<% 'pass = Request.Form("pass") IF ((Request.Form("pass") = 1) OR (Session("pass") = "pass")) THEN %> Speculative-Investor.com

    - Interim Update 27th September 2006

Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

Inflation Expectations

The fall in inflation expectations since the second week of May has effectively caused the Fed's monetary policy to become tighter even while the Fed has been keeping the official overnight interest rate unchanged...

Below is a chart of the "Expected CPI", calculated by subtracting the yield on an inflation-protected 10-year T-Note from the yield on a normal 10-year T-Note. We certainly aren't alone in our belief that the CPI bears little resemblance to the actual effects of inflation on the dollar's purchasing power, so the value of the "Expected CPI" is probably not an accurate reflection of the markets' inflation expectations. Rather, it probably just represents the effects of inflation that the markets expect the government to 'fess up' to. However, we have good reason to believe that the Expected CPI's trend reflects the trend in inflation expectations.

Since the beginning of 2004 the Expected CPI has oscillated between 2.3% and 2.7%. That is, since the beginning of 2004 readings of around 2.7% for the Expected CPI have coincided with short-term peaks in inflation expectations while readings of around 2.3% have coincided with short-term troughs in inflation expectations. The most recent peak occurred during the week ending 12th May -- the week during which gold, silver and copper hit their highs for the year and the week that bonds and the Dollar Index hit their lows. Inflation expectations have since been on the decline in parallel with declines in metal prices.

Bonds have been beneficiaries of the May-September decline in inflation expectations, which is not surprising. What is surprising is that the US$ hasn't rebounded by much from its 12th May low. The fall in inflation expectations since the second week of May has effectively caused the Fed's monetary policy to become tighter even while the Fed has been keeping the official overnight interest rate unchanged, which should have given the US$ more of a boost than has been the case thus far.


The Expected CPI is now close to the levels at which it has 'troughed' over the past three years, perhaps indicating that inflation expectations have gone almost as low as they are going to go and are about to embark on a new up-trend. A lot will depend, however, on what happens to metal prices. To be specific, in order to drive the Expected CPI below the bottom of its 3-year range the prices of gold and copper will probably have to break decisively below their June lows, but if the June lows for these metals hold over the coming month or so then the Expected CPI's 3-year range should remain intact and bonds will retrace their recent gains.

The Stock Market

Commodity-Related Equities: how low can they go?

Major oil producer Conoco Phillips (NYSE: COP) is trading at around 5-times earnings; in other words, it has an earnings yield (the reciprocal of the P/E ratio) of around 20%. Major copper producer Phelps Dodge is also trading at an earnings yield of around 20%. Gas-production majors Chesapeake Energy and Encana have earnings yields of around 13%, and most natural gas-oriented income trusts now have distribution yields in the 16%-20% range. Rio Tinto and BHP Billiton, the world's two largest mining companies, have earnings yields of 11% and 9%, resp.

Meanwhile, the S&P500 Index has an earnings yield of only 5.5%.

With the major commodity-related equities selling at such low valuations in both absolute and relative terms, how much lower can their stock prices go? In our opinion, not much lower in the absence of a large downturn in the broad stock market.

We think industrial commodities are a few months into a cyclical downturn that will ultimately last about 12 months, but it seems as if this view of ours has already been largely discounted by the stock market. The downside risk in commodity-related equities therefore appears to be significantly less than the downside risk in the commodities themselves. In fact, this week's upward reversal in the Morgan Stanley Commodity-Related Equity Index (see chart below) might be indicating that an intermediate-term bottom is already in place. 

And even if an intermediate-term bottom isn't in place the scene appears to be set for a tradable multi-month bounce in the commodity stocks.


Gold and the Dollar

Gold Stocks

Intermediate-term outlook

...for the anticipated (by us) October-November low in the gold sector to be followed by a major advance, as opposed to just a counter-trend rebound, there will probably have to be an upside breakout by TYX/FVX.

Our view is that the popular gold stock indices -- the HUI and the XAU -- will complete successful tests of their June lows during October-November. Considering that earlier this week the XAU traded within 2% of its June low and the HUI traded within 5% of its June low, if our outlook proves to be close to the mark then the ultimate correction lows for the major gold stocks aren't going to be far below this week's lows.

As things currently stand the main risk to our outlook is that a change in the liquidity trend -- from expanding to contracting -- has not yet been signaled (gold and gold shares are counter-cyclical and tend to do best when liquidity is contracting). It would certainly be possible for gold shares to rebound over the next few months in parallel with a further expansion in liquidity simply because they've become extremely oversold, but to get a rally that ultimately takes the gold stock indices to new multi-year highs there will most likely have to be a major change in the liquidity trend.

