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    - Interim Update 19th May 2010

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Pay no attention to what they say

As part of the 'rescue package' for financially distressed euro-zone governments, the ECB has said that it will purchase the junk-rated bonds issued by these governments. The bond purchases will be made using euros that the ECB creates 'out of thin air', and will therefore, by definition, be inflationary. However, the ECB has said that it will "sterilise" its purchases of junk debt, thus mitigating or eliminating any inflationary effects.

The ECB could implement this "sterilisation" by selling some of the assets (bonds) that presently reside on its balance sheet (when a central bank sells assets it takes money out of the economy). This would be the normal way for a central bank to offset its injections of new money. It seems, though, that the ECB is trying a different approach. According to the Reuters article posted HERE, the ECB is attempting to mitigate the inflationary effects of its bond purchases -- that is, it is attempting to remove money from the economy -- by paying commercial banks an interest rate of up to 1% to deposit money at the central bank. This, however, means that any inflationary effects are only being mitigated on a temporary basis, because the deposited funds could be withdrawn at any time at the discretion of the private banks (the deposits have a fixed time of only one week) and because the deposited funds could be used as collateral for new loans. It therefore appears to be "sterilisation" in name only.

In any case, the main point we want to make is that the ECB's promise to "sterilise" its purchases is meaningless, because central banks always make promises such as this regardless of their true intentions. Remember that the central bank has two main functions: to keep the inflation going AND to manage inflation expectations. The second of these functions is carried out by manipulating statistics and giving 'lip service' to fighting inflation.

Energy

Uranium

We do not have in-depth knowledge of uranium supply and demand. In general, those who do possess such knowledge have been anticipating a new upward trend in the uranium price since the second half of 2008. The following chart, however, shows that the spot uranium (U3O8) price is languishing near its low of the past four years. This tells us that despite all the plausible-sounding arguments for why the uranium price will need to rise in order to bring enough new supply onto the market to offset rising demand, at this stage there is ample supply to satisfy demand with the price in the low-$40s.


Chart Source: www.uxc.com

In our 13th January 2010 commentary we mentioned that uranium had been 'marching to the beat of its own drummer' rather than trading up and down with most other industrial commodities in response to changes in the US$. Our assessment at the time was that this could insulate uranium from the next intermediate-term commodity decline -- a decline that we expected would be underway by mid-year.

This is still our assessment. Uranium appears to have less downside risk than almost any other commodity, largely because it 'sat out' the post-crash rebound. But while having minimal downside risk is important, for something to be an interesting speculation it must have significant upside potential within a reasonable -- say, 12-month -- timeframe.

In our opinion, if the uranium price were going to experience a meaningful rally in 2010 then the rally would have begun by now. Therefore, we currently don't perceive sufficient intermediate-term upside potential in the uranium price to warrant having any uranium-related trading positions. We are, however, maintaining some long-term exposure to uranium-mining stocks in line with our view that nuclear energy is the only viable alternative to fossil-fuel energy for large-scale electrical power generation.

Oil and Gas

The top section of the following chart shows the price of crude oil and the bottom section shows the AMEX Oil Index (XOI).

Prior to Wednesday's bounce, the nearest oil futures contract had fallen on 10 out of 11 trading days. In other words, it was 'oversold'. It had also reached support defined by the February and December lows. The AMEX Oil Index was in a similar position, except that in its case the relevant support was defined by the lows of early-May, February and October.

The oil market and the oil sector of the stock market will probably rebound over the coming weeks, but it looks like intermediate-term peaks were put in place during April. In other words, it is reasonable to expect that rallies from here will end below the April highs and be followed by declines to new lows for the year.



The natural gas market held up quite well during the carnage of recent weeks, probably because it was already at a very depressed level. It has shown a few signs of strength, but won't confirm an upward trend reversal until it breaks decisively above resistance in the $4.40s (see chart below). Resistance in the low-$4.40s for the natural gas futures price is equivalent to resistance at $7.70 for the US Natural Gas Fund (UNG). As previously advised, we will switch to a 5% trailing stop on our UNG trading position after it closes above $7.70.



