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   -- Weekly Market Update for the Week Commencing 14th October 2013

Big Picture View

Here is a summary of our big picture view of the markets. Note that our short-term views may differ from our big picture view.

In nominal dollar terms, the BULL market in US Treasury Bonds that began in the early 1980s will end by 2013. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 23 January 2012)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000, where "secular bear market" is defined as a long-term downward trend in valuations (P/E ratios, etc.) and gold-denominated prices. This secular trend will bottom sometime between 2014 and 2020. (Last update: 22 October 2007)

A secular BEAR market in the Dollar began during the final quarter of 2000 and ended in July of 2008. This secular bear market will be followed by a multi-year period of range trading. (Last update: 09 February 2009)

Gold commenced a secular bull market relative to all fiat currencies, the CRB Index, bonds and most stock market indices during 1999-2001. This secular trend will peak sometime between 2014 and 2020. (Last update: 22 October 2007)

Commodities, as represented by the Continuous Commodity Index (CCI), commenced a secular BULL market in 2001 in nominal dollar terms. The first major upward leg in this bull market ended during the first half of 2008, but a long-term peak won't occur until 2014-2020. In real (gold) terms, commodities commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 09 February 2009)

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Outlook Summary

Market
Short-Term
(1-3 month)
Intermediate-Term
(6-12 month)
Long-Term
(2-5 Year)
Gold Neutral
(10-Sep-13)
Bullish
(26-Mar-12)
Bullish

US$ (Dollar Index) Neutral
(24-Dec-12)
Neutral
(18-Sep-13)
 
Neutral
(19-Sep-07)

Bonds (US T-Bond) Bullish
(24-Jun-13)
Neutral
(18-Jan-12)
Bearish
Stock Market (DJW) Neutral
(18-Sep-13)
Bearish
(28-Nov-11)
Bearish

Gold Stocks (HUI) Neutral
(10-Sep-13)
Bullish
(23-Jun-10)
Bullish

Oil Neutral
(30-Jul-12)
Neutral
(31-Jan-11)
Bullish

Industrial Metals (GYX) Neutral
(30-Jul-12)
Neutral
(29-Aug-11)
Neutral
(11-Jan-10)


Notes:

1. In those cases where we have been able to identify the commentary in which the most recent outlook change occurred we've put the date of the commentary below the current outlook.


2. "Neutral", in the above table, means that we either don't have a firm opinion or that we think risk and reward are roughly in balance with respect to the timeframe in question.

3. Long-term views are determined almost completely by fundamentals, intermediate-term views by fundamentals, sentiment and technicals, and short-term views by sentiment and technicals.

Future "inflation" and monetary madness

The Fed's mode of operation has drastically changed over the past 12 years. Prior to 2002 the Fed would tighten monetary policy in reaction to outward signs of rising "price inflation" and loosen monetary policy in reaction to outward signs of falling "price inflation", but beginning in 2002 the Fed became far more biased towards loose monetary policy. This bias is now so great that we are starting to wonder whether the Fed has become permanently loose.

The following chart comparing the Fed Funds Rate (FFR) target set by the Fed with the Future Inflation Gauge (FIG) clearly illustrates how the Fed has changed over the past two decades. Note that the Future Inflation Gauge is calculated monthly by the Economic Cycle Research Institute (ECRI) and should really be called the Future CPI Gauge, because it is designed to lead the CPI by about 11 months.



The chart shows that prior to 2002 the FFR tended to follow the FIG. After the FIG warned of rising "price pressures" the Fed would start hiking the FFR, and after the FIG started signaling reduced upward pressure on the CPI the Fed would start cutting the FFR. During 2002-2004, however, the Fed not only didn't hike its targeted interest rate in response to a sharp increase in the FIG, it continued to cut the FFR.

The Fed's decision to maintain an ultra-loose stance during 2002-2004 was the fuel for the real estate investment bubble and set the stage for the collapse of 2007-2009.

There was a lesson to be learned from what happened during 2002-2007, but the Fed apparently learned the wrong lesson. The lesson that should have been learned was: Don't provide monetary fuel for bubble activities, because the eventual economic fallout will be devastating. Unfortunately, the lesson that was actually learned by the Fed was: An economic bust can be avoided forever by keeping monetary policy loose forever. The result is that the divergence between the FFR and the FIG that arose during the first half of the last decade is nothing compared to the divergence that is now in progress. Moreover, the near-zero FFR doesn't do justice to the 'looseness' of the Fed's current stance, in that 4+ years after the end of the last official recession the Fed is still pumping money as if the US were in the midst of a financial crisis.

