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    - Interim Update 18th February 2009

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Jump-starting the economy

Of all the opinions floating around regarding the terrible state of the economy and what should be done about it, one of the most wrongheaded involves the idea that reduced consumer spending is a large part of the problem. This line of thinking leads to the totally false conclusion that the government should take actions designed to stimulate consumer spending.

We can't over-emphasise that reduced consumer spending -- and concomitantly increased saving -- is not part of the problem; it's the CORRECT response to the underlying problem. It is, in fact, the necessary first step along the road to recovery. To prevent the economy from taking this first step is to ensure that the economy becomes PERMANENTLY weak.

Robert Albertson, the Chief Strategist with Sandler O'Neill & Partners, 'hits the nail on the head' in an interview posted in the latest Barrons magazine when he says:

"I'm seeing very odd interpretations from the government, in particular about what we need. The government isn't thinking about deleveraging. The government is talking about jump-starting consumer credit. I hear the word jump-start all the time. It is such a bad word. Jump-start consumer credit for what? So we can be more indebted?"

"...We need to reduce the debt. If you jumpstart credit, you are just going to prolong the problem and deepen it. What we need now is the patience to de-lever. We don't need the stimulus package. We need a savings package, but that couldn't be further from the goals at the moment. The mistake is that the government believes credit drives the economy, instead of the economy driving credit. They have got that backward, and this is a very dangerous time to be misfiring."

As explained in many previous commentaries, it is equally wrongheaded to believe that the government should attempt to offset the necessary reduction in consumer spending by increasing its own spending. There are three main reasons for this: First, the government doesn't have any savings of its own to spend, meaning that the money the government spends must be taken from the private sector via taxation, borrowing, or inflation. Second, government spending is not guided by market signals (price and profit) and is therefore often non-productive. Third, direct investment by the private sector tends to decline as the government gets more involved in economic activity. This happens because government borrowing 'crowds out' private borrowing and because the future becomes more uncertain when the whims of politicians take-on greater importance. For example, as a result of the uncertainty created in the US economy by the rapid extension of the federal government's tentacles under Franklin Roosevelt's leadership, direct private sector investment declined throughout the 1930s.

To get it to make sense, just make a slight change to the wording

If the story unfolds roughly as we expect then a lot of mainstream economic commentary over the year ahead will begin with the word "despite". And in most cases the commentary will be a lot closer to the truth if you replace the word "despite" with the words "because of". For example, when you hear/read something along the lines of "despite the government's huge stimulus package and various schemes put in place to support troubled financial institutions, there are no signs of economic recovery", just pretend that the commentator said/wrote "because of the government's huge stimulus package..."

The Stock Market

From Wednesday's email alert:

"Tuesday's sharp drop in the US stock market broke the S&P500 Index (SPX) downward from its short-term consolidation. More importantly, it resulted in a new bear-market low for the BKX/SPX ratio and was a deviation from the typical post-crash pattern. The risk has therefore increased that something other than a routine post-crash rebound is occurring.
 
Having said that, this is probably a good time to be giving the market the benefit of the doubt. The reason is that the Dow Industrials Index ended Tuesday's session right at last November's bear-market low of 7552, meaning that it is now at an important support level and hasn't yet negated the rebound scenario. Additionally, the S&P500 Index ended Tuesday's session 1% above long-term support at 780 and about 5% above its November-2008 closing low, so it, too, has not yet weakened enough to negate the rebound scenario.
 
One of the most likely outcomes is that the Dow spikes to a new bear market low this week while the S&P500 and NASDAQ100 Indices make higher lows."

The market essentially went nowhere on Wednesday, which was strange considering the steepness of Tuesday's decline and the close proximity of major support.

The Obama Administration is churning out new policies at a frenetic pace and each new policy seems to involve government financial commitments amounting to tens of billions or hundreds of billions of dollars. One of the latest policy moves involves spending hundreds of billions of dollars to help some people stay in homes they can't afford and that are worth less than the amounts owing on the associated mortgages. One of the catchphrases being used to sell this scheme is "saving homes", as if the houses would crumble to the ground, rather than just change owners, if not for government largesse.

The overall economy will be hurt by government policies designed to support house prices and homeowners, and so will many of the direct recipients of the help. The reason is that if someone owes more on a house than the house is currently worth then from a purely financial perspective that person would be well advised to hand the keys to the lending bank. Most of the people that are currently 'underwater' on their home mortgages will likely be even further underwater a year from now if they continue to live the so-called home-ownership dream, so they should immediately cut their losses, begin to rent and begin the process of strengthening their personal balance sheets.

Perhaps the stock market is having difficulty mounting any sort of rally because many traders and investors are coming to realise that the government's attempts to help are counter-productive.

Gold and the Dollar

Gold Stocks

An Elliott Wave Interpretation

There are so many different Elliott Wave (EW) patterns that any market's price performance over any timeframe can, with the benefit of hindsight, be explained in EW terms. Unfortunately, the benefit of hindsight is never available to us when we are making our investing/trading decisions, and in real time it is often not possible to ascertain the correct EW interpretation. For this reason we have never been interested in risking money based on wave counts, but we know that some people have been able to make EW Theory work for them.

Although we never base investing/trading decisions on EW Theory we have read enough EW-style analysis to have a reasonable grasp of how it is supposed to work. For interest's sake we therefore thought we would explain our long-term outlook for the gold sector in EW terms. In doing so we are fitting what we know about wave theory to a view determined by other methods.

Our interpretation of the HUI's monthly chart in EW terms is shown below. In brief, we think the most appropriate way to describe the HUI's price action in wave terms goes like this:

a) The first major impulse wave (Wave 1 of 5) began in November of 2000 and ended in May of 2006

b) Even though the HUI moved well above its May-2006 peak during the final quarter of 2007 and the first quarter of 2008, the price action between May of 2006 and October of 2008 formed the first major corrective wave (Wave 2 of 5). Wave 2 took the form of an A-B-C decline.

c) The second major impulse wave (Wave 3 of 5), which will, in turn, be split into five waves comprising three impulse waves and two corrective waves, began in October of 2008. We are currently in the first impulse wave (Minor Wave 1) of Major Wave 3.

Note: The idea that the HUI's September-2007 through to March-2008 surge to well above its May-2006 peak was a counter-trend move within a multi-year downward correction might seem strange at first impression, but there are two reasons why we think it is the most reasonable interpretation. First, only a small number of gold stocks participated in the rally to a meaningful degree (very few made new highs). As we noted at the time, this was a period when the HUI and the other gold-stock averages did poor jobs of representing the performance of the average gold stock. Second, the October-2008 collapse in the gold sector makes more sense if viewed as the final capitulation in a multi-year correction.


If Wave 3 really did begin last October and if it ends up matching Wave 1 in magnitude then the HUI will rise to around 1500 over the next few years. Only 'died-in-the-wool' gold bulls probably expect the HUI to achieve that sort of performance, but it should be noted that the third wave is often of greater magnitude than the first wave. In other words, if our wave count is correct then 1500 would be a minimum target.

As we said above, we aren't basing anything on wave counts. The above is simply the wave-related interpretation that in our opinion most closely matches what has happened and what will happen.

Current Market Situation

On Wednesday the HUI closed above its 200-day moving average for the first time since last July and made a new ALL-TIME high relative to the S&P500 Index (meaning that the HUI reached its highest level relative to the S&P500 since its creation in early 1996). The new high in the HUI/SPX ratio supports our view that as gut-wrenching as last year's gold-stock decline was, it was a correction within an on-going bull market.

On the negative side of the ledger, the bearish divergences mentioned over the past week (the divergence between the HUI and the HUI/gold ratio and the divergence between the HUI and RGLD) remain firmly in place. Also, in the silver discussion included below we mention another potentially significant bearish divergence. These divergences suggest that the gold sector will reach an intermediate-term peak within the next two months.

With regard to our own accounts, in Wednesday's email alert we noted that we had just made a partial exit from three of our gold stocks and planned to do some additional selling if prices continued to move upward over the days ahead. We also noted that this selling was done purely for money-management purposes in that recent price gains had caused our exposure to the stocks in question to become larger than we were comfortable with. We did some additional pruning on Wednesday, but our exposure to the gold sector still dwarfs our exposure to anything else.

We expect that our gold-related stocks will relinquish their relative strength and that our non-gold stocks will begin to do much better once the broad stock market reverses upward, assuming, of course, that the broad stock market does actually reverse upward. We therefore plan to use some of the cash raised by making partial exits from gold stocks to increase our exposure to non-gold stocks (primarily natural gas, uranium and airline stocks), but most of the cash will be kept in reserve -- ready to be re-deployed into the gold sector as opportunities arise. Gold is the only real bull market.

Gold

The following monthly chart shows that gold blasted above long-term resistance at $720 during the final quarter of 2007 and then blasted above long-term resistance at $850 during the first quarter of 2008. This completed the first leg of its bull market. The chart also shows that the first major bull market correction took the price all the way back to former long-term resistance (now support) at $720.


Chart Source: www.mrci.com

The following daily chart shows that gold recently confirmed an end to its bull-market correction by decisively breaking the sequence of declining tops that occurred between March and October of last year. However, it is now modestly 'overbought' as it nears intermediate-term resistance at $1000-$1040. In euro terms it is very 'overbought'.


We think that downside risk from here is limited to a re-test of long-term support at $850. Upside potential is probably limited by resistance at $1000-$1040 in the short-term, but if economic confidence continues to deteriorate then we could get an upward explosion in the gold price. The small, but not insignificant, risk of an upward explosion combined with the minimal downside risk is why we are maintaining an intermediate-term bullish view at this time.

Silver

The good news is that the silver price has broken above resistance at US$14, suggesting an upside target of $15-$16 for the current rally. The bad news is that a potentially significant bearish divergence is developing between the silver price and the PAAS/silver ratio, suggesting that an intermediate-term peak will be in place in the silver market by the end of next month. As we explained in the Interim Update posted on 27th February 2008:

"The PAAS/silver ratio (the price of Pan American Silver divided by the price of silver) tends to peak and begin trending lower at least 6 weeks prior to an intermediate-term peak in the silver price. We therefore consider an upwardly mobile silver price combined with a multi-week downturn in the PAAS/silver ratio to be a bearish divergence, especially if it occurs after silver has been trending higher for at least 6 months."

In February of 2008 we cited the relative performances of silver and the PAAS/silver ratio as evidence that the silver market would reach an intermediate-term peak by early April at the latest. As it turned out, the peak was in mid March.

On the following chart comparison of the silver price (the top section of the chart) and the PAAS/silver ratio (the bottom section of chart) we've highlighted the 6-week bearish divergence that occurred during the first half of 2004, the 3-month bearish divergence that occurred during the first half of 2006, the 3-month bearish divergence that occurred during the first half of 2008, and the divergence that has occurred over the past 6 weeks. One notable difference between the current situation and the earlier bearish divergences is that silver is presently not at, or close to, a new high for the bull market, but this is not a good reason to assume that the end result will be different.


It is possible that strength in the general stock market over the weeks ahead will result in sufficient gains in the stock price of PAAS relative to the price of silver bullion to eliminate the bearish divergence discussed above. On the other hand, additional gains by silver that are not confirmed by new multi-month highs in PAAS/silver will increase the probability that an intermediate-term peak is close at hand.

Currency Market Update

A daily chart of the Dollar Index is presented below.

The Dollar Index broke upward from its multi-week consolidation at the beginning of this week. The upside breakout pointed to a test of the November peak, but this has already occurred so a short-term peak could be at hand. Whether it is or not will largely depend on whether a short-term bottom is at hand in the broad stock market.


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)

Northgate Minerals (AMEX: NXG, TSX: NGX). Shares: 255M. Recent price: US$1.51

The weakness in the Australian Dollar combined with the strong US$ gold price should ensure that NXG's Australian gold operations generate substantial cash flow during Q1-2009. Furthermore, these operations could generate sufficient cash flow over the remainder of this year to fund much of the construction of the company's Young-Davidson gold mine in Canada.

Like many gold stocks, NXG has risen a great distance from its lows of the past few months and now looks extended on a short-term basis. Also, the following daily chart shows that it will soon encounter short-term resistance. However, we doubt that it is close to an intermediate-term peak. Our longer-term valuation, assuming that Young-Davidson is brought into production over the next 2 years and a gold price in the US$900-$1000 range, remains at US$5/share. Also, the stock won't encounter intermediate-term resistance until it reaches US$2.50.

In our opinion it is not too late to buy NXG, although the optimum time for new buying would be following a pullback to US$1.25-$1.30.


    We added a trading position in Precision Drilling (NYSE: PDS) via Wednesday's email alert. The stock got even cheaper during Wednesday's trading session and ended the day at US$2.41, down a further 0.09. It has now fallen for 7 days in succession and on 14 of the past 15 days.

We will probably add one or two more trading positions when we see evidence that the stock market has reached a short-term bottom.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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