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    - Interim Update 16th June 2004

Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

Stockhouse Involvement

The only promotion we've ever done for TSI is to provide one article every couple of weeks to a few gold-focused web sites. These articles generally take the form of short extracts from the TSI commentaries.

Starting next week, however, we will be part of the editorial team at Stockhouse.com, which simply means that Stockhouse will also display the articles that we regularly send to the gold web sites. We've also committed to provide Stockhouse with one exclusive article per month. We won't be getting paid to write anything for Stockhouse, but TSI will hopefully benefit from the extra exposure (Stockhouse is Canada's largest financial web site with over 1 million unique users and 80 million pageviews per month).

Please be assured that our involvement with Stockhouse will not detract in any way from the service provided at TSI. All we will be doing, in addition to what we are already doing, is providing Stockhouse with a monthly article.

Here is a link to an article by Jeff Berwick, Stockhouse.com's chief editor, in which he introduces the newsletter writers who will be featured at Stockhouse: http://www.stockhouse.ca/shfn/editorial.asp?edtid=17170

The Hedge Fund Economy

Some of the strange linkages we've seen in the markets over the past 15 months and the absurd extremes recently hit by some popular technical indicators can, we think, be at least partially attributed to the proliferation of hedge funds. In theory the thousands of hedge funds that now exist should be a balancing force in the markets -- they should act to make the markets more efficient -- because in many cases they are looking to exploit situations where the markets have temporarily moved 'out of whack'. In reality, though, there appears to be an enormous amount of trend-following going on, with the hedge-fund community piling into, and then out of, trades in the same way that a herd of wildebeest might stampede in one direction and then suddenly change course upon the sighting of a lion.

One of the biggest influences on the markets over the past year was the putting-on and subsequent unwinding of carry trades (borrowing at a low rate and then 'investing' the proceeds in something that is expected to earn a higher rate). Specifically, speculators borrowed large sums of US dollars with interest rates at generational lows and exchanged the dollars for higher-yielding currencies. They also used the borrowed dollars to purchase investments that would likely benefit from the inflation that was clearly raging behind the scenes. And as long as the Fed was talking-up the prospect of DEFLATION, or, at least, refusing to acknowledge any INFLATION, this seemed to be a riskless trade. However, as soon as it became clear that the days of a 1% Fed Funds Rate were numbered there was a rush for the exits that caused sharp reversals of the preceding trends.

The carry trades probably haven't been fully unwound, which is why we get US$ strength combined with weakness in everything that benefits from rising inflation (gold, for example) every time something happens to CONFIRM the inflation. The reason is that the more visible the inflation becomes the more likely it is that the Fed will be forced to hike short-term rates aggressively and the less attractive the US$ carry trades will appear to be. It might not make sense, but this is the thinking that seems to be permeating the markets right now.

The popularity of the carry trade with hedge funds has caused a counter-intuitive response to inflation news over the past two years (talk of a DEflation threat has caused gold to rally and the US$ to fall whereas talk of an INflation threat has caused the US$ to rally and gold to fall), but this is not the only area in which we are seeing the footprints of the hedge fund community. The extremely high put/call ratios discussed in last week's Interim Update are also, we think, the result of hedge fund activity.

Very high values for the CBOE equity put/call ratio have historically been associated with important market bottoms because when the volume of put options is relatively high it is often a sign that the public is very fearful; and when the public becomes convinced that the markets are going to move in one direction the markets usually end up moving in the opposite direction. The recent surge in the put/call ratio has, however, occurred in the ABSENCE of fear. We know this because the volatility indices have remained low, the bearish percentage reported each week by Investors' Intelligence has remained low, and the NDX/Dow ratio has not broken down. Therefore, what we are most likely seeing in the equity-options market is hedge funds simultaneously buying and selling large amounts of put options in order to pocket a 'spread'.

