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    - Interim Update 6th September 2006

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A Strange Inverse Relationship

The inverse correlation between actual inflation and fear of inflation that's been evident over the past several years is not as strange as it might appear to be at first glance.

During much of the period between August of 2001 and July of 2003 one of the major concerns in the financial world was that deflation had become a legitimate threat. In fact, the fear of deflation became so pronounced during 2002 that Greenspan felt the need to wheel-out Ben Bernanke to discuss, in very blunt terms, the Fed's ability to devalue the currency by creating unlimited amounts of the stuff. Furthermore, the Fed, which has often attempted to paint itself as an inflation-fighter, began publicly worrying about an unwelcome FALL in inflation. Interestingly, however, and as reflected by the following chart of year-over-year M2 growth, the TROUGH in inflation fears coincided with the PEAK in actual inflation (money supply growth).

Around the middle of 2003 the fear of deflation quickly began to evaporate and prices began to rise. In fact, there was such a turnaround in sentiment that by the second quarter of 2004 inflation was once again viewed to be 'public enemy number one'. Sentiment had done a 180-degree turn due to surges in the prices of commodities, equities and houses, as well as signs that the labour market was becoming quite strong. However, with reference again to the following M2 chart notice that the re-emergence of the inflation bogey in the minds of market participants occurred after actual inflation had fallen to a relatively low level.


The inverse correlation between actual inflation and fear of inflation that's been evident over the past several years is not as strange as it might appear to be at first glance. It arises due to four main reasons: First, because there is usually a substantial time delay between the cause (growth in the money supply, a.k.a. inflation) and the effect (an increase in prices). Second, because the effects of inflation are almost always non-uniform (different prices are affected in different ways at different times). Third, because most people have been conditioned to view rising prices as the problem rather than as an effect of the problem. And fourth, because the Fed and all other modern central banks react to what's happening with prices (they frame their monetary policies in response to the lagged effects of the inflation rather than to the inflation itself)*.

So, what we end up getting is the following cycle:

1. In response to weak economic growth or some other perceived crisis, the central bank takes actions designed to cause inflation (designed, that is, to stimulate growth in the money supply). At this point inflation fears are low, but there is little fear of deflation.

2. The supply of money begins to grow rapidly in response to the central bank's inflationary policies, but as a result of falling economic growth and plunging asset prices the main fear is that the bank's efforts to elevate prices will come to no avail. The word "deflation" starts making regular appearances in the financial news media. Reporters working for the mainstream financial press seek-out the views of perennial deflation forecasters who are ready with their explanations for why the current surge in the money supply will inevitably be overwhelmed by the deflationary tide. Catchphrases such as "pushing on a string" are widely used to describe the futility of the Fed's inflationary efforts.

3. A large increase in the supply of money will ALWAYS lead to higher prices somewhere in the economy, so after a (sometimes substantial) time delay prices begin to rise in response to the central bank's actions. However, by this stage in the process the actual inflation rate (the money-supply growth rate) is well past its peak.

4. As time goes by the effects of the preceding inflation continue to bubble-up to the surface and eventually become apparent in the popular price indices. The debt market begins to discount more currency weakness (the market pushes bond yields upward) and central bankers, worried that inflation fears could soon get out of hand, decide to tighten monetary policy. By this stage in the process, however, market forces have caused the actual rate of inflation to fall to a much lower level, paving the way for a future REDUCTION in the rate of currency depreciation.

5. After a period of monetary tightening the central bank and the markets begin to fear that the risk posed by a weakening economy has become greater than the risk posed by currency depreciation (one of the main effects of inflation). That is, the fear of inflation has subsided and the fear of slower growth has gained the ascendancy. The central bank's tightening campaign thus comes to an end, but by this time a severe economic downturn is 'baked in the cake'.

6. In response to weakening economic growth and/or a crisis brought about by the unwinding of the preceding central-bank-created inflationary boom, the central bank begins implementing policies specifically designed to cause more inflation.

