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   -- Weekly Market Update for the Week Commencing 4th December 2006

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 will end during the first quarter of 2006, but a long-term peak won't occur until at least 2008-2010. (Last update: 13 February 2006)

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Outlook Summary

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Bullish
(04-Oct-06)
Neutral
(08-Mar-06)
Bullish

US$ (Dollar Index)
Bearish
(20-Nov-06)
Bullish
(31-May-04)
Bearish

Bonds (US T-Bond)
Bearish
(04-Sep-06)
Neutral
(23-Aug-06)
Bearish

Stock Market (S&P500)
Bearish
(27-Nov-06)
Neutral
(02-Oct-06)
Bearish

Gold Stocks (HUI)
Bullish
(04-Oct-06)
Neutral
(08-Mar-06)
Bullish

OilBullish
(04-Oct-06)
Neutral
(
25-Sep-06)
Bullish

Industrial Metals (GYX)
Bearish
(13-Nov-06)
Bearish
(25-Sep-06)
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.

Natural Gas Cycles

...a short-term peak is probably already in place or will be put in place in the very near future, after which there will be a 1-2 month pullback that results in a successful test of September's low.

Based on historical natural gas (NG) price cycles we began to anticipate an August-September bottom for this market as early as March. Here's how we summarised NG's cyclical/seasonal tendencies in the 5th July Interim Update:

"We've endeavoured to show, via the following monthly chart, that natural gas has a strong tendency to peak during December-February (usually December) and bottom during August-September (usually September). In fact, not counting the most recent peak in December of 2005 there have, over the past 10 years, been 5 intermediate-term peaks during the December-February period and with one exception (1997) each of these peaks was followed by an intermediate-term bottom during the ensuing August-September period.

Therefore, with December-2005 having provided us with an intermediate-term peak the odds are clearly in favour of natural gas making an intermediate-term bottom in either August or September of this year, with September being the more likely candidate."


An intermediate-term bottom ended up being put in place in line with the anticipated schedule (the NG price bottomed in late September), with the rally from this bottom to last week's intra-day peak achieving a gain of 125% on a continuous contract basis and a gain of 22% in the January-2007 futures contract. The weekly chart included below reflects the aforementioned 125% gain.

If NG continues to follow its typical cyclical pattern then a short-term peak is probably already in place or will be put in place in the very near future, after which there will be a 1-2 month pullback that results in a successful test of September's low. For example and with reference to the above chart, the Sep96 low was followed by a Feb97 test of the low, the Sep98 low was followed by a Feb99 test of the low, the Sep01 low was followed by a Jan02 test of the low, and the Sep04 low was followed by a Jan05 test of the low.

Given that the volume of NG in storage in the US is still relatively high there's a good chance that the typical cyclical pattern will prevail over the coming months. That is, the odds favour a test of the Sep06 low in January or February of 2007.


The NG price has followed our script as closely as could reasonably be expected. Unfortunately, though, the group of Canadian 'gassy' trusts that we selected has definitely not behaved as anticipated, the problem being that the Canadian Government got in the way of our best-laid plans by proposing a change to tax regulations and thus greatly decreasing the attractiveness of these trusts to many of the people who owned them.

As things currently stand we see three potential outcomes from our foray into Canadian gas-focused energy trusts. The first is that the natural gas price will do as well as we expect it to do over the coming 2 years (we expect the NG price to be back in double digits by 2008), resulting in our energy trust investment doing well but not as well as it would have done in the absence of the tax change. The second is that the natural gas price will continue to be weighed down by abnormally high inventory levels for another 1-2 years, resulting in our energy trust investment faring poorly. The third is that the Canadian Government will prevent new tax-exempt trusts from being formed but will allow existing trusts to maintain their current structure, resulting in our energy trust investment doing better than would otherwise have been the case because the existing trusts would then attract a scarcity premium.

We think the first of the above-described outcomes is by far the most likely.

