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   -- Weekly Market Update for the Week Commencing 30th September 2013

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 2013. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 23 January 2012)

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

Market
Short-Term
(1-3 month)
Intermediate-Term
(6-12 month)
Long-Term
(2-5 Year)
Gold Neutral
(10-Sep-13)
Bullish
(26-Mar-12)
Bullish

US$ (Dollar Index) Neutral
(24-Dec-12)
Neutral
(18-Sep-13)
 
Neutral
(19-Sep-07)

Bonds (US T-Bond) Bullish
(24-Jun-13)
Neutral
(18-Jan-12)
Bearish
Stock Market (DJW) Bearish
(15-Jul-13)
Bearish
(28-Nov-11)
Bearish

Gold Stocks (HUI) Neutral
(10-Sep-13)
Bullish
(23-Jun-10)
Bullish

Oil Neutral
(30-Jul-12)
Neutral
(31-Jan-11)
Bullish

Industrial Metals (GYX) Neutral
(30-Jul-12)
Neutral
(29-Aug-11)
Neutral
(11-Jan-10)


Notes:

1. In those cases where we have been able to identify the commentary in which the most recent outlook change occurred we've put the date of the commentary below the current outlook.


2. "Neutral", in the above table, means that we either don't have a firm opinion or that we think risk and reward are roughly in balance with respect to the timeframe in question.

3. Long-term views are determined almost completely by fundamentals, intermediate-term views by fundamentals, sentiment and technicals, and short-term views by sentiment and technicals.

Another nail in the coffin of the deflation case

For the entire history of the Federal Reserve prior to October of 2008, the Fed was not legally able to pay interest on bank reserves. However, the Emergency Economic Stabilization Act of 2008 gave the Fed the power to pay interest on reserves and the Fed has since made use of this power. We are going to explain why this change was made and why it greatly reduces the probability of future US deflation.

Before we outline the reason for the Fed's decision to grant itself -- by adding an item to an act that was being rushed through parliament at the time -- the power to pay interest on reserves, it is worth reiterating some facts about bank reserves. These facts rule out the reasons that have been put forward by some 'experts' to explain the Fed's new power.

Fact #1 is that when the Fed monetises X$ of assets it adds X$ to demand deposits within the economy and X$ to bank reserves held at the Fed (that is, held in Federal Reserve deposits). The demand deposits are liabilities of commercial banks and the reserves are assets of commercial banks. In effect, the reserves 'cover' the demand deposits.

Fact #2 is that although the reserves held at the Fed are assets of commercial banks, the commercial banks are strictly limited in what they can do with their reserves. The banks cannot, for example, loan their reserves into the economy or spend their reserves, but one bank can lend reserves to another bank and reserves will be transferred between banks as cheques are cleared (when a cheque written by a customer of Bank A is presented at Bank B, there will be a transfer of money and a transfer of reserves from Bank A to Bank B).

Fact #3 is that apart from a small annual drainage of reserves from the banking system due to the public's steadily increasing demand for physical notes and coins, all reserves held at the Fed will remain at the Fed until they are removed by the Fed. It is fair to say that the Fed has absolute control over the volume of reserves within the banking system.

Fact #4 is that total bank reserves can be separated into "required reserves" and "excess reserves". The amount of reserves defined as "required" is the amount needed to satisfy the minimum legal reserve requirement, but all reserves have the sole function of providing cover for money in commercial bank deposits.

Fact #5 is that reserves do not (and cannot) leave the Fed as a result of an expansion of commercial bank credit. When banks make loans and grow their deposits it is possible that some reserves will shift from the "excess" category to the "required" category, but an increase in bank lending cannot cause the banking system's total reserves to change.

A hypothetical example can hopefully make Facts 4 and 5 more clear. Assume that a) the total amount of money deposited in bank accounts is $10T, b) $2T of the aforementioned $10T is subject to reserve requirements, c) the legal reserve coverage is 10% (meaning that the banking system in our example is legally obligated to hold at least $200B of reserves), and d) the banking system holds $1T of reserves. The banks therefore have "required reserves" of $200B and "excess reserves" of $800B. Now assume that the banks lend $5T of new money into existence, $2T of which ends up in accounts that are subject to reserve requirements, while the Fed makes no additions to or deletions from bank reserves and the public's demand for physical currency remains the same. The result is that total bank reserves will still be $1T, but the quantity of reserves defined as "required" will now be $400B and the quantity of reserves defined as "excess" will now be $600B.

