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.

In nominal dollar terms, the BULL market in US Treasury Bonds that began in the early 1980s will end by mid-2010. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 09 February 2009)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000, where "secular bear market" is defined as a long-term downward trend in valuations (P/E ratios, etc.) and gold-denominated prices. This secular trend will bottom sometime between 2014 and 2020. (Last update: 22 October 2007)

A secular BEAR market in the Dollar began during the final quarter of 2000 and ended in July of 2008. This secular bear market will be followed by a multi-year period of range trading. (Last update: 09 February 2009)

Gold commenced a secular bull market relative to all fiat currencies, the CRB Index, bonds and most stock market indices during 1999-2001. This secular trend will peak sometime between 2014 and 2020. (Last update: 22 October 2007)

Commodities, as represented by the Continuous Commodity Index (CCI), commenced a secular BULL market in 2001 in nominal dollar terms. The first major upward leg in this bull market ended during the first half of 2008, but a long-term peak won't occur until 2014-2020. In real (gold) terms, commodities commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 09 February 2009)

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Outlook Summary

The Fed's BS

"BS", of course, refers to Balance Sheet.

There is widespread expectation that the Fed will soon take another big step along the inflation path by substantially expanding its balance sheet. Based on the way the US$ has been weakening and most investments have been rising in US$ terms, it seems that the markets have already gone a long way towards discounting this balance-sheet expansion. We stress, though, that the Fed is yet to take the widely expected action. As evidenced by the following chart of Federal Reserve Credit (a reflection of the size of the Fed's balance sheet), total Fed credit is presently less than 5% higher than it was at the end of 2008 and has been tapering off over the past few months.

We reiterate what we said in a previous commentary, which is that the further the markets go towards discounting "QE2" the less likely QE2 will become. In our opinion, the probability of QE2 happening within the next few months is now very low and will drop to almost zero if prices continue their current upward trends.

The fact that the markets have now moved so far in response to something that is yet to actually happen creates a risk. The risk is that the markets come to the realisation that QE2 is not going to happen anytime soon and quickly retrace the gains made over the past several weeks. Ironically, if the realisation that QE2 has become unlikely prompts sharp declines in equities, commodities, gold and bonds, the probability of a near-term monetary easing will receive a hefty boost. In other words, we perceive an inverse relationship between the probability of QE2 actually happening and the extent to which the markets anticipate the inflationary effects of a future monetary easing.

Interesting quote or fact of the week

The Stock Market

The latest report from the ISM (Institute of Supply Management) indicated that the US manufacturing sector continued to expand during September. The report, which was released on Friday, was roughly in line with expectations and therefore didn't move the stock market to a significant degree.

The US stock market is about to enter the most bullish 2-month phase of the Presidential Cycle's second year, but the market's short-term upside potential has been reduced by the fact that it didn't decline during the weeks leading up to this period. If the market had followed the Presidential Cycle model then it would have trended lower over the past 6 weeks and would now be very 'oversold', thus setting the scene for a strong multi-month rebound. However, it stopped following the model in late August and is entering the normally bullish period in an 'overbought' state. Our guess is that it will maintain its upward bias over the next couple of months, but won't make much headway.

Below are charts of the S&P500 Index (SPX) and iShares Brazil (EWZ). The SPX chart shows repeated tests of resistance at 1150 over the past two weeks and a series of rising intra-day lows. A daily close above 1150 would suggest a near-term target of 1175. The EWZ chart shows that intermediate-term resistance defined by the December-2009 peak is now being tested. A pullback from resistance is the most likely outcome.

It has been widely reported that September-2010 was the best September for the US stock market since 1939. What hasn't been widely reported is that the Dow Industrials Index lost 30% during the 9 months following September-1939.

This week's important US economic events

Gold and the Dollar

Gold

In US$ terms, gold continues to plod upward in relentless fashion and made another new all-time high on Friday. The steadiness of gold's ascent is indicated by the fact that over the past 47 trading days it has gained $160 without experiencing a single daily decline in excess of 1%.

In euro terms, gold peaked in June and closed at a new 6-week LOW on Friday.

The recent divergence between the US$-denominated gold price and the euro-denominated gold price is illustrated below.

