Big Picture View

Here is a summary of our big picture view of the markets. Note that our short-term views may differ from our big picture view.

Bonds commenced a secular BEAR market in June of 2003. (Last update: 22 August 2005)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000. The rally that began in October of 2002 will end during the first half of 2007. The ultimate bottom of the secular bear market won't occur until the next decade. (Last update: 02 October 2006)

The Dollar commenced a secular BEAR market during the final quarter of 2000. The first major downward leg in this bear market ended during the first quarter of 2005, but a long-term bottom won't occur until 2008-2010. (Last update: 28 March 2005)

Gold commenced a secular bull market relative to all fiat currencies, the CRB Index, bonds and most stock market indices during 1999-2001. The first major upward leg in this secular bull market ended in December of 2003, but a long-term peak won't occur until at least 2008-2010. (Last update: 13 February 2006)

Commodities, as represented by the CRB Index, commenced a secular BULL market in 2001. The first major upward leg in this bull market ended during the second quarter of 2006, but a long-term peak won't occur until at least 2008-2010. (Last update: 08 January 2007)

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Outlook Summary

A logical inconsistency of monumental proportions

...the central bank's purpose is NOT to set the price of credit at the CORRECT level... Instead, the main purpose of the central bank is to facilitate inflation by ensuring that the real price of credit remains at an artificially LOW level...

Most economists can readily explain why it would make no sense for a government committee to set the price of eggs. They will tell you, quite rightly, that no committee could ever gather sufficient information and react quickly enough to changing circumstances to ensure that the egg price set by the committee was consistently equivalent to the price that brought supply and demand into balance. They will also tell you, again quite rightly, that the price-setting errors that would inevitably be made by such a committee would create problems in the egg market. Specifically, they will point out that setting the price of eggs too high would create a glut because egg producers would respond to the artificially high price by producing more at the same time as egg consumers were responding to the artificially high price by consuming less; and that setting the price of eggs too low would create a shortage because it would cause producers to cut back at the same time as consumers were trying to take advantage of the low price by ramping-up their buying.

None of this is rocket science. It is, in fact, the main reason why Socialism and its various derivations (Communism, Fascism, Welfare-Statism, Interventionism, etc.) don't work and free markets do work. Strangely, though, when it comes to central banking many of the economists and financial market commentators who claim to believe in free markets dispense with this fundamental logic. They have no difficulty explaining why a central planning agency could not consistently set the correct price of something as simple as the humble egg regardless of how well-intentioned and well-funded this agency happened to be, and yet in the next breath they will argue that a central bank -- a central planning agency responsible for setting the price of something as complex as credit -- is a good thing. In doing so they prove that they are either disingenuous (they don't really believe in free markets at all) or clueless.

As is the case with eggs, when a central planning agency responsible for setting the price of credit (the interest rate) gets it wrong the inevitable result will either be a glut or a shortage of credit, although there is an important difference between the egg market and the credit market. The difference is that the producers of eggs have costs that effectively set a low limit on the selling price at which they will be prepared to produce, but under the current monetary system the main producers of credit -- the central bank and the rest of the financial establishment -- have no such limits (they can create credit/money at zero cost ad infinitum) or have devised ways of getting around any limits (structured finance and the Yen carry trade spring to mind). Therefore, unlike the producers of eggs the main producers of credit have the ability to profitably grow their businesses by ramping-up supply in response to every increase in credit demand spurred by a falling price.

Given that the right price of eggs or credit or anything else is the price that would bring supply and demand into balance, which is, in turn, the price that would be set by a free market, why on earth do we have central banks?

The answer is that the central bank's purpose is NOT to set the price of credit at the CORRECT level (the correct level is where the price would be in the ABSENCE of the central bank). Instead, the main purpose of the central bank is to facilitate inflation by ensuring that the real price of credit remains at an artificially LOW level most of the time. That's why, after several decades of central banking, we have arrived at the point where there is an enormous and unprecedented global glut of credit (sometimes mistakenly referred to as a savings glut).

