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   -- Weekly Market Update for the Week Commencing 10th December 2007

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
(19-Nov-07)
Bullish
(12-Nov-07)
Bullish

US$ (Dollar Index)
Bullish
(11-Jun-07)
Bullish
(31-May-04)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Bearish
(05-Dec-07)
Neutral
(23-Jul-07)
Bearish
Stock Market (S&P500)
Bullish
(28-Nov-07)
Neutral
(26-Mar-07)
Bearish

Gold Stocks (HUI)
Bullish
(19-Nov-07)
Bullish
(12-Nov-07)
Bullish

OilBearish
(23-July-07)
Bearish
(22-Oct-07)
Bullish

Industrial Metals (GYX)
Neutral
(28-Nov-07)
Bearish
(09-July-07)
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.

Making the price action fit the news

A lot of the explanations in the financial media for why the markets did what they did on a particular day are based on the false premise that if price move B followed news event A, then A must have caused B. The reality, however, is that the vast majority of price moves have nothing to do with the news of the day because the financial markets are always attempting to discount the future whereas news events are, by definition, things that have already happened. Furthermore, a price change in a major international market is the net result of millions of individual buy/sell decisions made for a myriad of reasons, so attempting to come up with an explanation for a daily price move -- whether the explanation be news-related or not -- is generally a waste of time.

We were prompted to re-visit this topic by a Forbes.com article headlined: "Oil Slides On Solid Jobs Report". We normally wouldn't bother reading an article in the mainstream press that attempted to explain the daily market action because such articles almost always apply the ridiculous formula cited above (if B followed A then A must have caused B), but we were curious to see what reasons the reporter had come up with for why the price of an economically sensitive commodity had fallen in response to better-than-expected economic data. Here's what we found out: According to the writer of the aforementioned article, the evidence of economic strength implied by the jobs report made it less likely that the Fed would cut rates by 50 basis-points at the upcoming FOMC meeting, which, in turn, would mean that the economy would get less monetary stimulation, which, in turn, would lead to a WEAKER economy and reduced demand for oil. Hmmm...low marks for logic but high marks for imagination.

Of course, if the oil price had risen on Friday the headline would have read: "Oil Rallies On Solid Jobs Report". And if this had been the case then linking the news and the price action would have required less imagination.

A bull market in bad ideas

Every government attempt to assist a special interest group involves bad economics because the help given to the targeted group can only come at the expense of other groups and the economy as a whole. These attempts to 'help' continue to happen, though, because the benefits to the targeted group are usually obvious to all and can be touted by politicians as evidence of government benevolence, whereas the insidious effects on the overall economy will usually be apparent only to those with some understanding of economics who take the trouble to think deeper than the political rhetoric.

However, the rescue plan for subprime borrowers being cobbled together by the Bush Administration differs from the standard government assistance scheme in that the bad economics at the heart of the Bush plan are as subtle as a two-by-four to the head. In this case the scheme is so inane, so unethical, and so riddled with blatantly negative implications that even shallow thinkers with minimal understanding of economics should be shaking their heads in disbelief.

In last week's Interim Update we briefly noted a couple of the obvious problems that would stem from the plan to help some borrowers by forcing lenders to keep mortgage rates at artificially low levels, but a more in-depth analysis can be found in Peter Schiff's article at http://www.321gold.com/editorials/schiff/schiff120707.html.

Did the odds of a 50bp rate cut just become longer?

In last week's Interim Update we wrote: "Due to the close proximity of such a finely balanced Fed policy decision, the US monthly Employment Report due to be released on Friday morning takes on greater importance than would normally be the case. The reason is that even though the numbers in this report tend to bear little resemblance to reality and will end up being revised -- perhaps dramatically so -- in the future, they will be fresh in the minds of the Fed representatives who attend next week's policy meeting. The markets are therefore well aware that Friday's employment numbers have the potential to tip the balance one way or the other. Specifically, a very weak Employment Report would shift the odds decisively in favour of a 50bp cut whereas an unexpectedly strong report would do the opposite."

As it turned out, the employment numbers were a bit stronger than expected and, in response, the Fed Funds futures market quickly adjusted to reflect a lower probability of a 50 basis-point rate cut on Tuesday (the market is still saying that a rate cut is a 'done deal', but that the odds now favour it being the 25 basis-point variety).

In our opinion a 50bp cut is still close to an even-money bet because the Bernanke Fed has demonstrated by its actions over the past 4 months that it does not mind erring on the side of monetary laxity. However, due to the shift in the market's expectations the reaction to a 50bp cut will now be more pronounced than it would have been if expectations had remained where they were last Wednesday.

The Stock Market

Risk Aversion

Increased risk aversion has been one of the main characteristics of the financial market environment of the past six months. Increased risk aversion is evidenced by the widening of credit spreads, the strength of short-term Treasuries relative to longer-term Treasuries, the strength of large-cap stocks relative to small-cap stocks, and the strength of gold relative to industrial metals. There are, however, signs that at least a temporary shift back towards riskier investments is presently underway. For example, the recent sharp rise in the HYG/LQD ratio illustrated by the following chart tells us that high-yield corporate debt has recently rebounded strongly relative to investment-grade corporate debt.

The recent performance of the HYG/LQD ratio is evidence that a short-term bottom is in place for the US stock market.


Current Market Situation

There are huge problems in the financial system that have been around for years, but have only quite recently come to light thanks to the downturn in the US housing market and the associated collapse of the subprime mortgage market. These problems are going to take years to work through, especially because governments can be relied upon to come up with more harebrained schemes to help that will actually have the effect of prolonging the corrective process. The key to the stock market, however, is the extent to which the problems have been discounted, and one of the few things we have to go on when attempting to ascertain how far the market has gone towards discounting the problems is sentiment.

As we've noted in previous commentaries, over the past few months some gauges of the public's sentiment have indicated extremes of negativity. As an example, when the stock market was bottoming in August the number of shares sold short by the public was much higher than it had EVER been. Furthermore, when the S&P500 Index dropped back to a higher low in mid November the level of public short-selling was even greater than it had been at the August low.

Another noteworthy item regarding sentiment was covered in last week's Interim Update. In that commentary we used a chart of the 10-day moving average of the OEX put/call ratio to make the point that the "smart money" now seemed to be less concerned than the general public (the "dumb money") about downside risk in the stock market. This viewpoint, by the way, is also supported by the Commitments of Traders (COT) data in that the latest COT report shows the Commercials (the "smart money") to be net-long S&P500 futures to the tune of 46000 contracts while small traders (the public) are collectively net-short by 19000 contracts.

Our conclusion is that at last month's low the stock market had fully discounted the short-term effects of the on-going debt crisis. We suspect that the longer-term effects of the problems are still being under-estimated, but this won't prevent the stock market from maintaining an upward bias over the coming few months.

Our guess regarding the market's path over the coming 1-2 months is: a peak this week (during the first two days of the week if the Fed cuts by 25bp or during the second half of the week if the Fed cuts by 50bp), followed by a pullback into year-end, followed by another tradable rally.

Airlines Update

We think an intermediate-term peak is in place in the oil market and we are bullish on the airline sector of the stock market as a result. However, the market is not yet convinced that oil has peaked so most airline stocks have not yet rebounded to a significant degree. The following chart of Continental Airlines (CAL), for instance, shows that the stock is still within about 10% of its lows of the past year.

We won't be able to confidently claim that a genuine rally has begun until CAL breaks decisively above its 200-day moving average and the top of its downward-sloping channel.


In order for the airlines to really 'take off' the market will have to come around to the view that an intermediate-term downward trend is underway in the oil market. There's no telling how far the oil price will have to drop in order for this view to gain traction, but our guess is that it will have to drop to the 70s.

Once the market reaches a consensus that oil is in a correction of intermediate-term significance then daily up-moves in the oil price will start being perceived as counter-trend moves and will stop having such a negative effect on airline shares. In other words, it's the perceived trend in the oil market that really matters as far as the airline sector is concerned.

Although our primary basis for being 'long' the airline sector is our bearish outlook for oil, our airline-related optimism is also given a boost by valuations within the sector. For example, this Forbes.com article notes that both Continental Airlines (CAL) and Northwest Airlines (NWA) have single-digit P/E ratios based on what "smart" analysts expect the companies to earn over the coming 12 months.

On a side note, we are short- and intermediate-term bearish on oil but we are not bearish on oil-related equities. Oil stocks are influenced as much, or more, by the trend in the broad stock market as by the trend in the oil price. Furthermore, most oil stocks ignored the final $20 rise in the oil price. Our expectation, therefore, is that if the broad stock market's rally continues for a few months and the oil price doesn't totally collapse then the oil sector of the stock market will make new highs during the first half of next year.

Japan

Everyone knows that the Japanese economy is in a never-ending funk and that the banks of the world are in dire straits, so it's noteworthy that the share price of Mitsubishi UFJ Financial Group (NYSE: MTU), Japan's largest bank, has just broken a 19-month downward trend in spectacular fashion (refer to the following chart for details).

MTU's performance over the past couple of week's supports our bullish intermediate-term outlook for the Japanese stock market. We would be buyers of MTU for an intermediate-term trade -- a trade with an expected duration of 3-12 months -- following a pullback to the US$9.50-$10.00 range.


This week's important US economic events

Date Description
Monday Dec 10
No important events scheduled
Tuesday Dec 11FOMC Policy Statement
Wednesday Dec 12 Trade Balance
Import and Export Prices
Treasury Budget
Thursday Dec 13 Retail Sales
PPI
Friday Dec 14 CPI
Industrial Production
Capacity Utilisation

Gold and the Dollar

Gold

With reference to the following daily chart of December gold futures, it continues to look like the gold price is tracing out a fairly routine mid-trend corrective pattern. There still hasn't been a material reduction in the speculative net-long position in COMEX gold futures, however, so it won't surprise us if the price drops to around $760 before the correction comes to an end.

Whether or not a correction low is already in place could be determined by the outcome of Tuesday's Fed meeting. If the Fed cuts by only 25 basis-points then gold will probably drop to new correction lows before the next upward trend gets underway, whereas a 50bp cut will probably 'kick-start' the next rally.


Gold Stocks

The gold sector of the stock market continues to behave in a way that can best be described as bizarre. While it was underway we mentioned repeatedly that the sector's August-November rally was extraordinarily narrow and was generally being led by gold stocks that did not offer high leverage to the gold price. And now we have the almost surreal situation of many exploration-stage gold stocks trading near their August lows even though the US$ gold price has experienced nothing more serious than a routine pullback from its early-November peak.

It could be argued that the exploration-stage stocks are being hurt by the market-wide shift away from risk and reduction in liquidity; but then why has Royal Gold (RGLD), a pure play on gold with no liquidity, cost control or political risk issues, performed in such a lacklustre manner? And why has Gold Fields Ltd (GFI), a major gold stock that offers plenty of liquidity as well as substantial leverage to the Rand-denominated gold price, fared so poorly against such a positive gold-price backdrop?

The second of these questions stems from a comparison of the following 6-year charts of GFI and the Rand-denominated gold price. Notice that GFI's price is roughly the same now as it was when the Rand gold price was about 50% lower.




Increases in production costs are partially to blame for the performance of GFI's stock price, as are events such as last week's single-day strike by South African mineworkers. However, if this is a gold bull market then investors should be looking beyond short-term profitability issues and assigning values to gold producers that are based largely on their economically-feasible gold resources. That this is not currently happening suggests either that October's upside breakout by the HUI was a giant 'head fake' within a cyclical bear market (a 1-2 year correction to a primary bull market) OR that at some point over the next few weeks stocks such as GFI will begin powerful multi-month rallies that will take them to new all-time highs.

The current combination of rampant global inflation (money-supply growth), rising credit and yield spreads, falling real interest rates and abundant government stupidity clearly points to the latter outcome. The only concern we have -- and have had for some time -- with respect to the gold sector's short- and intermediate-term prospects is the potential for a US$ rebound against the euro to prompt speculators to exit their 'long of gold' positions. It must be said, however, that the Bush-Paulson team is working feverishly to eliminate this concern of ours by implementing policies that are virtually guaranteed to have disastrous consequences for the US economy; and that Bernanke will quite possibly do his part to mitigate the risk of a large US$ rally by opting for a 0.50% rate cut this week.

From a technical perspective, one of the good things about the current situation is that the AMEX Gold BUGS Index (HUI) remains fairly close to important support at 400 and this support represents a clear demarcation line between bullish and bearish. The HUI has recently had a few opportunities to break below this support, but it has continued to hold fast. As a result, the short-term situation is unchanged: the downside risk and the upside potential are both substantial, but the odds favour an upside resolution.

Currency Market Update

The US$

The ECB decided to leave its interest rate target unchanged at last Thursday's meeting, but at a post-meeting interview the ECB's president suggested that it had been a 'toss up' between maintaining the status quo and opting for an interest rate HIKE. In other words, the ECB is still taking a 'hawkish' line, at least in its public utterances. In one important respect the ECB's on-going concerns about inflation risk are warranted in that the total supply of euros has risen by 12.2% over the past year.

Does the ECB's decision to maintain a tightening bias while the Fed proceeds with its rate-cutting campaign mean that the euro will continue to trend upward against the US dollar?

Not necessarily. The key is what happens on the interest rate front relative to what has already been factored into current exchange rates. For example, we know by looking at futures prices that the market is anticipating about 75 basis-points of Fed rate CUTS and about 50 basis-points of ECB rate HIKES over the coming four months. In other words, current exchange rates appear to be based on the expectation that there will be an interest rate shift in the euro's favour of around 125 basis-points over the coming 4 months. This means that if the Fed continues to cut rates as expected while things in Europe worsen to the point where the ECB decides not to hike rates any further, the dollar will probably strengthen against the euro.

The following weekly chart of the Dollar Index highlights the former long-term support in the 78-80 range. This former support will now act as strong resistance.

We think the Dollar Index has commenced a bottoming process that will take a few months to play out, with rallies capped by the aforementioned resistance and declines taking the price back to near the November-2007 bottom. Despite the best efforts of US monetary and political bosses, a substantial advance should follow this bottoming process in response to the general realisation that the European situation does not justify a hefty euro premium.


The Commodity Currencies

The two most important commodity currencies (the currencies of countries that rely heavily on commodity production) are the Australian Dollar and the Canadian Dollar.

If we didn't consider anything about the A$ apart from the following weekly chart then we would conclude that downside risk was limited to a test of long-term support in the low-80s. But while a drop to the low-80s at some point over the next couple of months might constitute a good opportunity to 'go long' the currency for a short-term trade, fundamental factors suggest that the longer-term downside risk is much greater.

Australia recently reported a record monthly trade deficit, which is not, in itself, a reason to be bearish on the A$ because a trade deficit could have positive or negative causes. It could, for instance, stem from Australia being an uncommonly attractive place for foreigners to invest (a good thing). Alternatively, it could be a symptom of an inflation problem (a bad thing). We found it strange, though, that a major commodity-exporter such as Australia would be reporting a record trade deficit in the midst of a commodity boom.

Australia has a large trade deficit because its imports are rising even faster than its commodity-related exports, and this is happening because the rate of domestic credit expansion is extremely high and continuing to rise. Symptomatic of this rampant expansion of credit is the 20.7% year-over-year growth in Australia's money supply. This is Third-World-style monetary inflation and why we do not believe that long-term support in the low-80s defines the downside risk.


Over the past two years, and especially over the past 12 months, the Canadian Dollar has moved up and down with the oil price. For example, the decline in the oil price from its July-2006 peak through to its January-2007 trough pushed the C$ well below the bottom of the long-term channel drawn on the following weekly chart, while the subsequent powerful upward trend in the oil price was accompanied by a C$ rally that took the currency all the way back to its channel top. Not surprisingly, the recent downward reversal in the oil market has coincided with a sharp downward reversal in the C$.

If our outlook for the oil market is correct then the C$ should trend lower over the next several months, but we think it has a lot less downside risk than the A$ because the supply of Canadian dollars is rising at an annual rate of 'only' 12% (it's an indictment of what central banks and governments around the world are doing to money that a 12% monetary inflation rate now seems relatively tame).


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)

Gold Fields Ltd (NYSE: GFI). Shares: 650M. Recent price: US$15.62

At Friday's closing price of US$15.62 GFI's proven-and-probable gold reserves were being valued by the stock market at only US$116 per ounce. This is half the valuation currently being assigned to the gold reserves of Kinross Gold, a major gold producer with a similar political risk profile to GFI. We think this discrepancy results from the gross under-valuation of GFI rather than the over-valuation of Kinross.

It is, of course, possible that GFI will become available at an even lower valuation before the market comes to its senses, but we don't think long-term investors can go wrong accumulating the stock near its current level. Furthermore, the potential is there for a large upward re-rating in the short term.

    The Semis

We recently added the Semiconductor HOLDRS Trust (SMH) to the TSI List to reflect our bullish outlook on this sector.

Below is a chart of Intel (INTC), the world's largest semiconductor company. INTC shares comprise 20% of SMH's holdings.

INTC is currently testing major resistance at $27.50-$28.00. If the Fed cuts by 50bp on Tuesday then INTC should break decisively above this resistance this week, but if the Fed opts for a smaller rate cut then INTC will probably spend a few weeks consolidating below $28 before breaking out to the upside.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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