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    - Interim Update 25th January 2012

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Making sure the Gold Trend Table's message is clear

There was a discussion in the latest Weekly Update under the heading "Gold's Real Trend", which included a table containing the most important drivers and indicators of this trend. As stated near the top of this discussion, we were addressing gold's trend in purchasing power terms rather than its trend in nominal currency (US$) terms. Although not specifically stated in the latest review of our Trend Table, on an intermediate-term basis the best way to assess gold's "real" performance is to measure how it does relative to commodities in general (as represented by the Continuous Commodity Index -- CCI) and non-gold equities. For example, 2008 was one of the best years for gold in real terms in that it gained about 40% relative to the CCI and more than 30% relative to the S&P500, but in US$ terms it was essentially flat.

The Trend Table's current message is that 2012 will be a good year for gold relative to most other commodities and the broad stock market. However, we currently expect that 2012 will also be a good year for the US$ relative to most commodities and equities. Therefore, the view expressed in our 2012 Yearly Forecast -- that over the course of the next 12 months gold will be roughly flat in US$ terms and strong relative to most other markets -- is consistent with the bullish result generated by our Trend Table.

On a related matter, although the outcome of the Trend Table is a number, compiling the Table is a qualitative process. The value of each factor in the Table is based on our current OPINION about what will happen over the coming 6-12 months. For example, we have reasons to believe that the general shift away from risk will resume by mid year and that this will result in credit spreads being materially wider by year-end than they are today (meaning: the "Credit Spread" is expected to be supportive of gold's real performance over the course of the coming 12 months), but it could be that we are too bearish on the global economy. If so, we'll have to make an adjustment at some point.

If our current opinions about the 2012 performances of factors such as credit spreads, the real interest rate and the yield-spread are correct then gold should do well in real terms this year. As evidence we cite the fact that over the past 12 years the gold/CCI ratio (a measure of gold's real performance) had an average annual GAIN of 12% during the 8 years when the Trend Table's result was bullish and an average annual LOSS of 4% during the 4 years when the Trend Table's result was either bearish or neutral.

One of the silliest comments we've read

The article posted HERE quotes economist Martin Murenbeeld on why a return to a gold standard -- as suggested by Republican Party presidential candidates Newt Gingrich and Ron Paul -- would be unrealistic. Here's a quote from the article that caught our attention:

"Assuming he [President-elect Gingrich] can ‘fix' the gold price at the right price, the next problem will be whether mine supply will allow the Fed to expand money supply in tandem with GDP, which would keep US prices stable. Subpar growth in new gold supplies entering the financial system will force deflation onto the economy. To see how well that works one should study Greece...today!"

So let's get this straight: He's pointing to an economic disaster caused by rapid creation of money out of nothing -- something that would be impossible if gold were money -- as evidence that a gold standard wouldn't work? That's just plain silly.

A gold standard is probably an unrealistic objective for political reasons. Also, while a gold standard would be a vast improvement on what we currently have, it is far from the ideal solution for reasons that have nothing to do with the concerns expressed by Murenbeeld. The reality is that any monetary standard implemented/controlled by a central bank or a government will eventually degenerate to the point where the money cannot be trusted.

However, anyone who shares Murenbeeld's belief that the supply of money should be increased at a certain rate to support the economy and keep prices stable doesn't understand the relationships between money, prices and economic growth.

First, money is simply the general medium of exchange, the supply of which does not have to increase for the economy to grow. In fact, the more stable the money supply the stronger the economy will be, all else being equal. The reason is that price signals will more accurately reflect real/sustainable changes in consumer preferences if the money supply is stable. By the same token, manipulating the money supply in an effort to keep prices stable will make price signals less indicative of real changes in consumer preferences and thus make the economy less productive. 

