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    - Interim Update 28th April 2010

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The Stock Market

Intermediate-term US stock market outlook

Market tops (and bottoms) are only identifiable with the benefit of hindsight. In real time, the most we can reasonably do is assess risk versus potential reward.

The following factors should be taken into account when assessing the US stock market's risk and potential reward:

1. Sentiment

Sentiment indicators such as surveys, put/call ratios and volatility indices currently reveal a remarkable lack of concern about downside risk in the market. Sentiment is a contrary indicator (large declines typically begin after investors have been lulled into believing that the risk is minimal), meaning that this particular factor is decidedly BEARISH right now.

2. Valuation

With the exception of the bubble period of 1998-2007, the US stock market has never been more expensive than it is today. This factor is therefore BEARISH.

3. Credit Spreads

Credit spreads (spreads between low quality and high quality debt securities) have generally been contracting since March of 2009, which is bullish. Our view is that credit spreads have become as narrow as they are likely to get, but at this stage there is no evidence of a trend reversal. This factor is therefore still BULLISH, but tenuously so.

4. Monetary Policy and Conditions

The Fed continues to hold its interest rate target near zero and is clearly willing to add money to the economy as deemed necessary to prop-up prices. Also, although TMS's year-over-year growth rate has tapered over the past few months, it is still above 10%. The monetary situation is therefore BULLISH.

5. Inflation Expectations

We consider "inflation expectations" to be bullish for the broad stock market when they are stable at a low positive level or falling from a high level. This factor is currently BULLISH, because inflation expectations are stable at a low positive level.

6. The T-Bond Yield

This factor is bullish when the T-Bond yield is trending downward and bearish when it is trending upward. We think the T-Bond yield will soon embark on a major upward trend, but we would define the current situation as NEUTRAL because an upward trend has not yet been established.

The last and the second-to-last factors are closely related in that most major T-Bond trends are responses to major changes in inflation expectations, but it is appropriate to view the T-Bond yield as a separate factor at this time due to the increasing risk of a direct debt default -- as opposed to an indirect default via inflation -- by the US government.

The above factors, when taken together, point to a neutral intermediate-term outlook for the stock market. However, we are bearish due to our perception of the market's current position within its long-term valuation cycle. Specifically, our perception is that a secular bear market is still in progress, which means that a) we expect the market to make progressively lower lows in REAL terms until it becomes under-valued, and b) we see the potential for the next intermediate-term decline to be much worse than a routine bull-market correction.

Our bearish view is also supported by the "Presidential Cycle", which points to an April peak followed by a downward trend to an October low.

Current Market Situation

Depending on what happens during US trading on Thursday and Friday, this could turn out to be a pivotal week. The reason is that if the S&P500 Index achieves a daily close below 1180 prior to the end of the week it will complete a key reversal to the downside, thus providing us with the first price-related evidence of a top. Just to be clear, up until now we've had a high-risk market environment but no evidence that the upward trend had ended. A daily close below 1180 would provide that evidence.


Hong Kong's Hang Seng Index (HSI) is in a weaker position than the S&P500 Index in that it peaked back in November and appears to have completed a counter-trend rebound earlier this month. A decisive close below 21000 would be the next piece of evidence that Hong Kong's market is rolling over to the downside.

A daily close below 21000 would create a chart-based target of 19500, and a daily close below 19500 would suggest a target of 16000.


Gold and the Dollar

Gold

Gold Versus Currencies

A point we have made numerous times over the years is that gold should NOT be thought of as the "anti US$"; rather, it should be thought of as the "anti fiat-currency". The reason is that gold rises in real terms as the general level of confidence in government-sponsored money declines. If, for instance, investors begin to lose confidence in the US$ but not in the euro and the other major fiat currencies, then gold will probably not fare particularly well in real terms because the decline in the investment demand for dollars will be offset by a rise in the investment demand for other fiat currencies. Only a general decline in monetary confidence can bring about a major advance in the real gold price.

For an historical example of what we are talking about we cite the 1978-1980 period. The biggest US$ gold price rally of the past 200 years extended from the second half of 1978 until January of 1980, and it occurred in parallel with modest STRENGTH in the US dollar's foreign exchange value.

A simple way to monitor how gold is performing in terms of currencies other than the US$ is via the gold/UDN ratio. UDN is a fund that moves inversely to the Dollar Index, meaning that UDN rises as the US$ weakens against the euro and other major currencies. Consequently, if gold did nothing other than rise by enough to offset a decline in the US dollar's foreign exchange value then the gold/UDN ratio would move sideways.

The top half of the following chart shows that gold/UDN is in a strong upward trend and is up by around 73% since the beginning of the financial crisis in mid-2007. The bottom half of the chart shows that gold is up by around 78% in US$ terms over the same period. In other words, almost none of the gains made by gold since mid-2007 can be explained by the change in the US dollar's foreign exchange value.


Current Market Situation

In the statement issued on Wednesday following its 2-day meeting, the Fed expressed confidence in the economic recovery and then demonstrated how confident it really is by reiterating its commitment to keep the overnight interest rate near zero for an extended period.

It should be understood that maintaining an artificially low short-term interest rate does not help the overall economy. Rather, it HURTS the economy by discouraging saving and promoting mal-investment. For example, the fact that there has been no net addition of real (non-government) jobs to the US economy over the past 10 years is largely an indirect result of the Fed's decision to suppress interest rates during 2001-2005.

The artificially low short-term interest rate does, however, provide substantial assistance to the banking industry. Banks get access to free (or almost free) short-term money and then 'invest' this money in Treasury Bonds, thus earning a no-risk spread and repairing their balance sheets at the EXPENSE of the overall economy.

The gold market didn't react to the Fed's decision to leave the "extended period" language in its latest policy statement. This could mean that the market had already priced-in the continuation of the Fed's bank support programme, or that Europe's government debt crisis is trumping all other considerations. In any case, the daily chart of US$ gold futures (see below) continues to evolve in a bullish manner. The December peak will be the minimum target following a decisive break above resistance in the low-$1160s, but the most likely target for the next short-term peak will be $1250-$1300.


Gold Stocks

We have mentioned resistance at 470 as a likely target for the HUI's next short-term peak. As depicted below, resistance actually begins at 460 and extends up to 480.


We are probably either too bullish on gold bullion or not bullish enough on the HUI, because it is difficult to imagine that the gold price could move up to $1250-$1300 while the HUI remains below its December-2009 peak.

Currency Market Update

In our opinion, the relationship between the debt of the European countries that have been grouped under the derogatory acronym "PIIGS" and the global government debt market can be likened to the relationship between US "sub-prime" mortgage debt and the overall US mortgage market. There were a few false starts to the 2007-2008 crash in the mortgage market as most people -- including all central bankers and Treasury officials -- were, for quite a while, willing to believe that the problem was contained within a relatively small section of the overall market, but eventually it became apparent that "sub-prime" was just the tip of the proverbial iceberg. Similarly, and notwithstanding the profuse assurances of officialdom to the contrary, there is a high probability that the problems currently being experienced by Greece will spread and eventually develop into a broad-based government debt crisis.

Because the government debt crisis is beginning in Europe, the euro is likely to be a relatively weak currency for many more months. As noted in an earlier commentary, we expect that the euro (EUR/USD) will trade below 1.20 before this year is over.

The euro will not, however, move lower in a straight line. There will be periods when it seems that the worst is over for PIIGS government debt and when speculators will take profits on their bearish bets. We have recently suspected that such a period was about to begin, but downgrades of Greek and Portuguese government debt on Tuesday set in motion another wave of speculative short-selling and pushed the euro below support defined by its late-March low. Refer to the following daily chart of June euro futures for details.

There is still a decent chance that a short-term euro rebound is about to begin, but traders of currency futures should have been stopped out of euro long positions on Tuesday.


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)

Fortuna Silver (TSX: FVI). Shares: 108M issued, 117M fully diluted. Recent price: C$2.15

The stock market reacted very negatively over the first half of this week to the results of the Pre-Feasibility Study (PFS) for FVI's San Jose silver/gold project. The PFS showed an after-tax Net Present Value (NPV) of only $36M at an 8% discount rate using metal prices of $15.12 and $897 for silver and gold. Also, the annual production forecast contained in the PFS revealed a slower-than-expected ramp-up of the project.

It seems to us that FVI's management is being very conservative and has essentially presented a worst-case scenario in the PFS. Of particular significance, the overall production from San Jose and the rate of annual production growth are likely to be much greater than revealed by the PFS due to the eventual conversion of "inferred" resources to "measured and indicated" status (the PFS only considers the ounces that are presently defined as "measured and indicated", which means that almost half the deposit has been omitted from the current assessment). Also, the 8% discount rate used by FVI is higher than the average rate used by comparable companies (all else being equal, a higher discount rate assumption leads to a lower NPV estimate).

The valuation-based target we have in mind for FVI is C$3.50/share, which is based on the assumption that the company's total annual silver production across its two projects will increase to about 5M ounces over the coming three years. This target is far enough above the current stock price to make FVI a reasonable candidate for new buying.


    Minefinders Corp. (AMEX: MFN). Shares: 66M issued, 74M fully diluted. Recent price: US$10.05

In the 23rd November 2009 Weekly Update we said that MFN, a Mexico-based gold/silver miner, would be fully valued at US$12.00-$13.50. We suggested making a partial exit near its price at the time of US$11.36 and a complete exit if it traded above US$13. The stock ended up peaking below $13 and subsequently pulled back to support at US$9.00-$9.50.

If "full valuation" were still at $12.00-$13.50 then we would probably exit MFN now in order to make way for a stock with greater upside potential, but our valuation-based target for this stock has risen in response to the recently-announced results of a study into the economics of including a mill at the Dolores project. The study showed that a) annual gold-equivalent (gold plus silver) production would increase from 180K to 270K ounces by spending about $160M on a mill, b) the project's NPV (at a 5% discount rate) would rise to around $1.4B at metal prices of $1100/oz and $17/oz for gold and silver, and c) the mill could be in production by the second quarter of 2012.

If debt-financed, the mill addition would increase our valuation-based target from $13/share to $17/share at current metal prices. Also, the increase in production would make MFN look more attractive to acquisitive large-cap gold producers.


    Great Basin Gold (AMEX and TSX: GBG). Shares: 333M issued, 438M fully diluted. Recent price: US$1.82

It has been slow progress for GBG over the past year, but the following chart shows that it has just nudged above short-term resistance at US$1.80. This could be an early warning that a stronger advance is about to begin.

Traders could take a position in GBG near the current price in anticipation of a move up to $2.50-$2.75, using a daily close below $1.60 as the initial 'stop' and switching to a 10% trailing stop after the price closes above $2.00.


    Catalpa Resource (CAH), Dominion Mining (DOM) and Resolute Mining (RSG), our three Australia-listed gold producers, are suitable for new buying near their current prices (A$1.59 for CAH, A$3.01 for DOM, and A$1.21 for RSG).

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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