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   -- Weekly Market Update for the Week Commencing 8th December 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 first half of 2008, but a long-term peak won't occur until 2014-2020. (Last update: 03 November 2008)

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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)
Bearish
(17-Nov-08)
Bearish
(24-Nov-08)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Bearish
(21-Nov-08)
Bearish
(22-Sep-08)
Bearish
Stock Market (S&P500)
Bullish
(16-Oct-08)
Bullish
(08-Oct-08)
Bearish

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

OilBullish
(17-Nov-08)
Neutral
(22-Sep-08)
Bullish

Industrial Metals (GYX)
Bullish
(26-Nov-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.

Gold and the Money Supply

Assuming that 0.20 approximates 'fair value' for the gold/TMS ratio under normal circumstances we arrive at a current inflation-adjusted fair value for gold of around US$1,100/ounce. ...speculators purchase gold in anticipation of the increased rate of currency depreciation and other problems that will eventually stem from a higher rate of monetary inflation, or sell gold in anticipation of the reduced rate of currency depreciation that will eventually stem from a lower rate of monetary inflation.

The following discussion mostly covers old ground, but the relationship between gold and the money supply has important investment implications and therefore warrants some repetitive treatment.

An inflation-adjusted 'fair value' for gold of several thousand dollars per ounce could be arrived at by taking the January-1980 high in the gold price as the starting point and then accounting for the amount of money-supply growth that subsequently occurred. However, gold was extremely over-valued at its 1980 peak, so it makes no sense to use this price level as the starting point for such an analysis. For this reason, the author of a recent "Seeking Alpha" article used January-1971 as the starting point. But this also makes no sense because gold was at least as under-valued in 1971 as it was over-valued in 1980. In January of 1971 the gold price had been fixed at $35/oz for about 37 years, a period during which the money supply expanded year after year after year. The bottom line is that by taking January-1980 as the starting point we end up with a ridiculously high inflation-adjusted 'fair value' for gold, whereas by taking January-1971 as the starting point we end up with a ridiculously low number.

The impossibility of determining a point in the historical record when gold was fairly valued is one reason we don't like the whole concept of using changes in the dollar supply to calculate the US$ price at which gold would be fairly valued today. Some analysts have gone to great lengths to do such calculations of gold's so-called fair value, but their calculations are invariably based on a number of arguable assumptions and a small change in any single assumption potentially leads to a large change in the end result. Another reason we don't like the concept is that over a normal investment timeframe (2-10 years) the rate of change in the supply of money is just one of several important drivers of the gold price.

In any case, if we are going to determine an indicative inflation-adjusted 'fair value' for gold we must use a sensible starting point. And in our opinion a reasonable assumption is that gold was close to being fairly valued at $35/ounce in the early-1940s. This assumption is primarily based on James Turk's analysis of net gold flows into the US. In a nutshell: the net flow of gold into the US suggests that gold was over-valued at $35/ounce during the second half of the 1930s and under-valued at $35/ounce from around the mid-1940s.

Keeping the above in mind, we'll now turn our attention to the following chart of the gold/TMS ratio (the chart shows the US$ gold price divided by the True Money Supply (TMS), with TMS expressed in millions of US dollars).

We unfortunately don't have TMS data prior to 1959, but it is very likely that TMS would have grown by at least 80% during the 15-year period leading up to 1959 because an 80% increase over 15 years equates to a compound annual growth rate of only 4%. We therefore assume that the gold/TMS ratio was around 0.20 in the early 1940s.

Significantly, 0.20 appears to be a reasonable starting point, or 'fair value', for the gold/TMS ratio for three other reasons. First, after the official lid was removed from the gold price in 1971 the gold/TMS ratio sprinted up to 0.20 before pausing for breath. Second, after the 1980 bursting of the gold bubble the gold price embarked on a steep downward trend that ended with the gold/TMS ratio slightly above 0.20. Third, ignoring the 1979-1980 upward spike and the dramatic under-valuation of the 1960s we can see that the long-term average is roughly 0.20.

Assuming that 0.20 approximates 'fair value' for the gold/TMS ratio under normal circumstances we arrive at a current inflation-adjusted fair value for gold of around US$1,100/ounce.


Long-term bull markets never end until the price of the investment in question moves a huge distance above its 'fair value' based on traditional valuation metrics. For example, gold's previous long-term bull market didn't end until gold was trading at 4-5 times its fair TMS-adjusted value. Our expectation, therefore, is that the gold/TMS ratio will move well above 0.20 before the gold bull market ends.

