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    - Interim Update 17th November 2004

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Bonds

Theme Trading

...right now an upward reversal in the US$ represents the biggest threat to the US bond market.

On the surface it was quite strange to see US T-Bonds remain stable in the face of a much higher-than-expected PPI on Tuesday and then bounce in response to a higher-than-expected CPI on Wednesday, but in one respect this was just par for the course. The reason is that although many commentators on the financial markets continue to express surprise whenever a fall in the US$ is accompanied by a rise in US bonds, there has been such a strong inverse correlation between bonds and the dollar over the past two years that a lot of traders are probably now conditioned to buy bonds whenever the dollar starts to head lower. So when the US$ continued its decline on Tuesday and Wednesday there was, quite naturally, a lack of downward pressure in the bond market.

In our opinion the above-mentioned inverse correlation between bonds and the dollar has its origins in the currency management programs of Asian central banks. In particular, it arose due to the Bank of Japan's large-scale purchases of US bonds in response to every significant drop in the dollar over the past few years. The Asian banks are still a big factor in the US bond market, but we suspect that it became such a well understood 'theme' that the relationship could persist for a while even in the absence of large-scale central bank intervention.

"The dollar's down so let's buy bonds" theme isn't likely to remain in place for much longer because at some point the connection will be made between a weakening currency and an increasing risk of an inflation problem, but right now an upward reversal in the US$ represents the biggest threat to the US bond market.

The relationship between interest rates and government deficits

...we are not bearish on US T-Bonds because we are anticipating further increases in the SUPPLY of US Treasury debt. Rather, we are bearish on bonds because we are anticipating a large drop in the DEMAND for bonds as a result of rising inflation expectations.

A point that we've made in the past, although certainly not in the recent past, is that the expectation of a large increase in the US budget deficit is NOT a reason to be bearish on US Treasury Bonds.

It isn't difficult to find examples that support the above statement. For instance, US government bonds rallied in parallel with a massive expansion in the US budget deficit during the first six years of the 1980s, Japanese government bonds have been very strong in parallel with massive increases in Japan's budget deficit over the past 10 years, and the rally in US government bonds during 2001-2003 occurred alongside a huge increase in the US budget deficit.

The opposite also holds true in that a reduction in the budget deficit does not necessarily lead to higher prices for government bonds (lower interest rates). In fact, in developed countries such as the US there is no consistent relationship between the government's budget deficit and the price of long-term government debt.

Further to the above, we are not bearish on US T-Bonds because we are anticipating further increases in the SUPPLY of US Treasury debt. Rather, we are bearish on bonds because we are anticipating a large drop in the DEMAND for bonds as a result of rising inflation expectations.

As an aside, we were reminded of the above-discussed lack of correlation between budget deficits and bond prices by the following two paragraphs from John Hussman's latest weekly commentary. Dr Hussman is one of the smartest analysts in the business and his Weekly Market Comments at http://www.hussmanfunds.com/weeklyMarketComment.html are always worth reading.

"A personal favorite is the idea that reducing deficits by raising taxes will lead to lower interest rates. Think through this. If you increase taxes, yes, you can reduce the supply of government bonds, which you might think would lead to higher bond prices. The problem is that you've also reduced the income of people with high propensities to save, which would have otherwise been used to buy bonds, so the demand curve for bonds also shifts back. The clear result is a reduction in the quantity of government bonds, but the effect on bond prices (and interest rates) is not clear at all. As an empirical fact, you'll find no obvious relationship at all between interest rates and government deficits. It doesn't work that simply. You have to think through the whole equilibrium, including both the supply and demand for funds, as well as whether those funds are used productively or unproductively. [Emphasis added]

Similarly, while you can certainly get an economic pop with a lump sum tax cut (though they tend to die off over several quarters, as this one threatens to do), you certainly don't stimulate gross domestic investment or economic productivity by doing so. The reason is that if you haven't cut government spending, the lump sum tax cut must be financed through an increase in Treasury bond issuance. In equilibrium, the extra money in the hands of the public must be used to buy the extra bonds issued by the Treasury. No doubt in the current instance, China and Japan have delayed our full realization of this harsh fact. But with the current account deficit now bursting at the seams, it's likely that weak growth in gross domestic investment will weigh on U.S. growth prospects for years to come."

The US Stock Market

Current Market Situation

...the earliest an important top is likely to occur is January-2005. ...The US stock market is very speculative in the sense that valuations, in general, are extremely high.

In last week's Interim Update we said "...the drop in the equity put/call ratio to around 0.60 is only a problem for the market if we make the ASSUMPTION that the consolidation that began during the first quarter of the year is still in progress. However, since we believe that the consolidation ended during August and that the market will remain in an upward trend for at least a couple more months we suspect that the put/call ratio is on its way to lower levels."

