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Copper

Following the run-up in the copper price to major resistance in the mid-90s our expectation was that December copper would drop to at least 86 before a correction low would be in place. A drop to 86 would have simply been a garden-variety bull market correction and, in fact, we wouldn't have been surprised if the copper price had drifted all the way back to the low-80s to test the earlier upside breakout. However, this week's drive to a new 6-year high clearly shows that the correction ended at around the 88 level. In a bull market most surprises will be on the upside.

Our preferred way to play the bull market in copper is via the stocks of junior copper explorers/producers, and in this regard our favorite stocks are Taseko Mines (TSXV: TKO) and Adrian Resources (TSX: ADL). Both stocks offer enormous leverage to the copper price and should be accumulated on weakness. These stocks regularly make daily moves of 10%-20% so they are not for the faint of heart, but there's a difference between volatility and risk. The NASDAQ100 Index, for example, has had extremely low volatility over the past several months but in our view it is a very risky proposition at the current price. TKO and ADL, however, have been extremely volatile over this period, but if the copper price continues along its upward path then the risk of owning these stocks is not particularly high for anyone with an investment time horizon of at least 12 months. Of course, individuals can create their own risk by investing too much money in any one stock.

The US Stock Market

A potential problem for the markets?

Associated Press, 28th November: 

"Four youngsters died of the flu in Colorado since last week in what U.S. health officials say could foretell a severe flu season for the country.

The children were 21 months old, 2, 8 and 15, and their deaths startled some health officials because they happened so close together and so early in the season. Last year, Colorado had four child deaths during the course of the flu season, which normally peaks in January and February and runs through April.

Even before the deaths, there were signs this could be an especially bad flu season. Some parts of the country -- particularly Colorado, Texas and Nevada -- have been hit hard a month earlier than usual.

The flu strain doctors are seeing is the H3N2 Fujian, part of a class of flu viruses that caused severe outbreaks in the U.S. in the 1990s.

Other flu-stricken children in both Texas and Colorado are being kept alive on ventilators in hospitals. "Doctors across the city are saying they've never seen a flu season like this," said Ned Calonge, chief medical officer for the Colorado Department of Public Health in Denver. He said nearly 4,000 cases of flu in adults and children have been reported in Colorado this fall."

News reports emanating from the US (see above) and from Europe indicate that the coming Northern Hemisphere winter could see a particularly severe outbreak of the flu. If these early signs prove to be indicative of what is to come then there could be important implications for economic growth and for the financial markets.

The Economy and the Stock Market

Recent economic data in the US have been very positive. In fact, economic growth throughout the world has generally been strong over the past few months. This, however, is not something that should have come as a surprise to TSI readers as our forecast was for a strong performance by the US economy during the second half of 2003. Furthermore and as explained in previous commentaries, money-supply growth trends suggest that it will be the second quarter of 2004 before significant evidence of economic weakness begins to re-emerge. 

An unusually severe flu season could, though, bring forward the starting point for the next bout of economic weakness to the first quarter of 2004. This, in fact, could be what is currently being discounted by the stock of the world's largest retailer (the Walmart stock price has been surprisingly weak of late given the generally positive equity-market environment). 

In recent commentaries we've mentioned the first half of January as being a likely time for an important stock market peak. A peak at around this time would be consistent with an economic slowdown beginning in the second quarter (or possibly as early as the first quarter if the outbreak of influenza is severe enough) because the stock market tends to move in advance of the economy (this is why important stock market peaks tend to occur amidst very positive economic news). A peak at around this time would also be consistent with the timing of several of the other major stock market peaks of the past 40 years and meshes with the bullish complacency that currently permeates the market.

Many financial market commentators are presently labouring under the belief that the enormous fiscal stimulus provided by the US Government combined with the enormous monetary stimulus provided by the Fed will ensure that the equity market and the economy will remain firm, or at least stable, until after the November 2004 Presidential election. Our view, however, is that the probability of economic and equity market strength/stability persisting for more than a few more months is close to zero. For one thing, the sharp downtrend in the money-supply growth rate over the past few months indicates that the much-vaunted monetary stimulus has already lost its effectiveness. And additional aggressive fiscal stimulus on top of the massive stimulus that has already been provided would, if it occurred, scare the living daylights out of private-sector bond investors due to the effect it would have on the already-huge budget deficit.

In our opinion, the best Mr Bush can reasonably hope for is that there will be a sharp fall in the stock market that ends by mid year. If things panned out in this way then the market could potentially be strong during the few months leading up to the November election, thus giving the impression that the worst was over.

Anticipating a cycle change

It has been very easy to make money in the stock market since March of this year. Regardless of whether you have owned tech stocks, or gold stocks, or financial stocks, or commodity stocks, or homebuilders, or biotechs, or bank stocks, or cyclical stocks, or any other kind of stocks, you've probably done well. All you had to do to make good money was to be long stocks of any type. However, the market moves in cycles and the cycles typically change in such a way that whatever worked during the current cycle won't work during the next cycle. On this basis a characteristic of the next cycle -- one which will probably begin within the next 3 months given that the current cycle appears to be 'long in the tooth' -- will most likely be that NO sector of the stock market will rally. During the next cycle you are probably going to lose a lot of money regardless of whether you own tech stocks, or gold stocks, or bank stocks, or commodity stocks, etc. 

By the way, we haven't yet seen any evidence that the above-mentioned cycle change is underway. Therefore, we don't yet see a need to take any precautions in addition to normal risk management practices (our normal risk management practices involve, for example, scaling out of some stocks once they become extended and maintaining a sizeable cash reserve at all times).

Current Market Situation

The bad news for the bulls over the first three days of this week includes the breakdown in the Walmart stock price (see chart below). WMT is probably now close to a short-term bottom, but the recent price action suggests that its early-September peak will turn out to be THE recovery high for this stock. With WMT appearing to have peaked and the S&P500 Index making a new recovery high this week we therefore have a potentially significant bearish divergence 'on the go' given WMT's tendency, over the past 18 months, to lead the S&P500 Index at important turning points.

Also in the 'bad news for the bulls' department is the fact that this week's new highs in some of the senior stock indices were not confirmed by a new high in the NDX/Dow ratio. As explained many times in the past, a downward reversal in the NDX/Dow ratio is something that should occur prior to a downward reversal in the broad market. 

There is, however, some good news for the bulls in that the Biotech Index (BTK) broke its short-term downtrend early this week (see chart below). The BTK remains below a longer-term trend-line, but its chart pattern has bullish connotations (more often than not, patterns such as this lead to large upward moves). A drop back to 440-450 by the BTK would not be surprising over the next few weeks, but as long as it remains above its November low the overall pattern will remain bullish.

And some additional good news for the bulls has come in the form of a sharp rebound in the Japanese stock market. Japan's Nikkei225 Index recently broke below important support in the 10000-10200 range, but this week's surge above this range suggests that a correction low is in place. Even if this proves to be the case, though, the Nikkei's risk/reward is not particularly attractive to us at this time. Or, to put it more aptly, we much prefer the risk/reward of some of the commodity-oriented stocks. 

In summary: the market appears to be headed higher over the coming month or so, but there are some potentially important signs of weakness. The action is consistent with a market that is working its way towards a January peak.

Gold and the Dollar

The Fed distorts interest rates throughout the world

The Reserve Bank of Australia (RBA) hiked the official Australian interest rate by 0.25% for the second time earlier this week (the first rate hike was last month). However, according to the US Federal Reserve there won't be any rate hikes in the US for the foreseeable future. 

The RBA might be making some attempt to contain the inflation problem in Australia, but the Fed's current interest rate policy -- which could appropriately be referred to as a pro-inflation policy -- is going to severely limit the ability of central banks throughout the world to use monetary policy in response to domestic inflation concerns. This is because the spread between official US interest rates and interest rates in most other developed nations is already very large. For example, official interest rates are now at 5.25% in Australia, 3.75% in the UK, 2% in the European Union and only 1% in the US. This, in turn, means that any central bank that tries to rein-in local inflation pressures by hiking official interest rates is going to increase the already-wide yield differential with the US and is therefore going to put upward pressure on its currency's exchange rate. Since most central bankers don't want their currencies to strengthen against the US$ they are somewhat hamstrung by the Fed's pro-inflation stance. In other words, the Fed's current policy is going to exacerbate the inflation problems in many other countries.

As well as distorting monetary-policy decisions throughout the world, the Fed's pro-inflation policy should ensure that any rebound in the US$ will be short-lived. We are anticipating a dollar rebound, most likely beginning from near the current level, but in the absence of a change in Fed monetary policy the magnitude of any US$ rally would be unlikely to exceed 10%.

Barrick Gold to close its hedge book

Barrick Gold, the gold mining company that forward-sold (hedged) more gold than anyone else, has announced that it is going to reduce its hedge book to zero over the next few years. Barrick's hedge book is presently around 16M ounces, so the amount of gold that will be available to the market over the next few years will now potentially be 16M ounces less than it would have been had Barrick decided to maintain its current level of forward sales. We say "potentially" because the total aboveground supply of gold won't change as a result of Barrick's announcement and the 16M ounces of gold that were loaned by central banks in order to facilitate Barrick's forward sales might simply be re-loaned to someone else as Barrick closes out its various contracts (*see note below).

The Barrick news can only be positive for the gold market because it means that one avenue for getting official gold reserves out of central bank vaults and into the hands of Indian jewelry manufacturers no longer exists. However, when it comes to the 'de-hedging' that has taken place over the past few years we've noticed that some gold market commentators have put, and continue to put, the cart before the horse. Specifically, it is important to understand that the gold bull market has caused the de-hedging, not the other way around. No gold mining companies were closing out hedges when the gold price was bottoming during 1999-2001, but as the gold price has moved higher an increasing number of companies have realised that it pays not to forward-sell future production. 

*Note: As part of every forward sale of gold by a mining company an intermediary (a bullion bank) borrows gold from a central bank and then sells the gold into the spot market. The intention is that the central bank's loan will eventually be repaid using the mining company's future gold production.

Gold and Silver Stocks

From the latest Weekly Update:

"The likelihood that gold stocks won't peak until after the Dow peaks is a point we've stressed over the past several months and is part of the reason we've been comfortable retaining substantial exposure to the gold sector (as long as the broad market was making new highs there wasn't any need to worry about a major decline in the gold sector). Now, though, we are approaching a dangerous time for the gold sector because it's been 3-4 weeks since the Dow Industrials Index made its most recent high for the year.

Obviously, if the Dow moves to a new high for the year over the next few weeks -- something we think it has a good chance of doing -- then the immediate danger for the gold sector will subside."

The Dow has just made a new high for the year and, as discussed earlier in today's commentary, there are signs that the broad market is headed for an important peak during the first half of January. If this proves to be the case then the earliest likely time for a peak in the gold sector would be late January. 

The market action over the first half of this week is consistent with the short-term forecast for the AMEX Gold BUGS Index (HUI) included in the latest Weekly Update, that is, it is consistent with the idea that there will be a 2-4 week pullback in the HUI followed by a final surge during January. As also mentioned in the Weekly Update, given how expensive many of the HUI's component stocks are relative to the gold price the ultimate high for this index might only be 5%-10% above the current level. There's a good chance, though, that many of the junior stocks will move considerably higher over the next 2 months.

The below point-and-figure chart of the HUI/gold ratio does a good job of illustrating just how extended the large and mid-tier gold stocks are right now relative to the metal price (refer to http://stockcharts.com/education/glossary/pointFigureChart.html for an explanation of point-and-figure charting). Also, our HUI-Gold Oscillator, although still comfortably below the levels that have occurred at previous intermediate-term peaks, is now at its highest level since May of 2002 (indicating that the valuation risk in gold stocks is now higher than it has been at any time since May of 2002). However, the trend is still up and we haven't yet seen any significant signs of weakness.

There are two times when silver stocks are likely to out-perform gold stocks. One is during a period when the economy is strengthening (because the silver price is driven by industrial demand as well as monetary demand whereas the gold price is driven almost solely by monetary demand). And the other is during the late stages of a rally in precious metal stocks.

The reason the silver stocks have tended to out-perform during the late stages of rallies is that this is the time when the most speculative stocks provide the highest returns and all silver stocks are speculative (there are no 'blue chip' silver stocks). We say this because the popular listed silver companies either have no revenue (they just have silver in the ground) or if they are actually producing silver they are small and currently unprofitable.

The below chart of the TSSI/HUI ratio (TSSI is the TSI Silver Stock Index) shows that silver stocks have been gaining relative to the large and mid-tier gold stocks that comprise the HUI since July of this year and have recently moved sharply higher relative to the gold stocks. The TSSI/HUI ratio is still well below where it was during May-June of 2002 (when silver stocks were peaking), but the recent performance of this ratio meshes with the view that we will get an important peak within the next 2 months.

In the TSI Stocks List we have exposure to silver via Western Silver, Cardero Resource and Metallica Resources. These stocks will probably move higher over the next 2 months, perhaps following some consolidation of recent gains, but hopefully none of our regular readers will feel the need to buy at the current prices because these stocks were recommended numerous times at much lower prices over the past several months. 

Gold and Currencies

A normal progression in the markets would go something like this: 

1. Gold stocks reach a major peak and start trending lower
2. Sometime after gold stocks have peaked the gold price peaks and begins trending lower
3. Sometime after the gold price peaks the US$ bottoms and begins to trend higher

The time between each of the above steps could be as little as a few days or as long as a few months.

If the markets follow the above progression this time around and gold stocks reach a peak in late January then the gold price isn't likely to peak and the dollar isn't likely to bottom until at least February-March.

Our view continues to be that the Dollar Index is close to a short-term bottom and the euro is close to a short-term top (our previously mentioned targets were 89 for the Dollar Index and 122 for the euro). However, we won't turn short-term bullish on the Dollar until we see a sign of strength (as mentioned in the latest Weekly Update, we will consider a daily close in the cash Dollar Index above its 50-day moving average to be such a sign). Also, while we were originally looking for the dollar to experience a 3-6 month counter-trend rally following a drop to the 88-90 range such an outcome is no longer consistent with the current action and expected future action in other markets. Instead, the Dollar is likely to resume its decline following, at best, a 1-2 month rally. 

Our gold market view is unchanged. Gold is expected to move up to $410-$420 before year-end and to trade up to $460 next year (probably during the first quarter of next year the way things are going). Major gold rallies tend to end with large upward price spikes and there has been no 'spikiness' in the recent gold move. Furthermore, the longer that gold can work its way upward in such a slow and steady manner the higher it should eventually go. 

Update on Stock Selections

At Wednesday's closing price of C$6.68 for NovaGold shares (TSX: NG) the NovaGold warrants (TSX: NG.WT) are, by our calculations, worth around C$3.10. However, these warrants closed at $2.38 on Wednesday. Needless to say (but we'll say it anyway), the NG warrants look very attractive at the current price.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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