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    - Interim Update 11th January 2006

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Bonds

The Conundrum

...it will only be feasible for foreign central banks to continue their practice of absorbing large quantities of US debt as long as these central banks aren't facing an inflation problem at home.

Inflation expectations remain low. How do we know? First, because the difference between the yield on a 10-year T-Note and the yield on a 10-year Inflation-Protected T-Note is currently only 2.37%, which suggests that the market is expecting the CPI reported by the US Government to gain an average of 2.37% per year over the next 10 years (the inflation rate and the rate of increase in the CPI are totally different things, but most market participants believe them to be one and the same so the expected CPI is a reasonable measure of inflation expectations). Second, the US stock market's high price/earnings ratio is evidence that most market participants consider the past few years' growth in corporate earnings to be real (not inflation-induced) and expect additional real (non-inflationary) earnings growth over the coming years (the stock market always prices 'real' earnings growth at a much higher level than earnings growth resulting from inflation). Third, there's not much of an inflation premium in the current gold price (gold has done well over the past year in terms of most fiat currencies, but it hasn't done well relative to most other metals).

The persistently low level of inflation expectations, rather than the failure of US bond yields to rise in response to the Fed's rate-hiking campaign, is the true conundrum as far as we are concerned.

Perhaps the answer is that the markets expect foreign central banks to continue buying enough US debt to keep long-term interest rates at a low level regardless of what's happening on the inflation front. If so then the markets will eventually be disappointed because it will only be feasible for foreign central banks to continue their practice of absorbing large quantities of US debt as long as these central banks aren't facing an inflation problem at home. The reason is that the process that ends with a foreign CB buying a large chunk of US debt begins with the foreign CB printing a large quantity of its own currency (Yen, Yuan, etc.). In other words, when a foreign CB provides artificial support to the US bond market it does so via the inflation of its own currency.

Current Market Situation

The following chart of T-Bond futures shows two important support levels. If support at 109 gives way then a test of support at 102 will become a likely short-term prospect, and if support at 102 gives way then there will be little doubt that a secular bear market commenced in June of 2003.


In our opinion, one of the biggest short-term risks for the bond market is that the Fed ends its rate-hiking campaign too soon. Additional rate hikes won't present a problem for bonds because they will tend to suppress inflation expectations and economic growth expectations, but if the Fed decides to stop hiking rates while the gold, commodity and stock markets are still in short-term up-trends then bonds will probably tank. We will be surprised if the Fed does signal an end to the monetary tightening as long as the aforementioned markets are still in rally mode, but given this risk and the fact that bond futures closed marginally below a short-term support level on Wednesday we are shifting our short-term bond market view from "neutral" to "bearish".

The Stock Market

Airline Stocks vs Oil Stocks

The below chart of the XOI/XAL ratio -- the AMEX Oil Index divided by the AMEX Airline Index -- shows a spike below the 200-day moving average during December followed by a sharp recovery to above the 200-day MA during the first 7 trading days of this year. This is an indication that the intermediate-term upward trend in oil stocks relative to airline stocks is intact. We are therefore going to immediately exit our short-term bet on the airline sector at a profit of 17.4% based Wednesday's closing level of 52.61 for the XAL and our mid-October entry at 44.82. We will consider trading the airline sector from the long side again if the XAL closes above 56 and/or the XOI/XAL ratio drops back below its 200-day MA.


Current Market Situation

...there is probably more upside in store for the US stock market over the next couple of months, but not a lot more.

One of the stock market indicators we monitor is the SOX/NDX ratio (the Semiconductor Index divided by the NASDAQ100 Index). This indicator is similar to the NDX/Dow ratio in that a rising trend in SOX/NDX suggests that market participants are becoming less risk averse -- a short-term bullish development and, when the market is very over-valued as it is right now, a prerequisite for a rally. On the other hand, a falling trend in SOX/NDX is indicative of increasing risk aversion -- something that tends to occur near the ends of rallies and during the early stages of intermediate-term declines. The reason the ratio operates in this way is that the semiconductor stocks are generally considered to be riskier than the NASDAQ100 components.