The below chart shows that the 10-day MA of the equity put/call ratio has since moved decisively below its April-August lows (shown as an upside breakout on the chart due to the inverted scale), thus providing further confirmation that an intermediate-term upward trend is in progress.


The reduction in the put/call ratio indicates that sentiment continues to become more complacent, but although an increase in complacency sets the stage for the next big decline the earliest an important top is likely to occur is January-2005. Between now and then, positive seasonality combined with the strong desire of fund managers to maximise their year-end bonuses should severely limit the extent of any pullback and push the stock indices to higher levels.

As far as short-term downside risk is concerned, the S&P500 Index has good support from 1143 up to 1163 (see chart below). Our thinking is that any pullback over the next few weeks would most likely end near the top of this support range, although a drop to the mid-1140s is possible.


The US stock market is very speculative in the sense that valuations, in general, are extremely high. What this means is that no one should be making long-term investments in US index funds. There are, however, stock markets in the world that offer the prospect of good long-term investment returns as well as short-term speculative returns. For example, at TSI we've chosen to participate in the global stock market rally by taking positions in three Asian markets -- Japan, Thailand and Malaysia -- that have good growth potential and are fairly valued based on current earnings.

Gold and the Dollar

Growth currencies versus safety currencies

...[there is a] strong tendency for AUD/EUR (the Australian Dollar in terms of the euro) to trend in the same direction as the US stock market.

When the Dollar Index is trending strongly lower it's likely that all of the other major currencies (the euro, the Yen, the Swiss Franc, the British Pound, the Australian Dollar and the Canadian Dollar) will be trending higher against the US$. By the same token, during those times when the Dollar Index is in a strong upward trend it is likely that all the other major currencies will be trending lower against the US$. Therefore, if we are short-term BEARISH and intermediate-term BULLISH on the US$, as is the case right now, then unless we specifically state otherwise it can be taken as read that we are short-term BULLISH and intermediate-term BEARISH on all the other major fiat currencies. Amongst the other major currencies there are, however, some interesting relationships, one being the strong tendency for AUD/EUR (the Australian Dollar in terms of the euro) to trend in the same direction as the US stock market.

The relationship between AUD/EUR and the US stock market is illustrated on the below chart. Note, in particular, that every significant reversal in AUD/EUR over the past 6 years has occurred at the same time as or shortly after a similar reversal in the S&P500 Index. What this means is that regardless of whether the A$ and the euro are rising or falling relative to the US$, the A$ generally out-performs the euro when the US stock market is trending higher and under-performs the euro when the US stock market is trending lower. In this respect, the Australian Dollar's strength relative to the euro over the past couple of months is not surprising.


The above-discussed relationship results from the A$ being a 'growth currency' -- one of the currencies that becomes attractive to investors when global growth is strong -- while the euro, like the Swiss Franc, is more of a 'safety currency'. Furthermore, if the relationship persists in the future ñ we can't think of a reason why it won't -- then the A$ will substantially under-perform the euro after the next major decline in the US stock market gets underway.

In the coming Weekly Update we'll review a couple of other interesting relationships between the non-US$ currencies.

Current Market Situation

...the only other time the commercial net-short position was near its current level was just prior to the start of a 12-month downward trend in the Swiss Franc. ...the lack of acceleration in the gold price and in the HUI means that there is a lot more to come on the upside OR that our indicators will warn us of a trend reversal very soon after a top has been put in place...

The US$ is still hitting new lows on almost a daily basis, but the below chart indicates that the 'rubber band' continues to be stretched. The chart shows that the net-short position of commercial traders in Swiss Franc futures has dropped to near its lowest level of the past six years and that the only other time the commercial net-short position was near its current level was just prior to the start of a 12-month downward trend in the Swiss Franc.

This chart, in effect, shows 'potential energy', but at this stage the market has not begun the process of converting potential energy into kinetic energy and there is no telling how far the rubber band will be stretched before a trend change occurs. When the dollar does eventually reverse higher, though, it is unlikely that we'll simply get a brief rally to relieve the oversold condition. Instead, a 6-12 month upward trend would be a more probable outcome.


We've decided not to act in ANTICIPATION of a trend reversal in the dollar because when a bona fide reversal does occur it should quickly become apparent in the performances of gold and gold stocks as well as in the behaviour of the currency market. And as things currently stand there are no signs of an impending trend reversal in the performances of gold and gold stocks. For example, the HUI/gold ratio (chart included below) appears to be consolidating ABOVE its 40-day moving average while gold's advance, to date, has been orderly (chart also included below). We suspect that some gold investors are lamenting the lack of acceleration in the gold price, but acceleration is typically something that happens near the END of a move.




