<% 'pass = Request.Form("pass") IF ((Request.Form("pass") = 1) OR (Session("pass") = "pass")) THEN %> Speculative-Investor.com
   -- Weekly Market Update for the Week Commencing 17th January 2011

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 mid-2010. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 09 February 2009)

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)

Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

Outlook Summary

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Bullish
(27-Oct-10)
Bullish
(12-May-08)
Bullish

US$ (Dollar Index)
Neutral
(01-Sep-10)
Bullish
(03-Jan-11)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(20-Sep-10)
Neutral
(03-Jan-11)
Bearish
Stock Market (S&P500)
Bearish
(22-Dec-10)
Bearish
(11-Oct-10)
Bearish

Gold Stocks (HUI)
Bullish
(01-Sep-10)
Bullish
(23-Jun-10)
Bullish

OilBearish
(03-Jan-11)
Bearish
(01-Mar-10)
Bullish

Industrial Metals (GYX)
Bearish
(03-Jan-11)
Bearish
(25-May-09)
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 giving an approximately equal weighting to fundamental and technical factors, and short-term views almost completely by technicals.

Long-term price targets are meaningless

Many commentators like to speculate on where the dollar-denominated gold price is ultimately headed. Some claim that it is destined to reach $3,000/oz, others claim that it won't top until it hits at least $5,000/oz, and some even forecast an eventual rise to as high as $50,000/oz. All of these forecasts are meaningless.

Long-term dollar-denominated price targets are meaningless because they fail to account for the change in the dollar's purchasing power, and the only reason a rational person invests is to preserve or increase purchasing power. To further explain by way of a hypothetical example, assume that five years from now a US dollar buys only 20% of the everyday goods and services that it buys today. In this case, the US$ gold price will have to be around $7,000/oz just to maintain its current value in purchasing power terms. To put it another way, in our example a person who buys gold at around $1360/oz today and holds it will suffer a LOSS, in real terms (the only terms that matter), unless the gold price is above $7,000/oz in January-2016. Considering a non-hypothetical example to make the same point, a resident of Zimbabwe who owned a small amount of gold and not much else would have become a trillionaire a few years ago, and would also have become broke.

The purchasing power issue is why the only long-term forecasts of gold's value that we ever make are expressed in non-monetary terms. For example, throughout the past 10 years we've maintained that gold's long-term bull market would very likely continue until the Dow/gold ratio had fallen to at least 5, and would potentially continue until Dow/gold reached 1.

If we were forced to state a very long-term target for the US$ gold price then it would be: infinity. The US$ will eventually become worthless, at which point gold will have infinite value in US$ terms. But then, so will everything else that people want to own.

Natural Gas Update

The price of natural gas remains at a very low level in absolute terms and especially relative to the price of oil (the natgas/oil ratio is currently not far from the 20-year low it reached in late-2009). This probably means that natgas is due for a period of strength, if not in dollar terms then at least relative to oil. However, the fact that natgas (the commodity) may well be in bargain-basement territory doesn't mean that the same applies to the stocks of natgas producers/explorers.

A strange situation has developed over the past couple of years in that natgas-related equities have generally performed well even as the price of the commodity has languished at a very low level. The situation is illustrated by the following chart, the top section of which shows the AMEX Natural Gas Index (XNG), a proxy for natgas equities, and the bottom section of which shows the XNG/natgas ratio (natgas equities relative to the underlying commodity).

Note that prior to 2009 the XNG/natgas ratio had never made a sustained move above 90, but during the first half of 2009 it surged well above 90 and has remained there. This has come about because the natgas price has recovered almost none of the loss incurred during the 2008 crash, whereas the XNG has recouped the bulk of its 2008 loss.

The upshot is that natgas looks cheap while natgas-related equities look dangerously extended to the upside. Strange, indeed.



As we mentioned in our 26th April 2010 commentary, there are some good reasons why natural gas equities have generally performed a lot better than the commodity since the beginning of 2009. In particular:

1. Most natgas producers also produce oil, and the oil price has trended upward

2. The stock market's post-crash rebound has been strong enough to lift almost all equities

3. New drilling technology makes it possible for natgas producers to be profitable at a lower commodity price

4. Most natgas producers hedge part of their production

But even taking these reasons into account, the extent of the out-performance is extraordinary.

