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    - Interim Update 22nd March 2006

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The Stock Market

How prescient is the stock market?

...the stock market is like a manic-depressive 600-pound gorilla; you really don't want to get in its way when it is on the rampage, but you shouldn't automatically assume that its chosen path will prove to be prescient.

The way some analysts talk you'd think the stock market was all-knowing and all-seeing. However, while the performance of the stock market can provide us with clues as to future fundamental developments, a lot of the time the market is wrong. What we mean is that the market spends a lot of its time being either very under-valued or very over-valued. This is why the stock market's history involves huge rallies followed by huge declines (the market moves a long way in one direction, realises it has gone way too far, and then moves in the opposite direction until once again it figures out that it has gone way too far, and so on). It is also why Warren Buffett was able to amass such a huge fortune (Buffett got rich by exploiting the stock market's tendency to be wrong about companies' future prospects).

For example, at the 'bubble peak' in 2000 the stock market's assessment of the future was so bright that it was prepared to assign a multiple of 40 -- almost 3-times the long-term average -- to the 12-month trailing earnings generated by S&P500 companies. However, rather than earnings growing rapidly to justify stock prices, stock prices ended up plunging in response to falling growth and the gradual recognition that valuation levels were ridiculously high.

Our view is that the stock market is like a manic-depressive 600-pound gorilla; you really don't want to get in its way when it is on the rampage, but you shouldn't automatically assume that its chosen path will prove to be prescient. We think it is appropriate to look to stock market action for information on such things as whether investors are becoming more or less risk averse and other changes in investor attitudes/preferences, but we don't think it makes sense to defer to the stock market when trying to forecast what the business environment is going to look like in the future.

A major trend change in the works?

...the focus of investment demand might actually be in the process of shifting from the oil sector to the airline sector.

We've previously referred to the AMEX Airline Index (XAL) as the "anti-oil index" because airline stocks usually trend in the opposite direction to the oil price almost regardless of what else is happening in the financial world. With this in mind, it is not surprising that the powerful upward trend in the oil price over the past 2 years has been accompanied by weakness in the XAL in absolute terms and extreme weakness in the XAL relative to the AMEX Oil Index (XOI). Furthermore, it would not be surprising if these trends continued for many years to come because, as everyone knows, the long-term outlook for oil stocks is incredibly bullish whereas the long-term outlook for airline stocks is incredibly bearish.

What everyone knows is often not worth knowing, however, and the following charts show that the focus of investment demand might actually be in the process of shifting from the oil sector to the airline sector. To be specific, the first chart shows that the XAL -- the "anti-oil index" -- is close to breaking upward from a 2-year consolidation, while the second chart shows that it wouldn't take much additional weakness in the XOI relative to the XAL to signal an end to the major upward trend that began during the second half of 2003.




We would interpret a break below the December-2005 low by the XOI/XAL ratio as an indication that oil stocks were probably going to under-perform airline stocks for an additional 3-6 months. However, if oil is in a secular bull market -- we are confident that it is -- then the downward move in XOI/XAL that began last September will prove to be a correction within a longer-term upward trend.

Current Market Situation

...a peak is likely to soon occur, but a downward trend in the broad market has clearly not yet begun.

The NDX/Dow ratio is a reliable leading indicator of the overall US stock market, and it turned down in January. Downward reversals in the NDX/Dow's intermediate-term trend usually lead downward reversals in the overall market by 1-3 months, so the January downturn in this ratio projected a top for the S&P500 Index during March or April. Due to the tendency for important turning points to occur in March, we are presently within the most likely timeframe for a peak.

The EMD/USB ratio -- the price of the Emerging Market Income Fund divided by the US Treasury Bond price -- is a reliable coincident indicator of the US stock market, and it has just hit new multi-year highs. The following chart illustrates the relationship between the S&P500 Index (shown in blue) and EMD/USB. (EMD/USB is, in effect, a way of measuring emerging market credit spreads. When confidence is rising the investment demand for emerging market bonds tends to increase relative to the investment demand for US T-Bonds, causing the EMD/USB ratio to move higher.)