Fact #6 is that the Fed currently pays the same rate of interest (0.25%) on all reserves held at the Fed, regardless of whether the reserves are defined as "required" or "excess". This means that if part of a bank's reserves shift from the "excess" to the "required" category due to an expansion of its deposit base, there will be no change in the amount of interest earned by the bank on its reserves. In broader terms, the total amount of interest paid by the Fed on bank reserves will not be affected by the amount of new loans made and new money created by the commercial banking industry.

One implication of the above set of facts is that the payment of interest on bank reserves provides no disincentive whatsoever to bank lending. This means that the Fed did not start paying interest on bank reserves in order to restrict the amount of new money loaned into existence by the commercial banks.

Rather than providing a means by which the Fed could discourage bank lending, perhaps the Fed's decision to start paying interest on reserves was part of the central bank's wide-ranging bailout of private banks. That is, perhaps it was just another way to boost the assets of the private banks. This is the explanation we favoured until recently, but the numbers don't make sense. At an interest rate of 0.25%, even with $2.5T of reserves the annual interest payment would only be $6B. In the context of the overall banking system and the multi-trillion-dollar wealth transfer from the rest of the economy to the banks that was engineered by the Fed over the past five years, this is 'chicken feed'. It would not be worth the trouble. To put the aforementioned $6B interest payment for the entire US banking industry into perspective, over the past two years a single US bank called JP Morgan paid $7B in fines, suffered an $8B loss on its "London Whale" trading fiasco, paid $10B in legal expenses and is reportedly in the process of settling mortgage-related claims for $11B, all without noticeably denting the bonuses of its top executives.

What, then, was the real reason that the Fed changed the rules to enable the payment of interest on bank reserves?

The answer is linked to the massive increase in bank reserves that occurred as part of the Fed's draconian efforts, beginning in September of 2008, to inflate the prices of certain assets.

To understand why the change was made, first consider the ramifications if the change had not been made. With such a huge volume of "excess" reserves in the banking system, very few banks would ever find themselves in the position of needing to borrow reserves from other banks, and most banks would always be happy to lend their reserves to other banks at a miniscule rate of return. Consequently, the Fed Funds Rate (FFR), the overnight rate at which banks lend reserves to each other and the main interest rate directly targeted by the Fed, would be stuck near zero. This would not be an issue as long as the Fed wanted the FFR to be near zero, as is the case right now, but what would happen in the future when the Fed decided that a higher FFR was appropriate?

Further to the above, if the Fed were still limited by its pre-2008 rules of operation it would have no way of increasing the FFR in the future without massively reducing both the quantity of money and the quantity of bank reserves. To put it another way, as long as the banking system was inundated with "excess" reserves, the effective FFR would be stuck near zero regardless of where the Fed set its FFR target. Increasing the FFR would therefore necessitate a huge monetary contraction, but this would collapse the equity and debt markets.

Just to be clear, the problem of not being able to hike the FFR without implementing a crisis-precipitating monetary contraction stems from having a gigantic quantity of "excess" reserves in the banking system. If reserve levels were roughly the same today as they were at any time during the 50 years prior to 2008, then the Fed would only need to make a small adjustment to the supplies of money and reserves in order to hike the FFR.

Enter the new power to pay interest on bank reserves. With this simple addition to its powers it is now possible for the Fed to increase the FFR to whatever level it wants without contracting the quantities of money and bank reserves. It simply has to make sure that the interest rate on bank reserves is the same as its FFR target. For example, if the Fed sets its FFR target at 1% and the interest rate on bank reserves at 1%, then no bank will lend reserves to another bank at less than 1% regardless of how many "excess" reserves it has.

In summary, the ability to pay interest on bank reserves eliminates the future need for the Fed to contract its balance sheet in order to hike its targeted short-term interest rate. It is therefore another substantial nail in the coffin of the deflation case. 

According to the financial markets, Europe is doing fine

The main reason that we were intermediate-term bullish on the Dollar Index until recently was that we expected the euro-zone's government-debt and banking-system crises to resume during the second half of 2013. These crises are eventually going to resume, because the issues that led to the sharp decline in confidence during 2010-2012 have not been eliminated. However, the markets are telling us that it won't happen this year.

