From The January 2012 HRA Journal

David Coffin and Eric Coffin

We are extremely comfortable that our prognosticating for 2012 may or may not work out.  Which puts us in the same camp as most others.  That said, a contrarian turn ahead of possible normalizing of the debt issues still with us that we suggested in December does seem to be gaining ground in the market.  With that should come a greater focus on basic technical indicators like metal stockpile changes.  We note small copper stocks on page 4, but will point out here these are focused by direction over weeks.  Don’t get hung up on day to day changes.  Both bull and bear issues in this market are really year to year, which means looking for value and for sustainability.

This month we review a gold juniors merger in the making.  It involves two Canadian focused explorers we have mentioned in the past, and which we put in the same room for reasons outlined in the review.  We are in an environment of high metal pricing, by historic standards, but weak risk appetite.  Combinations like this that pool talent in a busy sector plus complimentary assets may become more common.  They can lower risk in even early phase stories.              

Generally speaking, we are a little less cautious and a little more optimistic.  At a minimum, we expect gains to be more notable gains later in the year.

2012 has started out stronger than many were predicting.  Granted, the year is only two weeks old but some bullets have already been dodged.  Some credit for this should go to new ECB head Mario Draghi.  He's been a calm hand on the tiller so far.

The European Central Bank operates under many policy constraints. Germany's Bundesbank had heavy influence over the ECB's core mandate and it’s a Teutonic one indeed with inflation control and price stability as its sole remit.

Former ECB head Jean Claude Trichet followed the mandate closely until last year when he became more proactive.  Trichet still stuck to the script but became more creative in interpreting it.  His frustration with the Euro political class also became more evident as he neared the end of his tenure.

Trichet was ahead of the curve in raising interest rates twice and too slow to reverse the increases but he recognized the danger of a liquidity crunch in the banking sector.  Opening the lending window when he did in 2009 gave the Eurozone banking sector some breathing room.  Unfortunately, that respite wasn’t taken advantage of to clean up balance sheets in any meaningful way.

Draghi took over the ECB on November 1 and started to make changes quickly.   The first ECB governing meeting after he started the job marked the first cut in ECB rates in two years.  The real impact of the rate cut was psychological.  The message was sent that the new head of Europe’s central bank would do as much as he could while still staying within ECB mandate.

Draghi has generally agreed with the party line when discussing things like Eurobonds which Germany still flatly refuses to consider.   He has gotten considerably more creative when it comes to dealing with bank liquidity issues however.

In December, Draghi introduced the first three year refinancing operation for Euro area banks.   The facility allowed qualified institutions (basically any Euro area bank) to borrow from the ECB at a zero interest rate for a three year term.  Banks are required to put up collateral, normally holdings of sufficiently high grade sovereign bonds.

The facility was expected to total about 150-200 billion Euros.  The market was shocked when the loan total came in at close to 500 billion.

Banks needed the funding.  Euro area banks hold large amounts of medium term debt that has to be rolled over before the end of 2013 and many of the larger ones are being pressured to increase reserve ratios and tier one capital.

So is this the Euro version of Quantitative Easing?  Not exactly, though it looks like it if you squint.   Quantitative Easing is the creation of money out of thin air by a central bank for asset purchases.  The ECB didn’t (and probably won’t) take that step which would directly contravene its price stability mandate.   Draghi gets around that by setting up loan facilities.   When banks pay the loans back in three years (assuming they do) the ECB balance sheet would shrink again.

There would and should be some monetary expansion if the banks are taking these funds and re-lending them.  Traders treating the lending facilities as money printing are one reason for the Euro’s recent weakness.

A more important side effect can be seen in the charts above and below.  The chart above shows 10 year yields for the main Eurozone countries.  The scale is exaggerated because of Greece, but even at this scale you can see rates which were running higher start to peak and drop off after Draghi announced the credit facility in early December.

The chart below is shorter term and deals only with the three year yields for Italy and Spain.   The effects of the refinancing operations are much more obvious at this scale.  By the end of November things had spun out of control.   Yields were spiking higher and jawboning by politicians across the EU was having exactly zero impact on the yield curves.

The impact of the credit facility on the other hand has been dramatic.   Its helped to thaw the interbank lending market and some of it at least seems to be going into the sovereign debt market at well.   Draghi has noted that there are drops in money on deposit with the ECB on days when member states were holding bond auctions.

The implication is that some of these funds are being used to buy new sovereign bond issues.  These bonds can be used as collateral for the ECB credit facility.  There is little doubt this is part of what Draghi was hoping would happen though the health of the inter-bank market itself was a major concern.

Spain and Italy both sold bonds last week at roughly half the yield they had to offer to attract funds in December.  Bid to cover ratios were also significantly higher than later 2011 indicating generally stronger demand.

None of this makes the debt and deficit issues go away, but lower rates can help buy time and that is really the name of the game right now.  For most EU members and large European banks this is more a liquidity issue than a solvency issue.   Being able to roll over debt and issue new paper at half the interest rate is a huge help.

Note that we said it’s a liquidity issue for “most”.  For Greece it is very much about solvency and liquidity operations won’t be much help.  Greece needs a big debt write off. Period.  That was still being argued as this was written and there is real potential for it to end badly.

The biggest outlier on the chart on the previous page is actually Ireland.  It too is indebted to the point that it became a solvency issue.  Ireland’s issue was a real estate bubble that wiped out its largest banks that the government felt obligated to rescue.  Its fiscal situation was dire and it will take a long time to fix.  Unlike Greece however, the government and people of Ireland have made a lot of tough decisions to cut spending and the markets are taking them seriously.

Ireland’s yields have dropped 50% since mid-year.  While we’re leery of the short term economic impacts of hard austerity programs there are several countries that need to undertake them.  Ireland is proof the market will respond to a county’s efforts if they are serious and focused.

In the mist of these market changes S&P announced debt downgrades to a large number of EU states, notably France, as well as a rating cut for the European Financial Stability Fund.  It’s the last that was the largest concern.

S&P had telegraphed most of the other rating cuts, including France, and the markets took the changes in stride.  All three major rating agencies have seen their market credibility diminished after the subprime crisis.   They are viewed correctly as being behind the curve most of the time.  The other two major bond raters, Moody and Fitch, haven’t said what they would do though Fitch indicated it didn’t plan on downgrading France.

