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   -- Weekly Market Update for the Week Commencing 4th June 2007

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

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Neutral
(16-May-07)
Bearish
(21-May-07)
Bullish

US$ (Dollar Index)
Neutral
(04-Jun-07)
Bullish
(31-May-04)
Bearish

Bonds (US T-Bond)
Neutral
(26-Mar-07)
Bearish
(26-Mar-07)
Bearish

Stock Market (S&P500)
Bearish
(16-May-07)
Neutral
(26-Mar-07)
Bearish

Gold Stocks (HUI)
Neutral
(16-May-07)
Bearish
(21-May-07)
Bullish

OilNeutral
(12-Mar-07)
Neutral
(
25-Sep-06)
Bullish

Industrial Metals (GYX)
Neutral
(15-Jan-07)
Neutral
(26-Mar-07)
Bullish


Notes:

1. In those cases where we have been able to identify the commentary in which the most recent outlook change occurred we've put the date of the commentary below the current outlook.


2. "Neutral", in the above table, means that we either don't have a firm opinion on which way the market will move or that we expect the market to be trendless during the timeframe in question.

3. Long-term views are determined almost completely by fundamentals, intermediate-term views by giving an approximately equal weighting to fundmental and technical factors, and short-term views almost completely by technicals.

The industrial metals relative to gold

...as long as the demand for credit is strong enough to keep short-term interest rates in a rising trend and investors, as a group, remain confident about the prospects for global growth, the industrial metals markets should do fine.

We've included two charts below that highlight the main difference between gold and the industrial metals. The difference we are talking about can be described as follows:

Gold is not money anymore in the true meaning of the word (gold is not the general medium of exchange), but in many respects it acts as if it were still money. In particular, when economic growth is slowing and economic confidence is falling the demand for money tends to rise, as does the demand for gold, while the demand for credit tends to fall. (Note that rising demand for credit indicates rising demand for the things that people want to buy with borrowed money; it does not indicate rising demand for money.) In theory, therefore, gold should do well relative to the industrial (non-monetary) metals when short-term interest rates are falling and when growth-oriented investments are faring poorly, and vice versa. The following charts show that this is, in fact, exactly what happens.

The first of our charts is a comparison between the copper/gold ratio and the yield on a 2-year Treasury Note, with copper/gold lagged by 6 months. The chart's message is that trends in the copper/gold ratio have, over the past 13 years, followed trends in short-term interest rates with monotonous regularity. Specifically, when short-term interest rates begin to trend higher then about 6 months later copper begins to trend higher relative to gold; and when short-term interest rates begin to trend lower then about 6 months later copper begins to trend lower relative to gold (gold begins to out-perform).

It is quite possible that new intermediate-term trends got underway last year when a downward reversal in the 2-year interest rate in May was followed, about 6 months later, by a downward reversal in the copper/gold ratio. However, the 'global growth theme' appears to have got its second wind in March of this year, causing the 2-year interest rate and the copper/gold ratio to move back to near last year's highs.

If the 2-year interest rate moves above last year's high -- something that will probably only happen if the stock market rally continues for another 1-2 months -- then new highs in the copper/gold ratio should follow. On the other hand, a move below 4.5% by the 2-year interest rate would suggest that we had entered a multi-year period of strength in gold relative to copper.


The second of our charts compares the BSE/gold ratio (the Indian stock market in gold terms) with the GYX/gold ratio (the Industrial Metals Index divided by the gold price). The Indian stock market is being used here as a proxy for the global growth theme.

The chart's message is that when investors are bullish on global growth the industrial metals will out-perform gold (the GYX/gold ratio will trend upward), but gold will become relatively strong during periods when growth expectations are receding.


To summarise: as long as the demand for credit is strong enough to keep short-term interest rates in a rising trend and investors, as a group, remain confident about the prospects for global growth, the industrial metals markets should do fine. However, the downside risk in the non-monetary metals will increase exponentially once stock markets around the world commence their next intermediate-term corrections.

Interest Rates

Bonds

The following weekly chart shows that T-Bond futures broke below their January low last week and closed at their lowest level since last August. Importantly, the breakdown in the US bond market was confirmed by a similar breakdown in the Japanese bond market.

Last week's action suggests that the June-2006 bottom will be tested within the next few weeks.



As far as the coming 6-12 months are concerned we continue to believe that there's a lot more downside risk than upside potential in the bond market. However, if T-Bond futures were to drop back to near their May/June-2006 lows at some point over the coming three weeks then the stage would be set for a 1-3 month rebound. This is because the bond market often reverses direction during May-June and because sentiment indicators are starting to become supportive of bonds. On this latter point, the Commitments of Traders (COT) data show that Commercial traders are now net-long the combination of T-Note and T-Bond futures by a significant margin (accounting for the difference in contract size between T-Note futures and T-Bond futures, Commercial traders have gone from being net-short the equivalent of 35,000 T-Bond futures contracts on 15th May to being net-long the equivalent of 93,000 contracts on 29th May).

