Yearly Forecast

  Random Thoughts

1) There are similarities between the current situation in the US, the US of the 1930s and post-bubble Japan, but the monetary backdrop is very different in the US today than it was in the earlier post-bubble periods. The most obvious effect of the monetary difference is that the prices of most goods and services have continued to rise in the US since the bursting of the private-sector credit bubble in 2007.

2) The less obvious effects of the current period's much higher rate of monetary inflation include the slowing of the corrective process and the introduction of additional price distortions and inefficiencies.

3) The US eventually recovered from the bursting of the 1920s bubble despite the many idiotic policies implemented by the Hoover and Roosevelt administrations, but the US will not be able to recover from the bursting of the more recent credit bubble if the Fed continues to engineer a high rate of monetary inflation. If current Fed policies continue for at least a few more years, the US economy will end up in a far worse state than it has ever been before.

4) The above three points are copied from our 2012 Yearly Forecast. It has become clear that the Fed's policy of throwing new money at the economy in a horribly misguided effort to generate real growth is not only going to continue in 2013, but also going to be applied more aggressively than was the case in 2012. This money-pumping could prevent widespread recognition of recessionary economic conditions for several more months, but only at a substantial long-term cost. For an economy to function efficiently, price signals must be genuine; that is, price signals must accurately reflect sustainable consumption and production trends.

5) At the beginning of last year we wrote that there was nowhere near as much scope for a negative surprise out of China in 2012 as there had been in 2011, because China's central planners had begun to loosen the monetary reins and because China's economic problems had come to be more widely recognised. In a nutshell, we thought that China-related risk had fallen. This assessment appears to have been close to the mark, or at least wasn't disproved by events.

Our thinking is unchanged. China has huge economic problems, but these problems will come to the fore gradually over the space of a few years and won't likely be the cause of big moves in global financial markets during 2013.

6) At the beginning of last year we thought that the euro-zone's government debt problem was still a sizeable risk, but that its potential to wreak global havoc had been substantially reduced by virtue of the fact that it had been a "Page 1" story for many months. This assessment was largely validated by events, as the news out of Europe continued to get worse over the first seven months of 2012 and yet the euro didn't collapse and severe stock market weakness was restricted to the small number of euro-zone countries at the centre of the debt crisis.

'Everyone' is now confident that the worst is over for the euro-zone's financially-challenged governments and banks. Paradoxically, this means that the risk is now much greater. The cause of all the gnashing of teeth that occurred during the second half of 2011 and the first half of 2012 hasn't disappeared, it has only been temporarily put aside. The bailouts will continue, with Spain's government probably requesting an aid package during the first quarter of this year and Greece's government confessing that it is once again in need of help. Spain will get a bailout and the markets will breathe a sigh of relief, but by the third quarter of this year it should be apparent that France's government is in danger of defaulting on its debt. After all, the finances of France's government looked precarious even before a socialist president came to power and began to enact policies that are sure to drive many of the country's most productive people and highest tax-payers elsewhere.

We expect that the euro-zone's government debt disaster will return to "Page 1" during the second half of 2013.

7) Due to a mismatch between expectations and reality, we thought that last year's biggest issue for the financial markets would turn out to be weakness in the US economy (most people were expecting the US economy to "muddle through" and most equity analysts were anticipating good earnings growth during 2012). We were wrong. Even though the US economy was lacklustre and the rate of US corporate earnings growth dropped to almost zero, the popular "muddle through" view proved to be closer to the mark.

Unexpected weakness in the US economy is still an intermediate-term threat worthy of attention, but it is no longer one of our top three risks. The three biggest risks are the likelihood of the euro-zone's government debt predicament returning to centre stage (Point 6 above) and the issues outlined in Points 8 and 9 below.

8) Going into 2012 we thought that the second biggest intermediate-term risk facing the markets involved the potential for greater instability in the Middle East. We didn't think that there would be open military conflict between Iran and the US or between Iran and Israel, but we were concerned that escalating tension between these countries could have a big effect on the markets. We were also concerned that the political situations in Egypt and Syria would become more turbulent, and that there was an outside -- but not insignificant -- chance of Saudi Arabia getting caught up in the 'revolutionary wave'.