As noted in previous commentaries, an early warning signal of such a trend change would be a decisive break above its May high by the TYX/FVX ratio (the 30-year interest rate divided by the 5-year interest rate). As illustrated by the following chart, such a signal is yet to occur.

In other words, for the anticipated (by us) October-November low in the gold sector to be followed by a major advance, as opposed to just a counter-trend rebound, there will probably have to be an upside breakout by TYX/FVX.


While the June lows are important for the HUI and the XAU, the most important support levels reside a few percent below the June lows. To be specific, there is long-term lateral and trend-line support for both of these indices about 5% below their respective June-2006 lows. These long-term support levels are indicated on the following charts.




Short-term outlook

This week's lows in the XAU and the HUI were low enough to constitute tests of the June lows, so there might not be a future opportunity to buy the major gold stocks at significantly cheaper prices. We do, however, think that a drop to marginal new lows will occur within the next 2 months.

Gold and Silver

Sentiment

Current sentiment readings are generally consistent with the idea that the gold price is close to an intermediate-term bottom. For example, over the past week the MarketVane bullish consensus for gold hit a low of 57%, or just 4% above the 2-year low. And this was despite the fact that the gold price, at its worst levels over the past week, was still about 40% above its lowest price of the past two years.

In our opinion, sentiment only becomes a significant factor in a market when there is a substantial discrepancy between the public's perception of the market and the market's price action. A bullish discrepancy of this nature exists right now in the gold market in that the public has become more bearish than would appear to be justified by the price action.

Further evidence of market-bottoming sentiment is provided by the cumulative net cash flow into the Rydex Precious Metals Fund (RydexPM). As illustrated by the following chart, the amount of money invested by the public in RydexPM has just dropped back to the 3-year lows plumbed in June.


One sentiment indicator that appears, on the surface, to be at odds with the view that price is close to an important low is the premium to net asset value (NAV) at which the Central Fund of Canada (AMEX: CEF) trades (chart included below). CEF, which holds gold and silver bullion in approximately equal amounts, ended Wednesday's trading session at a premium of 7.68% to its NAV. Although well down from the 12%-20% premiums at which it regularly traded earlier this year, a 7.68% premium is unreasonably high and suggestive of some stubborn residual optimism on the part of the investing public.

Now, whenever a fund maintains a substantial premium for an extended period people invariably come up with explanations for why the premium makes sense and why it will be sustained. However, premiums ALWAYS end up disappearing. During the second half of last year, for instance, there were many opportunities to buy CEF at a DISCOUNT to NAV; and due to the introduction of the silver ETF in April of this year there is even less reason for CEF to trade at a premium now than there was in 2005.

The main point we want to make, though, is that we don't perceive CEF's current large premium to be in conflict with the view that the gold price is approaching an intermediate-term bottom. This is because during the 2004-2005 correction it wasn't until well after CEF's ultimate price low that its premium to NAV bottomed out. Rather than a lower price it was the dreary multi-month base-building process that followed the price low that ended up draining away the residual bullishness responsible for keeping CEF's premium at an elevated level.

In our opinion, investors will have the opportunity to purchase CEF at a premium of zero within the next 12 months. In the mean time, people looking to gain exposure to gold and silver bullion via the stock market should stick to GLD and SLV.


Current Market Situation

In the latest Weekly Market Update we mentioned that December gold futures had strong resistance at 615-620 and that a rebound at this time would probably end at, or below, this resistance. With reference to the following chart, the equivalent resistance level for December silver is $12.00.


Currency Market Update

The Canadian Dollar dropped to its 200-day moving average last week and then rebounded strongly, thus extending the consolidation pattern that began in May. As illustrated by the following daily chart of December CAD futures, the consolidation consists of a sequence of falling highs and rising lows. A breakout from this pattern would project a move of 3-5 points in the direction of the breakout.

The downward- and upward-sloping trend-lines drawn on the following chart will cross in about 2 months time, so the C$ will breakout of its multi-month consolidation pattern -- one way or the other -- within the next two months.


The above chart of the C$ has a similar look to the charts of the euro and copper futures included in the latest Weekly Update. Each of these markets appears to be coiling in preparation for a quick-fire move in one direction or the other. If we were forced to choose we'd say that the eventual breakouts will be to the downside, but it's definitely a close call. Fortunately, we aren't forced to bet on the directions of short-term moves in currencies and commodities.

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)

First Majestic Resource (TSXV: FR). Shares: 49M issued, 59M fully diluted. Recent price: C$2.55

As noted in our 8th September Market Alert e-mail, when the price of a stock plunges in a reaction to bad news the initial low is usually not the final low. Assuming the company's long-term outlook has not been damaged as a result of the negative development that resulted in the stock-price plunge, what typically happens is that there is a rebound followed by a drop to a new low prior to the start of a sustainable advance.

In FR's case, we said that the normal course of events following the stock's bad-news-related dive to an intra-day panic low of C$2.97 would involve a rebound followed by a drop back to the C$2.50-C$3.00 range. With FR having just dropped to the bottom of the aforementioned range there is now a reasonable chance that the stock's ultimate correction low is close at hand.

The bad news referenced above was, of course, the announcement that the exploration-stage Dios Padre project was probably uneconomic. This news probably justified a haircut of around 10%, so the fact that the stock market reacted by taking the share price down by more than 30% created a good buying opportunity. This type of over-reaction by the stock market is not uncommon, especially in the world of junior resource shares.

In our opinion, the 'investors' who panicked out of FR in the C$2.50-C$3.20 range failed to take into account that the company will be producing silver at the rate of 4M ounces/year before the end of this year and is on track to increase its production to 5M ounces/year by the end of next year. Using average gold stock valuations, which tend to be lower than average silver stock valuations, 4M ounces/year of profitable silver production would justify a market capitalisation of around US$210M, or a price per FR share of around C$3.90. And 5M ounces/year of profitable silver production would justify a price per FR share of around C$5.00. FR is a production story, not an exploration story.

As far as the stock's price performance is concerned, a near-term risk is that the company will almost certainly have to raise money via an equity financing within the next few months. That such a financing is going to happen should be well known and fully priced into the market, but you never know.

The last point we wanted to make is that someone's perceptions of whether the current price of something is cheap or expensive will often be strongly influenced by where the price has been in the recent past. For example, a year ago a gold price of $580 would have seemed very high because gold was, at the time, trading at only $460 and had not traded above $500 in more than 20 years. However, gold at $580 now 'feels' cheap because in the mean time the price has been as high as $725. Similarly, FR now feels cheap at $2.55 because it traded as high as $7 in May, but at this time last year a price of $2.55 would have been viewed as quite high.

While the stock price has been undergoing huge oscillations our valuation has remained relatively constant. For example, during the excitement earlier this year we said we thought FR was fully valued in the C$4-C$5 range on a short- and intermediate-term basis. It subsequently traded about 50% above the mid point of this range, thus creating a good opportunity to take some money off the table. We still think full valuation lies somewhere in the C$4-C$5 range, so with the stock trading about 40% below the mid point of this range we have a buying opportunity on our hands.

FR's oscillations between over- and under-valuation are evident on the following chart. During the manic activity of April-May the stock spiked well above the top of its 3-year channel, whereas it is now trading at the bottom of the same channel.


    Metallic Ventures (TSX: MVG). Shares: 51M issued, 59M fully diluted. Recent price: C$2.10

Early this week MVG announced the results of the independent scoping study on its 1.1M-ounce Goldfield project in Nevada. The results were good and have prompted the company to move the project into the pre-feasibility stage. Specifically, the scoping study completed by AMEC indicates the potential to produce 50K ounces of gold per year at an operating cost, including royalties, of US$294/oz. In our opinion, the scoping study results for this one project justify a stock price of around C$2/share for MVG.

The more important scoping study is the one currently being completed for the much larger (3.9M-ounce) Converse project. The results of the Converse scoping study are expected to be published within the next few weeks.

If the Converse results are also positive then we will almost certainly keep MVG in the Stocks List in anticipation of a doubling in its stock price over the coming year.

    Canarc Resource (TSX: CCM). Shares: 63M issued, 71M fully diluted. Recent price: C$0.76

CCM's New Polaris gold project in British Columbia looks better with each new set of drilling results. For example, the latest drill results included a spectacular intercept of 16.5m grading 23.1gpt of gold (http://biz.yahoo.com/iw/060925/0166439.html).

For anyone interested in accumulating a portfolio of exploration-stage gold stocks, CCM is an obvious candidate for new buying in the C$0.70s.

    Daylight Resources Trust (TSX: DAY.UN). Recent price: C$13.90

Further to the note included in the latest Weekly Market Update, our cost base for DAY.UN (a component of the TSI Energy Trust Index (TETI)) has been changed due to each old share of DAY.UN being replaced, on 26th Sep 06, by: 0.6642 new shares of DAY.UN + 0.0417 shares of Trafalgar Energy (TSX: TFL) + 0.0116 Trafalgar warrants (TSX: TFL.WT). For record purposes we will assume that the TFL shares and warrants were sold 'on market' at Tuesday's closing prices of C$4.17 and C$0.15, resp.

The net result is that our cost base for DAY.UN has increased from C$10.74 (the 14 July 06 closing price) to C$16.00. DAY.UN's weighting in the TETI has been adjusted accordingly.

Note that the TFL warrants expire on 23rd October, so if you own them you should either exercise them or sell them before this date.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
Copyright 2000-2006 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>