The Broader Issue

The Canadian Government's recent about-face on the tax treatment of income trusts is indicative of the much broader issue that governments cannot be trusted. As professional speculators we are always aware that our plans could be jeopardised by unexpected government action, whether the action be the blatant seizure of private property such as occurred within the Bolivian oil industry earlier this year or the reneging on promises that routinely happens in almost all countries. We occasionally suffer a portfolio draw-down as a result of stealing or rule-changing on the part of a government; but as we said, this is a risk we are well aware of whenever we speculate and in those cases when government action causes us to incur a loss we aren't required to alter our overall approach to the markets. What we do is re-evaluate the situation based on the new information and, depending on our assessment of risk versus reward, either maintain our current speculative/investment position or move on to pastures that look greener.

However, most people are not professional speculators and they plan their financial futures based on the rules as currently laid-out by the government. They are therefore in the position where a government's unexpected rule change or breach of promise could jeopardise their financial security.

But while the government will sometimes do things that are totally unforeseeable there are some government promises that we know, for sure, are going to be broken; and if you know a promise is going to be broken it will be irrational for you to base your plans on the assumption that the promise will be kept. As an example, the governments of most G7 countries have promised to provide future retirees with benefits that will cost way more than these governments will possibly be able to afford if taxation levels remain anywhere near current levels. This means that taxation levels will be increased and/or that promises not to tax certain types of accounts will be broken and/or that the promised benefits will not be paid or that the promised benefits will be paid in currency that has been massively de-valued via inflation. The point is that we know these promises will be broken, we just don't know exactly how they will be broken (although it's a good bet that surreptitious default via inflation will feature strongly). This means that anyone who plans to retire in, say, 20 years time and live off the benefits currently being promised by his/her government IS going to be disappointed.

When it comes to long-term financial planning we therefore think it would be prudent for people to assume that they will get nothing of real value from the government and that the currency of the realm will lose its purchasing power at an accelerated rate.

Oil and Oil Stocks

Below are weekly charts of oil futures and the AMEX Oil Index (XOI). The blue line on each chart is the 50-week moving average.

A point we've made in the past is that large-cap oil shares, as represented by the XOI, tend to reach major price peaks several months AFTER a major peak in the oil price. To see an example of this type of relative behaviour at important turning points we need go back no further than the most recent major correction in the oil market (the correction that began during the final four months of 2000).

With reference to the following charts, note that the oil price peaked in September of 2000 whereas the XOI, after moving lower in sympathy with the initial downward leg in the oil market, resumed its upward trend as soon as the oil price stabilised at a lower level and went on to make its ultimate high in May of 2001. In other words, during the last major oil market correction there was a gap of around 8 months between the peak in the oil price and the subsequent peak in the XOI.



At this stage the current oil market correction seems to be following the typical pattern exemplified by what happened during 2000-2001. In particular, the XOI fell in sympathy with oil's initial downward leg, but as soon as the oil price began to consolidate the XOI resumed its upward trend. A similar lag to that which occurred during the last major correction would see the XOI reach its ultimate high during February-March of 2007 in parallel with a substantially lower high in the oil price.

Lastly, notice that rebounds in the oil price during 2001 (the shaded area on the above chart) ended at, or just above, the 50-week moving average. Something similar this time around would result in oil moving back to the high-60s within the coming few months, but no higher. This, we think, is a reasonable expectation.

The Stock Market

Warning Shots

We don't think an important top is yet in place in the US stock market because the NDX/Dow ratio (a reliable leading indicator) hit new multi-month highs as recently as the past two weeks and because sentiment is yet to reach the sort of optimistic extreme that typically coincides with a major top. However, we do think there's a good chance of a major top being put in place within the next 3 months, in which case we should already be seeing a few early warning shots.

The evidence at this time isn't substantive but we are, in fact, seeing a few signs that a topping process is underway. Here are some examples:

1. The financial sector was a leader to the upside between the second half of June and the first half of October, but over the past 6 weeks this sector has been relatively weak. Take a look, for instance, at the way JP Morgan Chase (JPM) appears to be rolling over.


