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TSI Vacation

The Weekly Update will be posted as usual this Sunday (2nd January), after which we will be taking a 1-week break. As a result, there will be no Interim Update on Thursday 6th January and no Weekly Update on Sunday 9th January. However, if something that warrants an immediate comment happens while we are away then we will send out a brief message by email.

We wish you a very successful 2011 and thank you for your support during 2010.

The Stock Market

The Presidential Cycle Model

2011 will be the third year of the US Presidential Cycle, and on average the third year of the cycle is the strongest. As reported by Mike Burk in his free weekly letter:

"Over all years since 1928 the SPX has been up 67% of the time with an average gain of 7.3%. During the 3rd year of the Presidential Cycle the SPX has been up 89% of the time with an average gain of 14.9%. The last time the SPX had a down year during the 3rd year of the Presidential Cycle was also1939 when it lost 5.5%.

The chart below shows the average performance of the SPX over all years in red and average performance during the 3rd year of the Presidential Cycle in green."

The chart displayed above shows that the average third-year performance entails a strong upward trend through to July and then 'choppiness' over the remainder of the year. In other words, it shows that the market not only tends to be strong during the third year, but also tends to make all of its upward progress during the first 7 months of the year.

The stock market's average performance during the Presidential Cycle's third year is undoubtedly one of the reasons why most investors and commentators are optimistic about the year ahead. The question is: given that the current situation is unprecedented in many ways, how seriously should we take a model based on an historical average?

Last year we took the Presidential Cycle Model more seriously than we normally would, due to the fact that it meshed with what we thought was likely based on other considerations. As it turned out, the market followed the cycle average very closely during the first eight months of 2010, at which point it diverged markedly. This year the Presidential Cycle should clearly be viewed as a plus given that the fundamental basis for third-year strength should definitely be in operation (the incumbents will almost certainly take steps to boost prices during 2011 in an effort to create the illusion of a strengthening economy in the lead-up to the 2012 elections). However, we think that other fundamentals stand a good chance of overwhelming the Obama Administration's price-boosting efforts.

Sentiment: as optimistic as it gets?

Most of the sentiment indicators we follow show that the investing public's sentiment is now dangerously bullish. For one example, the TSI Index of Bullish Sentiment (TIBS) ended last week at its highest level since the major market top of October-2007. For another example, the AAII (American Association of Individual Investors) Bull/Bear ratio just hit its highest level since July of 2005 (according to last week's AAII survey, there were about 4 bulls for every bear).

Furthermore, while the public (the 'dumb money') appears to be extremely bullish, the professional money-management community (the 'smart money') appears to be very concerned about downside risk. The pros' concern about downside risk is evidenced by the 10-day moving average of the OEX put/call ratio, which has been incredibly volatile over the past several weeks and has just moved up to the uncommonly high level of 1.87. It is now just below the three highest levels of the past 20 years, which were reached in January-2000, September-2000, and February-2007. Ominously, January-2000, September-2000, and February-2007 were three of the worst times of the past 100 years to be heavily invested in the US stock market.

Now, it should be noted that while important turning points always coincide with sentiment extremes, sentiment extremes don't always mark important turning points (all poodles are dogs, but not all dogs are poodles). For example, the July-2005 extreme in the AAII Bull/Bear ratio coincided with the start of a modest 3-month correction, not an important turning point. Also, while the February-2007 extreme in the OEX put/call was followed by a sharp multi-day decline, a major market top didn't occur until about 8 months later.

The way we look at it, the sentiment picture doesn't definitively point to a negative short-term outcome, but it does suggest that downside risk is relatively high at this time. We therefore think that if you haven't already done so, now is a good time to be de-risking your portfolio by building up cash and shifting into stocks that have relatively small downside risk. Those who are experienced in the field of option trading should also give consideration to protecting core positions via the purchase of put options.

