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    - Interim Update 30th June 2009

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TSI Schedule Change

This report has been posted a day earlier than originally scheduled. This is partly because public holidays in both the US and Canada (the US markets will be closed on Friday and the Canadian markets will be closed on Wednesday) mean that there will be less trading than usual during the second half of the week, and partly because we didn't publish a Weekly Update at the beginning of the week.

California

The US federal Government has been spending far more than it earns (steals) for a very long time, and, as a result, the amount of its debt is now close to the entire nation's GDP. Moreover, its debt is expanding at an accelerating pace. And yet, it has no difficulty finding buyers for its bonds at low single-digit interest rates. Nor is it concerned enough about its financial predicament to seriously contemplate cutting back on its expenses. On the contrary, it is rapidly increasing its expenses.

The federal government can act the way it does and still find eager buyers for its debt because its access to money is, in effect, unlimited. Regardless of how burdened with debt its balance sheet becomes, the US federal government will always have access to the Federal Reserve's "printing press". It will therefore never be in the position where it is forced to directly default on its obligations. State governments, however, do not have the power to expand their obligations ad infinitum. A state government that consistently spends more than it rakes in can end up in the position of having to cut back on its expenses and/or directly default on its debt. This is the position in which the government of California now finds itself.

California's government has essentially run out of cash and is facing a $24B deficit over the coming fiscal year. Unlike the market for US Treasury Bonds, the market for bonds issued by the State of California is limited by the general perception of the State's ability to generate sufficient revenue in the future to cover interest and principal payments as they become due.

We aren't experts on California's financial situation, but detailed knowledge is not required to understand that one or a combination of the following is going to happen:

1. In an effort to bring its expenses into line with its income, the government of California will shrink in size by eliminating some state-run operations and by making others more efficient.

2. The government of California will sell-off some of its assets.

3. There will be increases in state taxes and other charges.

4. There will be a bailout by the federal government.

Given that the federal government has already bailed out private financial corporations and auto companies, a federal bailout of California -- which would amount to giving California's state government access to the Fed's printing press -- is a likely outcome.

With regard to bailouts it's important to understand that the federal government doesn't have surplus financial resources that can be drawn upon to support troubled corporations and state governments; rather, the bailouts involve the diversion of resources from some parts of the economy -- via taxation, borrowing, or monetary inflation -- to other parts of the economy. It's all about robbing Peter to pay Paul in the hope that Paul will return the favour at the next election while Peter won't realise, until much later, that he has been robbed.

California's economy is bigger than the economies of all except the largest countries, so bailing out the government of this state would likely require a huge amount of new money. Furthermore, a California bailout would set a precedent in that it would be hard to justify federal assistance to one state and deny it to another state that happened to be in a similar predicament. Consequently, if the US federal government chooses to use its unlimited powers of money creation to bail out California's state government it will constitute another hefty blow to the overall US economy and put another nail in the coffin of the deflation thesis.

Bond Market Update

By breaking above resistance defined by the downward-sloping channel drawn on the following daily chart, the September T-Bond futures contract has provided preliminary evidence that an intermediate-term bottom is in place. More important resistance lies at 122.50.

Although we are short- and intermediate-term bullish on T-Bonds we will be surprised if resistance at 122.50 is decisively breached within the next few weeks. Based on the way previous intermediate-term bottoms have formed in this market it is likely that the aforementioned resistance will limit the initial rally from the June low, and that the June low will be tested prior to the start of a multi-month upward trend.


The Stock and Commodity Markets

Shades of 2008

The performances of the stock and commodity markets over the past several months have been remarkably similar to their performances during the same period of last year (although at much lower price levels, of course). To illustrate what we mean we have included, below, a chart comparing the S&P500 Index (SPX) with the oil price. With reference to this chart, notice that oil began to power upward in February of 2008 and was later joined in its upward journey by the SPX. The SPX subsequently peaked in May while the oil price continued to defy gravity until July, after which both markets plunged in unison. As was the case last year, oil began to rally in February of this year and was joined the following month by the SPX.

There are tentative signs that the SPX's rebound is over, but there is not yet any evidence that the oil market has reached its ultimate rebound peak. If the similarities with last year persist then oil should peak during July.


The correlation between the stock and commodity markets evident on the above chart extends to the currency market. In particular, the following chart reveals a positive correlation between the Canadian Dollar and the oil price.

It is not surprising, or even especially interesting, that an intermediate-term positive correlation has existed between the oil price and the currency of a major oil producer (Canada). Of greater interest is that the C$ has tended to LEAD the oil price at intermediate-term turning points over the past couple of years. For example, the C$ turned down well ahead of the oil price during May-July of 2008 and turned up well ahead of the oil price during the final quarter of 2008. This lead-lag relationship suggests that oil should peak within the next few weeks IF the C$ peaked at the beginning of June (we think it did).


There's a good chance that the inter-market relationships that have been in force over the past 1-2 years will remain in force over the coming months. In other words, if intermediate-term peaks are in place for the SPX and the C$ then an intermediate-term peak for the oil market is probably either in place or close at hand. However, we don't think it is reasonable to expect that this year's market action will continue to mimic last year's. There are two reasons for this:

First, we do not have the sentiment extremes today that we had at this time last year. For example, during June-July of 2008 the Market Vane bullish percentages for many commodities, including oil, copper, and natural gas, were in the 80s or 90s, whereas they are currently all well below 50 (oil is at 39, copper is at 45 and natural gas is at 22). Furthermore, at around this time last year the bullish percentage for the Dollar Index was in the 'teens', whereas it is presently 50. In other words, while market sentiment was extreme at around this time last year (the financial world was exuberantly bullish on all things commodity-related and frothing-at-the-mouth bearish on the US$), today it is neutral.

Second, history never repeats itself in such a predictable manner because the nature of markets is to keep the majority of participants guessing most of the time. By way of further explanation, if the markets continue to follow last year's pattern for another month or so then a lot of people will begin to anticipate a repeat of the September-November crash, which, ironically, will preclude such an outcome because markets never crash when the majority is prepared for a crash. To put it another way: when the public positions itself for a particular market outcome it changes (lowers) the probability of that outcome.

Our view is that the downside risks for the stock and industrial-commodity markets exceed their upside potential by a sizeable margin on both a short- and intermediate-term basis, but aside from not expecting the sort of drama that occurred during the second half of last year we don't pretend to know the paths that these markets will follow over the months ahead. 

Gold and the Dollar

Gold

The most recent Commitments of Traders (COT) report showed a total speculative (large speculators + small traders) net-long position in COMEX gold futures of 195K contracts. Although this is about 30K less than at the early-June peak and about 60K less than at last year's peak, it is still quite high. In the gold market the speculators are usually correct about the intermediate-term trend, but when they become very positive about gold's prospects the short-term downside risk increases due to the potential for a price decline to be magnified by the liquidation of speculative long positions.

In our opinion, a likely outcome is that gold's performance over the next few months will be a less-dramatic version of what happened during July-October of last year. It's a good bet that many speculative long positions in the gold futures market are predicated on expectations of US$ weakness, so if the US$ defies these expectations and begins to trend higher then some gold 'longs' will run for the exit. As a result and as was the case last year, the INITIAL leg of a US$ rally will probably be accompanied by weakness in the gold price. It's unlikely that the weakness will be anywhere near as pronounced as last year, though, because gold's performance from November-2008 through to February-2009 proved that in times of stress the dollar's foreign exchange value is not the dominant influence on the gold market, and because the next round of market-wide de-leveraging should be less frenetic than the previous round.

Turning to the short-term price action, the following daily chart of August gold futures shows that the rebound of the past week was capped by the 18-day moving average and resistance at $940. A solid daily close above $940 would project a move up to around $980 while a daily close below $915 would project a move down to around $880.

We suspect that gold will remain within the $880-$980 range over the next 1-2 months.


Gold Stocks

In last week's Interim Update we said: "The most likely short-term outcome continues to be that the HUI will rebound for a few weeks, retracing 50%-70% of its preceding decline in the process, before dropping back to the vicinity of its 200-day moving average."

A 50%-70% retracing of the June decline would take the HUI back to 360-380. When it traded at 362 last Friday it had therefore already achieved our minimum expectation in terms of price, but at that point the rebound was only 4 days old. It would be unlikely for the rebound to end that quickly, so the current pullback will probably be followed by another move into the 360-380 range. This would, we think, set the stage for the second -- and likely final -- downward leg in the correction that began on 1st June.


We continue to believe that the gold sector will gain a lot of ground over the next few years and that investors should therefore look for opportunities to buy gold stocks near their 200-day moving averages over the next two months. Specific buy zones for three of our favourites (MFN, NGD and NXG) were noted in the 22nd June Weekly Update.

Currency Market Update

The following chart shows that the Dollar Index has support at 78 and resistance at 82.5. The dollar's resistance at 82.5 is similar to the T-Bond's resistance at 122.5 and probably won't be surmounted during the initial rebound from the June low.


We use the Baltic Dry Index (BDI), an index of ocean freight rates, as an intermediate-term currency market indicator. The reason is that important turning points in the BDI tend to coincide with, or follow, important turning points in the US dollar's exchange value (BDI peaks tend to coincide with US$ troughs and BDI troughs tend to coincide with US$ peaks). This rather strange relationship probably exists because investment gets drawn towards the higher-growth regions of the world during periods when global trade is on the rise, and then retreats to the perceived safety of the US during periods when global trade is on the decline.

The BDI's current situation is quite interesting. As illustrated by the following chart, it topped at the beginning of June and subsequently tested its June peak. This opens up the possibility that a small 'double top' is in the process of forming, which is interesting because similar price action occurred at the Q4-2007 and Q2-2008 intermediate-term peaks.

The BDI must now move below its early-June low to confirm a trend change and support our view that the US$ has bottomed. Alternatively, if the BDI moves above its June peak it will cast some doubt on our bullish US$ outlook.


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)

Red Hill Energy (TSXV: RH). Shares: 52M issued, 63M fully diluted. Recent price: C$0.50

RH, an exploration-stage Mongolia-based coal miner, announced about two weeks ago that it had arranged to sell its Ulaan Ovoo coal project for US$30M (C$34M), with the money to be paid in stages over a few years.

In our opinion this is a reasonable deal. It provides the company with more than enough cash to fund its exploration activities for a long time to come without diluting the stock, and leaves the company with the massive in-ground coal resources (819M tonnes in the measured-and-indicated category) at its Nyalga coal basin projects. Moreover, the agreed sale value for Ulaan Ovoo is more than RH's current market capitalisation.

In the 11th May 2009 Weekly Update we wrote:

"RH would be a reasonable speculation below C$0.50/share, but in the current environment and at current share prices we prefer exploration-stage uranium miner Khan Resources (TSX: KRI) to RH. We are comparing RH to KRI because both companies operate in Mongolia, a high-risk country. We prefer KRI to RH at current prices because KRI has a much stronger balance sheet (a lot more cash) and because we are more bullish on uranium than coal."

Although RH's balance sheet will be strengthened when the recent deal is consummated, we continue to prefer KRI because we are much more bullish on uranium than coal. However, given that the stock market is now valuing RH's 820M tonnes of in-ground coal at less than zero it is clear that the stock's upside potential is vastly greater than its downside risk.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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