There were good opportunities to scale out of natural-gas-related equities during March-April of this year, although with the exception of PWT.UN the 'gassy' energy trusts that we follow stopped a little short of the 'sell zones' we mentioned in TSI commentaries. A stock market rebound over the weeks ahead could create another good opportunity to do some selling.

Note that it would be reasonable to maintain some long-term exposure to natural gas producers and drillers.

The Stock Market

In our 9th May update we wrote: "If the US stock market is now at or close to a short-term bottom, the path from here will likely involve a quick rally followed by a pullback to test the low and then a longer/stronger rally. In wave terms: an A-B-C upward correction. This upward correction could play out over 1-2 months, after which the intermediate-term decline would likely resume."

At this stage the market appears to be following the expected path, with a quick initial rally ending on 12th May and then a pullback to test the low.


There is, of course, a possibility that the S&P500 Index will drop below its early-May low over the coming days, but any breach of the low in the near future would very likely be short-lived. In our opinion, to set the stage for a sustained breach of the early-May low the market will have to rebound, or stabilise, for at least a few weeks.

Gold and the Dollar


Gold

Gold Sentiment

Is gold sentiment at a dangerous extreme right now?

We don't believe so, because how could gold-related bullish sentiment be dangerously high when so few members of the general public own gold? Also, most sentiment indicators don't reveal unusually high bullish sentiment for gold at this time. For example, here are some numbers from Market Vane:

On 3rd March 2008 the bullish sentiment for gold was 95% with gold at $984
On 25th November 2009 the bullish sentiment for gold was 89% with gold at $1190
On 18th May 2010 the bullish sentiment for gold was 73% with gold at $1220

In other words, Market Vane's survey shows that bullish sentiment has been making lower highs even while the price has been making higher highs, and that a $240 increase in the gold price between 3rd March 2008 and 18th May 2010 was accompanied by a 22% slide in bullish sentiment.

In our opinion, sentiment should not be used as the primary decision-making factor in speculating, the reason being that sentiment usually just follows price. Sentiment tends to be most useful during periods when it diverges markedly from price, such as when the public gets more bearish despite constructive price action or gets more bullish despite deteriorating price action. In the gold market over the past 27 months there has been a positive sentiment divergence in that new highs have been accompanied by reduced enthusiasm.

Current Market Situation

The above sentiment discussion applies to gold in US$ terms. In euro terms, sentiment towards gold very likely reached a short-term extreme, and possibly reached an intermediate-term extreme, over the past few days, due mainly to extreme negativity regarding the euro. This was reflected by the euro-denominated gold price (gold/euro) moving 16% above its 50-day moving average, making it as 'overbought' as it was at the intermediate-term peaks of May-2006 and February-2009. A daily chart of gold/euro is displayed below.

Wednesday's upward reversal in the euro and decline in the US$ gold price is possibly an early warning signal that gold/euro made a peak of at least short-term significance on Tuesday 18th May. If Tuesday's peak was the short-term variety then support for gold/euro will likely be found over the next month at, or above, 900, but if it was the intermediate-term variety then support will probably be found at around 800 in 2-3 months time.

Despite how 'overbought' gold/euro recently became, our best guess is that this week's peak will turn out to be the short-term variety. Our reasoning is that the euro zone's government debt crisis could abate for a while, but will return to centre-stage within the coming three months.


In US$ terms gold has done no more than pull back to its 18-day moving average. Also, there is strong support in the $1160s (about $30 below Wednesday's closing price). Refer to the following daily chart of June gold futures for details.

The downside potential from here does not appear to be worrisome, but support in the $1160s must hold.


Relative to other commodities, gold has done exactly what it should have done -- considering the financial/economic backdrop at the time -- every step of the way over the past decade. And it continues to do so. For example, relative to the industrial metals, which are probably the most pro-cyclical commodities of all, gold has just broken out to the upside. Refer to the following chart of the gold/GYX ratio for an illustration of what we are talking about.

With growth expectations and the stock market rising from March of 2009 through to early-April of 2010 gold should have fallen in popularity relative to the pro-cyclical industrial metals, which, of course, it did. With evidence beginning to emerge that the recovery is over gold should now be gaining in popularity relative to the industrial metals, which appears to be the case.


Gold Stocks

As reiterated in the latest Weekly Update, our favoured scenario entails a gold-sector peak this month followed by a decline to an October low.

This week's price action suggests that the anticipated May peak was put in place last week. It also helps define some parameters, as follows:

1. The daily chart displayed below shows that the XAU has just dropped from the top to the bottom of its channel. On an intra-day basis it broke through the channel bottom on Wednesday and found support at its 200-day moving average, but then recouped enough of its losses to end the day right at the channel bottom. This means that it has fallen as far as it can without providing definitive evidence of an important peak. That evidence would come in the form of a daily close below Wednesday's intra-day low of 168.

2. A daily close above last week's XAU high of 190 -- which is not expected to happen within the next few months, but cannot be ruled out -- would now be a clear-cut signal that a new intermediate-term advance was underway, especially if it occurred after the first week of June.


Currency Market Update

Germany's policymakers panic...AGAIN!

Germanyís BaFin financial-services regulator said on 18th May that it would introduce a temporary ban on naked short selling and naked credit-default swaps of euro-area government bonds. The ban would also apply to naked short selling in shares of 10 banks and insurers including Allianz SE and Deutsche Bank AG.

Europe's political leadership clearly believes that a large part of 'the problem' is that speculators are betting against some euro-zone governments and financial institutions, and therefore believes that it can improve the situation by curtailing the ability to make such bets. This is an example of trying to cure the disease by suppressing the symptoms.

It is reasonable to ask whether Europe's policy-makers will be able to make enough wrong moves over the remainder of this year to drive the euro all the way to parity with the US$. We don't think they will, but only because of their counterparts in the US. It would be foolhardy, we think, to under-estimate the ability of the US Federal Reserve to underpin the euro by devaluing the US$.

Current Market Situation

The above-mentioned moronic policy move pushed the extremely 'oversold' euro to a new 4-year low on Tuesday, but probably only delayed the start of a rebound by 1-2 days.

With regard to the Outlook Summary that appears near the top of every Weekly Market Update, we almost always avoid having opposing short- and intermediate-term outlooks. For example, if we are intermediate-term "bullish" then in general we will be short-term "bullish" or "neutral", and if we are intermediate-term "bearish" then our short-term outlook will generally be "bearish" or "neutral". This is done due to overlapping timeframes and to minimise confusion, although there are rare occasions when we think it makes sense for our intermediate-term outlook to be the opposite of our short-term outlook. Now is one of those occasions.

We expect that the Dollar Index will move up to the 90s before year-end, but on a short-term basis the dollar's risk/reward appears to be skewed towards risk due to the potential for a strong euro rebound over the coming 1-2 months. We are therefore downgrading our short-term US$ outlook to "bearish" while leaving our intermediate-term US$ outlook "bullish".

Presented, below, are daily charts of the Dollar Index and the Swiss Franc. The dollar's short-term downside potential is probably limited by support at 81-82, while the Swiss Franc has the potential to rebound to former support (now resistance) at 92 over the next couple of months.




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)

US Silver (TSXV: USA). Shares: 251M issued, 289M fully diluted. Recent price: C$0.22

Because its financial performance is strongly leveraged to changes in the spot silver price, USA.V will be a good stock to own when silver finally makes a sustained move above its March-2008 peak. For the same reason, it will not be a good stock to own if silver trends lower over the months ahead.

We currently perceive enough risk of a multi-month decline in the silver price to prompt us to make an exit from USA.V. Based on Wednesday's closing price of C$0.22 and our October-2008 entry at C$0.17, the profit on this trade was 29.4%.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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