Interesting quote or fact of the week

Here are quotes from an article written by Frank Chodorov in 1962:

"The only limit to the inclination of every politician to spend money, in order to acquire power, is the refusal of the public to lend its money to the government. Of course, the government can then resort to printing money, to make money out of nothing, but at least the people will not be compounding the swindle. Therefore, I offer the following gratuitous advice: Don't buy bonds."

And:

"Internal debts...are never liquidated. When the burden of meeting the service charges becomes economically unbearable, and the State's credit is gone, repudiation or inflation is resorted to.

Of these two methods, repudiation is by far the more honest. It is a straightforward statement of fact: the State declares its inability to pay. The wiping out of the debt, furthermore, can have a salutary effect on the economy of the country, since the lessening of the tax burden leaves the citizenry more to do with. The market place becomes to that extent healthier and more vigorous. The losers in this operation are the few who hold the bonds, but since they too are members of society they must in the long run benefit by the improvement of the general economy; they lose as tax collectors, they gain as producers."

The article puts forward the arguments that it is unethical to invest in government bonds and that direct default on government debt is vastly preferable to default via inflation. We couldn't agree more.

The Stock Market

The US stock market continues to make slow and steady upward progress, thus maintaining its 'overbought' status and leaving bullish sentiment at a dangerously elevated level. In particular, as at the end of last week the S&P500 Index had risen for seven weeks in succession, more than 94% of S&P500 stocks were above their 200-day moving averages, and the US stock market's put/call situation was as bearish as it gets (the 10-day moving average of the equity put/call ratio was near a 10-year low and the 10-day moving average of the OEX put/call ratio was near a 10-year high).

We suspect that all the gains made over the past seven weeks, along with any additional gains made over the days ahead, will be given back in quick time.

One of the most interesting aspects of the recent market action is the way the stock market has 'turned a blind eye' to the goings on in the municipal bond market. As illustrated by the following daily chart, the US municipal bond market continues to plunge. But according to the stock market, it doesn't matter.


This week's important US economic events

Date Description
Monday Jan 17
US markets closed for MLK Day
Tuesday Jan 18Empire State Manufacturing Index
Housing Market Index
TIC Report
Wednesday Jan 19 Housing Starts
Thursday Jan 20 Existing Home Sales
Leading Economic Indicators
Philadelphia Fed Survey
Friday Jan 21 No important events scheduled

Gold and the Dollar

Gold

Current Market Situation

Gold futures broke below short-term support in the $1360s last Friday. For the February contract, the next levels of meaningful chart-related support lie in the $1320s and the $1270s.


We don't perceive a lot of downside risk in gold on either a short- or an intermediate-term basis. Despite the many assertions that gold is in a bubble and sentiment is too bullish, objective evidence indicates otherwise. For example:

1. The US$ gold price has essentially traded sideways over the past three months and at no stage over the past several months has it come close to the top of the moving-average envelope that has limited intermediate-term advances over the past decade.

2. Market Vane's bullish consensus for gold never exceeded 85% over the past few months and dropped below 70% last week. It could do what it did last July and fall as far as 60% before a correction low is in place, but the Market Vane survey suggests that the sentiment situation is now constructive.

3. Other sentiment indicators are consistent with the Market Vane survey. We note, for instance, that there has been a large decline in the speculative net-long position in COMEX gold futures and that the gold-stock indices are at low levels relative to gold bullion.

The sentiment picture suggests that a correction low will be put in place within the next three weeks and that support in the $1270s defines the maximum downside risk. Support in the $1320s is a more likely short-term price floor.

Gold relative to other metals

Our main concern is that while gold's price action and sentiment situation is not consistent with anything more serious than a routine short-term correction, silver and the silver/gold ratio became sufficiently 'overbought' during the past few months to create major peaks (peaks that hold for more than a year).

After rising in near-vertical fashion during August-December of last year, the silver/gold ratio has pulled back a little over the past fortnight (refer to the following weekly chart for details). Its reversal isn't yet definitive, but significant additional weakness from here would suggest that peaks of at least an intermediate-term nature are in place for both silver and gold. This wouldn't negate the idea that gold was within three weeks of reaching a short-term low, but it would imply that the rally that follows the upcoming short-term low will end below the December high.