In a world where counter-cyclical monetary policy dominates and where "Keynesian economists" are well respected, more inflation will always be the prescribed remedy for the problems caused by inflation. This is partly because so few people recognise the underlying cause of the problem and partly because many of the ones who do perceive the true cause think that it's better to implement a 'bandaid solution' that allows the game to continue for a while than to implement a long-term fix.

At the current time the financial world appears to have just entered Stage 5 in the above cycle, although things are precariously balanced. In particular, if the gold price were to break above its May high over the next 2 months -- not something we expect but certainly not something we can rule out -- then the markets and the Fed would likely shift back to Stage 4 (the Fed would resume its rate-hiking to prevent inflation fears from getting out of hand).

    *Central bankers don't operate in this way out of stupidity. They are well aware of the consequences of inflation, but their charter is not to stop the inflation in its tracks. Rather, their charter is to keep the inflation going whilst managing inflation expectations; and inflation expectations generally only rise to worrisome levels after the prices of commodities, goods and services have moved considerably higher in response to the inflation facilitated by the central bank.

The Stock Market

Current Market Situation

From the latest Weekly Market Update:

"Taking into account both the supportive sentiment situation...and the bearish signal just generated by the OEX put/call ratio, the short-term scenario that makes the most sense to us involves a 1-3 week pullback during September followed by a rally that takes the S&P500 Index to new highs for the year."

Wednesday's price action suggests that the anticipated September pullback has begun. If it is a pullback within an on-going upward trend then the S&P500 Index should remain above support at 1280.


Gold and the Dollar

Gold Stocks

Regardless of whether or not the gold sector closely follows our current roadmap (a September high followed by a November low), we think it makes sense to anticipate more corrective action prior to the start of the next intermediate-term rally.

The relative performances of the main gold stock indices (the HUI and the XAU) have been distorted over the past week by the Goldcorp-Glamis merger deal. The distortion has primarily occurred because the acquiring company (Goldcorp) has a larger weighting in the XAU and its stock price has plunged, whereas the company being acquired (Glamis) has a larger weighting in the HUI and its stock price has surged. In addition, the HUI contains a number of smaller stocks that have benefited from the general increase in takeover-related speculation catalysed by the Goldcorp/Glamis merger.

As a result of the merger deal the HUI's break above resistance at 350 has not yet been confirmed by an equivalent breakout in the XAU.

Unfortunately, the non-confirmations don't end with the XAU. In particular, the performances of Royal Gold (NASDAQ: RGLD) and Newmont Mining (NYSE: NEM), charts of which are included below, add some mud to the technical waters.

RGLD has a tendency to lead at important turning points in the gold sector, but the recent rally has not yet caused the stock to break above resistance at $31. And NEM, the world's largest unhedged gold mining company, has dropped back to near the bottom of a 7-month consolidation pattern and is in danger of breaking-out to the DOWNSIDE.




We expect that a) the XAU will confirm the HUI's breakout by moving decisively above 150, b) RGLD will break above resistance at $31, and c) NEM will soon reverse upward and break above the downward-sloping trend-line that dates back to its January peak. If we do get such obvious confirmations of strength over the next couple of weeks then most people involved in the gold sector will undoubtedly become very bullish and begin anticipating a major multi-month advance, thus creating the right sentiment backdrop for a sharp decline to an October-November bottom.

There are obviously alternatives to the scenario outlined above, but based on the way intermediate-term corrections have unfolded in the past it's very unlikely that the gold sector's most recent correction ended in June. Those who are saying that a major advance to well above the May-2006 peak has already begun are, in effect, saying that the LONGEST intermediate-term rally in the gold sector's bull market has been followed by the SHORTEST intermediate-term correction (if the correction ended in June then it only lasted 5 weeks, whereas the shortest intermediate-term correction over the preceding 5 years lasted 6 months). Regardless of whether or not the gold sector closely follows our current roadmap (a September high followed by a November low), we think it makes sense to anticipate more corrective action prior to the start of the next intermediate-term rally.