We present three charts as evidence that, rightly or wrongly, the markets are currently not worried about the euro-zone (EZ).

The first chart shows that the EURO STOXX Banks Index, a proxy for EZ bank stocks, recently made a new multi-year high. EZ banks have much weaker balance sheets, on average, than their US counterparts, but at the moment the stock market doesn't care.



The next chart shows the yield on the Spanish 10-year government bond. Despite a material increase during May-June, the 10-year yield remains near its lows of the past three years. Moreover, the current yield on the 10-year bond issued by the Spanish government is only 1.8% higher than the current yield on the 10-year bond issued by the US government. The debt market is therefore saying that an additional 1.8% per year compensates an investor for the higher risk of a Spanish government default versus a US government default.

This, in our opinion, is a good example of the madness of crowds. Investors are clearly ignoring the real risks in a scramble for yield.



The final chart shows the yield on the Italian 10-year government bond. The yield on Italian 10-year government bonds has risen by about 70 basis points (0.7%) over the past 5 months, but it is still very low. This reflects extraordinary complacency on the part of the debt market considering that a) Italy has one of the highest government-debt/GDP ratios in the developed world, b) Italy's economy is in a recession with no end in sight, and c) Italy is immersed in a political crisis precipitated by the legal problems of Silvio Berlusconi.

The Stock Market

The US S&P500 Index will probably make a new high within the coming month, but the US Bank Index (BKX) could be in the process of completing an intermediate-term top. As illustrated below, the BKX ended last week near a 3-month low and is testing well-defined support. Breaching this support would suggest that the banking sector had peaked.



We mentioned JP Morgan (JPM) above so it seems appropriate to now show a JPM chart. JPM's chart looks more bearish than the BKX's chart, but as is the case with BKX there is important support just below the current price. If this support is breached it will suggest that an intermediate-term top is in place.

Note that $42.50 would be the chart-based target for JPM following a breach of support at $50.

This week's important US economic events

Date Description
Monday Sep 30 Chicago PMI
Dallas Fed Mfg Survey
Tuesday Oct 01 ISM Mfg Index
Motor Vehicle Sales
Construction Spending
Wednesday Oct 02 No important events scheduled
Thursday Oct 03

Factory Orders
ISM Non-Mfg Index

Friday Oct 04 Monthly Employment Report

Gold and the Dollar

Gold

Last week's price action was non-committal. The gold market had a slight upward bias, but was unable to close above its 50-day MA. The price ended the week roughly mid-way between support at $1300 and resistance at $1376.



This week's price action will probably determine whether or not gold is going to test its June low. The reason is that the next installments of the ISM Manufacturing numbers and the Employment numbers, the two most important sets of monthly US economic numbers, will be published this week. How the gold market reacts to these economic data will likely be telling. For example, if gold shows resilience in the face of strong economic data it will suggest that the path of least resistance is to the upside and that the June low is not going to be tested.

We emphasise that it will be how the gold market reacts to the economic numbers rather than the numbers themselves that will tell us whether or not a test of the June low remains a realistic possibility. The coincident and backward-looking data could well reveal economic strength, but at some point the gold market will begin to discount the economic weakness coming down the track.

Aside from how gold reacts to this week's US economic data, a daily close above $1376 would rule out a test of the June low and confirm that an intermediate-term rally was underway.

Moving on, the following chart shows that the silver/gold ratio hit an 'overbought' extreme near the end of August and that September's market action has 'corrected' the situation. Note, though, that silver/gold is not yet 'oversold', which means that a low-risk short-term buying opportunity is not yet at hand for silver or gold.



Gold Stocks

At the end of the week before last, GDX, a proxy for the stocks of large and mid-size gold producers, broke below the upward-sloping trend-line that dates back to the late-June bottom. However, there was no follow-through to the downside last week. Instead, GDX essentially traded sideways.



GDXJ, a proxy for the stocks of junior gold producers and advanced-stage explorers, has performed better than GDX since the late-June bottom. As evidenced by the top half of the following chart, until now it has managed to hold above the upward-sloping trend-line that GDX recently breached. And as evidenced by the bottom half of the following chart, it is currently about 10% higher relative to GDX than it was at the late-June bottom.