By the way, this year's small decline in the FIG suggests that there is not going to be a significant change in the CPI's growth rate over the next 6-12 months. If so, policy-makers at the Fed will probably conclude that they have plenty of leeway to maintain an ultra-loose monetary stance.

By ignoring investment bubbles and erring far more in favour of "inflation" than it has ever done in the past, the Fed is currently setting the stage for the mother-of-all economic busts. We don't have an opinion on when the bust will happen and how it will unfold, other than we do not expect it to happen within the next six months and we do expect that it will be very different to the bust of 2007-2009. 

Gold and Bonds

Gold and Treasury Bonds have moved in the same direction during some periods and in opposite directions during other periods. As illustrated by the following chart, the past three years has been one of those periods when they've tended to move in the same direction.



When US$ inflation expectations are high or rising sharply, gold is usually the safe haven of choice. When US$ inflation expectations are falling sharply, T-Bonds are usually the safe haven of choice. But when US$ inflation expectations are stable at a relatively low level, it will be normal for both gold and T-bonds to be popular refuges during periods when financial-system risk is perceived to be high. That, in essence, is why gold and T-bonds have trended together over the past three years. Over the past three years they have both been popular refuges in times of trouble, which resulted in them rallying sharply together during the first 9 months of 2011 in response to rising fears of euro-zone financial collapse, leveling off between September of 2011 and early 2013, and then plunging in response to this year's 'risk-on' surge.

At this stage we think it's likely that gold and T-bonds will maintain a generally positive correlation over the coming 12 months, with both rallying when economic confidence declines or systemic threats emerge and both falling when economic confidence rises or systemic threats dissipate. If we are wrong it will probably be due to a sudden increase in US$ inflation fear that causes a sharp move to the upside in gold in parallel with a sharp move to the downside in T-Bonds. In our opinion, the most unlikely 12-month outcome would entail a large gain for T-bonds in parallel with a large loss for gold.

The Stock Market

The US

The Banks

The Bank Index (BKX) broke out to the downside during the first half of last week but negated the breakout during the final two days of the week. The chart pattern is currently neutral, needing a break above the September rebound high to signal a resumption of the longer-term upward trend or a sustained break below $62 to confirm that an intermediate-term decline is in progress.



The following price chart of JP Morgan (JPM), the bank that many 'goldbugs' love to hate, looks more precarious than the BKX price chart displayed above. JPM hasn't yet broken below support at $50, but it appears to be rolling over to the downside.

Last Friday JPM reported a loss for the third quarter of this year. The loss was obviously anticipated because the stock price initially rose in reaction to the news, but the gains were quickly given back despite strength in the broad stock market. Friday's price action therefore maintained the bearish look of JPM's price chart.



The Overall Market

The number of individual stocks making new 52-week highs, an important indicator of market breadth, has been deteriorating for months. Specifically, the number of individual NYSE stocks making new highs has been in a downward trend since May and the number of individual NASDAQ stocks making new highs has been in a downward trend since July, despite the NYSE and NASDAQ composite indices having remained in upward trends. This divergence shows that progressively fewer stocks have been driving the indices upward. It is a bearish divergence, but one that could continue for longer before it matters.

In last week's Interim Update, we wrote:

"Here's a scenario that appeals to us: A stock market rally soon commences on the back of political deals that ensure full government funding for at least a few more months. This rally takes some stock indices to new highs for the year, but the Dow doesn't come close to its September high before running out of steam. Some indices, including the Dow, then fall to new multi-month lows, leading to general fear that the future might not be as bullish as previously envisaged."

The following daily charts show that the Dow has since retraced about half of its preceding decline and remains well below its September high, while the NASDAQ100 Index (NDX) has moved back to near its high for the year. This paves the way for the NDX to soon make a new high for the year while the Dow makes a lower high. As long as the Dow fails to confirm the NDX's new high, the ensuing declines in both indices should be significant.

The World

The Dow Jones World Index (DJW) completed a normal pullback to support at 290. It is set to soon make a new high for the year, but the remaining short-term upside potential looks small relative to the downside risk.

Our short-term stock market outlook will shift to "bearish" if the DJW closes below 290 or moves up to 310 within the next three weeks.