This risk partly materialised, in that the political situations in Egypt and Syria certainly became more turbulent (Syria's instability degenerated into civil war, and Egypt's population, having thrown out their long-serving dictator in 2011, began to experience 'revolter's remorse' as the democratically-elected replacement showed signs of being equally bad). However, the financial markets ignored the troubles in Syria and Egypt, and the possibility of military conflict between Iran and US/Israel never became a big issue.

As 2013 begins, the potential for greater political and geopolitical instability in the Middle East remains one of the biggest intermediate-term risks facing the financial markets. This risk is more likely to materialise during the second half than the first half of the year, the reason being that the US government will be more inclined towards aggressive military action after it becomes clear that the US economy is in recession. Governments tend to view external threats as useful distractions during periods of economic weakness. Also, a real or imagined urgent need for military action provides an excuse for more government spending and more inflation.

9) There's a new big intermediate-term risk facing the financial world as 2013 gets underway: the risk that the government bond bubble will burst. The bursting of the government bond bubble is a more pressing concern today than it was, say, 6 months ago due to the immense political pressure being put on the Bank of Japan (BOJ) to reduce the purchasing power of the Yen. We don't know yet if the BOJ will actually take the actions required to reduce the Yen's purchasing power at the rate demanded by Japan's new government, but if it does then bond yields will be pushed a lot higher in Japan and the yields on other 'safe haven' government bonds will likely follow.

The potential for a large decline in government bonds is not only linked to the goings-on in Japan. Clearly, the Fed and the ECB are taking actions that will eventually lead to much higher inflation expectations and bond yields regardless of whether or not the BOJ joins the inflation party. The big unknown is -- and has always been -- the timing.

10) We think that 2013's best profit-creating opportunity will be provided by -- dare we say it -- the gold mining sector.

11) Going into both 2011 and 2012 we thought that money-making would be far more challenging over the year ahead than it had been during 2009-2010, and that our primary focus should therefore be on 'playing defense'. Unfortunately, as 2013 gets underway we still think it is appropriate to maintain a moderately defensive posture, meaning that we continue to advocate an above-average cash position.

  The US Stock Market

As is our wont, we were too bearish on the stock market in 2012. At least, our concerns weren't validated by the price action. We expected the market to hold up fairly well during the first few months of the year and then roll over into a major downward trend, with spreading recognition of a US recession being a primary driver of the downward trend. The first half of 2012 went according to plan, but the global stock market fared much better during the second half than we thought it would. The deviation from our 'plan' began in late July, not coincidentally around the time of ECB chief Mario Draghi's promise that the ECB would "do whatever it takes". We under-estimated the importance of the ECB's July-2012 shift.



Although this is the time of year when it is traditional for a newsletter writer to express an opinion on what will likely happen over the year ahead, right now we simply have no opinion on what the stock market will do during 2013 and see no point in pretending otherwise. The market is 'overbought' on a short-term basis, but sentiment is neutral and the 'overbought' condition could be eliminated by a routine consolidation. We think that the risk/reward balance is skewed towards risk in the short and intermediate terms, but a perception that risk is markedly higher than potential reward doesn't necessarily translate into a forecast. It doesn't even necessarily translate into a view that the market is more likely to rise than fall. To use an analogy, we would reasonably expect to win a round of Russian roulette, but it wouldn't make sense for us to play because the cost of losing would be too great. We view the current stock market situation in a similar way. Due to how the risk/reward is skewed, the cost of being wrongly bullish would be far greater than the cost of being wrongly bearish.

Lastly, as we've done in every yearly forecast beginning with the 2010 edition we reiterate our view that the S&P500's March-2009 low will prove to be its ultimate bear-market bottom in nominal dollar terms. This is due to the Fed-promoted depreciation of the US$. Another consideration noted in previous yearly forecasts is that a floor has effectively been placed under the US stock market's dollar-denominated price by the virtual certainty that the Fed will be a lot quicker to crank up the money pumps in reaction to stock market weakness in the future than it was during 2007-2008. Based on the Fed's actions over the past four months a rational observer could no longer doubt that this is the case. After all, the Fed is now introducing new money-pumping schemes for no reason other than the high unemployment rate, as if counterfeiting money could possibly bring about sustainable gains in employment.

