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Outlook Summary

Update #4, 10th July 2010

The anticipated stock market rebound is underway and is probably not yet complete, even though the S&P500 Index has already gone slightly above the 1050-1070 resistance range that we suspected would act as a ceiling. The counter-trend rebounds that occurred during May and June ended after the S&P500 Index moved up to its 50-day moving average, so if the current rebound has a similar destiny then there is additional upside potential of around 2% (the 50-day MA is presently at 1100, versus last Friday's closing price of 1077). The 200-day moving average lies about 1% above the 50-day moving average and could also come into play before the rebound ends.

Pointing to further gains is the 10-day moving average of the OEX (S&P100) put/call ratio, which just hit its lowest level in more than 10 years. Unlike the equity put/call ratio, the OEX put/call ratio is NOT a contrary indicator. The reason is that professional money managers (the "smart money") dominate the trading of OEX options whereas the public (the "dumb money") dominates the trading of equity options. Extreme lows for the OEX put/call -- such as we have right now -- should therefore be interpreted as bullish because they suggest that the "smart money" is generally less concerned than usual about immediate downside risk.

Also pointing to further gains is the relaxation in the market for European government debt, as evidenced by a sizeable general decline in the cost to insure the government bonds issued by the "PIIGS" countries. Keep in mind, however, that the present drift from fear to complacency could reverse direction at a moment's notice.

Taking into account the closeness of resistance defined by high-profile moving averages, the put/call situation, the (temporary) abatement of credit-related fears and the likelihood that the intermediate-term trend remains down, we conclude that a) the beginning of the next tradable decline is probably at least two weeks away, and b) the scope for additional upward progress is small.

Because the stock market is probably not going to gain much ground between now and when a rebound peak is reached, this is a reasonable time to accumulate the bearish positions -- as hedges or speculations -- mentioned in our 7th July update. The same applies to the precious metal hedges (the SLV and SLW put options) previously suggested, as the HUI's rebound should have almost run its course IF the 1st July break below support was the 'real thing'. (Note: don't buy put options unless you understand the risks and know what you are doing.)

Finally, the decline in the Baltic Dry Index (BDI) is worth a brief mention. The BDI, an index of ocean freight rates, has just fallen for an extraordinary 31 days in succession and is now at a 14-month low. The BDI's performance is consistent with our view that global economic growth is anaemic. It is also consistent with the idea that the direction of the US dollar's intermediate-term trend is still up.

Update #3, 8th July 2010 (prior to the start of US trading)

Markets always eventually return to their 200-day moving averages, so when a market moves a long way above its 200-day MA we always know that a sizeable pullback lies in the not-too-distant future. However, we never know exactly when the pullback will occur or the level at which it will begin. This is because markets that are very 'overbought' will sometimes become even more so and stay that way for a while.

During May-June, the euro-denominated gold price (gold/euro) rose to about 30% above its 200-day moving average. This is as 'overbought' as it usually gets, so the stage was set for a correction. However, there was no way of knowing when the correction would begin and there was no guarantee that gold would not first become even more 'overbought' (during the final months of its long-term bull market the gold price will probably exceed its 200-day moving average by a lot more than 30%). The best we can ever do in such circumstances is to identify the risk and take precautionary measures, which is what we did in this case.

We can't say for certain that a meaningful correction has begun in the gold market, but it most likely has. And if it has, a reasonable expectation is that over the coming three months gold will move back to the vicinity of its 200-day moving average in both US$ and euro terms. Given that the moving averages are rising, this suggests additional downside risk of no more than 10%.

The results of Market Vane's latest sentiment survey also suggest that the downside risk from here is no more than 10%, in that the bullish percentage for gold dropped to 64 earlier this week. In other words, even though the gold futures market made a new all-time high within the past three weeks and is now only five percent below its high, gold-market sentiment appears to be indifferent.

With gold most likely having entered 'correction mode', the gold-stock indices are poised to continue the intermediate-term corrections that began last December. Ideally, a correction low will be reached in October.

With regard to the very short-term (the next 1-2 weeks), normal rebounds would take gold and the HUI up to around $1230 and 470, respectively.

A couple of unrelated matters:

1. We've been asked why we would choose to bet on, or hedge against, a downturn in China's economy by taking bearish positions in major commodity producers, the Brazilian stock market and the A$, rather than taking a position in an inverse fund such as FXP that would directly benefit from a decline in China's stock market.

One reason is that we want to hedge against a downturn in China's economy rather than further weakness in China's stock market, and the link between China's economy and its stock market is tenuous. For why this is so, refer to the discussion under "The Shanghai Stock Casino" in the 2nd June 2010 Interim Update. Also of significance is that China's stock market has been trending lower since last August and therefore probably doesn't have as much additional downside risk as the foreign markets and stocks that are leveraged to China's economy.

Another reason is that FXP moves inversely to the FTSE/Xinhua China 25 Index, and this narrow index of 25 Chinese stocks has been diverging from the broad Shanghai stock market over the past year. Partly as a consequence of this divergence, someone who bought FXP at the peak of the Shanghai stock market in August of 2009 and held until now would actually have suffered a sizeable loss even though the Shanghai market has fallen 30% in the mean time.

Lastly, the bearish positions we have suggested would hedge against a global downturn in addition to a China downturn.

2. Dundee Resources has invested C$3M in junior uranium miner Energy Fuels (TSX: EFR), thus increasing its stake in the company to 19.8%. This is a vote of confidence in EFR.

Despite its extremely low share price the EFR story remains intact, and with the infusion of Dundee's money EFR's work program should be funded through the next 12 months. However, EFR along with most other uranium stocks will probably continue to struggle until the uranium market embarks on its next intermediate-term advance. At this time the uranium price is languishing near a multi-year low.

Update #2, 7th July 2010 (prior to the start of US trading)

We intend to post a short update on gold and gold stocks after we see what happens during US trading on Wednesday (some time on Thursday, that is). Today we are re-visiting the "China story".

Great credit expansions prompt investment decisions that only make sense within the fantasy-world created by a relentless deluge of new money. When the flow of new money slows or when the true nature of the inflation-fueled boom becomes apparent to a critical mass of people, many of the investments prompted by the easy money fail and the economy enters a recession. If the government then 'fights' the adjustment process by propping-up prices and dramatically increasing its own indebtedness, the recession will potentially transform into a depression. For example, it was most likely the government's response to the post-1929 and post-1990 economic downturns in the US and Japan, respectively, that converted recessions into depressions (where a depression is defined as more than a decade of slow, or no, real economic progress). 

Being rife with mal-investments encouraged by a seemingly endless flow of new money and credit, China's economy has been acutely vulnerable for some time. It could have remained superficially strong as long as the government was willing to promote further credit expansion or until inflation risk became a widespread concern, but it was just a matter of time before the gross misdirection of resources started to take a visible toll. As it turned out, the combination of a steeper upward trend in the prices of food and other essentials, obvious bubbles in the residential real estate markets of several major Chinese cities and blatant over-building in the commercial property sector pushed China's policy-makers into crimping the flow of new credit during the first half of this year. The result is a growing pile of evidence that China's economy is now in a slump. For example, the following information was included in Joan McCullough's morning comment to the clients of East Shore Partners on 30th June:

"...if you look at one month interbank rates in Shanghai, you will see that they have climbed steadily up to 4%. While the one-year interest rate is only 1%. Uh-oh. Houston, we have a problem. 

And evidently, talk is that domestic liquidity is very tight as foreign capital inflows have stopped. And as a stillpegged currency, M1 expansion (Renminbi) has also stopped. Meanwhile, they are experiencing inflation which has the US dollar trading at a premium in the black market as compared to where it is trading officially. This is not good. None of it. Money quietly flowing out. As a matter of fact, some even suggest that the $2.4 tril in dollar reserves which the world is always trying to pinpoint and which we all automatically, unquestioningly attribute to trade surplus are not what they appear. Rather, some cognoscenti suggest that perhaps less than half that number is attributable to trade. The balance? How about "borrowed" from global speculators?

Anecdotally local iron ore traders kid that the present is a good time for them to take vacation as things are so slow. Steel prices, as a matter of fact, have fallen for 7 weeks. And the car inventory distribution channels are said to be 6-months stuffed but this has been camouflaged. Because "reported car sales" are being counted exfactory, not as final sales."

We knew of the downward trend in steel prices and the proclivity of China's official bean-counters to count a consumer good as "sold" as soon it leaves the factory. We also knew that China's vaunted currency reserve stems from speculative capital flows in addition to trade flows. We didn't know about the elevated level of one-month SHIBOR (Shanghai Interbank Offered Rate) relative to one-year SHIBOR, although we note -- by referring to http://www.shibor.org/shibor/web/html/index_e.html -- that the gap between these rates has since contracted to around 0.2%. And we didn't know -- and haven't been able to verify -- that the US$ has recently traded in the black market at a premium to its official exchange rate against the Yuan.

Interestingly, a lot of people are still citing the "China story" as a reason to be bullish on industrial commodities. The completely bogus GDP numbers spewed out by China's 'ministry of information' help foster such beliefs, but you don't have to dig far beneath the surface to find evidence of an economy in trouble.

That being said, the unusually high level of control that China's government exerts over the rate of credit expansion in both the private and public sectors means that it will be important to stay alert for signs of a policy shift from 'tightening' to 'easing'. To put it another way, we shouldn't under-estimate the Chinese government's ability to re-ignite the inflation-fueled boom. When the next policy-shift occurs in China it will probably be time to turn intermediate-term bullish on industrial commodities, but right now the outlook remains bearish because China is still headed down the 'tightening' path and the rate of global economic growth is slowing.

Here are a few ideas on how to hedge against or speculate on additional weakness in China's economy, especially if equity markets rebound over the coming days (a rebound would create a better opportunity to enter bearish positions):

1. Buy put options on the stocks of major industrial-metal producers such as FCX and VALE (as one of the world's largest iron-ore and nickel producers, VALE would be hurt by further weakening in the demand for steel).

2. Buy BZQ (a leveraged fund that moves inversely to the Brazilian stock market) or put options on EWZ (iShares Brazil).

3. Short the A$ or buy A$ (FXA) put options.

Update #1, 4th July 2010

There were some important market-related developments last week.

First, the US stock market clearly broke below its February and May lows, leaving no doubt that the next leg of the intermediate-term decline is underway. 

Second, gold and the gold-stock indices broke below short-term support levels.

Third, the euro re-confirmed its short-term upward trend against the US$ after initially pulling back, and the A$ reversed downward after making what will probably turn out to be an intermediate-term 'double top' relative to the euro.

The stock market's recent weakness has allowed the S&P500's 50-day moving average to cross below its 200-day moving average, an event that technical analysts commonly call a "death cross". The term "death cross" sounds ominous, but such crossovers have no statistical significance in that they are only followed by meaningful additional losses about 50% of the time. Rather than being an indication of what lies in store, we consider the S&P500's "death cross" to be one of several milestones that had to be reached if we were correct to assume that an intermediate-term decline began in April. Last week's decisive break below the February low was another of these milestones. 

Interestingly, the US stock market failed to rebound during the final two days of last week despite being 'oversold' and within a strong seasonal time-window. The strong seasonal window extends for a few more trading days and the market is now even more 'oversold' (the NASDAQ100 Index has just fallen for 10 days in a row for the first time ever), so the stage is still set for a decent bounce. However, considering last week's performance and the lousy economic backdrop we will be surprised if any rebound from here takes the S&P500 beyond former support (now resistance) at 1050-1070.

Turning to the world of gold, we had mentioned $1220 for the nearest gold futures contract and 470 for the HUI as demarcation levels, the breaching of which would suggest downward reversals in short-term trends. These levels were decisively taken out on Thursday 1st July. Perhaps even more significantly, the euro-denominated gold price (gold/euro) closed below its 50-day moving average on 1st July. As noted in the 28th June Weekly Update, "...gold/euro's 50-day moving average is rising rapidly and will soon be high enough to be used as a timely indicator of a trend change."

Thursday's action indicates that gold is probably now in 'correction mode', with the $1160s being a likely target and the low-$1100s being a possible target for a low. It also indicates that the gold sector is probably STILL in correction mode (the HUI commenced an intermediate-term correction last December). Former support at $1220-$1230 for gold and 470 for the HUI will probably cap any rebounds over the days ahead.

We are often uncertain regarding the short-term outlook, mainly because almost half the time a market's short-term performance will be at odds with its 'fundamentals'. Looking at charts will sometimes provide us with useful clues, but there are plenty of times when the price action is non-committal or downright deceptive. Recently, our short-term gold-sector outlook has been about as uncertain as it gets, as evidenced by the following paragraph from the 28th June Weekly Update:

"The HUI's 10-year performance record suggests that there won't be a sustained move to a new high for the year until at least September. Furthermore, a downward trend to an October low continues to fit most neatly with our longer-term outlook for the gold sector and our views on other markets. However, the market doesn't always follow our script and the recent price action suggests that there is a good chance of an upside breakout in the near future."

This uncertainty, along with our view that general stock market risk was high, prompted us to remain well-hedged -- in the form of a substantial cash reserve and some just-in-case option insurance -- in our own accounts, and to suggest some option-related hedges in TSI commentaries. For example, over the past few weeks we have suggested hedging gold-related exposure via SLV and SLW put options and euro call options (there was a reasonable chance that a gold pullback would be accompanied by a euro rebound). These hedges will help mitigate temporary reductions in the market values of long-term positions if last Thursday's breakdowns evolve into larger declines. They should therefore be maintained, or perhaps even added to if the HUI and gold rebound to 470 and $1230, respectively, over the coming week. (Note: We took profits on our euro call options on Friday, but are maintaining other hedges).

With regard to the currency market, the following comment from our 28th June commentary remains applicable:

"...the euro has probable upside to 1.26 and possible upside to 1.30 over the next few weeks. Beyond the next few weeks, our outlook for the euro remains bearish. The catalyst for the next substantial euro decline will probably be the resumption of the euro-zone's government debt crisis or breaks to new lows for the year by the world's major stock markets."

The euro tested resistance at 1.26 on Friday.

On the economic front there was more bad employment-related news in the US last Friday. We generally don't pay much attention to the statistics reported by governments and seldom mention them at TSI, but one aspect of the latest US employment report is noteworthy. We are referring to the large reduction in the workforce indicated by the data. Taken together, the May and June employment reports indicate that almost one million people have left the US labour market over the past two months. These people have given up looking for a job and therefore don't count as being unemployed as far as the official statistics are concerned. But if they aren't unemployed then what are they?

Finally, our trading position in Silver Standard Resources (SSRI) was stopped out last Thursday for a loss of 7.5%. We like the leverage that SSRI offers to both gold and silver and will probably return it to the TSI List within the next few months.