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   -- Weekly Market Update for the Week Commencing 15th August 2005

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. Bond prices will move considerably lower (long-term interest rates will move considerably higher) during 2005. (Last update: 29 November 2004)

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 ended in March of 2005 and the October-2002 bottom (775 for the S&P500) will be tested during 2006. (Last update: 25 April 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 during 1999-2001. The first major upward leg in this bull market ended in December of 2004, but a long-term peak won't occur until 2008-2010. (Last update: 28 March 2005)

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 first quarter of 2005, but a long-term peak won't occur until 2008-2010. (Last update: 28 March 2005)

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Outlook Summary

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Neutral
(30-May-05)
Neutral
(6-Dec-04)
Bullish

US$ (Dollar Index)
Bullish
(20-Dec-04)

Bullish
(31-May-04)
Bearish

Bonds (US T-Bond)
Bullish
(15-Aug-05)
Neutral
(20-Jul-05)
Bearish

Stock Market (S&P500)
Bearish
(08-Aug-05)
Bearish
(05-Jan-05)
Bearish

Gold Stocks (HUI)
Bullish
(03-Aug-05)
Bearish
(01-Dec-04)
Bullish

General Commodities (CRB)
Bearish
(23-Mar-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.

Bonds

With an upward reversal having just occurred in the bond market at the approximate time when the bond-oil relationship was projecting an upward reversal, we have changed our short-term view on bonds from "bearish" to "bullish" in anticipation of a rally lasting at least 3 months.

For some reason turning points in the oil market have consistently led turning points in the US bond market over the past four years by 3-4 months. Furthermore and as illustrated on the below chart, this relationship has been particularly tight over the past year.

The chart suggests that an upward reversal in the bond market will occur at the end of this month, so if we were to take the chart literally we would assume that last week's low in the T-Bond price was going to be tested or exceeded at some point over the coming fortnight. That may well turn out to be the case, but it's not reasonable to expect that a chart such as this will be able to predict a turning point with such accuracy. Instead, a reasonable interpretation is that we are into a time window when a short-term trend change in the bond market (from down to up) is likely to occur.


Below is a chart of September T-Note futures. A daily close above resistance at 112 is needed to confirm a trend change, but last week's upward reversal looks significant. Unfortunately, from a risk management perspective, support lies a considerable distance below the current price (T-Note futures would need to breach the March low at around 108 in order to negate the potential for a rally to a new high for the year).


With an upward reversal having just occurred in the bond market at the approximate time when the bond-oil relationship was projecting an upward reversal, we have changed our short-term view on bonds from "bearish" to "bullish" in anticipation of a rally lasting at least 3 months.

Interestingly, at the same time as the short-term outlook for bonds appears to be improving the long-term outlook has become more bearish as a result of last week's upside breakout by Japan's Nikkei225 Index. We think the Nikkei will move much higher over the next few years, a view that is consistent with our long-term bearish outlook on bonds due to the inverse correlation between bonds and the Japanese stock market. However, the Nikkei looks very extended on a short-term basis so it will probably soon begin to consolidate its recent gains.

The Stock Market

The Fed and the Markets
 
Despite the 10 official rate hikes that have already occurred the Fed still characterises its monetary stance as "accommodative", which it undoubtedly is. However, will it remain accommodative?

Stock market bulls are betting that it will, as are gold bulls, commodity bulls and real estate bulls. Either all of these 'bulls' are going to be right about Fed policy or they are all going to be wrong. We think they will be wrong because the Fed will continue to 'push' until its monetary tightening is clearly taking a toll on the financial markets.

Current Market Situation

...some additional downside is likely, so we'll remain short-term bearish for now.

Our intermediate-term outlook for the US stock market is becoming increasingly bearish, but right now there are just too many divergent signals for us to be able to hold any short-term view with confidence. For example, the relentless rise in the oil price is a major negative, but at the same time the stock market's ability to shrug-off each successive new high in the oil price demonstrates remarkable resilience. Also, while the recent price action in the US stock market tips the scales in favour of additional downside over the next 1-2 weeks, the general strength stock markets around the world suggests that the US market is simply consolidating in preparation for another advance.

An index that has led the US market to both the downside and the upside over the past two years is the Semiconductor Index (SOX). The below chart shows that the SOX has pulled back since the beginning of this month and is approaching support at 440-450. A daily close below 440 would indicate that an important peak was in place for the SOX and would be a bearish omen for the overall market. By the same token, until the SOX is able to close below 440 it will be reasonable to assume that the current pullback in the market will be followed by a rally to a new high for the year.


In addition to monitoring the SOX's performance in absolute terms we will also pay close attention to how it performs relative to the NASDAQ100 Index (NDX) over the coming weeks. The reason is that SOX/NDX generally trends in the same direction as the overall market and leads the market at important turning points.

The below chart shows a modest downturn in SOX/NDX over the past fortnight, which is not significant yet but could develop into something significant.


Over the next two weeks the market is likely to either extend its decline to the point where important support levels give way, thus indicating that this year's peak is in place, or reverse higher without first breaching any important support levels. In each case some additional downside is likely, so we'll remain short-term bearish for now.

This week's important US economic events

Date Description
Monday Aug 15
No Significant Events
Tuesday Aug 16 CPI
Housing Starts
Industrial Production
Capacity Utilisation
Wednesday Aug 17 PPI
Thursday Aug 18 Leading Economic Indicators
Friday Aug 19 No Significant Events

Gold and the Dollar

Gold Overview

...Genuine gold bull markets are all about increasing risk aversion and declining confidence in central banks, but the recent run-up in the gold price has occurred in an environment where investors, as a group, have exhibited minimal risk aversion... ...although gold and gold stocks should be eventual standout beneficiaries of downturns in pro-growth investments, they are likely to be initial casualties.

There are very few objective observers of the financial scene who are as bullish on gold, as far as the coming 2-4 years are concerned, as we are. We not only expect that gold will trade at a multiple of its current level in US$ terms before the end of this decade, we expect that it will trade at a multiple of its current level relative to oil, copper, most other commodities, the S&P500 Index, and the average home. However, we don't expect great things from gold over the next 3-6 months, especially in US$ terms. This is partly because we think the US$ rally that began in January is not yet even halfway complete in terms of either time or price, but there's a lot more to it than that.

The main reason we don't think gold's recent advance is the start of the next major upward leg in its long-term bull market is that gold-related investments are rising in price alongside rises in the prices of almost all other assets. Genuine gold bull markets are all about increasing risk aversion and declining confidence in central banks, but the recent run-up in the gold price has occurred in an environment where investors, as a group, have exhibited minimal risk aversion and supreme confidence that the Fed will neither overshoot nor undershoot in its rate-hiking campaign. In particular, inflation expectations have remained low enough to give bond investors that 'warm and fuzzy feeling' at the same time as those playing the "inflation trade" have been having a great time.

Gold trades like money and tends to out-perform other investments when confidence in the official forms of money is falling, but as a result of the current widespread perception of a 'goldilocks' economic environment gold is not receiving any monetary premium. The below chart of the gold/GYX ratio (the gold price divided by the Industrial Metals Index) is evidence of this lack of monetary premium in the current gold price and the generally low level of risk aversion prevailing today in the financial markets. Putting it another way, the low price of counter-cyclical gold relative to the average price of cyclical metals such as copper, nickel and zinc, tells us that most investors believe the economic growth to be real (not inflation-induced)*.


That gold is not receiving a monetary premium does not mean that we shouldn't attempt to benefit from the current up-swing in the gold price. In fact, anyone positioned roughly in accordance with the suggestions made at TSI will have a larger-than-normal cash position and perhaps a small put-option position, but will also have a sizeable net-long position in gold stocks and will therefore be benefiting from the current rally. They won't be benefiting as much as the 'permabulls' who perpetually maintain a maximum long position in gold, but they also wouldn't have experienced the large draw-downs suffered earlier this year by the more rabid of the gold bulls.

The lack of a monetary premium means that the financial markets are presently not differentiating between gold and other metals (speculators are jumping into gold as part of a general commodity play). This, in turn, indicates that regardless of how high prices go in the short-term the gains will most likely prove to be unsustainable because something that rallies hard along with everything else will probably fall hard along with everything else. Therefore, we don't consider this to be a great time to be INCREASING our overall exposure to gold stocks. Actually, in order to avoid significantly increasing our exposure to the gold sector we will have to do some selling if the rally continues (the recent gains in stock prices have taken the cash percentage in our own account down to about 40% and in the current environment we wouldn't want it to get any lower than that).

