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    - Interim Update 18th August 2010

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Quick comment on Treasury Bonds

In the latest Weekly Update we speculated that "the bond market's apparent inability to appreciate the eventual effects of today's policies could stem from the fact that a lot of the demand for long-term bonds comes from short-term traders". Evidence to support the idea that short-term traders are now having a big effect on the market for long-dated US government bonds is contained in the following excerpt from Doug Noland's latest Credit Bubble Bulletin:

"August 11 -- Financial Times (Sam Jones):  "Hedge fund trading of US government bonds has surged in 2010, according to a comprehensive new survey of fixed income investors.  Hedge fund managers now account for a fifth of all trading volume in the $10,000bn US Treasury bond market, up from just 3% in 2009, according to Greenwich Associates.""

That is, hedge fund trading has gone from 3% to 20% of the T-Bond market over the past 12 months. There's a good chance that a lot of these hedge funds are trend-followers and have become increasingly 'long' as bond prices have moved higher.

We think the government bond market is a collapse waiting to happen, but we are currently not betting on such an outcome (and nor have we at any time over the past five years). This is a market we prefer to leave alone, because unlike the gold market the 'authorities' do have a realistic chance of making the bond market do what they want it to do. The reason is that in order to prop-up the price of something all you need is money, and money is something 'they' have an unlimited supply of.

The T-Bond market will eventually collapse, but we won't place a bet against this market until we see evidence that the Fed and the government are losing their ability to support it. And by the way, we are not suggesting that the current low levels of Treasury yields are solely, or even primarily, the result of manipulation. Right now, inflation expectations are low, the economy is clearly weakening, and trend-following speculators are playing a significant role.

The Stock Market

Approaching the point of recognition?

US economic data have been deteriorating over the past three months and are likely to deteriorate further over the next three months, but that's not necessarily a problem for the stock market. The stock market always attempts to discount the future, which means that economic weakness is only ever a threat when it hasn't been discounted. This is why the stock market often makes a sustainable up-turn months before the economic data begin to show any signs of improvement. In such cases it isn't so much that the stock market is able to presciently look beyond the current weakness to the brighter days that lie well into the future, it's that a lot of additional economic weakness has already been factored into current stock prices. So, more evidence that the US economy is deteriorating will only be a problem for the stock market if the market is expecting a rosier scenario. Assuming that the economic numbers are going to get worse, the relevant question with regard to the stock market's likely reaction is therefore: how much additional economic weakness is the market expecting?

That's a difficult question to answer, because it is only at those times when sentiment indicators reveal extreme optimism or extreme pessimism that the market's short-term expectations are readily apparent. Right now, sentiment indicators are generally in neutral territory.

In conference calls with analysts and investors over the past month, the managements of many large US corporations have been very cautious in their guidance. This has undoubtedly helped to lower the stock market's expectations. There's a big difference, however, from coming around to the belief that future growth will be modest and realising that future growth will be nonexistent or negative.

Our guess is that the market is ready for a period of slow growth, but not for a period of economic contraction. After all, a lot of the talk in the mainstream financial media now revolves around what the Fed can or will do to keep the economic recovery going. There is rarely any acknowledgement of the possibility that the economy has already dipped back into recession or never emerged from the recession of 2007-2009. In general, weakness in the economic data is presented as if it were either an anomaly or restricted to real estate, and there is much discussion about a "jobless recovery" (as if it were actually possible for the economy to make a genuine recovery without bringing about an improvement in the employment scene). We therefore think that if the economic data started pointing to a recession, the stock market would quickly lose at least 10% of its value.

As noted at the start of this discussion, further deterioration of the economic numbers is likely over the next three months. It is impossible to know if there will be sufficient deterioration to make a critical mass of stock market participants believe that the US economy is in, or headed towards, a recession, but in our opinion the risk of reaching such a point of recognition is high.

The mismatch between interest rates and stock prices

We mentioned above that the stock market could be approaching a point of recognition -- in this instance, the point where the market stops discounting additional recovery and starts discounting recession. The bond market, however, seems to have reached this point a few months ago, which means that there is presently something of an expectation mismatch between the stock and bond markets.