  The US Dollar

Most gold bulls are constantly expecting the US$ to tank, but this expectation is unrealistic considering the dollar's fiat-currency competition. It should always be remembered that the USD/EUR exchange rate comprises almost 60% of the Dollar Index, which means that a bearish view on the Dollar Index equates to a bullish view on the euro. Based on various considerations including interest-rate differentials, monetary-inflation differentials and sentiment, there are times when it makes sense to be bullish on the US$ relative to the euro and times when it makes sense to be bearish.

Here is how we stated our 2012 forecast for the euro and, consequently, the Dollar Index (the Dollar Index effectively being the reciprocal of the euro):

"...for 2012 we are anticipating a multi-month euro rebound, either beginning near the current level or after a capitulation (a final blow-off decline) that pushes the euro down to around 1.20. At this stage there's no point thinking beyond the likely euro rebound. Instead, we'll wait for the market to work off the massive euro net-short position and then consider whether or not a major new euro decline (US$ advance) is likely."

It took longer than expected for the euro to rebound and for the euro net-short position to be worked off, but it eventually happened. As things now stand, the euro has rebounded for about 5 months and speculators have shifted from being massively net-short euro futures to being approximately flat.



Once a sentiment swing from an optimistic or pessimistic extreme gets underway in the financial markets it usually doesn't end until the opposite extreme is reached. Given that sentiment in the currency market has shifted from an anti-euro extreme to neutral, this probably means that the euro will gain some additional ground before making an intermediate-term peak (a peak that holds for more than a few months). Our best guess at this stage is that the euro will peak at somewhere between 135 and 140 during the first half of this year and then roll over into a major multi-quarter decline driven by the resumption of the euro-zone's government debt crisis.

We now turn our attention to the most interesting currency of the moment: the Yen.

In our 2012 forecast we wrote:

"At some point over the next three years the Yen is likely to become very weak in response to huge-scale monetisation of Japanese Government debt, but right now the supply of Yen is growing at a much slower pace than the supply of dollars and the Fed is making sure that the US$ has no interest rate advantage over the Yen. Therefore, over the months ahead the Yen will probably experience nothing more bearish than a routine correction to its up-trend. Furthermore, the Yen could benefit from stock market weakness during the second half of the year."

The Yen has become very weak over the past few months in response to the ANTICIPATION of huge-scale monetisation of Japanese Government debt. At this stage it isn't known if the anticipated monetisation will begin in the near future, although there's a high probability of it beginning within the coming two years. It's the logical (from a political perspective) next step along the road to debt default.

We think the Yen is positioned similarly today to how the euro was positioned at its low points during the first seven months of 2012. Almost everyone is bearish for reasons that everyone is well aware of. According to Market Vane's sentiment survey, only 19% of traders were bullish on the Yen at the low point over the past week. By comparison, 24% of traders were bullish on the euro when it was bottoming in late-July of last year. It's possible that the currency-trading community will become a little more anti-Yen before we get a meaningful swing in the opposite direction, but there doesn't seem to be scope for Yen sentiment to get a lot worse.

Primarily for sentiment reasons, we expect that a substantial multi-month Yen rebound will begin by April. It should also be noted that long-term fundamentals still favour the Yen over both the US$ and the euro, but that will change if the BOJ begins to increase the Yen supply at a much faster pace.

Moving along, we expect that the main commodity currencies (the A$ and the C$) will be strongly influenced by the stock market during 2013 just as they were during each of the past several years. To be a little more specific, the A$ and the C$ will be in rising trends when the global stock market is strong and falling trends when the global stock market is weak.

  T-Bonds

Before we get to the US Treasury Bond (T-Bond) we need to discuss Japanese Government Bonds (JGBs), because what happens to government bonds in Japan could influence what happens to government bonds in the US during the course of this year.

In anticipation of the Bank of Japan (BOJ) giving in to political pressure to reduce the purchasing power of the Yen at the rate of at least 2% per year, currency speculators have been relentlessly selling the Yen over the past two months. The result is that the Yen has reached an 'oversold' extreme rarely seen in a major currency. Anticipation of the BOJ becoming 'looser' has also caused JGB yields to rise, but only by a small amount to date. As evidence we cite the following chart, which shows an up-tick in the yield on the 10-year JGB from a December-2012 low of 0.70% to a January-2013 high of 0.84%. This is strange, because long-term bond yields should be more sensitive than currency exchange rates to changes in inflation expectations. In effect, currency traders are saying "the BOJ is going to become much more aggressive in its attempts to depreciate the Yen", while bond traders are saying "despite all the political rhetoric and posturing, the BOJ is going to continue doing what it has been doing".


                                        Chart Source: www.bloomberg.com

We see three possible outcomes with regard to the interplay between Japanese politics and Japanese monetary policy. They are:

1. The BOJ yields to government pressure to set an "inflation" target of 2% and then boosts the Yen supply by enough to ensure that this target is achieved or exceeded.

2. The BOJ yields to government pressure to set an "inflation" target of 2%, but doesn't follow through with the monetary inflation required to achieve the "inflation" target.

3. The BOJ resists political pressure and keeps its official "inflation" target at 1%.

Our view is that Outcome 3 is by far the least likely. Outcome 1 is almost certain to occur within the next two years, but Outcome 2 is just as likely as Outcome 1 during the first half of this year.

Something that makes Outcome 2 just as likely as Outcome 1 over the next 6 months is that the Quantitative Easing (QE) process is different in Japan than it is in the US. Anyway, that's the way it seems to us, although we admit to not being experts on the way the BOJ conducts its monetary operations. The difference is that when the Fed does "QE" it adds to bank reserves and the economy-wide supply of money (bank reserves aren't counted in the money supply), whereas we get the impression that when the BOJ does "QE" it only adds to bank reserves. Additions to bank reserves don't directly affect the purchasing power of money.

Something else that makes Outcome 2 just as likely as Outcome 1 for at least a couple more quarters is the devastating effect that a significantly higher rate of "price inflation" would have on the Japanese government's financial situation. As we stated in our 24th December commentary under the heading "The Japanese vote for Inflationism":

"...if the BOJ inflated the Yen supply enough to cause the Yen to lose purchasing power at the rate of at least 2% per year then long-term interest rates would rise in Japan. This would create a big problem for Japan's government. The Japanese government's debt is now so massive (about 230% of GDP and rising) that more than half of its revenue goes to pay interest. And that's with interest rates at absurdly-low levels (the 10-year Japanese government bond yields about 0.8%). Economist Andy Xie has estimated that if the bond yield rose to 2 percent, the interest expense of Japan's government would surpass its total tax revenue. To put it another way, if government bond yields in Japan rose to 2% or higher then even if Japan's government were to cut all of its non-interest expenses to zero it would still run a budget deficit due to the interest payments on its debt.

This means that if Abe gets his way and the BOJ increases the rate of Yen depreciation to at least 2% per year, then the day when Japan's government is forced to default on its debt will quickly be brought much closer."

In any case, how the BOJ responds to the political pressure to inflate will affect the T-Bond, because the absurdly-low yields on JGBs help depress the yields on other 'safe haven' government bonds.

Before leaving Japan we present the following chart showing the yield on the 10-year JGB from February-1972 through to April-2012. We have included this chart to make two points. First, that the secular decline in Japanese bond yields dates back to the early 1980s, meaning that the secular bull markets in JGBs and T-Bonds began at around the same time. Second, that the ultimate low for the 10-year JGB yield was way back in 2003 (the May-2003 low for the 10-year JGB yield was about 0.20% below its December-2012 low).


                       Chart Source: www.gecodia.com/Japan-Government-10Y-Yields_a1305.html

The above chart shows that the JGB yield made its ultimate low and then spent the next 9-10 years basing. This is similar to how the secular US interest-rate decline of the 1920s-1940s came to an end. Yields on low-risk bonds reached their ultimate bottom in the early-1940s, but a major upward trend didn't get underway until the late-1940s. That is, the historical record suggests that secular bond bull markets tend to end with a whimper rather than a bang.

That long-term bond bull markets have tended to end gradually rather than with spectacular reversals is probably related to the nature of the market. Bonds are subject to speculative buying and selling like any other investment, but first and foremost they are purchased with the aim of earning an interest rate. As the price of a bond advances its yield-to-maturity declines, and if the price of a bond rises far enough then its yield-to-maturity will fall to zero. This places a virtual lid on the price of a bond that doesn't exist for commodities, equities or real estate. This virtual lid effectively limits the speed at which a long-in-the-tooth bond bull market can rise and the magnitude by which it can rise, so rather than the bull market ending with a huge upside blow-off followed by a definitive downward reversal (as per a long-term gold bull market), it just peters out.