Just to reiterate our general outlook, we think the gold stock indices made their price lows in June and that the next large decline will do no worse than 'test' the June lows. Rather than additional price weakness beyond what was achieved during May-June, what is needed to complete the correction is more TIME.

Further to the above, we think it would be a good idea for those who have substantial exposure to gold stocks to do some selling into strength over the next 3 weeks. As noted in the past, our approach is to maintain a sizeable core position in high-potential gold stocks at all times. We then add to this core position during 'the purges' and scale back to the core position during 'the surges'. If this approach is implemented properly then the dollar value of the core position will increase substantially over any 2-year period as long as the secular bull market remains intact.

Gold

Gold hasn't yet broken upward from its triangular consolidation pattern (see chart below), but the recent firmness in the major gold stocks suggests that it will soon do so. The short-term upside objective we have in mind for gold is the range between its July high and its May high ($690-$740 in the December futures contract).


The Dollar

Below is a daily chart of September euro futures.

The euro has spent the past 4 months oscillating within a 5-point range and the last month oscillating within a 2-point range. Furthermore, the euro's already-narrow trading range is contracting, so a breakout, in one direction or the other, should soon occur.

With gold and gold stocks looking like they going to head higher over the coming 1-3 weeks we would normally assume that the odds were in favour of the euro breaking-out to the upside (the US$ breaking-out to the downside) from its recent narrow trading range. However, given that last September featured strong concurrent rallies in gold, gold stocks and the US$, we aren't inclined to jump to any conclusions regarding the direction of the next multi-point move in the currency market. We will, instead, wait for the euro to close above 1.2950 or below 1.2750 before jumping to any conclusions.


Update on Stock Selections

(Note: To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question)

Claude Resources (AMEX: CGR, TSX: CRJ). Shares: 73M issued, 79M fully diluted. Recent price: US$1.35

We added CGR to the TSI Stocks List in August for two main reasons. First, the company's market capitalisation was more than fully justified by the 50K oz/yr of gold currently being produced by its 100%-owned Seabee Mine in Canada. Second, substantial upside potential was provided by the Madsen project in Canada's Red Lake mining district (refer to http://www.clauderesources.com/html/madsen.html for a description of this project).

Early this week there was a significant development with regard to the Madsen Project. But first, some background info from the 9th August Interim Update:

"CGR and GG [Goldcorp] have a joint venture arrangement whereby the major gold producer (GG) can earn a 55% stake in the Madsen project by completing a bankable feasibility study (BFS) by the end of 2006. In addition, after completion of the feasibility study CGR can elect to have its interest reduced from 45% to 40% by requiring that GG cover its portion of the mine construction costs. In other words, if everything goes according to plan then CGR will end up with a 40% stake in a profitable high-grade gold mine operated by Goldcorp without spending another dollar on the project.

It gets even more interesting, though, because there is no chance that GG will be able to complete the BFS within the allotted time. This means that to avoid losing its 55% stake in the Madsen project GG will have to either buy CGR or re-negotiate the terms of the earn-in arrangement between now and year-end. Whatever way this is resolved it's hard to imagine that CGR's shareholders won't benefit."

In other words, due to the impossibility of GG being able to meet the requirements to earn its 55% stake in the Madsen project it was certain that some sort of new arrangement would have to be negotiated.

As it turned out, CGR and GG were unable to come to terms and GG has forfeited its earn-in rights. Therefore, CGR now owns 100% of the Madsen project.

We view this week's news as a short-term negative and a longer-term positive. It's a short-term negative because the probability of CGR being taken over within the next few months is now a lot lower and because CGR will now have to finance 100% of the Madsen development. It's a longer-term positive because CGR now has ALL the upside potential associated with Madsen.