The following chart shows that SOX/NDX has just moved to a new 52-week high, which suggests to us that the stock market rally is not yet over. However, the ratio has also just hit the top of the channel in which it has been trading over the past 16 months.

Our short-term view -- which is supported by the performance of SOX/NDX -- is that there is probably more upside in store for the US stock market over the next couple of months, but not a lot more. As advised in the 10th January Market Alert E-mail, we've therefore shifted our short-term stock market view from "bullish" to "neutral".


Gold and the Dollar

Gold Sentiment

...most exploration-stage stocks did very little for many months as the gold price and the prices of the major gold shares drove upward, but these small-cap stocks have now come to life in spectacular fashion in response to a surge in the public's enthusiasm.

Some people are bullish regarding the short-term prospects for gold and gold stocks because they think the majority (the public) is too bearish, whilst other people are anticipating a sharp sell-off because they think the majority is too bullish.

Supporting the view that sentiment is a long way from reaching a bullish extreme is the cumulative cash flow of the Rydex Precious Metals Fund (Rydex PM), a fund that holds the shares of companies that mine precious metals. Specifically, the below chart shows that the 40% gain in the price of Rydex PM since the beginning of July-2005 has been accompanied by a 15% FALL -- from US$250M to US$211M -- in the net amount of cash invested in the Fund. In other words, the Fund has suffered net REDEMPTIONS totaling $43M in parallel with a 40% increase in its price.

This type of divergence borders on the ridiculous and we wonder if there's something totally unrelated to sentiment that has caused it. One of our readers suggested that people who might otherwise have been putting money into Rydex PM have, instead, been investing in Streettracks Gold Trust, a gold bullion ETF that trades on the NYSE under the symbol GLD. This might be part of the reason, although GLD didn't suddenly come into existence during the second half of last year (it was introduced during the final quarter of 2004). And Rydex PM has outperformed GLD by a wide margin over the past six months so anyone being drawn into the market by price action would have had no reason to favour GLD over Rydex PM. Unfortunately, we don't have cash flow figures for other PM-related funds and therefore can't check if the curious Rydex PM situation is fund-specific or indicative of a broader trend.


The relatively low level of the small traders' net-long position in COMEX gold futures also supports the view that the public is yet to become very bullish on gold.

There is, however, plenty of evidence in support of the opposing view (the view that sentiment is approaching a bullish extreme). For example, the premium over net asset value (NAV) at which the Central Fund of Canada (AMEX: CEF) trades has risen from zero to around 7.5% over the past month (see chart below). Now, a premium of 7.5% is obviously a lot lower than the 25% premium at which CEF traded in early 2003 and the 15% premium at which it traded during much of 2004; however, the 2003 and 2004 premiums are not comparable to the current premium because the Streettracks gold ETF (NYSE: GLD) -- a fund that invests in gold bullion and trades with no premium -- was introduced in late 2004. Since that time (late 2004) there has been no good reason for CEF to have any premium whatsoever except for the fact that 50% of its assets are held in the form of silver bullion and there is presently no silver ETF (there is no way for people to buy exposure to silver bullion in the stock market other than to buy the shares of CEF). Therefore, the current 7.5% premium for CEF is probably best understood as a 0% premium for the Fund's gold holding combined with a 15% premium for the Fund's silver holding. In other words, although silver is currently trading at US$9.00/oz today's buyers of CEF are, in effect, paying $10.35/oz. This suggests a high level of optimism.

On a side note, we suggested buying CEF at around US$5.50 in September when it was trading at a small discount to NAV and again at around $6.20 in December when it was trading at a small premium to NAV, but we would not be buyers at the current high premium. If a silver ETF is introduced then the CEF premium will drop to around zero.


