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    - Interim Update 25th February 2004

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China

China's economic miracle?

China's strong economic growth contributed to the surge in commodity prices over the past year and the consensus view is that burgeoning Chinese demand for metals, grains and oil will cause further sharp gains in prices over the coming 6-12 months. We, however, consider China to be a wildcard as far as the commodity markets are concerned because China's strong growth is being fueled by a massive expansion of credit and all credit-induced booms end in busts. In China's case the question, we think, is not if a bust will occur but when it will occur. Unfortunately, we don't have the answer to that question; all we can say is that it doesn't make sense to blindly assume that China is going to power ahead over the remainder of this decade or even the remainder of this year.

When a country is immersed in an economic boom its systemic flaws seem unimportant, or, at least, temporarily fade into the background. This has certainly been the case with China because its strong growth has taken the focus of many analysts and investors away from the country's dismal record in the area of individual rights and directed it towards the few concessions made by the Chinese government to entrepreneurship. It is worth remembering, though, that China's government does not tolerate any opposing views, so there is no freedom of speech and very little freedom of information in China. And that China has a weak banking system as a result of the banks having been forced, over the years, to lend huge sums of money to poorly-run state-owned enterprises. These problems don't seem important now, but they will once the rate of credit expansion slows (as it eventually must).

It is also worth noting that China's one-child policy has resulted in demographics that have long-term bearish implications for China's economy. Specifically, China's population is aging at a rapid rate and the ratio of males to females is inordinately high. South Korea, by the way, has a similar problem.

Yuan re-valuation

China's currency, the Yuan, is pegged to the US$ at a fixed rate, but the fact that China runs a large trade surplus with the US leads many to conclude that the current rate is too low and that an upward re-valuation should therefore be made. We agree that China's government might be contemplating an upward re-valuation, but not as a result of the trade imbalance with the US. Rather, if the Chinese Government does do something to increase the value of the Yuan relative to the US$ we think it will be because the weakening US$ is pushing up the amount that China has to pay for vital commodity imports such as oil and copper.

Something else to consider is China's worsening trade position. China experienced very strong export growth last year, but this export growth was surpassed by import growth (exports increased by about 32% while imports increased by about 39%). Therefore, although the total value of exports exceeded the total value of imports over the past year China appears to be heading rapidly towards the point where it will be consistently running a monthly trade deficit. In fact, China reported a marginal trade deficit in January, meaning that whatever trade surplus it ran with the US during that month was more than offset by deficits with other countries. A surge in imports leading to a large trade deficit is, of course, a natural consequence of a rapid expansion of credit. 

If the rate of growth in imports continues to exceed the rate of growth in exports then China's leaders might perceive a stronger Yuan to be in their best interests because it would result in lower prices for imports. In this case, though, China's growing overall trade deficit would probably prevent any action from being taken on the currency front. If, on the other hand, the rate of import growth slows due to a slowing of the Chinese economy then China's policy-makers will have an incentive to maintain strong export growth and will not likely do anything to weaken that growth.

Our guess, therefore, is that over the remainder of this year there will be a lot of talk, but no action, as far as the Yuan's value is concerned.

Commodities in non-US$ terms

Overview

In terms of the euro and other relatively strong currencies commodity prices have been a lot more docile, over the past few years, than they have been in US$ terms. Or, to put it another way, a lot of the strength we have recently seen in the CRB Index has been a result of US$ weakness as opposed to 'real' strength in commodities. This is not something that has escaped our attention and neither has it been a surprise to us since anticipated US$ weakness was one of the main reasons we went on record, during the dark days of Q4 2001, as saying that commodity prices were about to embark on a large multi-year rally. 

The response of the commodity markets to a weakening US$ over the past two years is not materially different from what happened during the 1970s. In fact, we can't think of a reason why there would ever be a huge, broad-based, multi-year rally in commodity prices if not for inflation and its effects on the relative values of the fiat currencies. For instance, if the US$ were as good as gold then the long-term chart of the CRB Index would, we think, approximate a horizontal line with a few minor oscillations. As an aside, a chart of the CRB/gold ratio covering the past 30 years does not approximate a horizontal line; but that's because the price of gold, under the current monetary system, tends to experience disproportionately large swings in both directions in response to changes in confidence.

Further to the above, if it is reasonable to assume that the US$ is in a long-term bear market then it is equally reasonable to assume that US$-denominated commodity prices are immersed in a long-term bull market. Also, taking note of how US$ inflation has affected US$ commodity prices it is reasonable to assume that commodity prices are eventually going to move much higher against all the currencies that have been, and continue to be, inflated at rapid rates. In other words, against all the major fiat currencies since they are all experiencing rampant inflation. After all and as explained at TSI many times over the past 3 years, when the supply of money increases at a rapid rate over an extended period it is axiomatic that prices will rise somewhere in the economy. The only thing we need concern ourselves with is WHICH prices.

