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    - Interim Update 11th April 2007

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Focus on the disease, not the symptom

It is not reasonable to conclude that a large deficit on the current account is a problem, or is indicative of a problem, simply because it happens to exist. ...we view the deficit on the current account as a SYMPTOM of an inflation problem...

A writer desiring to paint a bearish picture of US economic prospects and the US$ could choose to highlight the huge US current account deficit, because the word "deficit" has negative connotations. However, the huge current account deficit necessarily goes hand-in-hand with a capital account surplus of equal size; and "surplus" is a word with positive connotations. A writer desiring to paint a rosier picture could therefore choose to highlight the huge US capital account surplus.

Both writers -- the one citing the current account deficit as a problem and the one citing the capital account surplus as a benefit -- would, however, be missing an important point. The point is that neither a deficit nor a surplus on the current account (or the associated capital account) is, in itself, a positive or a negative. It all depends on what caused the deficit/surplus to arise.

To explain what we mean, we'll start with the popular argument that the large US current account deficit is a problem because it involves the US becoming increasingly indebted to the rest of the world. As Morgan Stanley's Stephen Roach -- a high profile worrier about global trade/investment imbalances -- is fond of saying: US$3.5B of foreign capital is needed each and every business day to finance the US current account deficit. According to Mr. Roach, the US will eventually run into the problem of being unable to finance its current account deficit, resulting in a collapse of the dollar's exchange value, a sharp rise in US interest rates and a plunge in US economic growth. From his perspective the trade/capital imbalance must be 'fixed' before it's too late.

But any thesis that begins with the notion that the large US trade/capital imbalance is a problem for which a solution must be found will be hopelessly flawed because the aforementioned imbalance is NOT a problem; rather, it is either the SYMPTOM of a problem or it is not indicative of any problem whatsoever. And in the former case, an economist who focused on reducing the imbalance would be akin to a doctor with a feverish patient who directed his attention toward cooling the patient down without taking into account WHY the patient was unusually warm.

We suspect that a lot of the confusion surrounding this issue stems from thinking about the US as an entity that runs a deficit on the current account and an offsetting surplus on the capital account. In practice, there is no such entity. Instead, what we have are billions of people throughout the world who are trading and investing with each other. When the effects of all these financial transactions are netted-out we find that the subset of the world's population that resides inside the US buys more 'stuff' from outsiders than it sells to outsiders; while the subset of the world's population that resides outside the US invests more money in US assets/debt than the US-based subset invests in foreign assets/debt.

The point is that the so-called trade/capital imbalance is the net effect of millions upon millions of individual decisions made voluntarily by people who believe that they will be better off as a result of their decisions. As such, an entity known as 'the US' does not have to come up with $3.5B of new capital each business day in order to 'finance' a deficit on its current account. Rather, this out-flow on the current account is simply the net result of transactions that could not have occurred in the first place unless there were sufficient external demand for dollars. It is therefore not reasonable to conclude that a large deficit on the current account is a problem, or is indicative of a problem, simply because it happens to exist.

To know if a current account deficit is indicative of a problem you first need to know WHY the deficit exists. In the US case, for instance, you need to know why people inside the US are generally finding it advantageous to buy more stuff from foreigners than they sell to foreigners, and why foreigners are generally finding it advantageous to do the opposite.

As discussed in previous TSI commentaries, our view is that the US's trade/capital imbalance has grown to such a tremendous size due to the relatively rapid rate at which its currency supply has expanded over the past ten years. In other words, we view the deficit on the current account as a SYMPTOM of an inflation problem (inflation is the cause, the huge current account deficit is one of the effects).

Inflation, we believe, has resulted in misdirected investment, reduced productivity and higher production costs within the US. At the same time, the normal effects on the prices of everyday items of a prolonged period of inflation have been masked by the massive increase in labour productivity within the emerging economies of the world (China and India, in particular). And the upward pressures on interest rates that would normally result from years of relatively high inflation have been largely absent due to a) the aforementioned masking of price increases, b) the large-scale purchasing of US debt securities by foreign central banks, and c) arbitrage related to Japan's near-zero interest rates. Lastly, high money supply growth combined with hardly any of the most visible NEGATIVE effects of inflation has helped maintain the illusion that the US economy is structurally sound, thus boosting foreign private-sector demand for the US dollar. 

Obviously, if the US current account deficit is the result of an inflation problem then the only viable solution is to reduce the rate of inflation. However, it seems that everyone wants to focus on the symptom and no one wants to deal with the disease.

The Stock Market

The stock market and inflation

Growing the supply of money cannot create sustainable prosperity. However, stock markets can be -- and often are -- given a boost by money supply growth (inflation).

Using the performance of the Zimbabwe stock market as an example, an article at http://www.mises.org/story/2532 provides a succinct explanation of how inflation can simultaneously harm the economy and elevate equity prices.

Stocks and Bonds

In the 2nd April Weekly Market Update we said that the two biggest near-term threats to the stock market were the potential for the Iran conflict to escalate and the risk of a sharp downturn in the bond market. The first of these threats has dissipated, as was always likely to be the case, but the other threat remains.

A quick look at the following chart will tell you that June T-Bond futures are presently 'oversold' on a short-term basis. They have just tested strong support at 110 and SHOULD begin to rally from here, even if the rally is just a counter-trend rebound within an intermediate-term decline. However, given that speculators, as a group, are heavily net-long the bond market (via T-Bond and T-Note futures) and that the sharpest declines often occur after a market has already become oversold, the potential exists for bonds to drag stocks down.


Current Market Situation

The US stock market supposedly fell on Wednesday due to fears -- sparked by the release of the latest FOMC meeting minutes -- that interest rates were going to remain at current 'elevated' levels for longer than previously expected. We say "supposedly" because bond futures and Fed Funds Rate futures barely moved at all in response to the aforementioned meeting minutes. The lack of movement in the debt market tells us that interest rate expectations didn't actually change on Wednesday.

Wednesday's price action can probably be explained by the equity market being 'overbought' and the bond market being 'oversold' prior to the start of the session. As a result, equity traders were most likely looking for an excuse to book some profits whereas bond traders were prepared to 'dig in'.

Over the next few weeks we will pay more than the usual amount of attention to the Dow Transportation Average (see chart below). The Transportation Average broke above resistance at 5000 in mid February only to quickly reverse course and plunge below this level, thus creating the appearance of a false breakout. It has since partially recovered, but remains below 5000.

A sustained move above 5000, and especially above 5200, would be a positive omen for the US stock market and the intermediate-term outlook for global growth. On the other hand, a move below 4600 would have decidedly bearish implications.


Gold and the Dollar

Gold

With reference to the following chart of June gold futures, gold is slowly working its way higher within the confines of a well-defined channel. If the gold price had broken below the bottom of this channel during the February-March correction it wouldn't have caused us much concern, but a break below the channel bottom at some point over the next few weeks would force us to downgrade our short-term outlook.

As things currently stand, we remain short-term bullish in anticipation of further gains over the coming month or so.


Gold Stocks

The more times a support or resistance level is tested the weaker it becomes and, as a consequence, the higher the probability of a breakout. As clearly evident on the following chart of the AMEX Gold BUGS Index (HUI), resistance in the low-360s has now been tested three times over the past four months. This resistance will have been weakened by the multiple tests and is therefore likely to be breached -- either immediately or following a short pullback.

Assuming that the HUI breaks above the aforementioned resistance at some point over the next few weeks, the monetary backdrop will determine what happens thereafter. An upside breakout could lead to a multi-month advance to well above the May-2006 peak OR a successful test of the May-2006 peak (a major 'double top').


Although the gold stock indices are near their highs of the past 10 months, the following chart shows that the cumulative net cash flow into the Rydex Precious Metals Fund (RydexPM) is still languishing near the multi-year low reached in early March. The amount of money invested in RydexPM is in a long-term decline, but even so we expect that this indicator will experience a decent bounce -- perhaps to around $175M -- prior to the start of the next significant correction in the gold sector.


Currency Market Update

The following chart of the Dollar Index reveals a potential positive divergence in the making in that lower lows in the dollar are being accompanied by rising lows in two momentum indicators (the RSI and the MACD). Ideally, as far as our short- and intermediate-term outlooks are concerned, the Dollar Index will drop below its December-2006 low within the next few weeks while the RSI and the MACD remain above their respective December-2006 lows. This would set the stage for the multi-month dollar advance we are anticipating.


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)

Stockbrokers

In the past we've suggested Boston-based StockCross Barry Murphy (SBM) as a brokerage option for non-Canadians interested in trading the Canadian resource stocks. During 2003-2006 SBM provided a good low-cost service, but based on reports received from some of our subscribers as well as our own recent experience it is clear that this broker's level of service has deteriorated of late. We will continue to direct a small portion of our personal business SBM's way, but will remove them from the list of brokerage suggestions included in Note (10) at the bottom of the TSI Stock Selections page.

We continue to like the service provided by interactivebrokers.com (IB), a US-based on-line broker that provides direct access to the Canadian stock exchanges and the stock exchanges of several other countries. However, as far as we know it is not possible to trade Canadian warrants via IB (it is possible to trade the Canadian warrants via SBM and, of course, via any Canada-based brokerage).

If any subscriber knows of an on-line US broker that enables its customers to trade Canadian warrants directly on the Canadian stock exchanges -- as opposed to via the dreaded US OTC markets such as the Pink Sheets -- then please drop us a line and we'll pass the info on to the rest of the TSI readership.

    Chesapeake Gold (TSXV: CKG). Shares: 29M issued, 43M fully diluted. Recent price: C$7.00

CKG made its way into the TSI Stocks List through the backdoor in that we received CKG shares, warrants and Class A shares when the merger between AAU (American Gold Capital) and CKG was completed in February.

Prior to its merger with AAU, CKG had plenty of cash, good management, an excellent exploration team, and several interesting early-stage projects. It didn't offer much leverage to the gold price, though, because the stock's upside potential was almost entirely associated with the proven ability of its exploration team to discover valuable mineral deposits. But with the acquisition of AAU's large low-grade gold deposits -- the Metates property in Mexico with its non-compliant low-grade resource containing 11.7M ounces of gold and 55M ounces of silver, and the Talapoosa project in Nevada with its measured-and-indicated resource containing 1M ounces of gold and 14.5M ounces of silver -- CKG now has substantial gold-price leverage to go with its other pluses.

In all likelihood CKG will become a core long-term holding for us.

From a technical perspective (see chart below), the stock is challenging intermediate-term resistance in the low-C$7 area. Breaking above this resistance would suggest that it was on its way to $10, while the short-term downside risk is probably limited to a re-test of support at C$6.00.

The ideal place to buy would be in the low-C$6 area, but there's certainly no assurance that it will trade that low again. Anyone who doesn't yet have any exposure to this stock might therefore consider taking an initial position near the current price with the goal of averaging-into a full position on pullbacks over the coming 12 months.


The CKG warrants (CKG.WT) issued to the former owners of AAU shares began to trade on the TSXV on Tuesday. The warrants have an exercise price of C$8.00 and an expiry date of February-2012.

When warrants issued as part of a private placement or a takeover first begin to trade they will often be priced at a significant discount to fair value because supply will initially overwhelm demand, but if anything the CKG warrants have commenced trading at a slight premium to fair value (with the stock at C$7.00 we think the warrants are worth around C$2.70, versus Wednesday's closing price of C$3.11). At current prices we'd therefore prefer the stock to the warrants, although if we already owned the warrants we would not contemplate selling them at this time.

Now that the warrants received in exchange for our AAU shares have begun to trade we will add them to the TSI Stocks List. We have calculated our initial cost for these warrants to be C$1.54 by assuming that the warrants have one-tenth the value of the Class A shares (each Class A share can be converted into 10 common shares whereas each warrant can be converted into a single share). Specifically, with C$2.25 being our original cost for AAU and with C$5.45 being the price assumed for our original cost of CKG shares (as explained in the 28th February Interim Update), the formula for calculation of our original purchase cost of the warrants and Class A shares is as follows:

0.29*5.45 + 0.029*A + 0.145*W = 2.25, where A is the value of a Class A share and W is the value of a warrant.

If we assume that A = 10W then the above equation can be solved to determine the value of W.

At this stage it looks like the Class A shares will not be listed on a stock exchange. If this proves to be the case then the value of the Class A shares will increase because they will become convertible into a slightly higher number of CKG shares. In this situation, however, holders will not have the convenience of being able to trade them and it will not make sense for us to add them to the TSI Stocks List.

If the Class A shares are not listed then it will simply be a matter of holding them until the gold price trades at an average of at least US$850 for a 90-day period, after which they could be converted into CKG shares at no cost.

    Northgate Minerals (AMEX: NXG). Shares: 254M issued, 259M fully diluted. Recent price: US$3.46

We are going to add gold/copper producer NXG to the TSI Stocks List as a trade with an anticipated hold period of 1-2 months.

NXG is expected to produce 285K ounces of gold and 75M pounds of copper this year. It is currently trading at only 7.2-times last year's earnings and has about US$260M (US$1/share) of cash in the bank. On the negative side of the ledger, about 60,000 ounces of low-priced gold forward sales contracts remain outstanding from an ill-conceived hedging program undertaken in 2003. It has also forward-sold almost half of this year's copper production, but we view this as neutral because we don't expect copper's average price during 2007 to be significantly more than the US$3.15/pound exercise price on these hedges.

With reference to the following chart, the stock appears to be completing a lengthy basing pattern. It is in anticipation of an upside breakout from this base within the coming month or so that we are adding NXG to the List. A break above the top of the base (US$3.90) would project a move to around US$5.00.

We plan to keep this trade on a fairly short leash because both the copper market and the stock market are presently 'overbought'. We have therefore placed an initial protective stop at US$3.23 (we will exit NXG if it CLOSES at 3.23 or lower).


    Chesapeake Energy April-2007 $32.50 Call Options

The natural gas price appears to be headed higher in the short-term, so Chesapeake Energy (NYSE: CHK) stands a good chance of continuing its recent rally as long as the broad stock market doesn't tank. However, we've run out of time as far as our CHK April call options are concerned.

In the 28th March Interim Update we said "...an opportunity to salvage something [from our CHK call option position] could still arise prior to the 20th April expiry date. Any move into the $33-$34 range would represent such an opportunity." The stock has traded in this range over the past two days, giving us the opportunity -- which we have taken -- to salvage about half of our initial purchase cost.

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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