2. The major European stock markets were relatively strong until around mid November, but have since been relatively weak. This could be indicative of an impending trend change.

3. During the first half of this year the stock markets of the Middle East were leaders to the downside, typically peaking about 3 months ahead of the G7 stock markets.

After stabilising between May and October the Middle Eastern markets have resumed their declines. In particular, the following weekly Fullermoney.com chart shows that Saudi Arabia's Tadawul Index has broken sharply to the downside over the past several weeks. As was the case during the first half of this year, the Tadawul's breakdown could be a warning shot for other stock markets.


4. Gold has been strengthening relative to base metals since late October, a possible sign that the sea of liquidity upon which stock markets have floated upward is about to dry-up.

Like the man with a hammer who sees everything as a nail, perhaps we are guilty of seeing topping signs simply because we are going out of our way to look for them. This is a risk, but note that during a secular bear market the potential cost of being too cautious is a lot less than the potential cost of being too bullish.

Current Market Situation

A correction is underway in most stock markets. At this stage our expectation is that this correction will last a few more weeks and be followed by a final move to new highs in early-2007.

Below is a chart of Hong Kong's Hang Seng Index (HSI). Over the past 5 months -- a period during which the HSI has been a top performer -- pullbacks have ended at the 50-day moving average and/or the channel bottom. The HSI will therefore need to make decisive breaks below its channel bottom and its 50-DMA to signal that a larger-degree correction is underway.


Spinning the housing downturn as a stock market positive

...the whole idea that the Fed's next move will be to lower the official interest rate deserves to be seriously questioned because it is based on the assumption that inflation expectations will remain low.

The downturn in the US housing market is being spun as a stock market positive on the basis that it will force the Fed to begin a rate-cutting program and, as everyone knows, Fed rate cuts are bullish for the stock market. Well, it's often the case that what everyone knows is not worth knowing and that certainly applies here because Fed rate cuts are often NOT bullish for the stock market.

When it comes to the setting of the Fed Funds Rate target the Fed will usually just follow the market in that some time after the market begins to lower short-term interest rates the Fed will start doing the same. However, lower short-term interest rates definitely wouldn't be a significant positive for a stock market priced in anticipation of strong earnings growth if the downward move in interest rates was a response to a sharp deterioration in the economic outlook.

In any case, the whole idea that the Fed's next move will be to lower the official interest rate deserves to be seriously questioned because it is based on the assumption that inflation expectations will remain low. There are, however, conditions that have a reasonable chance of arising over the coming months that would invalidate this assumption. Before we mention what these conditions are it's important to understand the Fed's greatest fear.

It is often said that the Fed fears deflation. This is true, but the Fed's fear of deflation can be likened to your editor's fear of swimming with Great White sharks. Your editor would be very fearful of jumping into the water if he suspected that a Great White was lurking below, but sharing a patch of water with a Great White is not something he spends any time worrying about because it is something he can easily avoid. It's the same story with the Fed and deflation. Deflation would be a nightmare for the Fed, but Ben Bernanke will never spend much time worrying about it because he knows he can easily avoid it.

What the Fed regularly does have to worry about is an out-of-control surge in inflation expectations. The Fed can create money in unlimited quantities at practically zero cost, but today's money continues to have value because most people TRUST that it is going to do no worse than lose its purchasing power at the rate of a few percent per year. Or, to put it another way, the money is essentially worthless but as long as most people BELIEVE that the money will decline towards ultimate worthlessness at a slow pace it can continue to be a useful medium of exchange.

The Fed and all other central banks face a problem, though, when a critical mass of people begin to anticipate a rapid acceleration along the road toward eventual worthlessness. If this happens then the Fed will be at risk of losing its ability to keep the world's greatest confidence game going, and it is this possibility, not the possibility of deflation, that will keep a central banker awake at night.

