking industry to have a net inflationary effect. Note, as well, that the current trend in overall bank credit is downward.

The fact that banks haven't done more with their "excess reserves" up until now suggests that they are being prevented from doing so by a reduction in the private sector's desire to take on debt, or by financial constraints such as large, but as yet unreported, holes in their balance sheets**. We suspect that it's a combination of the two.

The bottom line is that there will most likely not be a substantial expansion of US commercial bank credit over the next several months, especially if we are right to assume that the economic rebound has seen its best days. This means that if the Fed stops its "quantitative easing" in June then the US monetary inflation rate will soon begin to trend downward. Unfortunately, this doesn't mean that there is a realistic chance of the US experiencing deflation.

Since the inauguration of the TSI web site more than 10 years ago we've maintained that when the secular expansion in private sector indebtedness ended, as it inevitably would at some point, the government and the central bank would do whatever had to be done to keep the money supply growing. Until 2008 this was a theory based only on logic, but it is now a theory supported by both logic and empirical evidence. This is because the secular expansion in private sector indebtedness ended in 2008 (or, at least, it appears to have ended), and yet the Fed-Treasury team has managed to grow the total supply of US dollars by about 40% since August of 2008.

There is almost no chance of deflation, because if the commercial banks don't take over where the Fed 'leaves off' (as we expect) then the stock market will begin to trend downward and this will prompt the Fed to embark on a new round of QE. The sad truth is that under the current monetary system there is no limit to the amount of new money that can be created by the Fed, so the inflation will continue as long as the Fed's masters in government and banking desire more inflation.

    *Despite the assertions of some analysts to the contrary, "QE", as practiced by the US Federal Reserve, most definitely adds to the total supply of money within the economy, as opposed to just adding to bank reserves (bank reserves are not counted in the money supply). This is because QE results in the creation of new bank deposits as well as new bank reserves.

    **There are probably large holes in bank balance sheets associated with foreclosed residential properties. According to a NYT article on 22nd May, the biggest banks and mortgage lenders in the US "own more than 872,000 homes as a result of the groundswell in foreclosures, almost twice as many as when the financial crisis began in 2007, according to RealtyTrac, a real estate data provider. In addition, they are in the process of foreclosing on an additional one million homes and are poised to take possession of several million more in the years ahead." It's a good bet that the foreclosed houses that are assets on bank balance sheets have not been marked to market.

Uranium Update

Interesting quotes

The Stock Market

The US stock market will have very positive 'seasonality' at its back during this holiday-shortened week. This could pave the way for the senior US stock indices to make new 52-week highs within the next several trading days. However, such a move to new highs would likely coincide with some bearish divergences, one of the most important being a divergence between the S&P500 Index and the HYG/TLT ratio.

The HYG/TLT ratio is an indicator of risk aversion (the ratio rises as market participants become increasingly willing to accept risk) and usually moves in the same direction as the broad stock market. The relationship we are referring to is illustrated by the following chart. Everything was normal until mid April, when the S&P500 resumed its short-term upward trend while HYG/TLT continued to pull back. We now have the situation where HYG/TLT is testing its low for the year while the S&P500 is threatening to make a new high for the year.

This week's important US economic events

Gold and the Dollar

Gold and Silver

In our opinion, the most beautifully logical entity in the financial world is the gold/CCI -- or, in more general terms, the gold/commodity -- ratio. On an intermediate-term basis this ratio almost always does what it should do given the economic/financial-market backdrop. As evidence we cite the following chart-based comparison of the gold/CCI ratio and the TLT/HYG ratio. The TLT/HYG ratio trends in the same direction as credit spreads, which, in turn, trend in the opposite direction to economic confidence and/or financial market liquidity. In other words, an upward trend in TLT/HYG will generally be associated with a downward trend in economic confidence and/or financial market liquidity.

Gold, being the ultimate 'monetary commodity', should do better than commodities in general when economic confidence is declining and worse than commodities in general when economic confidence is on the rise. This should result in a positive correlation between the gold/CCI ratio and the TLT/HYG ratio, which is exactly what we observe on the following chart.

An important trend change appears to have occurred during the first two months of this year, with both gold/CCI and TLT/HYG reversing upward. This trend change is an intermediate-term bearish omen for the broad stock market.

The top section of the chart displayed below shows the US$ silver price and the bottom section shows the silver/gold ratio.

The importance of silver/gold's performance over the past few months should not be under-estimated. Silver/gold's huge run-up and ferocious downward reversal was a very clear signal that peaks of at least intermediate-term significance in the US$ prices of both gold and silver were either put in place at the beginning of May or would be put in place within the ensuing few weeks.

We are now well into a rebound that was almost obligatory following the crash that occurred during the first week of May. This rebound could lead to a new all-time high for gold bullion, but a new high by gold within the next couple of weeks would likely be accompanied by lower highs for silver, the silver/gold ratio, the HUI and the HUI/gold ratio; that is, it would likely bring about a situation that is rife with bearish divergences.

On a very short-term basis, there was a minor bearish divergence during the second half of last week due to gold breaking above its early-May rebound peak while silver and the silver/gold ratio remained below their equivalent peaks. However, there will hopefully be enough strength over the coming week or so to push silver back to the low-$40s, as this would create a good hedging/selling opportunity.

