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    - Interim Update 29th October 2008

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The Stock Market

Bear Market Comparison

The major decline in the US stock market that began in October of 2007 is part of -- quite likely the first downward leg of -- the second cyclical bear market within the secular bear market that began in 2000, the first cyclical bear market having occurred during 2000-2002. Furthermore, the post-Oct-2007 decline is the second-largest 12-month decline of the past 100 years, even exceeding the decline during the first 12 months of the 1929-1932 stock market collapse.

The past century's largest 12-month decline in the US stock market happened during 1937-1938. Interestingly, the 1937-1938 stock market decline was also the first downward leg of the second cyclical bear market within a secular bear market. And, as is the case with the 2007-2008 decline, it followed a government-sponsored inflation-fueled boom and prompted an unprecedented (at the time) increase in government indebtedness as the incumbent party desperately attempted to prop-up its languishing popularity by mortgaging the future. In 1938 and the years thereafter it was war that provided the justification for a massive increase in government indebtedness and monetary inflation. In the current cycle the justification is being provided by credit contraction, falling house prices and widespread insolvency within the banking industry.

The following chart compares the cyclical bear market of 1937-1942 with the cyclical bear market that began in October of 2007. The chart's vertical axis shows the percentage decline from the major peak and the chart's horizontal axis shows the number of weeks after the major peak.

Note that:

a) 12-13 months after the 1937 peak the market commenced an upward trend that would last about 7 months.

b) The 1942 low (the ultimate low of the 1937-1942 cyclical bear market) wasn't far below the 1938 low in nominal price terms. However, there was massive inflation during 1938-1942, so in real terms the 1942 low was much lower than the 1938 low. In this respect, the relationship between the 1938 and 1942 lows is similar to the relationship between the 1974 and 1982 lows. In both of these historical cases the final bear market low was close to the initial bear market low in nominal terms, but only because inflation masked what was really happening.


The comparison with the late-1930s, when considered alongside the sentiment extremes observed over the past month and the equally extreme policy responses that have occurred to date, suggests that the US stock market has reached an intermediate-term bottom. It also suggests that the market is close to its ultimate bottom in nominal price terms, but probably has a long way to fall in real terms. This is especially so because the government's draconian efforts to inflate its way out of the current mess will elevate prices while ensuring that real savings are not used in the most productive way, thus guaranteeing many years of poor economic performance.

Our guess is that the bear market will end in a few years time with the Dow near its current level in dollar terms and at less than 30% of its current level in gold terms.

Current Market Situation

All sorts of sentiment extremes have been reached over the past month. For example, in addition to the indicators of stock market sentiment that we have noted in earlier commentaries it is significant that consumer confidence in the US, as measured by the Conference Board, was reported this week to have fallen to its lowest level since 1967 (the year when records began). Like all measures of the public's sentiment, the Conference Board's index of consumer confidence is a contrary indicator in that the public is invariably very optimistic near important tops (when pessimism is warranted) and very pessimistic near bottoms (when optimism is warranted). In other words, the all-time low in consumer confidence reported early this week can be added to the pile of sentiment-related evidence that an intermediate-term stock market bottom is at hand.

The market action over the first three days of this week was bullish. As evidenced by the following daily chart of the S&P500 Index (SPX), the US market moved all the way back to its 10th October intra-day low on Monday and then rebounded ferociously on Tuesday. On Wednesday the market was 'choppy' as traders first tried to anticipate, and then reacted to, the Fed's interest rate cut.

There's a good chance, in our opinion, that Monday's decline will prove to be a successful test of the 10th October low and that Tuesday 28th October will prove to be 'Day 1' of a new intermediate-term upward trend. However, we are well aware that ferocious single-day rallies are quite common during bear markets and, therefore, that Tuesday's rally doesn't mean much in isolation. What we now need in order to confirm the upward reversal is a daily close above Wednesday's high (970).


The Commodity Rout

Included below are charts of Freeport McMoran (FCX), the world's largest publicly traded copper producer, and Teck (TCK), one of the world's largest diversified mining companies. These charts are presented to show the extraordinary nature of the downturn in commodity-related equities. Here we have two financially strong large-cap mining companies that have lost more than 80% of their market values within the space of a few months. Notice that the declines were proceeding in a fairly orderly manner until late September, at which point trap doors seemed to suddenly open.

