A New Era

We've devoted quite a bit of space in previous commentaries to the gold/silver ratio and have concluded that gold would continue to out-perform silver until either the stock market reached a long-term bottom or the general level of commodity prices began to trend strongly higher. This conclusion was based on historical performance data and the recognition that gold has more of a monetary role than does silver.

We've also looked at the relationship between gold and platinum in the past and concluded that gold tends to out-perform platinum during those periods when the US economy is weak and/or confidence in the US$ is low. This conclusion was derived from historical performance data and also makes sense on the basis that the dominant influence on the gold price is monetary (investment) demand whereas platinum's major uses are non-monetary.

During the 1995-2000 period the US Dollar trended strongly higher and the US economy boomed, so the platinum price was naturally very strong relative to the gold price. In fact, during the final quarter of 2000 and the first quarter of 2001 the platinum price reached its highest premium to the gold price since 1972. Of course, in 1972 gold had just been de-coupled from the US$ following 38 years of having its price fixed at $35/ounce.

This brings us to our point. The gold price has been persistently strong over the past 6 months, but there have been several rallies lasting 6 months or longer since the secular bear market in gold began in 1980. In terms of the increase in the gold price there is certainly nothing special about the current rally. It becomes special, however, when we note the incredible gains achieved by the gold mining shares despite the modest-only increase in the bullion price. The only other period over the past 40 years when gold stocks rallied to this extent without a concurrent large increase in the gold price was during 1965-1968. As we explained in the 15 May Interim Update this 1965-1968 gold stock rally in the face of a flat gold price forewarned of the coming gold bull market. 

One of the consequences of the gold bull market of the 1970s was that the platinum price went from being about 3-times higher than the 'fixed' gold price in 1971 to being less than 1-times the floating gold price by late 1974.

Below is the long-term chart of the platinum/gold ratio that we've shown in the past. Note the plunge in the ratio from its 1971 peak and the similar-looking plunge in the ratio from its early-2001 peak. Also note that once downward trends in the pt/gold ratio get started they tend not to end until the ratio falls below 1.

So, what is our point? We actually have two points to make (two for the price of one). Firstly, we've said on a few occasions over the past year that we would heavily overweight gold relative to platinum, and that remains the case. In fact, unless there is a major and unexpected change we will overweight gold relative to platinum until the gold price moves above the platinum price. We will, however, still retain some exposure to the stocks of PGM producers (some of these stocks are actually beginning to look very attractive on a valuation basis compared to the gold and silver stocks). Secondly and more importantly, the similarity in the way the pt/gold ratio has behaved over the past year and the way it behaved during the early-1970s is one more shred of evidence that we have a secular trend change on our hands, one result of which will be a gold rally of historic proportions.

The US Stock Market

Taking a 6-month view

There are numerous reasons to remain bearish on the US stock market taking a 6-month view. We plan to review these reasons in some detail in the coming Weekly Update, but in summary and in no particular order they are:

a) Many bellwether stocks are still trading at unreasonably-high multiples of sales

b) The money supply growth rate is trending lower

c) Long-term interest rates are likely to move much higher

d) Sentiment. There have been a number of panics over the past 2 years but the majority of people have maintained a generally optimistic outlook towards the stock market. This is not the attitude that usually prevails at long-term bottoms.

e) The 'smart money' continues to sell or short-sell.

Current Market Situation

The short-term forecast outlined in the latest Weekly Update was for a pullback during the first half of this week and then a continuation of the stock market rally until at least the end of this month. The market has pulled back and we now have a good set-up for a resumption of the rally. The set-up is good because:
a) During the first 3 days of this week some sentiment indicators (eg, put/call ratios, the NYSE McClellan Oscillator) reached levels that are consistent with what we would expect to see at a short-term low 
b) The Japanese Nikkei225 Index has moved up to within 55 points of its high for the year
c) The upside 'gaps' that were left by some of the major stock indices during last week's surge have now been filled (see NASDAQ100 chart below)

Since we try to only recommend trades at TSI that have an expected duration of at least 1 month and since we don't have any reason to believe that a rally at this time, assuming it does occur, will last more than 2 weeks, we are not going to recommend any long-side trades. If the rally does unfold as expected we will consider it to be an opportunity to buy more put options in preparation for the ensuing decline. 

Gold and the Dollar

Current Market Situation

Below is a weekly chart of silver futures. Although silver has edged above major resistance at $4.80 there has not yet been any follow-through so there is a danger that this will turn out to be a false breakout. False breakout or not, the move above $4.80 suggests to us that the demand for silver is finally beginning to outweigh the supply of silver and that the silver price will shoot higher at some point over the next few months. There is some resistance at 5.00 and 5.40, but once decisively above $4.80 we doubt that there will be any prolonged battle between the bulls and the bears until $5.80 is reached.

We sold about half of our trading positions in gold stocks in April and kept the remaining half in anticipation of a rise in the gold price to around 320 (note: trading positions are in addition to a core investment position in gold/silver stocks). The spot gold price peaked at 319.30 during yesterday's trading, so is it time to exit remaining trading positions?

