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   -- Weekly Market Update for the Week Commencing 8th February 2010

Big Picture View

Here is a summary of our big picture view of the markets. Note that our short-term views may differ from our big picture view.

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

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

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

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

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

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Outlook Summary

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Bullish
(01-Feb-10)
Bullish
(12-May-08)
Bullish

US$ (Dollar Index)
Neutral
(20-Jan-10)
Bullish
(02-Nov-09)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(18-Jan-10)
Bearish
(14-Dec-09)
Bearish
Stock Market (S&P500)
Neutral
(07-Dec-09)
Bearish
(11-May-09)
Bearish

Gold Stocks (HUI)
Bullish
(01-Feb-10)
Neutral
(16-Sep-09)
Bullish

OilNeutral
(28-Oct-09)
Neutral
(14-Oct-09)
Bullish

Industrial Metals (GYX)
Bearish
(21-Sep-09)
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 fundmental and technical factors, and short-term views almost completely by technicals.

Time to bet against junk bonds

In some respects the market action since March of last year has been a fairly typical reaction to the preceding crash. For example, although the rebound in the S&P500 Index has lasted longer than a typical post-crash rebound, its magnitude has been roughly in line with the historical average. In other respects, however, the market action has been extraordinary, most likely due to the huge amount of new money that the senior central banks have pumped into their respective economies.

One of the most extraordinary aspects of the post-March-2009 market action has been the phenomenal recovery within the realm of high-yield bonds, often called "junk bonds". In many instances these bonds have recouped almost all of their 2008 losses, even though default rates have risen and there is scant evidence of sustainable economic improvement.

The incredible recovery of the junk bond market is exemplified by the following chart of the Blackrock Corporate High-Yield Fund (NYSE: CYE), which recently exceeded its 2007 peak. 'Investors' in junk bonds and high-yield bond funds are literally partying like it was 2007. The famous phrase "irrational exuberance" springs to mind.


In our opinion, this is a good time for experienced speculators to bet against junk bonds (by, for example, shorting CYE) or bet on a widening of credit spreads (by, for example, going short CYE and long TLT (a fund that holds long-dated US Treasury Bonds) in equal dollar amounts). Risk could be managed by placing a 'buy stop' just above the recent high (the stop would go just above the recent high in the CYE/TLT ratio if betting on a widening of credit spreads).

The Stock Market

In last week's report we noted that the US stock market had quickly become very 'oversold' and might bottom via a downward spike during the first half of the week. Instead, it rebounded to begin the week and then plunged to a new low on Thursday. It dropped further during Friday's session before reversing direction and ending the day with a small gain.

There's a reasonable chance that a short-term bottom was put in place on Friday.


Even if we were very confident that a short-term bottom was put in place on Friday we wouldn't be buyers of the S&P500 Index at this time. This is because we don't perceive sufficient upside potential. We won't be surprised if the US market makes a new 52-week high within the next two months, but we will be surprised if it moves more than a few percent above last month's high.

If the S&P500 Index manages to make a new 52-week high within the next couple of months, our thinking is that the new high will be unconfirmed by many other indices. Australia's All Ordinaries Index (AORD), for instance, is showing signs of having already completed its post-crash rebound. With reference to the following chart, AORD has support just below its current price and will probably soon bounce; however, we suspect that its next rally will top out below the January peak.


The strategy that makes the most sense to us is one that involves a) maintaining a large cash reserve, b) accumulating gold stocks on weakness, and c) scaling out of most non-gold stocks on strength.

This week's important US economic events

Date Description
Monday Feb 08
No important events scheduled
Tuesday Feb 09No important events scheduled
Wednesday Feb 10 Trade Balance
Treasury Budget
Thursday Feb 11 Retail Sales
Friday Feb 12 Consumer Sentiment

Gold and the Dollar

Gold

What "usually" happens in a gold bull market

We occasionally read comments along the lines of "when gold is in a bull market it usually..." and "in gold bull markets such-and-such generally happens". Here are some specific examples of what we are referring to:

  - "In a gold bull market, silver usually does better than gold"

  - "Gold bull markets are associated with rising interest rates"

  - "Gold bull markets are driven by high and rising price inflation"

  - "Gold bull markets continue until the market value of the US gold reserve balances the value of US currency in circulation"

The point we want to make today is that comments about what usually happens in a gold bull market, including the examples cited above, are based on a sample size of ONE. Specifically, they are based solely on what happened during the 1970s. (Note: the idea that silver outperforms gold during a gold bull market is actually based on what happened during only the final 6 months of the 1970s, because during the first 9.5 years of that decade silver did not outperform gold.)

It is difficult for contrary evidence to penetrate a mind once that mind is set. Hence the term mind-set: a fixed mental attitude or disposition that predetermines a person's responses to and interpretations of situations. For example, the fact that silver has under-performed gold during the current (10 years and counting) bull market hasn't yet dented the popularity of the idea that silver "usually" outperforms when the precious metals are in long-term upward trends. Also, some analysts still assert that gold bull markets go hand-in-hand with rising interest rates, even though gold has trended upward over the past 10 years in parallel with falling interest rates.

Information can certainly be gleaned from what happened during the 1970s, but we shouldn't blindly assume that the characteristics of the current gold bull market are the same as those of the only prior gold bull market.

Current Market Situation

From the email alert sent to subscribers following last Thursday's dramatic market action:

"Rather than new developments, part of what we are seeing right now is a change in the primary focus of speculators -- from US economic/financial negatives to European negatives. Some time in the future the primary focus will undoubtedly return to the US and its trio of disasters known as the Fed, the Obama Administration, and the ocean of unfunded liabilities.
 
The realisation that the euro's fundamentals are just as bad as those of the US$ shouldn't be bearish for gold, but sentiment is the dominant driver in the short-term and the gold price tanked on Thursday in sympathy with a broad-based plunge in commodity prices. Short-term support in the $1070s was decisively breached and the preliminary sign of an upward reversal that appeared on Monday was negated. The correction is obviously still in progress."

Thursday's breach of support in the $1070s is clearly evident on the following daily chart of February gold futures. This support is now resistance and could limit a near-term rebound.


With the benefit of hindsight it is apparent that we shouldn't have upgraded our short-term gold outlook last week. However, we are not going to downgrade it in response to the price action of late last week. The reason is that we are risk/reward assessors, not trend followers, and although the downward correction is still in progress the Thursday-Friday decline was large enough to significantly reduce the remaining downside risk. Also, last week's strength in the gold stocks relative to the bullion is a short-term plus for both the stocks and the bullion. The bottom line is that if we hadn't upgraded our short-term outlook last week, we would be doing so now.

Just to be clear, we've thought for the past several weeks that the maximum downside risk on both a short- and intermediate-term basis was defined by major support at around $1000. This is still the case. As far as potential reward is concerned, we expect that the next rally will, at a minimum, retrace a large chunk of the decline that got underway in early December. This implies about $50 of additional short-term downside risk versus short-term upside potential of well over $100.

We don't want to downplay the significance of last week's market action, because the reality is that the market action of the past few trading days makes it more likely that gold's downward correction will prove to be the intermediate-term variety. However, this doesn't indicate to us that there is more downside risk than previously thought. In our opinion, the implication of this being an intermediate-term correction would be that we got several months of back-and-forth price movement prior to the start of the next major rally.

From a fundamental perspective, there are three main reasons why we don't perceive a lot of additional downside risk in the gold price. First, any significant increase in deflation fear (a potential source of downward pressure on gold) would prompt a quick inflationary response from both the Fed and the ECB; second, increasing instability within Europe's monetary union (a recent source of downward pressure on gold due to the upward pressure it put on the Dollar Index) should eventually lead to greater investment demand for gold as well as the US$; and third, US Federal Government spending is intentionally (you don't come up with a $3.8 trillion dollar budget by accident) out of control.

Silver

Whereas gold still has a realistic chance of making a new high within the next few months, silver's chance was all but eliminated last week when it plunged below intermediate-term support at $16.00. The top section of the following daily chart shows silver's current situation. The silver market is now very 'oversold' and will probably soon rebound, but we expect that any rebound in the near future will encounter formidable resistance in the $16-$17 range.

The bottom section of the following chart shows the silver/gold ratio, which has also broken out to the downside. On an intermediate-term basis the silver/gold ratio often trends with the broad US stock market, so the pronounced weakness in this ratio over the past few weeks could have implications beyond the precious metals. Interestingly, the silver/gold ratio turned upward a few months ahead of the broad stock market in October of 2008 and appears to have turned downward a few months ahead of the broad stock market in September of 2009.


Gold Stocks

Gold bullion lost about $17 over the course of last week while the HUI gained 16 points. This has created a bullish divergence between the HUI and the HUI/gold ratio as indicated on the following chart. This divergence has the form of a lower low for the HUI in parallel with a higher low for the HUI/gold ratio, followed by a rise to a new multi-week high by the HUI/gold ratio. It is the opposite of what happened between mid September and early December of last year, although on a much smaller time scale. Refer to the following chart for details.


Based on what happened during previous intermediate-term corrections over the past decade, our expectation is that the HUI's next multi-week rally will retrace 50%-70% of the decline from the 2nd December peak. If Friday's intra-day low of 363 proves to be the bottom of the decline then we will look for a rise to 440-470 within the next two months, with some hesitation along the way at 400 and 420.

In the email alert sent after the close of trading last Thursday we cautioned that even though the gold sector could be close to an important low it was not the time to be buying anything -- including gold stocks -- aggressively. In general terms, it can often be a mistake to buy quickly in response to a price decline or to sell quickly in response to a price rise; the reason being that prices will regularly move much lower during the downward corrections and much higher during the rallies than a rational observer initially expects. This is particularly the case when dealing in small-cap stocks, as is our wont. The fact is that many 'investors' are easily spooked, oblivious to value, and liable to either cough-up shares at ridiculously low prices or eagerly buy at ridiculously high prices.

The best way to take advantage of the market's manic-depressive nature is to methodically build positions over time during the purges and to methodically harvest gains over time during the subsequent surges.

Currency Market Update

The price action determines the news coverage

In October of last year there was a story in a British newspaper about the Gulf Arab states being in secret talks with Russia, China, Japan and France to replace the US dollar with a basket of currencies in trading oil. We said at the time that the story was probably untrue, but that in any case the dollar's relative value was determined by the global demand to HOLD it; not by its use in oil trading (the demand for dollars created by the oil trade is very small relative to the total demand for dollars). We also pointed out that the story about pricing oil in a currency other than the US$ always seems to crop-up after the dollar has been trending lower for several months, and that we considered it a contrary indicator.

Fast-forward to the present. These days, nobody in the mainstream press talks about the possibility of the Arabian Gulf states requiring payment in a currency other than the US$. The big story now is the threat that some of the Euro Zone's peripheral countries will default on their debts.

The stories that appear in the financial press are often nothing more than reactions to the most recent price action. The story about oil-producing nations shifting away from the US$ is a good example in that this story was just as irrelevant in October of last year as it is today, but it garnered a lot of credibility (and created a small storm) back then because it meshed with the price action. Similarly, the risk of Greece defaulting on its debt was just as real in October of last year as it is today, but back then the risk wasn't featured prominently in the mainstream media because the euro was in an upward trend.

Feedback loops regularly develop whereby the price trend prompts financial journalists to emphasise certain news stories, and the news coverage then helps to extend the price trend. In such cases it is generally the price action that sets the loop in motion.

Current Market Situation

The following discussion is probably going to seem a bit complex or convoluted, but it can't be helped.