Next up is a weekly chart of the GYX/gold ratio (the Industrial Metals Index relative to gold).

One of the biggest problems with the theory that direct manipulation of the gold price is a major force in the gold market is the fact that GYX/gold's performance over the past decade is consistent with what was happening at the time to the financial/economic landscape. Of particular note is that industrial metals, as a group, weakened relative to gold during the 2000-2002 economic downturn, trended higher relative to gold during the 2003-2006 boom, plunged relative to gold during the global financial crisis of 2007-2009, and then rebounded relative to gold during the post-crash recovery period that began in February-March of 2009. This is exactly as should be expected.

As at the end of last week the post-crash recovery was still in progress. Once it ends, the industrial metals complex should begin to weaken relative to gold.


Gold Stocks

In last week's Interim Update we wrote:

"If we interpret the HUI's early-December peak as a test of the early-November peak then the HUI's current position looks similar to its position during the second half of July, in which case support in the low-500s defines the maximum downside risk and a new multi-month advance should begin within the next three weeks.

A more bearish interpretation is also plausible, but even if an intermediate-term decline has begun we will likely get an initial low within the next three weeks and then a multi-week rally."

The following daily chart shows that the HUI ended last week within 'spitting distance' of the aforementioned support and that the HUI's daily RSI is approaching its lows of the past two years. In other words, the HUI is now 'oversold' on a short-term basis and is not far from an area that should offer good support. A sector-wide short-term buying opportunity is therefore emerging.


A point we regularly try to make is that taking advantage of short-term swings in the markets does not require forecasting accuracy. In fact, you never even need to have an opinion on the likely direction of prices over the weeks immediately ahead. The idea is simply to methodically and gradually scale into positions on short-term weakness and scale out of positions in the same way on short-term strength, all the while maintaining core exposure in line with the long-term trend. Resistance/support levels and momentum indicators can be useful in figuring where and when to place orders.

Currency Market Update

The following chart shows how the US$ has performed relative to the Swiss Franc since 1970. It is evident that the US$ has been in an ultra-long-term downward trend against the SF. It is also evident that the US$ has experienced cyclical bull and bear markets within the context of this ultra-long-term trend. Furthermore, these cyclical bulls/bears have traced out a pattern that can be described as: 8-10 years down followed by 6 years up.

If the pattern continues then the US$ has already commenced a cyclical bull market or will do so within the next 12 months.


By comparing the C$/A$ exchange rate with the Dollar Index, the following chart makes the point that the C$ tends to strengthen relative to the A$ when the US$ is in a rising trend and to weaken relative to the A$ when the US$ is in a falling trend. This relationship probably stems from the close economic ties between Canada and the US. The implication is that if the Dollar Index has turned upward on an intermediate-term basis (we think it has) then we have entered a period of at least 6 months when the C$ should generally be stronger than the A$.


The Baltic Dry Index (BDI), an index of ocean freight rates, hit a new 52-week low last week. In fact, with the exception of the 5-month crisis period of October-2008 through to February-2009 the BDI is now at its lowest level of the past eight years.

For whatever reason, intermediate-term turning points in the BDI tend to coincide with intermediate-term turning points in the currency market, with US$ highs coinciding with BDI lows and US$ lows coinciding with BDI highs. The three most recent BDI turning points of importance are good examples. These occurred in May-2008 (BDI high, dollar low), November-2008 (BDI low, dollar high), and November-2009 (BDI high, dollar low).

The next important BDI turning point should be a reversal from down to up and is likely to coincide with a US$ high. Based on our current US$ outlook, it would make sense if this turning point waited until at least the second half of this year.


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)

Potential agriculture exposure

Agricultural commodities and agriculture-related equities have recently been very strong. Although there's a good chance that they will soon begin short-term 'corrections', there is also a good chance that they will continue to be relatively good performers over the coming 12 months.

Sprott Resource Corp. (TSX: SCP), a former and potential future TSI stock selection, offers reasonable exposure to agriculture via its basket of investments. Specifically, included in its numerous investments are 70M shares of Stonegate Agricom (TSX: ST), an exploration-stage potash miner with projects in Peru and the US (Idaho), and 80% ownership of One Earth Farms Corp., a private company that is set to become Canada's largest crop and cattle farming operation this year.

