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

Industrial Metals

The March copper futures contract broke below short-term support at US$2.50 on Friday and ended the week at its lowest level since last March.

From a longer-term perspective the most important support lies at US$1.50. As noted on the following monthly chart, the $1.50 support level for copper can be likened to the $40 support level for oil. In both cases the support coincides with the top of a multi-decade base and in our opinion defines the MAXIMUM downside potential. We doubt that copper will test this long-term support in the absence of a global recession, but the low-$2 area looks achievable.

The main force behind copper's price weakness has been the growing belief that the strong upward trend in copper stockpiles will continue over the coming months/quarters (the LME copper inventory has almost doubled over just the past 4 months). However, the following extract from a Reuters article indicates that fund-related selling and fears of more fund-related selling are also taking a toll across the industrial metals complex. 

"LONDON (Reuters) - Base metals prices fell sharply on the London Metal Exchange on Friday on a report of heavy losses at a hedge fund and in the absence of Chinese buyers, dealers said.

"The market is collapsing," a European trader said.

Three-months zinc fell by nearly 9 percent at one stage, copper was down by over 6 percent and aluminium dropped by some 3 percent in a general
sell-off.

Traders said the selling was mostly on behalf of funds, triggered by a report of heavy losses at a hedge fund that specialises in metals trading.

Once prices hit specific chart levels the fall for most metals accelerated.

"Fund liquidation...a lot of stops triggered -- a lot of the stuff on the back of the Red Kite news," the trader said.

Hedge fund Red Kite, which posted strong gains in 2006, has suffered a roughly 20 percent loss in the first days of January and is now trying to stall investors who want to pull money out, The Wall Street Journal reported.

"It is quite scary, actually, a lot of volume going through and no one is buying the stuff," analyst Michael Widmer at Calyon said."

Copper and zinc prices have fallen by 24% and 32%, respectively, since early December and copper is now down by more than 40% from last May's peak. Given the large amount of speculative interest attracted by these markets over the past couple of years it would certainly not be surprising if declines of this magnitude resulted in some hedge fund blow-ups.

Although it dropped a little on Friday, up until now gold has not been affected in a big way by the sharp declines in industrial metal prices. (There is, of course, no good fundamental reason why gold should be adversely affected by falling industrial metal prices, but there was a risk that it would be because a lot of speculators bought gold during 2005-2006 as part of a general metals play). In fact, at this stage the metals-related carnage has been limited to the copper and zinc markets. The nickel market, on the other hand, ended last week at an all-time high in response to a near-term supply shortage (nickel stockpiles are exceptionally low); the tin price is also near an all-time high; and the recent downturn in the lead price looks more like a routine consolidation than the start of a large decline. Therefore, as has been the case for more than 6 months it is still difficult to generalise when discussing the industrial metals.

Our view has been, and continues to be, that most of the metals will end up following copper lower. Strong global growth was/is expected to lend support to prices during the first quarter of this year, but if we are correct to anticipate slowing growth during the second and third quarters then falling demand will probably run head-first into rising supply across the industrial metals complex before this year is out.

The Stock Market

How has inflation affected stock prices?

One of our more controversial opinions -- controversial as far as our readership is concerned, anyway -- is that the on-going US$ inflation (growth in the total supply of dollars) will ensure that US house prices remain in a long-term upward trend in NOMINAL terms. Or, to put it more aptly, our view is that it makes no sense to assume that there will be sufficient inflation to keep the long-term bull market in commodity prices going -- despite all the theories linking the commodity bull to the rapid growth of "Chindia", inflation has been and will continue to be the primary driver of this bull market -- and insufficient inflation to keep the MEDIAN house price trending higher.

We emphasised the word "nominal" in the above paragraph because we expect that prices will continue to trend higher for a few more years in terms of depreciating currency, but not in real terms. Our thinking is that the majority of houses purchased over the past three years will prove to be poor investments in real terms.

We also emphasised the word "median" for a reason. Specifically, we would not be at all surprised if certain sections of the market -- the sections that have 'benefited' from the greatest amount of speculation -- have already topped in both real and nominal terms, while the nominal "median" house price experiences nothing more serious than a mid-cycle correction. In this respect the US stock market might provide us with a useful analogy.

Clearly, technology was the main focus of speculation during the final years of the 1982-2000 bull market in US equities. This technology focus caused the NASDAQ to move ahead in leaps and bounds relative to the S&P500 Index and also led to technology-related stocks becoming an absurdly large chunk of the capitalisation-weighted S&P500 Index. As a result, when the speculative bubble burst the S&P500 was hit hard due to many of its largest components being cut in half and then cut in half again, while the technology-laden NASDAQ was absolutely clobbered.

Despite massive US$ inflation during the years since the bursting of the technology bubble, the capitalisation-weighted S&P500 Index is still about 6% below its March-2000 peak while the NASDAQ Composite Index remains more than 50% below its all-time high. However, the following chart shows that the Unweighted S&P500 Index barely hesitated when the NASDAQ's bubble burst in 2000 and then experienced a normal mid-cycle correction during 2001-2002 on its way to much higher levels.

Quite obviously, the long-term upward trend in the NOMINAL price of the Unweighted S&P500 Large-Cap Index did not end in 2000. Furthermore, neither did the long-term upward trends in the NYSE Composite Index, the S&P400 Mid-Cap Index and the S&P600 Small-Cap Index. It was, in fact, only a fairly small section of the overall market that failed to sustain its long-term advance in nominal dollar terms. THIS is what inflation can do.

Two additional points are worth making -- reiterating, actually, because we've made these points many times over the years -- before we leave this topic. The first is that post-stock-market-bubble America has gone down a very different path to post-bubble Japan. When the Japanese stock market was hitting its bubble peak in December of 1989 Japan's broad money supply was expanding at a year-over-year rate of around 12%, but soon after the bursting of the bubble the rate of money-supply growth slowed to a virtual standstill. It then remained at a low level for many years. In the US, however, the year-over-year rate of money-supply growth began trending UPWARD following the bursting of the stock market bubble and reached an 18-year high a full 20 months after the stock market's bubble peak. The rate of US money-supply growth has since slowed, but during the 7-year period since the bursting of the NASDAQ bubble it has expanded at a compound annual growth rate of around 8%. This compares to about 3% per year compound growth in Japan's total money supply during the 7-year period following the bursting of the Nikkei bubble.

The second point is that stock markets throughout the world have done particularly well over the past few years because there's been substantial inflation without a concomitant rise in inflation fears. What we've had are effects of inflation that hardly anyone correctly identifies because almost everyone has been trained to think that the CPI shows what's happening on the inflation front. This is important because investors, as a group, are never prepared to pay much for earnings growth that they perceive to be inflation-induced, but the fact that valuations in the US are currently near historic highs means that the earnings growth of the past few years is generally perceived to be real. Or, to put it another way: there is presently very little inflation risk priced into the US stock market.

In summary, the US experienced one of the all-time great stock market bubbles during the 1990s; however, thanks to massive inflation and the general non-recognition of an inflation problem the majority of stocks have remained in long-term upward trends to this day. The situation is precarious because either a significant fall in the inflation (money supply growth) rate or a rise in inflation fears would likely bring the bull market to a halt. Right now, though, there is plenty of inflation and inflation expectations are near an 'optimum' level: not too high to be a threat to the bond market and not low enough to usher-in a deflation scare.

Current Market Situation

In past commentaries we've harped on about the bearish divergence between the NASDAQ100 Index (NDX) and the Dow Industrials Index; that is, about the fact that the sequence of new 52-week highs in the Dow over the past two months has not been confirmed by new highs in the NDX/Dow ratio.

Another potential bearish divergence worth keeping an eye on at this time is highlighted on the following chart comparison of the AMEX Broker/Dealer Index (XBD) and the S&P500 Index. The XBD, which contains companies such as Merrill Lynch, Goldman Sachs, Lehman Bros. and Morgan Stanley, has been a leader to the upside over the past 2 years. This is not surprising given the huge amount of liquidity sloshing around the financial world, the global stock market rally and the plethora of M&A deals.

The interesting thing right now is that the most recent move to new highs by the S&P500 was not accompanied by new highs in the XBD. This is a bearish divergence that could quickly be eliminated by the XBD gaining only 1.5%, but it has our attention at the moment.

The Shanghai Stock Exchange Index (SSEC) charted below has gone through a typical bull market sequence over the past two years. There was a steady advance that didn't attract much attention; followed by some upward acceleration as speculators were drawn into the market; followed by an almost vertical ascent; followed by a large increase in volatility near the highs. It looks like an intermediate-term top is now in place, although it wouldn't be surprising to see some more sharp swings in both directions near the highs before a downward trend begins in earnest.

So, what do we make of the evidence that China's stock market has either topped or is very close to an important top?

It could turn out to be a warning sign as far as the world's major stock markets are concerned, but at this stage we aren't reading a lot into it because China's market tends to march to the beat of its own drummer; or, to be more accurate, to the Communist Party's beat.

The initial advance from the 2005 lows, for instance, was engineered by the Government because there were concerns within the Party that the stock market's sluggish performance was painting an 'unrealistically' negative picture of the country's economic situation. The efforts to elevate stock prices worked well, but then things got out of hand in the opposite direction and it became necessary to throw some water on the speculative fire. The sort of gains that the SSEC achieved during the final two months of last year are never sustainable beyond the short-term regardless of what the manipulators happen to be doing, but in this case the manipulators applied a little downward pressure via tighter monetary policy to make sure that the speculative frenzy came to an end sooner rather than later.

This week's important US economic events

Gold and the Dollar

Currency Market Update

Short-term Outlook

There's not much we can say about the short-term outlook that we haven't already said over the past week. In summary, we think it's likely that the Dollar Index will drop back to test its December low within the next 2 months, although before embarking on such a pullback we would not be surprised to see it spike to a new high for the year. The ideal situation would be for the dollar to spike higher and then reverse lower within the next week or so.

The Australian Dollar

The following weekly chart shows that the A$ has been consolidating for three years. The eventual breakout from this chart pattern is likely to be to the upside, but we suspect that a multi-month (or multi-quarter) decline to the low-0.70s will precede the rally that ultimately takes the A$ well above resistance at 0.80. At least, this is the outcome that would fit best with our other market views. In particular, Australia's economy is leveraged to commodity prices and the mid-cycle decline in commodities that commenced last May will probably extend into the second half of this year. The A$ has held up very well during the first 9 months of this commodity decline because much of the weakness to date has been concentrated in the 'energies'. However, the commodity decline should broaden if global growth begins to slow; and if this happens then the A$ will likely come under pressure.

The chart comparison included below has been set up to show that the A$ (the AUD/USD exchange rate) tends to follow the A$ gold price with a lag of around 2 years. The literal interpretation of this chart comparison is that a powerful A$ rally will begin during the third quarter of this year, although the tolerance on a long-term relationship such as this would be at least +/- 6 months.

Further to the above, a pullback to around 0.73 later this year would provide an excellent opportunity to go 'long' the A$ relative to the US$.

Gold

Below is a daily chart of February gold futures.

February gold managed to close above its early-December peak last Thursday and then reversed lower on Friday. Resistance in the high-650s is therefore yet to be decisively breached, but we continue to expect that it will be breached within the next few weeks.

Our expectation is that gold will test its May-2006 peak during the first half of this year, but we don't expect gold to move well beyond the 700s until yield and credit spreads become substantially wider; and yield and credit spreads probably aren't going to become substantially wider until after an intermediate-term stock market decline gets underway.

Gold Stocks

The price action during the final two days of last week was bearish, with the gold sector giving back early gains on Thursday and then following through to the downside on Friday. Strength in the US$ on Friday was certainly a contributing factor, but Thursday's action was a warning that some additional downside lay in store.

We doubt that last week's downward reversal will prove to have any significance beyond the immediate-term. It might, though, lead to some additional consolidation this week and another opportunity for traders to buy GDX (the ETF that tracks the AMEX Gold Miners Index) within $2 of the support level indicated on the following chart.

We continue to be bullish on the gold sector, but much more so on the juniors than the majors. The gold stock indices, which are dominated by the major mining companies, are unlikely to exceed their May-2006 peaks during the first half of this year. However, if there's enough strength in the majors to take the indices to within a few percent of last year's peaks then the stocks of many exploration-stage miners and junior producers should trade well above last year's highs.

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)

Crowflight Minerals (TSXV: CML). Shares: 190M issued, 240M fully diluted. Recent price: C$0.53

The results of CML's updated Feasibility Study for its Bucko nickel project were announced last Thursday and they were, to put it mildly, very positive. In particular, using a discount rate of 8% and a nickel price of US$8.00/pound (less than half the current US$18/pound spot price) the project was estimated to have a net present value (NPV) of C$157M and an internal rate of return (IRR) of 118%. Furthermore, at a nickel price of US$12/pound the NPV and IRR would rise to C$338M and 418%, respectively. These are obviously great numbers and support our view that the stock will trade above C$1.00 within the next 12 months. It is also worth noting that the numbers will get even better once the recently-reported 32% increase in measured-and-indicated resources is incorporated into the mine plan. 

The stock will likely trade a long way above C$1.00 if the nickel price is still near current levels when production begins in the first quarter of next year, but we think it's reasonable to assume that most of the industrial metals -- nickel included -- will eventually go the way of copper and have their long-term bull markets interrupted by large mid-cycle corrections. We therefore think it makes sense to base company valuations on a long-term price assumption of US$8/pound, even though this price is 55% below the current spot price. The current US$18/pound spot price reflects a temporary supply shortage, but nickel for delivery in April-2009 is trading at 'only' $10.80/pound.

We've highlighted CML as a buy 5 times over the past 4 months at prices ranging from C$0.35 to C$0.42, most recently in the 24th January Interim Update when it was trading at C$0.38. Therefore, TSI readers who are interested in the company are hopefully already 'set' at significantly lower prices. If not, then it would be reasonable to do some buying if the stock pulls back to the high C$0.40s. Keep in mind, though, that the stock can be quite volatile (daily moves of more than 5% are quite common) and that the risk level is still quite high.

    Golden Queen Mining (TSX: GQM). Shares: 78M issued, 88M fully diluted. Recent price: C$1.04

We had hoped that a good opportunity to exit GQM would have presented itself by now, but although the stock price has improved steadily over the past 4 months there hasn't yet been sufficient strength to take us out.

GQM's management has a long history of being extremely slow to deliver, but we are hopeful -- a case of hope triumphing over experience, perhaps -- that the long-awaited Feasibility Study for the company's Soledad Mountain gold/silver project will be published before the end of this month. If so then this could prove to be the catalyst that gets the stock moving and leads to a good exit point.

The sort of price-range we currently have in mind for an exit is C$1.30-C$1.50.

    American Gold Capital (TSXV: AAU) / Chesapeake Gold (TSXV: CKG)

Closing of the AAU-CKG merger has been delayed to 14th February, at which point AAU shareholders will be entitled to receive CKG shares, warrants and Class A shares in exchange for their AAU shares.

CKG broke-out to the upside last week (see chart below), which naturally gave AAU shares a boost since AAU is effectively a CKG derivative. By our calculations, though, AAU ended last week at a significant discount to the agreed merger consideration. Specifically, we estimate that Friday's closing bid of C$6.70 for CKG implies a value of around C$3.20 for AAU, yet AAU ended the week at only C$2.55. This is reminiscent of the discount at which Aflease was trading in November-2005, just prior to its merger with SXR (the merger that created SXR Uranium One).

AAU is a buy at the current price.

    Apogee Minerals (TSXV: APE). Shares: 39M issued, 52M fully diluted. Recent price: C$0.64

APE, an exploration-stage silver/zinc miner with projects in Bolivia, just can't seem to get any respect. The company reported very good drilling results from its Paca-Pulacayo project last week, including intercepts of 151m grading 120g/t silver and 33m grading 313g/t silver, but the market just yawned.

Political risk-related fears are almost certainly responsible for the stock's sluggishness and low valuation. It would be economically illogical for the Bolivian Government to do anything to discourage a company such as APE from progressing its projects since these projects will not be developed in the absence of foreign investment; but, as evidenced by the US Government's ethanol subsidies, economic logic is often overwhelmed by misguided political aspirations.

We don't think the Bolivian Government will end up taking any actions that have the potential to kill-off foreign investment in the mining sector, but it is certainly a risk that investors/speculators need to keep in mind. The good thing about obvious risks, though, is that they can lead to excellent speculations because the stock market will sometimes apply an excessive risk discount. This, we think, is the current situation with APE.

The main reason for mentioning APE again in today's report is that the initial NI43-101 resource calculation for the Paca project is scheduled to be complete by the middle of this month. The market has been largely ignoring APE's drilling results, but in the absence of a worsening political situation in Bolivia the independent confirmation -- the resource estimate is being put together by Micon International -- of a sizeable in-ground resource could grab the market's attention. If nothing else it should allow analysts (us included) to do preliminary estimates of the project's value, thus shining a spotlight on the large gap between the company's low market capitalisation (US$27M at Friday's closing price) and the potential value of its assets.

With reference to the below chart, the stock has dropped back to near the 52-week low reached in October. However, the slide since the early-November peak has the look of a consolidation as opposed to a new leg down. If so then the next move of note should be a rally up to resistance in the C$0.90-C$1.00 range. Breaking through this resistance range would then set the stage for a test of the 2006 peak.

Chart Sources

Charts appearing in today's commentary are courtesy of: