[This blog post is a modified excerpt from a recent TSI commentary]

The main purpose of the GDP growth numbers and most other economic statistics reported by China’s government is to tell the story that the central committee of the Communist Party wants to tell. In other words, the economic numbers form part of the State’s propaganda.

For example, during the first decade of this century the Party’s objective was to show that the economy was performing in spectacular fashion, so the reported GDP growth numbers were almost never below 8% and regularly above 10%. In more recent years the overriding concern has been to paint a picture of stability and sustainable progress, which has involved reporting consistent GDP growth in the 6%-7% range. Refer to the following chart for more detail. Amazingly, most Western analysts accept these figures as if they were accurate reflections of reality, partly, we suspect, because there is no way to prove that what’s being reported is bogus.

Once in a while, however, something happens that shines a light on the meaninglessness of the official numbers. An example was the claim by China’s government that its economy was still growing at an annualised pace of more than 6% during the worst point of the 2007-2009 global recession. Another example very likely will be the quarterly GDP growth that China’s government reports for the first quarter of this year.

The consensus view in the financial news media appears to be that due to the SARS-CoV-2 virus, China’s GDP growth rate in Q1-2020 will slide from 6%+ to ‘only’ 4%-5%. The reality, however, is that China’s economy could not be growing at the moment. Large sections of the country have been essentially put in lock-down mode, and many factories, restaurants, shops and other businesses have been temporarily closed. Tourism has ground to a halt, home sales have collapsed by 90% and vehicle sales are expected to fall by 50%-80% from the same period last year. In some large Chinese cities, including Shanghai, the government has directed state property owners not to collect rent from small- and medium-sized businesses during February and March.

Other examples of the virus’s dampening effect on economic activity are included in articles published on 13th February at the South China Morning (SCMP) and Caixin. According to the SCMP article:

“Recruitment site Zhaopin said this week that around 10 per cent of firms they surveyed were “on the verge of death”, with around 30 per cent planning job cuts and another 30 per cent saying they could not pay their employees on time.”

Along similar lines, the Caixin article notes:

“Even before the outbreak, many small businesses were already grappling with shrinking sales as China’s economy logged some of its slowest growth in decades. With business now at a standstill during the outbreak, many are facing existential liquidity crises. Large numbers say they are having difficulties just paying salaries, adding they can only survive for a matter of months using their current resources, even if Beijing provides support.”

It should be obvious to anyone with at least rudimentary knowledge of the world that China’s economy is contracting right now. Therefore, if the government reports GDP growth of 4%+ for the first quarter of this year it will be a tacit admission that the official numbers are totally fictitious. By the same token, to retain any semblance of credibility China’s government will have to admit that its economy shrank during the first quarter of this year.

That’s why China’s next quarterly GDP number will be a test.

In a TSI commentary last November I wrote about adjustments I was making to my stock selection process. These adjustments weren’t due to issues with any individual stock(s) or the performance of any individual stock-market sector. In particular, the poor performance of the average junior gold-mining stock during 2019′s gold rally wasn’t the primary driver of my decision to make some changes, although it was the proverbial “last straw”. The primary basis for my adjustment was evidence that the investing landscape had changed in a permanent, or at least a semi-permanent, way.

Long-term changes in the investing landscape happen from time to time, that is, the future is not always a simple extrapolation of the past. This occurs not because of a change in human nature (human nature never changes), but because of a change in the monetary system. For example, the investment strategy that involved shifting from equities to bonds when the stock market’s average dividend yield dropped below the average yield on investment-grade bonds worked without fail for generations prior to the mid-1950s, but from the mid-1950s onward it didn’t work. The reason this ‘fail safe’ approach to asset allocation stopped working was the increasing propensity/ability of central banks to inflate the money supply.

As part of their attempts to encourage more borrowing and consumption, over the past few years the major central banks manipulated interest rates down to unprecedented levels. Ten years ago very few people thought that negative nominal interest rates were possible, but in 2019 we reached the point where 1) a substantial portion of the developed-world’s government debt was trading with a negative yield to maturity, 2) some corporate bonds had negative yields to maturity, and 3) banks in some European countries were offering mortgages with negative interest rates.