Speculators who bet against the T-Bond could therefore be in for more disappointment than joy over the years ahead, even if a secular price peak was recently put in place.

We think that a secular price peak is either in place or will be put in place this year at not far above last year's high. We also think that a gradual multi-year rolling over of the T-Bond price (a gradual turning up of the T-Bond yield) is the most likely outcome following the secular peak, although we are well aware of the risk that due to the extraordinary actions of the Fed it could be different this time. It could be different because never before has the US central bank demonstrated such steadfast commitment to crackpot theories.

After that lengthier-than-intended preamble, we now turn to our yearly T-Bond forecast.

Our 2012 forecast was for the T-Bond market to weaken in parallel with a firm stock market over the first few months of the year and to then strengthen as the stock market trended downward. We thought there was a good chance of a new all-time high being made prior to the start of a major bear market and that the intermediate-term risk/reward was neutral.

Our 2013 forecast is similar, except that we would replace "a good chance of a new all-time high" with "a possibility of a marginal new all-time high". The intermediate-term risk/reward is still neutral, but only just. With the Fed 'playing fast and loose' with the US dollar and the Japanese government putting pressure on the BOJ to do the same with the Yen, the risk of an upside breakout in inflation expectations is increasing. However, the superficial effects of monetary profligacy could be offset for another 12 months by the combination of the private sector's continued de-leveraging and declining economic confidence.

Also worth noting is that the T-Bond will be supported over the months ahead by the Fed's December-2012 promise to "purchase longer-term Treasury securities ... at a pace of $45 billion per month." Be aware, though, that the Fed's buying will only provide support to the T-Bond market while inflation expectations remain in check. Once inflation expectations begin to surge, the Fed's bond monetisation will have the opposite of the intended effect by adding fuel to the inflation fire.

  Gold

Gold's ultimate price top in nominal dollar (or euro or some other currency) terms will be determined mostly by what happens to the official money. For example, a forecast that the US$ gold price will reach $10,000/oz within the next 5 years seems to be bullish, but if the US dollar's purchasing power plunges to the extent that 5 years from now a loaf of bread costs $50 then a rise in the gold price to $10,000/oz over this period would constitute a substantial decline in real terms. Long-term dollar-denominated gold price projections are therefore even less useful than the average long-term forecast. Actually, they are completely useless.

Rather than attempt to do the impossible and accurately predict the ultimate top in the US$ gold price by some means other than dumb luck, it makes a lot more sense to continually weigh the evidence in real time to determine if the long-term bull market remains intact. Along these lines, in our 29th October-2012 commentary we described four signs that will likely be seen at around the time of, or just prior to, gold's ultimate price top. For ease of reference, here they are again:

1) By the time the ultimate top of gold's bull market is close at hand the general public will have given up on the idea that returning to economic health requires more money-printing, more government spending and more debt. The purveyors of such economic quackery will still have their fans, but they will most definitely be in the minority.

2) Due to gold's historical tendency to FOLLOW major changes in the monetary situation by at least 2 years, gold probably won't reach its ultimate top until well after the Fed stops trying to stimulate the economy using cheap credit and money-pumping.

3) Based on the strong tendency observed under the current monetary system for long-term bull markets in commodities, equities and real estate to go to absurd valuation extremes and culminate in spectacular upside blow-offs during their final 12 months, gold's long-term bull market probably won't end until gold becomes extremely expensive following a 12-month price rise of well over 100%.

4) As a consequence of the link between long-term gold bull markets and long-term equity bear markets, the end of the gold bull market should roughly coincide with the end of the long-term valuation decline in the US stock market. The broad US stock market becoming very cheap by traditional valuation standards would therefore be a sign that the gold bull market was close to an end.

Not one of these signs has been evident during the past few years, and based on the time it would take for them to appear it is reasonable to conclude that gold's ultimate price top lies a minimum of two years into the future. In other words, we currently don't perceive a realistic possibility that gold's long-term bull market has already ended or will end this year.

Regarding the third of the above-mentioned signs of a major gold top, what would constitute a valuation extreme for gold? After all, gold doesn't have a P/E ratio or dividend yield.

The January-1980 peak is an example of a valuation extreme. When the gold price rose above $800/oz in January of 1980 gold was at an all-time high and a long way above its historical mean relative to the US stock market, the CRB Index, the average house and the wage of the average worker. A reasonable argument can be made that gold will exceed its real 1980 peak before the end of the current bull market, but we would almost certainly view a rise in the gold price to near its 1980 high in terms of inflation-adjusted (IA) dollars or the broad stock market as a clear sign that the bull market was near its end. By our calculations, in current dollar terms the 1980 high is about $3200/oz. The current-dollar 1980 high will, of course, rise as the US$ is depreciated.

That's the big picture. Let's now consider what we expected the gold market to do last year and what we expect of it to do in 2013.

Our 12-month outlook at this time last year is reflected by the following excerpts from our 2012 Yearly Forecast:

"...we suspect that over the course of 2012 gold will be a) roughly flat in US$ terms (up a few percent or down a few percent), b) up strongly (more than 10%) in euro terms, and c) higher relative to silver and the base metals. The odds favour it gaining ground against oil, but oil is 2012's biggest wildcard due to the elevated risk of large-scale military conflict in the Middle East."

"...the next upward legs (in US$ terms) in the long-term gold and silver bull markets probably won't begin until at least the final quarter of this year. The main reason for this belief is the extent to which the silver market became 'overbought' and 'overbullish' last April. After a commodity market's sentiment and price action reach the sorts of extremes that occurred in the silver market last April it usually takes at least 18 months for the conditions to be right for the start of a new major upward trend. This doesn't mean that we expect gold and silver to make new correction lows this year. Our favoured scenario is that the ultimate correction lows were put in place last month [December-2011] and that a multi-quarter period of base-building is now underway."

As it turned out, gold was up by 5%-7% in both US$ and euro terms in 2012, so we were roughly correct about the US$ gold price and a little too optimistic about the euro gold price. Gold was flat during 2012 relative to the base metals and relative to silver, meaning that it didn't do as well as anticipated relative to other metals. This is most likely because the stock market did better than anticipated.

As expected, gold and silver spent more than half of 2012 basing without breaking below their 2011 lows.

Before getting to our forecast for the next 12 months it's worth noting that the US$ gold price has now risen for 12 years in a row. What are the odds of a market rising for 13 years in a row?

To explain, we point out that the probability of 'heads' coming up 13 times in a row in a fair coin toss is 1 in 8,192 (about 0.012%), but that the probability of the thirteenth coin toss coming up 'heads' given that the first twelve tosses were 'heads' is 50%. We doubt that gold will make it all the way to the end of its long-term bull market without experiencing a single down year, but the fact that it has just risen for 12 years in a row doesn't, by itself, make it any more likely that 2013 will be a down year. After all, as 2013 gets underway gold is not close to being 'overbought' on either a short or an intermediate-term basis. Also, in inflation-adjusted dollar terms gold has been either flat or down in 3 of the past 5 years.

Our 12-month outlook for gold and silver is more bullish this year than it was last year. Our best guess is that gold and silver will end 2013 at least 20% higher than they ended 2012 in terms of all the major currencies, with the price gain driven by the combination of economic weakness and the increasingly aggressive efforts of the world's most important central banks to counteract this weakness by depreciating money. Note that we said "the world's most important central banks" in the previous sentence, rather than "the Fed". This was deliberate, as the next major up-leg in gold's bull market is just as likely to be fueled by euro issues as by US$ issues. It could even be fueled by Yen issues.

We don't have an opinion on the path that gold will take to get from where it is today to the higher level that we expect it to reach by year-end. For example, it wouldn't surprise us if there were a few more months of consolidation prior to the start of the next major upward leg and it also wouldn't surprise us if it turns out that the next major upward leg has already begun.