Both France and the EFSF carried out bond issues right after the downgrades.  France sold bills at better yields than last month and the short term EFSF bills were little changed.

None of the foregoing is going to change the drive for greater government austerity by northern Europeans.   That austerity will take its toll on this year’s EU growth rate.  How much of a toll will depend on how much slack gets picked up by the private sector and consumers to replace lost government expenditures.

The combination of ECB actions and market fears should help to ease things here too.  Recent investor surveys in Germany have shown the largest one month improvement in years and confidence surveys have also improved.  Most economic stats have been better than expected in the EU, though few doubt there will be some contraction this year at least.   It may be less severe that expected though if consumers in Europe continue to cheer up.   One side benefit of the uncertainty is the large drop in the Euro.   Germany is the world’s strongest export economy next to China.  Getting a 10% discount on its currency is a good thing.

Gold, Copper

The Euro discount is helping German exporters but didn’t do the gold price any favors.   Gold has seen a nice bounce in the past two weeks aided by Iranian sabre rattling.

The Euro could see more weakness if the economy gets worse or traders convince themselves the ECB’s ultimate aim really is printing Euros.   Draghi plans another lending facility in February and if it’s another big one that might generate Euro selling.

Notwithstanding the Euro, gold has seen heavy physical buying with strong demand from Asia and from ETF buyers.   Copper has also gotten an assist from China.   Beijing announced above consensus growth numbers for Q4.  It was sort of a Goldilocks number; strong enough to allay fears of a hard landing but weak enough to generate hope that Beijing would open its wallet and start spending heavily.  Strike activity has kept copper warehouse stocks on a downtrend.  LME stocks are sitting at the 350kt level they bottomed at in 2010.  More drawdowns should be supportive of copper prices.

Gold managed not to enter a “bear market” and has seen a good bounce.  More good news from Europe and stronger markets that generate more risk on trading can both help it.   The amount of physical and ETF demand as gold prices neared a 20% drop was impressive.  Traders are still very much “buying the dip” which is classic bull market behavior.

Stocks

Equity markets are looking less classic, but they have advanced much further than many seem to think.  The bottom for US markets followed the debt ceiling debacle and they have been climbing by fits and starts since.   Large US indices have now reached levels they last saw in July.

Unscientific as this may sound this simply feels like a market that wants to go up.  Its felt that way to us for over a month.  Recent trading activity and economic numbers have simply strengthened that impression. It would not take a lot of good news to start the next leg up.

Things have been tougher in the junior space, but trading is constructive.  We’ve been seeing strong volume on some of the most beaten down stocks.  This may be tax loss sellers repositioning which is the first step to recovery.  More high volume days are needed but a spring rally still looks like a strong possibility to us.

Ω

 HRA Advisories is pleased to host the inaugural Toronto Subscriber Investment Summit on March 3^rd, 2012 in Toronto. This subscriber only event is intended to provide YOU with expert insight into today’s resource market, as well as some of the most active public companies in the industry today. Don’t miss out on this exclusive event! For more details please go to: http://www.hraadvisory.com/summit_2012.html

Published by Stockwork Consulting Ltd.

Box 85909, Phoenix AZ , 85071 Toll Free 1-877-528-3958

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It’s too early to say with assurance that the bottom is in until the EU delivers but it’s time to be looking hard at undervalued stocks on the list.   Economic stats have also largely cooperated.  Barring another policy error it doesn’t look like there is a recession in the cards near term.

All that said, the technical damage to many stocks has been serious and we’re heading into tax loss season.  Stick with names that have resources in the ground they are growing.  They should react best and see less tax loss selling.  Earlier stage companies will find loss selling harder to avoid unless they are delivering good news and promising more to come.  Others should be waited on to see if better prices are available in November.

If you’re not comfortable yet, early November is worth waiting for.  If the EU delivers a weak plan for the banks there could still be another pullback.

The rollercoaster ride continues as markets gyrate daily based on rumour and innuendo.  This is going to continue until there is some sort of formal agreement between EU members, and palpable action by the core countries.

While the Greek situation still makes headlines, Greece itself is no longer the core issue.    This has always been about debt write offs and the impact they would have on the European, and by extension, world financial system.  We’re not saying that Greece is not the cause (or today’s version at least) of the problems.  But it’s also a symptom of broader political sclerosis that has kept cures from being implemented.

When the world teetered on the financial chaos three years ago, Europe and the US took different approaches to the problem.   In the US, enormous sums of money were thrown at the problem.  Many think too much money was expended on the issue and that “bankers” didn’t deserve the help.  Perhaps, but it was the right approach.  Major liquidity crises need major liquidity to quell them.  When the markets doubt the solvency of financial institutions and depositors start lining up to take their money out it’s not the time for half measures.

The US went for financial shock and awe.   The numbers were enormous both in terms of guarantees to underwrite potential losses and direct investments in failing companies to keep them afloat.

There is still debate over those measures but few disagree they were necessary at the time.   The world’s financial system very nearly collapsed.   Lehman was a test case and the market’s response was a total vaporization of liquidity and a frozen interbank lending system.  No one thinks the solution was perfect, but the list of US based banks traders are worried about now is not long.

Europeans had their own problems at the time.  Some were dealt with and the ECB also undertook major liquidity operations but the EU went much easier on the banks than the US and other jurisdictions.  Discomfort with expending more money than absolutely necessary on what was viewed as an American problem meant solutions were minimalist.

That is what is coming back to haunt the markets now.  Like the US, the EU ran stress tests on its major banks, but few outside the bureaucracy took those tests seriously.   The number of banks judged failures and the capital additions required were suspiciously low.  The tests did not include a sovereign default as a possible scenario, even though four EU member countries are on fiscal life support.   The tests were viewed as a PR exercise that failed woefully.

That fact was brought home when Dexia, a French-Belgian municipal bank, saw its credit lines dry up and had to be rescued.  Dexia was “rescued” in 2008 too, and judged to have adequate capital, if only barely.  The market and other banks thought differently.

Dexia is now being broken up and nationalized but its demise may be a blessing in disguise.  We’re not sure its failure qualifies as a “Lehman moment” but it definitely made the stakes clear for a large number of European politicians.

Market pressure has led to emergency meetings between the leaders of France and Germany which culminated with pledges that a plan to recapitalize Europe’s banks would be in place by month end.  Signs of some decisiveness have cheered the markets but this isn’t over yet.

Most major decisions and new initiatives at the EU level require backing by all 17 voting members.   Simple or even super majorities are not enough.   This system was designed to comfort smaller member countries that feared larger core countries would dominate the agenda. Admirable perhaps, but many would say unrealistic since the larger countries that foot most of the bill will always be the most important decision makers.

The drawback of this system is highlighted by the machinations involved in trying to create the European Financial Stability Facility (EFSF).  Creating the fund involves pro rata financial contributions from member countries based on their size.  That in turn requires a legislative vote to approve the contribution.

Sixteen counties voted for the EFSF.  The last vote was held in Slovakia and the first vote went against the ESFS.  In truth, the vote wasn’t really about the stability fund by the time it was made.  The first ESFS vote was appended to a non-confidence motion on the assumption this would get the vote through.  This gave one of the minority parties in the ruling coalition an opportunity to bring down the government which it proceeded to do.  Coalition members are still tussling over terms of a vote that would pass the EFSF as this is written.

Slovakia is the second poorest nation in the EU, accounting for 0.5% of the Eurozone’s GDP. Its contribution to the ESFS will be nominal.  Whatever the reasons for its no vote, letting decisions on something as serious as a banking crisis be hijacked points to the EU’s major weakness.  Giving everyone a vote is laudable but Europe needs some realpolitik.  Those paying the bills need to be able to make their decisions stick.

The markets took the Slovakian vote with surprising equanimity. This reflects the comfort markets are getting from renewed seriousness and focus on bank solvency by France and Germany.  Recent comments by Sarkozy and Merkel indicate they will hammer out a plan for bank recapitalization before next month’s G20 meeting.

Germany wants to see capital infusions come first from investors, then the bank’s home country if necessary and the EFSF only as a last resort.  This seems like the right order, though its likely to be tough to get investors to step up at this point. The plan being devised may also include recommendations to start talking about tighter integration of the EU financial system. Many counties are still unsure about this but some sort of central agency is clearly needed.  The current system simply can’t react quickly or forcefully enough during a crisis.

Things could still go wrong, but the markets have reacted positively to recent announcements.  The EU has a history of big promises followed by small actions. That pattern will have to be broken this time. Stickhandling recapitalization of multiple banks in different jurisdictions won’t be easy but it can be done.

It has to be done so that the EU can follow through with a Greek default.  It will be a managed default. Capital injections for banks will be the carrot; enforced larger write-downs of Greek debt will be the stick. The EU may try and stall this too but it’s inevitable. The market has already priced this in assuming a much larger write down for bondholders than the 21% agreed to in July.  As long as the EU acts forcefully enough to prevent contagion the effects of a default should not be major negative event.  Everyone knows it’s coming.

While Europe was going through this drama, the US was setting up for another season of political inertia. The Jobs Bill has been voted down and the wrangling will begin again.  It’s very possible there will be no substantive action on anything for the next year in Washington.  The market would not be pleased if Democrats and Republican can’t at least agree on budget cuts.

The chart above depicts the value of the Euro in UD Dollar terms for the past two months.  The twists and turns in the political drama are obvious on the chart.  As Greek default looked increasingly likely and the EU response weak the Euro fell by close to 10% during the month of September.  The move was magnified by flight to safety trades that moved money into US Treasuries.

Since Europe’s core countries acknowledged the depth of the problems and started working on the bank recapitalizations everyone wants the Euro has been climbing at an impressive rate.  Its moved up close to 5% against the $US in the past two weeks and is still climbing as this is written. The Euro/$US exchange rates is one of the most direct measures of the fear levels in the markets

Metal Markets

The Euro chart on the previous page goes a long way in explaining the gyrations in the gold price in the past month.   The fear trade generated both profit taking and margin calls across all markets and precious metals were not exempted.

When markets fall hard and the margin calls go out traders usually sell their winners first and hope for the best with losers.  As a winning trade, gold and silver were obvious choices for selling.   The downshift was exacerbated by increases in margin requirements of 21% for gold and 16% for silver put in place by Comex.  That would have simply made the selling decision that much easier.

The fear trade also saw the return of the Dollar Bulls, but we suspect their day in the sun will be brief.   With high odds of legislative gridlock in the US and continued slow growth the Dollar should move back to its recent trading range as long as the EU continues to advance solutions to its debt crisis.

Copper and other base metals saw even more dramatic price falls.  The red metal dropped 30% in the space of a few weeks, returning to price levels last seen in early 2010.

We were not surprised the copper price fell; we’ve been predicting for months that such a move was coming. Even so, the speed of the move was impressive.  To us, that implied there were some significant speculative positions being unwound. Margin requirements were also increased for copper which would have sped the selling.

Most base metals appear have found price bases as equities rise.  Copper inventories in both London and Shanghai have been falling.  The drop isn’t dramatic yet but this is the pattern you want to see when looking for a price bottom.  We don’t know if this is end users consuming copper or buyers stockpiling it for later but it’s still a good sign.

Bulk and agricultural minerals are still holding up well Iron ore has seen its price drop a few percent and potash is maintaining the price increases from the summer. Base and bulk mineral prices are all about China.  Recent data show a flat manufacturing sector and shrinking trade surpluses.   Beijing has kept monetary conditions tight all year to quell its growing inflate on rate. Inflation may have peaked but hasn’t fallen back much. China isn’t likely to loosen monetary conditions until it falls further.

 Outlook

 Virtually all of the world’s major bourses fell into bear market territory before the recent bounce.   Traders are discounting a recession in most regions.

Although analysts have predicted each month’s data would be worse than the last, that hasn’t been the case yet.   While weak, Purchasing Managers Indices in most of the G8 were better than predicted this month.  They are still at levels that imply continued growth, if only barely.

Likewise, retail sales in most regions continued to be positive.  September retail sales in the US beat expectations by a wide margin and the formerly flat August number was revised upward. Employment growth in the US exceeded low expectations and the prior two month’s numbers were also revised upwards.  Current economic readings imply growth near 2% for Q3, higher than recent predictions.

