The Fed gives gold investors a green light

The Fed left interest rates unchanged at Tuesday's monetary policy meeting, something that shouldn't have surprised anyone. What was of interest, though, was the way the Fed's monetary policy announcement was worded. In particular, the Fed reiterated its view that the main concern for the foreseeable future was for "undesirably low" inflation and confirmed that short-term interest rates could stay low for a "considerable period". 

Now, Greenspan and Co. can say whatever they want about interest rates but at the end of the day the market will determine when short-term rates are hiked and by how much. For example, there's a reasonable chance that bond prices will work their way higher over the next 2-3 months, thus giving the Fed some breathing room. However, this bond rally will most likely turn out to be a counter-trend move that will be followed by a drop to well below the recent lows. When long-term interest rates push above 5%, then 6%, and then start heading rapidly towards 7%, is the Fed really going to be able to or willing to hold the Fed Funds Rate at 1%? If they did then inflation expectations would spiral out of control, the US$ would collapse and we'd have a 4-digit gold price on our hands. The bottom line is; regardless of what policy-makers are telling us now, the Fed will only be able to hold the Fed Funds Rate at the current low level beyond the next few months in the extremely unlikely event that the US really does start to experience deflation.

The Fed's stated intention to leave short-term interest rates at an artificially low level for as long as deemed necessary is, however, important because it confirms that the Fed has no desire to be pre-emptive with regard to the building inflation problem. In effect, the Fed has confirmed that it will keep short-term rates at a low level until the market forces it to do otherwise, that is, until the inflation problem becomes obvious to all. This, in turn, means that the natural hedges against a loss of confidence in the US$ are going to have a lot more room to run than would be the case if the Fed was primarily concerned about suppressing the effects of inflation. This is why we headed this section with "The Fed gives gold investors a green light".

In addition to giving gold investors a green light the Fed has just given bond investors a kick in the stomach. This obviously wouldn't have been their intention because long-term interest rates must remain low if the great US credit expansion is to continue, but it would appear that the bond market is beginning to sense the inflation problem that has been brewing now for years. So when the Fed now says it is concerned about undesirably low inflation, thus implying that a goal of current Fed policy is currency depreciation, bond investors head for the hills. 

But why the sudden fear on the part of bond investors? After all, didn't everything in bond land seem rosy just 2 months ago? 

As we've argued in the past, we think the huge run-up in bond prices (plunge in long-term interest rates) over the first 6 months of this year was, to a large extent, a consequence of the falling US$. Specifically, the falling dollar prompted foreign central banks (mainly the Japanese) to aggressively buy dollars in the currency market and these dollars were, in turn, invested in US Treasury and Agency debt. When the dollar stopped falling a large slice of this central bank buying support was removed and US bonds were left to trade based on their own fundamentals. Therefore, a resumption of the dollar's downward trend will probably coincide with the start of a sizeable rally in the bond market.

The Fed is continually trying to manage inflation expectations in order to get the markets to behave in a particular way. The problem is; the gap between what the Fed wants the markets to do and what the markets should be doing based on the reality of the situation is becoming unmanageable.

Bonds

The initial sharp decline following a major peak tends to bottom about 2 months after the peak. If the US bond market follows this pattern then the initial decline from its mid-June peak should bottom around...now. 

Below is a daily chart of September T-Bond futures. Yesterday's plunge in the bond price could turn out to be a test of the 1st August low or a spike to a new low might occur in the immediate future. Either way, there is a reasonable chance that bonds are within a few days of an intermediate-term bottom and that the NEXT upward reversal in the bond market will be followed by a multi-month rally. 

The US Stock Market

Current Market Situation

Semiconductor equipment manufacturer Applied Materials (NASDAQ: AMAT) announced its latest quarterly results after the close of trading on Tuesday. In the ensuing conference call with analysts the company's management said that next quarter's revenue would be about 10% lower than previously expected, but at the same time they talked about how business was starting to improve. The stock was up 3.4% on Wednesday which clearly shows that stock-market participants are generally still willing to believe 'spin' over facts. This, in turn, is a bullish factor because it indicates a high tolerance for risk.

Below is a 2-year chart of the NASDAQ100/Dow ratio. This ratio broke down last week, a definitively bearish signal because it indicated that market participants were starting to become more risk averse (something that tends to happen in the early stages of a major decline). However, as mentioned above the market's reaction to the AMAT earnings report and guidance indicates the opposite. The most likely explanation for this apparent discrepancy is that a change in trend was confirmed last week and that the action over the first 3 days of this week was a counter-trend move. 

The S&P500 Index broke below the bottom of its 2-month consolidation pattern at the beginning of last week and has since rebounded in what appears to be a normal test of the breakout (see chart below). If this is the correct interpretation then the S&P500 and the other major stock indices should begin to head lower almost immediately. However, a daily close above 995 would negate this view and suggest that a rally to new recovery highs was underway.

Below is a chart of the Bank Stock Index (BKX). With a major peak in the bond market now behind us the bank stocks are most likely going to be relatively poor performers over the next 6-12 months. There is an outside chance that the counter-trend rally in the bond market that we expect to begin from whatever low is set this month will be sufficient to boost the BKX to a marginal new high for the year. It is, however, much more likely that an important peak for the BKX is already in place and that support at 850 will be taken out over the coming few weeks.

Just to be clear, there is no change to our short and medium-term views as outlined in recent commentaries. That is, we are expecting near-term weakness in the stock indices and have reason to believe that major peaks in some of the indices (e.g., the NDX and the BKX) are already in place. However, we expect that both the S&P500 Index and the Dow Industrials Index will make new recovery highs over the next few months BEFORE a major decline in the overall market gets underway.

Commodity-Cyclical Stocks

Here's a quick review of the charts of some of the most important commodity-cyclical stocks:

a) A daily close above $40 will not only break the intermediate-term downtrend in the International Paper (NYSE: IP) stock price shown on the below chart, it will also break the major downtrend that has been in force since January of 2000. We have IP and IP call options in the TSI Stocks List in anticipation of such an upside breakout.

b) In US$ terms, BHP, the world's largest diversified natural resource company, has been in an up-trend since September of 2001 and is currently near its all-time high.

c) The below chart shows the US$ stock price of base-metals producer Inco. The Inco chart looks quite similar to the BHP chart (both stocks have been in upward trends for around 2 years, have recently broken out to the upside and are close to the peaks reached in early 2000).

d) Alcoa broke out of a 2.5-year downward trend about 2 weeks ago.

Even if you don't trade on the stock market the price action in certain stocks can provide useful information. For example, if you were interested in figuring out what retail sales were going to be like over the next 6 months then you would probably benefit from monitoring the Walmart stock price. Similarly, the above charts contain clues with regard to future economic growth and commodity prices.

Although the charts of the major commodity-cyclical stocks have moved up quite sharply over the past few months the charts do not suggest that important peaks are close at hand. On the contrary, these stocks appear to have considerable upside potential over the next few months. This, in turn, suggests that global growth is going to reasonably strong over the next 6-9 months and that commodity prices will move to new multi-year highs once the current correction has run its course.

Gold and the Dollar

The bull market in gold stocks

In the latest Weekly Update we commented that if we owned any major gold stocks we'd start scaling out of these positions and would perhaps shift the proceeds into physical gold. We said this due to the high prices of many of the major gold stocks and the gold stock indices relative to the gold price. Gold stocks are generally considered to be leveraged plays on the gold price, but if the current prices of gold stocks already discount a substantially higher gold price then this leverage has, in effect, been removed. Considering that the risk in owning a gold stock is typically a lot higher than the risk of owning gold bullion there is no reason for investors to own gold stocks in preference to the bullion unless they can obtain greater leverage to the gold price by doing so. 

The senior gold stocks being more than fully priced relative to the current gold price is a sign that risk is increasing and that we are potentially close to an intermediate-term peak, but it is not a sign that an end to the gold-stock bull market is imminent. In fact, what appears to be underway is just the sort of progression that normally occurs during any major rally in the stock market. First, investors bid up the prices of the high-profile large-cap stocks. Then a gradual shift towards the more speculative end of the market occurs. 

If we were close to the end of the gold stock bull market then most of the junior gold stocks would be very expensive relative to the amount of gold they have in the ground. However, that is clearly not the case right now (as per the valuation analysis included in the latest Weekly Update, many junior gold stocks still offer excellent value and considerable leverage to the gold price). The public is yet to get enthusiastic about the gold stocks and all we've really seen to date is that a few of the larger and reputedly safer gold stocks - the ones that would tend to be favoured by institutions - have been pushed significantly higher than where they really should be based on the current gold price.  

In recent commentaries we've described what we consider to be the two most likely outcomes for the gold price over the remainder of this year. The first is that gold will soon embark on a rally that will take the price above $400 while the other is that gold will continue its consolidation for a few more months before taking off. Either way, the fundamental backdrop strongly suggests that the direction of the next big move in the gold market will be up and price action continues to confirm such an outlook. As such, and with our junior gold stocks generally being under-valued relative to the CURRENT gold price, we don't think it is wise to be taking much money off the table at this time as far as the junior gold stocks are concerned. Profit-taking opportunities will arise from time to time in individual issues and we'll do our best to identify such opportunities, but we think that whole-scale selling at this stage would be a mistake. 

Gold

Earlier in today's commentary we said that the Fed has just given gold investors a green light. This doesn't mean that the gold price will necessarily rocket higher over the next few weeks, but rather that the underlying trend for gold is going to remain bullish for some time. Prior to the Fed meeting our analysis already told us that a gold price of at least $450 was 'written on the wall' as far as the coming 12 months were concerned. The Fed's reiteration of its promise to pursue currency devaluation for the foreseeable future just increases our confidence that we are going to be right about this. The 'writing on the wall' is, however, only readable if you are standing a good distance from the wall. 

In the short-term the outlook for gold is ambiguous. A daily close above $378 would confirm to us that a rally to over $400 was in progress. Due to the recent strength of the gold shares we would put the odds at about 60% that such a rally was already underway. Alternatively, the consolidation that began in February could extend for a while longer with the gold price perhaps spiking below its 200-day moving average before embarking on the rally that will take it above $400.

Below is a 3-year chart of the HUI/gold ratio with a 40-day moving average. During those periods in which the ratio was surging higher, as it is now, pullbacks have tended to end at around the 40-day MA. If such a pullback occurred now it would result in a 10% fall in the HUI relative to the gold price. This, we think, defines the downside risk in the HUI assuming the bullish trend remains intact. At some point, of course, the HUI/gold ratio will break decisively below its 40-day MA and we will have a sign that the bullish trend has ended.

Currency Market Update

Below is a weekly chart of the Swiss Franc. Shortly after the SF peaked we identified support in the 0.70-0.72 range as a likely area for a correction low to occur. The SF reached this support in July and has since rebounded. Another test of the 0.70-0.72 range over the next few weeks would not surprise us, but the rapid rate at which commercial traders have purchased SF futures during the pullbacks suggests that this support will hold. If support at 0.70 is breached then a drop to 0.66 would become likely, but this is not a possibility we are seriously considering at this stage. It would, however, be worth giving serious consideration to such a possibility if the SF moved up to at least 0.76 and then dropped back to 0.72. 

Below is a daily chart of the September Swiss Franc futures. The SF has resistance at around 0.7480 defined by its late-July peak, but there is more important resistance just a bit higher at 0.7550. A daily close above 0.7550 would suggest that a rally to a new high for the year was underway.

Update on Stock Selections

We are going to add a trading position in anticipation of a rebound in the bond market over the next 1-3 months. Specifically, we will add the TLT December 2003 $85.00 call options (TLTLG) to the Stock List if they trade down to $0.90. In order for the options to trade this low bonds will need to move at least 1 point below yesterday's closing level. (TLT is the symbol on the AMEX for the 20+ Year Treasury Bond Fund). 

As discussed in recent commentaries we are generally not enthusiastic about the major North American gold stocks simply because they have moved up too far relative to the gold price. There is, however, one exception. 

The exception is Kinross Gold (NYSE: KGC, TSX: K), a stock that has lagged many of the other large and mid-size NA gold producers over the past few months. Whereas the AMEX Gold BUGS Index (HUI) has broken upwards out of its lengthy consolidation range, KGC remains within its own 14-month-long consolidation pattern (see chart below). It would be very unusual if KGC's consolidation didn't end in an upside breakout, particularly considering the price action in leading stocks such as NEM. Therefore, KGC looks interesting from a technical perspective. It also looks interesting from a valuation perspective because its reserves are selling at a substantial discount to those of the other NA gold producers that have market caps in excess of US$1B. For example, KGC's reserves are priced at about a 70% discount to Goldcorp's reserves, a 50% discount to Glamis Gold's reserves, and a 30% discount to Newmont's reserves. These discounts appear to be too high given that we are in a rising gold price environment.

KGC is a reasonable buy at its current level, as are the Kinross warrants (TSX: K.WT) that we added to the TSI Stocks List via the e-mail that was sent to paid-up subscribers earlier this week. (Three warrants plus C$15 can be exchanged for one share at any time prior to December 2007).

Northern Orion (TSX: NNO) is a stock with substantial upside potential. The stock is highly leveraged to copper and gold prices, but as advised in the above-mentioned e-mail even more leverage can be obtained by buying the NNO warrants (TSX: NNO.WT). The warrants have an exercise price of C$2.00 and an expiry date of May 2008.

In last week's Interim Update we said that Golden Phoenix (OTCBB: GPXM) was showing signs that it was about to move higher. The stock was trading at US$0.32 at the time and it subsequently traded as high as 0.50 before closing at 0.45 on Wednesday. New buying would be appropriate on a pullback to 0.37. Also, we plan to take profits on GPXM if it moves up to the 0.54-0.60 range.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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