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   -- Weekly Market Update for the Week Commencing 17th August 2009

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)

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Outlook Summary

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Neutral
(25-May-09)
Bullish
(12-May-08)
Bullish

US$ (Dollar Index)
Bullish
(10-Aug-09)
Bullish
(25-May-09)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Bullish
(10-Aug-09)
Bullish
(08-Jun-09)
Bearish
Stock Market (S&P500)
Neutral
(27-Jul-09)
Bearish
(11-May-09)
Bearish

Gold Stocks (HUI)
Neutral
(20-May-09)
Bullish
(17-Jun-09)
Bullish

OilBearish
(17-Aug-09)
Bearish
(25-May-09)
Bullish

Industrial Metals (GYX)
Bearish
(17-Aug-09)
Bearish
(25-May-09)
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 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 fundmental and technical factors, and short-term views almost completely by technicals.

Consumer spending: the caboose, not the engine

A popular line of thinking is that an economic recovery won't begin in earnest until consumers start spending more money. For example, some commentators claim that a genuine recovery won't begin anytime soon because consumer spending is slated to remain depressed for a long time to come, whereas others claim that the economy will soon begin to strengthen on the back of increased consumer spending. Both sets of commentators agree that consumer spending is the key. For its part, the government is aggressively promoting more consumer spending on the basis that this is the way to get the economy moving forward again.

It is obvious that economic growth goes hand-in-hand with increasing consumer spending, but it is apparently not obvious to most people that a greater amount of consumer spending is an EFFECT, not a cause, of economic growth. It can never be a cause of sustained economic growth because in order to consume more a person must first produce more. The way it works is that people add to their savings, which leads to more investment in the factors of production, which leads to greater production, and, lastly, to increased consumption. That is, an increase in consumer spending lies at the end of a process that begins with an increase in saving. Or, to put it another way: consumer spending is the caboose, not the engine.

It should be readily apparent to anyone who stops for a moment to think things through that consumer spending involves taking something out of the economy, and that if most people consistently take more out than they put in then the economy will shrink over time. In other words, government policies designed to boost spending and reduce saving must, if they achieve their intended result, lead to a WEAKER economy over the long-term. The fact that politicians go down such an illogical path is understandable, if not excusable, given that most politicians are only concerned with what happens to the economy between now and the next election, but economists and newsletter writers should at least get it right.

Commodities

Oil

Peak Oil

As we've noted in previous commentaries, Hubbert's "Peak Oil" theory appears to be valid. It is certainly supported by observation in that many cases can be cited where the production from an oil field or an entire oil-producing region has gone into decline exactly as predicted by this theory. However, we do not believe that geological limitations to oil supply constitute a major economic issue. There are vast untapped oil reserves in the world, and if the oil market were able to operate freely then these reserves would probably satisfy demand for generations to come. Furthermore, the free market would develop economically viable alternatives well before we reached the point where oil supply was limited by geology. In a nutshell, a sustained shortage of a commodity as useful as energy would never occur in a free market.

Which brings us to the root of the problem: the oil market is not free. This, and not any geological considerations, will potentially lead to troublesome constraints on oil supply in the future. In other words, if there is going to be an oil supply problem with grave economic consequences then the origin of the problem will be political, not geological.

The free market is very good at anticipating potential supply shortages and addressing the unanticipated shortages that periodically crop up, but governments around the world have their tentacles deeply immersed in the oil business, from oil exploration all the way through to the consumption of oil-based products. In particular, governments: a) heavily regulate oil exploration and production, b) control or influence the prices of oil and oil-based products, c) attempt to influence energy consumption trends, d) reduce, eliminate, or manipulate in some other way the economic incentives to expand supply, and e) use oil as a means of gaining geopolitical advantage. Here are some specific examples:

    * The US government has a history of imposing or threatening price controls and "windfall profit" taxes whenever there is a large increase in the oil price, thus discouraging the oil industry from responding in the appropriate way to price signals. The US government also places severe restrictions on where oil drilling can occur and is about to massively distort both the supply and the demand for oil via its "Cap and Trade" program.

