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    - Interim Update 15th August 2007

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The main problem lies in the leverage

...the $500B of US sub-prime mortgage debt was simply the weakest block in a huge debt-based pyramid with total value in the tens of trillions of dollars.

Here is an excerpt from an article entitled "Subprime Geopolitics" posted at www.stratfor.com on 14th August:

"There currently are three possibilities. One is that the subprime crisis is an overblown event that will not even represent the culmination of a business cycle. The second is that we are about to enter a normal cyclical recession. The third, and the one that interests us, is that this crisis could result in a fundamental shift in how the U.S. or the international system works.

We need to benchmark the subprime crisis against other economic crises, and the one that most readily comes to mind is the savings and loan crisis of the 1980s. The two are not identical, but each involved careless lending practices that affected the economy while devastating individuals. But looking at it in a geopolitical sense, the S&L crisis was a nonevent. It affected nothing. Bearing in mind the difficulty of quantifying such things because of definitions, let's look for an order of magnitude comparison to see whether the subprime crisis is smaller or larger than the S&L crisis before it.

Not knowing the size of the ultimate loss after workout, we try to measure the magnitude of the problem from the size of the asset class at risk. But we work from the assumption that proved true in the S&L crisis: Financial instruments collateralized against real estate, in the long run, limit losses dramatically, although the impact on individual investors and homeowners can be devastating. We have no idea of the final workout numbers on subprime. That will depend on the final total of defaults, the ability to refinance, the ability to sell the houses and the price received. The final rectification of the subprime will be a small fraction of the total size of the pool.

Therefore, we look at the size of the at-risk pool, compared to the size of the economy as a whole, to get a sense of the order of magnitude we are dealing with. In looking at the assets involved and comparing them to the gross domestic product (GDP), the overall size of the economy, the Federal Deposit Insurance Corp. estimates that the total amount of assets involved in that crisis was $519 billion. Note that these are assets in the at-risk class, not failed loans. The size of the economy from 1986 to 1989 (the period of greatest turmoil) was between $4.5 trillion and $5.5 trillion. So the S&L crisis involved assets of between 8 percent and 10 percent of GDP. The final losses incurred amounted to about 3 percent of GDP, incurred over time.

The size of the total subprime market is estimated by Reuters to be about $500 billion. Again, this is the total asset pool, not nonperforming loans. The GDP of the United States today is about $14 trillion. That means this crisis represents about 3.5 percent of GDP, compared to between 9 percent and 10 percent of GDP in the S&L crisis. If history repeats itself -- which it won't precisely -- for the subprime crisis to equal the S&L crisis, the entire asset base would have to be written off, and that is unlikely."

While interesting, the stratfor.com analysis misses a very important point. The total size of the US sub-prime market may 'only' be about $500B; however, the losses could potentially be at least an order of magnitude greater than this due to the debt-related leverage that has been employed. For example, in the low-interest-rate/low-credit-spread environment of the past few years, generating good returns has necessitated the use of substantial leverage and in many cases the leverage has taken the form of debt. As a result, there will undoubtedly be many hedge funds that have used one dollar of subprime mortgage-related securities as collateral for ten or more dollars of loans. The proceeds of these loans will then have been used to purchase other investments.

As we understand the situation, the $500B of US sub-prime mortgage debt was simply the weakest block in a huge debt-based pyramid with total value in the tens of trillions of dollars. When the weakest block began to crumble the entire structure became unstable, which is why the senior central banks of the world have reacted so aggressively over the past week. Obviously, if the likely worst-case were that $500B of US subprime debt would have to be written off then the central banking community would not have felt the need to inject almost $500B of liquidity into the global banking system over just the past several days.

The potential scope of the problem is enormous, but we think it's the sort of problem that the central banks of the world will be able to 'solve' over the coming 2 months in the usual way (by creating money 'out of thin air'). This type of solution will, of course, have longer-term adverse ramifications for the inflated currencies and will therefore buttress our long-term bullish outlook for gold.

Quick update on the bond market

Below is a daily chart of September T-Note futures.

We suspect that the bond market will peak shortly after the stock market bottoms, meaning that we see September-October as a likely time for a peak in T-Note futures. However, we no longer think that the short-term upside potential in the bond market is greater than the short-term downside risk. Our reasons are:

1. It is taking relentless stock market weakness to maintain upward pressure on bond prices, but a stock market rebound is likely to begin within the next few days.

2. Commercial traders now have a substantial net-short position in T-Note futures.

3. T-Note futures are now within spitting distance of important resistance.

We are therefore changing our short-term outlook for bonds from "bullish" to "neutral".


The Stock Market

Current Market Situation

Sentiment usually follows price, so when sentiment becomes very optimistic following a large price rise or very pessimistic following a large price decline it tells us nothing of real value. However, mismatches sometimes arise between sentiment and price action, and in such cases sentiment indicators can be useful.

A mismatch currently exists between sentiment towards the US stock market and the market's price action in that the amount of pessimism/fear is much greater than the price action would appear to warrant. To be specific, the S&P500 Index has only dropped by about 10% from last month's all-time high and yet this fairly normal decline has caused extreme sentiment readings as noted below:

1. During Tuesday and Wednesday of this week the CBOE equity put/call ratio was greater than 1, meaning that the volume of put options traded was greater than the volume of call options traded on both days. Prior to this week the daily equity put/call ratio had not been greater than 1 since July of 2004.

2. The 10-day moving average of the equity put/call ratio usually peaks at 0.80-0.85 near the ends of major corrections. At Wednesday's reading of 0.78 it hasn't reached the aforementioned range, but it is getting close.

3. The bullish consensus reported by Market Vane just hit a 2-year low.

4. The number of NYSE-traded shares sold short by the public had already moved well into all-time high territory prior to this week. This week's short selling total, when reported by the NYSE in about two weeks time, will probably reveal even higher levels.

5. The Volatility Index, a measure of the volatility implied by option prices, ended Wednesday's trading session at its highest level since March of 2003.

We also note, with reference to the following chart, that:

1. The percentage of S&P500 stocks trading above their 200-day moving averages (the purple line on the chart) just reached its lowest level since April of 2003.

2.  The percentage of S&P500 stocks trading above their 50-day moving averages (the green line on the chart) is presently as low as it was at the end of the dramatic 5-day selling squall that followed the September-2001 attacks by terrorists. In fact, the only time over the past 8 years that this indicator was more oversold than it is today was during the major bear-market capitulation of July-2002.


Our guess is that the US stock market will bottom during September or October and that the ultimate correction low won't be far below the current level.

Gold and the Dollar

Gold Stocks

Intermediate-Term Outlook

The financial backdrop is becoming increasingly bullish for gold and gold stocks, and yet many junior gold stocks are in free-fall and the gold-stock indices are breaking down. While we didn't predict such a short-term outcome it is not uncommon to see a market -- especially the market for gold stocks since so few people understand what is and isn't bullish for this market -- move in the opposite direction to the fundamentals for a considerable period. For example, we noted in a TSI commentary a few weeks ago that the gold sector trended relentlessly lower for a few months during the second half of 2000 at the same time as the underlying fundamentals were very bullish and becoming more so by the day.

The current situation is that a dramatic widening of yield and credit spreads is underway due to sharp declines in short-term interest rates relative to long-term interest rates and sharp declines in the prices of high-risk debt relative to low-risk debt. Also, by injecting large amounts of newly-created money into the global financial system the central banks are effectively reducing REAL interest rates even though they haven't yet begun to reduce their official targets for nominal interest rates. This interest-rate-related action is, in turn, setting the stage for major advances in gold and gold stocks. Furthermore, gold has begun to trend higher relative to industrial commodities, thus putting in place the conditions that will lead to the widening of profit margins in the gold mining industry.

At the same time and as noted in the first paragraph, the prices of most gold stocks are falling.

We therefore have the situation where the fundamentals are bullish (and becoming increasingly so) while the price action is now decidedly bearish. Wednesday's breach of support by the HUI could, of course, prove to be another 'head fake', but we won't make that assumption.

On account of the bullish fundamentals and the offsetting bearish price action we have downgraded our intermediate-term gold stock outlook from "bullish" to "neutral".

Short-Term Outlook

Yesterday's break below support by the HUI (see chart below) suggests that the June-2006 and October-2006 lows in the 270-280 range will be tested within the next three months, which is exactly what we were anticipating before the July surge in the HUI/gold ratio (discussed below) faked us out. Ugh!

Note, though, that yesterday's break below support doesn't suggest that lower levels will be seen in the immediate future. If the HUI continues to decline without an intervening multi-day rebound then an important low could eventuate as early as the first half of next week. Although another 2-4 down-days in succession would create considerable short-term pain for those who are substantially 'long' the gold sector, such a wash-out would probably lead to a sustainable low and would thus represent the more bullish of the two most likely outcomes. The alternative is that the current phase of the decline ends immediately and that the HUI rebounds to around 330 before returning to its downward path.

The price action is suggesting that we should downgrade our short-term view from "bullish" to "bearish", but the term "neutral" is a better reflection of how we see the current situation. An extension of the current decline that takes the HUI down to the 280s would almost certainly take us back to a bullish stance because at that point the short-term downside risk would, given the favourable fundamentals, be significantly less than the upside potential. On the other hand, a rebound over the coming 1-2 weeks that alleviated the oversold condition would most likely shift us to a short-term bearish stance.


The financial markets are very good at making it seem like they are about to do one thing before doing the exact opposite. For example, it is not uncommon to see a market breakout decisively in one direction and then quickly reverse course.

We've seen countless false breakouts in the past, which is why we generally don't put a lot of emphasis on such occurrences. However, the markets still manage to 'fake us out' from time to time, the most recent example involving last month's break in a sequence of declining tops by the HUI/gold ratio (chart included below). The bad news is that the HUI/gold ratio reversed sharply lower after breaking out to the upside. The good news is that the BEST buying opportunities for both gold bullion and gold stocks occur when the HUI/gold ratio drops well below its 40-day moving average (the blue line on the following chart), which is ALMOST where we are right now.

Significant additional weakness in gold stocks relative to gold bullion over the next few days would take the HUI/gold ratio to a level, relative to its 40-day moving average, that normally only occurs near the beginnings of major multi-month rallies. That's why a brief (2-4 day) extension of the decline would potentially be more bullish than an immediate rebound.


Actions to take

The e-mail that we sent to subscribers after the close of trading on Tuesday contained the following comments:

"We are no less positive on the gold sector now than we were at the end of last week, but this week's price action does not mesh with our outlook (the price action is a warning that we might be wrong). We haven't yet decided what, if any, changes will be made to the TSI Stocks List, but we will be doing a modicum of selling in our own account today (Wednesday). We hate selling into weakness, but risk management considerations dictate that we increase our cash position at this time. We could be selling at a short-term bottom, but so be it.

Note that we would do some more selling if the HUI were to close below 328 and would retreat to our "core exposure" to gold stocks if the HUI were to close below 317."

The problem with the idea of retreating to "core exposure" now that the HUI has closed below 317 is that panicked liquidation is currently underway at the junior end of the market. The gold-stock indices have fallen by less than 10% over the past two weeks, but the prices of many junior mining stocks have collapsed in response to "get me out at any price" selling by retail investors. As a result, any selling of the juniors in the current environment would necessarily be done at ultra-depressed levels. In fact, it would be done at prices that are bound to look extremely low 18 months from now, and perhaps even 6 months from now.

It is therefore unlikely that we will significantly scale back on our exposure to junior gold stocks at this time. Instead, most of the cash building will be done in the more liquid positions we own.

The performance of the overall market doesn't usually give us much cause for concern and in this regard the current situation is no exception. This is because we can confidently predict how the story is going to end and have seen enough in the past to realise that severe shake-outs are part and parcel of every long-term bull market. What we can't predict with anywhere near as much confidence is the long-term future of any individual stock, so stock-specific negative surprises usually bother us a lot more than general market surprises.

More JS Scare-Mongering

In addition to all the fear stemming from the general market turmoil, the junior gold stocks have had to contend with the fear inspired by Jim Sinclair's relentless warnings to the effect that many of these companies -- his own company being a notable exception -- will be badly hurt in a RISING gold price environment due to derivatives built into the project loans taken-out by the juniors or their major mining-company partners. JS's writings give the impression that MOST junior gold mining companies are at risk, and many shareholders in such companies have undoubtedly taken his words to heart and headed for the exits without first checking if the companies they own really are exposed to such a risk. Had they checked, by reviewing the annual and/or quarterly reports issued by the companies, they would probably have discovered that there was no reason to panic because, as far as we can tell, very few companies actually face the risk Mr. Sinclair is warning about (we don't specifically know of any, but there are almost certainly a few that we don't know about).

To back-up his opinion that a sharp rise in the gold price will send much of the gold sector to 'hell in a hand-basket', JS cites the recent US$2B quarterly loss reported by Newmont Mining (NEM). The thing is, the bulk of this huge quarterly loss was associated with the NON-CASH write-off of US$1.7B of goodwill in preparation for the sale of the company's merchant banking business unit. This goodwill write-off should allow NEM to report a large one-off profit when the merchant banking division is eventually sold and clearly has nothing to do with derivatives. NEM also incurred a CASH cost of $500M to close out gold forward sales contracts, which, of course, was a short-of-gold derivative-related loss. However, this liability had been clearly evident on NEM's balance sheet for years, so it wasn't exactly a 'skeleton in the closet'.

Very few gold mining companies will run into trouble due to a higher gold price, but over the past few years many have run into trouble as a result of having their profit margins squeezed due to the gold price being too LOW. Gold has fared reasonably well relative to paper money and most financial assets, but it has barely kept pace with the inputs to the gold mining process (energy, steel, copper, machinery, truck tires, labour, etc.).

In other words, the pressure on the gold mining industry and on the prices of gold mining stocks stems from a low gold price and will be removed by gold gaining ground relative to other commodities as well as relative to paper money. The risk is that the gold price doesn't rise; not that it does rise.

Gold

A daily chart of October gold futures is presented below.

While gold stocks were getting dumped over the past two weeks, gold bullion hardly moved at all. However, when gold stocks diverge from gold bullion and begin to trend strongly in one direction or the other, the divergence is usually eliminated by gold bullion coming into line with the stocks. This week's price action in the gold sector of the stock market has therefore prompted us to downgrade our short- and intermediate-term gold bullion views to "neutral".


Currency Market Update

As evidenced by the following weekly chart, this week's decline has taken euro futures to trend-line support. More important support is, however, defined by the June bottom (just below 1.33) because a close below the June bottom would break a lengthy sequence of rising lows dating back to November of 2005.

Our expectation is that euro futures, driven by the realisation that the European currency is, at best, no better than the US currency, will break below the aforementioned support within the next two months and will test the November-2005 bottom during 2008. However, a rebound to test last month's peak is a likely prospect prior to the commencement of a large decline. If such a rebound eventuates it will probably coincide with the temporary removal of downward pressure from the markets that have been hit hard over the past few weeks, especially if the euro rebounds relative to the Yen as well as the US$.


Outright Panic in the Uranium Sector

Many junior gold and base-metal stocks have been beaten-up over the past few weeks, but almost every stock in the uranium sector has been taken out back and shot. The uranium sector has recently provided a good example of just how quickly manic enthusiasm can transform into desperate fear in the stock market.

We are following two uranium stocks: Uranium One (TSX: SXR) and Energy Fuels (TSX: EFR). In the latest Weekly Update we said that SXR had probably bottomed last Friday when it spiked below C$10, but that we could envisage EFR trading as low as C$1.50 at some point over the ensuing weeks. Well, we might have been right about SXR having bottomed but we were certainly wrong about EFR. When panicked liquidation takes place amongst junior resource stocks, technical support and valuation mean nothing. This indiscriminate selling creates great opportunities for future profits, but it's important not to under-estimate just how stupid the public can be when it stampedes for the exits. In other words, it's important to pace yourself when buying during a sell-off.

The following chart of Pinetree Capital (TSX: PNP) provides a good illustration of the rapid transformation from irrational exuberance to blind fear within the uranium sector. PNP invests in junior resource companies, a significant number of which are involved with uranium exploration/mining. Due to its focus on small companies involved in uranium mining PNP became something of a proxy for the speculative end of the uranium sector.

The chart shows the stock's spectacular rise from $4 to $16 and its spectacular decline from $16 back to $4. And some people claim that the stock market is efficient?

To give you an indication of just how manic the uranium sector was earlier this year we note that when PNP was trading at $16 in April its net asset value (NAV) was only around $5. That is, PNP was trading at a 200% premium to NAV earlier this year. Now, investment companies like PNP normally trade at DISCOUNTS to NAV, meaning that PNP was at least 200% over-valued at its April high. Furthermore, the company's NAV was at an elevated level due to the large unrealised gains in its investment portfolio. In other words, prior to its spectacular decline PNP was trading at a 200% premium to an artificially-elevated NAV while similar companies outside the uranium sector were trading at significant discounts to non-elevated NAVs.

Even at yesterday's closing price of C$4.35, PNP would still be trading at a significant premium to NAV because its NAV would have fallen over the past several weeks. However, the gap between the share price and the per-share NAV would now be far more reasonable. In any case, the waterfall decline of the past few weeks should soon lead to a vigorous rebound.


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)

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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