To put what has happened to the commodity sector into perspective, the major commodity stocks have fallen by almost as much in just the past few months as the major tech stocks fell during the course of the entire 2000-2002 bear market. And what makes this even more mind-boggling is that the commodity stocks were not particularly expensive, by traditional valuation metrics, to begin with.




The spectacular decline in the commodity sector reflects a number of market dynamics. For example, the Lehman Brothers collapse in early September resulted in both the quick-fire unwinding of this investment bank's commodity-related positions and the stranding of some commodity-focused hedge funds that had used Lehman as their prime broker. Also, newly introduced regulations preventing the short selling of financial stocks forced short sellers to concentrate on non-financial stocks, and with some commodity-focused funds quite obviously in trouble the commodity sector became an attractive target. Most of all, though, the commodity sector's spectacular decline reflects the massive amount of leverage that had built up over the preceding years. It is now crystal clear that a lot of commodity stocks were owned 'on margin'.

With margin-related selling having driven the prices of most commodity stocks way below fair value, the stage is now set for an impressive rebound.

Gold and the Dollar

Gold

We had expected gold to do much better than it has done over the past two months, but then again we weren't expecting the sort of carnage that has occurred in the commodity and equity markets. Had we thought that a total equity and commodity rout was on the cards then we would not have been short-term bullish on gold. In any case, given everything that has happened gold bullion has held up remarkably well to date. It has pulled back in terms of the US$ and the Yen, the currencies that were desperately sought in order to repay debt, but it has rallied in terms of almost every other currency and has dramatically outperformed industrial commodities and equities.

It looks like some semblance of stability is returning to the financial world, at least momentarily. If this is true then we are probably entering a multi-month period in which gold partially retraces the gains it has recently made relative to most industrial commodities, including silver and platinum. A return to some semblance of financial-world stability would also pave the way for strength in gold stocks relative to gold bullion. 

With reference to the following daily chart of December gold futures, the early-October peak and the late-October trough in the gold price have helped to define a downward-sloping channel. The top of this channel is currently in the high-800s, but the most important resistance is defined by the series of peaks that were made at around $920 during September and October. Gold will have to surmount this resistance to signal the start of a new intermediate-term rally.


Gold Stocks

More evidence that the gold sector has FINALLY bottomed emerged over the first three days of this week. Referring to the following daily chart, the HUI tested last Friday's intra-day low on both Monday and Tuesday before moving sharply higher.

The HUI gained about 30% from Tuesday's low to Wednesday's high. It would not be surprising if a 1-3 day consolidation followed such a large percentage gain, but a strong upward bias should be maintained for at least a few weeks given that the gold sector is rebounding from its most oversold extreme ever. 


Gold stocks should be helped over the next 6 months by improvements in earnings. The third quarter of this year is when gold bottomed relative to oil and, therefore, when the profit margins of most gold miners will have bottomed out. Consequently, the third quarter's earnings (the earnings that are currently being reported) should mark a low point, with significant increases being achieved during the final quarter of this year and during 2009 (assuming that gold only gives back a portion of the gains it has recently made against oil and other commodities). If it does its job properly, the stock market will discount the improved earnings outlook over the next few months.

Currency Market Update

Intermediate-Term Outlook

The US$ has been given a hefty boost over the past several weeks by global de-leveraging and is now pulling back sharply as asset prices rebound and the urgent need for cash abates somewhat. However, the dollar's intermediate-term upward trend against the euro is underpinned by more than just the 'dash for cash'. It is also supported by the higher real interest rates that stem from falling inflation expectations (real short-term interest rates are trending upward even though the Fed is pushing downward on nominal short-term rates), and, perhaps most importantly of all, by the growing awareness of the euro's flaws.

