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    - Interim Update 20th July 2005

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Interesting Articles

We occasionally refer to Paul van Eeden's analysis of the long-term relationship between changes in the gold price and changes in the total supply of US dollars. A good article by Mr van Eeden dealing with this topic can be found at http://www.kitco.com/weekly/paulvaneeden/jul152005.html. In this article he notes that the current "fair value" of gold, based on changes in the total quantities of gold and US dollars over the past 60 years or so, is around US$770.

In addition to moving in response to US$ inflation over the very long-term (generations), it's important to understand that over shorter time periods -- periods of up to 20 years -- the gold price is influenced to a greater extent by inflation expectations than by actual monetary inflation. This is why gold makes huge moves above and below its so-called fair value and why it would be a bad idea to buy gold simply because it was below its fair value or to sell gold simply because it was above its fair value. For example, based solely on the total supply of US dollars gold was fully valued at $200 in mid 1978, but this didn't prevent the gold price from rising to $850 by January of 1980 in parallel with burgeoning fears that the inflation was going to get much worse. In other words, over a normal investment timeframe (1-5 years) an investor in gold must have good reason to believe that inflation expectations are going to rise.

Our view is that the actual rate of inflation (money supply growth) reached its high for the decade during the final quarter of 2001, but that fear of currency debasement will drive the gold price to a multiple of its "fair value" within the next 5 years.

We'd also like to draw your attention to a recent article by Antal Fekete posted at http://www.gold-eagle.com/gold_digest_05/fekete071205.html. This article primarily deals with the importance of incorporating a clearing system for "real bills" into any proposal for a return to gold-based money, but also covers other ideas relating to trade, banking, monetary history and the gold standard. It is much longer and more difficult to read/understand than the aforementioned van Eeden piece, but it's well worth the effort.

Bonds

...if an intermediate-term peak was put in place in the oil market earlier this month then a continuation of the bond-oil relationship would result in an October peak for bonds. ...if bonds move to new highs for the year by October and the Fed hikes the official short-term rate by 25 basis points at each of its next two meetings then the US will almost certainly end up with an inverted yield curve.

Bonds and Oil

In previous commentaries -- most recently in the 29th June Interim Update -- we discussed the somewhat strange lead-lag relationship between oil and US T-Bonds. The fundamental reason for this relationship escapes us, but it's a fact that over the past 4 years or so turning points in the oil market have consistently led turning points in the bond market by 3-4 months. The oil market failed to predict the sharp decline in the bond market that occurred during the second quarter of 2004, but it has predicted every other important turning point. Furthermore, every important trend reversal in the oil market over the past four years has been followed, 3-4 months later, by a similar trend reversal in the bond market.

The following chart shows the current bonds-versus-oil situation, including a projection of what the T-Bond price will do over the next few months if the relationship continues to work. If the relationship holds then the pullback in the bond market that began in late June will bottom within the next 5 weeks and will be followed by another strong rally. Furthermore, if an intermediate-term peak was put in place in the oil market earlier this month then a continuation of the bond-oil relationship would result in an October peak for bonds.



Bonds and the Fed

It would be an understatement to say that bonds were stronger during April-June than we had expected them to be. This creates a quandary for us because there's now even less value in bonds than there was at the beginning of the year, but we are now entering a 3-6 month period when the backdrop will likely become increasingly bond-friendly due to falling commodity prices. Also, Greenspan and Co. will probably continue to push short-term interest rates higher until there's substantial weakness in the stock and/or commodity markets, and in doing so they should ensure that inflation expectations remain low (the market won't worry about inflation as long as the Fed is perceived to be on the case). In other words, there isn't likely to be a major downturn in bonds until the Fed begins to overtly promote inflation; and that's probably not going to happen until after the stock and commodity markets tank.

Putting it all together

We've been intermediate-term bearish on bonds since 20 September of last year. There's been a lot of back-and-forth movement since then, but the net result has been little change (T-Bonds are now about 3 points higher than they were then and T-Notes about 1.5 points lower). It's just been a very frustrating market with price-insensitive buyers such as the Asian central banks doing enough to offset the downward pressure exerted by speculative short-selling.

Given that it now looks like bonds could remain firm until at least October it doesn't make sense for us to retain an intermediate-term bearish view on this market. However, the upside potential looks quite limited and there is a risk that the commodity and stock markets do not follow our script (if the stock and commodity markets move higher over the coming months then bond prices would probably tumble). The result is that an intermediate-term bullish view also appears to be inappropriate. We are therefore going to switch to an intermediate-term "neutral" position on the bond market whilst retaining a short-term bearish view in anticipation of some additional downside over the next few weeks.

On a side note, if bonds move to new highs for the year by October and the Fed hikes the official short-term rate by 25 basis points at each of its next two meetings then the US will almost certainly end up with an inverted yield curve. Some pundits, including the Fed Chairman, have already started making the case that a yield curve inversion within the next few months would not have the same implication it has had in the past (an inverted yield curve has, in the past, invariably been followed by a recession). Our view, however, is that a yield-curve inversion later this year coupled with the downturn in the rate of money-supply growth that has already occurred would make a recession a high probability outcome for 2006.

The US Stock Market

Current Market Situation

There is a tendency for turning points in the US stock market to occur between the 17th and 24th of July. The below chart, for instance, highlights the intermediate-term peaks that occurred in mid July of 1998, 1999 and 2000. Also, the S&P500's closing low of the 2000-2002 bear market occurred on 23rd July 2002.


With the S&P500 Index having just rallied strongly into mid July of this year and with sentiment indicators signaling that the market is presently 'overbought' there exists the POTENTIAL for another important mid-July turning point. In order for this potential to be realised, however, there will have to be a trend reversal -- from up to down -- between now and next Monday.

We haven't yet begun to see any meaningful signs of weakness in the market. For example, the below chart shows that the government debt issued by emerging market countries is still in a short-term upward trend relative to US Government debt, indicating that investors are continuing to become less risk averse. The NDX/Dow and SOX/NDX ratios are giving similar messages. Therefore, if the market does turn lower over the next few days the outcome would probably end up being more akin to what happened following the mid-July peak of 2000 than what happened following the mid-July peaks of 1998 or 1999. In 2000, the market dropped sharply during the second half of July and then rebounded to a marginal new high before a large decline got underway.


The Real S&P500

The below chart adds weight to the idea that a turning point might be close at hand. It shows that, in terms of gold, the S&P500 Index is currently at the very top of its 2-year range. Assuming we are NOT going to get an upside breakout in the S&P500/gold ratio, this means that the S&P500 will only be able to move higher if the gold price moves higher. If the gold price were to rebound to $430, for instance, then the S&P500 Index could move up to 1260 without causing the S&P500/gold ratio to move out of its 2-year range.


The stock market versus Greenspan

The US stock market is currently involved in a game of 'chicken' with Fed Chief Greenspan in that the market is saying "we are going to keep rallying because we know you will soon stop hiking the Fed Funds rate" at the same time as Greenspan is saying "we are going to keep hiking the Fed Funds rate until we see evidence that the rate hikes are taking an appropriate toll". Greenspan appears to be more interested in quelling speculation in real estate than in halting the stock market's advance, but the property market is unlikely to buckle until after the stock market gets hit.

Our money is on Greenspan to win this game.

Gold and the Dollar

Gold Stocks

We suspect that the May-July rebound in the gold sector has ended and that the next downward leg in the cyclical bear market that began in December of 2003 is underway. However, at this stage there isn't much in the way of evidence to either support or deny this view.

The clearest sign that a top is in place would be a move by the HUI/gold ratio to below its 40-day moving average. The following chart shows that this moving average is now quite near the current price so it wouldn't take much weakness in the major gold stocks relative to the metal to generate a bearish signal.


The only breakdown of note in the gold sector over the past few weeks has been NEM's drop below the support (now resistance) that exists at around 38.60.


Further to the above, the short-term outlook for the gold sector will become more positive if NEM is able to close above $39 during the coming days/weeks and HUI/gold remains above its 40-day moving average.

Current Market Situation

The US$ is immersed in its biggest correction since March. The correction is probably not yet over and could result in a test of support at 87.5-88.0 within the next couple of weeks.

The current correction will likely be followed by a rally to a new high for the year and we remain short-term bullish on the dollar in anticipation of such an outcome. However, as mentioned in a recent commentary the FIRST phase of the dollar's recovery from its December-2004 bottom is probably more than 80% complete.


If the dollar's correction does continue for another 1-2 weeks then gold will likely move a bit higher before it resumes its decline. We doubt that gold will trade in the 440s again in the near future, but a move up to around $430 would not surprise us.

The A$ and Gold

The following charts of the Australian Dollar (AUD/USD) and the Australian Dollar gold price have been offset by two years to reflect the idea that gold/A$ leads A$/US$ by that amount of time. These types of chart comparisons should never be taken too literally because major turning points can never be predicted months or years in advance, but they can be useful in molding our general expectations for the markets. This particular chart comparison, for example, suggests that IF a new multi-year advance in gold/A$ began during the first half of 2004 (we think it did) then a new multi-year advance in the A$ should begin during the first half of 2006. We are comfortable with this chart comparison because it meshes with much of our other work and because it is based on the very reasonable theory that gold rises in terms of the less-senior currencies before it rises in terms of the senior currency (the US$)*.


The A$ is a commodity currency and over the long-term it tends to reverse direction at the same time as, or in front of, similar reversals in the CRB Index. Therefore, an implication of the above chart is that the next multi-year advance in the CRB Index is unlikely to begin until at least the second quarter of next year.

    *The consensus view amongst gold market analysts seems to be that gold experienced a sizeable rally in US$ terms over the past few years and that the next stage of the gold bull market will see it rising in terms of all currencies. However, a review of long-term charts will tell anyone with eyes that gold began to trend higher against the euro, the Swiss Franc, the Yen, the Australian Dollar and the Canadian Dollar well before it began to trend higher against the US$.

Update on Stock Selections

We are going to add a second position in the DJX Dec-06 $104 put options (YDKXZ) to the TSI Stocks List at yesterday's closing price of US$4.80. Showing two positions in the TSI List in this one option contract will allow us to exit in stages, which is what we prefer to do with our own trading/investing.

    Broadwing (NASDAQ: BWNG) announced early this week that the August payment on its convertible debt would be made in cash rather than shares. Stock dilution due to paying-off debt using under-valued shares has previously put a lot of downward pressure on the stock price, so this week's announcement was very good news.

At yesterday's closing price of US$4.99 BWNG was being valued by the stock market at only 34% of its annual revenue, which is extremely low ASSUMING the company will be able to become cash-flow positive within the next few quarters. The next opportunity to see how close BWNG is to becoming profitable will be on 29th July when the next quarterly financial results are announced.

We think BWNG is a speculative buy at the current price.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html

 
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