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Grains

Governments, via incentives, subsidies and regulations, have increased the use of grains in the making of fuel at a time when other factors would already have created a very bullish supply/demand picture for these agricultural commodities. Add the bullish supply/demand fundamentals to massive monetary inflation and you have the recipe for a huge rise in grain prices.

The supply/demand fundamentals for agricultural commodities such as soybeans and corn remain unequivocally bullish, but we suspect that they are close to being fully factored into current market prices. Our reasoning is two-fold: First, the following weekly chart shows that if soybean futures end this week near current levels or higher they will have risen for 6 weeks in a row and on 12 of the past 13 weeks. Such extended sequences of rising weeks most often occur during the lead-ups to intermediate-term or major peaks. Second, Market Vane's bullish consensus for soybeans reached 96% this week, or, to put it another way, the latest survey showed that only 4% of traders were bearish on soybeans. The highest bullish percentage we have ever seen was the 98% achieved by silver near its H1-2006 peak.

Further to the above we think it likely that the grains, as a group, will reach an intermediate-term peak within the next two weeks.

The Stock Market

Current Market Situation

Sentiment has remained depressed since the January selling climax and this has limited the downside risk in the market. After all, it's difficult for a market to make additional downward progress if most traders are already either 'short' or 'out' in anticipation of additional weakness. Our thinking has therefore been that significant risk wouldn't return until market participants had become more optimistic, and that this probably wouldn't happen until the senior US stock indices had moved above their early-February highs.

As far as the S&P500 Index is concerned, the following chart shows that there is important resistance near 1400. A decisive break above this resistance would probably convince the majority that a new intermediate-term upward trend had begun, which, paradoxically, would increase the risk of a new decline.

For those speculators who are inclined to do so, the appropriate time to establish (or re-establish) bearish positions will be after the S&P500 rebounds to the low-to-mid 1400s, assuming that this happens within the next couple of weeks. However, unless something changes in the mean time this is not a trading idea that we will embrace because the worst we expect the market to do over the next few months is test its January low.

The dramatically oversold conditions reached on 22-23 January suggested that a) there would be a test of the lows within three months, and b) this test would be followed by a tradable multi-month rally even if a bear market had begun. So, rather than placing bearish bets in anticipation of a decline back to near the January lows it would make more sense, in our opinion, to get financially and emotionally prepared to place bullish bets in the event that such a decline takes place.

From our perspective, likely candidates for new bullish bets (buying) following a test of the January lows include coal stocks, natural gas stocks, airline stocks, tech stocks, and stocks that provide exposure to the Japanese market.

The chart of Intel (INTC) presented below reveals a pattern typical of many stocks at this time. Specifically, it shows a quick rebound from the January panic low to a peak on the 1st of February, followed by weeks of consolidation. The consolidation will probably end in the near future via an upside breakout.

INTC has resistance at $22 and $24. We currently have an INTC call-option position in the TSI Stocks List and plan to take profits on this position IF the stock price rises to near the higher of these two resistance levels within the next few weeks.

Gold and the Dollar

Currency Market Update

The US Ministry of Inflation (the Fed) reaffirmed its commitment to currency depreciation earlier this week, thus putting additional downward pressure on the US dollar's foreign exchange value. We don't think this market reaction makes a lot of sense, though, because when push comes to shove it's very likely that the European Ministry of Inflation (the ECB) will prove to be equally dedicated to its primary job function.

Our short-term bullish view on the Dollar Index was invalidated by Tuesday's close above 1.49 in the March euro futures contract (the Dollar Index is, in effect, the inverse of the euro). However, this week's action -- including the break to new lows by the Dollar Index -- is not inconsistent with our view that the US$ is embroiled in a multi-month bottoming process that began last November. Our expectation has been, and is, that this bottoming process will be complete by the end of March.

