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   -- Weekly Market Update for the Week Commencing 6th June 2011

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 ended in December of 2008. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 4 April 2011)

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

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Neutral
(19-Apr-11)
Neutral
(24-Jan-11)
Bullish

US$ (Dollar Index)
Neutral
(07-Mar-11)
Bullish
(02-May-11)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(20-Sep-10)
Bearish
(21-Mar-11)
Bearish
Stock Market (S&P500)
Bearish
(09-May-11)
Bearish
(11-Oct-10)
Bearish

Gold Stocks (HUI)
Neutral
(24-Apr-11)
Bullish
(23-Jun-10)
Bullish

OilNeutral
(31-Jan-11)
Neutral
(31-Jan-11)
Bullish

Industrial Metals (GYX)
Bearish
(03-Jan-11)
Bearish
(25-May-09)
Neutral
(11-Jan-10)


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 or that we think risk and reward are roughly in balance with respect to the timeframe in question.

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

What "backs" today's money?

All of the major central banks hold currency reserves in the form of gold or other national currencies, but it is not strictly true that these reserves "back" the associated currencies. For example, if the US' gold reserves or Japan's US$ reserves disappeared tomorrow, the US$ and the Yen wouldn't be worth any less than they are today. What, then, backs today's fiat money?

That's a trick question, because money isn't backed by anything. Money is what it is -- the most commonly used final means of payment within the economy. For example, when the US was on something close to a genuine "gold standard" during the last quarter of the 19th Century, gold was money and the gold wasn't backed by anything. Pieces of paper known as dollars circulated within the economy during this period, but the paper dollars weren't money; rather, they were receipts for money (gold) held in a vault somewhere. Of course, banks created more receipts for money than there was actual money, but this fraudulent practice -- known as fractional reserve banking -- is a separate issue.

Some people will no doubt argue that gold money wouldn't need to be backed by anything because gold has "intrinsic value", whereas paper or electronic money needs to be backed by something because it has no "intrinsic value". The problem with this line of thinking is that gold and paper money have exactly the same "intrinsic value": zero. All value is subjective. What, for instance, would gold bullion be worth to you if you were stranded alone on a desert island with no hope of ever being rescued? In that situation, a tree that provided a steady supply of coconuts would probably have a lot more value to you than one million ounces of gold. However, if you were living in a modern economy and the government was acting in a way that was guaranteed to destroy wealth and substantially reduce the purchasing power of the official money, gold would probably be very valuable to you. The point is that the value of any object is in the eye of the beholder; it is never inherent in the object.

Once something has taken on the role of money, its value, like the value of everything else, will be determined by its supply relative to its demand. The difference is that with money it really comes down to supply, because while changes in demand are often important on a short- or intermediate-term basis the long-term trend in the purchasing power of money will almost always be dominated by the change in the money supply*. Given that under today's monetary system the central bank determines the long-term growth rate in the supply of money, it is fair to say that the central bank (the Fed in the US) is by far the biggest influence on the value of modern money. However, the central bank is really just a tool of the government and the banking system, so if we take a step back we can see that the ability of today's money to maintain its usefulness as money is largely dependent upon the policies/actions of the government and the major private banks.

Therein lies the problem. The problem isn't that today's money is not "backed" by much in the way of reserves; the problem is that the value of YOUR money is determined by the actions of ethically-bankrupt institutions.

    *Note that we aren't implying, here, that there is a linear relationship between changes in the money supply and changes in money purchasing power, because that definitely isn't the case. Changes in the money supply have a non-uniform effect on prices within the economy, and there are often long and variable delays between changes in money supply and the resultant changes in money purchasing power. We are simply saying that the long-term shift in a currency's purchasing power will primarily be determined by the change in its supply.

Copper Update

The following daily chart shows that copper futures peaked in February and have rebounded since making some sort of bottom during the first half of May. At this stage the advance from the May low looks like a counter-trend move. If this interpretation is correct then the recent rebound will be followed by a decline to a new low for the year.

A daily close below 400 would suggest that the copper futures market was on its way to a new low, with the 360s being a reasonable short-term target. On the other hand, a solid daily close above 420 would suggest that the May low was more important than we currently believe and that a test of the February high was on the cards.



We are intermediate-term bearish on copper, mainly because the prices of copper and the other base metals are positively correlated with the stock market. This positive correlation is unlikely to change anytime soon, so our bearish outlook for equities translates into a bearish outlook for copper.

The next daily chart covers a longer period and shows how copper has performed in gold terms. Notice that although the copper/gold ratio made a new multi-year high in February of this year, the February-2011 high was only marginally above the August-2009 high. In other words, in gold terms almost all of copper's post-crash rebound was complete by August of 2009.

If the stock market and global growth trends evolve as we currently expect then the copper/gold ratio will probably break below its Q1-2009 bottom within the next 12 months. However, due to monetary inflation there is little chance of the copper market ever breaking below, or even seriously challenging, its Q1-2009 low in US$ terms.


