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   -- Weekly Market Update for the Week Commencing 12th February 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. The rally that began in October of 2002 will end during the first half of 2007. The ultimate bottom of the secular bear market won't occur until the next decade. (Last update: 02 October 2006)

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. The first major upward leg in this secular bull market ended in December of 2003, but a long-term peak won't occur until at least 2008-2010. (Last update: 13 February 2006)

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
(04-Oct-06)
Bullish
(29-Jan-07)
Bullish

US$ (Dollar Index)
Neutral
(08-Jan-07)
Bullish
(31-May-04)
Bearish

Bonds (US T-Bond)
Neutral
(29-Jan-07)
Neutral
(23-Aug-06)
Bearish

Stock Market (S&P500)
Neutral
(13-Dec-06)
Bearish
(02-Jan-07)
Bearish

Gold Stocks (HUI)
Bullish
(04-Oct-06)
Bullish
(29-Jan-07)
Bullish

OilBullish
(04-Oct-06)
Neutral
(
25-Sep-06)
Bullish

Industrial Metals (GYX)
Neutral
(15-Jan-07)
Bearish
(25-Sep-06)
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 on which way the market will move or that we expect the market to be trendless during 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.

Commodities

A problem with indices

The diverging of the CRB and the CCI is an extreme example of a general problem with indices... ...if there's a meaningful contraction in liquidity over the coming two quarters then the commodity downturn will likely become more broad-based than it has been to date.

In a recent article Adam Hamilton correctly points out that the gnashing of teeth provoked by last year's breakdown in the CRB Index makes little sense given that the CRB would not have broken down at all if not for the revisions that were made to this commodity index in 2005. That this is the case is evidenced by the performance of the Continuous Commodity Index (CCI), a chart of which is included below. The CCI is the CRB sans the 2005 revisions and has clearly not yet broken down.

The diverging of the CRB and the CCI is an extreme example of a general problem with indices, particularly weighted indices made up of a fairly small number of components. The problem is that under certain situations -- especially around important turning points in the market -- the performance of an index may not paint an accurate picture of the market it supposedly represents. For example, the Dow Industrials Index -- a widely-watched measure of the US stock market's performance that consists of only 30 stocks -- will often provide false signals near intermediate-term turning points; specifically, it tends to maintain its upward trend for some time after the overall market has begun to trend lower and maintain its downward trend for some time after the overall market has begun to trend higher.

Even though it came about due to major changes in the way the index was constructed and calculated, the recent CRB-CCI discrepancy is really just an example of a limitation of indices in general. Most indices are somewhat arbitrary, and what we have in the CRB-CCI situation is an example of an arbitrary change to what was already an arbitrary index causing a big change in performance.

Commodity bulls can choose to hang their hats on the CCI's relative strength and commodity bears can point to the CRB's breakdown, but in our opinion it would be dangerous to base an intermediate-term outlook on the performance of either index. Neither of these indices can be relied upon to provide the 'correct' representation of the overall commodity trend, but there could well be some information in the fact that such a discrepancy exists at all. To be specific: at important turning points some market components -- individual stocks, commodities, sub-sectors, etc. -- will invariably reverse direction ahead of others, thus causing market proxies with differing compositions to diverge.

The difference between the performances of the CRB and the CCI is indicative of a loss of consistency across the commodity universe stemming from some commodities reversing downward while others stayed on upward paths. It could therefore be interpreted as evidence that the commodity market trend is transitioning from up to down. This is, in fact, our interpretation (we think commodities are going through a mid-cycle downturn within a secular bull market).

Only a small number of commodities have broken down in a decisive manner over the past 6 months, but it's potentially significant that two of the ones that have broken down (oil and copper) are two of the most important. That many others are yet to break down is symptomatic of the on-going liquidity deluge, but if there's a meaningful contraction in liquidity over the coming two quarters then the commodity downturn will likely become more broad-based than it has been to date. The grain and gold markets might buck such a change in the monetary trend -- the grains for the reasons outlined in the 15th January Weekly Market Update and gold due to its counter-cyclical nature -- but most commodities would probably go the way of oil and copper.

Alternatively, if the liquidity deluge continues for several more months then the breakdowns in oil and copper will likely prove to be isolated incidents within an uninterrupted bullish trend. This is not the way to bet, though, because the re-ignition of the commodity bull at this time would force the major central banks to take quick counter-measures with the aim of keeping inflation expectations in check.


Natural Gas Update

The weather in the US has taken a rather dramatic turn over the past two weeks from being unseasonably warm to being unusually cold. In fact, after experiencing one of the mildest December-January periods on record the US now appears to be on track to experience one of the coldest Februarys ever. This sudden change in the weather has, in turn, gone some way toward mitigating the near-term supply glut in the natural gas market. The amount of gas in storage is still well above the 5-year average, but it is now slightly below where it was at this time last year.