Due to the draconian efforts of central banks to promote more spending and borrowing, it’s possible that the public is now effectively ‘tapped out’. This would explain why the quantity of margin debt collapsed over the past 18 months relative to the size of the US stock market, something that NEVER happened before with the S&P500 in a long-term bullish trend and regularly making new all-time highs. Also, it would explain why the average small-cap stock (as represented by the Russell2000) is trading at a 16-year low relative to the average large-cap stock (as represented by the S&P500).

Linked to the relatively poor performance of the average small-cap stock is the increasing popularity of passive investing via indexes and ETFs. Over the past several years there has been a general decline in the amount of active, value-oriented stock selection and a general rise in the use of ETFs. This has caused the stocks that are significant components of popular ETFs to outperform the stocks that are not subject to meaningful ETF-related demand, regardless of relative value. There is no reason to expect this trend to end anytime soon. On the contrary, the general shift away from individual stock selection and towards the use of ETFs appears to be accelerating.

At this stage I’m not making dramatic changes to my stock selection approach. I will continue to follow speculative small-cap stocks, but my selection process will be more risk averse and I will reduce the potential tracking error during intermediate-term rallies in mining stocks by putting more emphasis on ETFs and mutual funds. Also, when making future speculative mining-stock selections I will pay greater heed to the attractiveness of the assets to large mining companies. The reason is that regardless of the public’s willingness to speculate, large mining companies will always be under pressure to replace their depleted reserves and add new reserves. The easiest way for large companies to do this is to buy small companies that have discovered mineral deposits of sufficient size and quality.

In summary, as a result of unprecedented manipulation of money and interest rates it’s possible that some of the investing/speculating strategies that worked reliably in the past will not work for the foreseeable future. I think it makes sense to adapt accordingly.

[This blog post is an excerpt from a TSI commentary published on 26th January 2020]

Given the extent to which the US stock market is stretched in both momentum and sentiment terms, there doesn’t have to be a news-related catalyst for a significant correction. However, the mainstream financial press tries to link every move in the stock market to the current news. If a correction began last week or gets underway this week it’s likely that many fingers of blame will point to the Wuhan virus.

The situation is ‘fluid’, but at last count 13 Chinese cities had been placed under full or partial lockdown in an effort to prevent the virus from spreading. Furthermore, the number of countries with confirmed cases of the virus is growing.

In terms of global economic impact we think that the Wuhan virus will prove to be a minor issue, but if the number of confirmed cases continues to rise then many market participants could sell first and ask questions later. Based on what happened with similar viruses in the past, the number of confirmed cases might not peak until March.

Blame for a correction also could be directed towards the Fed, largely due to a misunderstanding of the Fed’s “repo market” operations.

The net amount of ‘liquidity’ provided by the Fed to the repo market has declined over the past couple of weeks, but not because the Fed has stopped supporting this market. The money provided to the repo market is a very short-term loan that often matures within one day, so the amount of repo money provided by the Fed will reduce over time unless the Fed adds new money (makes new loans) at a rapid pace. For example, the Fed ‘pumped’ (loaned) $74 billion into the repo market last Thursday, but there was a net decline of $10 billion on the day due to the expiration of $84 billion of previous loans.

Also worth mentioning is that the amount of money provided by the Fed to the repo market cannot exceed the demand for short-term loans in this market.

We assume that the Fed intends to withdraw from the repo market over the coming months, with the very short-term money it provides via this market steadily being replaced by the semi-permanent money it adds via the asset monetisation program — the program that we aren’t supposed to call QE, even though it is mechanically identical to QE — introduced last October. If this happens it will result in a large decline in the “Repurchase Agreements” line on the Fed’s balance sheet and could result in a small decline in the total size of the Fed’s balance sheet, but it won’t be a sign that the Fed is tightening or even becoming less easy.