Statistics on equity-options trading are now dominated by trading in QQQ (NASDAQ100 Trust) options, so the sort of trade that MIGHT be boosting the put/call ratio would, for example, be the sale of tens of thousands of QQQ September $40 put options and the concurrent purchase of the same number of QQQ September $37 puts. Such a trade would have the effect of pumping-up the put/call ratio, but it is not a fear-based trade. It is, in fact, a bet that the market will move sideways or higher over the coming few months. And it renders the put/call ratio meaningless because we don't know whether the hedge funds that are doing these trades should appropriately be classified as 'smart money' or 'dumb money'.

Another newsletter writer's take

Franklin Sanders publishes "The Moneychanger" newsletter (www.the-moneychanger.com), which focuses primarily on the gold and silver markets. In response to something we wrote last week Franklin sent us an e-mail that provides such an interesting perspective on why the markets are becoming progressively more erratic that we decided -- after obtaining Franklin's permission, of course -- to include the e-mail in today's commentary. Here it is:

Dear Steve:
 
You wrote in your 6/9/04 Interim update:
 
"We always think of the financial markets as pendulums, so this behaviour is not surprising in itself, but what is strange is the way in which the markets have been linked together and the way they are consistently reversing course shortly after 'confirming' a direction."
 
I began thinking about this during silver's startling March-April rise that blew past all my expectations. Why?  I think the explanation lies in (1) market structure and (2) market participants.
 
(1) I am 56.  When my wife and I married in 1967, her first job was working in a stock brokerage office as a secretary.  Looking from today, you can hardly imagine how primitive the conditions were, but more to the point, how limited were the trading vehicles.  There was, for example, no readily available means to trade currencies.  None.  Remember that silver trading only became possible after 1963, gold not until 1975.  Later, during the 1970s, Susan was also working for a stock brokerage when they began adding markets for all sorts of things, interest rate futures, etc., which markets did not before exist, outside specialty trading departments at huge banks.  The point is that the possibilities for speculation have vastly increased in the last 30 years as market structure has enlarged to accommodate trading.  Of course, this includes the over the counter derivatives revolution, which is the unseen part of the market's structural iceberg.  (Most market participants today, those under 40 at least, have no idea that markets this slow and limited once existed.)  Today's market structure, then, encourages more active trading and greater risk taking.
 
(2) Market participants today have been trained (especially in University) to follow markets more closely and work their money more intensively (trade more frequently) and to take more and greater risks.  The widening of market structure has made frequent trading more economical.  Not only market professionals but also Joe and Bob trading a $10,000 stock portfolio, listen to every broadcast of the financial media (of which there are SEVERAL networks today which didn't even exist 20 years ago) and they are whipsawed back and forth by the tidal wave of Internet information.  Huge new aggregations of money in the form of hedge funds, apportioned by managers with a hair trigger for jumping from one market to another, add to market volatility.
 
For all these reasons, I believe that markets react more strongly to central bank/government propaganda than ever before.  They are also more volatile because larger lumps of loose money managed by managers trained to trade more frequently have more trading vehicles by which they can, like Pavlov's dogs, hop onto the latest media- or government-hyped trend.  This helps explain the late surge in commodities, including gold and silver, on a flood of news and focus pieces on Chinese development.  People read so many stories about Chinese demand that in their minds it became large enough to soak up all the commodities in the world -- immediately --  so they all piled into commodities as the latest investment fashion.  Likewise, they reversed course when Greasepan began hinting about raising interest rates, and that became their sole focus and consideration.  Likewise last fall and the fall before they became concerned about an illusory "deflation" (maybe because of the leaves turning brown?) in the face of the Fed's disinformatsia campaign.
 
Where does this leave us?  The last 30 years developments in market structure and vehicles, new market participants (hedge funds, smaller investors, and more active central bank intervention) and market participant training have made markets much more volatile, more liable to whipsaw, more vulnerable to central bank & government propaganda, and much more dangerous than ever before.
 
Best wishes,
Franklin Sanders
The Moneychanger

Bonds

Bond futures rocketed higher on Tuesday, ostensibly because the US CPI was not as high as many traders had feared. The result was that bonds broke out of the steep downward-sloping channel in which they were mired over the preceding 3 months.



This week's breakout projects a move up to around 111, but keep in mind that all we are seeing in the bond market is a counter-trend bounce (a retracing of part of the March-May decline). Small traders have been betting heavily on a continuation of the bond market's decline, meaning that a rally at this time is 'par for the course' in order to get the weak hands to cover their short positions before the next downward leg commences.

The US Stock Market

Current Market Situation

The US stock indices that broke above downward trend-lines early last week (the NASDAQ100, the S&P500, the NYSE Composite) have since pulled back to these former trend-lines, while the indices that did not break out to the upside (the Dow Industrials, the NASDAQ Composite) remain just below their downward trend-lines. In other words, the market is delicately balanced. Either last week's breakouts in some of the indices were real and the others will soon follow suit, or last week's breakouts were a 'trap' and the short-term downtrends are still in force.

If the Dow Industrials and the NASDAQ Composite confirmed the recent breakouts in the other indices it would point to a sizeable bounce in the market over the coming month or so. For instance, if the Dow were able to close decisively above the channel drawn on the below chart it would create a technical target of around 11,000. We doubt that it would get that high even if it did breakout because there is substantial resistance in the 10,550-10,750 range that would likely cap any advance, but two hundred points or so of additional upside would be a reasonable bet if the Dow were able to break its downtrend.


The below chart of bellwether tech stock Intel (INTC) does a good job of illustrating how finely balanced is the current situation. INTC has resistance at 28.50, but while it managed to close above this resistance early last week it has since fallen back. Also, there is a well-defined upward trend-line just below yesterday's closing price. So, INTC is presently in a narrow gap between resistance and support and the gap is getting narrower each day because trend-line support is rising. One way or the other, INTC will break out very soon (by the end of next week).


In our opinion, even if the market breaks decisively higher in the near future it won't alter the big picture. Instead, the difference between 'breakout' and 'no breakout' boils down to: a major peak is either already in place or will be put in place via a rally to a new recovery high over the next several weeks.

The ability, or otherwise, of the stock market to break higher in the near-term will most likely be determined by what happens in the currency market. Specifically, in this topsy-turvy world in which the US$ weakens when outward signs of inflation subside, an upside breakout by the Dow would most likely go hand-in-hand with US$ weakness. This also means that an upside breakout by the Dow in the near future would likely go with strength in gold and gold stocks.

Given our expectation that the US$ will test its February low within the next 1-2 months we think the odds favour a bit more short-term strength in stock market, but if we are wrong about the Dollar then the stock market's rebound is probably going to fail near its current level.

The S&P500 versus Gold

As is the case with many stocks, indices and markets right now, the S&P500/gold ratio is presently 'on the edge'. Either the rally in the S&P500 Index relative to gold is going to fail at its current level or there is going to be an upside breakout in the days ahead. In the grander scheme of things, though, it wouldn't make any difference if S&P500/gold managed to breakout to a new recovery high in the near future. This is because the rally in this ratio over the past 16 months is almost certainly of the bear-market variety, breakout or no breakout. However, the short-term picture would obviously be affected.


Oil and the Stock Market

The ratio of the Dow Transportation Average and the Dow Industrials Index (TRAN/INDU) continues to push higher, and this is evidence that an important peak is in place in the oil market.


Gold and the Dollar

Gold Stocks

In the latest Weekly Update we included a chart of the gold price to show that if we ignore the surge during the second half of March then the gold price appears to have moved lower within a reasonably well defined channel since the beginning of this year. Below we've done the same thing with a daily chart of Newmont Mining (NEM), that is, we've drawn the channel that best fits the price action if the fake-out rally in late March is ignored. We are doing this to provide a different perspective.

Note that Monday's low for Newmont MIGHT have helped define the bottom of a shorter-term UPWARD-sloping channel.


Almost all gold stocks were weak on Monday on below-average volume, but Harmony Gold (HMY) was much weaker than most and also traded more than two times its average daily volume. Furthermore, as a result of Monday's decline HMY became the first major gold stock to breach its July-2002 low (refer to the 3-year chart below). It has subsequently moved back above this level, but some technical damage has been done.


HMY is not part of the TSI Stocks List, but it is a stock we've thought would make a good long-term investment and we were therefore more than a little interested to find out why it fell so sharply earlier this week. We aren't, however, aware of anything happening with the company that would explain the weakness. There was a rumour floating around that HMY was going to make a bid for Oxus Gold PLC, but even if this rumour turned out to be true it wouldn't explain the sell-off because Oxus wouldn't be a large acquisition for a company of Harmony's size.

The only thing we can come up with is that the persistent Rand strength combined with weakness in the US$ gold price on Monday prompted a mini panic in the shares of the most leveraged of the major South African gold miners. In this respect we might now be seeing something similar to what happened in April of 2003.

During the first half of 2003 virtually all major and mid-tier gold stocks bottomed in March, with HMY being a notable exception. As highlighted on the above chart, HMY spiked well below its March-2003 low during the second half of April-2003. This final downward spike by HMY was in response to extreme weakness in the Rand gold price -- the below chart shows that the Rand gold price bottomed during the last week of April 2003 -- but interestingly Harmony was the ONLY South African gold stock to make new lows at that time. That's why we say that something similar might now be 'on the go'.


It looks like HMY is going to be a phenomenal performer once the Rand gold price turns higher in earnest, but is going to remain under pressure until that happens.

Current Market Situation

Below is a daily chart of the Dollar Index. A couple of weeks ago it looked like the Dollar Index had broken down through the bottom of the up-channel that began to form early this year, but subsequent price action indicates that a breakdown has not yet occurred.

As at the close of trading on Wednesday the Dollar Index was just below its 50-day moving average. This is a likely place for the recent Dollar rebound to fail if, in fact, it is going to fail.


There are usually a number of ways to interpret the same price chart. On the below daily chart of August gold futures, for example, the pullback over the past two weeks could be interpreted as being a bullish 'flag' within a continuing short-term upward trend. Alternatively, a bearish interpretation would be that gold has butted its head up against the 18-day moving average on three of the past four trading days without being able to achieve a daily close above this moving average.

Our near-term view is that gold might drop to around $380, but shouldn't drop significantly lower than that.


Update on Stock Selections

We recommended exiting American Bonanza (TSXV: BZA) last November at C$0.45 due to concerns about its relative valuation (at that time it was expensive relative to many of the other exploration-stage gold stocks we follow). However, at yesterday's closing price of C$0.17 those concerns no longer exist.

BZA currently has a market cap of around C$34M. Also, it has no debt and about C$14M in cash, so its enterprise value is only C$20M. This is low for a company that has achieved the sort of drilling results achieved by BZA at its Copperstone gold project in Arizona. Based on previous drilling results Copperstone will probably turn out to be a very high grade 1M+ ounce deposit. Furthermore, drilling is continuing at a frenetic pace with the aim of making a production decision next year, so there should be plenty of news-flow from the company over the remainder of this year.

We have no immediate plans to return BZA to the TSI Stocks List -- we already have more than enough exploration-stage gold stocks in the List -- but wanted to highlight the attractiveness of this stock near its current price. The exercising of warrants that expired earlier this month is probably contributing to the downward pressure on the stock right now and if this is the case there should be a nice bounce as soon as these warrant-related shares are sold.

    In early May, Aquiline Resource (TSXV: AQI) announced that an updated resource estimate for its Calcatreu gold project in Argentina would be available by 15th May and that a scoping study would be complete by the end of May. At this stage, though, the aforementioned reports have not been issued.

We never like it when a company delays the announcement of results because it is usually only bad news that comes late, but in this case the delays are in large measure because the industry is straining at capacity and the consultants have all over-committed. AQI's consultant (Micon) will hopefully provide the updated information within the next few weeks and we doubt that it will contain any negative surprises. Rather, we expect that the revised resource calculations and the scoping study will confirm the attractive economics of the Calcatreu project.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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