    The Canadian energy trusts that have high natural gas (NG) weightings are, as you would expect, plays on the natural gas price. In addition, they are influenced by bond yields. This is mainly because a lot of the investment demand for the energy trusts comes from people looking for dividend income (the lower the risk-free bond yield the more attractive the energy-trust distributions will appear to be). Lastly, the trusts aren't usually influenced in a big way by the performance of the broad stock market. For example, when the broad stock market tanked during 2002 the natural gas trusts generally did OK.

Unlike the NG-focused energy trusts, the stocks of major gas-producing companies such as Chesapeake Energy (NYSE: CHK) and Encana (NYSE: ECA) tend to be influenced as much by the trend in the broad stock market as they are by the trend in the NG price. For this reason they've held up remarkably well in the face of the collapse in the NG price over the past 9 months and would likely be hit hard if the broad stock market were to tank in the future.

The main difference between the above-mentioned two sets of stocks is that the trusts payout the bulk of their earnings to shareholders, with the payouts increasing/decreasing in response to major changes in the NG price, whereas the likes of CHK and ECA are growth-oriented companies that re-invest the bulk of their earnings.

In the TSI Stocks List we have a short-term position in CHK and a (potentially) longer-term position in a bunch of NG-focused energy trusts. It's the CHK position that we want to re-visit today.

As clearly evident on the following chart, CHK has spent much of the past year oscillating back-and-forth within a $7 range. In mid-July we suggested buying either the stock or the January-2007 $30 call options on the expectation that the next rally would carry CHK out of this range and up to around $40. Soon after making this suggestion the stock surged from $29 to $34 and then, quite predictably, began to consolidate its gains.

If our short-term bullish view on CHK is correct then the price should hold above support at around $30.50 during the current pullback and then surge anew. By the same token, a close below the aforementioned support would invalidate our short-term bullish view and prompt us to exit.


    Brokers

Many of the resource stocks with the greatest upside potential trade on the Canadian stock exchanges. Therefore and as discussed in previous commentaries, we think it is vital for investors/traders to have brokerage accounts that provide DIRECT access to the Canadian exchanges. At least, it's vital for those investors/traders who want to maximise their returns.

In the past we've highlighted Stockcross Barry Murphy (SBM), an off-line broker based in Boston that provides a low-cost service to non-Canadian investors who want to trade on the Canadian exchanges. This company continues to be a reasonable option, although it has recently changed its policy such that orders to buy/sell Canadian stocks must be placed in US dollars (the orders will still be executed in Canada in Canadian dollars, but the person placing an order will now have to determine the US$-equivalent of the C$ price at which they want the order to be submitted). This, in our opinion, is a problem because it a) adds a level of inconvenience, b) makes it difficult for investors to control the C$ price of the order, and c) makes it impossible for an investor to determine the FX commission being charged on each executed order.

On the other hand, at www.interactivebrokers.com (a major US-based on-line broker) you can place orders in Canadian dollars, the brokerage cost is low, and the FX commissions are both clearly evident and low. The downside is that it's not possible to trade most Canadian stock warrants via Interactive Brokers (IB). (Note: the warrants can be traded via SBM). This is a significant disadvantage because the warrants on junior gold/resource stocks are where some of the best profit potential can be found.

Lastly, it is worth mentioning that larger investors interested in participating in the private placements routinely done by junior Canadian-based resource companies will not get the opportunity to do so via either an on-line discount broker such as IB or a US-based off-line discount broker such as SBM. To have the opportunity to participate in brokered private placements an investor will, instead, need to have an account with one of the full-service Canadian brokers that gets involved in such deals (Canaccord Capital, for example). The full-service brokers also provide research on individual companies that can, very occasionally, be useful.

The bottom line is that you will probably need to operate more than one brokerage account in order to take full advantage of the gold/commodities bull market.

    In the coming Weekly Market Update we plan to do a very brief (1-2 sentence) update on EVERY position (stock, warrant and option) in the TSI Stocks List.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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