The chart above shows the Conference Board’s Leading (blue) and Coincident (red) economic indicators going back 10 years.  The Coincident indicator continues to move up as does the Leading.   This measure isn’t perfect but it does indicate conditions are still expansionary.  The Leading Indicator doesn’t mean there can’t be or won’t be a recession but it’s not showing in the data yet.

Earnings season is upon us again.  Early reports will be dominated by the financial sector and most of those won’t be great.  Overall however, growth in earnings of 10%+ is still expected. This could help markets continue to heal—if Eurozone politicians get the job done right this time.

The situation is still shaky but things look far better than they did last month.

We’ll leave you with an interesting chart by Citigroup. The chart compared expected returns (solid blue line) with actual returns over the following 12 months (light blue shading). The chart shows that the higher the expected returns get the less likely it is they will be realized.  It’s a concrete representation of the contrarian idea.  The more euphoric traders are the more likely it is their hopes will be dashed.

The “good” news is that the markets are not euphoric at all right now and are actually just coming out of “panic” territory.   This model doesn’t predict tops and bottoms.  The fact it’s in panic territory doesn’t mean the market can’t go lower. It does imply 12 month forward returns should be positive, perhaps quite positive. Something you can look forward to after several months of ugly markets.

To view Eric Coffin’s latest interview on the Money & Wealth Show [October 1] please click here. Eric Coffin discusses with Victor Adair the current market volatility, when to get back into resource stocks and the Yukon area play.

Gold and, for once, senior gold stocks have been the place to be.  Even if markets stabilize, gold has proven itself to more new owners that ever before.  It would dip on stronger equity markets but its reached another new plateau.  Gold explorers make up the bulk of the updates and we have added a 2011 Yukon Watch list.   Northern gold explorers continue to trade very well given the horrible market backdrop.  We are still waiting for definitive results on this year’s crop but it seems clear a winner in the region will trade better than the markets.

Traders are giving up on politicians and counting on central bankers.  We may see better trading ahead of the US Fed’s Jackson Hole summit this weekend, the site of last year’s QE2 announcement.  We’re not convinced yet there will be a QE3, so we could see more turbulence afterwards.  Gold is the standout and will help companies that find it and mine it but the markets will not before the faint of heart for the next while.

Brinkmanship on one side, bumbling on the other and markets caught in the middle.   It’s been a terrible month for markets and an even worse one on the political leadership front.   Markets have suffered the worst dive since 2008. The markets direction going forward is very much dependent on traders believing politicians can get ahead of the curve and “deal with” debts issues in the US but especially in Europe.

Major indices in North America flirted with “bear market” drops of 20% and several large exchanges in Europe and elsewhere have already seen drops of that much and more.  Traditional indicators of fear across the markets including Treasury yields, volatility readings and, of course, the gold price have been pushed to extremes.

While many of the debt troubles can be traced back to the 2008 debt crisis, its politics that have become the heart of current market issues. So far, politicians have proven to be inadequate to the task at hand.  This does not bode well for the markets or the economy unless there is a sudden outbreak of stiff backbones and cooperativeness in the halls of power.

Leaders across the G7 (the ones not at their cottages at least) have insisted they were prepared to do whatever necessary to stop debt contagion.  A nice sentiment but, like many similar pronouncements in recent weeks, it included no concrete plans. Lack of direction or a roadmap out of the current crisis is keeping markets on edge.  Rumors of weakness at various large financial institutions are easily peddled, widely believed and traded viciously.

So far, the soothing has been left to central bankers.  The ECB has been the most forthright and active.  The European Central Bank has been buying up Italian and Spanish government debt to push those yield curves down.  That was a brave move on the part of Jean Claude Trichet. It’s no secret several members of the ECB board were screaming foul about that trade.

So far it’s also a move that has worked.   Yields on 10 year Italian and Spanish bonds have dropped 1.5% in the past two weeks. Two year notes issued by the Italian government on August 10th bore a 2.96% yield, 71 basis points below the yield on a similar auction a month ago.

In the US , it was left to Ben Bernanke to do something definitive, if not dramatic.   At this month’s Fed meeting, Bernanke put a timeline on the “extended period” of low rates, promising to keep the current rate in place until the middle of 2013.

This made markets happy for a couple of hours though it too drew catcalls from some.  The move does take away a lot of flexibility from its actions.  We’re not sure how good a thing that is.  The Fed already has constraints with such a dysfunctional bunch of politicians in Washington.  The Fed board could still increase its balance sheet but many of the stronger actions it might contemplate would need political cover that isn’t likely to be forthcoming.

There are several inflation hawks on the Fed board to satisfy.  They won’t be happy about the latest 0.5% CPI increase.  We think some moderate inflation is the best thing that could happen to a debtor country issuing chits in its own currency.  Inflation is the most painless way to debase the debt, even if it’s a genie that’s hard to control once it’s out of the bottle.

In the US, down-to-the-wire debt ceiling negotiations combined with a cynical and ineffectual last minute agreement weakened the markets considerably.  The big losers on both sides of the Atlantic have been the banking sector, though selling is broad based.

European politicians fared no better. EU members agreed to an expanded stability fund that most observers think should be three or four times the agreed size.  This is based on the assumption fund would take over the job of sovereign bond buying from the ECB.  Just getting the scaled down fund final approval will take a vote by 17 separate member country legislatures. The EU is not built for the speed that decision making during a financial crisis requires. The markets are making it clear they want to see concrete action, not just press conferences.

The US deficit deal led to the loss of S&P’s AAA rating.  The announcement rocked markets worldwide but should not have been a surprise. The credit rater drew a line in the sand months earlier, insisting a plan to cut $4 billion from US federal deficits over 10 years was the minimum requirement for keeping AAA.

The Washington agreement promises $2.4 billion in cuts and most of that must be determined by a committee certain to be as fractious as this month’s political farce.

Debt uncertainty, worries about recession, downgrades, runs on Italian debt and rumors of bank troubles in Europe created a perfect storm of selling.  In the past few sessions markets clawed back some losses though daily swings have been huge and the markets are only one bad day away from lower lows. The question now is whether the combination of shocks has been powerful enough to create a recession.