Incredibly, the logical inconsistency of the self-proclaimed free market advocates who also advocate central banking goes a step further in that every major problem caused by a central bank's intervention in the markets routinely gets trumpeted, by these people, as a reason for even more intervention by the central bank. For example, when a central bank creates a 'boom' by holding the price of credit at an artificially low level for an extended period and the 'boom' turns into a 'bust', as all inflation-fueled booms inevitably must, you can be sure that the 'bust' will be cited as justification for even more central-bank-sponsored inflation. It is akin to a doctor prescribing increased alcohol consumption for a patient suffering from the deleterious effects of alcohol consumption, and would be laughable if it weren't so serious.

Bonds

The Stock Market

Current Market Situation

We don't know whether the problems in the CDO (Collateralised Debt Obligations) market, which are, in turn, linked to the problems in the sub-prime lending market, will eventually have a large adverse effect on the broad stock market. What we do know is that IF the CDO/sub-prime drama is going to evolve into a major stock market problem then signs of stress will appear throughout the stock market well before a large decline occurs. At this stage we are seeing a lot of worrying as evidenced by the low level of optimism indicated by some sentiment surveys, the recent spike in the volatility implied by option prices, and the relatively high level of short-selling on the NYSE (the level of short-selling is well below where it was in early March of this year and slightly below where it was at this time last year, but is high relative to the market's price action); but we aren't seeing any signs of stress outside the sectors that are directly affected by the CDO/sub-prime problems.

Based on the generally positive price action and the way public sentiment towards the US stock market continues to become very fearful whenever the market shows the slightest sign of weakness, we don't expect the S&P500 to do any worse over the next few weeks than drop back to test the resistance identified on the following chart.

There appears to be considerably more short-term downside risk in the stock markets of Asia (ex-Japan) and other emerging-economy stock markets around the world than in the US stock market. The reason is that these foreign markets are where the average US investor has been doing most of his/her new buying. The US public has been indifferent-to-bearish on its own stock market for the past several months, but has directed a lot of money towards mutual funds that invest in emerging market equities.

This week's important US economic events

Gold and the Dollar

Gold Stocks

A Strange Relationship

Even if the following chart-based comparison has no predictive value, it is interesting. At least, we found it interesting, although that might say more about us than about the chart itself.

The comparison in question shows the 9-year performances of Centex (NYSE: CTX), a major homebuilding company that we are using as a proxy for the homebuilding sector of the stock market, and the AMEX Gold BUGS Index (HUI), with the HUI chart lagged by 10 months. The implication is that the bull market in the gold sector has been following along 10 months behind the bull market in the homebuilding sector.

If this strange relationship continues to hold (a big if) and if the homebuilding sector bottoms in July as we recently said it might (another big if), then the correction in the gold sector will end in May of next year (10 months after the July-2007 bottom in the homebuilding sector).

The only reason we are bothering to mention this relationship is that we think May of 2008 is one of the two most likely times for the gold sector's major correction to end, the other being October-November of this year. Furthermore, applying some reverse logic, and again making the big assumption that the relationship implied by the above chart comparison will continue to hold, leads us to the conclusion that the homebuilding sector of the stock market must bottom during the coming month if the gold sector's correction is going to end by May of next year.

One last point worth mentioning before we leave this topic is that the bull market in the US homebuilding sector began during the first quarter of 2000 -- at around the same time that the US stock market bubble was bursting. It was as if the equity market knew that the property market would be a major beneficiary when the Fed eventually got around to doing what it always does during a period of distress (ramp-up the money supply). The point is that the homebuilding sector proved to be more sensitive than the gold sector to the impending change in monetary conditions during 2000-2001 and may well prove to be more sensitive to a similar change during 2007-2008.  

Current Market Situation

With reference to the following chart, the AMEX Gold Miners Index (GDM) has intermediate-term support at 1000 and intermediate-term resistance at 1160. A break below 1000 would confirm our intermediate-term bearish outlook whereas a break above 1160 would invalidate it.

