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    - Interim Update 8th March 2006

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The long-term dollar bear

...events will once again conspire to eliminate the inflation-rate and interest-rate advantages that are the basis of the dollar's current upward trend. ...It is very unlikely, however, that the US$ will ever COLLAPSE in value relative to any other fiat currency.

Over the past two years the US$ inflation rate has been less than the inflation rates of the euro, the Pound, the Australian Dollar and the Canadian Dollar. This inflation rate advantage, combined with the dollar's interest rate advantage over most of its major competitors in the fiat currency world, has been the driving force behind a bull market in the Dollar Index that is presently 14 months old and is likely to last for at least another 6 months. We continue to believe, however, that this bull market is a counter-trend move within the context of a longer-term downward trend (a cyclical bull within a secular bear). Our reasoning is outlined below.

Although the US$ has experienced relatively less inflation over the past two years, between 1998 and 2003 there was a lot more inflation (money-supply growth) in the US than there was, for example, in the major economies of Europe. This made the dollar over-valued and thus set the stage for the long-term dollar bear market that began in 2001. Also, the US stock market was the focal point of the global boom in technology, telecom and internet stocks, so when the NASDAQ bubble burst in March of 2000 the US lost something that had been acting as a magnet for foreign investment; that is, it lost something that had been boosting the demand for the dollar.

It's important to note, though, that it wasn't until some time after the Fed had cut US interest rates aggressively in response to the 2001 recession, the 9/11 terrorist attacks and the plunge in capital spending that followed the bursting of the NASDAQ bubble that US$ supply began to overwhelm US$ demand and the Dollar Index began to trend lower in earnest. In other words, things happened during 2000-2001 that forced the Fed to adopt an ultra-easy monetary policy and it was this change in monetary policy (and the resultant inflation) that caused the dollar to weaken.

Our view is that events will once again conspire to eliminate the inflation-rate and interest-rate advantages that are the basis of the dollar's current upward trend. In particular, the huge costs of maintaining a military presence in the Middle East and re-building New Orleans, combined with the lack of any real desire to cut spending in other areas or raise taxes, all but guarantee a continuation of the current rapid pace at which the US Federal Government borrows dollars into existence. Furthermore, the Fed will again adopt an aggressive pro-inflation stance once the stock and commodity markets begin to trend lower with conviction and the economic data starts pointing towards a recession. As was the case during 2001-2004, large-scale deficit-spending by the US Government in combination with rate cuts by the Fed should catalyse another multi-year decline in the US$.

So, we expect that the main drivers of relative currency valuations -- inflation rates and interest rates -- will begin to pressure the dollar lower at some point during the second half of this year. It is very unlikely, however, that the US$ will ever COLLAPSE in value relative to any other fiat currency. The reason is that ALL of these currencies are in the process of being inflated into oblivion; it's just that over the next few years the dollar is likely to move towards that ultimate destination at a modestly faster pace than some of the other major currencies.

The dollar's orderly long-term decline against the Swiss Franc is illustrated by the following chart. Notice that the dollar has made a succession of lower highs and lower lows since 1970 and that there has never been a runaway bull or bear market. Rather, steady declines lasting 8-10 years have been punctuated by steady advances lasting 6 years. If this pattern continues then the next bottom will occur near the end of this decade with US$ and the Swiss Franc at close to parity.

If the dollar's decline ever did become disorderly, that is, if the dollar began to fall at an accelerated pace, then the central banks of the US's main trading partners could be relied upon to stem the decline by taking steps to weaken their own currencies. One thing you should never bet against is the ability of a central bank to devalue its currency. This is because someone with the power to create an unlimited supply of some 'thing' definitely has the power to lower the thing's value if they choose to do so.


Bonds

Although the 10-year Treasury Note has recently broken below all support levels that have formed over the past three years, the longer-dated Treasury Bond is still hanging in there. The following daily chart of March T-Bond futures shows that last November's low was tested earlier this week and that the test was successful. However, it would take a daily close above resistance at 112.50 to convince us that something more than just an 'oversold bounce' was taking place.



There has been an interesting change of structure in the bond futures market over the past several months in that Commercial traders no longer appear to be buying the dips. In particular and with reference to the following chart comparing the 10-year T-Note price with the net position of the Commercials in 10-year T-Note futures, note that: a) the June-2004, March-2005 and November-2005 lows in the T-Note futures price coincided with HIGHS in the Commercial net-long position, whereas the recent new lows in the T-Note price have been accompanied by new 52-week LOWS in the Commercial net-long position, and b) the Commercials have gone from being net-long to the tune of around 600,000 contracts in March of last year to now having a small net-short position.

With the Commercials no longer buying aggressively in response to price weakness there is a greater probability of a large decline.


