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    - Interim Update 19th July 2006

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Carry Trades

Behind every carry trade is a central bank

"Carry trade" is the generic name for any trade that involves borrowing at one interest rate in order to invest in something that provides a higher interest rate or, more generally, a higher rate of return. Over the past several years these types of trades have regularly provided hedge funds and investment banks with large profits and occasionally -- in the rare cases when the trades have gone awry -- caused them to incur large losses. For example, during 2001-2004, when US short-term interest rates were way below long-term interest rates, banks and hedge funds generated substantial profits by borrowing short-term money in order to finance the purchase of long-term bonds (note that by employing 10:1 leverage, a 4% spread between long-term and short-term interest rates can be parlayed into a 40% return on investment). And when this particular carry trade became non-viable due to the flattening of the US yield curve, that is, when the gap between short-term and long-term interest rates in the US became too narrow to make the aforementioned carry trade worthwhile, carry trades continued to flourish because investment banks and hedge funds were still able to borrow short-term money in Japan at extremely low interest rates.

Although hedge funds and investment banks are the major participants in the various popular carry trades, they don't create the trades. The fact is that every carry trade is the progeny of a central bank. Putting it another way, a carry trade could never exist without the support/intervention of a central bank. This is because the act of borrowing short-term money in order to buy something that has a higher return will, if done on a large scale, quickly elevate the cost of the short-term money to the point where the trade becomes unprofitable. It is only when a central bank intervenes to hold down the cost of short-term money -- something the Fed did during 2001-2004 and something the Bank of Japan has been doing for many years -- that the opportunity to make money from a carry trade will persist beyond the very short-term.

Think of it this way: if a situation arises where the cost of short-term money is low enough to entice large speculators into a carry trade then the speculative demand for short-term money will increase and, in the absence of an offsetting increase in money supply, the cost of the short-term money will rise. As a result, the trade will quickly lose its appeal. However, if a central bank happens to be standing there supplying whatever additional money is needed to keep the short-term interest rate from rising then an arbitrage opportunity that would otherwise have quickly disappeared becomes entrenched.

The bottom line is that in every case where a carry trade has become popular it is because a central bank has counteracted normal market forces. 

The Yen carry trade

The Yen carry trade has been popular for several years thanks to the Bank of Japan doggedly keeping short-term interest rates near zero, but over the past 18 months its popularity has grown to the point where it has become one of the most important influences on global currency, bond, stock and commodity markets. It has, for instance, caused the Yen to become a very weak currency (a Yen carry trade begins with the borrowing and selling of Yen) and boosted the prices of metals and equities (metals and equities have been purchased with the funds obtained via Yen carry trades).

The total quantity of Yen borrowed/sold as the result of carry trades is unknown, but it must be a gargantuan number and it represents a speculative short position in the Japanese currency. Speculative short positions must eventually be covered, so at some point there will be a veritable tsunami of Yen buying as the carry trades that have been established over the past few years get unwound. 

Despite the Bank of Japan (BOJ) having just taken the first step in a long journey towards a more normal interest rate environment (the official short-term interest rate in Japan was boosted from 0% to 0.25% late last week) there are no signs yet, however, that the large-scale unwinding of carry trades has begun. In fact, the Yen's recent weakness suggests that the Yen carry trade is still expanding.

Hedge funds appear to be taking the view that short-term money in Japan is still almost free and that getting Japanese interest rates to a 'normal' level will be a very drawn-out process. Furthermore, the hedge funds engaged in Yen carry trades will have been encouraged by the recent 'dovish' comments emanating from Japan's political establishment. It is clear that Japan's central bankers want to return the country to 'interest rate normalcy', but the politicians are fearful of doing anything that might lead to some short-term weakness in the economy.

The following weekly chart of Yen futures shows the currency's precarious technical position. This chart certainly won't cause carry-traders to lose any sleep because it suggests that the Yen is close to breaking towards new lows for the year.


Our view on the Yen is unchanged. We are long-term bulls on the currency, but don't expect it to make much upward progress this year. We also don't expect it to drop far below last December's low and would be accumulating longer-term positions in the low-80s.