We had been allowing for the nearest NG futures contract to make a final low during February, but the change in the weather might mean that the next pullback results in a higher low.

The probability that the ultimate price low is already in place will obviously increase if the cold spell continues. Also, a daily close above the $8.00 resistance level by the March natural gas (NG) futures contract would be evidence that the market had bottomed a bit earlier than we had originally expected.


The Canadian 'gassy' energy trusts (AVN.UN, DAY.UN, FEL.UN, SHN.UN, TET.UN, THY.UN and VNG.UN) are suitable for new buying near current levels. With the exceptions of FEL.UN and THY.UN, these trusts have all made substantial cuts to their monthly distribution amounts over the past several months. As a result, distributions are still high enough to provide attractive yields -- the average yield across the aforementioned trusts is about 16% -- but are now at levels that should prove to be sustainable assuming the NG price does not drop well into new-low territory. A distribution cut from C$0.12/month to around C$0.09/month might lie ahead for THY.UN, but the stock market appears to have already discounted such an outcome so if/when it happens it shouldn't have a big effect on the trust's unit price.

Gold versus the Industrial Metals

Over the past four months there has been a sharp upward move in the gold/GYX ratio (the gold price divided by the Industrial Metals Index), which we've been pleased to see because it's what we've expected would happen and what we've been positioned for. However, it's still too early to tell if we have a major trend change on our hands. The reason is that the surge in the gold/GYX ratio has not yet been confirmed by an upward reversal in the yield-spread.

To explain what we mean by "not yet been confirmed" we've included, below, a chart comparing the gold/GYX ratio with the TYX/FVX ratio (the 30-year yield divided by the 5-year yield -- a measure of the US yield-spread). Clearly, gold/GYX has been trending in the same direction as the yield-spread for many years.

Gold/GYX has just experienced its best rally in a long time, but until TYX/FVX confirms a change in its trend by breaking decisively above 1.05 there will remain a risk that the post-October-2006 strength in gold relative to the industrial metals is solely a response to the overshoot that occurred between October-2005 and October-2006. During the aforementioned 12-month period, rampant speculation in metals such as copper and zinc caused gold to plunge relative to the GYX even while it was rallying relative to paper money. And in the absence of a confirmed change in the yield-spread's trend it will be possible that gold's relative strength is a short-lived phenomenon driven by the unwinding of these speculative bets.


Bonds

It looks like T-Bond futures made a short-term bottom in late January, but the potential for a spike to new multi-month lows will remain until the March contract closes above the resistance indicated on the following daily chart. A daily close above the aforementioned resistance would immediately take our short-term bond market outlook to "bullish" in anticipation of a 1-3 month rally.


The Stock Market

...one of the many adverse ramifications of the US Government's ethanol subsidies will be a quicker/sooner rise in the cost of labour than would otherwise be the case.

The US stock market is showing initial signs of reversing lower. An important support level to watch is 1750 for the NASDAQ100 in that a decisive close below 1750 would indicate that an intermediate-term peak was in place for this leading stock index.

As discussed in previous commentaries, US corporate profit margins are extremely high at this time and the main reason they are high is that labour's 'slice of the pie' has fallen in size over the past several years. What has happened is that most other prices have risen at a faster pace than the price of labour, boosting corporate profit margins as a percentage of GDP since labour is the single largest cost for most businesses.

Profit margins are mean reverting, the only real question being the timing of the reversion. Specifically, the salient question is: will profit margins contract THIS year due to a rise in labour prices relative to other prices, or will the reversion be pushed further into the future?

The fact that labour costs have recently begun to rise at an accelerated pace suggests that the reversion is either already underway or will begin over the next couple of quarters, thus putting downward pressure on profit margins -- and potentially stock prices -- this year. In addition, it is possible that one of the many adverse ramifications of the US Government's ethanol subsidies will be a quicker/sooner rise in the cost of labour than would otherwise be the case. Here's why.

The rapid growth in the ethanol industry made possible by Government subsidies has caused the prices of corn and soybeans to move sharply higher, thus directly pushing up the prices of all the foods that contain corn and soybeans. But since soybean meal and corn are extensively used to feed cattle, pigs and poultry, the large increases in the prices of these two commodities will lead to higher prices for most of the popular meats. In other words, a very significant across-the-board increase in food prices will most likely stem from the ethanol subsidies. This, in turn, will undoubtedly grab the attention of the US consumers who have not experienced much wage growth over the past few years but didn't really care up until recently because the unstoppable upward trend in house prices -- a trend that is presently in hibernation -- was making them feel good about their financial situations.

In summary: there's a good chance that the acceleration in the cost of everyday food items due to the government-funded growth in the ethanol industry will prompt US wage earners to more aggressively seek increases in their wages. And the extent to which they are successful will put downward pressure on corporate profit margins.

This week's important US economic events

Date Description
Monday Feb 12
No significant events scheduled
Tuesday Feb 13
Trade Balance
Wednesday Feb 14 Retail Sales
Thursday Feb 15 Import and Export Prices
Net Foreign Purchases of US Securities
Industrial Production
Capacity Utilisation
Friday Feb 16 PPI
Leading Economic Indicators

Gold and the Dollar

Gold Stocks

...the best risk/reward ratios can be found amongst the exploration-stage miners, the small-scale producers and a select few mid-tier (or soon to be mid-tier) producers.

Gold's break to new highs on Friday was accompanied by a small decline in the gold share indices. This is bearish price action that might be signaling some up-coming consolidation in both gold bullion and the gold shares, but we won't attempt to read a lot into a single day's performance. As noted in last week's Interim Update, gold shares are generally oversold relative to the gold price and are therefore poised to out-perform over the next couple of months. In addition, gold's recent upward trend relative to some other important commodities should lead to higher profit margins for gold producers and, eventually, to some interesting upside in share prices.

Many gold market commentators are operating under the assumption that the gold sector embarked on another major upward leg last October. This assumption might prove to be on the mark, but up until now we haven't seen anything that differentiates the current rally from a counter-trend move within an on-going correction. There is, however, nothing unusual about this because the early stage of a new trend will often be indistinguishable from a counter-trend move (the financial markets are generally very good at hiding their true intentions).

The following chart of Newmont Mining (NEM) does a good job of illustrating the current lack of confirmation of an intermediate-term trend change. A preliminary sign of such a change would be a decisive break above resistance at $48.


We continue to expect the major gold shares to reach significantly higher levels within the next two months, but our primary focus remains on the juniors.

As has been the case for a long time (years, actually), the best risk/reward ratios can be found amongst the exploration-stage miners, the small-scale producers and a select few mid-tier (or soon to be mid-tier) producers. With a few exceptions there hasn't been much interest in such stocks over the past several months, but this will change at some point if the gold stock indices continue to grind upward. The thing is, if you want to make serious money by speculating in the small gold shares -- especially the shares of the exploration-stage companies -- you simply have to do the bulk of your buying when the public's interest in this area of the market is low. The reason is that once these types of shares begin to move they tend to do so very quickly and with very little warning.

Gold

...broad-based strength on gold's part could be an early warning sign of a general decline in monetary confidence.

Gold's recent strength in the face of a modestly firm US$ could be explained in a number of ways. For example, the trouble that is brewing in sub-prime mortgage land (high-risk US home mortgages that were packaged together, given a stellar credit rating and sold to large investors throughout the world as low-risk debt securities, have begun to default at an accelerated pace) could be creating some investment demand for gold, as could the growing realisation that the massive Iraq-related expenditures will continue indefinitely. Both the mortgage debt problem and the Iraq-expenditures issue equate to future downward pressure on the US$ because they will lead to more inflation, so it's possible that the gold market has begun to discount this future pressure. Another possibility is that technically-oriented speculators have been buying gold futures, thus driving up the gold price, in anticipation of the US$ peaking on a short-term basis near its current level. Due to the gold market being much smaller than the currency market it is certainly not uncommon for short-term trend changes to become evident in the gold price before they become evident in the US dollar's foreign exchange value.

In any case, there have been clues in the price action for months that gold was probably going to test its May-2006 peak at some point during the first half of 2007. We can only make guesses regarding the underlying drivers of the recent action because the market price is the net result of the buy/sell decisions of millions of individuals, each of whom has his/her own reasons for wanting to buy or sell. Furthermore, the price action has not exactly been dramatic in that Friday's rise was only 1.3% and the US$ gold price remains well within the range in which it has traded over much of the past year.

From our perspective, one of the two most interesting aspects of the recent market action is that gold appears to be breaking upward from consolidation patterns in terms of EVERY major currency. For example, the following chart of the euro-denominated gold price shows that 'round number resistance' at 500 has been decisively breached. This broad-based strength on gold's part could be an early warning sign of a general decline in monetary confidence.


The other aspect of the recent market action that has grabbed our attention is gold's strength relative to the industrial metals. This was discussed earlier in today's report and if confirmed by an upward reversal in the yield-spread will indicate that gold's current rally is 'real', rather than just a side effect of general metals-related speculation.

Instead of using a daily chart to highlight Friday's obvious (but currently unconfirmed by the gold shares) break above short-term resistance, we thought we'd take a longer-term view today and have therefore included, below, a monthly gold futures chart. The chart shows the long-term resistance at around $730 that capped last year's upward move and the long-term support that exists at around $500. This long-term support is the top of a multi-decade base and in our opinion defines the maximum downside risk. It is, we think, equivalent to the $40 level for oil and the $1.50 level for copper.

Surmounting long-term resistance on a sustained basis will probably require a deflation scare. This is not because gold is a hedge against deflation (it definitely isn't a hedge against genuine deflation) but because a) a deflation scare would provide the cover for the next round of central-bank-sponsored inflation, and b) in the absence of a deflation scare the central banking community will have the freedom to fight an upside breakout in the gold price with tighter monetary policy.


Currency Market Update

The only thing noteworthy that happened in the currency market last week was Friday's surge in the Canadian Dollar (refer to the following chart of March C$ futures for details). This price action, coming as it did after a prolonged period of weakness, is a clear sign of a short-term trend change.

There's a significant chance that the euro, the Swiss Franc and the Yen will spike to new lows before commencing tradable rebounds, but it looks like a 1-2 month rebound is already underway in the C$.


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)

American Gold Capital (TSXV: AAU) and Chesapeake Gold (TSXV: CKG)

The AAU-CKG merger is scheduled to be completed this week, resulting in AAU shareholders receiving CKG shares, warrants and Class A shares. At this stage no announcement has been made regarding when the new warrants and Class A shares will begin to trade and what their symbols will be.

Each new Class A share will confer the right to purchase ten CKG shares at C$1.00 per share within the coming 5 years, but the right only 'kicks in' after the gold price closes above US$850/ounce for 90 consecutive days. A new Class A share will, therefore, be more of a leveraged play on gold bullion than a leveraged play on CKG.

We have no idea how the market will value these Class A shares because the price will be almost entirely determined by the probability that the market assigns to gold trading above $850 within 5 years. For example, in our valuations we've assumed a 50% probability of gold achieving this objective, so with CKG at C$6.70 we end up with a rough value of C$28.50 for the Class A shares {10*0.5*(6.70-1.00)}. However, if the market were to assign a probability of only 20% to gold moving above $850 within 5 years then with CKG at C$6.70 the Class A shares would trade at only C$11.40 or thereabouts.

There won't be much liquidity in the market for the CKG Class A shares because the float will be small (around 900,000). As a result, they won't make good trading vehicles. Furthermore, the price will make large swings in response to changes in sentiment towards gold, so it will only make sense to accumulate them during periods when sentiment towards gold is 'in the dumps'.

    Ivernia Inc. (TSX: IVW). Shares: 134M issued, 143M fully diluted. Recent price: C$1.46

There might be a downturn in the lead market later this year in response to slowing global growth, but there are no signs of trouble at this time. In particular, LME stockpiles of the metal have fallen to near their lows of the past several years and the price appears to be undergoing a normal consolidation within an intermediate-term upward trend (see chart below).


As the owner/operator of the world's largest pure lead mine (the Magellan mine in Western Australia), IVW is benefiting from the current high lead price and will obviously benefit even more if lead moves to new highs in the near future. The company also seems to be progressing well on the operational front with production steadily increasing toward the design rate of 100,000 tonnes per year. Given these fundamentals, the current market cap of around US$175M is low.

Taking a look at the stock's chart (refer below), the price moved sharply higher during September-November and has since been tracing out a triangular consolidation pattern. It will have to break out of this pattern in one direction or the other within the coming 4 weeks and the odds favour the direction being up.

It would be reasonable, we think, to take partial profits on IVW at around $2.00 if given the opportunity to do so within the next two months, and to retain the balance as part of a core industrial metals position.


    Takeover Candidates

Potential takeover candidates in the TSI Stocks List include European Minerals (TSX: EPM), Minefinders Corp. (AMEX: MFN), Metallica Resources (AMEX: MRB), Nevsun Resources (AMEX and TSX: NSU), and Northern Orion Resources (AMEX: NTO). Of these, we think the two most likely recipients of takeover bids in 2007 are MFN and MRB -- MFN by either Gammon Lake Resources (AMEX: GRS) or Hecla Mining (NYSE: HL) and MRB by Xstrata (MRB's JV partner at the huge El Morro copper/gold project).

Both MFN and MRB are presently overbought on a short-term basis and near all-time highs, which means that right now would not be an ideal time to be doing any new buying. However, despite the recent gains in their stock prices and regardless of any potential for them to become the targets of other mining companies, it is our view that they still offer two of the best intermediate-term risk/reward ratios in the gold sector. We do, therefore, think that they would be suitable for new buying following pullbacks of 5%-10%.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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