This week's important US economic events

Date Description
Monday Oct 14 No important events scheduled
Tuesday Oct 15 Empire State Mfg Survey
Wednesday Oct 16 CPI
TIC Report
Housing Market Index
Fed's Beige Book
Thursday Oct 17

Housing Starts
Industrial Production
Philadelphia Fed Survey

Friday Oct 18 Leading Economic Indicators

Gold and the Dollar

Gold and Silver

Gold continues to work its way down to an October-November (probably October) low. On Friday it traded about 1% below its August low and ended the week roughly level with its August low. It also ended the week just above the bottom edge of a declining 'wedge' pattern. This could prompt a bounce as some short-term traders buy in anticipation of support holding.

A daily close above the September intra-day high of $1376 is needed to prove, beyond reasonable doubt, that a new upward trend has begun. However, a daily close above last week's intra-day high of $1331 would now be an early warning of a short-term trend reversal.

An important price bottom could be put in place at any time, but there is still downside risk to the vicinity of the late-June low ($1150-$1200).



The following weekly chart of the silver price shows the moving-average envelope that limits silver's short- and intermediate-term price trends in all but the most extreme situations. The bottom of the MA envelope is presently just above $19.00. This suggests that silver has short-term downside potential to around $19.

Our plan is to buy some physical silver if we get the chance to do so in the $19-$20 range within the next three weeks.



It is currently possible to purchase exposure to gold and silver bullion at significant discounts to spot prices. This can be done by purchasing units of Central Gold Trust (GTU) for exposure to gold bullion and Central Fund of Canada (CEF) for exposure to gold and silver bullion. The reason is that these closed-end bullion funds are trading at unusually large discounts to their net asset values.

As illustrated by the following chart, GTU began trading at a discount to its NAV in April and the discount has since expanded. The discount to NAV was 6.6% at the end of last week, which means that buying GTU units near the close of trading last Friday was equivalent to buying gold bullion at $1188/oz.



CEF ended last week at a 7.1% discount to its NAV. This means that buying CEF units near the close of trading last Friday was equivalent to buying gold bullion at $1182/oz and silver bullion at $19.80/oz.

The above-mentioned discounts to NAV reflect the depressed sentiment in the gold and silver markets. Within the next two years both GTU and CEF are likely to trade at sizable premiums to NAV.

Gold Stocks

The historical tendency of a market to make an intermediate-term extreme within a certain time window provides useful clues about the future on those occasions when the market in question trends strongly into the turning-point window and then reverses direction. Such reversals are usually followed by trends lasting at least 6-12 months in the opposite direction.

The gold sector is clearly in a downward trend and is within its traditional October-November turning-point window. This means that an upward reversal within the next few weeks would very likely lead to a rally lasting at least 6-12 months. Our opinion is that it would lead to a multi-year cyclical bull market, but there is no need to look that far ahead. First, we need to get the upward reversal.

At the end of last week the HUI was 'oversold' and marginally above its late-June low. This means that a test of the late-June low is now happening.



An upward reversal that marks an important turning point could take a number of different forms. For example, it could involve a sharp decline during the early part of the trading day followed by a complete recovery to end the day with a gain. Like pornography, we'll know it when we see it.

GDXJ, an ETF proxy for the junior end of the gold sector, has dropped back to intermediate-term support defined by its June-August lows. It would be reasonable for long-term speculators to average into GDXJ over the next few weeks, beginning immediately, but short-term traders should wait for evidence that the price trend has reversed.



Currency Market Update

Since breaking below support at 80.5-81.0 in September, the Dollar Index has twice rebounded to this former support (now resistance). Consecutive daily closes above 81 would indicate that a short-term bottom is in place, but until/unless that happens it will make sense to anticipate a test of intermediate-term support at 79.

We expect that support at 79 will hold if tested over the next two months, but it could be breached next year. Breaching intermediate-term support at 79 would project a test of long-term support at around 73.

Update on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Company news/developments for the week ended Friday 11th October 2013:

[Note: FS = Feasibility Study, IRR = Internal Rate of Return, MD&A = Management Discussion and Analysis, M&I = Measured and Indicated, NAV = Net Asset Value, NPV(X%) = Net Present Value using a discount rate of X%, P&P = Proven and Probable, PEA = Preliminary Economic Assessment, PFS = Pre-Feasibility Study]

  *Carpathian Gold (CPN.TO): During a week when the TSI Stocks List copped more than its fair share of company-specific bad news, the worst news came from CPN. Due to its weak balance sheet and gold hedge book we've been cool on CPN for more than 12 months and suggested scaling out of the stock in August after it rose to the low-C$0.20s, so the CPN news probably didn't cause as much financial pain as the PVG news. However, whereas the PVG news will most likely turn out to be a 'bump in the road', the CPN news points to there being little hope of recovery. Whereas PVG has its hands on one of the world's most valuable undeveloped gold deposits and should eventually generate good returns for shareholders, CPN has run out of money and is unlikely to survive in its current form.

Due to commissioning delays at its RDM gold project in Brazil, lack of money and the difficulty of raising additional money in today's market, CPN's management has decided to pursue "strategic alternatives". According to last week's press release: "The various alternatives being considered include, but are not limited to, a business combination with another company, a recapitalization, a sale of the corporation or its assets, a strategic investment in the corporation or its subsidiaries by a third party or any combination thereof."

We see two possible outcomes. One is that the company will be able to do a deal that results in its stock price recovering from the current C$0.08 to C$0.15-$0.20. The other is that CPN shareholders end up with nothing. At this stage it's a coin toss.

To make room for a stock with brighter long-term prospects (we have a few candidates in mind, but probably won't make a decision until we see evidence that the gold sector has bottomed), we have removed CPN from the TSI Stocks List and recorded a large loss on the position.

  *Dragon Mining (DRA.AX) announced that it has a maximum potential liability of 800,000 Swedish Krona (about US$125,000) stemming from a charge -- that the company denies -- of non-permitted environmental activities. This is not financially significant.

  *Pretium Resources (PVG): No more light was shed on the Strathcona resignation over the final two days of last week. As far as we can tell, neither of PVG's independent consultants has a problem with how the material for the 10,000-tonne bulk sample was selected. The disagreement between Snowden and Strathcona concerns the best way to reconcile the excavated material with the resource model. Strathcona wanted to rely on representative samples taken on site using a sample tower. Snowden wants to rely on the total amount of gold produced from milling the entire 10,000 tonnes of excavated material.

Note that in the above paragraph we said "reconcile the excavated material with the resource model", not "reconcile the excavated material with the resource estimate". There's a significant difference that we suspect gets to the root of the disagreement between Strathcona and Snowden. It's not only important that the total amount of gold in the actual deposit matches the resource estimate, but also that the gold is where the resource model predicts it to be.

Snowden will now be doing the final auditing and reporting on the Bulk Sample Program (BSP), but the results of the tower samples that would have been used by Strathcona to validate the resource model will still be reported. Therefore, analysts and investors who believe that Strathcona's approach would yield the more reliable conclusions regarding the validity of the resource model will still have access to the relevant data.

From an investor's perspective the problem now is that even if the results of the BSP turn out to be as good as PVG's senior management expects, Strathcona's resignation will ensure the persistence of skepticism. Consequently, PVG probably won't return to the $10+ levels over the next few months even if the BSP results are positive. That being said, due to the extent that the stock sold off last week it should rebound strongly after the dust settles and the overall sector reverses upward.

We neither bought nor sold PVG shares in the aftermath of last week's news-related price plunge. We might add to our PVG stake following evidence of a sector-wide bottom, but we also might wait for the BSP results before doing anything. We haven't yet decided.

One of the most sensible and objective responses to the recent PVG news can be read at http://www.metalaugmentor.com/reviews/bulk-sample-update/.

  *Ramelius Resources (RMS.AX) is scheduled to close its 1-for-4 rights issue within the next two weeks. Given that the stock is trading at A$0.13 and the rights are exercisable at A$0.18, it obviously doesn't make sense to exercise the rights. If you want to increase your exposure to this stock you should buy shares on the market at A$0.13 or less. The stock is a good speculation at A$0.13 and would be an excellent speculation near its low for the year (A$0.10-A$0.11).

  *Rio Alto Mining (RIO.TO, RIOM) announced record quarterly production of 59K ounces for the September quarter. The record isn't going to stand for long, though, because the December quarter's production is expected to be at least 10% higher. Production for this year should end up being near the top of the company's 190K-210K guidance range.

It's a tough market when a company with an under-valued and very 'oversold' stock can report good results and a bullish forecast, and yet its stock price continues to languish near a multi-year low. RIO actually made a marginal new low for the year on Friday 11th October.

We can easily justify a valuation of $3.50/share for RIO based on this year's likely production performance. That's why $3.50 remains our price target. However, due to the weak overall market for gold stocks it is going to take longer than originally expected to reach this target.

Sabina Gold and Silver (TSX: SBB). Shares: 194M issued, 209M fully diluted. Recent price: C$0.84

SBB has recently been quiet on the news front (prior to last week there had been no news since a drilling update on 22nd August) as the company focused on completing the PFS for its Back River gold project in Nunavut (northern Canada). The results of the PFS were issued last week.

The PFS results were disappointing. The economics indicated by the PFS are less robust than we were expecting and nowhere near as good as the economics indicated by the PEA completed in May of last year. Of particular note, the May-2012 PEA showed an IRR of 25% and an NPV(5%) of $650M at a gold price of $1250, whereas at the same gold price the PFS shows an IRR and NPV(5%) of only 12% and $179M, respectively.

The salient details and calculations for the PEA and the PFS are included in the following table. Note that the PFS economics shown in this table assume a gold price of $1350/oz, which is the long-term price assumption that we are comfortable with at this time.

  Sabina Gold & Silver (SBB.TO) Sabina Gold & Silver (SBB.TO)
Project Name Back River Back River
Location Nunavut, Canada Nunavut, Canada
Engineering Study / Date PEA / May-2012 PFS / Oct-2013
Planned Mine Type Open Pit + Underground Open Pit + Underground
M&I Resource (oz) 4.2M 4.6M
Avg Resource Grade 5.56 g/t 6 g/t
P&P Reserve (oz) 0 2.7M
Metallurgical Recovery About 90% 88%
Strip Ratio 7.7:1 10:1
Avg Annual Production (oz) 300K 287K
Cash Cost (per oz) $542 $685
All-In Cost (per oz) Not reported Not reported
Mine Life 12.3 years 8.4 years
Initial Capital Cost ($M) 450 605
Assumed Gold Price (US$) 1250 1350
NPV ($M) 650 290
IRR 25.0% 16.5%
Capital Payback Period   3.3 years
Project Ownership Percent 100% 100%
NPV of Company Stake ($M) 650 290
Current Stock Price (US$) 0.84 0.84
Share Count (M) 194 194
Current Market Cap ($M) 163 163
Net Cash ($M) 60 60
Current Enterprise Value ($M) 103 103
EV/NPV 16% 36%
Current Discount to NPV 84% 64%
EV + Capital Cost (EVCC) 553 708
EVCC/NPV 0.85 2.44

There are two main reasons for the large deterioration in project economics from the PEA to the PFS. The first reason is the increase in initial capex from $450M to $605M. There probably isn't much that can be done about this. The second reason is the decline in life-of-mine production from 3.6M ounces to 2.4M ounces. It should be possible to do something about this and greatly improve the economics shown in the next study (the FS due in H2-2014).

The total Back River resource is around 6.4M ounces, 4.5M of which are in the M&I category and the remainder of which are in the Inferred category. However, the PFS did not consider any of the Inferred ounces and only considered 2.7M of the M&I ounces. In other words, almost 60% of the project's total resource was excluded from the PFS. The result was slightly lower average annual production and a much shorter mine life than determined in the PEA.

It could be viewed as a plus that even though it used only 40% of the project resource, the PFS still showed a double-digit IRR at a gold price of only $1250/oz. This suggests that SBB's Back River project is more viable than most other exploration-stage gold projects. In any case, the economics will look a lot better if, by using more of the overall resource, the average annual production can be bumped up from 287K ounces to 300K ounces and the mine life can be expanded to 12-13 years.

We continue to like SBB as a long-term speculation. In addition to the Back River gold project the company has more than $60M of cash and a potentially valuable silver royalty on Glencore's Hackett River project.

The stock has intermediate-term support near its current price and intermediate-term resistance at C$1.40-$1.50.

Candidates for new buying

From within the ranks of TSI stock selections, below is a list of the best candidates for new buying at this time. Note that for this list of 'best buys' to be useful we must limit it to 5 stocks (it could contain less than 5, but not more than 5). At times like the present, when almost all of our stock selections are trading at ultra-depressed levels, that involves not mentioning stocks that offer excellent value and are good -- but not among the best 5 -- candidates for new buying. Note as well that the stocks included in this list of 'best buys' do not necessarily offer the best value. In the current market environment we are placing more emphasis than usual on risk, meaning that we could view a more expensive stock as a better candidate for new buying due to its lower risk. That's why we have removed PVG from the list of 'best buys'. PVG clearly offers better value now than it did a week ago, but last week's news has led to greater uncertainty and could keep a lid on the stock price until after all sampling results become available.

1) EDV.TO/EVR.AX (last Friday's closing price: C$0.54)

2) EVN.AX (last Friday's closing price: A$0.76)

3) PG.TO (last Friday's closing price: C$1.98)

4) PLG.TO (last Friday's closing price: C$0.81)

5) RIO.TO/RIOM (last Friday's closing price: C$1.72/US$1.75)

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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