Before leaving this topic we'd like to address the idea, expressed in the above-linked "Seeking Alpha" article, that moves in the gold price come before moves in the money supply.

The relationship between gold and the money-supply growth rate entails such long and variable leads/lags that a purely chart-based analysis could conclude that gold leads and the money supply follows. However, the opposite conclusion could also be drawn from chart observation, which is why logical deduction must, in this case, come before an assessment of the empirical evidence. Here is the way it SHOULD work: Some time after a new money-supply trend gets underway, gold speculators begin to discount the future effects of this new monetary situation on currency purchasing power. Specifically, speculators purchase gold in anticipation of the increased rate of currency depreciation and other problems that will eventually stem from a higher rate of monetary inflation, or sell gold in anticipation of the reduced rate of currency depreciation that will eventually stem from a lower rate of monetary inflation.

Logic therefore tells us that long-term (multi-year) money-supply trends should LEAD long-term gold trends. For their part, charts of the year-over-year TMS growth rate and the gold price tell us that the lead-time varies between 2 and 4 years. That is, the charts indicate that 2-4 years after a major trend reversal in the YOY TMS growth rate there will likely be a major trend reversal in the gold price in the same direction. Due to the length and variability of this lead-lag relationship, gold cannot be traded based on changes in money supply.

Taking this decade's events as an example, the money-supply trend suggested that there would be an important peak in the gold price between 2004 and 2006. The actual peak occurred in 2006. The money-supply trend also suggested that there would be an important bottom in the gold price somewhere between the 4th quarter of 2008 and the 4th quarter of 2010 (2-4 years after the October-2006 bottom in the TMS growth rate). Now, the gold price obviously moved well above its 2006 high during 2007 and ultimately reached an intermediate-term peak in March of 2008, but gold's 2007-2008 surge to new highs was not driven by money-supply changes. As we said earlier in this discussion, the rate of change in the supply of money is just one of several important drivers of the gold price.

Should counterfeiting be encouraged?

A popular view is that an increase in the money supply would be beneficial. If so, then counterfeiting should be encouraged. If the economy would benefit from printing more money then expert counterfeiters (those able to produce currency notes that are indistinguishable from the 'real thing') would be performing a valuable service.

But doesn't counterfeiting cause an undeserved transfer of wealth from most people to the people who print the money? The answer is yes, but that's no different to what happens when the central bank creates money out of nothing.

And doesn't counterfeiting, if done on a large scale, distort price signals and thus bring about a reduction in real savings? The answer is yes, but again that's no different to what happens when the central bank creates money out of nothing.

The point we are trying to make is that counterfeiting is unhelpful, regardless of whether it is done legally by the banking system or illegally by unregulated/unofficial operators. People often forget that money is not wealth and that adding more money to the economy does not add more real savings.

The problem is not now, and never will be, a shortage of money. One of today's problems in the US, Australia, and several other Western nations is a shortage of savings, and not only will increasing the money supply not help the situation it will very likely make the situation worse because it will lead to a further reduction in real savings.

Increasing the money supply by creating new money 'out of thin air' is always a bad idea, but it is currently a popular idea and is likely to remain so. That's one reason why recession-like economic conditions are likely to prevail for many years to come.

Commodities

The Commodity-Currency Relationship

The following chart illustrates the strong positive correlation over the past two years between the euro and the CRB Index, which naturally translates into a strong inverse correlation between the US$ and the CRB Index. The reason for including this chart in today's report, however, isn't to show that the commodity and currency markets have been 'joined at the hip'; rather, it's to show that the bottoming process currently underway appears to be similar to the topping process that occurred between April and July of this year.

Between April and July the euro traded sideways (it peaked in April and then successfully tested its peak in July) while the CRB Index moved steadily upward. Now we have the euro holding above its early October low -- and essentially trading sideways -- while the CRB Index moves steadily downward.

If the bottoming process lasts as long as the preceding topping process then the CRB will bottom in January, after which both the CRB and the euro will begin to trend strongly upward.



Oil

The following monthly chart shows that oil has long-term support at $38-$40. After acting as resistance for about 25 years, this price area was finally surmounted for good in 2004. At least, until recently it appeared to have been surmounted for good.

Oil's decline from its July peak has been much larger and much steeper than we expected, and we were expecting a large decline. It's a good bet that oil will rebound strongly during the first half of next year, but of some concern to us is that the July-December plunge could be just the INITIAL downward leg of a cyclical bear market -- in wave terms, the 'A' leg of an A-B-C correction -- and yet we are already closing in on long-term support. 

At the moment we are focused on the potential for a strong counter-trend rebound over the coming 3-6 months. The closer that oil gets to long-term support, the better the short- and intermediate-term risk/reward will be.



The natural gas (NG) price had been holding up relatively well, but oil's relentless decline finally took its toll last week and the NG market broke to new lows. NG will probably achieve a larger percentage gain than oil during the coming multi-month commodity rebound, but it is clearly going to be difficult for a gas rally to begin while oil remains in a short-term downward trend.

The commodity, equity and currency markets are entwined at the moment such that trend changes will happen together or not at all. We expect strong rebounds in equities and commodities over the next few months in parallel with a downward correction in the US$, but right now the markets seem intent on prolonging the commodity/equity bottoming process and the associated US$ topping process.

The Stock Market

The stock market hasn't yet shown much strength, but the bullish divergences continue to build. The following daily chart of the S&P500 Index (SPX) highlights the bullish momentum divergence that has developed since the 10th October low.

The chart also shows near-term resistance at 900 and the more important resistance that lies at 1000. A trend change from down to up won't be confirmed until the higher of these resistance levels is overcome, and this is not likely to happen until early next year. A daily close above the lower resistance level would, however, be a warning that a trend reversal was in the works.


One thing that hasn't yet happened, but should happen within a few weeks of the stock market reversing upward 'for real', is an upward trend reversal in the Baltic Dry Index (BDI). As evidenced by the following chart, the BDI is not yet showing any sign of strength.


Our view continues to be that the coming multi-month stock market rally will be the counter-trend variety (a rebound within an on-going bear market). However, we won't be surprised if the November-2008 low proves to be the market's ultimate price low in nominal dollar terms.

It should be clear to any objective observer that the Fed and its central banking cohorts will, by hook or by crook, ensure that the supply of money grows rapidly over the years ahead. This will eventually cause money to become worth substantially less, which will, in turn, support the money prices of equities. Therefore, while a lot of additional weakness is likely in gold terms we might already have seen the ultimate lows in nominal currency terms.

It is also worth noting that stock market valuations are now attractive in the US, and especially outside the US. In fact, many stock markets around the world are now at the sorts of valuation levels that are only ever seen near the ends of major bear markets.

This week's important US economic events

Date Description
Monday Dec 08
No important events scheduled
Tuesday Dec 09Pending Home Sales
Wednesday Dec 10 Treasury Budget
Thursday Dec 11 Trade Balance
Import and Export Prices
Friday Dec 12 PPI
Retail Sales

Gold and the Dollar

Gold

The Physical Premium

Much has been written about the large premiums to the COMEX price being paid in the retail gold/silver coin market in the US and a few other countries. The popular conclusion is that the divergence of the "physical" and futures markets indicates that the futures price is being held at an artificially low level by unnatural forces. Several points related to this issue are presented below.

First, it is not smart to pay a large premium for gold/silver coins, or, for that matter, any investment. One way or another the premium will disappear, so the people who pay today's large premiums for some types of bullion coin are guaranteed to lose that premium. Rather than paying the current high coin premiums, someone who wants to own more gold coins would be smarter to immediately obtain the equivalent amount of gold exposure in a way that does not entail paying a significant premium, such as via a non-levered futures position or an ETF or goldmoney.com or bullionvault.com, and to then switch to coins after premiums have dropped to more normal levels.

Second, the retail coin market is NOT the physical market; it is a small fraction of the physical market. About 20M ounces of physical gold, or about 2-3 times the amount of gold represented by an average day's trading volume on the COMEX, changes hands every day via the London Bullion Market Association (LBMA), and it does so at close to the COMEX price. In addition, more than 1M ounces of gold are imported into India each month at close to the COMEX price, and a lot of gold trading occurs in the Dubai market at close to the COMEX price. It is reasonable to conclude, therefore, that the COMEX price accurately reflects the overall supply/demand situation in the gold market.

Third, the fact that some members of the investing public are willing to pay large premiums for bullion coins should NOT be construed bullishly. As we've noted in the past, the existence of these premiums is either meaningless or a bearish divergence. We think it is meaningless because other sentiment indicators -- the COT data, for instance -- show that sentiment in the gold market is constructive (conducive to higher prices).

Fourth, the gold market SHOULD demonstrate different characteristics to every other commodity market because gold is the ONLY monetary commodity. (As part monetary commodity and part industrial commodity, silver shares some of gold's characteristics and some of copper's characteristics.) Gold's supply/demand picture is dominated by an aboveground supply accumulated over centuries, which means that traditional commodity analyses are totally inapplicable to gold.

Fifth, the gold market's perennial contango has shrunk to almost nothing. For example, as at the close of trading on Friday the Dec-08 contract was priced at $750.50, the Feb-2009 contract was price at $752.20, and the Apr-2009 contract was priced at $753.70. This reflects some tightness in the market, but we don't know that it says anything about gold's likely future price performance.

Sixth, gold has done what it should have done over the past several months given the financial backdrop: it has rocketed upward relative to all other commodities and most other investments.

Seventh, the reason to be bullish on gold right now is the only good reason to ever be bullish on gold: the expectation of monetary debasement and the loss of confidence in the official money that will eventually stem from the debasement.

Current Market Situation

December gold broke below short-term support on Friday, potentially setting the stage for a re-test of more important support in the low $700s over the coming days.

The 16th December FOMC Meeting could turn out to be a big event for the gold market because in addition to a reduction in the Fed Funds rate to almost zero there's a decent chance that the outcome of this meeting will include plans for a new inflation-promoting scheme (the suppression of long-term interest rates via debt monetisation, for example). We therefore suggest that traders take advantage of any further weakness in the gold price over the coming days to get positioned on the long side ahead of next week's meeting.

Gold Stocks

The first of the following daily charts shows that the HUI's lateral resistance, 50-day moving average and downward-sloping trend-line from its July peak are coming together at around 225. Friday's action was bullish in that the HUI plunged 10% during the early going and then recovered all its losses by day's end, but if gold re-tests support in the low-$700s during the first half of this week then the HUI will probably consolidate below 225 for a while longer before resuming its advance.


The next chart shows that the HUI/gold ratio is currently doing what it should be doing: holding above its 40-day moving average (the blue line on the chart) during the current consolidation. As noted in last week's Interim Update, if HUI/gold can continue to hold above its 40-day moving average during this short-term consolidation and then move above its late-November peak it will constitute additional evidence that a major bottom is in place.


The final chart shows Yamana Gold (NYSE: AUY). Like the HUI, AUY is consolidating below resistance and could continue to do so for a short while before resuming its advance.

We were stopped out of an AUY trading position at the beginning of last week, but we are now going to re-establish a trading position at Friday's closing price of US$4.94. We will set an initial sell stop at US$4.19 and will then switch to a 15% trailing stop.

Depending on price action we might add a couple more gold/silver trading positions within the next few days.


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)

Lion Selection (ASX: LST). Shares: 83M. Recent price: A$0.82

LST shareholders who participated to the fullest possible extent in the company's off-market buy-back have just sold 66.6% of their shares at A$1.47 per share. It would be reasonable, we think, to use part of this capital return to replace some of the LST shares that have just been sold given that the stock is now trading at around half its net asset value. Other possible uses for the returned cash include the shares and/or convertible notes to be issued by Resolute Mining (ASX: RSG) as part of its recently announced financing, and the shares of Dominion Mining (ASX: DOM). DOM has been remarkably strong of late and ended Friday's session at its highest level since July, but still has significant upside potential and would be a candidate for new buying below A$3.00.

    International Royalty Corp. (TSX: IRC, AMEX: ROY). Shares: 78M issued, 84M fully diluted. Recent price: C$1.42

The stock price of IRC has been almost dead flat near its all-time low over the past three weeks, but some interesting stuff has been happening beneath the surface. In particular:

1. The past three weeks contained the stock's three biggest single-day trading volumes of the past three years.

2. The company established a shareholder rights plan on 21st November designed to "ensure that all shareholders receive equal treatment, to give the IRC board of directors adequate time to consider and respond to any unsolicited bid for the company, and to maximize shareholder value in the event of a takeover bid or other acquisition that could lead to the change in control of IRC." Plans such as these are commonplace in Canada, but the timing of this plan is interesting given item 3 below.

3. Chris Verbiski announced on 4th December that he had recently acquired additional IRC shares and now controls 14.57% of IRC's share capital. Mr. Verbiski is the co-discoverer of the massive Voisey's Bay nickel project and was the co-owner of the company that sold IRC its 2.7% royalty on the Voisey's Bay project back in 2005. The sale price for the Voisey's Bay royalty was $180M, so it's reasonable to assume that Mr. Verbisky is 'well heeled'.

Mr. Verbiski's interest in IRC generates some intrigue and additional speculative appeal, but on its own it isn't a reason to buy the stock. The reasons to buy the stock are its extreme under-valuation and its relatively low risk (as a royalty company, IRC is not exposed to many of the normal mining-related risks).

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html



 
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