Chief among the euro's flaws, in terms of its ability to compete with the US$ over the long-term, is the lack of a political union to support the currency union. We've been saying for quite a while that as the economic situation across Europe deteriorates in response to the bursting of credit bubbles and the associated property bubbles, there will be a substantial risk that the weakest members of the monetary union will break away in order to re-gain the freedom-to-inflate coveted by almost every political leader. Furthermore, it seems to us that for the ECB to mitigate this risk it would have to gear its monetary policy to the needs of these weakest members. In other words, we see a distinct possibility that the ECB will end up either presiding over a downsized monetary union or becoming so loose as to make the US Federal Reserve look tight. Either outcome would be intermediate-term bearish for the euro relative to the US$.

In addition to the risk of Europe's monetary union coming apart at the seams, it appears that in at least one important respect the European banking system is in worse shape than its US counterpart. According to an article posted at Telegraph.co.uk on 27th October: "The latest data from the Bank for International Settlements shows that Western European banks hold almost all the exposure to the emerging market bubble, now busting with spectacular effect. They account for three-quarters of the total $4.7 trillion (£2.96 trillion) in cross-border bank loans to Eastern Europe, Latin America and emerging Asia extended during the global credit boom -- a sum that vastly exceeds the scale of both the US sub-prime and Alt-A debacles."

Current Market Situation

In the latest Weekly Update we mentioned that a normal correction would take the Dollar Index back to the low-80s. Wednesday's moves in the currency market confirm that a correction is underway.

Below is a daily chart of December Swiss Franc futures. Wednesday's action suggests that a short-term bottom is in place for the SF and potentially sets the stage for a rebound to the resistance that extends from 0.93 up to 0.945.


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)

Western Goldfields (AMEX: WGW, TSX: WGI). Shares: 137M issued, 155M fully diluted. Recent price: US$0.62

The market capitalisations of a number of junior gold/silver miners have recently fallen below the values of their cash in the bank. Furthermore, over the past week the situation became so absurd that the market capitalisation of New Gold (NGD), a mid-tier gold miner, fell below its cash value.

WGW is trading a long way above the value of its cash in the bank, but it is still a very cheap stock on a risk-adjusted basis. Its Mesquite mine in California is in production and is slated to produce 175K ounces/year at a cash cost of $420/oz beginning in 2009 (2008 production is expected to be 117K ounces), which means that the company should be able to achieve a gross margin of around $200/ounce if it can sell its gold at an average price of $700/oz. Applying a relatively conservative multiple of 10 to this cash flow suggests that Mesquite is worth about $350M (175K ounces at $200/ounce gross profit), or US$2.30 per WGW share (based on 150M shares). Moreover, the estimated value per WGW share doubles if we assume that its average sales price will be $900/oz rather than $700/oz.

The risk that WGW will end up getting an average price of less than $700/ounce for its gold is low because 66K ounces/year of WGW's production has been forward sold at $801/oz. This forward sales commitment is a longer-term negative because it caps the upside on almost 40% of the company's production; but it goes a long way towards ensuring that WGW will generate a lot of cash over the coming years, and in the current market environment that is a definite plus. Additionally, with plenty of cash in the bank and plenty of incoming cash from Mesquite, WGW will be in a good position to take advantage of the ultra-depressed prices that exist within the ranks of exploration-stage gold mining stocks. As we've noted in the past, Golden Queen Mining (TSX: GQM) is the most logical target for WGW. By purchasing GQM or another miner with a multi-million ounce development-stage project, WGW could water-down the long-term significance of its gold hedge.

    Crowflight Minerals (TSXV: CML). Shares: 268M issued, 307M fully diluted. Recent price: C$0.145

Emerging nickel producer CML announced early this week that it had taken advantage of the depressed nickel price by monetising the positive mark-to-market value of its forward sales book. The closing-out of 90% of its nickel hedge has allowed CML to repay $43M of debt, leaving a debt balance of only $7.6M, and has injected $19M of cash onto CML's balance sheet. This was an opportunistic and very sensible thing to do as it has resulted in CML becoming a much more financially secure company.

For new buying we continue to prefer gold equities to base metal equities, but those who are holding CML should, in our opinion, continue to hold.

We expect that base metal stocks will rebound with the broad stock market over the next several months, with the majors leading the way and the juniors joining in during the first quarter of 2009.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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