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   -- Weekly Market Update for the Week Commencing 13th February 2006

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 by the first quarter of 2006 and will be followed by a substantial decline to a higher low (above the Oct-2002 bottom) during the second half of 2006. The ultimate bottom of the secular bear market won't occur until the next decade. (Last update: 12 December 2005)

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 will end during the first quarter of 2006, but a long-term peak won't occur until at least 2008-2010. (Last update: 13 February 2006)

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Outlook Summary

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Neutral
(5-Dec-05)
Bearish
(06-Feb-06)
Bullish

US$ (Dollar Index)
Bullish
(13-Feb-06)
Bullish
(31-May-04)
Bearish

Bonds (US T-Bond)
Bearish
(11-Jan-06)
Bearish
(02-Jan-06)
Bearish

Stock Market (S&P500)
Neutral
(10-Jan-06)
Bearish
(05-Jan-05)
Bearish

Gold Stocks (HUI)
Neutral
(30-Nov-05)
Bearish
(06-Feb-06)
Bullish

General Commodities (CRB)
Neutral
(14-Nov-05)

Bearish
(23-Mar-05)

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.

The Velocity of Money

...whenever the central bank creates a lot of new money out of thin air in an effort to circumvent the need for production to precede consumption it sets into motion what Frank Shostak refers to as an exchange of nothing for something, an INEVITABLE consequence of which is a fall in the purchasing power of money.

The Fed may well print a lot of new money, but what happens if the new money is not spent? What happens if the velocity of money -- the rate at which money changes hands in exchange for goods, services and investments -- falls by enough to counteract the effect, on the purchasing power of money, of the monetary inflation caused by the Fed? Isn't it possible that we could end up with a situation where the Fed is aggressively inflating the supply of money while the purchasing power of money is INCREASING due to a general reluctance to spend the money, that is, due to a fall in the velocity of money?

The short answer is no, it's not possible.

The slightly longer answer begins with the point that money doesn't finance transactions, it facilitates them. For example, when a potato farmer sells 5,000kg of potatoes for $20,000 and uses the proceeds to purchase a new car the purchase of the car is being financed by the farmer's production of potatoes, not by his accumulation of money. Money has just acted as the medium of exchange, which, of course, is all it is supposed to do. In this example, the purchasing power of money can be expressed as follows: one dollar = 5,000/20,000 (0.25) kg of potatoes or one dollar = 1/20,000 (0.00005) new cars. Furthermore, a change in the supply of or the demand for potatoes, new cars or money will change the rates at which these entities are exchanged. In other words, if all else remains equal and the supply of money is increased then more money will be required to purchase the same quantity of potatoes and new cars*. The number of times that the same piece of money changes hands within a certain period of time -- the so-called "velocity of money" -- does not enter the equation.

The much longer and far more complete answer can be found in Frank Shostak's article at http://www.mises.org/story/918

The bottom line is that consumption can only be financed by production -- either the current or past production of the consumer or, in the case of a credit transaction, the current or past production of the creditor. And whenever the central bank creates a lot of new money out of thin air in an effort to circumvent the need for production to precede consumption it sets into motion what Frank Shostak refers to as an exchange of nothing for something, an INEVITABLE consequence of which is a fall in the purchasing power of money. There is simply no way around this basic economic truth. Furthermore, if enough people come to believe that the central bank is going to continue the rapid money creation well into the future then the rate at which money loses its purchasing power will begin to EXCEED the rate at which new money is being brought into existence due to people front-running the expected future loss of purchasing power.

    *This is an over-simplification that would only apply if all transactions within the economy involved potatoes and cars. In the real world there are millions of different things being bought and sold every day, but the point is that if the supply of money is increased while nothing else changes then the purchasing power of money will fall in proportion to the increase in money supply. In reality things are, of course, constantly changing, which just means that an increase in the supply of money will tend to have an uneven and difficult-to-pinpoint effect on prices throughout the economy.

Updates to Big Picture Views

Gold

In a world where currency inflation is pushing the prices of most commodities and other assets higher it makes sense to take currency out of the equation and look at how different asset classes are performing relative to each other. If we do this we find that gold's performance between the final quarter of 2000 and the final quarter of 2003 was far more impressive than its performance since that time.

In the "Big Picture View" included at the top of every Weekly Market Update we previously stated that the first major upward leg in gold's long-term bull market ended in December of 2004.

The gold price has moved well above its December-2004 high over the past 6 months, so either the second major upward leg in gold's long-term bull market began during 2005 or our previous "Big Picture View" was wrong and the first major upward leg has extended into 2006. As far as the US$ gold price is concerned we think it is the latter because the below chart reveals a very consistent upward trend starting at the April-2001 low followed by an accelerated advance over the past several months. Accelerated moves tend to occur during the CONCLUDING stages of trends, so the chart of the US$ gold price paints a picture of a single upward leg in the process of culminating.



However, if we only look at performance in US$ terms, or even if we only look at performance relative to fiat currency in general, we end up with a myopic view of the financial world. The reason is that ALL of the world's fiat currencies are being de-valued by inflation at varying rates, with the US$ sometimes being devalued at a faster rate than its fiat currency brethren and at other times being devalued at a slower rate. There will be periods when the US$ will be in an upward trend relative to currencies such as the euro and the Yen and periods when it will be in a downward trend relative to the other national currencies, but the purchasing power of EVERY fiat currency is in a secular downward trend. As a result, the prices of most commodities and tangible assets are in secular upward trends.

In a world where currency inflation is pushing the prices of most commodities and other assets higher it makes sense to take currency out of the equation and look at how different asset classes are performing relative to each other. If we do this we find that gold's performance between the final quarter of 2000 and the final quarter of 2003 was far more impressive than its performance since that time. For example, the following charts of the gold/CRB ratio (the gold price relative to the CRB Index) and the gold/GYX ratio (the gold price relative to the Industrial Metals Index) suggest that the first major upward leg in gold's long-term bull market actually ended during the final quarter of 2003 and that gold has, since then, been relatively weak. The gold/CRB chart could be used to make the case that the second major upward leg in gold's long-term bull market began in September of 2005, but there is no evidence in the gold/GYX chart that a second major upward leg has begun.





Our view is that the US$ gold price will complete the first major upward leg in its long-term bull market during the first quarter of this year. However, taking into account the performances of gold relative to the non-US$ fiat currencies, commodities, and the major stock market indices, as well as the performance of the AMEX Gold BUGS Index, we think it makes the most sense to consider the first major upward leg to have ended in December of 2003 and the second major upward leg to have begun in September of 2005. In this case, the ending of the FIRST major upward leg in the US$ gold price (Q1 2006?) will probably coincide with the ending of the first rally in gold's SECOND major upward leg when gold's performance is measured relative to most other investments.

Further to the above, the Big Picture View at the top of the Weekly Market Update now reads as follows:

"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."

Commodities

The CRB Index surprised us by moving above its March-2005 peak during the second half of last year. Energy-related commodities lead the index higher during the second and third quarters of 2005, after which metals took over the leadership role.

Despite the strength in the 'energies' and the metals over the past 9 months, the CRB Index has only managed to exceed its March-2005 peak by around 8%. If the stock market puts together a final surge into March as per our current short-term forecast then the early-February peak in the CRB Index might be tested or marginally exceeded before a substantial correction gets underway. However, we think the rally in the CRB Index that began during the final quarter of 2001 is essentially complete. What we have seen over the past three years is everything getting pushed upward by a rising sea of liquidity, but with the bull markets in US stocks and real estate appearing to be on their last legs the bull market in commodities is acutely vulnerable to a large setback.

With reference to the following chart, a move below 320 will push the CRB Index below the bottom of its long-term channel and confirm that an important peak is in place.


The Stock Market

Current Market Situation

...the Utility Index is CLOSE to generating a very bearish signal.

Leading indicators of the stock market and the economy -- the NDX/Dow ratio and the yield-spread, for example -- suggest that the US stock market is in the process of making an intermediate-term peak. Furthermore, the fact that the gold sector has been a relative strength leader over the past few months is a bad omen for the broad market because it points to a growing recognition that gains in earnings are, to a significant extent, being fueled by inflation. However, coincident indicators suggest that we should continue to allow for a final stock market rally over the coming 1-2 months that will likely result in the S&P500 Index making a new high for the year while the NASDAQ100 Index remains below its January high.

Something to keep an eye on over the coming days/weeks is the Utility Index. It didn't garner as much attention as the commodity, homebuilding and technology sectors, but the utility sector has probably had the most consistent upward trend in the US stock market over the past three years. At the present time that upward trend is, however, in jeopardy. Specifically, the Utility Index (see chart below) peaked at the end of September-2005 and appears to have made a secondary (lower) peak last month. Furthermore, it would only take an additional decline of 3% to break the Utility Index below a short-term trend-line, important lateral support at 400, the 200-day moving average, and the long-term upward-sloping trend-line (not shown on the below chart) that dates back to the Q1-2003 bottom. In other words, the Utility Index is CLOSE to generating a very bearish signal.


An important risk that we don't think is currently on the radar screens of many stock market participants is the potential for a breakdown in the bond market. From what we can gather, most stock market bears think long-term interest rates will remain low and most stock market bulls aren't giving much thought at all to the potential for rising bond yields to interrupt the cyclical bull market in stocks. We plan to deal with this topic in a future commentary.  

This week's important US economic events

Date Description
Monday Feb 13
No important events scheduled
Tuesday Feb 14 Retail Sales
Wednesday Feb 15 Net Foreign Purchases of US Securities
Capacity Utilisation
Industrial Production
Thursday Feb 16 Import and Export Prices
Housing Starts
Friday Feb 17 PPI

Gold and the Dollar

Gold

Gold and the Fed

...there could well be a period of a few months when the interest rate backdrop becomes less favourable for gold even though the Fed is attempting to loosen its monetary policy.

Whether the Fed's monetary policy is restrictive, accommodative or neutral is not determined by the level of the Fed Funds rate or by the current trend of the Fed Funds rate. It is, instead, determined by the level of inflation expectations RELATIVE TO the level of the Fed Funds rate. For example, monetary policy would become increasingly restrictive while the Fed was CUTTING the Fed Funds rate if inflation expectations were falling at a faster pace than the nominal short-term interest rate controlled by the Fed; and monetary policy would become increasingly accommodative while the Fed was HIKING the Fed Funds rate if inflation expectations were rising faster than the nominal short-term interest rate controlled by the Fed.

Further to the above, although gold is counter-cyclical and tends to do relatively well when the Fed eases monetary policy in response to economic weakness, the risk is that a general downturn in stock and commodity prices will initially have the effect of making monetary policy increasingly tight -- due to falling inflation expectations -- even if the Fed reacts to the downturn by cutting the Fed Funds rate. There are good reasons to be supremely confident that under such circumstances the Fed would eventually do enough to make its monetary policy accommodative, but there could well be a period of a few months when the interest rate backdrop becomes less favourable for gold even though the Fed is attempting to loosen its monetary policy.

The aforementioned risk has been present throughout the past year, but just because it hasn't yet caused a problem doesn't mean it is not relevant. Gold's downside potential will, we think, be limited to routine 10% (or so) pullbacks as long as the stock and commodity markets continue to push higher, but we think that gold will be hit during the INITIAL phase of a general downturn in stocks and commodities. However, once the Fed panics and begins to overtly promote inflation it is very likely that counter-cyclical gold will begin to move up strongly while the cyclical markets continue to trend lower.

Current Market Situation

The following daily chart of April gold futures shows that short-term support exists at around $548. A decisive daily close below this support would be a preliminary sign that an intermediate-term peak was put in place during the first week of this month.


The following weekly chart of gold futures shows that there is good support at $540 and then at $460-$480. The $500-$510 area should also offer support during a decline because it coincides with a big round number and with former long-term resistance (now support) defined by the 1983 and 1987 peaks.

If support at $540 is breached on a weekly closing basis then $500-$510 will probably be tested.


Our view is that if the CRB Index and the S&P500 Index remain in intermediate-term upward trends then a drop to test support at $500-$510 represents the maximum downside risk for gold (it probably wouldn't even drop that far). However, we expect intermediate-term declines to begin in the stock and commodity markets within the next 1-2 months and therefore think there's a significant chance of support at $460 being tested within the coming 6 months.

Silver

Our view is that silver will spike up to $10-$11 before an intermediate-term peak is put in place, but if the silver price closes below the upper support level shown on the following weekly chart (around $9.25) then we'd assume that an intermediate-term peak was put in place at the beginning of this month when the March futures contract hit $9.91.

Even if an intermediate-term peak is already in place we don't think there's much chance that silver will experience anywhere near the same magnitude of decline that it experienced following the April-2004 peak because speculation in silver-related investments has been a lot more subdued during the past 5 months than it was during the 5 months leading up to the April-2004 peak. Our thinking is that IF an intermediate-term decline is already underway then it will bottom near support at $8.20.


Currency Market Update

The Dollar Index consolidated just above its 50-day moving average during the first 4 days of last week and then put in an 'outside up' day to breakout of its short-term channel. Last week's performance by the US$ has convinced us that the late-January low will turn out to be the ultimate low for the correction that began in November, meaning that we think the Dollar Index's short-term downside risk is limited to about 2 points. As a result we are upgrading our short-term US$ view from "neutral" to "bullish".


In our opinion, the major currency with the worst risk/reward as far as the coming 6 months are concerned is the Canadian Dollar. The reason is that this currency has been elevated by widespread enthusiasm for energy- and metal-related investments and we expect this enthusiasm to wane over the coming 2 quarters.

Aside from the US$, we think the major currency with the best risk/reward as far as the next 6 months are concerned is the Yen because the Japanese currency is oversold and under-valued and will, at some point, experience a sharp recovery due to the unwinding of carry trades.

Gold Stocks

In last week's Interim Update we wrote:

"Regardless of whether we are seeing a pullback during an on-going intermediate-term advance or the initial downward move of an intermediate-term decline, a short-term bottom will probably be put in place within the coming week or so. The difference is that if history is a useful guide then the initial downward move in an intermediate-term correction would likely end with the HUI in the 270s, whereas a pullback within an on-going intermediate-term advance would likely bottom near the current level (300-315)."

Since writing the above we've seen a rebound (on Thursday) followed by a drop to new lows for the move on Friday, but nothing has really changed. As noted on the following daily chart of the HUI, support at around Friday's low should hold if the intermediate-term rally that began last May is intact whereas additional downside of around 10% will likely occur in the near future if the current decline is the first downward step in an intermediate-term correction. Either way there's a good chance that a short-term bottom will be put in place this week.


Update on Stock Selections

Below is a daily chart of the nickel price covering the past 4 years. Nickel was the leading industrial metal during 2002-2003, but since the first quarter of 2004 its price has consolidated within a wide range while the prices of copper, zinc, aluminium and lead have continued to advance.


We expect all the industrial metals to trade well below current levels within the next 6 months. Nickel, for instance, will probably move down to near the bottom of its 2-year range (US$11,000/tonne or US$5.00/pound). For this reason we were planning to retain core positions in some base metal stocks in line with the secular bull market in this sector (in a long-term bull market you should always be net-long), but weren't intending to add any new base metal plays to the TSI Stocks List in the near future. However, we've identified one stock that we think is worth accumulating near current levels.

The stock is International Royalty Corp. (TSX: IRC). IRC is a royalty company -- a company that invests money in early-stage mining ventures in exchange for a percentage of the revenue that will be generated if/when a mine is developed -- with a portfolio of over 60 projects (potential future revenue streams). Almost all of these projects are at the exploration stage and are therefore years away from providing IRC with any revenue, but in a long-term bull market for metals these projects have significant option value. One of IRC's projects is, however, set to provide the company with substantial revenue beginning this year. That project is the huge Voisey's Bay nickel deposit owned by Inco.

IRC owns a royalty such that it will get paid 2.7% of the value of all metals produced at Voisey's Bay, less certain deductions. Phase 1 of Voisey's Bay has already begun to produce metal and production is expected to ramp-up to the planned annual rates of 100M pounds of Nickel and 70M pounds of copper over the coming months.

At current metal prices the Voisey's Bay royalty would provide IRC with annual cash flow of US$23M (C$27M). For a company with a market capitalisation of C$228M and an enterprise value (market capitalisation + net debt) of C$236M at Friday's closing price of C$4.00/share, this is a significant amount of cash. It means that IRC is presently trading at only 8.7-times the cash-flow that will be generated, beginning this year, by ONE of its projects assuming current metal prices are sustained. Alternatively, if we take a more conservative view and do the cash-flow forecasts using our intermediate-term downside targets of around US$5.25/pound for nickel and US$1.60 for copper, we find that IRC is presently trading at around 10.8-times the cash-flow expected from Voisey's Bay. This is still very reasonable given the upside potential provided by the company's many other royalty projects and the potential for base metal prices to move considerably higher during 2007-2010.

IRC had its Initial Public Offering (IPO) in February of 2005, so there is only about 12 months of price history for the stock (the IPO price was C$4.30). Over this period the stock appears to have established a solid base at C$3.35-C$3.50, so this probably represents the maximum downside risk over the coming months. Our suggestion, for those who are interested in this stock, is to buy half a position near the current level with the goal of buying the other half following a pullback to the C3.50s.


We mentioned Lion Selection Group (ASX: LSG) in a previous commentary. The company trades in Australia and is, in effect, a closed-end fund that invests in small (usually exploration-stage) gold and other metal stocks. Buying LSG is a relatively low-risk way to obtain exposure to small Australian-listed gold stocks.

If the correction in the gold sector continues then LSG will probably become available near its long-term trend-line (see chart below), in which case we would add it to the TSI Stocks List. Specifically, we will add the stock to the List if it trades at A$1.85.


    We will add major gold producer Kinross Gold (NYSE: KGC) to the Stocks List if it trades at US$8.75 (a bit more than 10% below Friday's closing price).

    Last Thursday American Bonanza (TSX: BZA) announced an updated NI 43-101-compliant resource estimate for its Copperstone gold project in Arizona. Copperstone now has a measured-and-indicated resource of 335,000 ounces plus an inferred resource of 66,000 ounces.

Given the amount of money and time that has gone into exploring Copperstone over the past few years we thought the updated resource estimate was disappointingly low. We were also disappointed that the company has downgraded the current engineering work at Copperstone from a "Pre-Feasibility study" to a "Preliminary Assessment".

As a result of the slower-than-expected progress at BZA's most interesting project we've decided to exit the stock. The profit on the trade was 45% based on our August-2005 entry at C$0.44 and Friday's closing price of C$0.64.

BZA still has the potential to move up to around C$1.00 over the next two months IF the overall positive trend in the gold sector remains intact, but there's a limit to how many stocks we can follow and there are a few junior gold stocks that currently aren't in the TSI Stocks List that we think have better intermediate-term risk/reward ratios than BZA. These other stocks will be introduced if/when their prices drop to suitable levels for new buying.

    We were stopped out of our short-term trade in Chesapeake Energy (NYSE: CHK) on Friday for a loss of 9%.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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