The Stock Market

Current Market Situation

The instructions shouted by hedge fund managers to their head traders on Wednesday morning: "I don't care if it's S&P500 futures or gold or bonds or British Pounds or asset-backed securities collateralised by breast implants; if it moves, buy it; if it doesn't move, buy it anyway because, praise the Lord, Bernanke has just hinted that the Fed might stop hiking interest rates at some point".

We don't know who is sillier -- the central banker who makes silly comments or the trader who reacts to the comments as if they were meaningful.

There were spirited rallies in many markets, including the US stock market, on Wednesday after Fed Chief Bernanke reported to Congress that economic growth was moderating and, therefore, that inflation pressures were likely to ease over the coming months. Let's put aside, for a moment, the fact that real economic growth and inflation pressures are INVERSELY correlated (higher real growth results in the production of more stuff, which, in turn, puts downward pressure on prices unless there's an offsetting increase in the money supply) and recall that a) Wednesday's scenario has been replicated numerous times over the past few months, including just prior to the May peak in equity and metal prices, and b) there's a historical tendency for the US stock market to perform poorly during the 6 months and the 12 months following the END of a Fed rate-hiking campaign.

Although it was spirited, Wednesday's rally in the US stock market was not especially bullish. In particular, a 2% gain in the Dow was only accompanied by a 1.2% gain in the NDX. On a truly bullish day, a 2% gain in the Dow would be accompanied by a 3-4% gain in the NDX. Nevertheless, it's possible that more bullish behaviour will emerge over the coming days and that the Dow (see chart below) has just completed a successful test of important support.


Our view is that this is a dangerous time to make large short-term bets on either a bullish or a bearish outcome. Positive divergences are few and far between so it wouldn't be surprising if the recent rebound were to soon fail and be followed by a break to new lows for the year, but at the same time the market has become sufficiently oversold to support a rally that takes the S&P500 and the Dow back to their May highs. We therefore think it's prudent to wait for either a better buying opportunity or a better selling opportunity to emerge before speculating on any short-term outcome for the broad market.

By the way, there has been one notable positive divergence over the past 2 months: the positive divergence between the NASDAQ Composite Index and the NASDAQ's McClellan Oscillator (MO) shown on the following chart.


The bear market of 2005-2006

If a worldwide cyclical* bear market in equities began earlier this year then it has, to date, been a very selective one. Most of the Middle-Eastern equity indices are clearly immersed in cyclical bear markets, as are the technology-oriented sectors in the US. However, at this stage the declines experienced by most stock market indices don't look any more serious than the sorts of pullbacks that regularly occur within cyclical bull markets.

One US market sector that has most definitely been immersed in a cyclical bear market for quite some time is the homebuilding sector. Note, though, that this week's low in the Dow Jones US Home Construction Index (DJUSHB) hit a level that we mentioned, a few months ago, as a likely target for the ultimate bear market bottom (see chart below). If a bottoming process has begun it will likely entail a multi-week rally followed by a pullback to test the low; that is, a 'W bottom' as opposed to a 'V bottom'.

We aren't interested in making any bullish bets on the homebuilders at this time, but might become interested late this year or early next.


While we're on the topic of the homebuilders, note, with reference to the following weekly chart, that the >60% decline in the stock price of homebuilder Toll Brothers (NYSE: TOL) over the past 11 months has simply taken the stock to the bottom of its long-term upward-sloping channel.


The downturn in the homebuilding stocks has been brutal, but sector-wide declines of this magnitude are not uncommon during secular bull markets when gains of several hundred percent have been achieved over the preceding few years. As examples, the 1964-1980 secular bull market in gold stocks was punctuated by two declines of more than 50%, the Semiconductor Index (SOX) experienced two 50% corrections during the bull market of the 1990s, and the gold sector has already experienced two 40% declines during its current bull market.

    *Cyclical trends occur within secular trends. For example, the secular bear market in US equities that began in 2000 is likely to encompass a number of cyclical bull and bear markets.

Gold and the Dollar

Currency Market Update

Refer to the following daily chart of the Dollar Index.

The Dollar Index blasted out of its downward-sloping channel on Monday and consolidated its gains on Tuesday. It then pulled back sharply on Wednesday in response to the revelation that the Fed's rate-hiking campaign will eventually come to an end.

If Monday's upside breakout was real (we suspect that it was) then the Dollar Index should hold above its 50-day moving average during future pullbacks.


Gold

Gold quickly lost its war premium during the first two days of this week even though the conflict in the Middle East has, if anything, escalated. If more negative news emanates from the Middle East over the coming days/weeks then a war premium might once again get built into the gold price, but such gains will also prove to be transitory because, as discussed in the latest Weekly Market Update, gold is not a hedge against military conflict.

Gold Stocks

Current Market Situation

The gold sector rebounded strongly alongside a strong rebound in the financial sector on Wednesday, an indication that the gains were driven by expectations of rising liquidity. However and as discussed in many previous commentaries, gold-related investments do best relative to other investments when liquidity is contracting.

Wednesday's rally in the gold sector is most likely not the start of a big move to the upside. Note, though, that in the latest Weekly Update we said that the near-term downside risk appeared to be limited to around 10%. At Tuesday's low the HUI was down by 6.5% from Friday's closing level so at that point the market had dropped almost as far as we had said it might. Ideally the HUI would have pulled back to the low-300s -- an area that coincides with some lateral support and the 200-day moving average (see chart below) -- before beginning to rally, but the Bernanke-fueled surge in the prices of almost everything that could possibly benefit from easier money might have cut-short the pullback.


We continue to expect that there will be at least one full-blown test of the June low before the gold sector's correction comes to an end and that the correction is unlikely to end before November-2006. In the mean time, September is a likely month for an intervening rebound peak.

Not all gold stocks are in synch

Gold stock indices such as the HUI and the XAU peaked during the first half of May and probably made their price lows for the correction in June (although, as noted above, the correction is likely to continue until at least November). However, not all gold stocks are in synch with the indices. We've previously warned, for instance, that while the indices would likely hold above their June lows there was a good chance that many exploration-stage gold stocks would make progressively lower lows over the remainder of this year due to retail investors losing patience and 'throwing in the towel'. Unfortunately or fortunately, depending on whether you are a current owner or a prospective future owner of these types of stocks, the exploration-stage juniors are following the expected pattern.

It's also the case that some of the major gold stocks are out of synch with the indices. For example, the following charts show that Newmont Mining (NYSE: NEM) and Harmony Gold (NYSE: HMY) commenced intermediate-term corrections at the end of January (more than 3 months in advance of the indices) and are therefore already about 6 months into the corrective process.

NEM has superior management to HMY, but we are much more interested in HMY and highlighted it as a buy on a few occasions when it was trading near its lows in May and June. The reason we prefer HMY to NEM, despite the latter's superior management, is because it offers a lot more leverage to gold and because we expect the Rand gold price to rise relative to the US$ gold price over the next 12 months (it's the gold price in Rand terms that determines HMY's profit margin).

For those looking to take new positions or add to existing positions in the gold majors, the ideal area to buy HMY would be in the 13s (we doubt that it will trade below $13) and the ideal area to buy NEM would be in the high 40s. Alternatively, those willing to swap some upside potential for greater comfort could hold-off buying until the stocks break upward from their respective consolidation patterns. Daily closes above the June high for HMY and the July high for NEM would constitute upside breakouts.




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)

Lion Selection Group (ASX: LSG). Shares: 100M. Recent price: AUD1.93

We wanted to once again highlight LSG, an Australia-based investment company that invests in junior resource stocks. Late last week LSG announced that it had accepted a bid from AuSelect (ASX: AUS), another Australia-based investment company that invests in junior resource stocks, for one of its investments (Sedimentary Holdings). LSG has said that if the deal is finalised then the AuSelect shares it receives will be distributed to LSG shareholders. At the current AUS stock price this would be equivalent to a 20c dividend.

Earlier this year LSG realised a profit of AUD38M (38c per share) from the sale of another investment and it's very likely that a significant portion of this profit will also be distributed to LSG shareholders later this year.

LSG isn't likely to experience the spectacular price moves (in both directions) that are common amongst junior mining stocks because it is, in effect, a portfolio of junior mining stocks. Rather, it should be a steady performer over the coming years. Management's policy of paying out a large portion of each realised investment gain to shareholders reduces the leverage and therefore the potential upside in the stock price, but it also reduces the risk and means that LSG is a lot closer to being an investment-grade opportunity than most of the companies that are developing their own mines.

    American Capital Gold (TSXV: AAU)

The MD&A (Management Discussion and Analysis) published by Chesapeake Gold (TSXV: CKG) on 31st May contained the following update on the planned merger of CKG and American Capital Gold (TSXV: AAU):

"On March 3, 2006 Chesapeake agreed to merge with American Gold Capital Corporation ("American Gold"), a public company listed on the TSX Venture Exchange. American Gold owns two major gold-silver deposits, Metates and Talapoosa, located in Mexico and Nevada. If the proposed merger is completed, Chesapeake will have approximately $40 million in cash and long term investments, the largest undeveloped gold and silver deposit in Mexico, an advanced Nevada gold project with a mineral resource of over 1.2 million ounces together with a dominant pipeline of exploration and development projects in Mexico.
The merger closing date has been delayed until late July as a result of a due diligent review of the potential tax consequences to certain American Gold shareholders (post-merger)."

This is the latest information released by CKG/AAU regarding the status of the agreed merger, so at this stage we are assuming that the merger will be complete by the end of this month.

Our interest is in the CKG warrants and rights that will be issued to AAU shareholders when the merger is completed, and we added AAU to the Stocks List in April to ensure that we would have a foothold in these warrants and rights -- especially the rights -- at a reasonable price. The risk, at the time, was that the gold price would surprise us by rocketing up to $850 before the intermediate-term correction we were anticipating commenced. If this had happened the rights would have become very valuable (AAU would have become very expensive) because they confer the right to purchase CKG shares at C$1.00 if, and only if, the spot gold price trades at an average of at least US$850 for 90 days. Refer to our previous write-ups on AAU at http://www.speculative-investor.com/new/AAU.html for further details on the merger terms.

Below is a 3-year chart of CKG. The stock has been dragged down by the general weakness in exploration-stage gold shares and by a lack of news. It's such a thinly traded stock that it wouldn't take much additional selling to knock the price down to long-term support at C$3.50, but neither would it take much of an increase in buying to lift the price up to resistance at C$5.50-$6.00.

AAU is really just a derivative play on CKG and at Wednesday's closing price of C$4.25 we estimate the value of the CKG shares, warrants and rights that will be received by AAU shareholders as a result of the merger to be approximately C$1.90. AAU therefore offers good value at Wednesday's closing price of C$1.63.


If you expect that gold will trade handily above $850 within the next 5 years then you should consider buying some AAU shares now. Alternatively, you could reasonably decide not to buy any AAU shares and, instead, plan to purchase the CKG rights and/or warrants when they begin trading on the stock exchange. In our opinion, the strategy that makes the most sense is to own some AAU shares now in order to have the aforementioned foothold in the rights/warrants and to plan on buying more rights and/or warrants later.

    New opportunity: Chesapeake Energy (NYSE: CHK) or Chesapeake Energy call options

Further to the developing opportunity in natural gas (NG) that we've discussed in TSI commentaries over the past two months we've decided to add another NG-related position to the TSI List.

Chesapeake Energy (NYSE: CHK), which, by the way, is not related in any way to Chesapeake Gold, is a major US-based NG producer with substantial leverage to the NG price. On a price/sales basis the stock is quite expensive (it trades at more than 3-times annual sales), but on a price/earnings basis it is very inexpensive (it trades at less than 8-times earnings). In any case, we are adding CHK as a trade with an expected holding period of 2-6 months rather than as a longer-term investment, so valuation isn't a major issue.

With reference to the following chart, we like the fact that CHK has oscillated back and forth within a gradually narrowing range over the past 10 months. This pattern has the look of a consolidation within a longer-term upward trend as opposed to a major top.

We are going to add the Chesapeake Energy January-2007 $30.00 call options (CHKAF) to the TSI Stocks List at Wednesday's closing price of US$3.10, but those who are not familiar/comfortable with options should purchase the stock rather than the options. We've noted our suggested entry plan and initial stop-loss level on the chart.


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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