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   -- Weekly Market Update for the Week Commencing 6th October 2008

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, 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)

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. This secular trend will peak sometime between 2014 and 2020. (Last update: 22 October 2007)

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
Bullish
(30-Jun-08)
Bullish
(12-May-08)
Bullish

US$ (Dollar Index)
Neutral
(10-Sep-08)
Neutral
(22-Sep-08)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(14-Jul-08)
Bearish
(22-Sep-08)
Bearish
Stock Market (S&P500)
Neutral
(02-Jun-08)
Neutral
(30-Sep-08)
Bearish

Gold Stocks (HUI)
Bullish
(30-Jun-08)
Bullish
(12-May-08)
Bullish

OilNeutral
(03-Sep-08)
Neutral
(22-Sep-08)
Bullish

Industrial Metals (GYX)
Neutral
(18-Jun-08)
Neutral
(22-Sep-08)
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 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 fundmental and technical factors, and short-term views almost completely by technicals.

Inflation's New Upward Trend

Trend Change Signaled

In our 3rd October email alert we wrote: "The Fed expanded its balance sheet by $254B during the one-week period ending 1st October, which follows a $204B expansion during the preceding week. As a result, the Fed's balance sheet has grown by almost 50% within the space of just two weeks. This, we believe, is unprecedented."

Last week's money creation by the Fed won't appear in broader money-supply data until the end of this week, but the week-before-last's expansion of the Fed's balance sheet has given the True Money Supply (TMS), our preferred monetary aggregate, a substantial boost. In fact, it has pushed the year-over-year (YOY) TMS growth rate from 3.75% to 7.0%, thus signaling a new major upward trend. The situation is depicted below.


Money Velocity

..."money velocity" is a redundant concept at best and a misleading one at worst.

Many analysts will undoubtedly claim that the increasing rate of money-supply growth isn't important because the velocity of money will remain low, but such claims reveal a misunderstanding. There is no magical quantity called "velocity" that operates independently of money supply and demand, causing prices to rise during some periods and to fall during others. Like changes in the purchasing power of money, the thing commonly called "money velocity" is simply an effect of inflation.

By way of further explanation, during the early part of a major upward trend in money-supply growth it will typically be the case that inflation is not widely perceived as a problem. Actually, it's quite likely that deflation will be seen as the bigger threat. This is the situation that we often refer to as a "deflation scare" -- rising money-supply growth (inflation) combined with rising fear of deflation, with the fear of deflation being fanned by falling commodity and equity prices.

During the early part of an inflation cycle the demand for cash balances will tend to be relatively high -- due to falling inflation expectations -- and the average economist will perceive a low "velocity of money". But as time goes by the effects of the increased rate of money-supply growth will start becoming apparent and people will become a little more conscious of the inflation threat, the result being a decline in the demand for cash balances (people will begin to save less cash). The average economist will interpret this as an increase in the velocity of money and may well conclude that prices have begun to rise in response to the increased velocity. Clearly, though, both the increase in velocity and the rise in the general price level are just lagged EFFECTS of the preceding money-supply growth.

The bottom line is that "money velocity" is a redundant concept at best and a misleading one at worst.

A pronounced and sustained increase in the rate of money-supply growth ALWAYS leads to substantially higher prices somewhere in the economy, but due to the time-lags involved it will often be difficult to see the link between money-supply changes and price changes. For example, the rapid rises in the prices of many everyday items over the past three years occurred while the money supply was growing slowly. These price rises were an effect of the rapid money-supply growth that occurred during the first few years of the decade. Also, the quickening in the rate of money-supply growth that has just begun and looks set to continue over the coming year will probably be accompanied by a slowing rate of increase in the general price level, thus setting the scene for a "deflation scare". The reason is that the prices of everyday items have yet to react to the slower money-supply growth of 2005-2007.

Low-profile component of TARP paves the way for the Fed to create more money

In the 24th September Interim Update we mentioned that the Fed had requested the approval of Congress to pay interest on bank reserves, and explained why such a regulatory change would give the Fed a lot more freedom when it came to the printing of new money. The following excerpt from an Economist.com article published on 2nd October provides a bit more information on this issue:

"...although a rate cut remains on the table, the Fed will continue for the moment to rely on the growing use of its balance-sheet to counter the credit crunch. It has created many lending programmes since August 2007 to help banks finance holdings of illiquid assets and so avoid fire sales. But its balance-sheet is running up against constraints.

When the Fed makes loans, it deposits the proceeds in the accounts it holds for its customers -- the banks themselves. Until now it has not paid interest on those deposits, which means banks lend their excess reserves to other banks. All else being equal, that would push the fed funds rate below the Fedís target, which is why it sterilises those excess reserves by selling some of the Treasuries in its portfolio.

So far, so conventional. At the end of July last year, the Fed had $760 billion of unencumbered Treasuries, or 87% of its assets. But the Fedís lending commitments have soared: $29 billion to back the assets of Bear Stearns, a failed investment bank; $85 billion in support of American International Group, an insurer; eventually $300 billion in discount-window credit auctioned to banks; and a vast $620 billion ìswapî line which foreign central banks use to lend dollars to their own banks. It has also pledged to swap $200 billion of its Treasuries with investment banks. By October 1st Wrightson ICAP, a money-market research firm, reckoned the Fed had just $158 billion of unencumbered Treasuries left...

The Treasury has helped the Fed out by issuing additional debt exclusively for its use. This helps soak up the excess reserves created by the Fedís numerous loan programmes, which has caused its balance-sheet to balloon to $1.2 trillion. But the Treasury has congressional limits on how much debt it may issue. In search of a permanent way round the problem, the Fed has asked Congress to let it pay interest on bank reserves. It could then expand its balance-sheet indefinitely without driving the fed funds rate to zero; a bank will not lend out excess reserves at 0.25% if it can earn 1.75% at the Fed. The new bill would raise the debt ceiling and permit the Fed to pay interest on reserves immediately."

We understand that a provision allowing the Fed to pay interest on bank reserves was included in the Troubled Asset Relief Programme (TARP) approved by Congress late last week. This means that the Fed can now inject unlimited amounts of new money into the financial system without having to worry about pushing the Fed Funds Rate below its target.

Gold and Money-Supply Growth

Gold was one of the many winners from the last major upward trend in the money-supply growth rate, but this time round we suspect that it will be in a class of its own because the flaws in the monetary system are now more obvious than they were...

We can never know for certain, in advance, which items and which markets will be the eventual main beneficiaries of an upward trend in money-supply growth, but we can make educated guesses. In general, inflation will exert the most upward pressure on the prices of items/investments that are relatively scarce and relatively under-valued.

Value is always a matter of opinion and there are many smart people in the world who disagree with our assessment of relative value, but from our vantage point the broad stock market's high P/E ratio and low dividend yield disqualify it as a likely big winner from the coming inflation. The bond market also looks over-valued, as does the property market. Commodities are likely winners because in most cases their prices remain low in real terms and because the large nominal price gains of the past several years have not yet brought about large increases in supply, but industrial commodities such as oil and the base metals could languish for quite a while in response to the global growth slowdown. Gold, however, often benefits from illiquid financial markets and economic weakness due to its historical role as money. Furthermore, we think gold is cheap relative to most other commodities and most other investments.

Gold was one of the many winners from the last major upward trend in the money-supply growth rate, but this time round we suspect that it will be in a class of its own because the flaws in the monetary system are now more obvious than they were during the first half of this decade. But while it's very easy for us to make the case that gold will be a top -- perhaps even the top -- performing investment over the next few years, it is very difficult for us to identify the timing of the next major gold rally. The fact is that the historical relationship between money-supply trends and gold price trends has not been consistent enough for us to draw definitive conclusions as to WHEN the current surge in money-supply growth is most likely to positively impact the gold market. For example, there's a distinct possibility that the mid-September surge in the gold price marked the start of a major multi-year advance, particularly as it coincided with a sudden large expansion in the Fed's balance sheet; however, it is also possible that gold won't begin to react to the changed monetary conditions until some time next year.

It could be 1-2 years before the new upward trend in money-supply growth begins to have a meaningful effect on commodities in general and 3-4 years before it begins to boost the prices of everyday items, but gold's reaction is likely to occur much sooner due to the anticipatory gold-buying of large speculators (some large speculators will appreciate the inevitable/eventual effects of the monetary inflation and take positions in gold in anticipation of these effects).

The Stock Market

Earlier this year we regularly drew parallels between the performances of various financial markets during 2007-2008 and their performances during 1973-1974. However and as discussed in the 29th September Weekly Update, the spectacular way in which the 'Bush boom' of 2003-2007 has collapsed into a pile of financial rubble has caused the similarities between the current decade and the 1930s to become far more pronounced, with 2008 now looking like 1938 in some important respects. We therefore thought it would be worth comparing the US stock market's performance during 1937-1938 with its performance during 2007-2008, which is exactly what we've done below using a chart of the Dow Jones Industrials Index to represent the 1937-1938 market and a chart of the NYSE Composite Index to represent the current timeframe. The charts have been positioned so that the 1937 and 2007 peaks are aligned.


We are coming up to the 12-month anniversary of the 2007 stock market peak. At around the same point in 1938 (12 months after the major peak), the market commenced a rally that would ultimately last about 7 months and retrace about two-thirds of the preceding decline. It then traded in a wide range for years before dropping below its 1938 low during 1942. A similar outcome this time round would result in a rally from this month's low through to the second quarter of next year, followed by the return of the bear.

A similar outcome this time round is quite likely, because:

1. The OEX Volatility Index (VXO) hit 55 last week, and such extreme VXO readings have, in the past, always been followed by multi-month rallies.

2. The percentage of stocks trading above their 200-day moving averages has fallen to a level that has only ever occurred in the vicinity of an intermediate-term stock market bottom. A chart showing the percentage of S&P500 stocks above their 200-day moving averages is included herewith.


3. The huge volume of new money being injected into markets and the various other official interventions are likely to provide a short-term boost.

4. The huge volume of new money being injected into markets and the various other official interventions will reduce the economy's LONG-TERM growth potential and prolong the bear market.

5. Stock market valuations in the US are currently nowhere near bear-market-ending levels.

A short- and intermediate-term stock market bottom is probably very close in terms of time, but an upward reversal hasn't yet been signaled so there remains the risk of a final downward spike.

This week's important US economic events

Date Description
Monday Oct 06
No important events scheduled
Tuesday Oct 07FOMC Minutes
Consumer Credit
Wednesday Oct 08 Pending Home Sales
Thursday Oct 09 No important events scheduled
Friday Oct 10 Import and Export Prices
Trade Balance

Gold and the Dollar

Currency Market Update

Trichet's Faulty Thermometer

The central banks of the world continue to provide us with excellent examples of why they shouldn't exist.

The ECB's sole mandate is to keep inflation low. Despite financial turmoil and recession-like economic conditions, the ECB has therefore kept its focus on inflation and has not yet yielded to political pressure to cut its official interest rate target. This creates the impression that the ECB is acting responsibly, especially compared to the blatantly irresponsible Federal Reserve. However, this impression is wrong because the ECB is not really focused on inflation; rather, it is focused on the Consumer Price Index (CPI).

Even if it were possible to calculate the average economy-wide price level, the result of such a calculation would, at best, be a backward-looking indicator because purchasing-power changes generally lag changes in the actual rate of inflation (the rate of money-supply growth) by years. In other words, even if the CPI were a valid number it would not be much help in guiding monetary policy. In effect, basing monetary policy on the CPI is like driving a car forward while fixing one's gaze on the rearview mirror.

For reasons explained in previous TSI commentaries the CPI is not, however, a valid number. It is not even a good backward-looking indicator because it is simply not possible to come up with a single number that represents the average price in the economy. That is, the supposedly prudent ECB is letting its monetary policy be dictated by the ups and downs of a meaningless number. 

When we think about ECB chief Jean-Claude Trichet's recent assertion that the upside risks to price stability have not yet disappeared, and, therefore, that a rate cut is not yet the appropriate course of action, the image that springs to mind is a man standing in his underwear in Northern Siberia in the middle of winter holding a faulty thermometer that tells him it's hot. His hands and feet are frostbitten and he is about to go into cardiac arrest due to the extreme cold, but he continues to claim that it's hot because his thermometer tells him so.


The central banks of the world continue to provide us with excellent examples of why they shouldn't exist. Most of the time they fix the price of short-term credit too low, but once in a while they err by fixing it too high. The problem is, they always err one way or the other, and, as a result, they always distort the markets and make the economy function less efficiently.

Current Market Situation

The currency market, like all the other markets, is presently being dominated by de-leveraging. The de-leveraging process entails the unwinding of long-commodity/short-US$ bets that were placed during 2006, 2007, and the first half of 2008. It also entails a flight to safety, causing the US$ to strengthen relative to all the other currencies and the Yen to strengthen relative to all currencies except the US$.

A sign that the de-leveraging process and the associated flight to safety is coming to an end, at least temporarily, will be a decline in LIBOR (the interest rate that banks outside the US charge each other for short-term loans). A downward reversal in LIBOR will probably mark a short-term peak for the US$.

Gold

As indicated by the following daily chart, last Thursday's sharp decline caused December gold to break below support at $860. This former support is now resistance.

Our suggestion is that investors use additional weakness over the coming days to add to positions in physical gold. Specifically, we would be buyers in the low-800s and, although we don't expect the price to get that low, in the vicinity of last month's low (around $740).

Short-term traders should have been stopped out last Thursday and at this stage should remain on the sidelines.