We like the current situation because the lack of acceleration in the gold price and in the HUI means that there is a lot more to come on the upside OR that our indicators will warn us of a trend reversal very soon after a top has been put in place (because only a small amount of weakness will be needed to signal a reversal).

The below chart shows that the Newmont Mining (NYSE: NEM) stock price has moved up to just below its December-2003 and January-2004 peaks, so if it reverses course from near the current level it will look like a 'triple top' has been put in place. As we've mentioned many times in the past, though, triple tops USUALLY don't hold, meaning that any pullback that begins from around the $50 level will probably turn out to be a consolidation within a continuing upward trend.


Stockbrokers

We often get asked to recommend US-based brokers that can be used for the trading of stocks on the Canadian exchanges. One broker that we've mentioned in the past that appears to offer a reasonable service in this regard is Pennaluna and Company (www.penntrade.com). The only problem we know of with Pennaluna is that it is not registered in all states and is therefore not available to all of our US-based subscribers.

Another stockbroker previously mentioned at TSI is Barry Murphy and Co. (www.barrymurphy.com), a company based in Boston and registered in all 50 states. Based on our experience this company will be able to provide a good solution for non-Canadians (including people in countries other than the US) wanting to trade the junior gold/silver stocks (or any other stocks) on the Canadian stock exchanges. Barry Murphy and Co. can offer a flat rate of US$29.95 for each trade on a Canadian exchange, regardless of the number of shares traded or the price of the shares. Please contact Mr Damian Gates at Barry Murphy and Co. on 1800 2212111 or 617 4261770 for further details. Note that to get the above-mentioned flat rate you MUST identify yourself as a Speculative-Investor subscriber. Please also note that we receive no commissions or any other form of payment from any stockbrokers.

In addition, several of the major on-line brokerages in the US provide their customers with the ability to trade on the Canadian exchanges. Scotttrade.com and Interactivebrokers.com are two that we know of that offer this service.

Most of the small Canadian-based gold and silver stocks also trade on the US over-the-counter markets (the Pink Sheets or the OTC BB). However, we'd strongly advise against trading on these markets because they are generally illiquid and inefficient. As a result, buy/sell spreads are often very high (meaning that you could end up paying a few percent more when you buy and then end up receiving a few percent less when you eventually sell) and your order may not be filled even if the stock trades through your buy or sell price. The bottom line is that if you are interested in trading these stocks and your current broker doesn't allow you to trade on the Canadian exchanges then you'd be well served to spend the 20 minutes it takes to open an account with a broker that does provide such a service.

Update on Stock Selections

In the e-mail sent to subscribers on Monday we provided brief updates on Lynx, Zinifex, First Majestic and Metallic Ventures, and advised that we were going to exit Plum Creek Timber for a gain of 53%. The e-mail has been archived at http://www.speculative-investor.com/new/stockemail.asp

    On Wednesday Desert Sun Mining (TSX: DSM) reported a 300K-ounce increase in the measured and indicated resource at its Jacobina project in Brazil and mentioned that additional resource calculations would be announced before year-end. Because construction of the Jacobina mine is almost complete any increase in reserves is potentially important because in this situation even a modest increase can result in a much better internal rate of return for the project.

Wednesday's 'news' should not have come as a surprise to anyone who has been following the DSM story, so in that respect the 21% leap in the stock price was a little strange. Therefore, rather than simply a reaction to the predictable news we suspect that Wednesday's surge in the stock price was the culmination of several months of consolidation during which stock was transferred from 'weak hands' (people who were worried by the preceding decline in the stock price and who thought the gold bull market might be over) to 'strong hands' (people who recognised that the stock offered exceptional value). This consolidation most likely resulted in the absorption of a lot of overhead supply, meaning that once a technical breakout occurred there was nothing to get in the way of a sharp rise in the stock price.

The following extract from the 22nd September Interim Update was written when DSM was trading at C$1.31 and it is still applicable, but note that you DON'T make money in junior gold stocks by buying AFTER a stock has already broken out and rocketed higher.

"DSM is on track to bring the 100K oz/yr Jacobina Mine into production during the first quarter of next year and to increase its mineable reserves to around 2M ounces. Once Jacobina is in production at the design production rate and assuming the aforementioned 2M-ounce reserve (the current reserve is around 1M) a reasonable market value for the company would be US$200M (100K ounces of production at US$2,000/oz or 2M ounces of reserves at US$100/oz). This would equate to around C$3.50/share assuming a total share count of 75M."


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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