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   -- Weekly Market Update for the Week Commencing 9th May 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.

Grantham channels Malthus, and gets the big issues completely wrong

When Jeremy Grantham argued in his Q3-2010 Letter that gold was essentially useless because it paid no dividend, could not be eaten and for the most part sat idly and expensively in bank vaults, we thought that his analysis of monetary and macro-economic matters couldn't get any worse. We were wrong, because his April-2011 Letter is much worse. His latest piece of analysis, which is titled "Days of Abundant Resources and Falling Prices Are Over Forever", is extraordinary for the large number of major-league errors and bad ideas that are crammed into it. The error that we will zoom in on has to do with the supposed price-related evidence that a change in the long-term commodity trend has occurred, but before we do so here are some of the other logical problems.

First, he attributes the dramatic increase in wealth and scientific progress during the 19th and 20th Centuries to the 'lucky' discovery, near the beginning of the 19th Century, that hydrocarbons could be tapped for energy. Nowhere in the entire piece does he mention increasing economic freedom or the spread of Capitalism.

Second, he argues that continued economic growth will cause food, energy and other natural resources to become exhausted, and that we are close to reaching the limit. His argument is largely based on the assertion that all compound growth is unsustainable, but he makes the mistake of equating real economic growth with the greater consumption/accumulation of physical resources. This is clearly evident in his hypothetical example of Ancient Egypt, in which he shows that it would have been impossible for the ancient Egyptians to have increased the size of their physical possessions at a compound annual growth rate of 4.5% for thousands of years. However, real economic progress is about doing more with less, not the accumulation of more physical stuff. For example, some of today's handheld computers are more powerful than the room-sized mainframe computers of 40 years ago.

Third, having decided that a shortage of resources is about to become a permanent feature of our lives, he concludes that the solution is for the government to address the shortage. So, let's get this straight: the same government that a) can't run a monopoly post office profitably, b) spent 10 years and trillions of dollars and hundreds of thousands of lives in an effort to kill one terrorist, c) blatantly lied in order to justify the invasion of Iraq, and d) makes a mess of almost everything it touches, will be our saviour. Free markets, on the other hand, don't even warrant a mention.

Fourth, as per the rallying call of President Carter and all other socialists throughout history, he claims that we need to sacrifice for the greater good and the good of generations to come.

Fifth, he states that we should focus on "qualitative", not "quantitative", growth. He also says that we should redesign lifestyles to emphasise quality of life. Given that every rational individual is already focused on improving the quality of his/her life, we get the impression that he is again talking about the government taking on a bigger role. Apparently, we need the government, or perhaps a committee of experts, to tell us what does and doesn't add to the quality of our lives, and to then enforce this well-intentioned advice via new laws.

Sixth, according to Grantham we should practice "income redistribution" in order to get everyone out of poverty. After all, forced income redistribution worked so well to combat poverty in Soviet Russia, Communist China, and everywhere else it has been tried.

Seventh, he correctly points out that technological progress led to declining real prices for commodities, which, in turn, helped to boost real wealth. But he then makes the absurd claim that this was just an historical accident. Blind luck.

Eighth, he applies the label "monetary maniac" to anyone who attributes the past decade's rapid increase in prices to monetary factors. As explained below, the "monetary maniacs" are right.

Ninth, he claims that the commodity markets are less subject to irrational speculation than, say, the equity markets, because "commodities are made and bought by serious professionals" with realistic supply and demand being the main influence. Therefore, whereas we should treat extremely high valuations in other markets as temporary aberrations, we should treat extremely high valuations in commodity markets as evidence of permanent changes in real supply versus demand. This seems like the sort of logic that spawned the "Dow 36000" book at the peak of the tech-stock bubble, but in any case the current real prices of commodities are not beyond normal extremes when a proper adjustment is made for the effects of inflation. Grantham only thinks they are beyond normal extremes because his data use official price indices to do the inflation adjustment.

Following on from our last comment above, Grantham's epiphany regarding the coming permanent shortage of resources was prompted by the misinterpretation of price data. Specifically, he has been drawing conclusions based on data that have not been properly adjusted for the effects of inflation. He doesn't explain how his inflation adjustment has been done, but we assume that he has used one of the official price indices. This would substantially reduce the calculated effect of inflation over the past 15 years and substantially increase the calculated 'real' price increase over the same period.

Before we show a couple of our own inflation-adjusted charts to make the point that there is no evidence of a "paradigm shift" in commodity supply versus demand, we'll note that monetary inflation, due to the non-uniform way in which it works, causes much greater price rises in some goods, services and assets than in others. This is known as the "Cantillon Effect", and explains why monetary inflation leads to large gains in REAL prices in some parts of the economy. This, in essence, is why fractional reserve banking combined with central bank manipulation of money results in the boom/bust cycle.

The large gains in real prices in some parts of the economy that stem from monetary inflation always prove to be temporary, which is why commodity prices periodically experience massive inflation-fueled price increases and then lose all of their gains in real terms. For example, despite the way the chart has been labeled, the first three bull markets shown on the long-term inflation-adjusted commodity chart included in Grantham's letter (for ease of reference, a copy is included below) had monetary roots, which is why the massive gains were always retraced in full. The fourth bull market (the current one) has similar roots and is bound to end the same way.


Let's now take a look at two charts that better reflect the true situation. Note that in our charts, the adjustment for the effects of inflation on currency purchasing power is done as described in our 15th December 2010 article.

Our first chart shows the inflation-adjusted (IA) oil price since 1959. The IA oil price momentarily spiked above its 1980 high in 2008, but then collapsed.


There is a paradigm shift evident on the above chart, but it isn't the one that Grantham perceives. Rather, it relates to the dramatic increase in price volatility that began shortly after the US government removed the official link between the US dollar and gold. There are those monetary roots again!

What, then, would have happened to the US$ oil price if the dollar had remained linked to gold at the $35/oz rate that applied at the beginning of the 1970s, and, by implication, if the Fed had run a monetary policy that enabled the $35/oz exchange rate to be maintained?

It's impossible to say for certain, because removing the link between the dollar and gold led to a dramatic increase in the volatility of everything, including the gold/oil ratio. It's interesting, though, that when measured in terms of gold, oil is a little cheaper today than it was in 1970. This is counter to Grantham's theory, because there has never been and there never will be any shortage of gold. It is, however, consistent with our theory that we are seeing waves of boom and bust driven by monetary mischief.

Our second chart shows that the 2008 peak in the IA price of copper was just below its 1974 peak and just above its 1980 peak. It now appears to be rolling over after testing its 2008 peak earlier this year.

The huge swings shown on this chart are evidence of monetary instability, not a major change in real supply versus real demand.


The final point is that even in the extremely unlikely event that Grantham is right and the world is reaching some sort of commodity-production limit, the optimum solution is NOT for the government to take on an expanded role. That would almost certainly make things worse. Part of the optimum solution would be for the government to get out of the way and let the markets do what they do best: respond to price signals.

Quick T-Bond Update

As we warned at the time, the US Treasury Bond futures market was sufficiently 'oversold' in early February of this year to prompt a multi-month rebound. In response to a deluge of bearish T-Bond commentary, we subsequently explained -- during March -- that Japan's earthquake and PIMCO's exit from its T-Bond position were not significant negatives for this market going forward.

After an interruption between mid March and early April, the T-Bond rebound that began in February has continued. At the end of last week the market was 'overbought' on a very short-term basis, perhaps paving the way for a 1-2 week consolidation, but we don't think that it makes sense to bet against the T-Bond at this time. Next month's completion of "QE2" will reduce one source of T-Bond demand, but with the commodity markets showing signs of having turned down on an intermediate-term basis there's a distinct possibility that the reduction in the Fed's demand will be more than offset by increasing safe-haven-related demand. The result could be a significant extension to the overall rebound.


The Stock Market

The following chart compares the S&P500 Index (SPX) with the HYG/TLT ratio. The HYG/TLT ratio indicates what's happening with credit spreads, in that the ratio rises when credit spreads contract (bullish for the stock market) and falls when credit spreads widen (bearish for the stock market).

Since early April the SPX has pulled back and then risen to a new multi-year high while the HYG/TLT ratio has drifted downward. This constitutes a bearish divergence.


Based solely on the SPX's price action, the most likely outcome is that the US stock market will make a new high for the year before the end of this month. However, last week's definitive downward reversal in the silver/gold ratio means that the stock market's short-term downside risk now trumps any additional upside potential (the implications of this ratio's reversal go well beyond the precious metals sector). Also of concern are the widening of credit spreads noted above, the fact that the most recent Investors Intelligence survey indicated that 83.5% of advisors were bullish (54.9% were outright bullish, while another 28.6% were bullish but expected a short-term pullback), and the on-going bearish put/call situation. We have therefore downgraded our short-term stock market outlook to "bearish".

This week's important US economic events

Date Description
Monday May 09
No important events scheduled
Tuesday May 10Import and Export Prices
Wednesday May 11 International Trade Balance
Treasury Budget
Thursday May 12 PPI
Retail Sales
Friday May 13 CPI
Consumer Sentiment

Gold and the Dollar

Gold and Silver

Current Market Situation

Here, again, are the two short-term scenarios we outlined in the email sent to subscribers following the 2nd May trading session:

1. Gold and silver will make lows this week. Both will then strengthen for 2-4 weeks, with gold moving well above this week's high and silver doing no better than testing its high. This price action will result in a bearish divergence between gold and the silver/gold ratio (new highs in gold accompanied by lower highs in silver/gold) and will be followed by declines in the prices of both metals to their 200-day moving averages within the ensuing two months.

2. Gold and silver have just made intermediate-term peaks and will trend lower to the vicinities of their respective 200-day moving averages over the next two months.

In the 4th May Interim Update we said that Scenario 2 had become the more likely, and that Scenario 1 would be eliminated from contention if "the gold price were to close below this week's low within the next two weeks."

The following daily chart shows that last week's low for June gold was just above $1460, so it would take a daily close below $1460 to completely rule out Scenario 1. It is fair to say, though, that Scenario 2 now has by far the higher probability.


Last week's dramatic price action in the silver market certainly warrants some discussion. It is important to remember that silver NEVER declines slowly after reaching an intermediate-term peak. It always plunges in spectacular fashion. However, last week's decline was unusually steep even by the silver market's standards. By way of comparison, after reaching intermediate-term peaks in April of 2004 and May of 2006, the silver price fell around 35% within the space of 5 weeks. This time around it achieved a similar peak-to-trough decline in less than two weeks, with almost all the decline happening last week.

Don't bother trying to come up with news-related explanations for last week's silver collapse; it is, in our opinion, primarily a reflection of just how irrationally exuberant the market had become during the weeks leading up to the collapse. It was a similar story throughout the commodity world, but silver had been the focal point of the speculation and therefore took by far the biggest hit.

So, is the decline already complete? If not, when and at what price is it likely to end?

It's very unlikely that a sustainable price low was reached last week, but there is a reasonable chance that a 1-2 week low is in place. The fact that the silver/gold ratio's RSI (refer to the bottom section of the following chart) moved below 30 last Thursday means that the ratio is now 'oversold' enough for a temporary bottom to have been reached.


Rather than marking the end of the overall correction, it's more likely that Friday's silver-price reversal from around $33 marked the end of the first downward leg of a correction that will play out over 1-2 months. It would certainly be unusual for a correction of this magnitude to end before the market had traded at or below its 200-day moving average. Also, the following weekly chart shows that intermediate-term silver corrections typically end with the weekly RSI at around 40, versus the current level of 53.

The bottom line is that any rebound over the days ahead will likely be followed by a decline to new correction lows.


We mentioned in last week's Interim Update that we took profits on 20% of our SLV put-option position on Wednesday 4th May. We took profits on another 40% of these puts on Thursday 5th May, so we have now exited about 60% of our precious metals insurance position. Regardless of what happens with the balance, the options served their purpose admirably.

We will consider buying some more SLV put options if the silver price rebounds to around $40 during the coming week or so, but we probably won't do it. Silver has already crashed, but other markets have the potential to crash during the next 6 months and we'd prefer to buy insurance to protect ourselves against the potential future crashes. The Australian Dollar is one market with the potential to crash during the next 6 months.

ETF Premiums

As we've discussed in TSI commentaries over the years, the premiums/discounts to net asset value (NAV) at which gold and silver bullion ETFs (CEF, GTU, PHYS and PSLV) trade can be used as sentiment indicators. However, be aware that when the market price is volatile, as it has been recently in the silver market, the reported daily NAV premiums/discounts are sometimes very inaccurate. The reason is that the metal price used in the calculation of the NAV is sometimes very different to the metal price that prevailed at the time the ETF finished trading. CEF, for instance, uses the London fixes for gold and silver when calculating the NAV that gets reported daily at its web site, but this NAV calculation is compared to a market price for the fund several hours later -- at the close of trading in New York. For example, the calculation done for Friday assumes a silver price of $34.20 (the London fix), but silver closed in New York at $35.60.

If you are capable of doing your own accurate comparisons of ETF prices and NAVs, and you notice that an ETF is trading at a large discount to its NAV or that one ETF is trading at a large discount to another ETF with similar assets, then you could attempt to take advantage by purchasing the under-valued ETF. Based on current prices and NAVs, for example, if you owned Sprott Silver ETF (PSLV) it would make sense to sell it and use the proceeds to buy CEF (due to PSLV's much higher premium).

Canadian billionaire Eric Sprott led the charging silver bulls over the past several months and in the process generated a lot of enthusiasm for his silver bullion fund (PSLV). Therefore, when it comes to indicating market sentiment PSLV is probably the most useful of the bullion funds at this time. PSLV ended Friday at a premium of 15% (http://www.sprottphysicalsilvertrust.com/NetAssetValue.aspx). A decline in the premium to less than 5% would suggest that sentiment was consistent with a sustainable price low.

Gold Stocks

The short-term potential for the HUI to break above 600 and move up to 670-700 has, for all intents and purposes, been eliminated by last week's market action. Short-term upside potential is probably now limited by former support (now resistance) in the 570s.

There is a lot of support in the 500-525 range. The top of this range was touched last week, opening up the possibility that the correction is close to an end in terms of price. The problem is that the associated metal markets are probably just one week into intermediate-term corrections. Is it possible that the correction in the mining stocks could be close to an end while the corrections in the associated metals are just beginning?

It's possible, but unlikely. We suspect that the stocks will hold up relatively well as the metals work their way lower over the next 1-2 months, but it is reasonable to assume that the gold-stock indices will trade significantly lower than last week's lows before the correction ends. The bottom of the 500-525 range is a plausible target, but given the speed of last week's decline it won't surprise us if the HUI trades as low as 475 before the next intermediate-term advance gets underway.

We think that 475 is a realistic downside target because it is just below the bottom of the moving average envelope shown on the following daily chart. With the exception of the 2008 decline, every intermediate-term gold-stock decline of the past 10 years ended with the HUI trading at or slightly below the bottom of this MA envelope (the 2008 decline took the HUI a long way below the bottom of the envelope).


In any case, the future is always uncertain and the big money is not made by trying to guess the likely directions and magnitudes of short-term moves. The big money is made via steady accumulation into substantial weakness and steady profit-taking into substantial strength. With the HUI in the 520s or lower, steady accumulation of gold stocks would be warranted.

Currency Market Update

The euro's weakness was exacerbated late last week by a story in Germany's Der Spiegel newspaper that Greece was considering leaving the euro zone and re-establishing its own currency. On the surface, a Greek exit from the euro would seem to strengthen the 'euro chain' by removing the chain's weakest link, but few things in the world of international econo-politics are what they superficially seem. Of particular relevance, all the so-called austerity measures and financial support programs adopted within the euro zone have absolutely nothing to do with helping the economically weak members of the monetary union (the economically weak members will almost certainly become even weaker as a result of these measures and programs). Rather, it has all been about helping banks and bank bondholders. If Greece leaves the euro zone then banks and bondholders will be forced to take large losses on their investments, which apparently must be avoided regardless of the cost to the rest of the economy.

The best solution for Greece would be for the country to a) retain the euro, b) dramatically reduce its government spending, and c) immediately default on the bulk of its government debt. Unfortunately, it probably won't be permitted to do both a) and c). The most likely short-term outcome is that a way will be found to prolong the agony via some more stopgap measures that do nothing to address the underlying reality that the Greek government is bankrupt.

Given that it occurred in the wake of a downward reversal in the silver/gold ratio, last week's euro decline could be the start of a new intermediate-term trend. However, the following daily chart shows that at this stage the euro has simply moved from the top to the bottom of its short-term upward-sloping channel.

A daily close below 1.42 would be initial confirmation that an important trend change had occurred.


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)

Gold-Ore Resources (TSX: GOZ). Shares: 83M issued, 89M fully diluted. Recent price: C$0.78

In the 6th April Interim Update we wrote that strong support at C$0.75-C$0.80 probably defined the short-term downside risk for GOZ, a profitable 45K-oz/year gold producer based in Sweden. Last week's sharp sector-wide decline caused the stock to momentarily trade a couple of cents below this support range, but the support held on a weekly closing basis.

GOZ is a reasonable candidate for new buying near its current price. As previously advised, C$1.50 is our intermediate-term target for the stock.


    Hathor Exploration (TSX: HAT). Shares: 107M issued, 117M fully diluted. Recent price: C$2.22

HAT is the highest quality and lowest risk exploration-stage uranium stock that we know of. The high grade of its Saskatchewan-based Roughrider deposit means that the deposit will likely be attractive to larger mining companies even in the unlikely event that the uranium price fails to recover from the hit it took in response to Japan's recent "nuclear emergency".

HAT is presently bumping up against resistance in the low-C$2.20s. Breaking through this resistance would create a short-term chart-based target of C$2.60-C$2.80, where those who bought following the Japan-related March crash in the uranium sector could consider taking partial profits.

We think the stock is a reasonable candidate for accumulation below C$2.20 and a strong buy below C$2.00.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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