Consumer spending and employment numbers in the US were ok, if not great, for July.  Weekly unemployment claim numbers have fallen back slightly though these can’t be correlated to the monthly employment report with any real confidence.  Corporate profits have remained strong and balance sheets are in the best shape they have been in for years.  All these factors point to continued, albeit modest, growth.

On the downside, consumer sentiment numbers have been terrible.  We’ve never found small moves in this reading to be predictive when of near term consumer spending but you can’t ignore the worst reading in 30 years.   The average person is clearly spooked right now. This could be enough to tip the US into a recession.

The market massacre itself will reinforce negative sentiment.  That impact will be blunted if the indices can gain a few more percent near term but something needs to spark a gain.

Recession or not is the crux of the matter now. If the US and core EU countries avoid falling into recession then the markets are fairly valued at worst, and probably undervalued after the recent drop when compared to historically low treasury yields.  If things continue to worsen and a number of countries fall into recession the market could still go lower.  It’s really that simple.

At this point it’s, pun intended, a confidence game.  The baseline numbers are not recessionary yet, but are getting closer all the time. Recession could come fast unless people believe the problems we all know about are being dealt with.

Few doubt that the US can get past its debt and deficit issues if they want to. Interest rates at all-time lows and the ability to issue debt in its home currency gives the US huge flexibility. For all the moaning, there is plenty of scope to increase revenues too. The real question is whether there is the political will to make the hard decisions.  It doesn’t look that way at the moment.

The US agreement should force cuts if a plan isn’t agreed to before year end.  This may be as good as it gets.  Even those cuts will be a drag on an economy with a weak growth rate.  There is some logic to waiting on large cuts but we sympathize with those who don’t want to.  It’s taken over a decade for Americans to even acknowledge the problem.  If there is momentum to fix it no one wants to squander it at this point.

The debt issue is far more serious in Europe, but the confidence issue is the same.  Aside from the PIGS, most European countries have debt/GDP ratios that are manageable, though not low.  Most are lower than the US for that matter.  The real task in the short run is to convince markets that issues will be dealt with and not glossed over.

Credit markets are spooked bur not yet disarrayed like 2008.  Yield spreads used to measure risk temperament like the TED spread, LIBOR and Treasury-OIS have risen but by amounts that are still small compared to 2008.

Concerns about some large French banks are disturbing, but at least they are French.  Gallic pride will probably demand they be bailed out and a “Lehman scenario” doesn’t seem likely under Paris’ watch.

The only cure for this kind of situation is time and enough action by the political class to decrease uncertainty.  If the large economies are still growing, it will show up in the numbers, with US employment and consumer spending being the most heavily watched.  Only time will tell when confidence lost during the past weeks of political farce will return.

On a positive note, market weakness has affected energy prices substantially. A $40/bbl drop in oil prices is a good tailwind, particularly for the US, if prices stay down. Also good are strong growth numbers out of China and India.  Beijing is (finally!) letting the Yuan rise.  If that continues, the increased purchasing power would do a lot of good. With China’s current inflation rate a new bout of government spending like late 2008 is very unlikely.

One thing different (so far) about this market drop is that resource stocks, especially juniors have not been harder hit.  The percentage drop in the Venture index since late July is less than the S&P.  If you’ve been through a few cycles like we have you know this is very unusual.

Gold prices are the main reason for this of course.   Unlike 2008, many have taken refuge in the gold market this time, running the price past $1800/ounce.

A lot of it is fear buying.  If the markets manage to calm themselves the pullback in gold prices is a reasonable expectation. We don’t expect a massive drop.  There is plenty of “disgust” buying along with the fear purchases. Its impressive how poorly the US$ fared given the massive flows into the Treasury market.  Some of that distrust will remain and support gold if it eases back to recent highs in the $16-1700 range.

Silver’s industrial side kept it from matching gold’s gains this month and the same is true for Platinum and Palladium.  It’s not as countercyclical as gold.  If the markets calm it  may outperform gold in the next while.

Things were anything but rosy for the red metal.  Copper gets pounded hard right along with equity markets.  We’ve expected a pullback even before major markets crashed.  The speed of the downside move was impressive and it looks like a lot of longs have exited the market.  The copper price is getting closer to reasonable but if markets fall harder copper will fall with them.  We see no point in getting brave about copper equities until the markets sort themselves.  The same holds for other base metals.

So far at least, bulk minerals like Potash and Iron Ore have been almost unscathed by the crisis.  Both moved up in price but that won’t help producers and explorers in the bulk mineral space.  The pro cyclical nature of these stocks is so ingrained that they will recover with and only with the larger indices.

We’d love to give you a definitive target for the major indices but to do that we would need to literally be mind readers.   At a big picture level, a lot of the bad news is out there unless we encounter a “Lehman moment”.  From here forward growth, or lack thereof in the major economies will determine the direction of markets.

A return of confidence depends on citizens believing things won’t get worse.  That requires a greater sense of stability and purpose than politicians on either side of the Atlantic have delivered. If everyone acts on the assumption crises cannot be controlled then we will have a recession sooner rather than later.   It’s no more complicated than that.

Gold and discovery can help cushion things if some stability returns. There are not many bolt holes if it doesn’t though gold and gold stocks would be the best of the worst.  The market will be a very dangerous place for the next few months, even in the best case.

HRA Advisories is pleased to host the 2nd annual Subscriber Only event on September 26^th in Vancouver. The Subscriber Investment Summit is intended to provide YOU with expert insight into today’s resource market, as well as some of the most active public companies in the industry today. Don’t miss out on last year’s sold out event! For more details please go to: http://www.hraadvisory.com/summit_2011.html

The HRA – Journal, HRA-Dispatch and HRA- Special Delivery are independent publications produced and distributed by Stockwork Consulting Ltd, which is committed to providing timely and factual analysis of junior mining, resource, and other venture capital companies.  Companies are chosen on the basis of a speculative potential for significant upside gains resulting from asset-based expansion.  These are generally high-risk securities, and opinions contained herein are time and market sensitive.  No statement or expression of opinion, or any other matter herein, directly or indirectly, is an offer, solicitation or recommendation to buy or sell any securities mentioned.  While we believe all sources of information to be factual and reliable we in no way represent or guarantee the accuracy thereof, nor of the statements made herein.  We do not receive or request compensation in any form in order to feature companies in these publications.  We may, or may not, own securities and/or options to acquire securities of the companies mentioned herein. This document is protected by the copyright laws of Canada and the U.S. and may not be reproduced in any form for other than for personal use without the prior written consent of the publisher.  This document may be quoted, in context, provided proper credit is given.

