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    - Interim Update 26th January 2011

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The FOMC meeting changes nothing

The Fed reacts to changes in market prices and economic data, so what the Fed does in the future will be determined by what happens in the interim to various financial markets (primarily, the stock market) and economic numbers such as the monthly reports on employment and consumer prices. Since the Fed governors don't know what's going to happen to these markets and economic numbers, they have no idea what they will do in the future. What, then, is the point of painstakingly analysing the subtle changes in wording from one FOMC policy statement to the next?

In our opinion there is no point, but many people do it anyway. For example, in the article linked HERE there is great significance attributed to the small differences between the words chosen by the Fed in this week's statement and the words it chose in the preceding statement.

All you really need to know is:

1. There were no new policies announced at the conclusion of this week's FOMC meeting.

2. If the stock market tanks at some point over the next few months, the Fed will almost certainly react by stepping up its inflation-promoting efforts.

3. If the stock market continues its up-trend over the next few months and the T-Bond market tanks, the Fed will become concerned about an inflation problem and will cut back on its inflation-promoting efforts.

The Stock Market

The US stock market remains dull. This is good news for the bulls, because with the market 'overbought' and with sentiment near an optimistic extreme any increase in volatility will almost certainly be to the downside.

The action in China's stock market has been a little more interesting of late, in that the Shanghai Stock Exchange Composite Index (SSEC) has dropped back to an area of important support. The following daily chart shows the situation as at the completion of trading on Wednesday. A daily close below 2600 would constitute a breakdown and would suggest that the SSEC was headed back to its July-2010 low (the lowest level of the past 18 months).


Experienced traders looking for an effective way to hedge short-term downside risk in the stock market could purchase some VIX June-2010 $25 call options, which are currently priced at around $2.60. We suspect that all it would take is a quick 10% stock market decline at any time within the next three months to generate a sufficiently large upward spike in the Volatility Index (VIX) to lift the price of these options to at least $5.

Gold and the Dollar


Gold

Over the past couple of weeks we mentioned that the 1320s was the most likely area for a short-term bottom in the US$ gold price. Gold dropped to this area during the first half of this week and has initially bounced. Furthermore, the price decline to the $1320s was accompanied by a decline in Market Vane's bullish percentage to 63 and by Central Gold Trust (GTU) trading at a discount to its net asset value for the eighth consecutive trading day. This means that when the price dropped to support at $1320 sentiment was consistent with what we'd expect to see at a short-term bottom. This doesn't guarantee that a short-term bottom is in place, but the odds are in favour of it.

The initial rebound from this week's low should encounter stiff resistance in the $1360s.


Sometimes a market will do just enough to convince us that we are wrong, before reversing course and doing what was originally expected. Such is the case with gold in euro terms (gold/euro).

During previous occasions over the past 10 years when gold/euro became as extended to the upside as it was last May-June, the ensuing correction never ended until the price had fallen far enough to touch its 200-day moving average. Consequently, our expectation during the June-October period of last year was that gold/euro would test its 200-day moving average before commencing the next intermediate-term advance in its long-term bull market. We were a little surprised, then, when gold/euro broke to a new high in November, thus seemingly deviating from its well-established pattern.

As it turned out, November's upside breakout was a 'fakeout'. The gold/euro correction that began in June of 2010 is still in progress and has finally resulted in a test of the 200-day moving average. The correction may not be over, but it appears to us that the maximum downside risk in gold/euro is no more than 10% on both a short-term and an intermediate-term basis. The likely downside is a lot less than 10%.


Gold Stocks

Current Market Situation

The HUI ended last week just above support at 500. We said in the Weekly Update that it could spike a little lower before starting to rebound, but that a rebound should soon begin. As it turned out, the HUI dropped a little below 500 on Tuesday -- to its 200-day moving average in the mid-490s -- before rebounding strongly on Wednesday.


The magnitude of the HUI's decline from its early December high to this week's low is within the bounds of a routine short-term pullback. For example, it is roughly the same (16%-17%) as the pullback that occurred last May. And as was the case last May, an upward reversal has immediately followed a marginal breach of the 200-day moving average. Therefore, one of the two most likely scenarios is that a correction low is now in place.

The second of the two most likely scenarios is that we've just seen the low for the first downward leg of an intermediate-term correction. Under this scenario the HUI would be expected to rebound and then decline to the ultimate correction low. A typical counter-trend rebound would take the HUI back to the vicinity of its 50-day moving average.

Either way, a short-term buying opportunity has occurred.

Under-valued gold producers with >150K-oz/yr of current production

Over the past 6 months the stock market has ruthlessly marked down the stock prices of gold producers that missed production forecasts, even if the miss was relatively minor. Also, any gold producer that announced potential obstacles to its future growth has taken a disproportionately large hit in the stock market. The result of this harsh treatment is that some of the best bargains within the gold sector can be found amongst the stocks of companies with production in the 150K-400K oz/yr range. In some cases it almost seems as if the stock market is viewing current profitable production as a negative, preferring, instead, the stocks of companies that are years away from being able to generate any income from the mining of gold.

Golden Star Resources (GSS) is a good example of the phenomenon we are referring to. GSS reached US$6/share in early November, but then announced that it would miss its 2010 production forecast by about 10%. This caused the stock to plunge and set in motion the downward trend clearly evident on the following daily chart. At Tuesday's low of US$3.41, GSS had lost 43% of its value. The gold price was down by only 7% over the same period.


Due to its recent price action the Ghana-based in-ground gold resources of GSS now trade at a discount to the Ghana-based in-ground gold resources of some exploration-stage miners. So, would we be buyers of GSS near its current price?

The answer is a qualified yes. We actually did purchase a small initial position for our own account in the $3.50s on Tuesday, but we don't plan to make a substantial addition to this position unless the stock price drops to the low-$3 area*. Also, we most likely won't add GSS to the TSI Stocks List unless it drops to the low-$3 area. This is not because we expect the stock to drop that far or because it doesn't offer reasonable value near its present level; it's because we already have plenty of exposure in both our own account and in the TSI List to 150K-400K oz/yr gold producers that are as attractive, or more attractive, than GSS. We are referring to Jaguar Mining (JAG), Minefinders (MFN), Northgate Minerals (NXG), and Resolute Mining (ASX: RSG). If we were building a gold-stock portfolio from scratch we would be inclined to buy these stocks before we would buy GSS.

The one thing that the above-mentioned stocks have in common is failure to achieve expected levels of production and/or production cost over the past 9 months. Each of them, however, has the potential to shine during 2011 due to the remedial actions that were taken last year and the fact that operational improvement is not factored into current stock prices.

    *One point we occasionally make is that successful speculation doesn't require accurate short-term forecasting. You don't even need to have an opinion on the likely short-term direction of prices. You should, however, think ahead and plan how you would react under different short-term scenarios. For example, we don't know what will happen to the stock price of GSS over the next few weeks, but we do know that if there were no meaningful change to the company's operations then we would: a) make a significant addition to our exposure if the stock price fell to the low-$3 area, and b) exit our current position if the stock price rebounded to the vicinity of resistance at $4.75.

Australian gold stocks

By "Australian gold stocks" we mean the stocks of companies that produce most of their gold in Australia, as opposed to stocks that are listed on the Australian Stock Exchange (ASX). For example, Resolute Mining is listed in Australia, but most of its gold production comes from Africa so for the purpose of this discussion it doesn't qualify as an Australian gold stock. Crocodile Gold (TSX: CRK), however, does qualify as an Australian gold stock, even though it trades on the Toronto Stock Exchange (TSX). This is because all of CRK's production comes from Australia.

Part of the reason that many Australian gold stocks have had lacklustre performance over the past year is reflected by the following chart, which shows that the A$-denominated gold price has been in 'consolidation mode' since February of 2009. This occurred because the A$ strengthened against the US$ by roughly as much as gold strengthened against the US$. The other part of the reason is that over the same period the cost of producing gold in Australia continued to rise. The overall effect was downward pressure on gold-mining profit margins.

To put it another way, Australian gold stocks have been weighed down because the A$ managed to hold its own relative to gold at the same time as it lost purchasing power.


The TSI gold-stock selections that can be classed as "Australian", by virtue of producing more than half of their gold from operations located in Australia, are: Catalpa Resource (ASX: CAH), Crocodile Gold (TSX: CRK) and Northgate Minerals (NXG). These stocks should perform relatively well once the A$ begins to trend downward against the US$.

The A$ has the potential to fall a long way against the US$ and against gold over the next 12 months. However, we said the same thing at this time last year. During 2010 the A$ did roughly what it was supposed to do (from our perspective) during the first half of the year (it weakened against the US$ and gold, thus reducing the extent of its over-valuation), but then ramped upward during the year's second half in response to increased speculation in equities and industrial commodities.

Currency Market Update

It is reasonable to expect that the US$ will continue its downward drift for as long as -- but for no longer than -- the stock market continues its upward drift. A turning point could occur at any time.

Currency traders will no doubt be keeping a close eye on the political situation in Ireland over the weeks ahead. It looks like the Irish will go the polls to elect a new government during the second half of next month, with the country's financial bail-out being one of the main campaign issues. At this stage the election doesn't appear to be a big threat to euro-zone stability, but it will probably have some effect on the currency market. As noted in a Financial Times article on Monday:

"The two parties considered most likely to form a coalition government after the election have made no secret of their intention to seek a renegotiation of the terms of rescue package from the European Union and the International Monetary Fund -- in particular the interest rate charged and the treatment of bondholders who lent to Ireland's collapsed banks."

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)

Pretium Resources (TSX: PVG). Shares: 81M issued, 84M fully diluted. Recent price: C$6.05

We introduced PVG and its huge low-grade Snowfield/Brucejack gold project in last week's Interim Update.

An article about Pretium that was posted at Mineweb.com a couple of days ago contained the following interesting comment:

"...there is potential to start mining a high grade section to develop good cashflow while continuing to explore the main lower grade bulk tonnage zones of this potentially enormous deposit.  He [Pretium CEO Bob Quartermain] believes that ultimately it will make sense to combine Snowfield/Brucejack with KSM into a single massive mine, but recognises that this type of operation would be well beyond the capabilities of a junior to finance and operate.

But meanwhile Pretium is undertaking a significant drill programme to explore the high grade zones and if these are as consistent as expected the company could move closer towards a smaller scale near-term mining operation."

Until we read this article we weren't aware of the potential to build a smaller-scale mining operation to exploit a high-grade portion of the overall deposit. Pretium's speculative appeal will be enhanced if this potential is confirmed by drilling results over the months ahead.

    Jaguar Mining (NYSE and TSX: JAG). Shares: 84M issued, 88M fully diluted. Recent price: US$6.32

JAG's stock price probed intermediate-term support on Tuesday and then rebounded along with most gold stocks on Wednesday.


The reason that GSS's stock price was hit so hard in November after the company announced a reduction in its production forecast was that the market had become convinced that GSS had put its forecast-missing days behind it. The miss therefore caused an immediate plunge in confidence. JAG is in a very different situation, in that it would be difficult for confidence to fall much further. In effect, its current low valuation is the market's expression of a total lack of belief in the ability of JAG's management to significantly improve the company's mining operations. This greatly reduces the stock's vulnerability to a negative surprise.

We think that JAG is a good candidate for new buying near its current price, although it could be a few months before the remedial actions that were taken last year start to have a meaningful positive effect on the reported operational performance.

    Our Northgate Minerals (NXG) trading position was stopped out on Monday for a loss of 17%. There is still a longer-term NXG position in the TSI Stocks List.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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