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    - Interim Update 18th January 2006

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Important Note

Please note that TSI will be on vacation from Sunday 22nd January until Friday 3rd February, inclusive. As a result, the Weekly Market Update that would normally have been posted on Sunday 22nd January will, instead, be posted on Saturday 21st January and then the next commentary will be the Weekly Market Update on Sunday 5th February. In other words, we will miss three commentaries (there will be no Interim Update on Thursday 26th January, no Weekly Market Update on Sunday 29th January, and no Interim Update on Thursday 2nd February). If anything dramatic and/or totally unexpected happens while we are away we will send out a short update via e-mail, but hopefully that won't be necessary.

The Sea of Liquidity Continues to Rise

...there appear to be forces at work that have more than offset the Fed's attempts to tighten the monetary reins.

The US Fed has now been hiking short-term interest rates for about 18 months, but are monetary conditions in the US actually any tighter today than they were 18 months ago? After all, with the prices of all asset classes having gone up in relentless fashion it is clear that the financial world remains awash in liquidity. Also, despite the Fed's tightening stance the total supply of US dollars is 8.4% higher today than it was 12 months ago, which is not the sort of money supply growth that would normally be associated with even modestly restrictive monetary policy. Is it possible, therefore, that the Fed is attempting to give the appearance of running an inflation-fighting campaign while simultaneously inflating with gusto?

We take no issue with the notion that the Fed would pretend to fight inflation while working hard to facilitate inflation in the background because this is the way the Fed often operates. In this case, however, it looks like the Fed has attempted to slow the pace of credit creation but has, to date, been unsuccessful. We say this because the monetary aggregates over which the Fed exerts the most direct influence are barely higher today than they were 12 months ago whereas the bulk of the growth has occurred in the monetary aggregates over which the Fed exerts little direct control*. In other words, there appear to be forces at work that have more than offset the Fed's attempts to tighten the monetary reins.

We suspect that the biggest of the aforementioned forces is the borrowing/spending conducted by the US Government.

The debt of the US Federal Government has increased by $557B over the past year**, so borrowing by the government has added up to $557B to the total supply of US dollars (the actual quantity of new dollars that were created would depend on how much of the new debt was monetised). This is only part of the story, however, because the rate at which the US Government goes into debt has ACCELERATED over the past few months. Specifically, since the beginning of October the Federal debt has increased by $226B, or at an annualised rate $775B.

If the rate at which US consumers borrow new money into existence continues to fall then the rate at which the US Government borrows new money into existence will most likely continue to rise. This is what we've been saying would happen for years in response to the argument that deflation would become inevitable once US consumers became 'tapped out'. And it is why gold is such a 'no brainer' as far as long-term investments are concerned.

    *Over the past 12 months M1 -- the monetary aggregate over which the Fed exerts the most direct control -- has risen by only 0.4%. However, the non-M2 components of M3 -- monetary categories over which the Fed exerts almost no direct control -- have, as a group, risen by 15.9%. The non-M2 components of M3 include large time deposits, eurodollars, and institutional money market funds.

    **The year-over-year increase in the Federal Government's debt represents that TRUE annual budget deficit.

The Stock Market

Current Market Situation

The US stock market pulled back over the first two trading days of this week in response to additional gains in the oil price and disappointing earnings news from some high-profile stocks. However, considering the news backdrop the market's performance was actually quite good. In particular, despite the stock price of the world's largest semiconductor company (Intel) plunging 11% on Wednesday in response to a negative earnings surprise, the Semiconductor Index (SOX) was UP on the day. Also, the number of declining stocks was only slightly higher than the number of advancing stocks and the Dow Transportation Average was strong.

We continue to expect that the senior stock indices will move to new multi-year highs over the coming 2 months.

Japan

Japan's Nikkei225 Index was hammered during the first half of this week. The catalyst for the sharp decline was news that the offices of an internet-related company had been raided by the authorities as part of a criminal investigation into the company's securities' dealings, but we think the magnitude of the reaction has a lot more to do with the amount of 'hot money' that has flowed into the Japanese stock market over the past several months than anything else. As we noted in the 5th December Weekly Market Update, "The rally [in the Japanese stock market] is underpinned by positive fundamentals, but the rapid pace of the advance is obviously due to hedge funds and other professional money managers piling into the world's best-performing senior stock market in order to maximise year-end results. These chasers of short-term performance are probably setting the Nikkei up for a sharp correction during the early part of next year."

At this stage all we've seen is a 2-day shakeout within an on-going upward trend, although it is certainly possible that an intermediate-term peak was put in place for the Nikkei225 Index early this month (see chart below). A daily close below Wednesday's panic low of 15,059 for the Nikkei would be strong evidence that an intermediate-term correction was in progress.

We suggested taking partial profits in iShares Japan (AMEX: EWJ) on 4th January with the Nikkei trading at around 16,300 and still consider the 16,000-16,500 range to be a reasonable place for some profit taking. Furthermore, we plan to make a complete exit from EWJ should the Nikkei225 Index move above 19,000 during the first 4 months of this year. On the other hand, we think it would be reasonable to accumulate EWJ if the Nikkei were to move below 14,000 and to buy EWJ aggressively if the Nikkei were to move below 12,500.


Gold and the Dollar

Gold

China and Gold

...ALL of the world's central banks and governments have a vested interest in keeping the current monetary system going because it's a system that allows them to get something for nothing.

China's State Administration of Foreign Exchange recently said that one of its targets for 2006 was to "improve the operation and management of foreign exchange reserves and to actively explore more effective ways to utilise reserve assets". This statement generated a great deal of discussion about the possibility of China selling some of its US$-denominated reserves and increasing its gold reserves, actions that would potentially have huge impacts on the currency, bond and gold markets given the enormity of China's US$ reserves.

