The Dramatic Drop and Quantitative Easing 4

This week, Ivan Lo talks about QE4, why inflation hasn’t hit us the way it should have, the effects of money velocity, and gives an update on new coverage from RBC Capital Markets and Dundee Securities for Timmins Gold.

Dear Readers,

I mentioned in September that the Fed’s QE3 totalled $85 billion per month when combined with operation twist. In less than a few weeks operation twist will be over. But don’t think that QE is.

The last FOMC meeting took place this week. It’s also the last Fed meeting before the fiscal cliff deadline. Since the Fed has no control over the fiscal cliff, it’s firing its bullets.

We now have QE4.

Quantitative Easing 4: $2 Trillion +

The Fed will now “print” $85 billion a month until the unemployment rate falls below 6.5% and inflation projections remain no more than half a percentage point above 2% for two years out. In addition to buying Both Treasuries and Mortgage Backed Securities with the $85 billion, the Fed will also begin rolling over its maturing Treasuries as of January.

But here’s the big kicker: For the first time, the Fed is now pegging QE directly to quantitative thresholds – namely, inflation and unemployment data, as opposed to its normal calendar-based guidance. That means it will print until the problem is solved. Furthermore, now that the inflation neutral operation twist is out of the picture, the additional $45 billion per month is coming directly from the printing press. How can you not call that Quantitative Easing 4?

As I mentioned last week, QE3 would cost over $1 trillion if calculated over a one year span. With QE4 now in place, we’re going to see $85 billion of stimulus per month for at least 2 more years. That’s a total of more than $2 trillion in additional stimulus.

Considering this is the biggest QE of all, why aren’t the markets rallying as they did for previous QE’s?

Furthermore, with so much money printed, why aren’t we experiencing a major rise in inflation?

According to the Fed:

…inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Why is inflation so low?

The Velocity of Money

Central banks fear deflation more than anything else because it produces slow growth, high unemployment, and worldwide imbalance.

Over the past several years, the Fed and central banks around the world have been trying to combat these pressures by flooding the world with newly created money; fighting deflation with inflation. But it hasn’t worked.


Because while the Fed can print as many dollars as they want, they cannot control how the dollars are used once it enters the system. Inflation can only occur when money is being spent.

We call this the velocity of money.

The velocity of money measures the rate at which money flows through an economy, in other words, how much money changes hands; it has to do with the amount of economic activity associated with a given money supply. It’s also is a key input in the determination of an economy’s inflation calculation.

A higher velocity means the same quantity of money is being used for a greater number of transactions. As a result, it means people are not just making money, they’re spending it. Economies that exhibit a higher velocity of money relative to others tend to be further along in the business cycle; thus, should have a higher rate of inflation, all things being constant.

But the opposite is true of lower velocity. A low velocity means people aren’t spending; thus, the economy struggles and inflation remains low.

Take a look at the graph below that represents the Velocity of MZM (Money Zero Maturity) Money Stock:

velocity of money

This is a measurement of all liquid money within the economy. MZM represents all money in M2, less the time deposits, plus all money market funds.

MZM has become one of the preferred measures of money supply because it better represents money readily available within the economy for spending and consumption.

As you can see, the velocity of the MZM money stock is now at its lowest level since the currency crisis of the 1960s that led to the end of the Bretton Woods system in 1971. The last time we witnessed such dramatic drops in money velocity? The Great Depression.

The Fed and other central banks around the world are trying to avoid another Great Depression scenario. That’s why they are printing so much. They want inflation to happen so they can turn this whole money velocity downfall around.

However, what they’re doing is counterproductive because no matter how much money gets printed, the Fed cannot force people to use it; they can only instill confidence. So the more money they print, the more supply they produce which causes the velocity of money to go further downhill, provided consumer spending remains constant.

As I mentioned in a past letter, we’re battling between inflation and deflation. The dramatic shocks of the original QE’s are already turning around with commodity prices falling, and food prices now at two-year lows. Right now, we’re stuck in the middle of this battle.

It’s no wonder why the Fed has boldly reemphasized a massive, and thus far unlimited, round of QE.

Continued Growth

Early this year, when I predicted the stock market would climb, people thought I was nuts. Yet here we are, and the markets are looking stronger.

The market relies on confidence and it seems that everyone believes the fiscal cliff issue will be resolved, as I had mentioned before. If people thought otherwise, the market would still be falling.

World stocks are rising, signalling that investors believe the global economy has stabilized and is on the path to growth. Remember that sentiment, not true fundamentals, dictate the market; often becoming a self-fulfilling prophecy.

If this keeps up, bonds will finally fall out of favour and that means more money available for stocks.

Given that there’s no end in sight for the Fed’s fixation on low interest rates, those looking for return in cash and fixed income won’t get it from conventional debt instruments like Treasurys and money market funds.

So how do conservative investors and pension funds, who require an average of 8 per cent return to remain viable, balance their portfolio without adding more risk?

Eventually, they’ll have to turn to assets like stocks, commodities and higher-yielding bond products that carry greater return – and greater risk. But that’s exactly what the Fed wants. The Fed wants you to spend, take risks, and consume to increase the velocity of money.

I expect that stocks will soon outperform bonds, but be weary of short term fiscal cliff related dips.

The Turnaround

There’s no way to predict the exact time when things will turn around. But if confidence continues to grow and translates into true market fundamentals, inflationary pressures will eventually take over as the velocity of money will finally increase. It won’t happen overnight but there’s a strong possibility we could slowly see this in the market next year if the global economy continues to stabilize and growth patterns continue.

Then gold will climb much higher.

Gold No Longer Rising?

Despite the Fed openly announcing a $2 trillion QE last Wednesday, gold remained quiet.

It’s possible that the muted inflation rates announced by the Fed have coerced investors into believing that there’s no need to hedge inflation with gold. Or perhaps the manipulatory forces are hard at work to prevent gold from rising. Regardless, don’t fall for it.

Gold will continue to its upward trend, despite minor hiccups along the way. The down dips in gold simply present us with more buying opportunities.

While many believe gold stocks are out of favour, I believe that certain gold stocks will outperform; as every gold stock in our Equedia Select Portfolio have done this year.

Equedia Select Portfolio Update:

Timmins Gold (TSX:TMM) (NYSE MKT:TGD)

Two very well respected firms, RBC (Royal Bank of Canada) Capital Markets and Dundee Securities initiated coverage on Timmins Gold (TSX:TMM) (NYSE MKT:TGD) last week. Both firms gave Timmins a strong recommendation with price targets much higher than where Timmins Gold currently trades.

Having these two big and well respected firms covering Timmins could open up further retail exposure to the Company; especially considering the amount of firms now covering Timmins Gold. I also expect other big firms to follow suit.

This is an added plus for all of our readers as we originally added Timmins Gold to the Equedia Select Portfolio back in August, when Timmins was trading at only CDN$2.21.

Here are some highlights from the analyst reports:

Dundee Securities Ltd., December 11, 2012:

…After restarting the mine in 2010, TMM has made steady progress in expanding production to a 100k oz/a run-rate while cash costs declined to ~US$715/oz in 2012. By keeping things simple and delivering on its objectives, shareholders have benefitted and we expect this trend to continue.
…Given the combination of open-pit mining, a proven mining contractor and a low strip ratio, TMM has streamlined mining costs. Meanwhile, reasonable grades and good leach kinetics allow for low-cost, heap leach processing with modest sustaining capital requirements. As a result, the San Francisco mine produces consistent free cash flows and with cost saving initiatives and operational improvements being implemented, we expect this trend of cash flow growth to continue.

RBC Capital Markets, RBC Dominion Securities Inc..December 11, 2012:

Timmins has been one of the best performing gold stocks in 2012 (up 59% ytd vs. the S&PTSX Index up 2%) and we believe there is further upside because its cash generating abilities and exploration upside are not fully priced in.

Highest free cash flow yield in our coverage universe: We estimate that 10% of the gold companies listed on the TSX with market caps more than $50MM have generated free cash flow so far in 2012 and Timmins is one of those companies. We forecast free cash flow (FCF) of $41 million in 2013 growing to $84 million in 2014 once San Francisco reaches steady state and capital projects are completed (based on our gold price assumption of $1,700/oz for both years). This translates to a FCF yield of 9% based on 2013, which is the highest in our coverage universe, and would be 18% based on 2014.

Exploration could increase NAV: Our base case NAV of $3.61 assumes 75% of the inferred resource surrounding the San Francisco pit is added to the mine plan and 400koz is added to the La Chicarra Pit; however, this does not include any value for exploration potential. Based on gold intersections 1km east of the San Francisco pit, we believe 1MMoz could be added through the $20 million exploration program in 2013…Exploration success could also warrant an expansion of the mine.

Takeover candidate: We believe Timmins is more likely to be an acquirer than a target; however, given its stable production base, exploration upside, and relatively low risk jurisdiction, we believe Timmins could be an attractive target for another mid-tier producer looking to add production.

Shares not pricing in cash flow potential: TMM shares are trading at 0.9x NAV; however, if 1MMoz were added to the back end of the mine plan they would be trading at 0.7x, in line with Tier III peers. Timmins is trading at 5.4x 2013 CFPS, a significant discount to Tier III peers at 11.0x. We see upside potential in the shares if the NAV can be increased through exploration success, and a higher P/CF multiple would be warranted on successful completion of the expansion in early 2013.

My heart and love goes out to all of the families affected by the tragic incident in Connecticut this week. As parents, our kids are our lives and words alone will never express the deepest sympathies we share for you all.

Until next week,

Ivan Lo

Equedia Weekly

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