Chart Source: http://www.sharelynx.com/

The Stock Market

Current Market Situation

Below are charts of the Utility Index and the S&P600 Small Cap Index.

The Utility Index traded below its 200-day moving average on Wednesday for the first time since April-2003, but recovered to end the session right at this moving average. We think this index is in the process of forming a major top, but additional weakness will be needed to confirm this view. As things currently stand, the price action would be consistent with either a major top formation OR a correction within an on-going bull market.

The S&P600 Index -- one of the leading indices over the past few years -- came close to breaking below the bottom of its short-term channel yesterday. However, it had rebounded enough by the end of the day to remain within this channel and avoid sending a bearish signal.




We expect that a substantial decline will occur over the next 6 months, but even if we are right it's quite possible that some indices will first move to new multi-year highs.

Gold and the Dollar

Gold, Gold Stocks and Silver - Overview

In the 20th February Weekly Market Update, with spot gold trading at $552, we upgraded our short-term view on gold from "neutral" to "bullish" and have been prepared to give the short-term bullish case the benefit of the doubt as long as the price remained within the upward-sloping channel drawn on the following chart. However, yesterday's decline resulted in a decisive break below the channel bottom. We have therefore gone back to a short-term "neutral" view on gold.

In early February, with spot gold at $567 and the XAU at 148, we turned intermediate-term bearish on both gold and the gold sector of the stock market. Our views were that a) intermediate-term peaks were either already in place or would be put in place within the ensuing two months, and b) gold and the major gold stocks would be trading at significantly lower levels within the ensuing 3-6 months. As a result of this week's action it is now almost certain that an intermediate-term peak was put in place in the gold sector of the stock market at the end of January and very likely that an intermediate-term peak was put in place in the gold market at the beginning of February. However, in terms of price the intermediate-term correction in the XAU is probably already 75% complete and the intermediate-term correction in gold bullion is probably already 50% complete. We are therefore upgrading our intermediate-term views on gold and gold stocks from "bearish" to "neutral".

Ideally, the XAU and the HUI will work their way down to around 115 and 260, respectively, over the coming 4 weeks and gold bullion will drop to the low-$500 area. We say "ideally" because such a decline would set up a good opportunity for investors to accumulate exploration-stage gold stocks and/or gold bullion.

Unlike gold, silver hasn't yet broken its short-term upward trend. If gold breaks below support at $540 then it's a good bet that silver will be pushed low enough to confirm an end to the short-term upward trend, but we don't think silver will be vulnerable to the sort of spectacular decline it experienced during the second quarter of 2004 unless it first spikes well above last week's high.


Gold Stocks

The odds are in favour of the HUI trading below yesterday's low within the coming few weeks, but the sort of collapse that occurred in 2004 is unlikely to occur this year.

Below is a chart comparison of the HUI and the stock price of NovaGold Resources (TSX and AMEX: NG) -- in our opinion the world's premier exploration-stage gold mining company because it has the best combination of projects and management -- covering the period from the beginning of October-2003 through to the end of May-2004. Notice that:

1. NG and the HUI peaked together in early December of 2003 and then experienced 2-week pullbacks

2. The HUI then rebounded to a marginally lower peak at the beginning of January-2004 while NG moved well above its December peak.

3. On the day that the HUI was making its secondary (lower) high in early January the NG stock price gained about 10%.

4. The HUI then dropped to a lower low (below its December pullback low) by early February while NG dropped to a higher low. A 2-month rebound/consolidation then got underway.

5. The HUI and NG then declined to well below their respective 200-day moving averages.


Now let's take a look at what has happened to the HUI and NG in the recent past. With reference to the below chart comparison, notice that:

1. NG and the HUI peaked together in early February of 2006 and then experienced 2-week pullbacks

2. The HUI then rebounded to a lower peak at the beginning of March-2006 while NG moved well above its February peak.

3. On the day that the HUI was making its secondary (lower) high in early March the NG stock price gained about 10%.

4. The HUI has since dropped to a lower low (below its February pullback low) while NG has remained comfortably above its February low.


If the similarities between the 2003-2004 topping action and the current situation persist then the HUI will make a short-term bottom about 3 weeks from now. There will then be a modest 2-month rebound followed by a collapse.

The odds are in favour of the HUI trading below yesterday's low within the coming few weeks, but the sort of collapse that occurred in 2004 is unlikely to occur this year. The rally that ended in December of 2003 for the major gold stocks and in the first quarter of 2004 for the exploration-stage gold stocks was the LAST intermediate-term advance within a 3-year bull market, whereas the rally that began in May of 2005 will, in our opinion, prove to be the FIRST intermediate-term advance within a new multi-year bull market. We are therefore expecting a normal intermediate-term correction -- as opposed to a cyclical bear market -- to play-out at this time.