Although last week's action put a dent in the US$ gold price chart, it didn't do any damage to the charts of gold in terms of most other currencies. For example:

1. In euro terms, gold appears to be breaking upward from a multi-month consolidation.


2. In terms of the South African Rand it looks like gold is about to embark on its next intermediate-term advance.


3. In Australian Dollar terms gold made a new all-time high last week.


4. The Japanese Yen is the major currency in terms of which gold looks least bullish. However, the July-September decline stopped where it needed to stop (at support defined by the May-2006 peak), so it is possible that the correction in gold/yen is complete.


Gold Stocks

...the market has downgraded stocks indiscriminately, thus creating an opportunity to reduce overall portfolio risk without reducing upside potential.

Prior to last Thursday the AMEX Gold BUGS Index (HUI) and the other gold-stock indices were behaving in a bullish way. They had risen sharply from their September lows to their 50-day moving averages, which, as noted in TSI commentaries, were likely levels for pullbacks to commence. Pullbacks did commence and at the close of trading on Wednesday these pullbacks looked routine. However, Thursday's decline was certainly not routine.

Within the space of just one day (last Thursday) the HUI gave back almost all the gains it had made over the preceding weeks, effectively taking us back to "square one". It was one of the most extraordinary days in an extraordinary year, and, for us, the most disappointing. Based on the emails we received it is clear that it was also the most disheartening day for many of our readers.

It is possible that last Thursday will prove to be the final 'give up' for the gold sector -- the day on which many long-term holders of gold shares finally decided that they couldn't hold any longer. However, there is no evidence, yet, that Thursday's action represented a successful test of the September bottom. Furthermore and as mentioned in Friday's email alert, a short-lived spike below the September low would create the most bullish setup because it would create a low within the reliable October-November turning-point window.

We won't suggest any additional short-term trading positions until the HUI closes above last Friday's high (287) or some other evidence emerges of an upward reversal.


If you have substantial exposure to gold shares in general and junior gold shares in particular then you will have suffered a large portfolio draw-down over the past few months, but if you have invested in real companies -- well-managed companies with good quality assets -- then you don't have anything to worry about unless you are in the position of having too much debt and insufficient cash. If your personal balance sheet is in reasonable shape then you should be able to ride-out this storm and will eventually profit greatly from the coming major upward re-valuation of gold in the ground.

Our view is that some junior gold shares bottomed last month, others will bottom this month, and most of the rest will bottom in response to tax-loss selling in December. This is not the time to be selling such stocks because, in our opinion, an historic bottom is in the making, but this is also not the time to be taking additional risk with the aim of quickly recouping prior losses.

Due to the fact that the prices of almost all junior resource stocks have been hammered regardless of their risk, the opportunity now exists -- and will probably continue to exist for 3 more months -- to improve the quality of one's portfolio by shifting out of the most risky juniors and into those that offer more safety. An example of a relatively safe junior gold/silver stock that has been hit just as hard as, or even harder than, many of its riskier brethren is discussed below. The point is that the market has downgraded stocks indiscriminately, thus creating an opportunity to reduce overall portfolio risk without reducing upside potential. 

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)

New Stock Selection: US Silver (TSXV: USA). Shares: 215M issued, 258M fully diluted. Recent price: C$0.17

We weren't going to add any more junior gold/silver stocks to the TSI List at this time because we are already following too many stocks of this type and because the beaten-down juniors will probably come under additional pressure as year-end approaches due to tax-loss selling. However, at its current price we think it would be unreasonable of us not to present the case for taking a position in US Silver.

In August, USA.V was producing silver at its operations in Idaho at the rate of 2.3M ounces/year and was on track to reach an annual production rate of 3.0M ounces by year-end. The company also has lead and zinc by-products.

Production costs are currently high ($10.92/oz in August), but are expected to fall sharply over the next few months due to higher silver production and a greater contribution from the by-products (the proceeds of lead and zinc sales are subtracted from the cost line rather than added to the revenue line).

Importantly, especially in the current market environment, USA.V has $11M of cash and $8M of investments on its balance sheet. The cash should be more than enough to see the company through to the point where it is profitable. In other words, there should be no need for USA.V to do any more equity financings to get to the point where it is self-funding.

We mentioned USA.V favourably in a couple of previous TSI commentaries, but never added it to the List because its valuation wasn't attractive enough relative to other opportunities. However, despite its low political risk and current production USA.V has been one of the hardest-hit juniors over the past 6 months. Consequently, it now offers very good value in absolute terms and relative to other junior silver stocks.

USA.V is the only silver producer we know of that is trading at around one-times annual sales revenue (assuming 3M ounces of production and a silver price of $12/ounce, USA's current market cap equates to about one-times annual revenue). It is rare for such stocks to trade at less than three-times annual sales.

The main company-specific risk is that the ramp-up to the 3M oz/yr production rate will not go as planned, and, as a result, that production costs will remain high.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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