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    - Interim Update 24th July 2013

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The Stock Market

The recent slow upward drift in the S&P500 Index must be lulling many stock market participants into a false sense of security. The price action creates the impression that nothing untoward will happen.

We don't think that a major decline (a new bear market) will begin within the next few weeks, but a sizeable (10%+) correction looks likely.



Gold and the Dollar

Gold

Why the gold bull market isn't over

If we had to give a one-line explanation for why gold's bull market is almost certainly not over, it would be this:

Nothing has been learned.

A longer explanation would begin by pointing out that the Fed chairman and all other senior members of the Fed, as well as most economists, politicians, analysts, financial journalists and other commentators still believe that economic weakness should be tackled by boosting the money supply. It's true that some observers are concerned that the Bernanke-led Fed has gone too far with its debt monetisation, but almost everyone who has reservations about current Fed policy believes that it was right for the Fed to inject huge amounts of money into the economy during 2008-2009 in response to the financial crisis and recession of the time. Conventional wisdom is that it was only this aggressive money-pumping that saved the US from a great depression.

Outside the growing but still relatively small "Austrian" school of economics there is virtually no understanding of how monetary inflation adversely affects the economy. Almost everyone outside the Austrian school believes that a rapid rise in something called the "general price level" -- which, by the way, doesn't actually exist in the real world -- is the only potential negative effect of pumping money into the economy, and that monetary inflation will never be a problem as long as the "general price level" is only rising slowly. Almost everyone also believes that a decline in the "general price level" would be as bad as a rapid rise in the "general price level". Heaven forbid that you should be able to get more for your money as time goes by!

Only the Austrians understand that it's the distortions to relative prices caused by monetary inflation, rather than the rise in some immeasurable average price, that matters the most. To use an analogy, assume that a patient experiences a 10% weight gain with all the gain concentrated in the right leg. Doctors of the "Keynesian" and "Monetarist" schools would treat the patient's body as an amorphous mass and only be concerned about the overall increase in weight, whereas doctors of the "Austrian" school would focus on how the weight gain is dispersed and would try to understand the implications of all the gain being concentrated in the right leg. Using the same analogy, now assume that the patient's head becomes 30% heavier, and that the increased weight of this one part of the body is offset by decreased weight over the rest of the body such that there is no change in overall weight. Doctors of the "Keynesian" and "Monetarist" schools would perceive no cause for concern (because there has been no change in overall weight), whereas doctors of the "Austrian" school would be very concerned.

The persistent popular thinking that it is reasonable for the central bank to ramp up the money supply in response to economic weakness and that monetary inflation will never be a problem unless/until it causes a large rise in the "general price level", all but makes a genuine economic recovery impossible. It also guarantees that the inflation problem will continue to get worse until it becomes blatantly obvious to everyone.

Summing up: Stupid, counter-productive policy-making is destined to continue. Therefore, so is the gold bull market.

Current Market Situation

The gold bull market is destined to continue, but bull markets never go from beginning to end in a straight line. The long-term gold bull market is probably nearing the end of its first major correction.

Preliminary evidence that the first major correction is nearing its end emerged over the past three trading days. The evidence is that the current rebound has already been stronger than the rebound that followed the April low. The top of the $1320-$1350 resistance range hasn't yet been breached, but the fact that it has been tested differentiates the current rebound from the preceding one.

If gold is able to overcome resistance at $1350 within the next two weeks then by early September it should rise to around $1400 and could rise as high as $1500. The stage would possibly then be set for a decline to an October-November low.



The following two gold-related charts from the excellent sharelynx.com web site are topical.

The first chart covers the entire period from 1970 to the present and is split into four sections. From top to bottom, these sections show the US$ gold price, the COMEX open interest converted to millions of ounces (the number of open 100-oz futures contracts multiplied by 100), the COMEX gold inventory in millions of ounces, and the COMEX open interest relative to the COMEX gold inventory. The chart indicates that:

1) Over the long-term, the COMEX gold inventory has tracked the gold price.

2) Considering the long-term relationship between inventory and price, this year's sharp decline in the COMEX gold inventory is not strange (it is consistent with the price action).

3) On a long-term basis the current open interest in COMEX futures is not unusually high relative to the COMEX gold inventory, or, to put it another way, the current COMEX gold inventory is not unusually low relative to the open interest.



The second chart shows the gold futures spread since the beginning of this year. This is a picture of a commodity market in "contango", in that the more distant the delivery time or expiry date, the higher the price.

The occasional small dips by the nearby futures (the blue line) to below the spot price (the black line) have generated excitement in some quarters and led to the tout that the gold market is in "backwardation" (the opposite of "contango"). However, we explained in previous TSI commentaries that when short-term US$ interest rates are close to zero it will be possible for a minor fluctuation in the price of the nearby futures relative to the spot price to cause the futures price to dip below the spot price. This is a mole hill, not a mountain.



Gold Stocks

Over the past five months we've done plenty of selling in the gold-mining sector, but none of the selling was prompted by the emergence of good profit-taking opportunities. It generally involved the selling of relatively low-quality gold stocks to enable our exposure to relatively high-quality gold stocks to be increased while keeping our cash reserve at a comfortable level (for us, minimum cash level is 20%-25% of total portfolio value). However, there is evidence in the recent price action that the gold-mining sector is in the early stages of becoming a more normal market -- a market that occasionally offers-up good selling opportunities as well as good buying opportunities. Chief among this evidence is the fact that for the first time since the steep downward trend got underway in the final quarter of last year, the HUI has closed above the low of an earlier consolidation (in this case, the low of the April-May consolidation). Also worth noting is that the HUI has just closed above its 50-day moving average for the first time since last October.

That the current rebound is overcoming obstacles that were not overcome during earlier rebounds points to a change of character. It suggests that the major trend is in the process of reversing.



Note that some corrective activity and a decline by the HUI to below its 50-day MA over the days ahead wouldn't negate the above-mentioned evidence that the major trend is in the process of reversing.

Currency Market Update

We don't know what to make of the Dollar Index's performance since early May. It first moved sharply higher, then sharply lower, then sharply higher again, then sharply lower again, and is now back to where it started. If the decline of the past three weeks was a routine correction then it would ideally have ended at or above 82.5, but it didn't.

An effect of this confusing price action is that we are confused. There is nothing to be done except wait for additional information (new clues) to emerge.

Update on Stock Selections

Notes: 1) 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. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

International Tower Hill Mines (NYSE: THM, TSX: ITH). Shares: 98M issued, 103M fully diluted. Recent price: US$0.41

On 24th April we wrote: "The FS [Feasibility Study] will provide the first indication of the economics of developing Livengood into a mine, the reasons being that the company bypassed the PFS phase and the PEA completed in August-2011 is no longer relevant (due to substantial changes in mine plan and costs)." THM announced the results of the long-awaited Feasibility Study for its Livengood gold project (Alaska) after the close of trading on Tuesday 23rd July.

According to the FS, Livengood has a large in-ground gold inventory (about 10M gold ounces in the Proven and Probable reserve category) with the potential to be developed into a mine that produces an average of 578K ounces of gold per year over a 14-year mine life. Unfortunately, the FS reveals a high initial capital cost ($2.8B) and a high all-in production cost ($1474/oz). As a result of the project's high cost structure, the large in-ground gold resource cannot be economically extracted at anywhere near today's gold price. In fact, at the currently-estimated costs the project would require a gold price of more than $2000/oz to become economically viable.

The Livengood economics revealed by the FS were much worse than we expected. We expected that the project would be marginal at best with gold in the $1300s, but that it would be viable at a gold price of $1500-$1600. Also, we wrongly thought that the mine plan would be based on a staged development, beginning with a relatively low-capital-cost starter pit.

The cost structure can almost certainly be improved. Of particular note, due to reduced demand for labour and equipment the costs of building and operating a gold mine began trending downward a few months ago and will probably continue to decline for another 6-12 months. However, it is clear that THM has effectively become a well-out-of-the-money long-dated call option on the gold price. It's a good bet that there will be a massive advance in the price of THM shares after it becomes obvious to the speculating herd that the gold price is headed to new highs, but in the meantime a THM shareholding will be 'dead money'.

THM has been clobbered in the stock market over the past year and by some measures is now incredibly cheap. For example, its enterprise value is now about $20M, which means that its P&P gold reserves are being valued at only $2/ounce. However, there are other gold-mining companies with better projects that are also incredibly cheap. It therefore doesn't make sense to have substantial exposure to this stock, although it could be appropriate to retain a small position on the basis that a) the company has enough cash to keep itself going for two more years at a reduced burn rate, and b) two years from now the gold price will probably be at or close to a new all-time high.

We have decided to retain a small amount of exposure to THM in our own portfolio, but have removed it from the TSI Stocks List and recorded a large (90%+) loss.

    New TSI stock selection: Sprott Inc. (TSX: SII). Shares: 248M. Recent price: C$2.37

SII is a provider/manager of mutual funds and other wealth management products. It was recently brought to our attention (as an investment opportunity) by Ross Clark of Institutional Advisors.

As per the company's web site, SII's investment themes include natural resources, precious metals, opportunistic equity, small cap, enhanced equity and specialty fixed income. Alternative equity and income investment strategies include long/short equity, long/short equity and income, long/short fixed income and foreign exchange, long-biased small cap, market neutral and private credit. Investment vehicles include mutual, hedge, offshore and closed-end funds as well as managed accounts and tax efficient corporate class funds and flow through limited partnerships.

The company's major shareholders are Eric Sprott, the company's chairman, and Rick Rule, a director. Eric Sprott owns 94M shares (38%) and Rick Rule owns 25M shares (10%). Some of the most important company insiders therefore have a lot of 'skin in the game'.

SII's price chart reveals a roller-coaster ride. The stock price went from $9 in early-2008 down to a low of $2.06 in late-2008 up to $9 in early-2011 down to a recent low of $2.21. It closed at C$2.37 on Wednesday 24th July, so it is presently not far from this year's low and its 2008 crash low.



The fact that SII has fallen back to within spitting distance of its 2008 crash low doesn't, by itself, make the stock a buy. What makes the stock a buy is that this a very solid company with excellent leadership, about $9B of assets under management and almost $300M of working capital that has temporarily fallen so far out of favour that it is trading near a 6-year low.

We don't expect the rebound from this year's low to be as rapid as the rebound from the 2008 low, but the upside potential over the coming 1-3 years is much greater than the remaining downside potential. The remaining downside potential is linked to the risk that commodity markets haven't yet bottomed and that a large stock market decline lies ahead. Also, there's a risk that the company will report losses for its June-2013 and September-2013 quarters, possibly leading to its $0.03 quarterly dividend being temporarily suspended. However, it looks like these risks have been factored into the stock price. In any case, new investors in SII shares can manage risk by scaling into a position over the coming few months, perhaps beginning with an initial purchase near the current price.

    Quick comment on Lydian International (LYD.TO)

LYD announced some bad news on Wednesday 24 July that caused its stock price to plunge. We'll discuss the news in the Weekly Update.

One effect of the news will be a significant delay to the completion of the updated Feasibility Study for the company's Amulsar gold project in Armenia, but we don't yet have enough information to fully assess the effects. Although our initial reaction to the decline in the stock price is that it's a terrific buying opportunity, we wanted to point out that it usually isn't a good idea to buy immediately following a stock-specific news-related plunge. That's especially the case when the full implications of the news are unknowable. In other words, there should be no urgency to undertake new buying.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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