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    - Interim Update 2nd June 2004

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Is the Fed cranking up the printing press?

M2 money supply increased by $101B (21% annualised) over the most recent 4 weeks for which monetary figures are available, so the Fed must be aggressively printing money, right? Actually, no; the components of the total money supply over which the Fed has direct control -- M1 money supply is a reasonable proxy for what the Fed is doing in the money-printing department -- did not experience unusually-large gains over the past 4 weeks.

When we look at the money-supply components we see that $86B of the aforementioned $101B growth in M2 resulted from increases in household savings deposit and money market deposit accounts. In other words, the recent surge in money supply growth was caused by the same thing -- consumer borrowing -- that caused the surge in money supply growth last year, and the year before that, and the year before that. Obviously, somebody forgot to tell the US consumer that he/she is supposed to be 'tapped out'.

The recent rapid increase in the money supply had its origins back in March when the number of mortgage applications moved sharply higher in response to a drop in long-term interest rates. This is, in turn, consistent with the pattern in the US since 1995.

The pattern is that every significant drop in long-term interest rates causes prospective home owners to apply for mortgages and existing home owners to apply to re-finance their mortgages (often with the aim of monetising some home equity), leading to high money supply growth over the ensuing few months. The latest jump in the money supply simply tells us that nothing has changed...yet.

The pattern will eventually change, though, because at some point the consumer will become unwilling or unable to respond to a drop in interest rates by increasing his/her debt burden, or interest rates will move high enough to eliminate any incentive to re-finance existing home loans. However, there's no way to accurately forecast when this point will arrive. Our guess is that it will occur within the next 12 months, but it might not occur for many years. In any case, a pullback by the consumer is not likely to usher-in a period of deflation, it's likely to kick-off a period during which the Fed takes DIRECT control of the inflation process and really does crank-up its monetary printing press.

Up until now the virtuous circle comprising interest rates, mortgage lending, money-supply growth and house-price growth has generally allowed the Fed to stand aside and let consumer borrowing be the engine of inflation, with the only exceptions occurring during crises (September 2001) or perceived crises (the months leading up to the Year-2000 transition). However, when consumer borrowing and spending eventually slows we expect to see much higher rates of growth in the money-supply components directly controlled by the Fed.

Interest Rates

The yield on the 13-week T-Bill has moved sharply higher over the past week (see chart below) and in doing so it has removed any similarity with the first half of 2002 (during the first half of 2002 the T-Bill yield briefly pushed above the Fed Funds Rate only to quickly move back below the FFR). This means the markets are absolutely convinced that it's time for the Fed to start hiking rates.

If the next FOMC Meeting were to be held today the only question would be whether the Fed was going to move the official rate up by 0.25% or 0.50%. The Fed Funds Futures, which are the market's forecast of what the Fed is going to do and which are very accurate forecasters of near-term Fed action, are currently saying that there is a 100% probability of the Fed hiking rates by 0.25% before the end of June and almost a 100% probability of the Fed hiking rates by 0.50% before the end of July. In our opinion the current message of the Fed Funds Futures will prove to be correct unless something dramatic -- an example of "something dramatic" would be a 1500-point decline in the Dow -- happens over the next few weeks.



The recent sharp rise in the T-Bill yield has had the effect of pushing the yield-spread sharply lower. The below chart of the 30-year yield divided by the 13-week yield illustrates this effect.



The drop in the yield-spread shown on the above chart is bullish for the US$ and, by extension, bearish for gold and gold stocks. In this case, though, we suspect that the April-May correction in the gold market anticipated the current action in the yield-spread, so we don't expect to see substantial additional weakness in gold and gold stocks in response to the recent contraction in the yield-spread. If the yield-spread continues to contract it will, however, limit the downside in the US$ and support our view that the Dollar Index is not in the early stages of another major decline but is, instead, just pulling back to 'test' its February low.

The US Stock Market

Current Market Situation

Although the market has made a nice recovery over the past few weeks we are a long way from being convinced that our bearish view is 'off the mark'. Where we are probably going to be wrong is in our timing because it is now unlikely that an important low will be in place by the end of June, but this might just mean that the market bottoms 1-2 months later than originally anticipated.

As things currently stand, the NASDAQ100 Index (NDX) has just rebounded back to its downward-sloping trend-line (see chart below), which means that the sequence of declining tops that began in January remains intact. The other senior stock indices (the Dow, the S&P500, the NASDAQ Composite) are currently below similar trend-lines, so now is a likely time for a rally failure to occur. In other words, now would not be an opportune time to turn short-term bullish.


