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Melman Minutes - By Leonard Melman
MELMAN MINUTE July 25, 2012


I had a most interesting conversation yesterday with a long-time friend whose opinions on economics have proven to be of great value over time.  He pointed out a most interesting fact about the psychology underlying current markets, namely that the world seems to desire nothing more than an avalanche of bad news which would then presumably force the Fed and other central banks to loosen up and once again flood the markets with abundant monetary stimulation.


Well, this morning it appears they just might be on the verge of receiving exactly what they desire.  News regarding further deterioration of many economies continues to haunt print and electronic media and the Fed has finally issued a statement that they are moving closer to taking new steps to stimulate economic activity. 


As reported by financial writer John Hilsenrath in the Wall Street Journal, "New worries are emerging at the Fed that the economy is falling short...The commerce Department is expected to report this week that the economy grew at a rate substantially below 2% in the second quarter (2012) after expanding just 1.9% in the first quarter.  The unemployment rate at 8.2% in June has moved little since January.  Retail sales have been soft in recent months and financial markets, particularly in Europe, have been strained in past weeks."


Some of the means of stimulating new economic activity include buying mortgage-backed securities (via QE3), keeping short-term interest rates low beyond 2014 and continuing the recent ":Operation Twist" where the Fed buys up government long-term loans carrying a relatively high rate of interest and replaces them with lower rate short-term loans.


Those people welcoming serious discussions regarding such 'solutions' might recall the old proverb, "Be careful what you wish for.  You just may get it!"


One commodity reacting to this morning's financial news is our old friend gold.  Once the change in sentiment at the Fed became a matter open for public discussion, gold began to rise sharply and by mid-morning, the yellow metal's price had moved above the $1,600 per ounce mark for the first time in several weeks.



What we at The Melman Report find particularly encouraging is that once again gold failed to break down despite negative news regarding low inflation, declining economic activity and so forth.  In our experience, when an investment fails to fall on presumed bad news, that can be a strong indication that a positive change in direction may very well be in the winds.


When I look at this gold chart, two conflicting technical conditions appear to be taking place at one and the same time.  From a negative point of view, we have a series of "declining tops", where each subsequent rally falls short of the previous one, dating back to late February.  However, we also have a new pattern of "rising bottoms" where each sell-off stops at a higher level than the preceding one and this pattern has held true since mid-May.


In my opinion, for the gold chart to turn seriously bullish, we need to first exceed the previous peak near $1,620 and then rise above earlier resistance near $1,640.  On the negative side, declines to below $1,545 and then $1,530 would show serious new weakness.


(Mr. Melman is a member in good standing of the Canadian Society of Technical Analysts.)


Returning to the tenor of the economic news background, if anything, it continues to accelerate to the downside.  Both of Europe's remaining economic powerhouses are now showing signs of economic contraction as Germany and France have each reported falling manufacturing output in their latest reports. Given that any reading under '50' in a nation's Purchasing Managers' Index" (PMI) means contraction; it is a matter of serious concern that the latest PMI figure for France is 48.0 and Germany's has declined to 47.3.  In addition, new order books in each country are also on the decline.


Declining economic activity in each of those nations suggests they may not be in a position to help bail out other nations and, therefore, speculation is now rampant that without additional loans, Greece may indeed be forced out of the Euro community and into a restoration of their national currency, the Drachma.  Few analysts so far have been able to offer a clear picture of the level of trauma which might accompany that move, should it occur.


But there is much more to worry about.


One of the few bastions of economic stability in Africa, the Republic of South Africa (RSA), was just warned by the World Bank that their forecast for growth in the RSA was being trimmed back from 2.7% to 2.5% and that a full-blown Euro crisis could reduce that figure to near 'zero'.

Seventy percent of the country's population receives state welfare which has been supported mainly by an expanding economy.  Should that economy begin to contract, the government's ability to maintain its mammoth social-welfare programs might vanish, with unpredictable social consequences.


The island of Sicily in an autonomous region of Italy and it is a matter of interest that the Italian government has now gone out of its way to state that Sicily must rein in their spending in order to qualify for further assistance.  Of course, the warning was accompanied by assurances that Sicily was in 'no danger' of defaulting on debt - but that is precisely the message we have heard from every county that has been forced to apply for rescuing,


Great Britain just reported that they are now in recession as their second quarter GDP contracted by 0.8% following the first quarter figure of -0.3%, satisfying the "two consecutive declining quarters" definition of a recession.  Previous official forecasts calling for at least a modicum of growth this year are being re-written and Scott Corfe, senior economist at the Center for Economics and Business Research was quoted in the British press, declaring, "...The economy will almost certainly show a contraction for 2012 as a whole."  Weaker economic growth - or actual contraction - suggests government tax revenues will shrink, making it almost impossible to meet deficit-reduction goals which would then make it likely that bond rating agencies could easily reduce the ratings on British government debt paper, forcing interest rates higher which would just exacerbate the entire cycle.


Our conclusion is that the level of uncertainty is on the rise while at the same time, public confidence in the competence of their leaders continues to decline.  We believe that both factors will work to the advantage of the precious metals as the 2nd half of 20112 advances.


As of 9:30 AM PDT, precious metals continue to rally to their highest levels of the day with gold now up by almost $30 to $1,604 while silver is ahead by over 50 cents to $27.33.  Financial markets are mixed with the Dow Industrials average is ahead by 38 points - well off its earlier highs - and Canada's TSX Index is reacting to lower petroleum prices by falling slightly.  Base metals are moderately higher on balance and mining share indexes are posting strong gains of about 2%.


Crude Oil is down by more than $1.00 per barrel to just above $87, the US Dollar Index is down by 30 basis points to below 84 and long-term interest rates are little changed so far today.



All quotes US$ unless otherwise indicated.


Next Melman Minute scheduled for Friday, July 27, 2012



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