Gold Stocks

The main reason we expect the gold-stock indices to break below their May lows is that intermediate-term corrections in gold and silver bullion have very likely just begun, or if they haven't yet begun they will soon do so. The gold-stock indices sometimes lead at turning points, but it would be unprecedented for them to bottom near the START of an intermediate-term correction in the bullion. Another reason to be cautious is that the broad stock market is probably nearing an intermediate-term peak.

That being said, the likely downside isn't substantial. With the exception of the 2008 collapse, a repeat of which has almost zero chance of happening during 2011 due to the supportive monetary backdrop (regardless of what the Fed does with its QE, there is already enough monetary inflation in the system to preclude a 2008 repeat), no intermediate-term gold-sector correction over the past 10 years has resulted in the HUI dropping far below the bottom of the moving-average envelope shown on the following daily chart. In each historical case, the correction low was at or just below the bottom of the envelope. That's why we have picked 475 as a likely downside target for the HUI.

While the HUI stands a good chance of trading below its May low before the overall correction comes to an end, some individual gold stocks have probably already bottomed. For example, Catalpa Resource (ASX: CAH), Jaguar Mining (JAG) and Pretium Resources (TSX: PVG) probably bottomed during the first half of May at A$1.36, US$4.11 and C$7.89, respectively.

It is normal for many individual stocks to peak and trough at different times to an index that purportedly represents the stocks in question. That's one reason why buy/sell decisions should generally be made on a stock-by-stock basis, without placing a lot of weight on anyone's short-term forecasts for the associated indices. Another reason not to place a lot of weight on any short-term forecast is that doing so involves taking unnecessary risk. Rather than trying to buy at the bottom and sell at the top, which is an approach that often goes horribly wrong, it is much better to gradually build up positions on weakness and harvest gains into strength. Along these lines, we've been putting cash to work in the gold sector over the past three weeks due to below-the-market buy orders getting filled.

Moving on, the following chart shows the Junior Gold Miners ETF (GDXJ).

Upside targets for the current rebound are the 50-day moving average at $38.50 and resistance at $40-$42. A rise to the $40-$42 resistance range within the coming fortnight would create an excellent short-term selling opportunity, although we'll be surprised if it gets that high.

A drop back to the low-$30s would create a decent buying opportunity and a spike down to the $26-$28 support range would create a great buying opportunity.

Below is an interesting chart from Canaccord's latest "Junior Mining Weekly" report. The chart, which compares the gold price (the red line) with the P/NAV ratio (price divided by net asset value) for the universe of senior and mid-tier gold producers tracked by Canaccord (the black line), shows that the average valuation assigned by the stock market to gold producers has trended downward since Q3-2009. Over the same period, the gold price has trended upward. By the P/NAV measure, senior and mid tier gold producers are now, on average, about half as expensive as they were almost two years ago and almost as cheap as they were at the bottom of the 2008 crash. By other measures gold stocks are nowhere near as cheap today as they were at the 2008 bottom, but the P/NAV graph indicates that there is scope for a general upward re-rating of gold stocks.

Valuation usually isn't the most important short-term price driver, but low valuation limits downside risk.

Currency Market Update

The Dollar Index pulled back over the final two days of last week, partly due to suggestions that the ECB would continue with its rate-hiking program. The ECB should, of course, continue with its rate-hiking program, because artificially low interest rates can't possibly provide a net economic benefit. However, with two of the four largest euro zone economies (Spain and Italy) in recession, a few of the smaller economies in recession and several governments within the Monetary Union careening towards debt default, we suspect that the political pressure not to hike will become irresistible.

The US dollar's intermediate-term bottoming process was always likely to entail an initial rally followed by a decline to test the low. Last week's market action could mean that the initial rally is complete, especially considering that the Swiss Franc made a new high on Friday, although we can't yet rule out the possibility that the initial rally is still in progress. What we can say is that we would be buyers of US dollars, or sellers/hedgers of most other major currencies, if the Dollar Index dropped back to the vicinity of its early-May low.

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)

An example of how an equity financing SHOULD be done

Exploration-stage uranium miner Hathor Exploration (TSX: HAT) announced late last week that it had raised $13M via an equity financing. Everything about this financing was right. In particular, the new shares were issued at a 10% premium to the current market price with no warrants attached, and the financing was arranged in the aftermath of news that had driven the stock price sharply higher.

HAT didn't need to do a financing at this time because it had more than enough cash in the bank to fully fund its activities over the coming 12 months, but the best time to negotiate a debt or an equity financing is when you don't need the money. This is when you are likely to get the best deal. So often we see junior mining companies that are reliant on equity financing do nothing in response to large run-ups in their share prices, and then some time later with the stock price near a 52-week low and almost nothing left in the bank go 'cap in hand' to brokers in search of more money. The guideline that applies to investors/speculators also applies to company managements, in that shares should be sold when they are relatively expensive not when they are relatively cheap.

Last week's C$3.00/share financing will help to underpin the price of HAT shares. Absent a large fall in the uranium price, support in the C$2.20s probably now defines the maximum downside potential.

Chart Sources

Charts appearing in today's commentary are courtesy of: