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    - Interim Update 13th June 2007

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Commodities

Agricultural Commodities

We continue to be bullish on agricultural commodities, primarily the grains. We therefore continue to believe that it makes sense to scale into DBA -- an ETF that invests in corn, soybeans, wheat and sugar futures.

Be aware that this bullish outlook is of the 'big picture' variety and that we have no expectations regarding what will happen to grain prices over the next few months, other than we certainly don't expect them to collapse. Short-term price moves will continue to be determined to a large extent by the effects of weather on crop conditions, and we have neither the time nor the inclination to become experts on such things.

Our view, in a nutshell, is that a secular bull market has commenced in the agricultural sector due to the coming-together of three major long-term price drivers. These price drivers are:

1. Inflation

Rampant money-supply growth throughout the world has put upward pressure on the prices of all commodities, but the agricultural commodities have generally been affected to a much lesser degree than the base metals and 'energies'. This has left the real (inflation-adjusted) prices of most agricultural commodities at extremely low levels relative to the real prices of many other commodities, thus setting the stage for big catch-up moves.

2. Using food for fuel

Rational concerns about energy security and depleting supplies of conventional fuel, along with irrational (we think) concerns about "global warming", are causing rapid growth in the demand for renewable fuels made from agricultural commodities (corn-based ethanol, for instance).

3. Increased Chinese demand

China's demand for food commodities (grains, pork, beef) is growing much faster than its ability to produce these commodities. As a result, China will be importing a lot more food in the future than it has in the past.

The ETF mentioned above (DBA) is not the sort of investment that's likely to provide a quick double, at least not at this stage of the long-term bull market. By the same token, it has minimal downside risk compared with other investments because even if a global recession were to begin later this year the demand for food would probably continue to rise; as would the demand for renewable fuels such as ethanol. That is, we think DBA is close to being 'crash proof'.

Coal

Coal was one of the two most important energy sources over the past 50 years -- the other being oil -- and will almost certainly remain so for at least the next 20 years. This is despite going out of fashion to some extent in the developed world due to the shift toward cleaner sources of energy.

As is the case with many commodities, increased demand from China will help keep the price of coal in a long-term upward trend. It wasn't that long ago that China was a huge net-exporter of coal (China's net exports of coal amounted to 830M tonnes in 2003), but in the first quarter of this year it became a net-importer of the stuff.

The following www.fullermoney.com chart shows that the price of coal more than doubled within the space of 18 months during 2003-2004 and then spent almost 2.5 years drifting lower. The lengthy correction seems to have ended at the beginning of this year, though, perhaps partly in response to China becoming a net importer.


Our only coal play is Red Hill Energy (TSXV: RH), an exploration-stage coal mining company that owns coal deposits in Mongolia. The Mongolian location might not seem ideal at first glance, but the deposits are actually well situated given that China is now looking outside its own borders for the coal it needs to satisfy its voracious appetite for energy. The location will also look fine from the Russian and Japanese perspectives.

Our interest in RH has revolved around the Ulaan Ovoo project with its 209M-tonne M&I coal resource. However, based on the press release issued by RH earlier this week it is clear that we should also be taking into account the company's Chandgana Tal project, which appears to contain more than 100M tonnes of coal and to be amenable to relatively low-cost open pit mining. If this is the case then we should be valuing RH based on the assumption that it owns 300M tonnes of in-ground coal.

It is likely that RH will end up being purchased by a large coal-producing or coal-consuming company. We don't know what RH's in-ground coal would be worth to such a company, but a value of only US$1/tonne -- versus the current spot price of around US$47/tonne -- would equate to more than C$5/share for RH. With RH having closed at only C$1.13 on Wednesday the potential reward intrigues us.

Anyhow, RH is not so much a play on coal as it is a play on a very under-valued in-ground resource that just happens to be in the form of coal. Regardless of whether the coal price drops back to near last year's low or moves up to near 2004's high over remainder of this year, the investment case for RH won't change much. Someone will either buy it, in which case it will be a financial 'home run', or they won't, in which case it will probably be 'dead money'.

A chart of RH is included below, as is a chart of major coal producer Peabody Energy (NYSE: BTU).

BTU is a more direct play than RH on coal's upside potential. It should do well over the long-term as the coal price trends upward, but as is the case with most large-cap energy stocks its shorter-term performance will be strongly influenced by the performance of the broad stock market. In other words, BTU will likely be a good performer over the next few months if -- and only if -- the broad stock market continues its advance.



 

Bonds

Below is a weekly chart of T-Bond futures.

In our opinion, everything that has happened in the bond market over the past 5 years is part of a giant topping pattern. The topping pattern will be complete once the T-Bond breaks decisively below long-term support at 103-104.

The fact that the German and Japanese bond markets have already breached their 2003-2004 lows is part of a mountain of evidence pointing to an eventual breakdown in the US bond market, but we expect that US T-Bonds will remain above the aforementioned long-term support for at least another two months. With bonds having become very 'oversold' and with a cyclical turning point due this month, we think the most likely scenario entails a short-term bottom this month followed by a multi-week -- or perhaps even a multi-month -- rebound.


The Stock Market

Current Market Situation

"Dow Posts Best One-Day Gain of 2007" was one of the headlines in the aftermath of Wednesday's rally, but from our perspective the previous day's action -- a day on which the Dow fell 130 points -- was more bullish because it contained some positive divergences. In particular, with respect to Tuesday's market action we were impressed by the ability of the stock market to remain above last week's lows even while bonds were plunging to new lows for the year and also by the strength in the NDX relative to the Dow.

Last Friday's upward reversal in the bond market was not sustained and Wednesday's upward reversal might also prove to be fleeting. However, we expect that if bonds did not make a short-term bottom on Wednesday then they will do so within the next several trading days, thus removing significant downward pressure from the stock market.

A short-term bottom in the bond market at around this time would open the door to the 1987 scenario discussed in the latest Weekly Market Update. Under such a scenario the stock market would be free to rally as long as bonds remained above their June-2007 lows, but a break below the June lows by the bond market later this year would bring-on a bear market in equities.

The potential for the Yen carry trade to unwind remains a short- and intermediate-term risk. It wasn't a coincidence, for example, that Wednesday's strong rebound in the stock market was accompanied by weakness in the Yen relative to both the US$ and the euro. Weakness in the Yen emboldens large traders to borrow this currency at less than 1% to finance speculations in higher-yielding currencies.

We noted several weeks ago that the currency market backdrop that provided the most support for the stock market entailed weakness in the US$ relative to the euro and weakness in the Yen relative to the US$ (extreme weakness in the Yen relative to the euro, that is); and that the worst situation for general equities would therefore entail strength in the US$ relative to the euro and strength in the Yen relative to the US$ (extreme strength in the Yen relative to the euro, that is).

The risk posed by the potential for the Yen to rebound from its present ultra-depressed level prevents us from being short-term bullish on equities, but the likelihood of the short-term bond market threat dissipating in the near future means that a short-term bearish view is no longer appropriate. We are therefore shifting our short-term stock market view to "neutral".

A potential trade in the "semis"

We've decided to feature charts of the Semiconductor sector today because the recent price action within this group might be pointing toward a significantly bullish outcome over the next few months.

The first of our charts shows the performance of the Semiconductor Holders ETF (AMEX: SMH) over the past 12 months. Of note is that an 8-month consolidation between $33 and $35.50 was followed by an upside breakout in April of 2007 and then a May-June pullback to 'test' the breakout. Also of note is that Wednesday's action might have signaled an end to the May-June pullback.

It looks like SMH could be on its way to  new highs for the year.


The second of our charts shows that a move by SMH to new highs for the year might have longer-term significance in that it would potentially signal an end to the consolidation that began way back in January of 2004.


We aren't going to add SMH to the TSI Stocks List because we probably won't have time to provide regular updates on it in the commentaries (when we add a position to the TSI List we create a commitment to follow-up, and in this regard we already have more commitments than we can handle). However, in response to Tuesday's positive stock market divergences and the turnaround in the bond market we added some personal exposure to SMH at the start of trading on Wednesday.

If SMH closes below its early-June low then we will assume that our positive short-term outlook on the semiconductor sector is wrong.

Gold and the Dollar

Gold/Silver Stocks

Sentiment

Disinterest has been evident in the gold sector for some time, but another sign of a general lack of enthusiasm towards gold stocks has recently emerged. We are referring, here, to the heavy way in which small-cap gold stocks have been trading of late. More to the point, the slow and relentless declines in the prices of many small- and micro-cap gold/silver stocks over the past several weeks is a sign that the public has begun to 'throw in the towel'.

As a group, the small-scale gold stocks (junior producers and explorers) performed quite well relative to their larger-sized brethren during the first four months of this year. At the time we noted that this was a bearish divergence because it indicated that 'the public' was more optimistic than 'the pros' about the gold sector's prospects. Periods when the juniors are relatively strong are fun for those of us who concentrate on these types of stocks, but it should be remembered that such periods usually only occur during the final stages of major rallies or the early stages of major corrections.

In an environment where there is a general dearth of new buying it doesn't take much selling to push the stocks of the small-scale miners downward. In fact, all it might take to get the price of an exploration-stage mining stock to fall by 5% or more is for a couple of part-time investors, who between them own no more than $10,000 worth of the stock in question, to give-up and place 'at the market' sell orders. Therefore, if you speculate within this area of the market -- and we emphasise that it is an area worth speculating in because over the course of the long-term bull market it is where the greatest profits will be achieved -- then you simply must do some selling during the good times (the rallies) because during the bad times (the corrections) there will often be no-one to sell to.

Evidence that the public has begun to 'throw in the towel' is not, however, necessarily a sign that a sustainable price low is close at hand. As we are fond of saying: sentiment follows price, not the other way around. To be confident that sentiment was about to bottom-out we would therefore need to be confident that the price was about to make a sustainable low for some reason other than sentiment.

If we thought that a normal intermediate-term correction was underway then we would view the current sentiment backdrop as a big plus because the current pessimism would add fuel to the next rally, but we don't think this is a normal intermediate-term correction. Instead, we suspect that a much larger-than-normal correction commenced during May of last year and that the second downward leg in this major correction is still in its early stages. If so, then sentiment will become considerably more pessimistic over the next six months.

Current Market Situation

The following chart shows that GDX has short-term support defined by the lows of the past three weeks and intermediate-term support defined by the June/October-2006 lows. Our guess is that short-term support will hold for now and the gold sector will rebound over the coming 1-3 weeks, but this is not a rebound that we would attempt to play. Rather, we think that those who have not yet retreated to their 'core' gold/silver stock exposure should use near-term strength to lighten-up.

We expect that intermediate-term support will be tested within the coming 4 months.


The following chart of mid-tier silver producer Pan American Silver (NASDAQ: PAAS) shows the important support that exists at US$26. A break below this support would create a technical objective of $20.

A rebound in PAAS over the coming 1-3 weeks should, we think, be viewed as a selling opportunity.


Intermediate-term peaks in the PAAS/silver ratio usually lead intermediate-term peaks in the gold stock indices by at least a few weeks. However, the most recent intermediate-term peaks in PAAS/silver and the gold stock indices were concurrent.

With reference to the following chart, a move below 2.0 by PAAS/silver would constitute further evidence that an important top is in place in the gold/silver sector.


Currency Market Update

The following weekly chart shows that euro futures are presently mid-way between intermediate-term resistance at 1.36-1.37 and intermediate-term support at 1.30. From our euro-bearish perspective, the ideal situation would be for the euro drop to around 1.30 before it commences a rebound or consolidation. However, it is currently working on its 7th down week in succession, meaning that the decline is becoming extended on a short-term basis.

Whether it bounces now or from a lower level, we think it's just a matter of time before the euro moves back below 1.30.


There's been a lot of talk over the past month about the impact on the gold market of the sale, by the Bank of Spain, of 108 tonnes (about 25%) of that country's official gold reserves during March-May of this year.

In our opinion, there is so much money sloshing around the financial world these days that the sale of around $2B of central bank gold over the space of 3 months will not create a problem for the gold market. This particular sale might, however, be a sign of impending trouble within the European Monetary Union and, therefore, an impending euro problem. We say this because Spain's unexpected sale of 25% of its official gold reserve looks like an act of desperation by a country that's beginning to experience the inexorable bad effects of a massive credit expansion.

In the spirit of Keynes, governments these days like to address the problems caused by inflation (excessive money-supply growth) via...more inflation. Elementary-school logic will tell you that this can only result in even bigger problems down the track, but this won't matter if your overriding goal is to get re-elected. If this is your goal then you will be inclined to embrace stopgap measures that mask the underlying problem in the short-term (between now and the next election, that is).

One of the inherent weaknesses of the euro has always been the likelihood that the monetary union would become strained, and eventually crack, once it became clear to some member governments that their desire to inflate their way to victory in the next election had become incompatible with the ECB's monetary policy. Spain's recent gold sales could mean that cracks are about to appear at the periphery of the Union.

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)

USEC Inc. (NYSE: USU). Shares: 87M. Recent price: US$18.21

The stock price of uranium enrichment company USEC plunged during the first three days of this week, from a high of US$22.27 on Monday to an intra-day low of US$17.12 on Wednesday. It rebounded from the low hit during the early going on Wednesday and ended the session at US$18.21.

The catalyst for USU's dive was a very negative article in the New York Times (NYT). The NYT article contained nothing new; in fact, it mostly just dredged-up negatives that have been well known for years. It had a big effect on the stock, though, because sentiment towards USU had recently become way too bullish. After the public becomes 'frothing at the mouth' bullish towards any investment then that investment will likely experience a substantial price decline if an unanticipated negative development occurs.

We remain long-term bulls on USU. However, we recently suggested taking profits on the stock in the $22-$24 range because it had run up too far/fast and had become fully valued. The question now is: would we return to the stock as buyers at this time?

The answer is no. USU is probably only 1-2 weeks into a correction that will last at least a few months. It may not trade much lower than Wednesday's panic low of $17.12, but in the absence of a takeover bid for the company it is unlikely to trade appreciably higher until after a lengthy period of basing has occurred and financing is in place for its new centrifuge project.

Those who didn't follow our earlier suggestion to take money off the table in USU should look to do so if it rebounds back to the low-20s over the next few weeks.

    Copper Fox (TSXV: CUU). Shares: 69M issued, 78M fully diluted. Recent price: C$1.06

In case you missed it, here is a link to Copper Fox's press release explaining why trading in the stock has been halted:
http://biz.yahoo.com/cnw/070611/copper_fox_trade_halt.html?.v=1

The bottom line is that an earlier press release understated the grade of the Schaft Creek resource. The total resource won't change, but an updated calculation will show a higher classification of the resource. This is obviously good news.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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