It looks like a lot of traders had a similar game plan to us since most of the major gold stocks surged during early trading on Tuesday then reversed sharply lower as the gold price approached 320. To take one example, Goldcorp was up by $1.30 at one point but finished the day with a loss of $0.54 on 4-times its average daily volume. This occurred despite the gold price holding most of its gains to close $2 higher on the day. There is a widespread belief that the stocks of the major gold producers are now fully priced or over-priced and that the rally in the gold price has gone about as far as it is going to go in the short-term. We certainly concur that the major gold stocks are, in general, over-priced (and therefore risky for new buyers), but we are not so sure that the gold price has reached a short-term peak.

Our previous intention to sell the remaining trading positions as soon as the gold price rose to 320 was based on the idea that such a rise would be in the form of a spike and would, therefore, constitute a buying climax. However, as illustrated on the chart included in the latest Weekly Update the gold price has been steadily moving higher in a 'stair-step' fashion. This continues to be the case. In other words, the recent price action in the bullion market does not indicate that a significant peak has been reached. The gold price has just risen for 6 days in a row so some sort of a correction should occur over the next few days, but the odds favour new rally highs after a short and shallow pullback. 

The decline in gold stock prices that occurs concurrently with a near-term pullback in the bullion price might not be shallow due to the speculative premiums being sported by most gold stocks, but we've decided to retain some trading positions in gold stocks for now. In fact, as discussed below we are actually going to add a gold stock (one that does not have a large speculative premium built into its current price) to the Portfolio. We will, however, take profits on SSRI, one of our silver stocks. 

When a market is trending strongly higher the natural tendency of most people is to focus on how much money they will make if the trend continues. Our approach is a little different in that we are always trying to figure out what might go wrong. A bull market will, for a while, bail-out those who overpay for stocks, but those who consistently overpay in the belief that someone else will overpay by an even greater amount in the future are eventually going to lose in a big way.

Over the past few weeks we've recommended that new buying be focussed on the stocks of silver producers/explorers because they hadn't been the beneficiaries of as much speculative ferver as the gold stocks and were thus more attractively priced. There was, therefore, less that could go wrong with these stocks (there was a greater margin of safety). However, it is getting harder and harder to find anything to buy since all the silver stocks we follow have rallied by 30%-50% over the past 2 weeks. The silver price may well be on its way to $5.80, but such a rise has already been priced into most silver stocks.

Perhaps we will need to start directing our attention to the PGM producers as far as new buying is concerned, even though we expect platinum and palladium to dramatically under-perform gold over the next 12 months. At $18/share (the current stock price) a buyer of Stillwater Mining stock (NYSE: SWC) is paying about US$26/ounce for platinum and palladium reserves. If SWC's reserves were gold and not predominantly palladium then its stock price would probably now be at least $60, despite the fact that an ounce of palladium is worth around 10% more than an ounce of gold.

By the way, the list of the 25 most actively-traded stocks on the NASDAQ yesterday comprised 24 tech stocks and...Durban Roodepoort Deep.

Oz Golds

Below is a monthly chart of an index of Australian gold stocks. This chart pattern is clearly very bullish.

Although the Aussie gold stocks have done very well over the past 12 months there doesn't appear to have been anywhere near the amount of gold-stock speculation in Australia as there has been in North America and South Africa. As such, the Oz golds will probably make large catch-up moves at some point.

We are going to add another Australian gold stock to the Portfolio. The name of the company is Croesus Mining and it trades on the ASX under the symbol CRS. Croesus is producing gold at the rate of about 300,000 ounces per year at a cash cost of US$180 and has a market cap of US$113M at today's closing price on A$0.71. Reserves are low, but the company has achieved a great deal of exploration success over the past several months so the reserve problem is being addressed.

Update on Stock Selections

Below is a long-term chart of NEM. NEM recently moved above a 4-year resistance line, thus providing some more technical evidence that a major bull market is underway. If NEM pulls back to around $28 over the next few weeks we may recommend the purchase of some long-dated call options on this stock as a leveraged way to participate in the coming gold-price explosion.

Pan American Silver (PAAS) is buying our Corner Bay Silver (BAY) in an all-stock deal. Therefore, the price of BAY will now move with the price of PAAS. The PAAS stock price is extended from both technical (see chart below) and valuation perspectives, so traders should take some profits now (in BAY and/or PAAS). However, since we have decided to take profits on another one of our silver stocks (SSRI) we are going to grit our teeth and continue to hold BAY (soon to be PAAS) in order to retain sufficient exposure to silver.

The acquisition of BAY is a good deal for PAAS - it increases the value of each PAAS share - but as noted above the stock price is extended and new buyers at this time are at risk of experiencing a sharp draw-down (although current prices are probably cheap compared to where they will be in 6 months time). From a risk/reward perspective the best way to obtain exposure to silver at the present time is, funnily enough, to buy silver.

CRS was added to the Portfolio at A$0.71 as discussed above. We will place an initial sell-stop at 0.56.

LightPath Technologies (LPTH) continues to grind lower along with the other stocks in the optical telecommunications sector. LPTH is unlikely to buck the trend in its sector of the market, but it is better value and is in better financial shape than most of its higher-profile brethren. The stock is trading below book value without assuming any value for its intellectual property (49 US patents) and goodwill. This, of course, doesn't mean it won't trade lower in the short-term.

As noted above, we will sell our trading position in SSRI. The profit will be around 70%.