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Time to buy 'the grains'?

From the 26th April Weekly Update:

"..the downside risk in "the grains" is probably a lot lower than it is for speculative favourites such as oil, the base metals and the PGMs. At least, the risk of a sharp price decline in response to the next market-wide plunge in confidence appears to be a lot lower for the grains than for most other important commodities. At the same time, there is the potential for bullish speculators to eventually find their way to the grain markets, as they did during 2007-2008, and/or for grain prices to be boosted by the realisation that supply will be less plentiful than currently anticipated.

The relatively small downside risk combined with the potential for either a speculation-related or a supply-related boost has piqued our interest in being 'long' the grains via an agriculture fund such as DBA. We aren't going to do anything yet, though, because the price action isn't right."

Since writing the above, near-perfect growing conditions and evidence that the widely-touted economic recovery is running out of steam have put additional downward pressure on grain prices and caused DBA to decline from US$24.75 on 23rd April to a low of US$22.87 on Monday 7th June. It ended Wednesday's session at $23.09.

DBA's recent decline has brought it to within spitting distance of the Q4-2008 panic low (see chart below), and, in our opinion, has skewed the intermediate-term risk/reward sufficiently toward "reward" to justify taking an initial position. We are therefore going to add it to the TSI Stocks List, using a 10% trailing stop for risk management purposes (as usual, the trailing stop will be based on daily closing prices).

Note that when averaging into a longer-term speculation or investment it generally doesn't make sense to use a protective stop, but the TSI Stocks List is not set up in a way that enables scaling into and out-of positions (it is not operated like a portfolio). As a result, the setting of protective stops is the only form of risk management that we can ever reflect via the Stocks List.

Relative to gold, the grains have been in a bear market since 1998. The latest major downward leg in this bear market began almost exactly two years ago and is clearly evident on the following daily chart of the DBA/GLD ratio. This bear market probably has a few more years to run, but the stage has been set for a substantial counter-trend rebound because in gold terms the grains are now cheaper and more 'oversold' than they have ever been.

An intermediate-term rally in the grains could be 'played' via fertiliser stocks such as POT, but at this stage we prefer direct exposure to the commodities. This is mainly because the fertiliser stocks will likely be slaves to the trend in the broad stock market.

The fertiliser stocks could become interesting speculations after the broad stock market bottoms out.

The Stock Market

China Update

The information in the short article linked HERE could be significant. According to the article, Chinese steel mills have begun to cut prices due to dwindling orders in downstream sectors like auto, shipping, home appliances and property.

China's government has considerable control over the ebb and flow of money and credit. This doesn't give it the power to create real economic progress, but does give it greater power than its Western counterparts when it comes to igniting and extinguishing inflation-fueled booms. When considering the outlook for China's economy it is therefore important to ask: What does the government want? If China's government wants a rapid credit expansion and the outward appearance of economic strength, then a superficially positive outcome has a good chance of happening. On the other hand, if the government's main concern is that prices are rising too quickly then it's a good bet that a credit contraction and economic slow-down lie in store.

Based on their words and actions, the high level of residential property prices appears to be the dominant concern of China's senior policy-makers at this time. Therefore, although there are warning signs -- such as the decline in steel prices mentioned above -- that the economy is slowing, government policy will likely be directed more towards 'cooling' than 'heating' for a while yet.

We expect to see more evidence of economic weakness coming out of China during the second half of this year, which will add to the downward pressure on stock markets and industrial commodities.

Current Market Situation

The S&P500 Index is holding above support (see chart below), but only just. Our forecast has been for the downward trend that began in April to continue until October, but if the S&P500 moves to a new low for the year in the near future then an intermediate-term bottom will probably be put in place well before October. To put it another way, in order for the overall downward trend to extend into the final quarter of this year there will probably have to be a larger and much longer intervening rebound than we have seen to date.

The stock market has obviously been affected by Europe's debt crisis, but the main problem is that a mismatch between perception and reality developed during the months leading up to the April stock-market peak. Whether it was because they believed that the combination of monetary and fiscal stimulus would really work or because they anticipated a traditional post-WWII business-cycle recovery, market participants discounted a far more substantial improvement in corporate earnings than could possibly be delivered under the circumstances.

Evidence of the unrealistically-great expectations priced into the US stock market earlier this year can be found in the earnings forecasts of Wall Street analysts. According to John Hussman's latest Weekly Comment: "Several weeks back ... Bill Hester plotted the operating profit margins that were implicitly being forecast by Wall Street Analysts... noting "Last October, analysts were about half way to pricing in profit margins that matched the record levels of 2007. Now, they are just about there." If this doesn't reflect the expectation of Wall Street analysts for a "V" shaped recovery, I'm not sure what does."

Gold and the Dollar

Gold

In Email Alert #206, which we sent to subscribers in response to Monday's market action, we wrote:

"The US$ gold price has moved up to within $10 of its May peak. In terms of momentum and sentiment indicators it is nowhere near as 'overbought' as it was at the December-2009 and March-2008 peaks, so the potential exists for significant additional gains over the weeks ahead.
 
We are more concerned about the euro-denominated gold price. Gold/euro pulled back after reaching an 'overbought' extreme in May, but the surge of the past few days has already returned it to a similar extreme. In particular, gold/euro has returned to the top of the moving-average (MA) envelope that capped intermediate-term advances during 2005-2006 and 2007-2008. We will include a chart in this week's Interim Update to illustrate what we mean."

Here is the gold/euro chart mentioned above.

Gold has become far more 'overbought' in euro terms than in US$ terms because the primary driver of the gold rally that began in early February has been euro-zone government debt problems and the associated weakness in the euro. This probably means that there will be a sell-off in the gold market if euro-related panic subsides. A temporary subsidence is the most that's likely to happen, though, because the debt problems cannot possibly be ameliorated by the 'solutions' currently being proposed and implemented. After all, a problem of excessive debt can't be solved via the creation of new debt.

In the above-mentioned email alert we said that with Europe's government debt crisis being the dominant short-term driver of gold's strength, long-side exposure to gold could potentially be hedged via euro (or FXE) call options. This indirect hedge would not be ideal in that it would not guard against a deflation scare that caused the US$ to strengthen against both gold and the euro, but it would offer one advantage over a direct gold hedge: it could pay-off in the absence of a decline in the gold price. It is possible, for example, that a strong euro rebound would result in gold pulling back in euro terms while holding its ground in US$ terms.

The following chart shows that the US$ gold price has just tested its May peak. An upside breakout would suggest a near-term target of $1300.

Gold Stocks

From Email Alert #206:

"With the US$ bullion price having moved up to just beneath its May peak, the 'risk' has increased that the gold sector's anticipated catch-up move will start sooner rather than later. Consequently, we are upgrading our short-term HUI outlook from "bearish" to "neutral". In this case, "neutral" means that there is large upside AND downside potential over the next few months. Whether the next 70-100 HUI points are to the upside or the downside will very likely be determined by whether gold makes a sustained break above $1250 in the near future or rolls over to the downside after testing its May peak. 
 
We don't have any short-term bets on the gold sector at the moment, but those who do should seriously consider placing a 'stop' just below Monday's intra-day HUI low. Specifically, exit any long-side trades if the HUI closes below 440."

The following chart shows why 440 is shaping up as an important demarcation level for the HUI. A daily close below 440 would breach lateral support, moving average support (the 50-day moving average), and trend-line support.

The HUI is set up to make a sizeable (15% or greater) move over the next 6 weeks, but the most likely direction is not clear to us. We think the odds currently favour the downside, but not decisively so. Furthermore, if gold were to make a sustained break above $1250 then the odds would shift in favour of a sharp multi-week HUI advance.

This is not a good time to be making aggressive bets on any particular short-term outcome.

Currency Market Update

Over the past two years the A$/euro exchange rate has done a terrific job of defining the overall trend in the financial world. As evidenced by the following chart, this exchange rate plunged during the second half of 2008, reflecting the rapid decline in the generally perceived outlook for global economic growth, and then ramped upward until early May of this year as investors around the world became more optimistic about global economic growth.  It dropped sharply from its May-2010 peak, thus reflecting the emerging realisation that the post-crash rebound would not likely evolve into a genuine recovery, but, as is the case with most stock markets, it remains at a very high level considering the underlying fundamentals.

As noted on the above chart, we see A$/euro dropping back to around 0.58 during the second half of this year. This target is based on the assumption that the A$ will do no worse than lose the 'growth premium' that was built into its relative valuation between October of 2009 and May of 2010. We are not anticipating a repeat of 2008.

A risk with the aforementioned target for A$/euro is that Europe's monetary union will break apart sooner rather than later. If this were to happen then the A$ would likely do better against the euro and worse against the US$ than we currently expect (we have previously mentioned 6-month targets of 0.72 and 0.66 for the A$ relative to the US$).

Update on Stock Selections

(Notes: 1) 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. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html)

If the following chart of senior gold producer Kinross Gold (TSX: K) was all you had to go on, you would never guess that gold bullion was near an all-time high in terms of all major currencies and the CRB Index. K has been moving within a downward-sloping channel since September of last year and is not far from an 18-month low.

We don't have any interest in the stock, but we do have an interest in the Kinross warrants that trade on the TSX under the symbol K.WT.C. These warrants have an exercise price of C$32.00 and an expiry date of September-2013.

The Kinross warrants are currently not as attractive as the FNV warrants we mentioned in the latest Weekly Update, because they are too far 'out of the money'. They do, however, offer one significant advantage in the form of an additional 18 months of time (the FNV warrants expire in March of 2012).

It would be reasonable to take an initial position in the K warrants near their current price (around C$2.80). Alternatively, speculators could decide to wait for the stock to break above C$20 before doing any buying. The warrants will naturally cost more after the stock breaks above resistance at $20, but a breakout would provide some assurance that K had bottomed and that a new intermediate-term rally had commenced.

    Uranium One (TSX: UUU). Shares: 777M issued, 799M fully diluted (assuming that all convertible debentures are converted to shares). Recent price: C$2.19

UUU announced on 8th June that it had agreed to issue 356M new shares to Russian nuclear company ARMZ in exchange for US$610M cash and ARMZ's ownership in two Kazakhstan-based uranium mines. If this deal is approved by regulators and UUU's other shareholders it will result in ARMZ owning at least 51% of UUU and shareholders other than ARMZ receiving a special cash dividend of at least US$1.06/share.

The market reaction to the proposed deal was negative, probably due to concern that the post-deal UUU would be operated in a way that served the interests of the Russian government rather than the interests of all shareholders. This is a legitimate concern, although the increased Russian involvement could reduce the political risk associated with doing business in Kazakhstan.

The projects that are being acquired by UUU are expected to eventually add 6M pounds of annual production, but the press release didn't specify the capital expenditure and time needed to achieve this production rate. Without this information it isn't possible to fully assess the merits of the deal or to figure out what the post-deal UUU would be worth. We therefore don't know whether the stock-price decline of the past two days has created a buying opportunity.

We'll have more to say after we get some more information.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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