  Gold Stocks

The 31st December-2012 Weekly Update contains a detailed discussion of the "big picture" for gold stocks, in which we explained the salient differences between the gold-stock bull market of the 1930s and the later gold-stock bull markets (the current one and the one that extended from the early 1960s through to 1980). Of particular significance, we pointed out that the gold mining sector (as represented by the Barrons Gold Mining Index - BGMI) was still performing similarly to how it performed during the 1960s-1970s bull market, both in nominal dollar terms and relative to gold bullion. We zoomed in on the rather extreme weakness in gold mining stocks relative to gold bullion during the 1970s and over the past several years, explaining that "price inflation" (escalation in the cost of building and operating a gold mine) was the main cause of this relative weakness.

In the aforementioned commentary we stated the following thoughts regarding the expected performance of the gold mining sector during 2013:

"When we compare the current positions of the BGMI and the BGMI/gold ratio with their positions throughout the 1960s-1970s bull market we conclude that the current situation is most similar to either December of 1972 or the second quarter of 1977... If the current situation is, in fact, similar to either of these prior times then the gold mining sector will do well in nominal dollar terms over the next 12 months. Relative to gold, the mining stocks will do well over the coming 12 months if the current situation is analogous to late-1972 and poorly over the next 12 months if the current situation is analogous to Q2-1977.

We like the comparison with the 1970s because we are dealing with the same sector responding to similar problems and opportunities, and because the bull markets of the 1960s-1970s and 2000s-2010s have unfolded similarly to date. However, we should always be wary when it comes to historical comparisons, and considering the fundamental differences between the present and any earlier time period we should now be even more wary than usual of such comparisons. In other words, don't hang your hat on the price action over the next year mimicking either 1973 or 1977-1978.

One plausible way that 2013's price action could deviate from the 1973 and 1977-1978 scenarios involves a decline to test the May-2012 low during the first half of the coming year."

Due to the price action over the past two months we think there's a 50% probability of the May-2012 low being tested during the first half of this year, but regardless of whether or not this test occurs we expect the gold-stock indices to finish 2013 with substantial 12-month gains in nominal dollar terms. To be a little more specific, a test of the HUI's all-time high of 638 seems possible this year prior to a major upside breakout in 2014. This assumes that we are right to forecast a sizeable gain in the gold price, because even though the average gold stock has a low valuation there is very little chance of it achieving a meaningful price gain over the course of this year unless the bullion price does the same. The reason is that mining costs will probably rise again in 2013, causing profit margins to shrink unless the increase in the gold price is greater than the increase in costs. Even with valuations at depressed levels in the gold mining sector, it isn't reasonable to expect the investing community's demand for gold stocks to increase in the face of shrinking gold-mining profit margins.

As stated in our 31st December report, we continue to believe that it makes sense to focus on the junior end of the gold mining sector. The juniors can be adversely affected as much or more than the seniors by "price inflation" (rising costs), but this risk is counteracted by vastly greater upside potential.

We also pointed out in our 31st December report that speculating in exploration-stage juniors requires a different approach now than it did during 2001-2007. The reality is that buying in-ground ounces just because they happen to be very cheap wasn't a valid approach last year and probably won't be a valid approach this year. Obviously, if all else is equal then it is better to pay a lower price for ounces in the ground, but all else is rarely equal. For example, in the current environment it could (probably would) make more sense to pay $100/oz for a stake in an undeveloped gold deposit in a good location with above-average grade and low projected capital costs than to pay $10/oz for an undeveloped gold deposit in a sub-par location with below-average grade and high projected capital costs. That's why it will be important over the months/quarters ahead to direct most of our attention and money towards two types of gold mining stock: exploration-stage miners with low political and permitting risk, low technical risk, good management, sizeable cash reserves and high net present values relative to projected capex requirements, and profitable producers with strong balance sheets and low political risk.

    Industrial Commodities

The above discussions ran much longer than planned, so our 2013 forecast for industrial commodities (the base metals and oil) will have to be brief. This is actually appropriate, because in the absence of a war that threatens the global supply of oil the industrial commodities can be relied upon to trend up and down with the stock market. Since at this time we don't have an opinion on what the stock market will do during 2013, we also don't have an opinion on what the oil and base metals markets will do during 2013.

However, we think that the intermediate-term risk/reward is more bullish for oil and the base metals than for the global stock market, due to the greater reward potential of the commodities. For the base metals the greater reward potential is mainly associated with central bank money-pumping. For the oil market it is mainly associated with the uncomfortably-high probability of war.