In summary: we are anticipating an upward reversal this month, but the reversal will probably occur at a lower level.

Short-Term Interest Rates

The recent breakdown in long-dated bonds was interesting and potentially significant, but the action at the short-end of the market has been even more interesting. What we are referring to is the extraordinary divergence since mid March between the yield on a 3-month T-Bill and the yield on a 2-year T-Note, with the 3-month yield falling from 4.85% to 4.55% in parallel with a rise in the 2-year yield from 4.55% to 4.97%. The following chart illustrates the divergence.

We are confident that the Federal Reserve is not the driving force behind the recent strange decline in the 3-month interest rate. The way we see it, the Fed is concerned that the 'inflation genie' could soon escape from the bottle and would almost certainly prefer the 3-month yield to be where it would normally be: near the Fed Funds rate target (currently 5.25%).

For its part, the Fed has been doing what it needs to do to keep the effective Fed Funds rate near the official target rate -- adding reserves to the banking system whenever the actual rate moves above the target rate and removing reserves from the banking system whenever the actual rate falls below the target rate -- and is, we suspect, a little miffed that the market has pushed the 3-month interest rate down to the point where it is trading at a 70 basis-point discount to the Fed Funds rate.

In other words, we don't think the Fed is fighting its own monetary policy.

We are also confident that the market's anticipation of Fed rate cuts is not the reason for the 3-month interest rate being at such a low level relative to the Fed Funds rate. This is because the December-2007 Fed Funds Futures contract is currently priced as if there were almost no chance of an official rate cut before year-end. In fact, as the 3-month T-Bill yield has declined from 4.85% to 4.55% over the past 2.5 months the December-2007 Fed Funds Futures contract has gone from discounting two 25 basis-point rate cuts to discounting no rate cuts.

So if the T-Bill discrepancy is not the result of meddling by the Fed or the market's anticipation of future Fed rate cuts, then what's causing it?

One explanation worth considering is that T-Bill yields have been pushed downward in response to a temporary supply shortage, which, in turn, has stemmed from higher-than-expected tax revenues (the higher the tax revenue the lesser the quantity of new T-Bills issued by the Treasury). That is, an unexpected fall in T-Bill supply due to the actions of the US Treasury could theoretically have caused T-Bill prices to rise and T-Bill yields to fall. We don't favour this explanation, though, because we suspect that under such a scenario there would be temporary downward pressure on the yields on all short-dated Treasury securities, not just T-Bills.  

In our opinion, the Yen carry trade is the most plausible explanation for the recent anomalous decline in T-Bill yields (and many of the other strange happenings in the financial world over the recent past). We doubt that it's a coincidence, for example, that the dramatic divergence between 3-month and 2-year interest rates since mid March has been accompanied by a relentless slide in the Yen. With credit spreads having shrunk to almost nothing, perhaps carry traders have begun to direct a greater proportion of their Yen borrowings toward one of the world's lowest-risk and most liquid markets -- the market for 3-month US Treasury Bills.


The Stock Market

Current Market Situation

We have again included a chart comparison of the S&P500 Index and the euro/Yen exchange rate in today's report (see below), because as far as the stock market's short-term trend is concerned it continues to seem as if euro/Yen is the only thing that really matters. This past week, for example, the euro hit a new high relative to the Yen, thus enabling the S&P500 to ignore a sharp correction in China's stock market and end the week at a new high of its own.

One of the reasons we can't embrace the stock market's relentless advance is that we expect the Yen to soon reverse course against both the euro and the US$. But at the same time, we aren't keen to step in front of this fast-moving train.

Betting against the stock market's advance doesn't interest us at this time because there is no evidence that a downward reversal has occurred or is imminent, but in our opinion the downside risk is high relative to the upside potential. We therefore think it is a good time to be hedged -- either by holding a larger-than-usual cash reserve (our preference) or by purchasing some put options. As discussed in a previous commentary, there's a big difference between betting that the market is going to decline and taking out some insurance in case it does decline.


A risk facing the stock market that we've mentioned quite regularly over the past few months is the risk of a breakdown in the bond market. The stock market ignored last week's move to new 9-month lows by bond futures, but falling bond prices always have an adverse effect on stock prices in the end; at least, they always have in the past.

Another risk -- one that was 'brushed off' last week -- is that China's stock market bubble will soon burst. China's Government has sent a clear message that it will do whatever it takes to halt the stock market's parabolic rise, so we can be sure that if last week's small (0.2%) increase in the tax on share transactions doesn't work then something else will be tried. A large decline in China's stock market would take a toll on the US stock market, although it would probably take a bigger toll on emerging market equities and industrial metals.