The biggest risk for the gold sector over the next few months is a large downturn in the broad stock market.

Currency Market Update

In the latest Weekly Update we wrote:

"The Dollar Index closed below its 50-day moving average at the end of last week, a sign that a drop back to test the January low is going to occur over the next few weeks. However, the discrepancy between the performance of the US bond market and the performance of the US$ during the final two days of last week makes us suspect that either the weakness in the bond market or the weakness in the US$ was a 'head fake' (there had been a strong inverse correlation between bonds and the dollar prior to last Thursday).

If bonds reverse higher this week then the Dollar Index is probably on its way to support at 88 and has an outside chance of moving all the way back to the more important support that exists at around 86, but if bonds keep moving lower then there's a good chance that the US$ will reverse upward."

Bonds continued to move lower and the US$ reversed higher during the first half of this week, meaning that last week's breakdown in the Dollar Index was probably a 'head fake'. The drop in the US$ that occurred late last week was a reaction to the ECB's decision to boost the official euro interest rate by 0.25%, but we suspect that a concerted effort by the ECB to tighten its monetary policy would represent more of a threat to the upward trend in commodity prices than to the upward trend in the US$. This is because the dollar's interest rate advantage is not going to disappear in the near future.

The following chart shows that the Dollar Index has important resistance at 91 and at 92.5. A weekly close above 91 would be a definitive bullish signal.


The following chart shows that Canadian Dollar futures have just broken below the bottom of a "rising wedge" pattern. However, we'll need to see a close below 0.85 before we will be confident that an intermediate-term correction is underway.

The C$ has had one of the highest inflation rates of the major currencies over the past two years, making it vulnerable to a sharp decline. Up until now the demand for the C$ has been given enough of a boost by the bull markets in energy-related commodities and metals to more than offset the effects of increasing currency supply, but once it becomes clear that large corrections are underway in the oil and industrial-metal markets we think the C$ will become a relatively weak currency.


Update on Stock Selections

Below is a chart of NovaGold Resources (TSX and AMEX: NG) covering the past 4 years.

NG is our favourite long-term investment in the gold sector, but with the stock price currently a great distance above its 200-day moving average we don't think it makes sense to be doing any new buying at this time. During each of the past 4 years there has come a time when NG traded at least 10% BELOW its 200-day moving average (the blue line on the following chart) and we have no reason to think that this year will be different.

So why not make a complete exit from the stock now with the aim of buying back at a much lower level later this year?

Because the future is not certain. It is almost a certainty that NG will drop back to its 200-day MA at some point over the next 12 months, but we have no way of knowing where this moving average will be when the stock price reaches it. For example, if NG were to do a deal in the near future that involved a major mining company agreeing to fully fund the development of the Galore Creek project in exchange for 50% equity in the project then the NG stock price might quickly surge to $25 before a large correction got underway. In this case, by the time the stock price corrected back to 10% below the 200-day MA the moving average might be at C$18 or higher.


In general, if you have good reason to believe that a stock's long-term upside potential is much greater than its short-term downside risk then it will make sense to retain a core position in the stock. An exception to this general rule would occur if a stock with good long-term upside potential became very over-valued relative to other stocks, in which case it might make sense to switch out of the over-valued stock.

    When the gold sector was rocketing higher we mentioned above-the-market price levels for individual stocks at which some profit-taking might be appropriate, but now that a correction is well underway it's reasonable to note price levels for individual stocks at which some new buying might be appropriate. Here are a few ideas (sorted alphabetically):

  - Canarc Resource (TSX: CCM) -- buy in the low-C0.70s (current price: C$0.75)
  - DRDGold (NASDAQ: DROOY) -- buy in the US$1.20s (current price: US$1.40)
  - Golden Queen Mining (TSX: GQM) -- buy below C$0.60 (current price: C$0.58)
  - Kinross Gold (NYSE: KGC) -- buy in the US$8.70s (current price: US$9.24)
  - Lion Selection Group (ASX: LSG) -- buy in the A$1.80s (current price: A$1.92)
  - Metallica Resources (AMEX: MRB) -- buy at US$2.30-$2.50 (current price: US$2.97)
  - Metallic Ventures (TSX: MVG) -- buy below C$2.45 (current price: C$2.40)
  - New Gold (AMEX: NGD) -- buy in the US$6.70s (current price: US$7.73)
  - Nevsun Resources (AMEX: NSU) -- buy below US$2.20 (current price: US$2.17)

With the exception of Kinross Gold, Lion Selection Group and New Gold, the above stocks are current members of the TSI Stocks List.

Note that how much you buy and at what price you attempt to buy will be partly determined by your current exposure to the gold sector. For example, if you already have a sizeable core position in gold stocks then you can afford to be more stingy than someone who is just starting to build a portfolio.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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