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    - Interim Update 19th December 2007

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TSI Vacation Reminder

Just a reminder that we'll be on vacation from 21st through to 30th December, inclusive, so there will be no Weekly Update on Sunday 23rd December, no Interim Update on Thursday 27th December, and no Weekly Update on Sunday 30th December. We plan to send out a brief update via email on Monday 31st December, but the next full report will be the Interim Update on the 3rd of January.

Very best wishes for a fun-filled, healthy and safe Holiday Season, and thank you for your support during what turned out to be an unusually challenging 2007.

Uranium Update

We are nowhere near as confident about the sustainability of the uranium bull market as we are about the sustainability of the gold bull market. There are simply a lot more things that could go wrong with a long-term investment in uranium than with a long-term investment in gold.

In order for gold to maintain its upward trend and rise to a few thousand dollars per ounce, all we need is for central banks and governments to continue along their current inflationary paths. This, in our view, is a 'no brainer' because with so much debt in the world the governments and their banks have no politically-feasible alternative. The only question is the route that will be taken by gold over the next several years in the journey from its current price to a multiple of its current price.

We would therefore give a MUCH higher weighting to gold equities than to uranium equities in an investment portfolio.

Having said that, the uranium sector possibly offers the stock market's best SHORT-term risk/reward ratio because uranium stocks have been beaten down as much as financial stocks over the past six months and yet the fundamental backdrop for the uranium-mining business remains bullish. In fact, the uranium sector is in such a depressed state right now that in-ground uranium can literally be purchased for almost nothing. We say this because the current market capitalisations of some exploration-stage uranium miners with proven in-ground resources are only slightly greater than the amount of cash these companies have in the bank. Mongolia-based Khan Resources (TSX: KRI) and Western Prospector (TSXV: WNP) are good examples.

Investors are obviously (and rightly) leery about Mongolia's political risk, so in this respect the cheapness of KRI and WNP is somewhat understandable. Note, though, that these stocks would look ridiculously cheap at their current prices even if we assumed the worst (the worst being that the Mongolian government steals 50% of the companies' projects). And anyway, it's not only the uranium juniors burdened with substantial country risk that have been sold down to bargain-basement levels. Case in point: Energy Fuels (TSX: EFR), a member of the TSI Stocks List and a company that was written up in a Mineweb.com article earlier this week.

At Wednesday's closing price of C$1.18, EFR had an enterprise value (market capitalisation minus net cash) of only C$30M. This is a company that plans to commence uranium mining next year and to have low-cost annual production of around 2M pounds (equivalent to annual revenue of $180M at the current uranium price) three years from now.

Why does EFR have such a low valuation? Well, in addition to the ultra-depressed investor sentiment afflicting the uranium sector and the effects of tax-loss selling, we suspect it's because the market doesn't understand the EFR story.

Most exploration-stage companies spend many years and tens of millions of dollars proving up in-ground resources. Even though these in-ground resources often don't get developed to the point where they translate into actual profits, they are what the valuations of junior resource companies are most commonly based on. EFR, however, is taking a very different path. Rather than using up years of precious time and huge amounts of shareholder funds proving-up resources they already know exist, EFR's senior managers have put the company on a fast track to production and profits. This makes EFR a real business, but means that the company rarely reports the sort of exploration-related news that tends to grab the stock market's attention.

People interested in positioning themselves for a potential recovery in the uranium sector, but who aren't comfortable with the juniors, could consider taking a position in Uranium One (TSX: SXR), a mid-tier uranium producer, and/or Cameco (NYSE: CCJ), the world's largest uranium producer. The following chart shows that CCJ has just bounced off major support. We won't be surprised if this support is breached at some point over the coming 12 months, but a rebound is a likely short-term outcome.


The Stock Market

Current Market Situation

We are short-term bullish on the US stock market on the expectation that the pullback from the early-December high will be followed by a tradable advance during the first few months of 2008. Note, though, that this view is predicated on the market holding above the November low.

If the S&P500 broke its November low it would be a significant bearish development because it would mean that the most important US stock market index had not only breached short-term lateral support, but also dropped below the bottom of the long-term channel drawn on the following chart. We would therefore not maintain our positive outlook if that were to happen. Specifically, our short-term bullish view will be 'stopped out' if the S&P500 Index closes below 1400.

 

Gold and the Dollar

Gold

After reaching an 'overbought' extreme in early November gold has consolidated in a fairly normal fashion. As indicated on the following daily chart of February gold futures, this consolidation appears to be taking the form of a triangle.


Our view is that the Dollar Index has begun a multi-month bottoming process that will entail one or two tests of the November low and during which rallies will likely be capped by former long-term support (now resistance) at 78-80. If this view is close to the mark then the Dollar Index's current rebound is at least two-thirds complete and the short-term downside pressure being applied to gold by US$ strength will soon abate. And if so then gold should do no worse than test support at $780 prior to embarking on its next short-term upward trend.

We remain short-term "bullish" on gold, but will immediately downgrade this view a single notch if the February gold futures contract takes out $780 on a daily closing basis.

Silver

We thought we'd take a quick look at silver's "big picture" in today's report, via the following monthly chart (the chart is courtesy of www.mrci.com).

The chart shows the long-term resistance at $15 that capped the 2005-2006 rally and that appears to have capped the 2007 rally. Once a decisive break above $15 occurs the logical intermediate-term objective will be $25.

In our opinion there's a very high probability that a decisive/sustained break above $15 will occur within the next 18 months, but a low probability that it will occur within the next 3 months.


Gold Stocks

Re-visiting an old scenario

The following chart (minus the note at the bottom) originally appeared in our 23rd July commentary and shows the two potential scenarios we had in mind for the AMEX Gold BUGS Index (HUI) at that time. We are dragging it out again now because the "Red Scenario" -- the one represented by the red line on the chart -- remains relevant, even though the market did a good job of convincing us otherwise.


We all but gave up on the "Red Scenario" because two things happened that should not have happened if this scenario were really 'in play'. First, the pullback from July's short-term peak resulted in a new low for the year, which it should not have done if the "Red Scenario" was applicable. Second, the rally from the August low to the November peak should, at best, have resulted in a test of the May-2006 peak, but it ended up taking the HUI 15% above its May-2006 peak. Again, this should not have happened. However, putting aside August's false downside breakout and the potentially false upside breakout that occurred during October-November, on a purely directional basis the HUI's performance since its July peak has been totally consistent with the "Red Scenario". Furthermore, the following chart of the HUI/euro ratio shows that in terms of a relatively strong currency there was no upside breakout during October-November.


In the next section we mention an indicator that could soon tell us whether or not something along the lines of our old "Red Scenario" is the most likely outcome. Note, though, that a decline from the November-2007 peak to a bottom around May of next year would not occur in a straight line. As discussed in the latest Weekly Update, a short-term bottom during December or January would probably be followed by a 1-2 month rebound and then a drop to the ultimate low.

Trying to fit the pieces together

One of the things that has made the past six months such a challenge is that the pieces of the inter-market puzzle have not fitted well together. At least, that's the way it has seemed to us.

From our perspective the main issue has revolved around the US dollar's anticipated performance relative to the euro. Over the past few months the US$ has been dramatically under-valued and oversold relative to the euro, convincing us that an intermediate-term advance in USD/EUR was on the cards. At the same time, however, gold's fundamentals and price action were unequivocally bullish, and the definitive breakout by the AMEX Gold BUGS Index (HUI) in October seemed to suggest that the gold sector of the stock market had embarked on a new major upward leg in its long-term bull market. This created a quandary for us because it would be unusual, in the extreme, for the gold sector to commence a major upward leg just prior to an intermediate-term bottom in the US dollar's foreign exchange value. Both the HUI and gold are quite capable of rallying during the latter stages of a USD/EUR rally, but the initial stages of a meaningful US$ rally invariably coincide with weakness in gold-related investments. We therefore couldn't reconcile our strongly-held view that the US$ was bottoming with what was happening on the gold front.

Last week's break below intermediate-term support by the HUI has added a modicum of clarity to the confusing inter-market picture in that the HUI is now behaving exactly the way it should IF the US$ has commenced a bottoming process that will, after a few months, lead to a strong US$ rally. In other words, the HUI has begun to move into line with our currency market outlook.

The pieces still aren't fitting together particularly well, though, because gold's intermediate-term fundamentals remain very bullish. Specifically, powerful trends towards wider yield and credit spreads have been established, real interest rates are low and falling, and the positive fundamental backdrop for gold continues to be confirmed by strength in the monetary metal relative to the industrial metals. Furthermore, gold's price chart looks bullish in that the decline from the early-November peak has the appearance of a correction within an intermediate-term upward trend. Considering how overbought the market was in early November it was reasonable to anticipate a multi-week correction back to the vicinity of the 50-day moving average, and a routine correction back to the 50-day MA is all that has happened thus far.

One possibility that occurs to us when we attempt to fit the various pieces together is that the markets will soon come around to the belief that the worst of the debt crisis is over. If this happens then interest rate spreads will become narrower, financial stocks will rebound strongly, Treasury Bonds will begin to trend lower, the US$ will begin to trend higher and gold will probably do no better than test last month's high before commencing an intermediate-term decline. Such an outcome would paint the 2007 financial crisis as an elongated version of the 1998 crisis, making sense of gold's bullish performance over the past few months whilst being consistent with the idea that a sizeable US$ rally is close at hand. It would also be a fundamental justification for the HUI's "red scenario" discussed above.

An alternate possibility is that last week's breakdown in the HUI was yet another impressive 'head fake' and that the best we can reasonably expect from the US$ over the coming 6 months is the occasional counter-trend bounce. If this is the case then the HUI and the gold price will probably trade above 600 and $1000, respectively, by the second quarter of next year.

The performance of the gold/SPX ratio -- gold's performance relative to the S&P500 Index, that is -- should provide us with an important clue as to which of these very different alternatives is closer to reality. The reason, as evidenced by the following chart, is that the HUI and the gold/SPX ratio usually move in lock-step, a relationship that makes intuitive sense given that there will generally be no reason for the investing community to increase its demand for gold stocks unless gold is doing better than the broad stock market. Furthermore, periods when these two entities move in different directions tend to be short-lived and divergences tend to be meaningful. For example, it proved to be significant that the August-2007 plunge in the gold sector was not confirmed by the gold/SPX ratio.

The current situation is that a) gold/SPX broke out to the upside in November and then pulled back to just below its breakout level, and b) the sharp decline in the HUI over the past week was NOT confirmed by gold/SPX.

The gold/SPX ratio should now either confirm the HUI's breakdown by moving to a new multi-week low, or remain positive and thus label the HUI's recent downside breakout as another 'fakeout'.


Current Market Situation

In the latest Weekly Update we wrote:

"Last week's break below support does not mean that additional weakness will occur in the near future. However, a significant drop in the HUI over the coming 1-2 weeks would simplify the situation, especially if it occurred alongside resilience in the gold price. We say this because a quick additional decline of around 10% in the HUI in parallel with a much lesser percentage decline in the gold price would most likely cause our HUI/Gold Oscillator (HGO) to generate a buy signal, potentially setting the stage for a strong rebound. In other words, significant follow-through on last week's downside breakout -- a quick drop to the mid-300s, for instance -- would soon lead to a very good short-term buying opportunity provided that the gold price continued to trace-out a routine consolidation pattern.

Additional near-term weakness could make things easy by setting up a relatively low-risk buying opportunity, but the markets have recently tended to make things as difficult as possible (the market environment since July of this year has been one of the most challenging we've ever had to deal with) and if they continue to do so then a rebound will begin immediately. A rebound that began without the HUI first becoming severely 'oversold', as measured by our HGO or by momentum indicators such as the RSI, would keep our short-term outlook 'up in the air' and in all likelihood be capped by former support (now resistance) in the 398-405 range."

When the HUI dropped sharply on Monday in both nominal terms and relative to the gold price it looked like the market was going to make things easy by setting up an excellent short-term buying opportunity. In fact, if Tuesday had been similar to Monday then our HUI/Gold Oscillator (HGO) would have generated a rare buy signal. Unfortunately, however, the small rise on Tuesday followed by the even smaller decline on Wednesday has prevented that from happening. A drop to 350 or lower between now and year-end is still possible and would set-up the aforementioned buying opportunity, but it's more likely that the top of the support range identified on the following chart has limited the downside for now.

A drop to 350 or lower within the next two weeks will cause us to immediately upgrade our short-term outlook to "bullish", but failing that we will probably remain "neutral".


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)

Sabina Silver (TSXV: SBB). Shares: 66M issued, 83M fully diluted. Recent price: C$1.66

So many junior resource stocks are trading at absurdly low valuations right now that it is difficult to decide which ones to feature as candidates for new buying. However, SBB is a standout in that its Hackett River project located in Canada's Nunavut region has a Measured-and-Indicated resource containing 205M ounces of silver plus 4.3B pounds of zinc, and yet the company's current enterprise value is only C$66M (C$110M market cap minus $50M cash). This means that buyers at Wednesday's closing price of C$1.66 are paying $0.32/ounce for SBB's silver and getting the zinc for free.

With reference to the following chart, the stock is currently testing support defined by its August-2007 low. It could remain under pressure for a few more days due to the remnants of tax-loss selling, but it should then rebound strongly.


    NovaGold Resources (AMEX and TSX: NG). Shares: 105M issued, 120M fully diluted. Recent price: US$7.39

We added some exposure to NG to our own account earlier this week in the low-US$6 area and planned to add it to the TSI Stocks List via today's report, but the darn thing surged 21% on Wednesday. The long-term risk/reward is very attractive at Wednesday's closing price of US$7.39, but we will hold off adding it to the TSI List for now in the hope that it will pullback to $6.50 or lower (we will add it to the List if it trades at US$6.50 within the coming 4 weeks).

NG traded as high as US$22 last month, but was clobbered due to huge upward revisions to the capital cost estimates for its Galore Creek (50/50 JV with Teck) and Donlin Creek (50/50 JV with Barrick) projects. It now looks like NG's share of the capital costs across both projects will be around US$4.5B, an amount that will be almost impossible for a company of NG's size to finance without diluting its current shareholders into oblivion. But regardless of NG's ability to obtain sufficient reasonable-cost financing there is enormous option value in these two massive projects, and if the gold bull market continues then this value WILL be realised one way or another.

If we are right to believe that gold is now in a long-term upward trend relative to industrial metals as well as relative to paper currency then major diversified mining companies such as BHP, Rio Tinto and Xstrata will probably become interested in expanding their gold-mining businesses at some point over the next few years. And if so then small companies with huge in-ground gold resources in politically secure locations -- NovaGold being a classic example -- will be gobbled up. The $2B needed to fund 50% of the development budget at the 30M-ounce Donlin Creek project represents a big obstacle for NovaGold, but it is pocket change for BHP.

Lastly, it should be kept in mind that NG has assets in addition to Galore and Donlin. For example, NG's 100%-owned 100K-ounce per year Rock Creek gold project, scheduled to begin production early next year, is probably worth around US$200M (almost $2/share).

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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