Displayed below is a daily chart of the Dollar Index covering the past 24 years. The intermediate-term lows that occurred during this period -- excluding the November-2009 low, which has not yet been 100% confirmed as the intermediate-term variety -- have been shaded in yellow. The blue line on the chart is the 200-day moving average (MA).

The chart shows that there were seven intermediate-term lows during 1986-2008, and that six of these lows involved an initial multi-week rally followed by a decline to test the low (note that the test of the low is sometimes difficult to see on the long-term chart, but in each case it becomes apparent when viewing a chart that zooms-in on the price action around the low). The lone exception was the low that was put in place during the third quarter of 1992.

The strong historical tendency for the Dollar Index to 'test' its low is why we have thought that last November's low would probably be tested prior to the start of a multi-month advance that would, at a minimum, take the Dollar Index up to 90.

The chart also shows that a) when intermediate-term lows have formed via an initial multi-week rally followed by a decline to test the low, the initial rally has never exceeded the 200-day MA, and b) with only one exception (early 1992), a move from well below the 200-day MA to above this MA has always been followed by significant additional gains over the ensuing 1-2 months.

Putting the above together, the combination of the recent price action (the recent advance has taken the Dollar Index well above its 200-day MA) and the historical record suggests that: 1) there will be no pullback to test the November-2009 low and the Dollar Index will maintain its short-term upward trend over the coming 1-2 months, OR 2) the November-2009 low was NOT the intermediate-term variety (meaning that the current short-term advance will be followed by a decline to a new 52-week low).


The obvious question then is: how will we know which scenario is in play?

We won't know for certain until the Dollar Index moves to a much higher level or breaks to a new low, but the extent of the next pullback should give us a pretty good idea.

Zooming in to the current situation (refer to the chart displayed below), we see the Dollar Index's recent break above lateral resistance and the 200-day MA. If an intermediate-term advance is in progress -- meaning that Scenario 1) is most likely playing out -- then the next pullback should not breach former resistance (now support) at 78.0-78.5. In this case, the next pullback would probably look similar to the one that unfolded between the 3rd week of December and the second week of January. Alternatively, a break below 78 would suggest that the Dollar Index was headed to a new 52-week low and perhaps even to a new all-time low.


Below is a chart showing the S&P500 Index and the Canadian Dollar. The chart's message is that you shouldn't be bullish on the Canadian Dollar unless you are bullish on the US stock market.


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 trading position: Junior Gold Miners ETF (NYSE: GDXJ). Recent price: US$22.93

We are going to add a short-term trading position in GDXJ to the TSI Stocks List at Friday's closing price of US$22.93. The initial stop on this trade will be a daily close below US$21.10. The stop has been set at this level because the trade is based on the idea that a short-term bottom was put in place on Friday, meaning that a daily close below Friday's intra-day low ($21.18) would indicate that the basis of the trade is wrong.

As previously suggested, longer-term speculators who don't want the hassle of selecting and following individual junior gold/silver companies could simply scale into a GDXJ position over time during periods of weakness.

    VIX Futures ETN (VXX). Recent price: US$32.65

Due to the likelihood of the US stock market having made a short-term bottom last Friday we have decided to exit VXX at Friday's closing price of $32.65. The profit on the 3-week trade was 12.7%.

As indicated by its name, VXX is designed to track VIX futures rather than the VIX itself. This means that VXX will sometimes move by significantly less than the VIX and at other times move by more than the VIX.

One of the keys to how VXX performs relative to the VIX during a market decline will be the difference between the VIX and the nearest VIX futures contract at the beginning of the decline. For example, when the nearest VIX futures contract is well above the VIX -- as was the case when we added VXX to the TSI Stocks List in mid January -- then it's likely that the futures contract will rise by substantially less than the underlying index in response to the increase in fear that accompanies a short-term market decline. This is because the futures market has already discounted some of the increase in volatility.

Therefore, if we decide to return VXX to the TSI List in the future we will pay more attention to the difference between the Volatility Index (VIX) and the VIX futures at the time the trade is entered.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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