Another indication that the public has embraced the gold rally is the goings-on at the speculative end of the gold share universe. Specifically, most exploration-stage stocks did very little for many months as the gold price and the prices of the major gold shares drove upward, but these small-cap stocks have now come to life in spectacular fashion in response to a surge in the public's enthusiasm. On a related matter, a few months ago the stock market was generally ignoring good news announced by 'the explorers', and newsletter/brokerage buy recommendations were having almost no effect on stock prices. Recently, however, small stocks have been rocketing higher in response to positive publicity. For example, over the past week we've seen our Desert Sun Mining shares gain 30% in two days in response to a buy recommendation from Canaccord and our Exeter Resources shares gain 24% in one day in response to a buy recommendation from Casey Research.

Weighing all the evidence, we don't think there's much doubt that sentiment towards the gold sector is bullish. However, the current optimism about the future prospects of gold and gold shares goes hand-in-hand with the current optimism towards commodities in general and shares in general. Most prices continue to be pushed higher by a rising sea of liquidity and when liquidity is abundant the future almost always looks bright.

Currency Market Sentiment

Based on the pattern of the past few years, the current upward correction in the Swiss Franc (downward correction in the Dollar Index) won't end until AFTER speculators in Swiss Franc futures have become net-long.

One of the most reliable indicators of sentiment in the currency market is the speculative position in Swiss Franc futures. However, like all sentiment indicators this one needs to be recalibrated based on the market's price trend. This is because 'overbought' and 'oversold' extremes occur at different levels depending on whether a bull market or a bear market is in progress.

The following chart compares the Swiss Franc (SF) with the speculative net-long position in SF futures. With reference to this chart, notice that:

a) Between July of 2001 and December of 2004 -- a period during which the SF was in a bull market -- the speculative net-long position in SF futures spent most of the time above zero (speculators were generally 'long' in line with the bullish price trend). Also, interim peaks in the SF generally didn't occur until after the speculative net-long position had moved up to the 30,000-40,000 range and the speculative net-long position never dropped below -30,000.

b) Between January of 2005 and the present day -- a period during which the SF was in a bear market -- the speculative net-long position in SF futures spent almost the entire time below zero (speculators were almost always 'short' in line with the bearish price trend). Also, interim bottoms in the SF didn't occur until after the speculative net-long position had moved below -60,000 and the two interim tops -- in mid March and early September of 2005 -- occurred soon after the speculative net-long position moved above zero.


The latest Commitments of Traders (COT) report revealed that the total speculative net-long position in SF futures was around -30,000 (large and small speculators, as a group, were net-short the SF to the tune of around 30,000 contracts). Based on the pattern of the past few years, the current upward correction in the Swiss Franc (downward correction in the Dollar Index) won't end until after speculators in Swiss Franc futures have become net-long. Furthermore, the current correction is probably of larger degree than either of last year's corrections and therefore might not end until after the speculative net-long position in SF futures has moved up to around 20,000 contracts.


Current Market Situation

The jury is still out as to whether or not gold is in the process of making a double top. In favour of the view that higher levels will be seen over the next few weeks is the simple fact that there has not yet been any sort of downward reversal; instead, after moving up to the vicinity of its December peak the gold price has oscillated within a narrow range. The other side of the coin is that a consensus seems to be building -- even amongst those who aren't usually very bullish on gold -- that a move up to $600 is imminent. When high price targets start being bandied about by mainstream analysts a short-term peak is probably not far away.

We think gold's best chance of making it to $600 in the near future would be if it first pulled back to the 520s before moving back up to, and through, the 540s.


Please refer to the latest Weekly Market Update for our short-term outlook for gold stocks. Our view, in a nutshell, is that a blow-off move is underway. This blow-off move will end soon, but even if it lasts only 2-3 more weeks it will yield some additional large gains for the holders of exploration-stage stocks. Keep the upside target-ranges mentioned in the 4th January Interim Update in mind and don't forget to take partial profits if the stocks spike up to these levels.

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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