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Oil

The following picture may not be worth a thousand words, but it is worth at least a few hundred. It clearly illustrates that over the past two years the price charts of oil, the S&P500 Index and the Canadian Dollar have been very much alike. Almost every squiggle in one matches a squiggle in each of the other two.

An implication is that unless you expect war to break out in the Middle East (a Middle-East war would cause a large rise in the oil price and a concurrent large decline in the S&P500 Index), your outlook for oil should be the same as your outlook for the broad US stock market. To put it another way, it makes no sense to be bullish on oil and bearish on the stock market, or bullish on the stock market and bearish on oil.

We are bearish on the stock market. Therefore, we are bearish on oil.

The Stock Market

The Barrons Roundtable

At the beginning of every year Barrons Magazine puts together a "panel of Wall Street luminaries" to discuss the likely course of the financial world over the year ahead and to offer suggestions on how to profit from the expected performances of the markets. This week's issue of the magazine had the first installment of the 2011 Roundtable.

The Roundtable discussion is worth reading to get a general feel for the sentiment of investment professionals. Although it has only 10 members, the group assembled for the Roundtable is a good cross-section of the professional investing community in that it includes contrarians and out-of-the-box thinkers as well as mainstream/conventional thinkers.

Here are some of the more interesting comments contained within the first Roundtable installment:

Marc Faber: "Janet Yellen, vice chair of the Federal Reserve, said about a year ago that if it were possible to push interest rates into negative territory, she would vote for that. This is a very important statement because it implies that the Fed will keep real interest rates negative as far as the eye can see. Negative real rates amount to expropriation and destroy one function of money: to be a store of value and a unit of account. If you measure the stock market not in dollars but gold, it is down 80% since 1999. I no longer regard the U.S. dollar as a valid unit of account. People shouldn't value their wealth in dollars because one day, in dollars, everyone will be a billionaire."

Felix Zulauf: "In the late 1970s and early 1980s, Paul Volcker [then the chairman of the Federal Reserve] crunched inflation by applying very high real interest rates for several years. Now we are getting the same process, just in reverse. Just as it took several years for the market to see that Volcker's policies would lead to declines in inflation and interest rates, it will take several years for the market to realize the Fed's current policies are highly inflationary. They will lead to a debasing of the currency, which is happening to varying degrees in most of the industrialized countries."

Fred Hickey: "A year ago people were talking about an exit strategy. I knew there wasn't going to be one, ever. The economy has structural problems and we aren't dealing with them. Money-printing won't work, yet that's the prescription we continue to give the patient. If the Fed keeps printing after June, we'll have higher gasoline and food prices and more imbalances until this ends. And at some point it will end, because the dollar will fall apart. What we are doing now makes everything appear rosy. But it is a devastatingly terrible policy for the long term."

As far as the stock market's likely 2011 performance is concerned, our impression is that the sentiment of the Roundtable crew matches the overall sentiment situation. Specifically: Bulls on the economy are bullish on the stock market because, well, because they are bullish on the economy. Bears on the economy are generally also bullish on the stock market because they expect that economic weakness will perpetuate the Fed's easy money policies, prompting stock prices to rise in nominal terms. Hardly anyone is bearish on the stock market (none of the Roundtable members expect the stock market to have a bad year).

The outlooks of the more astute economic bears are encapsulated by the following two quotes from the Barrons Roundtable:

Hickey: "If the Fed continues printing, the market will go higher. It will continue printing, because the economy probably would collapse if it didn't. The stock market could go up 10% this year."

Faber: "The U.S. market has almost doubled since March 6, 2009. Some emerging markets have gone up much more than that. A correction is overdue. Then we'll have the second leg of the bull market. In the third year of the presidential cycle, you want to be in the most speculative stocks. As we approach the 2012 election, the Fed is going to print like hell. I am bearish about everything, but in my bearishness I'll be better off in stocks than government bonds."

Current Market Situation

The US stock market pulled back a little over the first two trading days of this holiday-shortened week, but remains in a precarious position. It is 'overbought' on an intermediate-term basis and sentiment is almost as complacent as it ever gets.

The risk is currently high, in our opinion. This means that investors should proceed with great caution, but it doesn't mean that equity-related long positions should be avoided altogether. In a world where central banks and governments are "hell bent" on depreciating their currencies, some 'long' exposure to the stock market will generally be appropriate.

Aside from the gold sector, which is counter-cyclical (gold stocks are quite capable of trending up while the broad stock market trends down), we are intermediate-term bullish on the uranium and agriculture sectors. Most uranium and agriculture stocks are 'overbought' on a short-term basis, but would likely be pushed down to attractive levels for new buying by a sharp pullback in the broad stock market.

Gold and the Dollar

Gold and Silver

Silver and the silver/gold ratio recently became sufficiently extended to the upside to create tops of at least intermediate-term significance, but in each case the price decline since the peak has not been as fast as it would typically be if the peak were the intermediate-term variety. To put it another way, we are yet to see the sort of rapid price decline that usually follows an intermediate-term peak.

The following daily charts help explain what we are talking about.

The first chart shows that the silver/gold ratio hit extremes in April-2004, April-2006, December-2006 and March-2008, and that a sharp decline occurred in the immediate aftermath of each of these price tops. A similar extreme was hit during November-December of last year, but the price decline since the latest peak has been far less dramatic than the declines that followed the earlier intermediate-term peaks.

The second chart shows that the recent price decline in the March silver futures contract looks like a routine pullback to the vicinity of the 50-day moving average. It also shows that the 200-day moving average is a long way below the current price, which suggests that the downside risk is quite high even if the current pullback proves to be the short-term variety (even if the pullback that began three weeks ago is followed by a rise to a new multi-year high, there's a very good chance that silver will trade at or below its 200-day moving average at some point over the next 6 months).

The upshot is that neither silver nor the silver/gold ratio has yet fallen far enough to confirm that anything more serious than a routine short-term correction is underway.

Platinum's performance lends some weight to the possibility that silver and gold are experiencing routine short-term corrections. It appeared as though platinum had reached an intermediate-term peak in November and would do no better than partially retrace its November decline during December-January, but the following chart shows that platinum has made it to a new 52-week high.

Gold Stocks

The gold sector, which is represented on the following daily chart by the HUI, is 'oversold' on a short-term basis and within a few percent of good support. We continue to expect that some sort of low -- either a correction low or a low that holds for at least a few weeks -- will be put in place over the coming fortnight.

Short-term resistance lies in the low-550s.

The gold sector remains our favourite sector of the stock market for the long haul. It is the one sector of the market that benefits from economic weakness, and sub-par economic performance is all but guaranteed by the policies being followed by many of the world's most important governments, including the governments of the US, most European countries, Japan and China.

Currency Market Update

Displayed below is a daily chart of the Dollar Index covering the past three years. We've drawn boxes around 2008's bottoming pattern and the price action of the past few months.

The Dollar Index has broken decisively below its 50-day moving average, which clearly isn't bullish. However, notice that it fell below its 50-day moving average twice during the 2008 bottoming process. In 2008 it wasn't until the Dollar Index broke above its 50-day moving average for the third time that a substantial upward trend got underway. Confirmation of the new trend was provided by a solid break above the 200-day moving average.

Our best guess is that something similar to the 2008 bottoming process is happening now. Obviously, for this interpretation to remain valid the Dollar Index must hold above last year's low during any further weakness.

On the basis that the Dollar Index's recent pullback has reduced its short-term downside risk to about 2 points, we have decided to upgrade our short-term US$ outlook to "bullish".

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)

Chesapeake Gold (TSXV: CKG). Shares: 38M issued, 45M fully diluted. Recent price: C$14.31

Investment bank Dahlman Rose recently issued a very detailed report on CKG that included a $91/share estimate of the company's net asset value (NAV). This NAV is Dahlman's long-term price target for the stock.

The $91/share NAV assumes that CKG's huge Metates gold/silver/zinc project is developed into a mine that performs in accordance with the parameters outlined in the Preliminary Economic Assessment (PEA) completed in mid-2010. There are obviously risks associated with these assumptions, especially given that the project is almost certainly more than 4 years from production. These risks can be accounted for by discounting the calculated NAV. For example, Dahlman suggests a 12-month target of $25/share by applying a substantial discount to factor-in the many uncertainties that exist at this early stage of development. This 12-month target looks reasonable to us.

So, would we be buyers of CKG at the current price?

The answer is no, because at current prices we think there are more attractive alternatives. One of them (Pretium Resources) is discussed below.

    New TSI stock selection: Pretium Resources (TSX: PVG). Shares: 81M issued, 84M fully diluted. Recent price: C$6.40

PVG is a new company (it IPO'd last month) under the stewardship of Bob Quartermain, the former CEO of -- and the person largely responsible for the past decade's strong growth of -- Silver Standard Resources (SSRI). It was formed for the purpose of taking over SSRI's Snowfield and Brucejack projects -- two adjacent gold projects in northern B.C. (Canada) that, when combined, constitute one of the world's largest undeveloped gold deposits.

The current estimate for the gold resource at Snowfield/Brucejack (SB) is 26.0M ounces in the M&I category plus 15.9M ounces in the Inferred category, or a total gold resource of 34M ounces assuming that the total resource equals 100% of the M&I gold plus 50% of the Inferred gold. This means that the SB project contains almost twice as much gold as CKG's Metates project, and yet PVG presently has a lower enterprise value (market cap plus debt minus cash, or market cap minus net cash) than CKG. Therefore, if CKG is very under-valued at its current price (as discussed above), then what does that make PVG?

As is the case with CKG's Metates project, a PEA was completed for PVG's SB project last year. The 'headline' results of the two PEA's were actually quite similar. The SB project is expected to be a bit bigger (700K oz/yr versus 550K oz/yr LOM avg gold production and $3.5B versus $3.2B initial capex), but the 'guesstimated' net present values and internal rates of return are in the same ballpark.

For the SB project, the PEA came up with a pre-tax net present value (@5%) of $6B assuming a gold price of $1235/oz. This equates to $74/share, a figure that would have to be substantially discounted to arrive at a reasonable 12-month price target. By applying the same discount that Dahlman Rose used when determining a 12-month price target for CKG, we end up with a target of $18 for PVG.

Other points of interest:

  - SSRI owns about 40% of PVG
  - PVG has about $50M of cash in the bank
  - PVG's news-flow should be OK, in that a resource update (to reflect the results of last year's drilling) will be completed during the first half of this year and new drilling results should be available during the second half of this year
  - There exists the potential for PVG's SB project to be combined with Seabridge's KSM project to form the world's largest undeveloped gold project

There's no point showing a chart of PVG because the stock has only been trading since mid December. During its brief trading history it has spent most of its time in the C$6.20-C$6.50 range. The IPO price was C$6.00.

We have added PVG to the TSI Stocks List at Wednesday's closing price of C$6.40.

    Fairborne Energy (TSX: FEL). Shares: 102M issued, 112M fully diluted. Recent price: C$4.77

Natural gas stocks have generally fared well over the past 12 months, but mid-tier natgas producer FEL has unfortunately been an exception. We can't be sure why, but it's possibly because FEL's current production is leveraged to the natgas price (the best-performing natgas stocks have tended to be those of companies that are focused on drilling services, or have no (or very little) current production, or have very low production costs).

Our most recent FEL write-up was in the 8th November Weekly Update, when we noted that the stock had dropped back to the bottom of an 18-month triangular consolidation pattern. Our suggestion at the time was that traders buying near the current price (around C$4.00) manage risk by placing a 'sell stop' just below the 2010 low.

The stock didn't do much until Tuesday of this week, when it gained 12% in response to production guidance that obviously impressed the market. It remains within the consolidation pattern that has defined its progress for more than 18 months, but this week's action is perhaps a sign that an upside breakout will soon occur. A breakout would create a chart-based objective of C$7.50-$8.00.

In our opinion, traders using 'stops' should move them up to around C$4.20.

    Keegan Resources (TSX: KGN, AMEX: KGN). Shares: 71M issued, 75M fully diluted (including the latest financing). Recent price: US$7.55

KGN announced a "bought deal" financing prior to the start of trading on Tuesday. The company is raising at least $185M by issuing at least 24.7M new shares at C$7.50/share. The amount of money raised and the number of new shares issued will rise to $213M and 28.4M, respectively, if the underwriters exercise their over-allotment option. As is normal in these cases, the stock price quickly dropped back to near the $7.50 financing price.

Relative to company size, this is a huge financing (KGN's market cap was only $360M prior to the new issue of shares). It is also a surprising financing in that KGN, a company that is only at the pre-feasibility stage of project development, now appears to be fully funded through to production (assuming the over-allotment option is exercised, KGN will have about $250M in the bank upon completion of the financing). Adding to the surprising nature of the financing is that KGN will very likely be purchased by a larger mining company well before it commences mine construction.

When a company with a lot of valuation-related upside does a large equity financing, some of the upside potential is given away. Such is the case with KGN. Due to the financing announced on Tuesday we are reducing our valuation-based upside target for this stock from $15/share to $13/share. On the positive side of the ledger, the risk has also been reduced.

KGN is a reasonable candidate for new buying at around $7.50 and would be a strong candidate for new buying at around $7.00. We doubt that it will trade significantly lower than $7.00.

As an aside, that a small company such as KGN was able to do such a large "bought deal" financing, with no warrants attached, is evidence of two things. First, it confirms that there is a lot of money sloshing around the markets. Second, it tells us that there is strong demand from serious investors for the shares of high-quality junior gold stocks.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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