This week's important US economic events

Date Description
Monday Jun 04
Factory Orders
Tuesday Jun 05ISM Services
Wednesday Jun 06 Q1 Productivity
Thursday Jun 07 Consumer Credit
Friday Jun 08 Trade Balance

Gold and the Dollar

Reactions to economic news

One of our tenets is that trends never change in response to economic news, but the way a market reacts to news can provide useful information about its underlying trend.

Taking the topical example of the Monthly US Employment Report, a strong jobs-growth number is generally perceived to be supportive for the US$ because it supposedly puts upward pressure on US interest rates. A US$ bounce in the wake of an employment report that revealed a stronger-than-expected increase in payrolls would therefore be 'par for the course' and would tell us very little about the dollar's underlying trend. However, failure by the US$ to bounce in the wake of good news on the job front would be evidence that the dollar was in a downward trend. Along similar lines, if the US$ were to move higher in the wake of a much weaker-than-expected employment number it would be a sign that the dollar was in an upward trend.

The most recent US Employment Report was released last Friday and showed a larger-than-expected increase in non-farm payrolls. However, the US dollar's reaction to this bullish news -- irrelevant news, actually, but as noted above a strong US jobs-growth number is generally PERCEIVED to be 'dollar bullish' -- was unimpressive in that the knee-jerk gain in response to the news was quickly given-up. This suggests to us that the dollar's short-term trend has not yet reversed direction (from down to up).

We turned short-term bullish on the US$ in late April because we thought that a) the downside risk was small, and b) an upward reversal would probably happen within the ensuing few weeks. We still think the downside risk is quite small (2-3 points), but prior to Friday the rebound from the late-April low already looked suspiciously like a consolidation within a downtrend rather than the initial rally in a new up-trend. The Dollar Index had, for instance, laboured for about 5 weeks just to get back to its 50-day moving average and the first line of lateral resistance (refer to the following chart for details). Then came Friday's failure to sustain an advance in response to bullish news.

Further to the above, the Dollar Index is still trading like it is in a downward trend. We don't perceive much downside risk, but we can no longer justify a short-term bullish view.


Gold Stocks

Re-visiting the late-60s model

Below is an updated version of our chart comparing the Barrons Gold Mining Index (BGMI) of the late-1960s with today's AMEX Gold BUGS index (HUI). The chart lines up the March-1968 peak in the BGMI with the May-2006 peak in the HUI, and suggests that we are now at the equivalent of April-1969. If this model is valid then the HUI will trade in the 325-355 range over the coming few weeks and then commence a major decline during July.


Note that our intermediate-term bearish outlook for the gold sector is not based on the late-60s model. However, the model is consistent with our outlook, and, as previously discussed, we think the overall financial environment at this time is analogous to the late-1960s in a number of ways.

We will potentially be able to use the model as a roadmap assuming an intermediate-term bearish scenario actually does play out. We will also be able to use it as an indicator that something other than an intermediate-term bearish scenario is playing-out. With regard to this latter use, a daily close by the HUI above its April-2007 high at any time over the next few months would represent a definitive departure from the late-60s model. We would interpret such an event as evidence that the gold sector had commenced a new upward leg in its long-term bull market.

For interest's sake and because today's financial scene resembles the late-1960s, we thought we'd take a look at how the US stock market performed during 1968-1970.

The following chart shows that the Dow Industrials Index was strong from March of 1968 through to May of 1969, but then embarked on a major correction lasting 12 months. If we are presently at the equivalent of April-1969, as the above BGMI-HUI comparison suggests, then the US stock market will commence a large decline in July.


Current Market Situation

With reference to the daily chart of the AMEX Gold Mining Index (GDM) included herewith, notice that the rally from early October through to the beginning of December last year has been followed by 6 months of back-and-forth trading within a narrowing range. 6 months of essentially going nowhere has undoubtedly caused many gold share investors to become frustrated, especially since other sectors of the stock market have been in strong upward trends over the same period.

The feelings of frustration would have eased slightly during the second half of last week because the gold sector, which had become very oversold, rebounded on Thursday and Friday the way a beach-ball held underwater would rebound upon removal of the force holding it down. We think this will prove to be a counter-trend rebound, but if we are wrong then the market will let us know by taking GDM and the other gold stock indices above their April highs. The April highs are less than 10% above Friday's closing levels, so the indices won't have to do much to negate the bearish scenario.

There's little to be gained and potentially a lot to be lost by fighting for the first 10% of a major rally, particularly in a case like this where a decidedly bearish intermediate-term scenario could be brewing. Let the other guy have the first 10%. 


Gold

As evident on the following daily chart of June gold futures, the gold price rebounded during the final two days of last week.


News that the ECB doesn't intend to sell any more gold between now and September might have contributed to last week's rebound. However, we think the gold selling conducted by the ECB under the Washington Agreement is vastly over-rated in terms of its effects on the gold price (it draws a lot more attention than it deserves).

The ECB sold significantly less gold last year than it was entitled to sell under the Washington Agreement and has also parted with significantly less gold this year than it could have done had it maintained the run-rate implied by the Agreement (about 40 tonnes per month). Based on Friday's announcement it seems that the pace of selling is going to be reduced even further, however this is not the sort of development that will have a meaningful impact on gold's price trend. There will invariably be knee-jerk reactions to news such as this, but gold's trend is not determined by, or even strongly influenced by, the ECB's bullion-related operations.

Our intermediate-term outlook for gold turned bearish a couple of weeks ago for the reasons outlined in the 21st May Weekly Update. Based on the evidence as we see it, we strongly believe that a sombre intermediate-term view of the gold market is appropriate at this time; however, if we are wrong it will probably be because the inevitable ill-effects of the past year's massive monetary inflation -- the supplies of 18 of the world's top 20 currencies are expanding at double-digit rates -- rise to the surface earlier than expected.

Our short-term outlook, on the other hand, is less certain, and the bounce during the final two days of last week has unfortunately not added any clarity.

Last week's rebound began from above the March low, meaning that gold hasn't yet made a lower low to 'lock-in' a downward reversal in its short-term trend. Also of note is that a typical counter-trend rebound will retrace about half the preceding decline, which as far as June gold is concerned would involve a move up to around $675 (a level that happens to coincide with some lateral resistance and the 50-day moving average). At this stage, therefore, gold's rebound from the 650s to the low-670s has not done anything to negate the possibility that the short-term trend has reversed downward.

As is the case with the gold stock indices, the most important nearby resistance for gold bullion lies at the April high ($700 for the June contract). A break above the April high would be a powerful signal that a large advance was in its early stages, but as is also the case with the gold stock indices there is little to be gained at this time by anticipating such a breakout.

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 (OTC: WGDF, TSX: WGI). Shares: 108M. Recent price: US$2.07

WGDF has spent almost the entire time since late-March oscillating between US$1.90 and US$2.00, but on Friday it finally broke upward from this narrow range.

Based on the 3.87M-ounce measured-and-indicated resource at the company's Mesquite gold mine in California and the likelihood that the mine will be producing gold at the annual rate of 165K ounces by this time next year, we think WGDF would be fairly valued at around US$3.00/share. In other words, we perceive upside potential of around 50% based on valuation.

From a technical perspective a move up to around US$3 (the May-2006 peak) also looks feasible, although there is significant resistance at US$2.50 and WGDF's ability to rally will obviously be influenced by the overall market for gold shares.


WGDF is in the TSI Stocks List as a trade and could still be purchased for a trade -- with an anticipated holding period of 1-3 months -- at the current price. As noted above, the upside potential is significant and risk can be managed be placing a protective stop at US$1.85 (an increase from our initial $1.58 stop).

    Nevsun Resources (TSX and AMEX: NSU). Shares: 114M issued, 143M fully diluted. Recent price: US$2.39

Our last mention of NSU was at the end of February when the stock was trading at US$2.04. At that time we concluded that some 'nibbling' might be appropriate given the stock's under-valuation and its close proximity to intermediate-term support.

It has since moved a bit higher, despite more bad news related to the company's Tabakoto gold mine in Mali. Since being put into production this mine has performed far worse than predicted in the feasibility analysis. In fact, even with the gold price in the US$650-$700 range NSU loses money on every ounce of gold it produces at Tabakoto. The market was therefore able to shake-off last week's news that the mine would have to be closed for a while due to a water shortage.

In any case, NSU's speculative appeal has always revolved around the poly-metallic Bisha project in Eritrea. The location (Eritrea) is non-ideal to say the least, but the project's size and grade make it a world-class asset.

Sweden's Lundin Mining apparently offered to pay $5/share for NSU in negotiations with NSU's management last year, an offer that NSU's management rejected. Based on what has subsequently transpired, the rejection of Lundin's offer was clearly a monumental blunder. However, that a company of Lundin's stature was prepared to make such an offer in the first place highlights the potential value of the Bisha project.

The upside potential offered by Bisha continues to interest us, but we don't want to hold NSU through Bisha's construction phase if NSU's current management remains in charge. It is therefore likely that we will exit the stock within the next few months, preferably in response to corporate activity (a takeover).

Technically, there is substantial resistance at US$2.50 (see chart below) and a close above this resistance would indicate that an intermediate-term bottom was put in place earlier this year.


We don't think NSU is well suited to investors who are looking for stocks to add to a long-term 'core' position in the gold sector. However, it has some short-term speculative merit and could be purchased as a trade following a pullback to around US$2.25 or following a daily close in the US$2.55-2.65 range.

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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