We’ll preface those comments in turn by stressing the debt crisis in Europe is very fluid.  This is a crisis of confidence as much as anything else.  Markets will be highly volatile and subject to reversals on every bit of news, rumor or innuendo until traders decide to take a time out.  We’re about to find out how good Europe’s political class really is at calming a crowd. Their track record hasn’t been great but if nothing else the latest market dives should add some immediacy and focus to the political tussles.  That’s a good thing, even coming at the expense of a market drop.

The Bond Vigilantes are making the rounds again in Europe. You could almost hear them saying “you’re next” to Italy as they continued to trash other PIIGS sovereign debt issues.  The chart below depicts the percentage change in bond yields for the hardest hit EU members over the last three years. Italy’s bonds look stable by comparison but that is misleading;

Italian bond yields have risen about 50% in the past week.  As this issue was being completed Italysold one year bills at a yield of 3.67%.  This compares to a yield of 2.15% at the last auction a month ago.  The fact that both the Euro and the Milanstock exchange moved up smartly after this auction tells you how much fear there is in the markets.

Yields on 10 year Italian bonds ran up through the 6% level that is considered unsustainable prior to the auction, though it has fallen back since.  The Euro has continued to rally, as have other markets and gold afterItaly’s leadership promised to get serious (again) about austerity measures.

Yields on Greek and Irish debt indicate traders expect both of these countries to default, period.  That outcome would not surprise us.  We expected, and saw, a deal in Greece but no one other than a handful of core EU political leaders and Eurocrats view this as more than extend and pretend.

Italyis a much bigger potential problem, having far larger debt balances, but it’s really not in quite the dire straits that Greece and Ireland are. Italyhas larger domestic ownership of its debt load and higher savings rates that could allow it to take over more of the outstanding debt.  That said, it also has low growth and productivity and a political class that is a running farce more adept at providing titillation than leadership. Italyis in a better position to convince the markets that itsMediterraneanneighbors, if its stops dodging and dawdling and gets on with it. Italy’s finance minister, who seems the most capable guy in the room by far, pledged to pass austerity measure by the end of the week rather than the end of the summer.

We lay these issues out first because they are going to dominate trading and, in the final analysis they are all about politics.  We could do reams of number crunching and prognostication but it would be meaningless without seeing how the politics get settled.

Italians have to decide if they will get serious about fixing their finances.  Northern and central Europeans have to decide whether they suck it up and just pay allowance to Greece, and Irelandand whomever.  They can afford to do it. The real question hinges on whether they are willing to do it. The debt numbers involved with those two countries are not large in relation to the EU economy but an actual decision needs to be made and stuck to.

It comes down to whether the populace in the better managed countries is willing to pay to keep the EU as presently constituted together.  If not, they should cut loose the fiscal basket cases and let them devalue their way back to mediocrity and be done with it.  Until we see how that question is decided no one really knows what the ultimate fallout is. Lest anyone have any illusions, a similar set of decisions faces Americans and there too the situation is completely politicized.  With our rant du jour out of the way, we’ll move on to the specific of the sectors we’re dealing with.

The best reason to pick up juniors on the cheap during the summer months is that market issues are behind them.  We still wouldn't say that the market should be comfortable about either western debt or eastern inflation fighting.  However, the second reason for summertime bargain hunting is share prices so badly beaten down they are too cheap to ignore even if you are thinking medium term.  Lately, quite a few traders seem to have come to that conclusion, though they are making the judgment about specific companies, not the sector as a whole.

That works if sellers finished offing before pulling out beach towels.  The macroeconomic realities actually made this more likely as sellers don't want to wait for September when thinking about the mess outlined above.  That does imply higher market risk this coming autumn, but looking at valuations and forward to eastern growth we think selective bargain hunting can begin.  If the past week is any gauge, at least the algorithms that increasingly trade even small companies are willing to take the risk.

With Portugal joining Greeceon the Euro bail out 2 (BOII) list we don't think the recent run in the copper price has a lot to do with recovery, per se.  There are however unusually heavy snow in Chile and strikes in Indonesia that  are slowing supply of mine product to smelters, and until Japan sorts out its power situation smelting capacity is below the glut level miners were enjoying before the tsunami took down generators.

Market listed stocks of the red metal inShanghaimoved up 10K to 90K tonnes in the past week while the light decline of LME listed stocks begun a month ago has become a trend line.  Barring a large shift in the macro picture, the copper price has found a range above $4/pound pending news of how demand will be impacted by eastern inflation fighters.

China hasn't yet seen a peak number on the inflation front and we expect at least some further tightening there. Harmony (or ’peace’ according to Premier Wen’s recent comments inLondon, which may be more to the point) will demand costs for lower wage Chinese drive policy.

If it were simply a matter slowing domestic demandChina’s growth could decline measurably enough to dampen inflation with little impact on metal prices. However, in the context of global trade and western uncertainties some over compensating is more possible.

One area where governments’ policy has maintained good order is, so far, on keeping trade liberal.  So long as beggar thy neighbor doesn't rear its ugly head in trade rules any inflation-related slowing in China and other growth economies should be short lived.  If trade was to become a political football the copper support from supply/demand balance plus a new role as a paper money hedge would slip.  That would mean hunkering down, but traders would look for lower support levels rather than a cascade as they did in late ’08-early ‘09.

We think gold has similarly found a trading base from the $1500 level, pending in this case whether the Euro or the Dollar gest more distain going forward. We’d be more comfortable if the prices gains were less about fear buying, but that has always been part of the gold market. The rerating of senior gold producers also appears to have reached a bottoming point.  There has been some tearing of cloth over the fact that gold producers haven't kept up with gold for price gains.  We think that seeming anomaly should now be done.

Barrick and Newmont are up about 350% from both 10 years ago and Credit Crunch bottoms, while growth oriented Goldcorp has gained more like 450% over those periods.  The metal is up 600% over 10 years and 100% from Crunch lows.  Comparing these to the copper space is uninspiring, but there were no copper bugs to support weak bottom lines during the bear market.  Base metal companies were badly hit during the “commodities are dead” Tech Bubble, and typically recovered first when this secular bull started.

As we have said before weak gold equities is a case of ’be-careful-what-you-wish-for’.  Gold companies are becoming a normal part of portfolio planning, which means they are also being priced to normal valuation levels — you can’t anticipate higher gold prices after they have arrived.  The Credit Crunch rebased everything, but it came before gold producers had finished rebalancing output to more realistic cost assumptions.

Yes, we did go through this not so long ago.  However, we thought it worth repeating since the notion of retying national currencies to gold is getting a bigger listen these days in some quarters.   We aren't convinced that is good for gold over the longer run.  Gold, copper, oil and other commodities are already effectively part of the monetary system.  Trying to fix a part of the system that isn't broken we can do without.  The notion may be good for gold companies near term though and is worth keeping an eye on.

As far as more local major markets go, traders will have to depend on earnings season to keep interest up.  Job numbers in the US have been awful.  We can only hope that situation improves but no one will believe until it happens at this point.

While the market hasn’t priced in European calamity, it’s set up for positive earnings surprises.  The chart above from Bespoke Investment Group shows the weeks with either positive or negative earnings revisions by analysts going back three years.  We’re currently in the longest successive streak of negative earnings revisions in the whole period. With all the scary stuff out there analysts have been cutting earnings estimates constantly since the last earnings season.   This is actually positive news.  Its evidence that market sentiment is gloomy and substantially increases the odds that earnings surprises will be positive rather than negative.  Odds are the earnings season we are entering will help support broader markets in the current range, assuming the world’s political class doesn’t screw things up yet again.

Few observers doubt the potential good this movement in the Arab Street portends.  About the same number would suggest they can see just what it will have brought in a year’s time.  It’s that added layer of opaque on a global economy already being rapidly repositioned that is causing an itch.  The editorial this month attempts to put the Arab street movement in some historic context. We understand the concern about uncertainty, but see a lot of potential as well.

Since markets continue to focus on potential downside issues, we continue to focus on updates in this issue.  We are tracking a growing list of spec stories and expect to lay a few of them out during the summer doldrums.  For the time being it is still best to look for opportunity and then wait for the markets to indicate it’s time to act on it.

David Coffin & Eric Coffin

US equity markets had continued to benefit from export driven bottom line growth, but are now sagging on hesitancy about the US domestic economy ahead of QEII buoyancy drying up in June.  The Dollar decline that allowed export strength has also boosted US import costs. This could mean a modest US summer driving season unless recent declines in oil prices continue. China’s inflation concern has taken up more of its policy.  The tighter Yuan policy isn't showing up in the inflation rate but it will have some impact and mean that growth engine downshifts.  On top of that the vagaries of nature and street crowds continue to add uncertainty.

We began the year with an “expect the unexpected” stance.  May began with the death of bin Laden, which caused only the barest ripple of market applause.  We stir entrails this time of year on whether to look for bargains early in the northern summer, or not — a tough call this year.

The sector we focus on has been consolidating after doing very well.  This downward move accelerated recently, which could hasten the start of a buying period.  The recovery of the broader equity market after March events seems to be stalling after new highs again in the past couple of weeks.  It’s not looking comfortable though, and volumes are low.  Are the market’s about to repeat last summer’s pause?

“Events” have been hard on the algorithmic.  The muddle of just-in-time manufacturing waylaid by tsunami wasn't expected, but adjustments can be made for it.  It’s possible to program varied responses to currency and bond or inflation related policy shifts.  However, aging powers having to choose between the old buddy system or newly emboldened Arabic Street is quite variable rich.

Despite these weakening events, inflationary pressure would be the most likely cause for a pause.  It’s not the G7 economies that are the big concern for us.  The real pressure is in the growth economies that the high income economies still need for export support.  This pressure comes from resource price gains and most worryingly from high food prices and simple demand growth across many local markets.  This again is event related.

Weather events have been getting a lot of ink lately, the most recent being the unusually heavy and deadly North American storm season.  Our sympathy goes out to the victims of the southern US tornado onslaught, but it is slower motion events that concern markets.  Weak crops and high food inflation are becoming a plague.  Those still looking for a second market collapse and double dip recession will remind us the ‘30s dust bowl deepened the Depression.  Markets run on perception so analogies like this can have an impact.

Perception aside, the problem is a real and serious one.  The chart above, courtesy of the Food and Agriculture Organization of the UN, shows their food price index hitting new all-time highs, in both nominal and real terms.  The price measure is already well above the levels reached in 2008.  The one cause for optimism is that the commodity rout going on the past few sessions is driving speculative money out of grain and other “soft” markets too.  This helps, but speculators aren’t the main Within the pile of issues hitting this market, the one with the oddest feel is what some are calling the “Arab Spring”.

Although there have been few protests in large oil producers, oil is part of the concern. It’s unclear how broad an area this Spring may impact, and what it may mean in a region that has been a focus of foreign security concerns for a long time.  Simply put it’s a wild card, but then some wild cards are welcome.

Arab “Spring” of course alludes to overturning totalitarian regimes of Eastern Europe as the Soviet system fell apart.  Some of the parallel themes in North Africa and southwestern Asia seem to be fairly obvious.  However the markets’ twitchiness underscores some real and important differences between that early ‘90s Spring and the Arab one of the early ‘10s.

Neither the Soviet experiment’s highly centralized, “planned” economy nor the brutality of Stalinism attached to it early on is unique to human experience.  They combined in Russia, which had been pegged as a coming power a century before the Soviet experiment got underway.  Its failing’s aside, the Soviet system did generate both high science and high art with Russian accents.

Even the global competition between Russia and the USA that became the Cold War was probably over well before it got underway.  Few would have predicted Marxist musings coming into play (Marx would probably have thought Russia unripe for a “workers utopia”).  The Soviet dictatorship of the proletariat lasting as long as it did testifies to Russia’s strengths going in.

