A Melman Minute — October 29, 2012

Thanks to that dandy storm, Hurricane Sandy, securities markets which have their home in New York City are shut down for the day, sharply limiting both trading volume and the flow of information into the financial news marketplace. Regardless, we will struggle on as best we can this morning.

The calendar seems to be flying by - the election calendar that is - and the US election is now just eight days distant. Trying to get a firm reading based on election polling is proving to be virtually impossible as conflicting polls abound and it seems new results are published virtually every hour. The only area of wide agreement is that the election contest between Obama and Romney appears to be very close, as are the contests for control of the U.S. Senate. Pundits appear to have conceded the reality that the Republicans will retain control of the House of Representatives.

Interest in the American election has become so intense over the past month or so that it has obscured important developments on the European scene, and it is time to take a look at that problem area. After reviewing recent data, I have reached the conclusion that not only is the European situation not improving; it is deteriorating at an ever-increasing rate. Here is why.

The new epicentre of growing concern is Spain and for good reason. Spain's economy is much larger than that of Greece, the previous center of attention, and, therefore, a calamitous failure in Spain could have much greater impact on the world's scene. With that in mind, it becomes a matter of some real importance that Spain appears to be coming apart at the seams, and I mean that quite literally.

Spain's National Statistics Institute reported last Friday that the Unemployment Rate in Spain just reached the incredible level of 25.02%, an increase from last month's 24.63% and a rate the full equivalent of the worst rate reached during America's Great Depression of 1929-1939. Not only is their unemployment rate worthy of deep concern, but the Institute also reported that the overall Spanish economy was now contracting at an annualized rate of 1.7% - another figure reminiscent of the Great depression era.

But there is even more. Despite the bailout received a few months ago, Spanish banks once again appear to be on the road to catastrophe. Nationalized Spanish bank "Bankia" just reported a loss for the first nine months of the equivalent of $9.14 billion while Banco Popular Espanol and Caixabank SA reported jumps in bad loans and set aside more cash to cover real-estate loan defaults.

The problem of bad real estate loan defaults in Spain has been aggravated by the immense numbers of unemployed who, for obvious reasons, are unable to pay on their mortgage payments and the employment situation is also negatively impacted by a sharp decline of 11% in retail sales this year, placing many private retail shops in jeopardy.

The overall situation is serious enough to prompt Justin Knight, a European rate strategist at UBS AG in London to report, "...Spain is going to miss on its deficit target again this year making next year's goal very unlikely to be achieved. Spain is eating into its cash reserves and is probably not going to be able to fund itself into 2013..."

At The Melman Report, we believe that if Knight is correct, a full-blown rescue program for the Spanish government must take place, and it must be achieved quickly. However, the great problem to overcome is that Span's economy is the fourth-largest in Europe and dwarfs Greece's in comparison - meaning that any full Spanish recue program would quite likely be many multiples of that of Greece - and rescuing Greece almost toppled the European community and the European currency just by itself.

Spain's future outlook is further clouded by a rapidly growing movement in Spain's most active economic region, the State of Catalonia, to break up the country by having Catalonia reform itself into a new and independent nation. A preliminary indication of the separationists' strength is scheduled to take place on November 25th when a regional parliamentary election is to be held and those parties espousing separation and now in the lead.

Spain is hardly the only European nation facing monumental problems where the situation continues to worsen despite all measures taken by the European community. Greece is another example where despite all the monumental efforts to strengthen that economy, a CNBC report showed that many European corporate CFOs now regard Greece as being a riskier country in which to invest than either Syria or Libya and on a par with Iraq and Iran! A list of other once-highly-regarded nations which are rapidly descending in terms of perceived safety includes both France and Japan.

I believe that once the American election is over, focus will once again return to the litany of troubled nations elsewhere in the world - and multitudes around this globe will not enjoy what they are likely to read.

From our point of view, this rising tide of turmoil should provide a sound basis for rallies in the precious metals and we continue to hold a favourable view for both gold and silver over the long term.

Anyone who doesn't believe in free market economics should study the above chart on Crude Oil. After the sharp decline of 2008 bottomed out, a solid rise in the price of Crude began to develop, one which carried the price back up to above $110 per barrel - but then a strange thing happened. The price of Crude began to look 'toppy' and the entire chart now looks like it might break to the downside.

In this case, it is relatively easy to match the economic fundamentals to the chart price weakness. During the past two years we have seen demand factors begin to abate while supply factors - particularly in North America - have risen. We believe the combination of rising supply in the face of moderating demand is responsible for the failure of Crude Oil to rise further.

However, if the price should break down sharply, other economic forces may come into play as the cost of obtaining crude from various sources is rising sharply and a lower market price could result in a suspension of many projects, thereby reducing the supply of new oil and that could result in a return to rising prices.

We have seen this pattern hold true in the world of potash. Several years ago, a developing supply shortage in the early years of this century drove prices sharply higher and potash mining securities leapt higher (see Potash Corp. chart).

As has been the case with Crude, prices then corrected, had a secondary rally, and are now showing renewed weakness. In fact, Potash Corp. of Saskatchewan recently announced they were suspending production at two of their major properties to work off excess supply thanks to reduced contracts from India and China.

As of 9:45 AM PDT, our only reliable North American general market quote is from the TSX Index which is down by about 25 points thanks to lower metals and crude prices. Gold is off by about $4 to near $1,708; silver is down by 30 cents to $31.80; base metals prices, led by copper and nickel, are down sharply and we are unable to obtain quotes on mining share indexes due to American market closures.

In other markets, Crude oil has just dipped below the $85 per barrel mark; the US$ continues to strengthen, up by about 30 basis points, and long term interest rates are sharply lower.

All quotes US$ unless otherwise noted.

Next Melman Minute scheduled for Wednesday, October 31. Hope the ghosts and goblins are not too much in evidence!

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