The expectation mismatch is illustrated by the following chart comparison of the NASDAQ100 Index (NDX) and the 5-year T-Note yield (FVX). We included the same chart in the 2nd August Weekly Update to make the point that even though the NDX was rebounding, the continuing decline in the 5-year yield suggested that the stock market's intermediate-term trend was still down. Since then the NDX hasn't done much, but the 5-year yield has stayed on its downward path and is now as low as it was at the recession trough in early 2009.

When inflation expectations are low, interest rates tend to decline in anticipation of economic weakness. So, either the bond market is completely wrong or the stock market will soon make a catch-up move to the downside.


Current Market Situation

In the latest Weekly Update we noted that after only four down-days the NASDAQ Composite Index's McClellan Oscillator (MO) was already low enough to suggest that a rebound was likely to alleviate the 'oversold' condition. We also noted that a short rebound at this time would be consistent with the "Presidential Cycle" Model.

A rebound has occurred, and as illustrated by the following chart it has been of sufficient strength to push the NASDAQ's MO back to zero (the neutral level). In other words, the market has worked off its 'oversold' condition.


Although there is no requirement for it to do so, the market could maintain an upward bias into next week. However, the Presidential Cycle Model tells us that a substantial 1-2 month decline should be underway by the end of next week.

That the market has been closely tracking the Presidential Cycle Model since the beginning of the year doesn't guarantee that it will continue to do so. It is important, therefore, to consider what would have to happen to indicate an alternative outcome. With this in mind, we point out that a solid close above 2320 by the NASDAQ within the next two weeks would be an important divergence from the Model we've been using.

Moving along, everybody knows that the homebuilding sector of the US economy has been very weak. As a result, nobody should be surprised that the Dow Jones US Home Construction Index (DJUSHB) has a bearish-looking chart (see below).

The point we want to make is that the fundamentally and technically weakest sector of the stock market will very likely continue its downside leadership, which means that a move to a new low for the year by the DJUSHB could be used as an early warning sign that the broad market was about to make a big move to the downside. By the same token, a failure by the DJUSHB to break below its recent low of 220 in the near future would cast doubt on our short-term bearish view.


Gold and the Dollar

Gold

December gold has nudged above resistance at $1220-$1230, but unless it also breaks above resistance in the low-$1260s we think it will be prudent to operate on the basis that at least 1-3 months of additional 'corrective' activity will occur before the next major advance gets underway.


Gold Stocks

The combination of gold's move above resistance at $1220-$1230 and some strength in the broad stock market has enabled the HUI to exceed resistance at 470. The next resistance of significance lies about 5% higher -- at the big round number (500).

We certainly can't rule out the possibility that the HUI is about to rise to 500, or even that it is about to make a major break to new all-time highs (above 520), but with the broad stock market probably within a few days of commencing a large decline and with gold now extended to the upside on a short-term basis we certainly wouldn't bet on it. The most likely outcome is that the HUI peaks below 500 within the next three trading days.

Note that if the HUI does manage to rise to 500 within the next few days it will be as 'overbought' as it was at the May and June highs, so the stage will still be set for a peak of some description. We point out, though, that triple tops usually don't hold (they usually lead to upside breakouts), so if the HUI rises to 500 at any time over the next couple of weeks then we will definitely have to re-think, and probably have to revise, our forecast for an October-November correction low. To put it another way, if our favoured scenario (a decline to an October-November correction low) is going to play out then the peak of the current HUI advance should be comfortably below 500.


Unlike the HUI, Royal Gold (RGLD) has already tested its February low. RGLD tends to hold up relatively well during the final phase of an intermediate-term decline in the gold sector and then lead to the upside during the first phase of the ensuing intermediate-term rally. It is therefore possible that RGLD will do no worse from here than test its July low, even if our favoured scenario plays out.


Currency Market Update

The Dollar Index rebounded sharply last week as the stock market fell, and then pulled back over the first three days of this week as the stock market rebounded. We expect that the Dollar Index will continue to move inversely to the stock market over the next couple of months, meaning that we would expect a sharp stock market decline to an October low to be accompanied by a strong advance in the US$.

Update on Stock Selections

(Notes: 1) 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. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html)

New stock selection: Sulliden Gold (TSX: SUE). Shares: 156M issued, 204M fully diluted. Recent price: C$0.69

SUE is developing the Shahuindo gold project in Peru. Shahuindo is located about 80 kms south of the 2M-oz/yr Yanacocha gold mine operated by Newmont.

A Preliminary Economic Assessment (PEA) completed in February of 2010 determined that Shahuindo could be developed into a mine that produces 95K ounces of gold per year. Importantly, it estimated that Shahuindo would have an Internal Rate of Return (IRR) of 55% and a Net present Value (at an 8% discount rate) of US$165M, assuming a gold price of US$975/ounce. At $1140/oz the estimated NPV rises to US$240M, which equates to about C$1.40/share if we assume a share count of 180M. In other words, SUE is potentially worth twice its current stock price with gold about $80/oz below its current level.

Although SUE offers reasonable value based on the cash flow that it will POTENTIALLY be able to generate from Shahuindo, it doesn't look particularly cheap based on the size of its in-ground resource. At least, it doesn't look cheap compared to many of the other exploration-stage gold stocks that we track. For example, we know of several juniors that are now being valued by the stock market at less than US$20/oz, compared to about US$70/oz for SUE's 1.4M-ounce resource (1.1M ounces Indicated + 0.3M ounces Inferred).

We think that $70/oz for SUE's current in-ground resource is an attractive deal, however, due to the simplicity (read: relatively low risk) of its project. Of particular note, the PEA is based on using an open-pit, heap-leach mining process to extract gold from only the 1.1M-ounce oxide portion of the overall deposit.

In addition to the simplicity and low-cost nature of the forecast mining process, SUE's speculative merit is enhanced by the speed with which it will be progressing the Shahuindo project and the likelihood of significant resource growth. Regarding the expected rate of progress, we note that the company jumped straight from the PEA stage to the Feasibility Stage and is planning to have a completed Feasibility Study (FS) by year-end. Regarding the potential for significant resource growth, in parallel with the engineering work related to the FS the company will be carrying out a 30,000m drilling program. This drilling program should add to the resource and ensure good news-flow over the months ahead.

Also worth mentioning is that SUE has about C$14M of net cash (C$17M cash minus $3M debt), which is more than enough to finance its aggressive work program over the next 6 months.

Turning to the price chart (see below), SUE peaked at just above C$1 last December and probably bottomed at C$0.50 in July. If there is a sector-wide decline to an October-November low then SUE could test its July low, but we doubt that it will do much worse than that.

The short-term upside potential is probably limited by resistance at C$1.00, so the short-term risk/reward isn't enticing (upside to $1.00, downside to $0.50). However, on an intermediate-term basis the risk/reward looks good. Our intermediate-term valuation-based upside target is C$1.50 assuming a gold price of $1100-$1200, and would be higher at a higher gold price.

For an exploration-stage junior, SUE's stock is reasonably liquid. For example, it has traded an average of 280,000 shares per day over the past three months and traded 900,000 shares on Wednesday 18th August.

Our suggestion is to take an initial position in the high-C$0.60s with the aim of adding on weakness over the next three months.


    Gryphon Gold (TSX: GGN). Shares: 88M issued, 99M fully diluted. Recent price: C$0.11

In February, GGN entered into a 50/50 joint venture with Sage Gold (TSXV: SGX) to develop GGN's Borealis gold project in Nevada. The JV was terminated by mutual agreement at the beginning of this week.

When the JV was established in February we didn't think it added any value. The reason is that Sage, like GGN, is a very small company with minimal financial resources, so GGN's decision to team up with SGX didn't help to address the all-important construction-financing obstacle and progress Borealis through to production. We therefore don't think that the termination of the JV has removed any value. Actually, an argument could be made that the JV deal removed some value in that it caused GGN's share of the Borealis project to drop from 100% to 50%, and that the deal's termination has added this value back.

The Borealis project has a 2.5M-ounce in-ground resource, and at GGN's current stock price the resource is being valued at an incredibly low $5/oz. However, this gold resource is likely to remain 'dirt cheap' until something is achieved on the financing front.

GGN will be no better than a 'hold' until financing is in place or a JV deal is done with a stronger partner.

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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