Gold, in our opinion, will eventually benefit greatly from downturns in the stock and commodity markets because these downturns will pave the way for the next inflation cycle. Also, the fact that gold is not receiving a significant monetary premium and is, therefore, incredibly cheap right now compared to almost everything else greatly enhances its longer-term upside potential. However, one of the INITIAL effects of a sharp downturn in the stock market and/or the commodity market will most likely be a further decline in inflation expectations and a consequential rise in REAL interest rates, a negative development for gold. As a result, although gold and gold stocks should be eventual standout beneficiaries of downturns in pro-growth investments, they are likely to be initial casualties.

To summarise the above in one sentence: What we are probably seeing in the financial markets right now is the end of something (blow-off moves in the investments that performed well over the past few years), not the start of something.

    *One of the main reasons cyclical commodities have been able to rally as much as they have without generating inflation fears is the 'China story'. Specifically, the link between a currency problem and rising commodity prices has not been made in the minds of most investors because they believe that the higher commodity prices can be put down to rapid REAL growth in China (as opposed to a fall in the relative value of fiat currencies). However, China's rapid growth has been fueled by a massive expansion of credit and is no less inflation-induced (no more sustainable) than the growth achieved by the US economy over recent years.

Current Market Situation

The downside target we've previously mentioned for the current correction in the Dollar Index is 86.5, which is slightly below Friday's low. Major support lies a point lower at 85.5 (refer to the below chart for details). With the US$ now as 'oversold' as it was at the March low (based on momentum indicators such as the RSI) we expect it to reverse higher from near its current level or, at worst, to reverse higher following a drop to test the aforementioned support.

As far as the next few months are concerned we think the Dollar Index has 1-2 points of downside risk versus 5-8 points of upside potential.


Below are daily charts of December gold futures and December silver futures.

Silver's under-performance relative to gold over the past month has been quite dramatic, and given that silver has tended to lead gold at turning points since the beginning of this year the current divergence between the two metals is bearish. However, despite this bearish divergence the weight of evidence suggests that the current rally in the gold price has not yet peaked. In particular, Friday's new recovery high in the HUI/gold ratio indicates that both the gold price and the HUI will probably move higher before their respective rallies come to an end.

We consider the current situation in the gold market to be very risky. For one thing, gold spiked well above resistance at $451 -- a level that we did not think would be exceeded in the short-term -- last Friday before giving up most of its gains and ending the day right at this resistance. Therefore, the possibility of a failure at $451 still exists even though the performance of the HUI/gold ratio suggests that we haven't yet seen the ultimate rebound peak. For another thing, the gold market is clearly extended on a short-term basis. Lastly, we won't know for sure until the Commitments of Traders data are reported at the end of this week but it's likely that commercial traders now have a larger net-short position (speculators have a larger net-long position) in COMEX gold futures than they had at the March, April or June peaks in the gold price. An uncommonly large speculative net-long position in gold futures will never cause a gold rally to end, but when such a situation arises it indicates that the downturn following the rally will probably be steep.

As a result of it having been such as laggard over the past few weeks silver appears to offer the best risk/reward right now for anyone wanting to trade the precious metals from the 'long' side. Unlike gold, silver is presently in the lower half of its trading range and well below important resistance (important resistance for December silver lies at $7.60-$7.80). Also, there is good support (at $6.90-$7.00) not far below Friday's closing price.


Gold Stocks

Price action in the gold sector remains bullish, so although we are skeptical with regard to the sustainability of recent gains we will remain short-term bullish.

From a technical perspective Newmont Mining (NEM) is of more interest to us right now than either the HUI or the XAU because it is closer to an important support level. NEM has well-defined support at $40 and should hold above this level during any near-term pullbacks as long as the up-trend remains intact. In other words, a close below $40 would be a clear warning that a trend reversal had happened.


Update on Stock Selections

American Bonanza (TSX: BZA), a small exploration-stage gold company, was a member of the TSI Stocks List during 2002 and 2003. We exited the stock at a split-adjusted price of C$1.82 in November of 2003 because we thought it had become relatively expensive.

We are now going to return BZA to the TSI Stocks List at Friday's closing price of C$0.435 because a) it has fallen to a level where it offers very good value in both relative and absolute terms, and b) we like the chart.

The company owns 3M ounces of gold resources, meaning that with 90M shares outstanding and at C$0.435 per share this in-ground gold is being valued by the stock market at only US$11/ounce. What makes the valuation particularly attractive, though, is that the gold resources are high-grade and located in parts of the world where the political risk is low.

The company's main assets are the Copperstone project in Arizona, which is currently in the feasibility stage and is expected to be producing gold at the rate of 80K oz/yr by 2007, and the Fenelon project in Quebec. BZA plans to bring its total annual gold production up to 150K oz/yr by putting Fenelon into production in 2008.

Given the quality of BZA's gold resources, and in particular the high probability that the above-mentioned projects will be developed into profitable mining operations over the next three years, we think US$25-$35 per ounce-in-the-ground would be a reasonable market valuation for BZA at this stage of its life. Therefore, the stock appears to have considerable upside potential.

Now, there are always reasons why an under-valued stock is under-valued, and in BZA's case we think the main reasons are the general lack of interest in exploration-stage mining companies (many stocks in this sector of the market are very under-valued right now) and the fact that BZA's senior managers are 'serial dilutors' (they have, in the past, issued a lot of new shares at inopportune times and at large discounts to current market prices, thus severely diluting the interests of long-term shareholders). Management's poor record in the area of stock dilution is a longer-term risk, but since the company is presently cashed-up thanks to a recent equity financing it hopefully won't be an issue over the next 12 months.

As mentioned above, we also like BZA's chart. Specifically, there are signs that the stock has 'bottomed out' (the stock bottomed in May and looks to have successfully tested the May low in July) and it wouldn't take much to break it out of the downward-sloping channel in which it has been mired since last October.


First Majestic Resource (TSXV: FR) remains our favourite silver stock. Management's goal is to develop the company into a 10M oz/yr silver producer by 2007. Importantly, this goal looks realistic taking into account the company's current asset base (FR owns several advanced-stage silver projects in Mexico) and management's track record.

At current metal prices a company with 10M ounces of low-cost annual silver production (FR's production cost per ounce is expected to be around US$3.00) would be worth at least US$320M, or about C$11/share based on FR's current fully-diluted share count of 34M. In order to finance the development of its various projects the company will have to issue a lot more shares, but we expect that the positive impact of gains in the silver price over the next two years will offset the negative impact of a higher share count.

FR is not the sort of stock that should be bought by a trader looking to play a short-term rally in the silver price. We think it does, however, deserve a place in the portfolio of someone who believes that silver is in a long-term bull market and who can tolerate the volatility inherent in small-cap mining stocks.

As far as a reasonable entry price for this stock is concerned, over the past several months we've identified C$1.50-C$2.00 as the range in which new buying would be appropriate. It's spent much of the past 3 months within this range and actually spiked as low as C$1.65 at the end of June, so there have been plenty of opportunities to purchase the stock at attractive levels. We continue to think that the aforementioned range is a good place to be accumulating this stock (FR closed at C$1.97 on Friday). Remember, the idea is to scale into positions over time during periods of weakness.

BTW, Endeavour Silver (TSXV: EDR) appears to be a similar company to FR in terms of size, assets and strategy, but we know a lot more about FR and are therefore more comfortable with it.

    De Grey Mining is a small exploration-stage mining company (mostly gold, but also other metals) that trades in Australia under the symbol DEG. It's too 'early-stage' to be part of the TSI Stocks List -- we've made a couple of exceptions in the past, but we usually won't add an exploration-stage company to the List unless it has already defined a resource of at least 1M ounces of gold -- but is one that our Australian-based readers might want to look into.

With reference to the below chart, DEG rocketed higher in late-2003 on the back of a new gold discovery and has spent much of the past 18 months retracing that move despite the fact that more good drilling results have been announced in the mean time. The main difference between DEG at 70c in early 2004 and DEG at 24c today is the attitude of investors towards exploration-stage gold mining companies (they were ebullient during the first quarter of 2004 and are disinterested today).

With about A$9M of cash in the bank and a good exploration team, DEG looks like a reasonable speculation near its current depressed level.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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