We'll now return to our original discussion. There is a significant chance that additional weakness in the housing market will prompt the Fed to begin reducing the official short-term interest rate target within the next few months, BUT ONLY IF inflation expectations happen to be under control. On the other hand, if the gold price were threatening to breakout to new multi-year highs then cutting interest rates would likely be the last thing on the collective mind of the Fed. This would be the case regardless of how weak the housing market happened to be unless the rise in the gold price could reasonably be attributed to something other than rising inflation expectations.

This week's important US economic events

Date Description
Monday Dec 04
No significant events scheduled
Tuesday Dec 05 Q3 Productivity
Factory Orders
ISM Services
Wednesday Dec 06No significant events scheduled
Thursday Dec 07 Consumer Credit
Friday Dec 08 Monthly Employment Report

Gold and the Dollar

Currency Market Update

No US$ collapse on the horizon

The Dollar Index will probably test long-term support at 80 within the next 4 weeks and as it approaches this support area the forecasts of an impending dollar collapse will no doubt become more prevalent and more brazen. However, there's little chance of the dollar ever collapsing against the euro (the US$-euro exchange rate is more than 50% of the Dollar Index, so a collapse in the Dollar Index would require a collapse of the US$ against the euro) because in some important respects the euro has even less going for it than the dollar. Furthermore, there's almost no chance of the dollar collapsing against the euro while the US$ has an interest rate advantage, as is the case right now.

There is, though, a very high probability of the US$ eventually collapsing against gold, but the probability of such a collapse happening within the next 6 months is low because the Fed is still in the position where it could quickly put a lid on inflation expectations via moderately tighter monetary policy should the need arise.


Current Market Situation

Going into Friday's trading session the currency market looked stretched and in need of a short break, but the recent trends (down in the dollar, up in the major European currencies) continued in response to some frighteningly-bad US economic news. When we say "frighteningly-bad" we are, of course, being facetious because the additional wave of dollar selling on Friday was prompted by news that the Institute of Supply Management (ISM) Manufacturing Index printed 49.9, or just a smidgen below the expected 51. This difference between the actual and expected numbers is insignificant, but it had a significant psychological impact because an ISM Index reading of below 50 is widely accepted to mean that the US economy is shrinking.

Now, we have no problem with the idea that the US economy is shrinking. In fact, if accurate estimates of real economic growth were available we think they would show that the US economy has been shrinking since the second quarter of this year. However, it is absurd to think of the difference between an ISM Index of 51 and an ISM Index of 49.9 as representing the difference between an expanding and a contracting economy.

We'll tell you why, but first we'll quickly note that the ISM Index is determined by surveying purchasing managers at around 300 industrial companies across the nation and asking them questions like: "Are business conditions improving?" A reading above 50 for the index would mean that more than half the purchasing managers answered this question with a "yes".

The ISM Index is actually one of the most useful coincident economic indicators, but small changes in this index are irrelevant because of the way it is calculated. From what we can gather, all that would have to happen to change the reported index value from 51 to 49.9 would be for approximately three purchasing managers to change their answers from "business is improving" to "business is getting worse". In other words, whether an economy with 300M people is considered to be expanding or contracting supposedly ends up being determined by the opinions of three guys.

Whether the ISM Index prints marginally above 50 or marginally below 50 is neither here nor there. What is of significance is that the index has been trending lower for some time, but we doubt that the US economy will deteriorate much more in the short-term. This is mainly because a) the US economy probably won't get much weaker without some help from abroad and leading indicators such as credit spreads suggest that global economic growth will remain firm for at least a few more months, and b) the US stock market probably wouldn't have been as strong as it has been over the past two months if the US economy were about to become considerably weaker in the immediate future (the stock market is a leading indicator of the economy and seldom fails to turn down months ahead of a serious economic decline).

Our take is that news such as Friday's ISM Index helps bolster the idea that a weakening US economy will soon result in the elimination of the dollar's interest rate advantage. This is the speculative theme de jour in the currency market and speculators will milk this theme for all it's worth in the same way they milked the "dollar is headed into the toilet due to the expanding trade deficit" theme during the final two months of 2004.