There are other non-confirmations of the recent new highs achieved by the US$-denominated gold price, chief among them being the HUI/gold ratio's inability to break above its May high.

With regard to gold's intermediate- and long-term prospects, the non-confirmations mentioned above don't concern us at all. When considered alongside the extent to which gold is now 'overbought' in US$ terms they do, however, temper our short-term optimism.

For us to become more enthusiastic about gold's short-term prospects there will have to be a significant pullback. By "significant" we mean a pullback that lasts at least a couple of weeks and/or takes the price back to near the 50-day moving average (now at $1238 and rising). On the other hand, if the upward trend continues without any meaningful interruption and the above-mentioned non-confirmations remain in place then every move to a new high will simply add to the risk.

By the way, one thing we aren't concerned about is the current high level of the speculative net-long position in COMEX gold futures. In the gold market the large speculators constitute the "smart money". When most speculators are involved on the 'long' side of the gold futures market there is the potential for a downward correction to be exacerbated by long liquidation, but an unusually high speculative net-long position is not, in and of itself, a danger sign.

Gold Stocks

Current Market Situation

We are beginning to wonder how high the gold price will have to go to push the HUI above major resistance at 515-520. Obviously, $1320/oz isn't high enough.

The HUI is clearly having trouble breaking out to a new high as we enter a multi-week time window when the gold sector often declines or consolidates. If it couldn't break out during the seasonally strong multi-week period just ended, how will it break out during the seasonally weak multi-week period that is just about to begin?

Seasonality is just one small piece of a large puzzle, so the fact that October has tended to be a sub-par month for the gold sector doesn't mean that the HUI won't break decisively above 520 in the near future. However, taking into account the bearish divergence between gold/US$ and gold/euro and that gold/US$ is very 'overbought' on a short-term basis, the odds certainly appear to favour 'corrective activity' during October.

A normal short-term pullback would take the HUI back to its 50-day moving average, which is now at 476 and rising at the rate of around one point per day. A larger degree pullback would take the HUI back to near its 50-week moving average (now at 447), but we don't think a decline of this magnitude is likely over the next several weeks.

It will be difficult for anyone who is bearish on the gold sector to maintain their stance if the HUI clearly breaks above 520. This could mean that there will be substantial follow-through to the upside after the breakout eventually occurs, due to the short-covering and new long-side positioning of the former bears. Still, in our book it is always better to buy pullbacks to support than breakouts above resistance.

Gold Royalties

The gold royalty business-model is attractive, because if implemented correctly it provides shareholders with exposure to the upside of gold mining while greatly reducing exposure to the risks of gold mining. For example, most of the royalties owned by companies such as Royal Gold (RGLD) are the Net Smelter Return (NSR) variety, which means that the royalty-owner's income is solely determined by the amount of production and the price of gold. That is, an increase in mining cost usually won't affect the royalty owner.

But despite the attractiveness of its business model the following chart shows that RGLD, the top company in the gold royalty space, has under-performed gold bullion by a wide margin since the beginning of 2003. In other words, although RGLD has generated a reasonable return in US$ terms over the past 7 years and 9 months (as evidenced by the top section of the chart), its shareholders would have been far better off owning gold bullion. There is no point owning a gold stock that doesn't handily outperform gold bullion, because even the best-quality mining stock in the world is a lot riskier than bullion. It is therefore fair to say that RGLD has been a relatively poor investment for many years.

Valuation is the main reason that RGLD began to under-perform gold at the beginning of 2003. Specifically, the stock had become extremely over-valued thanks to its spectacular ascent over the preceding few years, and extreme over-valuation invariably leads to relatively poor long-term performance. Another probable reason is that large royalty companies are very difficult to value. They usually look expensive based on current earnings, but they have royalty agreements associated with many dozens of exploration-stage projects. Valuing the royalties on these exploration-stage projects is problematic, because some of them will eventually become "cash cows", some of them will eventually be proven worthless, and all of them are years away from production.

Anyhow, the main point we wanted to make today is that RGLD is presently in the bottom quartile of its 8-year range relative to gold. This suggests that the stock stands a good chance of providing respectable leverage to FUTURE gains in the gold price. For example, a 15% rise in the gold price along with a return to 0.065 by the RGLD/gold ratio would require a gain of around 100% in the RGLD stock price.