To further explain, note that even though many commentators lump the Fed’s repo market support program together with the Fed’s asset monetisation program to arrive at a total amount of new Fed-generated monetary inflation, the two programs are very different and should not be combined. The reason is that despite “repo” being short for repurchase, repo operations do not involve asset purchases per se. When the Fed does a “repo” it lends money (that it creates out of nothing) to a borrower and receives collateral, usually in the form of a Treasury security or a Mortgage-Backed Security (MBS), to secure the loan. When the loan is repaid, which happens one or fourteen days later depending on whether it’s an overnight loan or a term loan, the money is returned to the Fed (and is immediately extinguished) and the collateral is returned to the borrower.

Any monetary inflation caused by the Fed’s repo operations is therefore self-extinguishing within a very short time (1-14 days). However, monetary inflation caused by the Fed’s asset monetisation program could be permanent. The reason is that although the debt securities (T-Bills) purchased by the Fed with new money will mature within a few months, the Fed has said that it will re-invest (rather than extinguish) the proceeds received when the securities mature.

The upshot is that even if the total size of the Fed’s balance sheet reduces as the repo support program winds down, as long as the Fed is adding ‘permanent’ money via its asset monetisation program it is acting in an inflationary manner. Consequently, it will not be reasonable to blame a near-term stock market downturn on the Fed becoming tighter or less easy.

Just to be clear, the Fed is at least partly responsible for the fact that the stock market rose in a virtual straight line from mid-October through to 23rd January. However, the Fed is not responsible for the market pulling back from an overbought/overbullish extreme.

The crux of the matter is that regardless of the fundamentals, large and liquid markets don’t go up or down in straight lines for long. There are always corrections. Surely we don’t have to rack our brains in an effort to come up with a fundamental reason for a correction when some short-term sentiment and momentum indicators are stretched to historic extremes. It’s more of a challenge to explain why a correction didn’t happen sooner.

Do gold mining stocks, as represented by the Barrons Gold Mining Index (BGMI) or the XAU or the HUI, lead gold bullion at significant turning points? According to many analysts the answer is a resounding “yes”. However, according to the historical record the answer is “sometimes, but not consistently”. I’ll go with the historical record.

There are plenty of examples of gold mining stocks leading the bullion price at a turning point from down to up or up to down, but there are at least as many examples of gold mining stocks lagging the bullion at a turning point. The most blatant example of the latter occurred in 1980. It is well known that gold bullion reached a long-term price top in January-1980, but it is less well known that gold mining stocks, as represented on the following weekly chart by the BGMI, experienced a huge rally after the major high in the gold price and didn’t reach a long-term peak of their own until September-1980.

Another example of gold bullion leading the gold-mining sector at a meaningful turning point occurred during the mid-1980s. First, gold bullion reached a multi-year bottom in February-1985, but it wasn’t until July-1986 that the XAU reached a similar bottom. Second, the XAU commenced an intermediate-term rally in late-July of 1986, but as noted on the following daily chart the associated bottom in the gold price occurred about 6 weeks earlier.

Here are examples of the same lead-lag relationship from the more recent past:

1) Gold bottomed on a long-term basis in early-December of 2015, but the equivalent low for the HUI didn’t occur until mid-January of 2016. Gold then reached an intermediate-term top in July-2016, but the associated top for the HUI wasn’t put in place until about a month later. In other words, the gold-mining sector lagged the bullion market at both the start and the end of the 2016 intermediate-term rally.

2) Gold made an intermediate-term bottom in August-2018, whereas the HUI waited until September-2018 to make an intermediate-term bottom of its own. Then, in May of 2019 the HUI made a sequence of lower correction lows while gold bullion remained above the low it made at the beginning of the month.

In my experience, rather than labour under the unreliable assumption that gold stocks lead the bullion at turning points, any divergence or non-confirmation between gold stocks and gold bullion should be viewed as potentially bullish after prices have become stretched to the downside and potentially bearish after prices have become stretched to the upside. For example, after prices have been trending downward for several months, a new multi-month low in the gold price that isn’t quickly confirmed by the HUI or a new multi-month low in the HUI that isn’t quickly confirmed by the gold price should be viewed as a bullish sign. By the same token, after prices have been trending upward for several months, a new multi-month high in the gold price that isn’t quickly confirmed by the HUI or a new multi-month high in the HUI that isn’t quickly confirmed by the gold price should be viewed as a bearish sign.

