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    - Interim Update 17th September 2008

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Natural Gas Update

The NG market made important lows during September of 2001, 2003, 2004, 2006 and 2007, and is on track to make an important low during September of 2008. Here's a weekly NG price chart highlighting the September lows of the past 7 years and a table outlining the trough-to-peak price gains achieved by the market during the 1-3 month rallies that followed the September lows:


Year    Timing of NG Price Low    Timing of Rally High    Approx. % Gain

2001    Mid September                Early November                75%
2003    Mid September                Mid December                   55%
2004    Mid September                Late October                     90%
2006    Late September               Early December                100%
2007    Mid September                Early November                 64%

Over the past 7 years, the average gain achieved over the course of the 1-3 month rally that has always followed a September low is 77%. Therefore, if the recent low of US$7.00 proves to be the ultimate correction low (it very likely will) and this low is followed by an 'average' rally then NG will trade at around $12 at some point over the next three months.

A direct way to gain exposure to the coming NG rally is via the United States Natural Gas Fund (AMEX: UNG) or via UNG January-2009 call options (the options are far more risky than the stock, but offer a larger potential reward). A less direct way, but one that should still provide good returns if the rally occurs as per the historical pattern, is via the 'gassy' Canadian energy trusts that we follow at TSI. A third way is via the stocks of large-cap natural gas producers such as Chesapeake Energy (NYSE: CHK) or via call options on these stocks (again, the call options offer a much higher potential profit in exchange for a lot more risk). A fourth way is via mid-tier Canadian NG producer Fairborne Energy (TSX: FEL). FEL's stock price rocketed upward during August on the back of a very important natural gas discovery at one of its projects, but due to the general market malaise it has since given up all of those gains. It is a good candidate for new buying below C$10.

Deflation versus Deflation Scare

We define a deflation scare as a period when most people perceive deflation to be a clear and present danger even though the money supply is growing at a robust rate. For example, there was widespread fear of deflation between mid-2001 and mid-2003, and yet the year-over-year percentage change in True Money Supply (TMS) remained in double digits throughout this period. In other words, 2001-2003 was characterised by general fear of deflation at a time of rapid INFLATION. 2001-2003 was a classic deflation scare.

Fear of deflation was able to coexist with rapid inflation during 2001-2003 because most people confuse cause and effect. Specifically, they equate deflation with falling prices rather than falling money supply. As a consequence, with commodity prices at ultra-depressed levels courtesy of a 20-year bear market and with equity prices in a powerful downward trend the popular conclusion (delusion) during much of 2001-2003 was that deflation was knocking at the door. At the same time, those who understood the causal relationship between money-supply changes and price changes were trying to figure out which prices were about to embark on major advances in response to the massive inflation that was happening in the background.

While in progress a deflation scare will look and feel the same as actual deflation, but for people who look beyond the next few months when making their investment plans there's a big difference between genuine deflation and a deflation scare. If the money supply is undergoing, or is likely to undergo, a prolonged contraction then investors will be best served by concentrating on cash and zero-risk government debt securities, whereas a deflation scare offers the investor a great opportunity to buy assets at prices that will look very cheap once the money-supply growth has its inevitable effect.

We've argued in the past that deflation scares are likely from time to time, if only to provide the cover for the next round of monetary inflation. We've also argued that a deflation scare was likely within the next 12 months. However, we can't be quite as confident about the eventual outcome today as we were back in 2001-2002. The reason is that when the fear of deflation was palpable during 2001-2002 the money supply was growing rapidly, but today's monetary backdrop is very different. We suspect that the 12-month rate of change of TMS is in the early stages of a new upward trend, but as things currently stand the US monetary growth rate is only around 4% and a trend reversal (from down to up) has not yet been confirmed. Our view is that a massive increase in both monetary and fiscal stimulus over the coming 12 months -- regardless of who moves into the White House early next year -- will lead to the next wave of inflation, but unlike 2001-2002 we now have to use some imagination in order to be bullish on inflation.

The Bond Market

When inflation fears were running rampant during the second quarter of this year we warned against shorting US Treasury Bonds. Our view was that T-Bonds were approaching an intermediate-term bottom and would likely benefit over the ensuing months from a downturn in commodities and a resumption of the financial crisis. However, we thought that high-yield bonds (relatively high-risk corporate bonds) were reasonable short-sale candidates in anticipation of economic weakness and increasing risk aversion. We also thought that it would be reasonable to bet on an increase in the yield spread between high-yield bonds and Treasury Bonds.

The following chart shows that high-yield bonds, as represented by HYG, have since crashed relative to Treasury Bonds (as represented by TLT). The collapse in the HYG/TLT ratio evident on this chart reflects a blowout in credit spreads in response to the strengthening of the T-Bond market and the concurrent dramatic weakening of the market for high-yield bonds.

There will probably be a lot more upside over the next 12 months in the bearish-HYG and bearish-HYG/TLT trades, but the panic being witnessed this week in the credit markets offers a good profit-taking opportunity for speculators who previously bet on a fall in high-yield bonds and/or a rise in credit spreads.


The Stock Market

Another New-Lows Extreme

Prior to this week the day of a new-lows climax, defined as a day on which the number of NYSE stocks making new 52-week lows exceeds 1000, has never failed to mark a bottom of at least short-term significance. Furthermore, in all bar one of the historical cases the pattern for both the Dow Industrials Index and the S&P500 Index following the new-lows climax has been:

1. An initial multi-week bounce

2. A pullback to test the low

3. A rally that takes the market above the high of the initial multi-week bounce

The above-described pattern has played out in bull and bear markets alike, the difference being that in bull markets the 'Step 3' rally leads into a major new upward trend whereas in bear markets the end of the 'Step 3' rally leads into the next downward leg. The one exception to the pattern occurred in August of 2007, at which time a new-lows climax was followed by a strong 2-month advance to a new all-time high (there was no intervening test of the August-2007 low).

The two most recent new-lows climaxes occurred in January and July of this year. Following the January climax the market rebounded for a few weeks, pulled back to test the low in March, and then rose to a new multi-month high in May. In other words, the market action during the months following the January climax matched the pattern predicted by the historical record. Following the July climax the market rebounded for a few weeks and then pulled back to test the low in September, which is where we are right now (at this stage the plunge during the first three days of this week COULD prove to be a successful test of the July low, but if so an upward reversal must occur immediately).

The difference, this time round, is that the test of the July low -- if that's what we are now seeing -- has resulted in another new-lows climax. This has never happened before. In fact, we have just had two new-lows climaxes on consecutive days (Tuesday and Wednesday of this week) for the first time ever. On a related note, the new-lows climaxes are now occurring far more frequently than they ever have in the past. Specifically, there have only been 9 new-lows climaxes since 1970, but five of these have happened over just the past 13 months and two have happened this week.

The situation is illustrated by the following decisionpoint.com chart. The bottom section of the chart shows the number of new NYSE lows and the top section shows the Dow Industrials Index. Note that the chart doesn't include Wednesday's action (on Wednesday the Dow made a new low for the move and there were 1238 new lows on the NYSE).


The fact that the test of the July low has resulted in TWO new-lows climaxes means that we are now in uncharted waters. 

Current Market Situation

Wednesday's plunge to new lows by the senior US stock indices will likely provoke official intervention of some form. We don't think the trading of index futures by the so-called Plunge Protection Team (PPT) is of any real consequence (assuming it happens at all) because the resources of the PPT amount to only a drop in the ocean of global liquidity. However, other forms of intervention, such as the manipulation of short-term interest rate targets, can be important.

For some reason the Fed not only decided to keep its interest rate target unchanged at this week's FOMC Meeting, it decided to reiterate its concern about inflation. This was an absurd thing to do given the backdrop of plunging commodity and equity prices, soaring T-Bond prices, slow money-supply growth, and market-controlled short-term interest rates way below the Fed's target, and puts Bernanke and Co. in the unenviable position of having to either go back on what they said just two days ago or defy the huge pressure that will be brought to bear on them to do something to save the day.

Whether or not the Fed yields to the pressure and offers-up an emergency rate cut, the stock market has probably either just made a short-term bottom or will do so before the end of this week. The markets are now in panic mode and such an emotional extreme can never be sustained beyond the immediate-term. In addition to the two consecutive new-lows climaxes discussed above, blatant signs of panic include Wednesday's decline in the 3-month T-Bill yield to ZERO and surge in the OEX Volatility Index (VXO) to 39.

Gold and the Dollar

Gold

After the close of trading on Tuesday it was announced that the Fed was going to dip into its petty cash drawer to obtain up to $85 billion dollars of financing for on-the-rocks insurance company AIG. The initial market reaction to this announcement was strangely subdued. In particular, gold only gained a few dollars. Amazingly, from our perspective, the market did not appear to perceive any inflationary consequences or any significant risk that the steady stream of bailouts revealed an out-of-control situation. When the US stock market opened for trading on Wednesday morning gold was still up by only a couple of dollars and the gold-stock indices actually began the day with small losses. This really was extraordinary. But then, it was as if the markets suddenly woke up from a deep sleep and, for the first time in a long time, began to look around at what was happening.

The result was a very clear upward reversal in the gold market. With reference to the following daily chart of December gold futures, this reversal has taken the gold price straight back to resistance at $850-$860. We would not be surprised if some consolidation occurred in the vicinity of this resistance, but additional gains are likely over the coming weeks.


In the latest Weekly Update we discussed the fact that some of our intermediate-term gold market indicators had turned negative, but went on to say:

"...like the HUI's plunge below support at 275-285 the deterioration that has just occurred amongst our intermediate-term bullion indicators could prove to be an overshoot resulting from the forced unwinding of leveraged trades, and could mark the END of the downturn. Moreover, last week's low or whatever new low is made this week will likely be followed by a tradable rebound regardless of whether or not the longer-term outlook has just turned bearish.

Our intention is to monitor the performances of all our intermediate-term indicators during the coming rebound to ascertain if the intermediate-term outlook has actually turned negative, or if, as we currently suspect, the action of the past 1-2 weeks was an overshoot. If we are correct to maintain our intermediate-term bullish stance then this rebound should be accompanied by a 'steepening' of the US yield curve and by significant strength in gold relative to the broad stock market, industrial metals, oil, and the euro."

So far, so good. For example:

1. The following chart shows that the TYX/FVX ratio, a measure of the US yield-spread, broke out to the upside and moved sharply higher over the past three days. In other words, the US yield curve has just 'steepened' considerably.


2. After moving marginally below the bottom of this year's trading range at one point last week, the following chart shows that the gold/SPX ratio has just zoomed back to near the top of its range. As unfathomable as such an outcome would seem to be at this time, a sustained break to new highs by the gold/SPX ratio would suggest that the HUI was on its way to a new all-time high.


3. Gold has just hit a new 4-year high relative to the Industrial Metals Index (GYX).

4. The following chart indicates that gold has turned the corner relative to oil


5. The euro-denominated gold price has just moved back above its 50-day moving average

Gold Stocks

In our most recent two commentaries we said that the bear-market signal generated by the HUI's break below support at 275-285 could have occurred at the END of the bear market and almost certainly occurred just prior to the start of a multi-month rally. And in the latest Weekly Update we said that the HUI's 50-day moving average was a reasonable target for the first leg of the anticipated rally.

The action over the first three days of this week provided additional evidence that a very important low was put in place last week. In particular, the following chart shows that the HUI has quickly recovered to well above the 275-285 range and, as confirmed by the RSI and MACD shown at the bottom of the chart, is not yet close to being overbought.


The gold sector's risk/reward looks good over every timeframe, but with the exception of special situations -- one of which is discussed below -- we would be inclined to wait for a pullback before doing additional buying. We understand that these aren't exactly normal times, but it would certainly be normal for the HUI to consolidate its recent sharp gains before resuming its advance.

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)

Andina Minerals (TSXV: ADM). Shares: 73M issued, 81M fully diluted. Recent price: C$1.10

We thought that ADM offered very good value when it was trading in the C$3.40s in July. Nothing has happened in the mean time to suggest that we were wrong, except that the stock is now trading in the low-C$1 area.

ADM has close to 10M ounces of in-ground gold in a single deposit in a politically secure location (Chile). And at its current share price this gold is being valued at only US$8/ounce. If we weren't seeing it with our own eyes we would not believe that it would be possible for such a large and high-quality gold deposit to achieve such a low valuation.

We are hearing rumours that some institutions and hedge funds that invested in junior resource stocks are being forced, by the need to meet redemptions or simply the need to raise cash at any cost, to exit their holdings in such stocks. We suspect that ADM's quick decline from the C$2.20s to around C$1.00 since the beginning of this month was largely driven by the need/desire of an institutional investor to get out at any price, and had nothing to do with a change in ADM's prospects.

2.5M shares of ADM changed hands on Wednesday, which is not a lot in dollar terms but did represent the second-largest daily trading volume in the stock's history. Wednesday's high trading volume hopefully means that the desperate seller -- whoever they are -- has now liquidated the bulk of their position. In any case, it seems that we have finally reached the point where new buyers are prepared to 'step up to the plate' and absorb substantial supply.

Traders should focus on the large-cap and mid-tier gold stocks, but investors should not ignore the incredible bargains currently on offer amongst the juniors. ADM's valuation is absurdly low and patient gold bulls should buy it near the current price.

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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