The bottom line is that a peak is likely to soon occur, but a downward trend in the broad market has clearly not yet begun. When an intermediate-term decline does begin it should be accompanied by a fall in the EMD/USB ratio.

There's some additional discussion on the stock market outlook in the "Updates on Stock Selections" section of today's commentary.


Gold and the Dollar

Gold and Silver

Gold has been consolidating since early February and has, we think, about $40 of short-term downside risk. A drop below $520 would create a short-term buying opportunity.

Silver continues to grind higher within the price channel that began to form last September (refer to the following daily chart of May silver futures for details). It was very strong on Tuesday on the back of news that the Barclay's silver ETF is probably going to become a reality, but while making it easier for investors to obtain exposure to silver is a long-term bullish development for the metal we don't see it as a bullish development in the short-term. For one thing, the fact that the SEC appears ready to approve the silver ETF suggests that the managers of the ETF have been able to obtain a substantial amount of physical silver which may not have previously been available to the market to satisfy investment demand.

If/when the silver ETF begins trading we think it will make more sense for investors to accumulate the ETF rather than shares of companies such as Pan American Silver, Silver Standard Resources and Silver Wheaton. The reason is that physical silver stands a good chance of out-performing the larger-cap silver stocks over the next several years for the same reasons (discussed in previous commentaries) that physical gold stands a good chance of out-performing the larger-cap gold stocks. The stocks of junior gold/silver producers and exploration-stage companies are a different 'kettle of fish' and should be accumulated on weakness.

Also, bear in mind that if a silver ETF begins to trade in the US then the premium over net asset value at which Central Fund of Canada (AMEX: CEF) currently trades will probably drop to almost zero. This means that the listing of the new silver ETF could lead to a fall of around 9% (the current CEF premium) in the price of CEF assuming no change in the silver price.


Gold Stocks

The correction in the gold sector that began at the end of January can, we think, be likened to the intermediate-term corrections that began in May of 2001 and June of 2002 (the highlighted areas on the following weekly chart of the HUI). These previous corrections didn't end until after the weekly RSI had dropped to 40-45 and the weekly MACD had dropped to around zero (the RSI and the MACD are shown at the bottom of the chart, with green arrows pointing to the oversold extremes). It is reasonable to expect that the aforementioned momentum indicators will reach similar levels before the current correction comes to an end.

As mentioned in a previous commentary, we think the current correction requires additional time more than additional price deterioration (we think the HUI's short- and intermediate-term downside risk from its current level is around 10%). Sentiment towards the gold sector just isn't bullish enough for there to be a major liquidation.


Currency Market Update

Over the past two years the Canadian dollar has been very strong relative to the Australian dollar and for the two years before that the A$ was very strong relative to the C$. However, the following charts show that both currencies are in long-term declines relative to gold. Both currencies are weak, but there are periods when the A$ is weaker than the C$ and other periods when the C$ is weaker than the A$.

Over the next 6 months we think the C$ will be significantly weaker than the A$, for two reasons. First, in gold terms the A$ has just reached the bottom of its long-term downward-sloping channel whereas the C% is still about 10% below the bottom of its channel. Second, we think oil will, at best, keep pace with the CRB Index over the remainder of this year, and as explained in the latest Weekly Update the C$'s relative strength over the past two years has coincided with strength in oil relative to the CRB Index.




Update on Stock Selections

For those who are interested in buying put options in order to speculate on a sizeable correction in the US stock market over the coming two quarters, our suggestions are to accumulate the DJX (Dow Industrials Index) Dec-06 $108 put options (DJVXD) and the QQQQ (an ETF that tracks the NASDAQ100 Index) Jan-07 $42 put options (VCQMP). The aforementioned QQQQ puts are already in the TSI Stocks List and we will now add the aforementioned DJX puts to the List at Wednesday's closing price of $2.40. Note that the DJX Dec-06 $104 puts are already in the List, but the $108 puts look like better buys at this time.

We think it's good to hold a mixture of QQQQ and DJX puts because the NASDAQ100 Index tends to be the weakest of the major US stock indices in the early stages of an intermediate-term decline whereas the Dow Industrials Index tends to be the weakest index near the end of a decline. In other words, the Dow tends to lag the NDX and then make a catch-up move. This also tends to happen during intermediate-term rallies, which is why we have recently seen the Dow making new multi-year highs while the NDX languishes well below its January peak.

We caution now, as we've done many times in the past, that there is invariably a lot of risk associated with speculations in out-of-the-money options (most of the time the options expire worthless). As a consequence, we always limit the MAXIMUM amount of money we have at risk across ALL option speculations to the maximum amount we could write-off in full without losing any sleep. For us, this amount is about 5% of total portfolio value.

To give you an idea of how we view the situation, the current allocation across our own accounts is roughly as follows:

  - commodity-related stocks and stock warrants (primarily exploration-stage gold and silver stocks): 40-45%
  - other stocks: 5-10%
  - cash (primarily US$): 40-45%
  - gold bullion: 5%
  - options (primarily DJX and QQQQ put options): 3%

Note that the above allocation is not a recommendation and is not necessarily (is probably not, actually) the best way for YOU to be positioned.

We might boost our put option exposure a bit over the next couple of weeks, but as long as we maintain a sizeable core holding of gold and commodity stocks we will be at risk of experiencing a significant draw-down in portfolio value if the broad stock market tanks because gold and commodity stocks, having rallied with the broad market over the past 10 months, would most likely be taken down in a broad-based decline. However, this is a risk we can't avoid if we want to remain in synch with the secular upward trends. An alternative would be to dramatically reduce our core investment position in gold stocks, but in our opinion this would expose us to a much greater risk. Another alternative would be to build-up a much larger put-option position, but then we would have a big problem if the market did NOT drop.

As things stand, we expect that the put options we own will partially offset losses elsewhere in our portfolio in the case of a large stock market decline. The effect on our portfolio of such an outcome will also be mitigated by our cash position. On the other hand, if a large stock market decline does not materialise it will probably be because central banks back away from their monetary tightening programs and facilitate another deluge of liquidity. In this case we would have to write-off our put options, but in such circumstances the gold price would probably move well above $600 and our exploration-stage gold stocks would go berserk; that is, profits on the gold stocks would probably be many times the losses on the put options. The point is, someone who has a substantial core position in gold stocks and who is also making a modest bet against the stock market need not be concerned that they will be wrong about a stock market decline.

Our current plan is to reduce our cash position and correspondingly increase our gold bullion and exploration-stage gold stock exposure over the coming 6 months. Over the coming 12 months we will also likely change the make-up of our cash position (we expect to greatly reduce US$ exposure in favour of the Yen and the A$).

Obviously, we are not big fans of diversification (in the usual meaning of the word).

    A few weeks ago we mentioned that the US$1.20s would be a reasonable price-area to accumulate DRDGold (NASDAQ: DROOY). The stock has reached our suggested buy area so investors could consider doing some buying right now. Traders, however, might want to hold-off on buying until there is a break of the downward-sloping trend-line drawn on the following chart. A break of this trend-line would be evidence that a correction low was in place.

DROOY is very under-valued relative to the average mid-tier gold stock and sells at a large discount to Harmony Gold, the company with the most comparable set of assets.


    In a previous commentary we said we would add Australian-listed Lion Selection Group (ASX: LSG) to the TSI Stocks List if it traded at A$1.85. This price was chosen because it is just above long-term support (see chart below) and was therefore a likely place at which an intermediate-term correction would bottom. The stock traded as low as A$1.88 today and closed at A$1.90, which is close enough to our suggested buy price. LSG has therefore been added to the Stocks List at today's closing price.

Just to recap, LSG is effectively an exchange-traded fund that invests in Australian-based exploration-stage metal (primarily gold) stocks. The company typically makes its investments in junior miners by providing financing in exchange for equity.

By our reckoning, LSG is currently trading at around a 10% discount to its net asset value.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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