Remembering an old quote

With a massive increase in US Federal Government spending and indebtedness having failed to improve the employment situation, and with recent data suggesting that the US economy is headed towards another official recession (unofficially, it never left the 2007-2009 recession), we are reminded of the following quote. It is from an address to Congressional Democrats in May of 1939 by Henry Morgenthau, Franklin Roosevelt's Treasury Secretary.

"We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong ... somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises ... I say after eight years of this Administration we have just as much unemployment as when we started ... And an enormous debt to boot!"

The Stock Market

First up, we have a weekly chart of Hong Kong's Hang Seng Index (HSI). The HSI rocketed upward last Tuesday, and then spent the rest of the week giving up all those gains and more. The result is the long tail on the weekly candlestick.

In effect, the HSI has gone sideways over the past 8 months. Based only on the price action there is no way of telling whether it is consolidating within a continuing multi-year upward trend or completing a large rounded topping pattern. We suspect it's the latter.


Next up, we have a weekly chart of the S&P500 Index (SPX). The SPX has just fallen for five weeks in a row, but three of these weekly declines were very small and it isn't yet very 'oversold'. The channel that defined the QE2 rally has been decisively breached, but the most important support lies at 1250. A weekly close below 1250 would confirm that an intermediate-term top is in place.

Even if it turns out that an intermediate-term peak was put in place at the beginning of last month, we expect that this peak will be tested before a major downward trend gets underway. This is due to the way multi-year stock market rallies usually top out.


This week's important US economic events

Date Description
Monday Jun 06
No important events scheduled
Tuesday Jun 07
Consumer Credit
Wednesday Jun 08 Fed's Beige Book
Thursday Jun 09 International Trade Balance
Friday Jun 10 Import and Export Prices
Treasury Budget

Gold and the Dollar

Gold and Silver

Our view is that gold either made an intermediate-term top at the beginning of May or will make an intermediate-term top very soon. This view is largely based on the performance of the silver/gold ratio, which clearly signaled an important trend reversal during the final week of April and the first week of May. Such trend reversals in the silver/gold ratio generally coincide with intermediate-term gold peaks or lead them by no more than a few weeks.

If gold is going to make a new high before commencing a multi-month correction, then this week is the most likely time for it to do so. Also, in order to maintain the short-term potential for a new high the nearest gold futures contract should not close below the support indicated on the following daily chart ($1520 for the June contract).


Silver made an intermediate-term top in late April and has been consolidating since 6th May. Short-term resistance lies at around $39.50.

If gold manages to make a new high this week it will be interesting to see where silver is trading at the time. A new price high for gold along with a sub-$40 silver price would be a definitive bearish non-confirmation.


As soon as silver's correction began, the 200-day moving average became a likely downside target. It also became the minimum downside target, in that intermediate-term corrections usually result in the price dropping below this moving average.

Silver's 200-day moving average is now at $30 and is rising at the rate of about $2/month. This means that silver could reach its 200-day moving average within the next three months without breaking below its May low.

While it is certainly possible that silver will eventually reach its 200-day MA without breaking below its May low, this is not the most probable outcome. In fact, it would be very strange if it turned out that the ultimate correction low was put in place just two weeks into the correction. It is more likely that silver will trade at least a few dollars below its May low before bottoming on a sustained basis, with a decline to the low-$20s being the maximum realistic downside over the months ahead.

Gold Stocks

The top half of the following daily chart shows that the HUI reversed downward after almost reaching resistance at 560-570 early last week. The bottom half of the chart shows that the HUI/gold ratio has dropped back to near its May low.

Note that if the HUI manages to break above 570 at some point over the next few weeks, we won't necessarily take it as confirmation that the correction is over. It will, however, represent a significant change to the anticipated pattern that will need to be assessed at the time.


The Rydex Precious Metals Fund (RydexPM) is an open-ended mutual fund that holds mostly gold and silver equities.

The chart displayed below shows RydexPM and the cumulative net cash flow into this fund. The most interesting aspect of this chart is that it reveals a decline to a new 3-year low in the cumulative net cash flow even though the price is still within 10% of the 3-year high reached in April. This is a sentiment mismatch with bullish implications, because it suggests that the public (the 'dumb money') is far more bearish than would be justified by the price action.


Given that a) our HUI/Gold Oscillator came close to generating a rare buy signal last month, b) the gold sector of the stock market has now been in correction mode for 6 months, c) gold stocks are generally under-valued relative to gold bullion and d) the public appears to be excessively bearish on precious metals equities, the stage appears to be set for a multi-month rally in the gold sector. The problem is that downward corrections in gold and silver bullion are probably not close to being complete, which probably means that the beginning of the aforementioned rally is still some way off.

Currency Market Update

China's Currency (the RMB)

China's government effected a large devaluation of the RMB in 1994 and then kept its currency at a constant level against the US$ for the next 10 years. However, in 2005 the government-controlled link to the US$ was made more flexible, paving the way for a steady rise in the RMB that has continued to this day. Refer to the following monthly chart for details.


Although the RMB has been 'allowed' to trend upward over the past six years, throughout this period it has undoubtedly been lower, relative to the US$ and other major currencies, than it would have been in the absence of the Chinese Government's exchange-rate management. Moreover, keeping the RMB at an artificially low level against the US$ has entailed the creation of new RMB at a rapid rate, which means that exchange rate policy has been a major contributor to China's current inflation problem. Regardless of what else is done, the inflation problem will worsen unless the money-supply growth rate is substantially reduced.

One of the problems now faced by China's government is that it has conflicting plans and objectives. For example, the desire to slow the rate at which prices are increasing conflicts with the plan, as discussed in the Reuters article posted HERE, to 'paper over' hundreds of billions of dollars of debt taken on by local governments. These are the sorts of policy conflicts that central planners always end up facing.

If political pressure to bail out local governments and banks takes precedence over the political pressure to stem increases in the cost of living, then China's inflation problem will get much worse and the RMB will transmogrify into a weak currency. In fact, it is possible that there has already been sufficient monetary inflation in China to eventually result in significant RMB weakness.

We suspect that if the RMB were set free from its US$ peg in the near future it would quickly rise by at least a few percent in knee-jerk fashion, but that it would then begin a long-term decline due to the effects of its relatively high inflation rate.

Current Market Situation

In the 30th May Weekly Update we wrote:

"The US dollar's intermediate-term bottoming process was always likely to entail an initial rally followed by a decline to test the low. Last week's market action could mean that the initial rally is complete, especially considering that the Swiss Franc made a new high on Friday, although we can't yet rule out the possibility that the initial rally is still in progress. What we can say is that we would be buyers of US dollars, or sellers/hedgers of most other major currencies, if the Dollar Index dropped back to the vicinity of its early-May low."

The action of the past week leaves little doubt that the initial rally is complete and the decline to 'test' the low is now in progress. There is no guarantee that the test will be successful, but we expect that it will be.


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)

Pretium Resources (TSX: PVG). Shares: 85M issued, 90M fully diluted. Recent price: C$9.36

During the final two trading days of last week PVG exhibited strange price action in the form of an 8% decline on Thursday and an 8% rise on Friday. Thursday's price action was particularly strange in that it occurred in reaction to positive news. At least, we thought the news was very positive and expected that the stock would rise in response.

Thursday's news was a press release advising the results of a Preliminary Economic Assessment (PEA) for the high-grade portion of the company's Brucejack project. The PEA, which is by definition very preliminary in nature, indicates that this part of the overall project could be developed into a mine with a net present value of around US$1.4B at today's metal prices. Importantly, the preliminary estimate for the total capital cost is $282M, an amount that a company of PVG's size should be able to finance. We don't know why anyone in his/her right mind would have sold in response to this news.

The PVG story continues to unfold as expected or better than expected. The company is rapidly moving ahead on two fronts, the first involving the development of a huge low-grade deposit that will require many years and billions of dollars to bring into production, and the second involving the development of a medium-size high-grade deposit with nearer-term production potential.

Last week's strange price action created another short-lived opportunity to buy at the support that begins at around C$8.50 and extends down to C$8.00. Resistance lies at C$10.00.


    Sabina Gold and Silver (TSX: SBB). Shares: 154M issued, 166M fully diluted. Recent price: C$6.89

In a very interesting press release last Thursday, SBB announced that it has sold its Hackett River silver-zinc project to Xstrata. Due to the way the sale has been structured, SBB will retain considerable exposure to the silver component of the project. Specifically, Hackett River has been sold for $50M cash plus 22.5% of the first 190 million ounces of payable silver mined from the project plus 12.5% of all payable silver from the project thereafter at no future cost to SBB. In effect, SBB now owns a royalty that will give it around 2.7M ounces of silver per year once Hackett River goes into production. At a silver price of $30/oz, the silver royalty would amount to a payment of $81M/year.

A silver or gold royalty of the magnitude mentioned above on a project that is still a few years from production would probably have a market value of around $800M (assuming $30/oz for silver). Furthermore, based on how royalty companies are currently being valued by the stock market the royalty's market value would probably rise to at least $1.6B once the project was in production (again, assuming $30/oz for silver).

We suspect that SBB will end up selling the silver royalty to Silver Wheaton, thus giving it more than enough cash to fully fund the Back River gold project through to production.

In our opinion, by essentially eliminating all of SBB's exposure to base metals the Xstrata deal reduces both the downside risk and the upside potential of SBB shares. Our 'back of the envelope' estimation of SBB's current value is now $1.4B, which is arrived at by adding $200M cash and $400M for the Back River project to the above-mentioned $800M estimate for the market value of the new silver royalty. Using the fully diluted share count, this equates to about C$8.40/share.

Our view continues to be that a decline to around C$5/share would create a new buying opportunity. There is, of course, no guarantee that the stock will pull back that far.

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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