As was the case at the end of 2004, once speculative short positions in the dollar have reached an extreme -- a likely occurrence within the coming 4-6 weeks -- the stage will be set for another multi-month advance in the US currency.

Gold

Our expectation has been, and continues to be, that gold will test its May-2006 high during the early part of next year. There will no doubt be pullbacks along the way, but the short-term trend should remain up for at least another month.

From a fundamental/valuation perspective gold looks much better than the base metals at this time. In particular, the gold price is extremely low relative to the prices of most base metals and gold stands to benefit if more evidence of an economic slowdown begins to emerge. Gold also looks much better from a technical perspective in that it has been gradually building-up strength over the past several weeks whereas the base metals either look dangerously extended due to recent almost-vertical climbs (zinc, nickel and lead) or appear to be on the verge of breaking below support (copper).

Gold Stocks

The XAU has broken decisively above a downward-sloping trend-line, but is now challenging the more important lateral resistance that lies at 150-155 (see chart below). We suspect that the gold sector will continue to push higher into year-end, but wouldn't be surprised at all if a brief pullback occurred prior to a resumption of the advance.

Support defined by the early November high (the low-140s for the XAU and the low-340s for the HUI) should hold during any pullback that begins from near current levels.


One reason we don't expect a tradable decline to begin at this time is that many individual gold stocks look strong, but are not yet close to being overbought. For example, Gold Fields Ltd (NYSE: GFI) broke above a downward-sloping trend-line last week, but has only just begun to rally and is still quite close to long-term support. Also, Royal Gold (NYSE: RGLD), a stock that is way too richly valued for our liking but one that we pay attention to because it is often a leader at important turning points, has only just broken above lateral resistance at $31 (see chart below) and is likely to find support at this former resistance during any near-term pullback.


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)

Nevsun Resources (TSX and AMEX: NSU). Shares: 114M issued, 143M fully diluted. Recent price: US$2.41/C$2.76

NSU has dropped back to intermediate-term support (see chart below) and is a good candidate for new buying near the current price. Significant political risk must be taken into account due to the location of the company's most valuable asset (the Bisha project in Eritrea), but the stock's low valuation means that a large risk-related discount has already been applied.


We consider NSU to be a gold stock, but it has been trading more like a junior copper stock over the past couple of months and hasn't participated at all in the gold sector's rally. Bisha is more of a base metal project than a gold project, but the plan is for almost 100% of Bisha's production to be gold during its first two years of operation. Also, the company owns the Tabakoto gold mine in Mali, a mine that has been designed to produce gold at the rate of 100K ounces/year.

Two series of NSU warrants trade on the TSX, but in our opinion the warrants are currently very expensive relative to the stock. For example, the C$3.00 Oct-2008 warrants (TSX: NSU.WT.A) closed at C$1.00 on Friday, but by our calculations the fair value for these warrants would be around C$0.75 with the stock at its current level.

    Metallica Resources (AMEX: MRB). Shares: 84M issued, 106M fully diluted. Recent price: US$4.05

Despite the gains it has made since late October, MRB still offers one of the most attractive risk/reward ratios in the gold sector.

Technically (see chart below), the stock is consolidating following the recent 40% surge in its price. Former resistance in the US$3.70s should now provide good support and a pullback to this price area would, we think, be a buying opportunity.

The C$3.10 December-2008 warrants (TSX: MR.WT) closed at C$2.03 on Friday and would be suitable for new buying in the low-C1.80s.


    Cameco (NYSE: CCJ). Recent price: US$39.31

CCJ has only been in the TSI Stocks List for two weeks, but we are going to exit now for a quick 20% gain.

The stock was added to the List as a short-term trade based purely on price action and by rebounding back to near the top of its channel (see chart below) has done what we expected/hoped it would do, albeit in quicker time.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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