1160 currently seems a long way away, but note that if GDM were to surprise us by rising through 1160 then the bulk of the gains in the major gold stocks, and almost all the gains in the small gold stocks, would still lie ahead. Therefore, even if you disagree with our view that the gold sector is more likely to breakout to the downside than to the upside there isn't a lot to be gained -- and there is potentially a lot to be lost -- by being fully invested at this time in anticipation of an upside resolution.

As far as the next couple of weeks are concerned, the gold sector remains oversold and stands a good chance of rebounding before it moves significantly lower. If there is some near-term strength then those who haven't yet scaled back to a core position should take the opportunity to 'lighten up'.

Gold and Silver

The following daily chart shows that August gold did just enough during the final two days of last week to end the week above support at $650. This means that the gold market ended the week in 'no man's land' (the territory that extends from $650 up to $703). A break below $650 would confirm our intermediate-term bearish outlook whereas a break above $703 would negate it. Oscillations within these boundaries are, in effect, just 'noise'.

In gold's favour, the Commitments of Traders (COT) data is now decidedly bullish. For example, over the past three years the net-long position of small traders in COMEX gold futures has only been as low as it is right now on three occasions: May of 2005, November of 2005, and October of 2006. These were all good times to be buying gold.

The relatively bullish structure of the gold market at this time could support the price for a while, but sentiment alone won't change the trend. Putting it another way, the current lack of interest by small traders means that there will be plenty of fuel to propel the price higher IF the trend changes for some other reason, but the lack of interest won't CAUSE the trend to change. Furthermore, note that if the current correction is of a larger degree than the other corrections of the past several years then sentiment indicators such as the COT report should end up becoming far more depressed than they were at the earlier correction lows.

In the absence of the US$ gold price breaking above resistance defined by the February and April highs, some things that would turn our intermediate-term outlook more bullish include:

a) Further widening of credit spreads

b) Lower REAL short-term interest rates brought about by lower nominal interest rates and/or increased inflation expectations

c) Further weakness in the US$

d) Strength in gold relative to the euro

While gold managed to end last week above support defined by its March-2007 low, silver did not. As evidenced by the following weekly chart, silver futures have broken-out to the downside. This doesn't mean that silver will continue its decline in the immediate future because after having just fallen by 10% over the past 4 weeks the silver market is now oversold. However, last week's action added weight to the intermediate-term bearish case.

Our expectation is that silver will test its June-2006 low before year-end.

The Dollar

With reference to the following chart, the Dollar Index touched trend-line resistance during the week before last and has since pulled back. It closed below its 50-day moving average on Friday, but this sign of weakness was not confirmed by the gold market. As discussed in last week's Interim Update, turning points in the currency market tend to be led by turning points in the gold market.

We don't expect the Dollar Index to do any worse over the coming few weeks than test its April low. On the other hand, it needs to close above its early-June high to signal that a tradable rally is underway.

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)

Northern Orion Resources (TSX: NNO, AMEX: NTO)

The proposed 3-way merger between Yamana Gold (TSX: YRI, NYSE: AUY), Northern Orion Resources (TSX: NNO) and Meridian Gold (NYSE: MDG) announced after the close of trading on 27th June involves, amongst other things, YRI making a conditional all-stock bid for NNO. In response to this 3-way merger proposal we commented: "...we aren't interested in having any exposure to Yamana at this time so we are going to take this opportunity to remove the NNO warrants from the TSI List. For record purposes we will use the average price during today's (Thursday 28th June) trading session as our exit price."

The average price for the warrants turned out to be C$1.87, giving us a profit of 188% based on our February-2005 entry price of C$0.65.

Our C$1.87 exit price was a lot lower than we expected it would be given the initial premium implied by YRI's offer. Unfortunately, for two reasons very little of the initial premium ended up materialising. First, the YRI stock price plunged by 10% as shareholders sold en masse in reaction to the huge dilution that would result from the Meridian component of the 3-way merger proposal. And second, the market discounted the risk that the takeover of NNO would not actually go ahead due to Meridian shareholders rejecting the YRI offer (the offer for NNO is contingent upon YRI gaining control of Meridian).

