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    - Interim Update 4th August 2004

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The US Stock Market

Oil and the stock market

The oil price continued its relentless move higher during the first two days of this week, but then made a sharp downward reversal on Wednesday (refer to the daily chart of NYMEX September oil futures below) after the US Department of Energy reported that a) inventories of gasoline and distillates each rose by more than 2M barrels last week, b) growth in gasoline demand has stalled out, and c) inventories of heating oil will be at normal levels when the winter begins. At this stage yesterday's downward reversal in the oil market doesn't look particularly significant, but it was sufficient to encourage a rebound in the stock market following a sell-off earlier in the day.


Persistent strength in the oil price from here is not a prerequisite for a sharply lower stock market (there are other reasons why the stock market is likely to move lower over the coming months), but if the oil price continues to push higher an eventual result will be a much weaker stock market. This is not just because rising energy prices act like a tax increase but also because there has been a positive correlation between the oil price and short-term US interest rates over the past 6 months (rising energy prices have been putting upward pressure on short-term interest rates).

Current Market Situation

The senior US stock indices continue to meander along within the broad channels that have defined their progress since the beginning of this year, making it devilishly difficult to make money on either the short side or the long side. We continue to anticipate a large break to the downside, but considerable patience has been required over the past several months and might be required for a while longer as a definitive breakout remains elusive.

The recent tests of their respective May lows by the S&P500, the Dow and the NASDAQ have predictably led to rebounds which could continue for at least another fortnight, particularly if the pressure in the oil market has temporarily abated. However, the stock price of tech bellwether Intel has already rebounded back to a logical resistance level (see chart below) and reversed lower, so it is quite possible that the market will resume its decline without first moving appreciably higher.


The problem we have right now is that we can't divine much at all from the technical and sentiment indicators. There are what look like intermediate-term topping patterns all over the place, but that has been the case for a few months now. At the same time, we can see that it would be possible to make a short-term bullish argument. For example, the Semiconductor Index has begun to rebound from near the bottom of a well-defined channel and the recent action in the ever-important Bank Index could be interpreted as a saucer-type bottoming pattern.


Unfortunately, if we look outside the US for clues as to what to expect in the near future we see an equally fuzzy picture. Japan's Nikkei225 Index, for instance, dropped quite sharply over the past month but stopped falling once it hit trend-line support. In other words, there hasn't yet been a significant breakdown.


By the way, although we think a sharp (10%-15%) decline in the stock indices remains a good prospect at some point between now and October, the best opportunity to generate some trading profits will probably come from 'going long' during the rally that will most likely follow a sharp break to the downside. Until we get a sizeable decline, though, we won't be giving a great deal of thought to the possibility of a tradable rally. 

Gold and the Dollar

Why hold gold stocks at all?

Our view that the US$ will trend higher over the next several months and, as a consequence, that gold stocks are likely to trade at lower levels at some point between now and November, has prompted questions from subscribers along the lines of: Why do we suggest maintaining a sizeable position in gold stocks in the current environment? Wouldn't it be better to just get out of all gold stocks and re-enter later this year once the corrective activity comes to an end and the next major advance gets underway?

Well, getting out of all gold stocks would be a reasonable thing to do if we could be absolutely CERTAIN that the stocks we own were going to trade significantly lower in the future, but that isn't the case. Rather, there's a good CHANCE that the stocks will be available at lower levels before year-end, but this is a reason to be cautious and to maintain higher-than-usual cash reserves (something we've been strongly advocating since January); it is not a reason to be completely out of the market.

Being completely out of gold stocks would be akin to betting everything on a single short- or intermediate-term call and would, in our opinion, fly in the face of sensible risk management practice. The reason is that while most gold stocks will PROBABLY be available at lower levels the magnitude of the upside risk is generally many times greater than the magnitude of the downside risk. We can show what we mean by this by doing a 'back of the envelope' valuation of NovaGold (TSX, AMEX: NG).

If things go roughly to plan then NG will have annual gold production of around 700,000 ounces by 2008. Currently, the average market cap per ounce of gold production across the entire gold sector is around US$2000, so the aforementioned production would be valued at around US$1.4B if the gold price were near current levels (a higher gold price would increase the value of gold production). Now, assuming that NG has to issue another 10M shares over the next 4 years in order to finance project development -- a reasonable assumption given the company's current cash reserves and the likelihood that earlier projects will provide the cash to finance later projects -- then a US$1.4B market cap in four years time would be equivalent to a stock price of US$19 (C$25).

The above-calculated price of C$25/share for NG is 280% higher than yesterday's closing price of C$6.44 and, as mentioned, assumes ZERO increase in the gold price. However, we expect that the gold price will be trading well north of US$1,000 by 2008 so the actual stock price could be MUCH higher than our calculated value.

So, that's the potential upside over the next few years for one of our stocks and against this we must balance the risk of a drop back to around C$5.00 at some point over the next few months.

Most gold stocks don't have NovaGold's growth prospects so the above example is not representative of the sector as a whole. As far as the overall gold sector is concerned, though, a similar argument can be made in that the upside potential over the next few years can be shown to dwarf any short- or intermediate-term downside risk. In particular, with current sentiment towards the gold sector ranging from disinterest to pessimism (refer to the below discussion on gold market sentiment) the probability of another large down-swing in the prices of gold shares is low. What would, instead, be more likely is a drop back to near the May lows or, perhaps, to a few percent below the May lows; and against this downside risk we must balance the potential for another multi-year advance of similar magnitude to the one that unfolded during 2001-2003.

When it comes to gold stocks something else that unfortunately needs to be taken into account at this time is the very real potential for another large-scale terrorist attack. As discussed in the 26th July Weekly Update, gold stocks would probably get hit hard if the broad stock market tanked UNLESS the reason for the plunge in the stock market was terrorism, in which case gold stocks would move sharply higher if the September-2001 experience was anything to go by. In other words, at this time it might be appropriate to hold some gold stocks as a hedge against a financial crisis brought on by the destructive acts of barbaric terrorists.

Further to the above, we think it's important to be aware of the downside risks in the gold sector as far as the next several months are concerned, but not to allow the potential for additional counter-trend moves in gold and the US$ to completely override our longer-term views and all other considerations.

Gold Market Sentiment

TSI is not a "gold newsletter", but as mentioned in a previous commentary the level of interest in the TSI web site tends to ebb and flow with the level of interest in gold-related investments. Specifically, when rising prices cause the public to become more enthusiastic about gold and gold shares we see an increase in subscriptions (trial subscriptions and paid subscriptions) whereas the level of interest in the TSI service invariably drops off during corrections in the gold market. In this respect this year's gold market correction has had a similar effect as the corrections that occurred during 2002 and 2003, and even though the prices of gold and gold stocks have made a moderate recovery over the past 2.5 months it appears as if sentiment has remained quite depressed.

Other sentiment indicators paint a similar picture to our experience at TSI. For example, the commitments of traders (COT) data show that small traders were only marginally more bullish on gold with the gold price trading above $400 in July as they were when gold was trading in the 370s during the first half of May. Also, the below chart shows that the total assets in the Rydex Precious Metals Fund are now less than they were when gold and gold stocks were near their lows in May. In other words, since the May bottom the public has continued to lose interest in gold-related investments. This is, of course, bullish from a contrarian perspective and should help to limit the downside from here because it means that a lot of the weak hands are out of the market.


Current Market Situation

The below chart of Newmont Mining (NEM), the world's leading gold stock and a reasonable proxy for the gold sector, shows that $40.50 has acted as support and resistance over the past 6 months. Right now it represents important resistance.

With NEM turning lower on Wednesday after testing resistance at $40.50 during each of the preceding three trading days it appears as if the resistance has held and that a drop back to near the May low is on the cards. This is our favoured scenario and as far as we are concerned the sooner we can get a test of the May low out of the way the sooner we can commence the next major advance in the gold-stock bull market.

The most likely TIME for a correction low in the gold sector is November, but as discussed in recent commentaries it might be possible to bring the timing of a low forward to mid August if there is sufficient weakness during the first half of this month. Alternatively, we could get a test of the May low during August followed by a rebound and then a second test during November. Such a pattern would be similar to what happened during the 2002-2003 correction in the gold sector and to the lengthy mid-cycle correction experienced by the S&P500 during 1994.


During early trading on Wednesday it looked like the Dollar Index might be about to make a decisive break above 90, but the early strength couldn't be sustained (see chart below). Interestingly, the Dollar began to weaken on Wednesday as soon as the oil price started to come off and we've noticed a similar interplay between the currency and oil markets at other times over the past few months.

There is a school of thought that the dollar is benefiting from the rise in the oil price because oil is traded in dollars so a higher oil price creates more demand for dollars. This explanation doesn't ring true, though, because the international trading of all commodities is conducted in dollars and commodity bull markets tend to go hand-in-hand with dollar bear markets (the opposite would be the case if higher commodity prices provided a significant boost to dollar demand). A more reasonable explanation is that interest rate differentials are the dominant force in the currency market right now and that the dollar is only appearing to benefit from a rising oil price due to the upward pressure that the energy market is putting on short-term US interest rates.


The Dollar Index might spend some more time consolidating between 89 and 90, but we expect that it will eventually break above 90 on its way to 100. 

Update on Stock Selections

First Majestic Resource (TSXV: FR) announced on Tuesday that its La Parrilla silver mine in Mexico was now operating on a full-time basis following a period during which the plant was overhauled, tested and upgraded. It will be interesting to find out what the production rate and costs are when the first full month of production is reported at the end of August.

So far, things are generally going according to plan with FR and we expect that by the first half of next year the company will have at least two silver mines in production (La Parrilla plus at least one of the other past-producing mines recently acquired) producing a combined total 2M-4M ounces of silver per year at a cash cost of around US$3/ounce. Doing some quick calcs, if the company were able to achieve a production rate of 3M ounces within 12 months then this would result in cash-flow of around US$10.5M per year assuming the aforementioned cash cost and a silver price of US$6.50/ounce; meaning that if the stock traded at only 5-times cash-flow the stock price would be around C$3.00.

Further to the above, we think FR has a very attractive risk/reward at its current price of around C$1.64 because the stock provides good leverage to the silver price (we are very bullish on silver taking a 1-2 year view), but substantial strength in the silver price should NOT be required in order to achieve a high return from this investment.

By the way, in addition to being a cash-flow play FR also offers some blue-sky exploration potential due to its Niko silver project. The first drilling results from Niko are expected to be released next month.

    Afrikander Lease (AFKDY.PK) now has financing in place to see it through the coming 12 months (refer to http://www.sharenet.co.za/v3/sens_display.php?tdate=20040802120501&seq=1165 for details).

The financing came at a hefty price in that it will result in a 50% increase in the Aflease share count, but large-scale dilution of existing shareholders was always going to be unavoidable due to the company's precarious financial position. The important thing is that Aflease's ability to stay in business over the coming 12 months is no longer in question, meaning that its management can now focus on generating value for shareholders from its stable of gold and uranium projects. There is, in particular, the potential to realise enormous value from the company's uranium assets.

    We aren't aware of any new developments that would explain it, but the Saskatchewan Wheat Pool (TSX: SWP.B) stock price has been very strong of late and broke out to the upside on Wednesday. If it can now hold in the mid-40s during any near-term pullback then a move up to the 0.60-0.70 range would become a likely prospect.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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