For investors prepared to hold for at least two years, we think RGLD is a reasonable buy at its current price and would be a strong buy below $45.

Currency Market Update

Based on the daily 14-period RSI (Relative Strength Index), the Dollar Index is now more 'oversold' than at any time since April-2008. However, the weekly 14-period RSI shown at the bottom of the following Dollar Index chart hasn't yet reached an 'oversold' extreme (we consider below 30 to be extreme). In other words, the Dollar Index is at an extreme on a short-term basis, but not on an intermediate-term basis. 

When the Dollar Index began its decline during the second quarter of this year we didn't think it would fall anywhere near far enough to become 'oversold' on an intermediate-term basis. We were expecting a normal downward correction within the context of a continuing intermediate-term advance, but what we've ended up with is an intermediate-term decline. We'd like to blame the Fed, but as discussed near the beginning of today's report the Fed hasn't actually done anything in the recent past to devalue the dollar. The transformation from a normal downward correction to a full-blown intermediate-term decline has largely been driven by expectations of what the Fed may do in the future.

Even if the Dollar Index is on its way to becoming 'oversold' on an intermediate-term basis, it is likely to experience at least a 2-point bounce in the near future.

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)

Clifton Star Resources (TSXV: CFO). Shares: 31M issued, 38M fully diluted. Recent price: C$4.23

CFO's joint venture partner (Osisko) reported another round of drilling results for the Duparquet project last Thursday. The results were generally good, and included the following meaningful gold intercepts:

88.0m of 1.90 g/t
25.5m of 3.37 g/t
40.0m of 2.26 g/t
16.5 of 3.12 g/t
43.5m of 1.29 g/t
177.0m of 1.46 g/t
100.0m 1.66 g/t

The stock price fell 6% on the day, but we doubt that this was a reaction to the news. As noted above, the results were good.

We suspect that the current inability of CFO's stock price to get any traction is primarily due to the consistent selling of one large shareholder (Joe Dwek Management - JDM). This shareholder has indirect control over about 13% of CFO's fully diluted share count, and for reasons that in our opinion have nothing to do with CFO's speculative merits appears to be set on making a complete exit by selling into any strength.

A daily close above resistance at C$4.80-$5.00 would be a clear sign that new buying demand was beginning to gain the upper hand. In the mean time, speculators should take advantage of the weakness created by the relentless selling of the aforementioned shareholder.

The 2010 drilling campaign at the Duparquet project is complete, but at this stage the results have been reported for less than half of the drilled holes. This should mean that there will be good news flow over the next few months as Osisko works through its reporting backlog.

    Northgate Minerals (AMEX: NXG, TSX: NGX). Shares: 290M issued, 297M fully diluted. Recent price: US$3.05

The full details of NXG's US$150M (increased from the original $135M) convertible note offering were announced on Thursday. The notes will bear interest at 3.5% per annum and will be convertible into common shares at an effective price of US$4.08/share. Of greatest importance, upon conversion NXG will have the option of providing cash in lieu of shares. Consequently, there won't necessarily be any share dilution as a result of this note offering.

Large convertible note offerings such as the one just completed by NXG tend to put a lot of downward pressure on the shares in the very short-term because the buyers of the notes will often hedge their risk by short-selling the common shares. From a longer-term perspective, however, the financing was structured in a positive way.

    Fairborne Energy (TSX: FEL). Shares: 102M issued, 112M fully diluted. Recent price: C$4.36

FEL, a mid-tier natural gas producer, has spent the past 17 months oscillating within a large contracting triangle. C$8.00 would be the measured objective following an upside breakout from this triangle.

We think that FEL would be a reasonable short- or intermediate-term speculation at around C$4.00, using a daily close below C$3.50 as an initial stop.

    Agriculture ETF (NYSE: DBA). Recent price: US$26.65

DBA closed a few cents above our 5% trailing stop on Friday, but it looks like the short-term upward trend has ended in the agriculture sector. We are therefore going to remove the short-term DBA position from the TSI List. The profit on the trade was 15.4%.

Chart Sources

Charts appearing in today's commentary are courtesy of: