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In the previous essay, we emphasized that gold is to move higher, and since it has just moved significantly higher, it seems that you may wonder what we think about the situation in its sister-metal - silver. However, before providing you with technical details, we would like to provide you with not-so-bullish views on China, and briefly comment on how it might affect the precious metals market.

If you saw the Hollywood thriller “Speed” several years ago with Keanu Reeves and Sandra Bullock, you might recall that they were trapped on a bus rigged to blow up if the speed of the bus dipped below a specific level. That, according to one economist, is China’s situation. If and when the economy slows down below a certain level, China’s economic boom will go bust, like a huge bubble pricked by a pin.

We recently read an interesting white paper on the subject, titled “Watch Out for China’s 10 Big Red Flags,” by Edward Chancellor, an analyst with GMO, a privately-held global investment management firm.

Chancellor outlined the 10 “red flags” that indicate the formation of a bubble and how China’s economy shows many of the classic symptoms of a great speculative mania.

China’s economic outlook is of vital interest to gold investors. Chinese demand for gold is set to double within just ten years according to the latest World Gold Council’s 74-page report, Gold in the Year of the Tiger. Chinese gold consumption was worth more than $14 billion in 2009, equivalent to 11% of global gold demand. Over the past five years, Chinese demand for gold has increased at an average rate of 13% per annum. The report estimates that China could exhaust its known gold mining reserves six years from now.

So, will the Chinese miracle continue, or will the boom turn to bust?

Here are the 5 out of the 10 “red flags” that, according to Chancellor, indicate the formation of a bubble and how each applies to China.

1. Great investment debacles generally start out with a compelling growth story, perhaps a new revolutionary technology such as railways in the 19th century, radio in the 1920s, or more recently, the internet.

Chancellor points out that it is generally assumed that the Chinese Dream will continue to grow at around 8% annually in the coming years. In recent months China has overtaken Germany as the world’s number one exporter, and Japan as the world’s number two economy. It has recently surpassed the U.S. as the largest national car market. The inevitability of China’s ascent to global economic primacy is reflected in the title of a recently published book by Martin Jacques, “When China Rules the World: The Rise of the Middle Kingdom and the End of the Western World.”

2. A blind faith in the competence of the authorities is another typical feature of a classic mania. In the 1920s, for example, investors believed the recently established Federal Reserve would bring an end to boom and bust.

According to Chancellor, both economic theory and history argue against central planning as the optimal mode of economic development. China’s rapid growth can be deceptive because the state can invest resources more quickly than can the private sector. However, the quality of investment is lower. In other words, you can't always trust the numbers that a government is putting out.

3. Great booms are invariably accompanied by a surge in corruption.

All great speculative manias have been accompanied by rising levels of fraud. Only in the time of bust do the Enron’s and Madoff's come to light. China has recently slipped to 79th place in Transparency International’s 2009 Corruption Perceptions Index, just below Burkina Faso.

The New York Times estimates that up to half of sales of luxury goods in China are purchased to be given as bribes.

4. Strong growth in the money supply is another leading indicator of financial fragility. Easy money lies behind all great episodes of speculation starting with the Dutch Tulip Mania of the 1630s.

Low interest rates are part of Beijing’s policy to promote investment. Low interest rates also drive Chinese households into speculating in stocks and real estate. Last year the money supply grew by nearly 20% while interest rates were maintained well below the economy’s nominal growth rate.

5. Dodgy loans are generally secured against collateral, most commonly real estate. Thus, a combination of strong credit growth and rapidly rising property prices are a reliable leading indicator of very painful busts.

High stock turnover, a rising number of new share issues, strong early trading gains and the establishment of new stock exchanges are all classic signs of speculative euphoria. Meanwhile, the real action has been taking place in China’s overheating property market. Over the course of the last decade, national home prices rose at annual rate of 8%. Commercial real estate investment grew by 121 % last year. The total amount of floor space under construction in China is equivalent to the size of Rhode Island. The real estate market displays the classic symptoms of a bubble—stretched valuations, rampant speculation, and frenzied new construction. Sooner or later this bubble will burst, says Chancellor.

What usually happens in times of economic turbulence and fear and when fiat currencies tank? Investors flock to gold and silver. Since we have covered the situation on the gold market in our previous essay, this time we would like to focus on the white metal (charts courtesy of http://stockcharts.com).

click to enlarge

As it was the pattern in August 2009, silver is leading Gold and PM stocks to the upside. The RSI is in the overbought area and suggests some temporary resistance, but it seems that the coming move lower will not take silver dramatically lower.

Please note that in September 2009, silver didn't drop visibly before the RSI indicator moved much above the 70 level, and this is what we expect to see also this time. Additionally, please look how the 50-day moving average proved to be a strong support during both August 2009, and in March 2010. Should the history repeat itself once again, it seems that silver may move higher during the next few weeks.

On an immediate-term basis, it would not surprise us to see a few days of trading sideways (or even lower), before silver resumes the rally (in fact we have just sent a Market Alert to our Subscribers regarding details), as it has just moved above the medium-term declining resistance line.

Summing up, the silver market may consolidate for the next several days, but it seems that the coming weeks will provide us with higher prices of the white metal.

Disclosure: No positions

Source: China Shows Classic Symptoms of a Great Speculative Mania