China presently holds about US$800B of foreign currency reserves -- most of it US$-denominated -- and is likely to have at least one trillion dollars of reserves by this time next year. In comparison, the combined total of gold reserves reported by the world's central banks is around 30,000 tonnes, or US$530B of gold at the current gold price. Note, though, that about half of this gold has probably been loaned or swapped in order to generate income and/or keep a lid on the gold price, so the actual amount of physical gold in the vaults of the world's central banks might only be in the vicinity of 15,000 tonnes (US$265B worth of gold at the current gold price). In other words, if China's Government decided to make a shift in the way its reserves were allocated such that in 12 months time 25% of its reserves were gold, the amount of gold it would need to purchase would be equivalent to the sum total of all the gold currently held in the vaults of the world's central banks. Furthermore, even if China decided to convert only 5% of its dollar-denominated reserves into gold it would need to purchase the equivalent of one year of the world's total mine supply.

Obviously, if China attempted to shift only a small portion of its reserves from dollars to gold the effect on the gold price would be substantial, to say the least. In fact, if China were to go into the market and convert 5% of its current foreign exchange reserves into gold it would probably have the effect of doubling or tripling the gold price. This, quite naturally, is a possibility that excites many gold bulls.

However, the dramatic effect on the gold price that would be caused by China making even a small shift out of dollars and into gold all but eliminates the possibility of such a shift taking place. If China held a lot less dollars and there was a lot more gold in the world then shifting reserves from dollars to gold might be feasible, but as things currently stand it's really not an option.

At this stage inflation fears remain surprisingly low, thus supporting a high average price/earnings ratio in the US stock market and low bond yields throughout the world, but the sort of gain in the gold price that would result from large-scale official-sector buying on the part of China would change everything. Bond yields would soar, stock prices would tank, and the US economy would plunge into recession. Knock-on effects would include a large reduction in the amount of Chinese goods purchased by US consumers, a recession and burgeoning unemployment in China, and, quite possibly, enough social unrest in China to threaten the survival of the current leadership.

What needs to be understood is that ALL of the world's central banks and governments have a vested interest in keeping the current monetary system going because it's a system that allows them to get something for nothing. As long as the vast majority of people have confidence in today's paper money, that is, as long as most people expect the money they use every day to do nothing worse than lose its purchasing power at the rate of 2%-4% per year, then the system will be viable and governments will be able to pay for their growth by creating money out of thin air.

The bottom line is that there are many good reasons to expect the gold price to move much higher over the next few years, but the buying of gold by China's Government is not one of them. And by the way, if China's Government ever did decide to break ranks and convert a meaningful portion of its US$ position into gold it would not publicise its intention.

Current Market Situation

Gold is in the midst of a blow-off move that could end at any time, but there is no evidence that it has already ended. A daily close below $530 by February gold futures (see chart below) would suggest that the top was in place.


Gold Stocks

Current Market Situation

As mentioned in the latest Weekly Market Update, the HUI would have to move up to 370 in order for the rally that began in May of 2005 to match the MINIMUM percentage increase achieved during any of the intermediate-term rallies that occurred during the HUI's first major upward leg (the one that ended in December of 2003). However, we think it's unwise to buy the major or mid-tier gold stocks at this time in anticipation of such an outcome because almost all of these stocks are extended from both technical and valuation perspectives.

There are still plenty of exploration-stage stocks that offer very good value, but it's important to be selective. For example, it's generally not a good idea to buy stocks that have just experienced such large percentage gains that they now have vertical price charts because what goes up in a steeply-sloped straight line will usually come back down the same way.

We will continue to highlight stocks in the TSI commentaries when they reach levels at which new buying becomes appropriate.


Gold Stocks versus Base Metal Stocks

The following chart compares the PD/NEM ratio (the stock price of major copper producer Phelps Dodge divided by the stock price of major gold producer Newmont Mining) with the NYSE Composite Index. The chart's message is that base metal stocks outperform gold stocks when the broad stock market is trending upward and under-perform gold stocks when the broad stock market is trending downward. This is another way of saying that base metals are cyclical whereas gold is counter-cyclical.

The start of the next prolonged period of general stock market weakness should herald the start of the next multi-year advance in the prices of gold stocks RELATIVE TO base metal stocks.


Currency Market Update

Below are daily charts of March euro futures and March C$ futures. Interestingly, the euro appears to be setting up for a break ABOVE short-term resistance at 1.22 whereas the C$ appears to be setting up for a break BELOW intermediate-term support at 0.85.




The currency market has been 'choppy' over the past few months and will probably remain so for another 1-2 months, after which we expect the dollar's bull market to resume. The US government's rampant borrowing is clearly a negative for the dollar, but more so relative to gold than relative to other forms of paper money. Furthermore, interest rate differentials usually trump all other considerations over the intermediate-term.

Update on Stock Selections

European Minerals (TSX: EPM) announced on Monday that it was having problems with its mine construction contractor. The contractor -- MDM Ferroman -- appears to be experiencing financial trouble and has, at this stage, been unable to provide the performance bond required under its contract with EPM.

In our opinion, the worst case outcome for EPM as a result of MDM's financial difficulties would be a delay of a few months in the construction of the Varvarinskoye mine. Such an outcome would not materially alter our valuation or assessment of the stock.

In the latest Weekly Market Update we said that EPM would be suitable for new buying at around C$0.92, but as a result of Monday's news it was possible to do a bit better than that because the stock traded in the low-to-mid C$0.80s during Monday's trading session and during the early part of Tuesday's session. It closed at C$0.88 on Wednesday.

There is good support in the C$0.80-C$0.85 range that SHOULD hold on a daily closing basis (see chart below). We continue to believe that EPM is a reasonable stock to accumulate near current levels.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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