It's quite possible that the stock indices will break above their downtrend lines, but even if this happened we doubt that there would be substantial follow-through to the upside because the geopolitical situation is way too precarious for money managers to be paying-up for stocks. It would be one thing to buy in the current environment if the Dow had just plunged 2,000 points and had therefore gone a long way towards discounting 'the worst', but right now nothing bad appears to be priced into the market (not a surge in the oil price nor a terrorist attack nor a botched handover in Iraq nor higher interest rates nor slowing profits growth). Furthermore, although sentiment indicators have pulled back from the optimistic extremes seen earlier this year they still reveal way too much complacency to support the idea that a multi-month upward move is underway.

Therefore, if the downtrends were broken in the near future we think there would, at best, be an additional 2-3 weeks of upward movement before the market turned lower.

One of the biggest anomalies over the past two months has been the concurrent strength in the Transportation sector and the oil price. When such anomalies occur it is tempting to come up with fundamental explanations as to why things are now different, and over the past few weeks we've read explanations as to why the 'transports' have been performing well in the face of a rising oil price. However, we don't think there's any possibility that the nature of the transportation business has suddenly, over just the past two months, altered to the extent that the average transportation company is now LESS vulnerable to higher fuel costs than the average industrial company. Instead, what we have here is a market divergence and these divergences are inevitably closed, one way or another.

The current divergence could be closed by either a plunge in the oil price or a plunge in the Dow Transportation Average (TRAN). The stock market is clearly anticipating the former (a plunge in the oil price).

Below is a chart of the TRAN. As strong as the transportation stocks have recently been, the TRAN is yet to exceed its April high.


Gold and the Dollar

Current Market Situation

We've been focusing on the Swiss Franc (SF) in recent commentaries because it has been the leading currency over the past six weeks. It's likely to retain this leadership role in the short-term, so as long as the SF looks technically strong we will anticipate additional weakness in the US$.

Below is a chart of June SF futures. The SF made a very decisive upside breakout last week and now appears to be consolidating. We expect that a move to new recovery highs will follow this consolidation, but in order for the short-term outlook to remain bullish the SF must not drop below 0.7875.


Gold has pulled back over the past few days after hitting resistance late last week. We expect that the current pullback will be followed by a move up to 415-420, but in the mean time June gold must hold above $385 for the short-term bullish outlook to remain valid.


As mentioned in recent commentaries, critical resistance for the AMEX Gold BUGS Index (HUI) lies at 207.75. After reaching its 50-day moving average at the end of last week the HUI has pulled back as anticipated. We expect that the current pullback will be followed by a move up to 205-215, but aren't looking much beyond that at this stage. A drop to test the May low is likely at some point.


When the Dollar Index broke below its 50-day moving average late last week it also broke below the bottom of a channel that has defined 'the trend' since early this year (see chart below). The channel break projects a drop to around 85.5, which is consistent with our view that the Dollar Index will test its February low within the next two months.


Gold Stocks

Today we are going to take a look at the intermediate-term technical picture for the gold/silver sector by reviewing log-scaled weekly charts of eleven different gold and silver stocks.  We've selected a mixture of majors, mid-tiers and juniors for this review with the charts presented in order of market capitalisation (largest at the top to smallest at the bottom).

1. Newmont Mining (NYSE: NEM)

NEM has major support at $33-$34 and important resistance at around $41. Conservative investors should accumulate this stock at around $35, but we would not be buying at the current level.


2. Gold Fields Ltd (NYSE: GFI)

GFI and Harmony (HMY) are the South African gold stocks that we think offer the best risk/reward for long-term investors. Of the two, HMY offers the greater leverage to the gold price. However, GFI's operational performance has recently been better and GFI is more geographically diversified (it has less exposure to SA). We'd therefore lean towards GFI if we were going to buy just one major South African gold stock.

GFI has been trading sideways now for two years and there is no reason why this tedious range-trading couldn't continue for another year. However, the sideways trading looks like a continuation pattern rather than a topping pattern so we expect that an upside breakout will eventually occur, sending GFI on its way to $20.


3. Kinross Gold (TSX: K, NYSE: KGC)

Like GFI, Kinross has traded sideways for the past two years. K's chart pattern is more bearish than GFI's, though, because the March-2003 low was decisively breached during the recent correction.

K will sometimes be a good stock to trade because it offers a lot more leverage to the gold price than any of the other North American majors, but it's not a stock we'd be interested in holding for the long-term.


4. Agnico Eagle (NYSE: AEM)

AEM is another gold stock that has gone nowhere over the past two years. The stock is presently quite close to the top of its long-term consolidation pattern, meaning that now would not be an opportune time to buy.

The operational problems that have weighed on AEM over the past two years seem to have been resolved and the company had excellent success on the exploration front last year. As a result we think the stock would be a buy if it dropped back to $10-$11.


5. Bema Gold (AMEX: BGO)

BGO consistently produces terrible operating results, but the company owns some great assets and tends to be a speculative favourite whenever the gold price is in an upward trend. The stock price hit the bottom of its long-term channel during May, so a correction low is probably in place.


6. Pan American Silver (NASDAQ: PAAS)

PAAS is the world's premier silver mining company, which is not saying much because there aren't any blue-chip silver miners. The stock is rebounding after completing what appears to be the initial downward leg in an on-going correction. US$10 is a likely level for a correction low.


7. Golden Star Resources (AMEX: GSS)

GSS has a high market capitalisation relative to the size of its business (this is not an under-valued stock by any stretch), but the stock price hit the bottom of a well-defined channel last month so a correction low is probably in place.


8. Northgate Minerals (TSX: NGX)

NGX is an under-valued situation, but from a technical perspective appears to have a bit more downside. The long-term channel bottom currently lies at around C$1.70.


9. Western Silver (TSX: WTC)

WTC rebounded strongly from its May low on the back of some excellent drilling results. The ideal place to buy WTC would be just above major support at C$5.00, but in order for the stock to become available at this price there would probably have to be severe weakness in the stock market.


10. NovaGold Resources (TSX and AMEX: NG)

NG broke out of a downward trend last October and the recent decline represented a pullback to the former downtrend-line. The low appears to be in place for NG, although a test of the low would not be surprising.


11. Nevsun Resources (TSX: NSU)

A brief discussion on NSU was included in the e-mail sent to subscribers earlier this week. From a valuation perspective we like NSU near current levels and from a technical perspective a correction low appears to be in place.


Update on Stock Selections

As far as NovaGold (TSX and AMEX: NG) is concerned the technical situation looks fine (as noted above) while the fundamental situation is extremely bullish.

NG has 10 projects in various stages of exploration, with the two most important ones being Donlin Creek and Galore Creek.

The 25M ounce Donlin Creek project is currently 70% owned by NG and 30% owned by Placer Dome (PDG), but PDG has exercised its back-in right on the project and must therefore now spend US$32 million toward project development, complete a bankable Feasibility Study, and make a positive decision to construct a mine to produce not less than 600,000 ounces of gold per year on or before November 2007. If Placer Dome is unable to make a positive mine construction decision by November 2007 then they earn no additional interest in the project and management reverts back to NovaGold. Furthermore, should Placer Dome make a decision to construct a mine, NovaGold is not required to contribute any additional funding until Placer Dome invests at least US$32 million.

Relying on a major company -- in this case PDG -- to advance the Donlin Creek project might not appear to be ideal, but the Donlin Creek arrangement with PDG is really a no-lose situation for NG. For example, if PDG moves too slowly then NG will end up with an additional 40% of the project (10M ounces of gold) whereas if PDG moves quickly then NG gets carried through to the point where a production decision is made on what will probably end up being a 1M ounce/year mine. PDG has budgeted to spend US$6M on the project this year and plans to commence a Feasibility Study by the 4th quarter so it looks like the major company is going to make a serious effort to meet its deadline, thus allowing NG's management to focus on Galore Creek and the other projects.

Galore Creek is a large, high-grade copper/gold/silver deposit with the potential to be developed into a mine that would, at current metal prices, generate revenue of about US$330M/year at a high profit margin. The deposit is primarily copper, which is fine with us because we expect the copper price to move considerably higher over the next few years. Once the planned merger with SpectrumGold is complete NG will have the right to earn 100% of Galore Creek (there are no back-in rights) by making payments of US$20.3M over 8 years.

Accounting for the new shares that will be issued to complete the SpectrumGold takeover NG's current enterprise value is only about US$225M. This is extremely low given the value of just the above-mentioned projects, that is, it is extremely low without even assigning any value to the company's other projects.

    The Dow Industrial Index hit the 'stop out' point for our put options on Wednesday. As discussed above, though, we are more likely to be off in our timing than wrong altogether. As such, instead of simply exiting the DIA July $96 puts (DIAUR) we are going to roll into the September $96 puts (DIAUR).

Rolling out into the later month involves, in this case, closing the position in the July contract and simultaneously buying a position in the September contract. Based on Wednesday's closing prices this would cost about $1 per option (for example, sell the July contract at 0.50 and buy the September contract at 1.50), which has the effect of increasing our base cost for the position to $2.30 ($1.30 for the original July option plus an additional $1 to roll into the September contract).

    We are also going to roll our GFI $15 call options into a later month. Specifically, we'll exit the July $15 calls (GFIGC) and buy the October $15 calls (GFIJC). This should cost around US$0.30 per option and will increase our base cost for the position from $1.00 to $1.30.

    We'll send out another e-mail to subscribers tomorrow (Friday) with our latest thoughts on Metallica Resources and Cardero Resource.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/

 
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