Current Market Situation

Monetary inflation cannot possibly help the overall economy. In fact, it can only hurt. However, it can -- and almost always does -- cause some prices to rise, with the stock market often being one of the first beneficiaries of faster money-supply growth.

The following weekly chart of the NASDAQ100 Index (NDX) illustrates the power of monetary inflation. Despite the US economy being 'in the toilet' and unemployment being well into double digits, the NDX has recouped all of its 2007-2008 losses and is likely to make a new 5-year high in the near future.

If the NDX does move to a new multi-year high it will probably raise the optimism of the 'dumb money' to an even higher level, thus further increasing the downside risk.

While the US stock market has responded extraordinarily well to US$ inflation, China's stock market has responded in a far less impressive manner to much greater Yuan inflation. The Shanghai Stock Exchange Composite Index (SSEC), for example, is currently about 50% below its 2007 peak and now appears to be in the early part of a new intermediate-term decline (refer to the following daily SSEC chart for further details). We suspect that the main reason for the relatively poor response of China's stock market to the rapid monetary inflation of the past two years is that the effects of China's inflation have been concentrated in the real estate market.

Gold and the Dollar

Gold, Silver and Platinum

In previous commentaries over the past few months we referred to platinum as the "weak link" in the precious metals sector. Our view has been that as long as the "weak link" was holding up, the stronger markets (gold and silver) would not be in imminent danger.

In the 17th November Interim Update we said that platinum had quite likely reached an intermediate-term peak in early November, but that it would partially retrace the initial decline from its peak and that this 'retracement' could be accompanied by moves to new highs in gold and silver. Gold and silver subsequently made marginal new highs in early December as platinum rebounded, and at this stage platinum remains in rebound mode.

If platinum's counter-trend rebound is not yet complete, then the rallies in the stronger precious metals very likely have further to go.

This week's new multi-year high in the silver/gold ratio supports the idea that the gold and silver rallies have further to go. The silver/gold ratio remains dangerously extended to the upside, but until it either reverses sharply lower or diverges bearishly from the gold price it will be reasonable to assume that new highs lie in the near future for both gold and silver.

A daily chart of February gold futures is displayed below. Any pullback over the days ahead will probably do no worse than take the price back to the $1390s, although the price could drop all the way down to the December low (just above $1360) without doing major technical damage.

To mitigate downside risk in short-term trading positions, it would be reasonable to place a sell stop just under the December low.

Gold Stocks

Current Market Situation

We have included a daily Stockcharts.com chart of GDXJ (the Market Vectors Junior Gold Miners ETF) below, for two reasons: First, to make the point that the decline from the early December peak has the look of a routine correction within a continuing short-term upward trend. Second, to make the point that Stockcharts.com and most other providers of charts automatically adjust historical prices to account for dividends.

With regard to the second of the above-mentioned points, GDXJ went "ex" a $2.93/share dividend on 23rd December, and yet the chart shows a small rise in GDXJ's price on that day. The reason is that on 23rd December all prices prior to that date were adjusted downward by Stockcharts.com so as to prevent the dividend from creating a large decline that would, in effect, have been artificial. This is the correct way to do it, but it could lead to some confusion in that the pre-23rd-December prices shown on the chart are now different to the actual pre-23rd-December prices. For example, the chart shows that GDXJ peaked at $41.63 in early December, but the actual (non-dividend-adjusted) peak at the time was about $3 higher.

At this stage it looks like the junior end of gold sector, as represented by GDXJ, is going to make new highs during the first half of January, and that the senior end of the sector, as represented by the HUI and the XAU, will do likewise. How high the prices of GDXJ, the HUI and the XAU go before they top out will obviously depend to a great extent on how high the prices of gold and silver go, which is anyone's guess. One realistic possibility is that gold won't achieve much more than a marginal new high (say, $1450), while another is that it will trade as high as $1600 in the near future. Although much less likely, there is also an outside chance that the market will become sufficiently manic over the weeks ahead to take the price up to $2000. The higher it goes, the greater the ensuing correction will be.

A point worth reiterating at this time is that many junior gold/silver stocks will probably reach intermediate-term peaks months AFTER the gold-stock indices peak. The likely pattern involves the juniors declining along with the seniors during the weeks immediately following an intermediate-term top in the HUI, and then rallying to new highs while the HUI rebounds to a secondary (lower) high. For example, if the HUI were to make an intermediate-term peak during the first half of January, it's quite possible that many junior gold/silver stocks would wait until March-April before completing intermediate-term peaks of their own.

Mine Development Risk Profile (MDRP)

A gold -- or any other type of metal -- mining project naturally becomes much less risky after it has been developed to the point where it is not only fully operational, but operating in accordance with its design parameters. However, prior to this point being reached the lowest risk period in a mining project's life is, in our opinion, the period after exploration has uncovered a significant resource and before the project enters the feasibility stage. We refer to this period as the 'sweet spot', because it is the time-window when there is the highest probability of good news and the lowest probability of negative surprises.

The so-called 'sweet spot' is Stage 2 in our Mine Development Risk Profile (MDRP). TSI stocks that are presently in Stage 2 are CFO.V, KGN, SBB.TO and THM.

Stocks often fare poorly during the initial period of production (MDRP Stage 5), but provided that the company gets through this stage without being forced to dilute its stock to oblivion it generally gets a substantial upward re-rating in the stock market upon entering MDRP Stage 6. TSI stocks that are likely to shift from Stage 5 to Stage 6 over the next few months are CAH.AX, GOZ.TO, and MFN. Also, ATN.TO, JAG and RSG.AX have the potential to shift from Stage 5 to Stage 6 in the not-too-distant future.

Currency Market Update

The Dollar Index looks like it could be rolling over to the downside. If so, then support at around 78.5 would be a reasonable near-term target.

Our view is that the Dollar Index made an intermediate-term bottom during the first half of November, which means that we think the November low of 76 defines the maximum downside risk from here.

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)

"January Effect" Candidates

There is a tendency for the US and Canadian stock markets to be strong, and for small-cap stocks to be stronger than large-cap stocks, during the first half of January. This is known as the "January Effect". It results, at least in part, from the tax-related selling of losing stocks prior to the end of December in order to offset capital gains, and the subsequent ploughing of sales proceeds back into the market during January. The effect is more evident amongst the small-caps because these stocks are less liquid.

In general, the best candidates for a "January Effect" rebound are small-cap stocks that experienced tax-loss selling during November-December. With regard to the current members of the TSI Stocks List, that points to Andina Minerals (TSXV: ADM), Atna Resources (TSX: ATN), Duoyuan Global Water (DGW), Fairborne Energy (TSX: FEL), Gryphon Gold (TSX: GGN) and Jaguar Mining (JAG) as probable candidates.

We think that each of these stocks has an attractive risk/reward ratio, but we wouldn't buy any of them solely as a play on the fabled "January Effect". The 2-3 week timeframe for such a trade is too short for our liking. Instead, if we were already planning on buying shares in one of the above-mentioned companies we would be inclined to do at least some of the buying now, thus positioning ourselves to benefit from any "January Effect" that happened to emerge without relying/betting on it.

    Northgate Minerals (AMEX: NXG, TSX: NGX). Shares: 290M issued, 297M fully diluted. Recent price: US$3.16

We mentioned earlier in today's report that this is an appropriate time to de-risk one's equity portfolio. De-risking would generally entail building up cash and favouring lower-risk stocks over their more speculative brethren.

Within the group of junior and mid-tier gold/silver mining companies in the TSI Stocks List, NXG is the stock that we think has the lowest risk at this time. This is due to its spread of mining assets in politically secure regions (Canada and Australia), its strong balance sheet, and its relatively low valuation. It is also due to the weekly price chart inserted below, which reveals that NXG has been in consolidation mode for the past year and is close to its 50-week moving average. In other words, NXG is not remotely close to being 'overbought'.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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