On the following weekly chart of the Dollar Index we've highlighted the intermediate-term bottoms that have occurred over the past 2 decades. The most recent bottom highlighted on the chart is obviously yet to be confirmed by price action and therefore might not prove to be a bottom at all, but the point we wanted to make is that with only one exception the prior bottoms were multi-month processes. Each entailed an initial low followed by a few months of bouncing around in the vicinity of the low before a tradable rally got underway.

The previous intermediate-term bottoming process for the dollar that bears the closest resemblance to the present situation is the one that unfolded between October of 1990 and February of 1991. As illustrated by the following chart, the 1990-1991 bottoming process involved a break to new multi-year lows just prior to the start of a large rally. If today's market follows this pattern then the Dollar Index will reverse upward within the next two weeks.

Silver and Silver Stocks

The PAAS/silver ratio (the price of Pan American Silver divided by the price of silver) tends to peak and begin trending lower at least 6 weeks prior to an intermediate-term peak in the silver price. We therefore consider an upwardly mobile silver price combined with a multi-week downturn in the PAAS/silver ratio to be a bearish divergence, especially if it occurs after silver has been trending higher for at least 6 months.

On the following chart comparison of the silver price (the top section of the chart) and the PAAS/silver ratio (the bottom section of chart) we've highlighted the 6-week bearish divergence that occurred during the first half of 2004 and the 3-month bearish divergence that occurred during the first half of 2006. We've also highlighted the current 2-month (and counting) bearish divergence. (Note: the chart doesn't include Wednesday's action.)

Assuming the current bearish divergence persists for no longer than the longest of the previous two such divergences, silver will reach an intermediate-term peak by early April. In other words, if the pattern of the past several years repeats then silver is within 6 weeks of an intermediate-term peak.

But even if the aforementioned timing assumption is valid, silver might not yet be close to an intermediate-term peak in price terms. The reason is that this market tends to make near-vertical moves during the final weeks of intermediate-term rallies (the bulk of its trough-to-peak gains tend to occur towards the ends of rallies).

With respect to the remaining upside potential, we have mentioned in previous commentaries over the past few months that $25 would become a logical target once resistance at $15 had been decisively breached. $25 remains a logical upside target and could be reached by early April, although on the way to $25 there would almost certainly be some hesitation near the big round number of $20.

The stock of the average silver producer, like the stock of the average gold producer, has not done a particularly good job of leveraging the price-gains in the metal over the past few years. This is evidenced by the long-term downward trend in the PAAS/silver ratio.

If the silver price rockets upward over the coming month or so then the large producers such as PAAS will undoubtedly make new highs in nominal dollar terms, but it's very unlikely that they will make new highs relative to silver. In fact, we don't think the major silver stocks have attractive risk/reward ratios with respect to either the short-term or the intermediate-term. However, it's a different story when it comes to the junior silver producers and explorers. That the juniors have done so little over the past several months has added to their already-large upside potential and reduced their downside risk. This is the area where most new buying should be focused, and as far as specific stock selection ideas are concerned we have re-printed, below, the brief note included in yesterday's (27th February) email to subscribers.

"Silver is probably within 6 weeks of an important peak so this is not the time to be moving aggressively into silver-related speculations, but those who currently have minimal exposure to "poor man's gold" can still find some reasonable buying opportunities at the junior end of the silver-stock universe. For example: as a junior with a substantial in-ground resource, about 4.5M ounces/year of unhedged current production and a market capitalisation of only C$330M (70M shares at C$4.70/share), First Majestic Silver (TSX: FR) should benefit greatly IF silver continues its surge over the next few weeks [note: a chart of FR is displayed below]. This is because the company would experience a sharp increase in its profit margin and because the stock market would be forced to assign a much higher valuation to FR's 175M ounces of in-ground resources under such a circumstance. We think that Sabina Silver (TSXV: SBB), a tiny exploration-stage company with a massive in-ground resource in a politically secure location, would also fare extremely well if the degree of speculation were to increase over the coming weeks.

A small silver producer that looks interesting at this time, but is not a current member of the TSI Stocks List, is US Silver (TSXV: USA). USA is expected to ramp-up its production to around 3.5M ounces/year over the next 2-3 quarters and has a market capitalisation of only C$160M (206M shares at C$0.74/share).

Due to insufficient liquidity the above-mentioned juniors -- and junior resource stocks in general -- aren't well suited for short-term trading, but someone who buys now with the aim of holding for 1-2 years could end up with significant short-term gains."

Gold Stocks

The following chart shows that the Gold Miners ETF (GDX) has moved up to resistance defined by its January and November peaks. Regardless of where the rally is ultimately headed it would not be surprising to see GDX consolidate below this resistance for at least a few days.

Over the past fortnight we twice suggested buying GDX for a trade when it was in the $47-$48 range, but the time for new short-term buying has since passed due to GDX's move from just above important support (the early February low) to near intermediate-term resistance. Current 'long' positions should, we think, be protected via in-the-money stops.

As far as the coming three months are concerned, two very different gold-stock scenarios appear to be almost equally plausible. One is that spectacular gains in the gold-stock indices over the next several weeks will culminate at intermediate-term tops during April-May, while the other is that the indices will soon peak a short distance from current levels and then consolidate for about 2 months before resuming their advances.

The latter of the above-mentioned scenarios is more consistent with our overall financial-market outlook, but in any case there is no need to bet heavily on one or the other of these potential short-term outcomes. The best approach, in our opinion, would be to have sufficient long-term exposure to the gold sector that you would welcome a 4-6 week surge, and to simultaneously maintain a large-enough 'cash cushion' that a 20% pullback would feel more like an opportunity than a problem. Of course, if you are positioned in this way and the market rockets upward over the next few weeks then you will wish you owned more, while if the market pulls back to the tune of around 20% then you will wish you owned less. In other words, in neither case will you be totally satisfied. The point, though, is that in neither case will you be stressed out.

Update on Stock Selections

(Note: 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)

Gold-Stock Warrants

The following information was included in the email sent to subscribers on Wednesday 27th February:

"This far into a gold rally the junior gold stocks would normally be running hard to the upside and the warrants on these types of stocks would be going berserk, but, as we've discussed many times in TSI commentaries, the current gold-stock situation is not normal. As a result, most junior gold stocks are still in consolidation patterns and some of the warrants on these stocks are still reasonably priced. Here are two examples of warrants that are candidates for new buying near current prices:

1) European Minerals April-2010 C$1.20 warrants (TSX: EPM.WT.A).

With EPM at Tuesday's closing price of C$1.40 we calculate fair value for EPM.WT.A to be around C$0.50, but paying anything up to the high-0.50s would be OK.

2) Great Basin Gold April-2009 C$3.50 warrants (TSX: GBG.WT).

With GBG at Tuesday's closing price of C$3.37 we calculate fair value for GBG.WT to be around C$0.65, but anything up to around C$0.70 would be OK.

The above-mentioned warrants are a lot more risky than the underlying stocks. For example, if GBG were to trade sideways over the coming 14 months then someone who owned the stock wouldn't lose any money, but someone who held the warrants over this period would lose 100% of their investment (the warrants will expire worthless if the stock price is below C$3.50 at the April-2009 expiry date). The EPM warrants are less risky because they are 'in the money' (their exercise price is below the current stock price) and because they have an extra 12 months of time prior to expiry, but there is still a significantly greater risk of loss with the warrants than with the stock.

Despite the additional risk, warrants are sometimes worth considering due to the leverage -- and the associated additional upside potential -- that they offer. For example, a rise in GBG's stock price to around C$5.50 over the next few months would result in a rise to more than C$2.00 in the fair value of GBG.WT; that is, a 60% increase in the stock price over the next few months would lead to an increase of at least 180% in the warrant price."

Note that the GBG warrants jumped up to C$0.75-C$0.80 in response to the favourable mention in our email, but the EPM "A Series" warrants are still available in the high-0.50s.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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