Our impression may not be accurate, but the way it looks to us is that:

1) NNO's management shopped the company around.

2) YRI's management was interested, but was concerned that such an acquisition would result in a company that was more of a copper play than a gold play (this would be a concern because gold mining companies sell at hefty premiums to copper mining companies).

3) To remove the 'sticking point' mentioned in item 2) above, NNO's management offered to help finance a bid by Yamana for Meridian Gold. The 3-way merger proposal was thus born.

YRI is now very oversold and will probably bounce over the next two weeks assuming that nothing really negative happens to the overall gold sector. If so, this will provide the holders of NNO shares and warrants with a better opportunity to exit their positions. Just to be clear, though, we do think that these positions should be exited in the near future.

The possibility exists that a higher bid will emerge for NNO, but we see this as a long-shot (we previously considered Xstrata to be a likely buyer of NNO, but our guess is that NNO's management approached Xstrata before deciding to do a deal with Yamana).

    USEC Inc. (NYSE: USU). Shares: 87M. Recent price: US$21.98

During April and May we suggested taking PARTIAL profits in uranium enrichment company USU in the $22-$24 range, but we've now decided to make a complete exit from the stock. Based on our January-2006 entry at $11.95 and Friday's closing price of $21.98, our profit was 84%.

We've decided to make a complete exit from USU because we are uncomfortable with the way the company's management is approaching the financing of the $2B enrichment plant currently under construction. In the current financial and commodity market environment the required $2B could be raised with consummate ease at a low cost by issuing debt, or equity, or a combination of debt and equity (with the stock price in the 20s it would make sense to raise at least half the required sum by issuing new shares). However, USU's management seems determined to obtain some form of federal government support (handout), and has even intimated that government assistance will be necessary if the new plant is to be built.

If government assistance is forthcoming then USU's financial position will be strengthened. However, while management is busily trying to paint an unrealistically dismal picture of the company's financial condition in order to qualify for government aid an opportunity is going begging to use the debt and/or equity markets to raise more than enough money at very competitive rates.

    Crowflight Minerals (TSXV: CML). Shares: 234M issued, 276M fully diluted. Recent price: C$0.94

CML, a development-stage nickel miner operating in Canada, has completed a scoping study undertaken to assess the potential to increase production at its Bucko mine from the current design rate of 1000 tonnes per day (tpd) to 1500 tpd. According to this scoping study the expansion would cost only C$8.5M and would increase the annual cash flow from C$100M to C$143M assuming a nickel price of US$12/pound.

Based on the expanded production cash flow stated above and applying a fairly conservative 5-times cash flow multiple, our valuation for CML remains at C$2.50/share using the current fully-diluted share count of 276M (note that our earlier valuations were based on a lower share count and a slightly higher nickel price). We therefore continue to believe that CML is very under-valued at its current price, although some execution risk obviously needs to be accounted for given that the Bucko mine isn't expected to be in production until the 2nd quarter of next year.

We are comfortable with the way CML is progressing and would be buyers of the stock on weakness. Speculators who currently don't own any CML shares should consider taking an initial position near the current price of C$0.94, while those who are looking to add to existing positions could anticipate a drop to the support area shown on the following chart. Note that for CML to drop to this support range there will probably have to be a sizeable sell-off in commodity-related equities or significant additional weakness in the nickel price.

The following nickel chart illustrates the main reason for the recent weakness in CML and most other junior nickel miners. The nickel market has just experienced a bona fide crash, with the nickel price tumbling 33% in 6 weeks. Notice, though, that this crash has taken the price back to support defined by the peaks made between August and December of last year. This could mean that there won't be a lot of additional downside, at least in the short-term.

Our best guess is that nickel is close to a correction low, but that a considerable amount of time (at least 1-2 years) will transpire before this year's peak is exceeded. The thing is, in order for CML to do well over the coming 12-18 months we don't need a higher nickel price; what we need is for the nickel price to not fall much lower and for CML's management to execute its current plans.

Chart Sources

Charts appearing in today's commentary are courtesy of: