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    - Interim Update 30th August 2006

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The property market, the stock market and the economy

...the financial markets do not appear to have gone very far towards discounting the INDIRECT adverse effects of the real estate downturn. ...the Fed's response to the next major economic downturn, whenever it occurs, will involve the large-scale creation of more dollars.

At around this time last year (in the 14th September 2005 Interim Update) we wrote:

"...while there appears to be a lot more downside risk than upside potential in housing and housing-related equities right now, the situation could be very different 12 months from now. For example, if a recession combined with a deflation scare were to take the average house price down by 10% and the average homebuilding stock down by 40%, and if central banks were to react to such a situation in the same way they reacted to the 2001-2002 downturn (it's a virtual certainty that they would), then by this time next year the stage could well be set for another multi-year upward leg in property-related investments."

Since that time the price of the average house has fallen by a few percent and the average homebuilding stock has fallen by almost 50%. Furthermore, most homebuilding stocks are now trading at close to book value, which suggests that there isn't a lot of scope for additional large declines within this sector of the market. So, is the worst over for the US housing market?

We are tempted to say it is given that it is becoming difficult to find any financial commentary or news service that isn't emphasising how bad the residential property market is right now and how much worse it's likely to get in the future. With the negatives now so well known and dire forecasts everywhere isn't it reasonable to assume that the worst is in the past?

The problem is, despite the carnage amongst the housing-related equities the broad stock market has held up remarkably well and there is scant evidence that a major economic downturn has begun. This is a problem because it means that most of the knock-on effects of the real estate downturn -- whatever they may turn out to be -- are yet to be felt. Let's put it this way: we'd certainly be a lot more willing to accept that the worst was in the past if, for example, the US economy was officially in recession, the yield-spread had been in a strong upward trend for several months, deflation fears were dominant, low-quality debt had tumbled relative to higher-quality debt, the copper price had fallen by around 50% from its May peak, the S&P500 Index was trading well below its June-2006 low, and the Fed had begun to openly promote inflation in an effort to stem the tide.

As it is, the DIRECT adverse effects of major downturns in the construction and sale of new homes have probably been almost fully discounted in the prices of homebuilding stocks, but the financial markets do not appear to have gone very far towards discounting the INDIRECT adverse effects of the real estate downturn. And with the housing boom having been such an important generator of US economic activity over the past several years these indirect adverse effects could be substantial. In particular, rising house prices have led to increased spending throughout the US economy by making people feel richer and, via home equity loans and cash-out re-financings, allowing them to treat their homes as ATM machines. Take away this positive force and things could get ugly.

We can't predict, with any real confidence, how ugly things are going to get over the next 6-12 months or even if they are, in fact, going to get lot uglier than they are right now. In any case, there's not a lot to be gained by trying to predict how bad things are going to get. If we make a guess and our guess proves to be close to the mark then we'll have 'bragging rights', but rather than guessing it makes sense to simply watch the stock market for clues.

There's an old saying that the stock market correctly forecasts seven out of every two recessions -- an acknowledgement of the fact that many of the stock market's gut-wrenching declines don't foreshadow anything particularly bad as far as the economy is concerned. However, while the stock market often cries "recession" when there is no recession on the horizon, it never fails to turn down well ahead of an actual recession. In other words, when used as a leading indicator of a major economic downturn the stock market will provide many false positives, but no false negatives. Therefore, let's not don the morose-coloured glasses as long as the S&P500 Index remains above its June low.

One thing we can predict with immense confidence is that the Fed's response to the next major economic downturn, whenever it occurs, will involve the large-scale creation of more dollars. And as long as a supernatural being doesn't repeal the laws of supply and demand we will be prepared to bet heavily that when the Fed does, again, begin inflating like crazy in an effort to overcome the problems caused by previous Fed-sponsored inflation that it will, again, be successful in lowering the value of the US$. This, as discussed in many previous commentaries, is why it makes no sense to be long-term bearish on NOMINAL house prices.

The Stock Market

An interesting chart that's making the rounds

We've included, below, a chart prepared by Merrill Lynch showing a strong positive correlation between the NAHB Housing Index and the S&P500 Index when the S&P500 Index is lagged by 12 months. If the relationship depicted on this chart continues to work like it has worked over the past 10 years then the US stock market is going to trend relentlessly lower over the coming 12 months.


The above chart is interesting and obviously has very bearish intermediate-term implications, but even if the general relationship is still in effect the chart doesn't tell us what to expect over the remainder of this year. In particular, when constructing the chart the Merrill Lynch analyst lagged the S&P500 Index by 12 months, no doubt because doing so created a neat fit, but note that the comparison would look almost as neat if the S&P500 were lagged by 18 months. In the latter case, though, the chart's message would be that the US stock market was going to remain firm for another 6 months, which is perhaps not what the analyst wanted the chart's message to be.

Current Market Situation

...it's possible that too many people have bought into the idea of a major 4-year cycle low occurring within the next few months for such a thing to actually transpire.

Most people think of put/call ratios as being contrary indicators, meaning that they view a high volume of put options relative to call options as being indicative of excessive fearfulness and, therefore, as being bullish on the basis that market participants usually only become excessively fearful near important bottoms. When it comes to equity options this is the correct interpretation, but the opposite applies when it comes to S&P100 (OEX) index options. The difference, we think, stems from the fact that the public (the 'dumb money') is the dominant force in the trading of equity options whereas professional money managers dominate the trading of OEX options. 

Further to the above, extreme highs in the equity put/call ratio tend to coincide with market bottoms whereas extreme highs in the OEX put/call ratio tend to coincide with market peaks.

The below chart shows that the 10-day moving average of the OEX put/call ratio has just hit an extreme high (shown as a low on the chart due to the inverted scale) and that a short-term peak in the stock market has followed closely on the heals of previous similar put/call readings over the past three years. In all but one of the previous cases a stock market correction began within a few days of the OEX put/call ratio hitting an extreme, the one exception being January-2004 (in January-2004 the market continued to move higher for about three weeks following the OEX put/call signal).


The above chart suggests that a pullback should soon begin. However, the sentiment backdrop does not appear to be conducive to a large decline in that most sentiment indicators are revealing a remarkable lack of optimism on the part of the investing public. For example: the amount of public short-selling remains at a high level despite the stock market's rebound, the bullish percentages reported by sentiment surveys are at depressed levels, and the public's demand for bear funds is almost as high today as it was when the stock market was bottoming in June.

Further to the above, it's possible that too many people have bought into the idea of a major 4-year cycle low occurring within the next few months for such a thing to actually transpire.

Our view is that a pullback will begin within the next few days and that this pullback will be followed by a rally to new highs for the year (new highs, that is, for the S&P500 Index, but not for the NASDAQ100 Index).

Gold and the Dollar

The Gold-Oil Relationship

...changes in the oil price are neither here nor there as far as the price of gold bullion is concerned. ...Changes in the oil price do, however, have an important effect on gold mining shares...

If you spend (waste) a lot of time reading or listening to the explanations in the mainstream financial press for why the gold market did what it did on a particular day you will probably come away with the impression that the oil market drives the gold market. For example, whenever gold and oil prices fall on the same day you'll almost certainly see headlines such as "gold follows oil lower"; and whenever both markets rise together there will usually be headlines such as "gold bounces in response to higher oil price".

The idea that the oil price is an important driver of the gold price has also been given weight by the commentaries of the many gold bugs who, over recent years, have often cited the rising oil price as a reason to expect a higher gold price. Some gold bugs even claim, in one breath, that a higher oil price is bullish for gold and then, in the next breath, that gold is money. It seems not to have occurred to them that there's no reason for the demand for money and the demand for industrial commodities to move in the same direction.

On a side note, gold is unfortunately not money right now, but in many respects it still trades as if it were. For example, it typically turns in its best performances when real economic growth and confidence are falling.

When a particular viewpoint becomes entrenched it will often be self-fulfilling in the short-term. For instance, the idea that the widening US trade deficit all but guaranteed a continuing decline in the dollar over the coming 12 months gripped the markets during the final quarter of 2004 and encouraged a lot of speculative 'shorting' of the dollar. Even though it was based on a false premise this speculative 'shorting' had the effect of pushing the dollar down at the same time as interest rate differentials were setting the scene for a US$ recovery. In a similar way, the mistaken view that the oil market is an important driver of the gold market is causing a stronger correlation between the two markets than there should be, which, in turn, reinforces the faulty analysis.

But just as the "dollar is going to plunge due to the widening trade deficit" idea that was so popular at the end of 2004 was eventually overwhelmed by real interest rate differentials (the true fundamental drivers of intermediate-term exchange-rate trends), we suspect that the "oil price drives the gold price" idea that is currently quite popular will, before much longer, be overwhelmed by genuine fundamentals.

In our opinion, changes in the oil price are neither here nor there as far as the price of gold bullion is concerned. Under the current monetary system the directions of the long-term price trends in oil and gold will tend to be the same because inflation is a primary driver of both markets, but it is what's happening on the monetary front, not what's happening with oil supply/demand, that matters to the gold market.

Changes in the oil price do, however, have an important effect on gold mining shares, but it's not the effect that most people would expect. To be specific, as far as gold mining equities are concerned a rise in the oil price is BEARISH and a fall in the oil price is BULLISH. The reason, of course, is that gold miners are major CONSUMERS of oil (a large chunk of a gold miner's costs are energy-related).

In theory, therefore, a comparison of longer-term charts of oil and the AMEX Gold BUGS Index (HUI) should reveal a slight inverse correlation. Fortunately, this is what the following chart comparison of the oil price and the HUI actually does reveal (we say "fortunately" because it's nice when market trends make sense). In particular, the chart shows that:

a) The start of the long-term bull market in gold shares in Q4-2000 coincided, almost to the day, with an intermediate-term PEAK in the oil price

b) The largest percentage gains made by gold shares occurred between Q4-2000 and Q4-2003, a period during which the oil price was basing

c) Oil's upside breakout from its base coincided with the start of a major downward correction in the gold shares

d) Between November of last year and May of this year the oil price and the HUI both surged upward. In light of what happened over the preceding 7 years this action was anomalous, although it simply reflected the fact that the gold price was rising at a faster rate than the oil price during this period (gold was strong enough relative to oil to offset the adverse effects, on the profit margins of gold miners, of higher energy prices)

Of interest, but not shown on the below chart, is the fact that ALL the gains in the major gold shares relative to the gold price were made while the oil price was below $35.


In summary, the oil price does not drive the gold price and the only reason the two markets have similar long-term trends is that they have one important long-term driver in common: monetary inflation. There is, however, an inverse relationship between the oil price and the prices of gold shares, but this relationship only comes to the fore during periods when the oil price is moving sharply lower or sharply higher relative to the gold price.

Current Market Situation

Things have recently been so slow in the currency market it almost seems as though the market has stopped trading. The euro, for instance, has spent the past 4 months oscillating between 1.25 and 1.29 and the past 4 weeks oscillating between 1.27 and 1.29. However, a break in one direction or the other is going to happen soon, perhaps in response to the US Employment numbers due to be announced on Friday morning.

There has also been a lack of action in the gold and silver markets over the past month. Again, though, a breakout in one direction or the other is going to happen soon. With reference to the following daily charts of December gold and silver futures, our thinking is that gold will break upward from its recent consolidation and that silver will move up to near the top of its channel over the next few weeks.




Gold Stocks

The following chart shows that the cumulative net cash flow into the Rydex Precious Metals Fund hit a 3-year low early this week.

The gradual downward trend, over the past few years, in the amount of money invested in the Rydex PM Fund is no doubt partly explained by the introduction of a few ETFs that enable the public to easily gain exposure to gold and gold shares. However, during a bull market for an asset class it's normal for the public's demand for the asset to outstrip any and all increases in supply...right up until the final blow-off. The advent of a few new ways to invest in gold and gold shares therefore doesn't account for why the amount of money invested in gold-oriented mutual funds is as low as it is right now. Rather, we think it boils down to a general lack of enthusiasm towards the gold sector on the part of the public.

The low level of enthusiasm towards gold shares does, we think, reduce the risk that a sharp decline is about to begin and improves the odds of an upside surprise.

We continue to anticipate some additional gains in the gold sector prior to a drop back to test the June low.


In the immediate-term, trading in the gold sector will be dominated by the extraordinary merger announcement made earlier today. What we are referring to is the announcement that Goldcorp (NYSE: GG) will be buying Glamis Gold (NYSE: GLG).

The aforementioned merger news is extraordinary for two reasons. First, Glamis is an incredibly expensive stock and yet Goldcorp's offer is pitched at a 33% premium to Wednesday's closing price. Second, back in December of 2004 Glamis made an offer to buy Goldcorp at a 23% premium (that is, the situation was reversed), an offer that was rejected by Goldcorp. So, Goldcorp previously rejected a merger deal with Glamis that would, it seems, have been completed on vastly more favourable terms for Goldcorp shareholders than the current deal.

In our opinion, today's merger news is terrific for GLG shareholders and terrible for GG shareholders. It could, however, generate some speculative interest in the gold sector.

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: 33M issued, 51M fully diluted. Recent price: C$4.00

FR is our favourite long-term investment in the silver sector. It doesn't have as much upside potential as Sabina Silver (TSXV: SBB) or Apogee Minerals (TSXV: APE), but it's a much larger company than the aforementioned explorers and its success is more assured.

We last highlighted FR as a buy when it was bottoming in mid-June. After rebounding strongly from its June low it has pulled back to just above its 200-day moving average, creating another opportunity to buy the stock at a reasonable price. 


    American Gold Capital (TSXV: AAU). Recent price: C$1.69

We added AAU to the TSI Stocks List in April, primarily to gain a foothold in the Chesapeake Gold (TSXV: CKG) warrants and rights that are going to be issued to AAU shareholders as part of the planned merger of AAU and CKG. CKG's latest quarterly report was released after the close of trading on Wednesday and contained the following update on the merger:

"On March 3, 2006 Chesapeake and American Gold agreed to a business combination of the two companies. Pursuant to the agreement, Chesapeake will issue for everyone (1) outstanding common share of American Gold ( i ) 0.29 Chesapeake Common shares ("Shares"), (ii) 0.145 Chesapeake common share purchase warrants ("Warrants") and, (iii) 0.29 Chesapeake rights ("Rights"). Based on 30,855,525 outstanding common shares of American Gold this would result in the issuance by Chesapeake of approximately 8,948,102 shares, 4,474,051 Warrants and 8,948,102 Rights.

Each Warrant will entitle the holder to purchase one (1) Chesapeake common share at $8.00 for a term of 5 years. Each Right will be exercisable for one (1) Chesapeake common share at $1.00 for a term of five years in the event that the average London PM fix closing trading price of gold for the trading days on such market during any 90 day period is equal to or greater than US$850 per ounce. If the proposed transaction is completed it is anticipated that Chesapeake will have a total of 28,685,897 shares issued and outstanding. Of these shares approximately 68.8% will be held by the existing Chesapeake shareholders and 31.2% will be held by the existing American Gold shareholders. In addition it is anticipated that American Gold shareholders will hold Warrants to acquire approximately 4.5 million additional shares and Rights to acquire a further approximately 9.1 million shares which if fully exercised would represent approximately 53.4% of the then outstanding shares.

Both parties are continuing in their efforts to complete, and expect to be in position to execute the definitive combination agreement between the companies in late August-early September, 2006. The delay in executing the definitive agreement results from the efforts made in evaluating and structuring the proposed transaction to achieve an optimal fiscal outcome from the perspective of both parties and their shareholders.

Once the definitive agreement is executed, American Gold will finalize the information circular for mailing to its shareholders in connection with the holding of a Special Meeting to approve the proposed business combination. It is expected that the meeting materials will be mailed to American Gold shareholders in September for a Special Meeting to be held in October. If the proposed business combination is approved by American Gold's shareholders, the business combination should close in early November, 2006." [Emphasis ours]

Earlier in the same report it was noted that if the proposed merger is completed then "Chesapeake will have approximately $40 million in cash and long term investments, the largest undeveloped gold and silver deposit in Mexico, an advanced Nevada gold project with a mineral resource of over 1.2 million ounces together with a dominant pipeline of exploration and development projects in Mexico."

Chart Sources

Charts appearing in today's commentary are courtesy of:

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

 
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