Current Market Situation

Below are 6-year charts of the Industrial Metals Index (GYX) in terms of the euro and the oil price in terms of the euro. 

GYX/euro moved sharply higher between the beginning of 1999 and September of 2000. It then 'corrected' for more than 2.5 years and made a higher low in June of 2003 before surging anew. If the advance that began in mid-2003 turns out to be of similar length and magnitude to the one that occurred during 1999-2000 (at this stage of the game it looks quite similar) then GYX/euro will peak in May of 2005 at around 2.3 (about 35% above its current level). 

Like GYX/euro, oil in terms of the euro rocketed higher between the beginning of 1999 and September of 2000. However, rather than pulling back and then resuming its ascent, as has been the case with GYX/euro, oil/euro pulled back and then went into an extended sideways consolidation. Its chart is therefore not as bullish as the GYX/euro chart because there is no firm evidence, at this stage, that a correction low is in place (for the correction that began in September of 2000).

The US Stock Market

Current Market Situation

The results of the latest Investors Intelligence (II) sentiment survey show that 82.6% of newsletter writers were bullish on the stock market as at the end of last week. This is close to an all-time high. Furthermore, this 82.6% comprises 60.2% who are both near-term and longer-term bulls and 22.4% who are longer-term bulls but expect a pullback in the near-term. Once again, this 60.2% figure for near-term bulls is close to an all-time high.

The results of sentiment surveys are used as contrary indicators because historical data shows that market participants and investment advisors tend to be at their most bullish near important market peaks and at their most bearish near important market bottoms. However, while a major peak won't ever occur unless there are a majority of bulls and a major bottom won't ever occur unless there are a majority of bears, there have been periods when sentiment has remained near an extreme for an inordinately long time. For example, the below decisionpoint.com chart showing the Investors Intelligence bull and bear percentages reveals that newsletter writers, as a group, were relentlessly bearish for about 9 months prior to the start of the huge 1995-1998 advance in the stock market; and that they have been relentlessly bullish over the past 10 months. In fact, over the 16 years covered by this chart there has never been a period of such persistent bullishness as the one that began in May of 2003 and continues to this day (the only period that comes close is November-1998 through to July-1999).

The current sentiment situation doesn't preclude the possibility of new recovery highs over the coming months. Rather, it is simply an indication of risk because it means there are a lot of potential converts to the bearish case and very few potential converts to the bullish case.

The below chart of Intel (NASDAQ: INTC) shows that this bellwether tech stock is close to breaking down. A decisive close (preferably a weekly close) below 29.50 would signal a break of support and project a move down to $25-$26.

It will be very interesting to see where the market closes on Friday. For instance, as mentioned above Intel is quite close to breaking down. Also, if the NDX manages to end this week below its January low of 1458 it will be a sign that the current correction is going to continue for at least another month and add to our confidence that a major peak is already in place for the NDX. 

As an aside, Alan Greenspan has stepped out of his 'monetary policy shoes' over the past few days and cautioned about the fast growth of the Government Sponsored Enterprises (Fannie Mae, Freddie Mac) and the problems the government might have in meeting future social security obligations. We don't know why the Fed Head would be going out of his way to discuss these issues unless he just wants to make sure he is on record as having provided timely warnings when the 'brown stuff' eventually hits the fan.

Gold and the Dollar

Yield-Spread Update

One of the most important influences on gold stocks is the spread between long-term and short-term interest rates. Specifically, a rising yield-spread -- caused by long-term rates rising faster than or falling slower than short-term rates -- is bullish for the gold sector whereas a falling yield-spread is bearish. 

One way to measure the yield-spread is to divide the yield on the 30-year T-Bond by the yield on the 13-week T-Bill, and when we chart this ratio (see below) we see that the interest-rate backdrop has been bullish for gold stocks over much of the past 3 years. We also see that although the long-term trend remains positive there has been a pronounced downturn in the yield-spread over the past 7 weeks.

The yield on the 13-week T-Bill is unlikely to move significantly lower than its current level of 0.94%. In fact, the 13-week yield is much more likely to move higher than lower over the next several months. Therefore, if there are going to be any further substantial gains in the yield-spread they will almost certainly have to come about due to a surge in long-term interest rates (lower bond prices).

Now, in the current environment higher long-term rates will most likely only occur if there is additional strength in the US$; and US$ strength is a negative for gold and gold stocks. In other words, if long-term rates began to move higher then any short-term benefit that gold stocks would normally receive as a result of a widening yield-spread would probably be counteracted by a stronger US$ and its effect on the gold price. 

If we look at what happened in June-August of last year we see that gold stocks did not immediately benefit from the sharp up-move in the yield-spread that occurred when the bond price collapsed. This was because the bond-price collapse occurred concurrently with, and partly as a result of, a US$ rally. However, once the dollar stopped rallying and bonds stopped falling gold stocks took-off like scalded cats. That is, even if a rising yield-spread fails to boost gold stocks in the short-term it sets up conditions that allow for sharply higher gold-stock prices once the pressure of a rising dollar is removed.

Current Market Situation

In the latest Weekly Update we argued that an intermediate-term bottom was probably not in place for the US$, but that the current counter-trend move would probably extend for another month or so. The wild currency-market action over the first three days of this week has done nothing to alter this view.

The below daily chart of March euro futures shows a downside breakout from the short-term channel. This breakout projects a drop to around 119, which happens to be close to the 200-day moving average and just above support defined by the October high. Also, 118 would be the technical target created by a move below the support that exists at around 123.50 (the January lows).

There's a chance that the January lows will hold any further decline in the euro, but a drop to 118-119 over the next 4-6 weeks looks more likely.

Last Friday's market action indicated that the correction in the gold market was not over and set up a likely downside target of $380 (+/- $3). We think $380 is a reasonable target because it is just above the May-2003 peak in the gold price (the most important short-term support level once support at 390-395 is breached) and in the general vicinity of the 200-day MA. Also, if we look at the price action from a wave perspective -- something we do from time to time -- we see what appears to be a typical A-B-C correction in the making. In this case, making the assumption that Wave C will equal Wave A gives us a target of $383 during the first half of March.

As discussed in the latest Weekly Update and in many other commentaries, there has been a strong tendency for gold to lead the US$ over the past few years; so if, for example, the dollar rebound is going to continue for another 4-6 weeks (a reasonable expectation) then we should expect gold to bottom within the next two weeks.

Below is a chart showing the HUI/gold ratio and its 40-day moving average. As gold works its way towards a correction low what we should see is some stabilisation in the major gold stocks, resulting in HUI/gold remaining above its January/February lows.

We expect a multi-month up-move in the gold sector to get underway within the next few weeks -- perhaps following a test of the HUI's early-February low -- and that the best performers during this up-move will be the exploration/development-stage juniors and the unhedged South African majors. However, Newmont Mining is likely to be one of the strongest stocks near the end of the correction and during the initial part of the next up-swing because it is widely perceived to be the safest gold stock and because it should be less affected by any panicky liquidation of small traders/investors. We'll therefore be watching NEM closely over the coming weeks.

Update on Stock Selections

From a valuation perspective Desert Sun Mining (TSX: DSM) is, at its current price of C$1.43, one of the best buys we know of in the gold sector. The company currently has a 1M ounce reserve, a 4M ounce resource, and existing mining infrastructure at its gold project in Brazil. Also, the reserve and resource numbers are likely to increase over the course of this year (to 2M and 5M, respectively) and the company expects to bring its mine into production over the next 12 months at the annual rate of 100,000 ounces. All this and DSM has an enterprise value (market cap + net debt) of only C$60M.

It's possible that DSM will get cheaper over the next few weeks, but we doubt that it will get a lot cheaper.

Northgate Exploration (TSX: NGX, AMEX: NXG) announced some good profit results after the close of trading on Wednesday, although these results shouldn't come as a surprise to the market.

NGX's biggest problem is its 350K ounces of forward sales. The company has a plan in place to eliminate these hedges over the next 4 years, but it means that about one quarter of each year's production will be sold at around $300/ounce between now and 2007.

NGX's biggest positive, as far as investors are concerned, is the multi-million ounce Kemess North deposit because the market appears to be attributing almost no value to this deposit. However, the Kemess North feasibility study is due to be completed in April and will probably confirm a gold reserve of around 3M ounces. Once this happens it will be difficult for the market NOT to factor the Kemess North into NGX's valuation.

The dispute between IMA Exploration (TSXV: IMR) and Aquiline Resource (TSXV: AQI) over the Navidad discovery in Argentina appears to be about to heat-up again. Refer to this Mineweb article for details: http://trinity.mips1.net/mgan.nsf/UNID/TWOD-5WHSZZ?OpenDocument

As mentioned in the past, we don't think there is any downside here for AQI aside from the fact that a protracted legal battle would absorb a lot of management time.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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