SCP is far from being a pure agriculture play in that ag-related investments currently constitute less than half its net asset value. Of the non-ag-related investments in its stable, the most significant are 229M shares of Orion Oil and Gas (TSX: OIP) and 74,000 ounces of gold bullion.

Due to the way the company does its accounting, the net asset value (NAV) that it states in its quarterly financial reports is a lot less than the NAV that would be arrived at by summing the current market values of its investments. Assuming a total share count of 113M, our assessment is that SCP's NAV is presently between C$5.60/share and C$6.00/share. This implies that SCP ended Friday's trading session at a discount of at least 18% to its NAV.

Although the above-mentioned discount is meaningful, we don't think it is sufficient to make SCP shares a strong buy in light of the current market situation and other risks. In our opinion, the stock will have to drop below C$4 over the weeks ahead to become a strong buy. We are therefore not going to add SCP to the TSI List at this time, but are hoping for an opportunity to do so in the future at a lower price.

The following chart shows that the stock has important support at around C$3.80 and C$3.50. The lower of these support levels probably defines the maximum downside potential.


    New gold stock selection: Carpathian Gold (TSX: CPN). Shares: 385M issued, 428M fully diluted. Recent price: C$0.59

CPN is developing the Rovina Valley gold/copper project in Romania and the Riacho do Machados (RDM) gold project in Brazil.

Rovina Valley has a porphyry-style deposit comprising 3.1M ounces of gold and 759M pounds of copper in the M&I category plus 3.9M ounces of gold and 663M pounds of copper in the Inferred category. A Preliminary Economic Assessment (PEA) completed in March-2010 estimated that with initial capital expenditure of $509M, the project could be developed into a mine that produced an average of 200K ounces of gold and 50M pounds of copper per year for 19 years at a cash cost of $379/ounce (taking copper as a byproduct). Assuming a gold price of $1000/oz, a copper price of $3.00/pound and a conservative discount rate of 10%, the project's net present value (NPV) was estimated to be US$544M.

The Rovina Valley project is a long way from production and will be the subject of further exploration during 2011.

The RDM project in Brazil is smaller, but is a lot closer to production. In fact, CPN's current plan is to develop RDM into an open-pit 102K-oz/yr gold mine by the end of 2012.

The project's total resource is presently estimated to be around 1.5M ounces (0.8M ounces M&I + 0.7M ounces Inferred), 1.1M ounces of which are in the open-pit-able portion of the deposit. A PEA came up with estimates of $113M for the initial capex and $143M for the net present value (assuming a gold price of $1000/oz and a discount rate of 7.5%).

For all intents and purposes, the RDM project is fully funded through to production in that CPN has about $50M of cash in the bank and is close to finalising a $75M debt facility.

The sum of the NPVs of the above projects is $687M, or $1.60 per share (using the fully diluted share count). Due to country risk (Romania) and execution risk (construction of the RDM mine), we think it is prudent to apply a sizable discount to this figure and assume that CPN would be fully valued at $1.00-$1.20/share. However, even with our risk-related discount there appears to be substantial upside potential in CPN's stock price, especially considering that the NPV figures are based on a gold price of $1000/oz.

Here are some other noteworthy points:

First, on the plus side, management/insiders own 35% of the company. Also on the plus side, news-flow is likely to be good over the next few months. For example, an updated resource estimate and Feasibility Study for the RDM project are expected during the first quarter, and regular drilling updates are expected for both the Rovina and RDM projects.

On the negative/risk side of the equation, CPN has forward-sold 12.5% of the annual production from its RDM mine at $400/oz in exchange for up-front payments totaling $30M. Consequently, RDM will effectively be a 90K oz/yr, rather than a 102K oz/yr, operation. Also, there is a risk that the company will be unable to convert the Rovina Valley exploration licence into a mining licence.

The optimum place for new buying of CPN shares would be just above the support level indicated on the following chart. That is, around C$0.50. However, at Friday's closing price of C$0.59 the risk/reward is good enough to warrant some buying and to warrant CPN's inclusion in the TSI List.

In our opinion, a reasonable approach would be to take an initial position near the current price with the aim of scaling up to a full position on weakness.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
Copyright 2000-2010 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>