If gold bullion drops back to test its June low then the gold-stock indices and ETFs will probably make new multi-year lows. Such a bearish short-term outcome will remain a realistic possibility unless the mid-September spike highs ($28.64 for GDX) are exceeded on a daily closing basis.

Currency Market Update

The following chart shows that the recent weakness in the Dollar Index is linked to weakness in large-cap US stocks (represented by the S&P500 Index) relative to large-cap European stocks (represented by the EURO STOXX 50 Index). The implication is that for the Dollar Index's downward trend to continue, European equities will have to keep outperforming US equities.



Continued outperformance by European equities is more likely to occur in parallel with a continuing global stock market rally, and a break below support at 79 for the Dollar Index will probably require several more months of global stock market strength. This is not the most likely outcome, but it can't be ruled out.

We are short- and intermediate-term neutral on the Dollar Index. We expect support at 79 to hold over the remainder of this year, but a meaningful US$ rally will require the sort of flight away from the euro that doesn't look like happening over the next few months.

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

Company news/developments for the week ended Friday 27th September 2013:

[Note: 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) reported results from infill drilling at its Tuligtic gold-silver project in Mexico.

The purpose of the infill drilling was/is to upgrade resources from Inferred to M&I and to confirm the continuity of high-grade mineralisation in the deposit's main zone. In this respect the drilling has been very successful to date, as exemplified by intercepts of 41.2m averaging 11.4 g/t gold-equivalent in Hole TU-13-309 and 89.5m averaging 2.0 g/t gold-eq in Hole TU-13-306.

  *Dragon Mining (DRA.AX) announced that it had earned a 60% stake in some exploration permits adjacent to its Svartliden gold production centre in northern Sweden. This news is not significant.

  *Energy Fuels (EFR.TO), a junior US-based uranium producer and the owner/operator of the only conventional uranium mill currently operating in the US, announced that it is raising $5M via a "bought deal" equity financing. The company will be issuing 31M new shares at C$0.16/share.

This low-priced financing reduces the overall per-share value, but is probably necessary for risk management purposes due to the low uranium price.

  *Pilot Gold (PLG.TO) was recently discussed by Bob Moriarty at http://www.321gold.com/editorials/moriarty/moriarty092313.html. Bob does a good job of explaining the tangible and intangible qualities that make PLG an excellent speculation.

  *Pretium Resources (PVG) announced more results from drilling linked to the bulk sample program and exploration drilling. The results contained numerous narrow intercepts grading more than 1,000-g/t of gold and were generally consistent with previous results.

In addition to reporting the results of Strathcona's bulk sample analysis, PVG will be completing an updated resource estimate and FS early next year.

  *Sprott Inc. (SII.TO), a fund management company focused on natural-resource-related investments, announced last Friday that it has launched a new global mining fund with Zijin Mining, China's largest gold miner and second-largest copper miner. The new fund will invest in publically-listed equity and debt instruments of gold, other precious metals and copper mining companies, and will initially be seeded with $10M from SII and $100M from Zijin. The aim is to grow the fund to around $500M through commitments from Chinese investors.

This gets SII's foot in the China door and is therefore a good deal for the company, although not a financially significant one at this time.

Candidates for new buying

From within the ranks of TSI stock selections, here are the best candidates for new buying at this time. These stocks have been singled out because in addition to having very attractive risk/reward ratios, they were among the strongest rebounders following the late-June gold-sector bottom (meaning: they stand a good chance of being among the strongest rebounders following the next bottom) and they do not have any financing difficulties.

1) EDV.TO/EVR.AX (last Friday's closing price: C$0.68)

2) EVN.AX at around A$0.75 (last Friday's closing price: A$0.87)

3) PG.TO (last Friday's closing price: C$2.14)

4) PVG (last Friday's closing price: US$6.99)

5) RIO.TO/RIOM (last Friday's closing price: C$2.09/US$2.04)

Apart from updating the Friday closing prices, the above is a repeat of what we wrote last week. Last week's price action supported our view that these stocks will probably be among the strongest rebounders following the next sector-wide bottom, because they were relatively strong on the couple of occasions last week when the gold sector tried to rally.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://bigcharts.marketwatch.com/



 
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