Second, economic progress naturally leads to lower prices. Is it a problem for the computer industry that people are able to buy much better computers at much lower prices today than they could 20 years ago? Of course it isn't! And would it be a problem if people could save money and be secure in the knowledge that their money would have more buying power in the future than it does in the present? Of course it wouldn't! The fact is that the last thing we need is to have a central bank ramping up the money supply in an effort to eliminate the benefits that savers and consumers would otherwise get as a result of increasing productivity.

Falling prices are good, but it isn't correct to describe the downward trend in prices that naturally stems from real economic progress as "deflation". To have genuine deflation there must be a contraction in the supply of money. Genuine deflation is possible under a fiat monetary system such as the one we currently 'enjoy', because when vast sums of money are created out of nothing it will always be possible for vast sums of money to be obliterated. However, genuine deflation would be virtually impossible if gold were money, because gold is a physical element that can be neither created nor destroyed by banks.

Penntrade.com (PT) versus Interactivebrokers.com (IB)

We have previously suggested both PT and IB. Of particular relevance, both of these on-line US-based brokerages enable their customers to trade on the Canadian stock exchanges. 

IB has the advantage of having the better on-line trading interface. Also, it is usually more cost effective to trade Canadian stocks via IB than via PT, the reason being that Canadian trades done via PT always involve currency conversion charges between USD and CAD. This charge usually amounts to about 1% of the value of every purchase or sale. With IB, currency conversion charges can be avoided because funds can be held in CAD.

PT offers the advantage of being able to trade all listed Canadian stock warrants (some of these warrants can't be traded via IB). Also, although we have no reason to doubt the safety of either IB or PT, we have more confidence in the safety of PT. The reasons are outlined in the document posted at http://secure.penntrade.com/SafetyofAccounts.pdf.

The Stock Market

Good financial results from Apple (AAPL) combined with the suggestion of more money-pumping by the Fed broke the NASDAQ100 Index (NDX) above intermediate-term resistance to a new 10-year high. That this breakout occurred with the market near an 'overbought' extreme means the risk of a breakout failure is higher than usual.



The conditions are in place for an intermediate-term stock market peak, but this doesn't guarantee that an intermediate-term peak will occur in the near future. It's all about probabilities and risk versus reward. 

We think there's a lot more risk than reward in the senior US stock indices, but at the same time we are well aware that important stock market tops tend to be drawn-out affairs. In particular, tops are often tested before a consistent downward trend gets underway. This means that if the market is now at or close to an important top, the most likely path over the next three months would encompass an initial decline followed by a rebound to 'test' the peak. With this sort of topping action, a decline worth trading wouldn't get underway until March at the earliest.


Gold and the Dollar

Gold

In the latest Weekly Update we wrote:

"The gold market is not yet close to being 'overbought' on even a short-term basis. Actually, by some measures -- most notably, the COT report and Market Vane's sentiment survey -- it is still 'oversold'. This suggests to us that gold will break above $1670 within the next few weeks and rise to resistance at $1750-$1800."

Thanks to the Fed (as discussed below), resistance at $1670 was decisively breached almost immediately. This confirms $1750-$1800 as a viable short-term target. The aforementioned target could be reached within the next few days or in a few weeks from now, depending on whether or not there is an intervening pullback.



The Fed excited the markets on Wednesday by stating that economic conditions would probably justify keeping the Fed Funds rate target near zero until late 2014. Artificially low interest rates have done more harm than good up until now, but what the heck -- if the medicine makes the patient sicker the solution is to up the dosage!

It should be understood that although the Fed is threatening to keep its interest rate target near zero for another three years, what it actually does will be determined by the performances of the financial markets and the economy. The Fed won't, for example, keep interest rates near zero if commodity prices start zooming upward or if its favourite measure of "inflation" gets too high. The statement that the interest rate target will potentially be kept near zero until late 2014 is therefore meaningless, except that it proves for the umpteenth time that the Fed will go to absurd lengths to ensure that there will be inflation and nothing but inflation in the future. We wonder how many more times this will have to be proved before intelligent people stop forecasting deflation.

The other novel step taken by the Fed on Wednesday was the announcement of an official "inflation" target. Specifically, the Fed has set itself the goal of manipulating money and interest rates such that the annual change in the price index for personal consumption expenditures (PCE), a bogus number concocted by the US government each month, is around 2%. An increase of 2%/year in this bogus number apparently equates to "price stability".

Due to the way it is calculated, to get a 2%/year increase in the PCE price index most prices will have to increase at a much faster rate than 2%/year. Therefore, formalising this so-called "inflation target" is another way of making it clear that savers will be punished.

Gold Stocks

Wednesday's Fed-inspired surge took the HUI from intermediate-term support at 490-500 to short-term resistance defined by its 50-day moving average and its mid-January peak, whereas the XAU has clearly broken above both of these 'technical' obstacles. The following daily chart shows that Wednesday's XAU rally did, however, stop at a downward-sloping trend-line. This trend-line constitutes psychological resistance and could prompt some consolidation over the days immediately ahead, but significant additional upside is likely within the next few weeks.



The XAU has performed better than the HUI over the past two months. This isn't of great importance, but it does reduce the probability that the HUI's next upside breakout won't be immediately confirmed by the XAU. As we've seen in the past, upside breakouts by the HUI that aren't led by or immediately confirmed by the XAU are usually followed by sizeable price declines.

Currency Market Update

In the latest Weekly Update we wrote:

"The currency market's reaction to this Wednesday's Federal Reserve policy statement will probably give us a clue as to whether a final blow-off decline lies in store for the euro. We aren't expecting the Fed to announce any new "QE" programs or make any specific promises about new inflationary measures this week, but we get the impression that many people are expecting the Fed to do something soon. This creates the potential for 'risk assets' such as equities to sell off and for the US$ to rise sharply in the aftermath of the FOMC meeting."

It seems that we under-estimated the willingness of Bernanke and Co. to undermine the US$, wreak havoc with price signals and make the US economy less efficient. Consequently, the currency market made it past the FOMC test without any increase in downward pressure on the euro. The next big test will come at the end of this month, when EU leaders meet again with the aim of solving the sovereign debt dilemma.

Although some tests are yet to come, the evidence is building that the euro made a multi-month low earlier this month.

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

Crocodile Gold (TSX: CRK). Shares: 310M issued, 399M fully diluted. Recent price: C$0.58

Luxor Capital has announced an increase in its proposed CRK takeover price -- from C$0.56/share to C$0.62/share. CRK's board of directors has recommended that shareholders accept the revised bid.

On the one hand, we suspect that Luxor does not want to be a long-term operator of Australian gold mines and will therefore look for an opportunity to make a profitable exit from its CRK position within the next 12 months. This is one reason to consider retaining exposure to the stock. Another reason is that the stock is very under-valued if we assume that the Cosmo mine will be brought on line as currently planned.

On the other hand, there is a risk that the operational problems of the past year will persist through 2012. Also, the stocks of many junior gold miners are very under-valued at this time, which means that exiting CRK would free up funds that could be redeployed in stocks that are equally under-valued and perhaps not as risky.

Due mainly to the current glut of buying opportunities within the ranks of junior resource stocks we think the appropriate course of action is to accept Luxor's bid and thus free up money that could be put to good use elsewhere. However, if you do intend to accept the bid it would make sense to wait until next Tuesday-Wednesday before doing so, just in case a new bidder comes out of the woodwork. Note that Luxor's offer expires on 7th February.

For TSI record purposes we will assume an exit at Luxor's C$0.62 offer price. This means that CRK will go into the books as a loss of 53%.

    GLDX Trade

We added a trading position in GLDX (the Global X Gold Explorers ETF) to the TSI List in December to reflect our view that there would be a good rebound at the junior end of the gold sector during the first quarter of this year. We will continue to assess the situation in real time, but if given the opportunity to do so within the next two months we will take profits near resistance at $14.

 Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html

 
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