Those strengths kept the system going despite the hollowing out caused by centralized planning.  It was too late for the system by the time its rot was finally accepted at the top.  By then digging out the rot simply weakened the system further and it crumbled in a spectacular whoosh that opened the way for the eastern European “Springs”.

How well Soviet satellites have done since then has reflected what they were before being taken over by the Soviet expansion.  Areas of Eastern Europe that democratized during earlier springs have made real the trappings of democracy built into the system.  Areas with no such history have fared less well.

Coming out of a short lived and globe spanning empire also helped the cause in Eastern Europe.  Much has had to be undone and we certainly don't mean to suggest its been easy.  Still, pre Soviet days were a living memory and establishing ties to the kindred west has been relatively straight forward. The east European Spring has been a renewal.

Contrast this with the Arab world that was established and flowered centuries before Russia began taking root on the western steppes.  In fact both the zenith of the Arab empire and the start of Russian unification began with the westward push of the Mongols.  In the Arab core that is a recent event.

The “mid-East” was our first region of cultivation and city building.  Egypt has been the center of North Africa for many millennia.  Street protests have been part of the region’s politics throughout that history.  The question for the market isn't so much why has the Arab Street risen, but rather why now?

Facebook and Twitter may deserve some organizational credit, but are hardly the cause.  Certainly there are large groups of young, educated and underemployed people through the region, but that isn't new.  A better clue is the Syrian placards written in Chinese seeking aid from the outside world.

In both China and India new deals between elites and broader populations are bringing prosperity.  If the same doesn't happen in the Arab world, and other areas for that matter, the broader population may get left out of the new deals to be cut with these rising economic powers.  China’s first aircraft carrier is in the works, a sign its concern for ‘security’ will equal that of the West.

Security + Arab has equaled crude oil for over a century now, but that is more external to the region than local.  Clearly the more important message is that people want a greater say in choosing their own futures.  Neither the rants of Al Qaida-like groups nor the promise of some eventual payday from western investment is at play here.  Real choice is.

It is true that countries with real ties and outlines of western style democracies have so far had an easier time of generating change.  As with Eastern Europe, having the mechanisms of choice in place has been useful.  The hard parts are however just underway.

No one, including the protest leaders, can outline what this movement will bring in terms of policy shifts.  The protesters have been clear that whatever comes it needs to come from within.  An understandable stance given that “uncertainty” has been the main bugaboo for ignoring bad leadership that was friendly with western democracies.  This time, you take what you get.

Markets really do hate uncertainty so the ill ease they are demonstrating simply makes sense, at that level.  That doesn't mean a bad outcome should be expected.  In fact, this Arab Spring looks as likely to be a tonic for uncertainty in the medium term.

The concern isn't about the desire to democratize, but about the lack of much experience with western norms for democracy.  Some are also concerned that Islam isn't built for the concept.  Western democratic norms actually developed to overcome the ridged centralization of the Christian world through the Vatican.  Islam has its own theological divisions, but not a centralizing institution vaguely like the Vatican once was.

Talking shops the Arab world and Islam do have.  The real change so far has been that their voices have become more effective, and that is the real wellspring of democracy.  We can’t pretend to know the details of what comes from this movement or that we will like all of them as they arrive.  However, we don't know the details of what comes from the market focused democratizing going on in China, or other regions, either.  So far those have meant more balance and more prosperity.

The less Pollyanna view of uncertainty in the Arab world is potential oil supply disruption.  Concern about “peak oil” is matched by concern about unfriendly Arab regimes coming to power.  We have said before that peak oil, like peak copper or iron ore, is really about needing higher prices to bring new “lower grade” sources to the table.  These are found in the oil rich Middle East as much as anywhere else.

A “Comment” article in this weekend’s Toronto based National Post speaks to that potential in Israel where a well-funded company is setting up to test oil reserves in shale.  The article speaks in terms of security concerns and the politics of oil hampering development of this resource in the past.  That may be true, and the lead Canada’s oil sands have been able to get amongst high cost sources, because it is in a secure area, speaks to that.  But the cost issue is part of the deal.

The mid-East and North Africa as a whole could be generating more oil if risk premiums were to come down.  The crowds in the street, who mostly just want to speak their minds and eat better, are protesting their own leadership with little focus on which foreign powers have been backing them.  A muddle of other issues can certainly come into play, but the crowds aren't likely to oppose investment if they think it will help put food on the table.  The system now in place, fed in part by keeping tension high, hasn't been doing that well enough.

Mideast political risk premiums won’t be coming down before this Arab Spring has solidified around some guiding principles.  Those will differ in different parts of the region, and only if those principles encourage investment will they generate reduced premiums.  It will take a while for this process to work through and for direction to be recognized.  Markets will be edgy while the process continues.

However, no one has put an alternative route to lower risk premiums on the table.  We doubt there is one.

The Arab Spring is just one more uncertainty in a market full of them.  The more “western” issues like debts, deficits and stimulus will play out through the summer. If there is to be resolution to those issues (or really well handled extend and pretend) it’s likely to come in the next ninety days.  Until at least a couple of those uncertainties are dealt with things will be soft.  Going with the flow and waiting for a turn, hopefully in the dog days of summer, makes more sense for now than fighting the tape.

The HRA – Journal, HRA-Dispatch and HRA- Special Delivery are independent publications produced and distributed by Stockwork Consulting Ltd, which is committed to providing timely and factual analysis of junior mining, resource, and other venture capital companies.  Companies are chosen on the basis of a speculative potential for significant upside gains resulting from asset-base expansion.  These are generally high-risk securities, and opinions contained herein are time and market sensitive.  No statement or expression of opinion, or any other matter herein, directly or indirectly, is an offer, solicitation or recommendation to buy or sell any securities mentioned.  While we believe all sources of information to be factual and reliable we in no way represent or guarantee the accuracy thereof, nor of the statements made herein.  We do not receive or request compensation in any form in order to feature companies in these publications.  We may, or may not, own securities and/or options to acquire securities of the companies mentioned herein. This document is protected by the copyright laws of Canada and the U.S. and may not be reproduced in any form for other than for personal use without the prior written consent of the publisher.  This document may be quoted, in context, provided proper credit is given.

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