To put it more simply, non-confirmations between the gold price and the related mining indices matter, but it doesn’t matter whether the non-confirmations involve relative strength or relative weakness in the mining sector.

[This post is an excerpt from a recent TSI commentary]

Over the past four months the Fed has added about $400B to its balance sheet. To put this into perspective, since early September the Fed has expanded its balance sheet at an annualised rate of around 30%. According to the Fed, the purpose of this dramatic monetary expansion was to address a temporary liquidity issue in the “repo” market. The question is: If the Fed is dealing with only a temporary shortage of liquidity in the market for short-term money, why did it introduce a program in mid-October to supplement the temporary injections of “repo” money with $60B/month of permanent money?

The answer is that the Fed is dealing with something more than a temporary shortage of liquidity in the market for short-term money. The fact that the Fed sees the need to remove $60B/month of Treasury supply from the market in addition to the Treasury supply that is being removed on a temporary basis via “repo” operations implies that the overall demand for Treasury debt is falling short of Treasury supply at the Fed’s targeted interest rates. Looking from a different angle, it is clear that at current interest rates the global financial system wants more dollars and less Treasury debt. The Fed is accommodating this desire by increasing the supply of dollars to the market and reducing the supply of government debt that must be absorbed by the market.

The key phrase in the above paragraph is “at current interest rates”. If the supply of and the demand for money and credit were permitted to balance naturally then interest rates would now be much higher. However, the Fed doesn’t want supply and demand to strike a natural balance; the Fed has decided that it wants the price of credit at a certain level and that it will use its power to create and destroy money to override natural market forces. In this regard the current situation is unusual only in degree, because the Fed has been attempting to override market forces for more than 100 years.

The US Federal government is not about to slow the pace at which it emits new debt. On the contrary, the rate of growth in government debt supply looks set to rise. Therefore, one of two things will have to happen if interest rates are to stay near current low levels: The Fed will have to keep absorbing Treasury supply at a rapid pace or the market’s desire to hold Treasury debt will have to increase substantially. The latter could occur in response to a sizable decline in the US stock market or a crisis outside the US.

Within a week of its mid-October announcement we wrote that the Fed’s promise to inject $60B/month of new ‘permanent’ money was a potential game-changer, in that it could extend the current cycle (prolong the equity bull market) and lead to more “price inflation” than earlier programs. We continue to think that a cycle extension could be on the cards, but if so the recession warnings that were generated by leading indicators during the second half of last year must disappear within the next couple of months.

[This post is an excerpt from a recent TSI commentary]

Over the past three months the year-over-year rate of growth in US True Money Supply (TMS), a.k.a. the US monetary inflation rate, has jumped from a 12-year low of 1.5% to a 2.5-year high of 6.1%. Refer to the first of the following charts for the details. This is due to the combination of the Fed’s new money-pumping scheme, which we are told is not QE even though it is identical to QE in terms of its effect on bank reserves, the money supply and the financial markets, and the expansion of commercial bank credit at close to its fastest pace in 10 years. The second of the following charts shows the year-over-year rate of change in commercial bank credit. If the commercial banking system continues to expand credit at the current pace and the Fed runs its new asset monetisation program until at least the end of March, then by the third quarter of next year the US monetary inflation rate will be above 10%. What does this mean for the financial markets and the economy?

Once a boom turns to bust there is nothing the Fed can do to stop or even delay the hardship that most people experience during periods of economic recession or depression. There also is very little the Fed can do after the boom-bust transition has occurred to prevent asset prices from tumbling. However, before the boom collapses, as eventually it must, it can be given a second (or a third or a fourth or a fifth) wind by a substantial new injection of money. Therefore, IF the boom is still mostly intact then the strong rebound in monetary inflation could prolong the cycle.

Given that the senior US stock indices are at all-time highs in dollar terms and are yet to signal long-term downward reversals in gold terms, it’s possible that the boom is intact. This means that the rebound in monetary inflation COULD prolong the boom phase of the current cycle. Whether it actually will is not knowable at this time. One of the ‘tells’ will be whether or not there is a sizable pick-up over the next three months in new manufacturing orders.

If the boom phase of the cycle is extended by the monetary inflation rebound it will be bullish for oil, industrial metals and the stocks of cyclical companies (the more cyclical the better), and bearish for gold, T-Bonds and “defensive” stocks.

Like old soldiers, old beliefs never die. In the financial world, one of the many old beliefs that clings to life despite a pile of conflicting evidence is the one about gold being primarily a hedge against, or a play on, so-called “CPI inflation”.

The belief that big moves in the gold price are primarily driven by “price inflation” as measured by the CPI was spawned by what happened during 1972-1982. As illustrated by the following chart, there was a strong positive correlation between the gold price and the 12-month rate of change in the CPI during this period. However, it is clear that the positive correlation of 1972-1982 did not persist over the subsequent 37 years. In particular, the chart shows that the most recent two major rallies in the gold price (the rallies that began in early-2001 and late-2008) had nothing to do with “CPI inflation”. These rallies got underway in the midst of steep declines in the CPI’s growth rate and were at no time supported by a rapidly-rising CPI. The chart also shows that 2019′s significant up-move in the gold price had nothing to do with a rising rate of “CPI inflation”.

All substantial gold rallies are driven by falling confidence in the monetary authorities. The fall in confidence can be associated with so-called “price inflation”, but it certainly doesn’t have to be. As was the case with the major gold rallies that began in 2001 and 2008, it can be associated with stock market weakness, concerns about future economic growth, stresses in the banking system and minimal “price inflation”.

At some point within the next 10 years there could be a major bullish trend in the gold price that is linked to a large rise in the CPI, but that’s not the most likely scenario. There’s a better chance that the next major gold rally will be set in motion by a long-term trend reversal in the US stock market. In fact, even the gold bull market of the 1970s had more to do with a long-term bearish trend in US equities (the US stock market peaked in the late-1960s and bottomed in 1982) than rapid “price inflation”.

Naturally, the US$ gold price will rise over very long (50+ year) periods as the US$ depreciates, but so will the US$ prices of many other assets. Within this group of assets that tend to rise in terms of depreciating currency over the very long term, gold’s unique property is its counter-cyclicality. Gold racks up the bulk of its long-term appreciation during the bust phases of economic cycles.

[This blog post is an excerpt from a recent TSI commentary]

During a gold bull market the “true fundamentals”, as indicated by our Gold True Fundamentals Model (GTFM), will be bullish most of the time. However, even during a bear market there can be periods of a year or longer when the fundamental backdrop is bullish most of the time. This means that the GTFM can’t be used to determine whether gold’s long-term trend is bullish or bearish. The historical sample size is small, but the most important prerequisite for the start of a gold bull market appears to be the start of a bear market in US equities.

That’s why we use a long-term weekly chart of the gold/SPX ratio with a 200-week MA to identify gold bull and bear markets. Unfortunately, at this time the chart (see below) is noncommittal, because gold/SPX bottomed in August of 2018 but is yet to make a sustained break above its 200-week MA. It’s possible that a gold bull market got underway in August of last year, but it’s also possible that we are dealing with a 1-2 year up-swing within a bear market.

The inverse long-term relationship between gold and the US stock market is not always evident over the short-term or even the intermediate-term, although over the past two years it does seem like the gold market and the stock market have been taking turns. This is illustrated by the following chart. The chart shows that there was a net gain in the SPX over the periods when gold trended downward and a net loss in the SPX over the periods when gold trended upward.

The implication is that gold’s next 3-month+ upward trend should unfold over a period in which the SPX generates a poor return (most likely a significant loss).