  * The federal and provincial governments in Canada have a history of changing the rules (royalties and taxes, for instance) on the oil and gas industry, thus creating more uncertainty than there should be.

  * China consumes far more oil than it should because its government ramps up the money supply at a rapid rate and simultaneously caps the gasoline price at an artificially low level.

  * Russia has used its control over European gas supply as a geopolitical weapon in the past and will probably do the same in the future.

  * Some governments, the Venezuelan government being the highest-profile example, have "nationalised" (read: stolen) privately-owned oil production facilities and reserves, to the detriment of oil supply.

The bottom line is that sustained shortages of useful commodities only occur when the government inserts itself into the supply/demand equation. The oil market is no exception, so if insufficient oil supply becomes a serious long-term economic problem then the underlying cause will be political, not geological.

Current Market Situation

A daily chart of September oil futures is displayed below.

As a result of Friday's $3 drop in the oil price it is beginning to look like the oil market has just completed a successful test of its June peak. If this is the case then the short-term downside risk is much greater than the short-term upside potential. In our opinion, the short-term downside risk is defined by the December and February lows (we expect that these lows will be tested after the post-crash rebound runs its course).



We have shifted our short-term oil outlook from "neutral" to "bearish" on the basis that the rebound in the oil price from its early-July low to its early-August high is looking more like a counter-trend move than the next up-leg of an intermediate-term advance. If the nearest oil futures contract closes above its June peak at some point over the next few weeks then we are clearly wrong about this and will immediately shift back to the sidelines.

Considering the economic backdrop, even if the oil price were to break above its June peak ($75 in the September contract) we doubt that it would make significant additional headway. However, we have learned not to under-estimate the effects of trend-following speculation on this market. After all, the oil price was able to rise from the $70s in mid-2007 to the $140s in mid-2008 in parallel with deteriorating fundamentals (rising physical supply and declining physical demand). In that instance, speculation regarding US$ inflation was the primary driver of the price trend.

If the oil price does break out to new highs for the year then the catalyst will likely be a break to new lows by the Dollar Index (improbable, but not out of the question) or rising geopolitical tensions in the Middle East (impossible to handicap).

Copper

The rebound in the copper price from its December-2008 low to last week's high was impressive, to say the least. It was all the more impressive considering that there didn't appear to be a good fundamental reason for it. A post-crash rebound was inevitable, and a typical rebound following the sort of crash that occurred last year would have taken the price back to the low-$2 area. However, the copper price almost touched $3.00 last week.



There has been a substantial decline in the amount of copper stored in LME warehouses, but that's only because hundreds of thousands of tonnes of copper have been transferred from reported inventories in the West to unreported inventories in China. It is also noteworthy that the recent copper rally was the only copper rally of the past 6 years that unfolded without the market moving well into "backwardation". As evidenced by the following Fullermoney.com chart, so far this year the copper market has only made a couple of brief and shallow forays into "backwardation" (the chart shows the extent of "backwardation" or "contango", with the market being in "backwardation" when the line on the chart is above zero and in "contango" when the line is below zero). This is a stark contrast with other rallies of the past six years.

That copper has spent the bulk of this year in "contango" indicates that the market has been well supplied throughout. The large run-up in price (beyond what would have been expected for a post-crash rebound) is therefore a puzzle. 



Although the rebounds in copper and the other industrial metals should continue until the stock market peaks, and although the odds favour the stock market maintaining its upward bias for at least a few more weeks, the short-term risk is now high by virtue of the speed with which industrial metal prices have risen since early July. We have therefore shifted our short-term outlook to "bearish".

The Stock Market

The S&P500 Index edged above 1000 on the 1st trading day of this month and has since traded sideways within a narrow range. It is gradually working off its 'overbought' condition.

We think the downside risk is large enough to warrant considerable caution, but we doubt that the market has reached anything more than an interim peak. In our opinion, the most bullish thing it could do from here is pull back by enough over the next 1-2 weeks to enable the S&P500 Index to 'test' July's break above resistance (now support) at 950, as this would most likely eliminate the 'overbought' condition without doing any technical damage. The stage would then be set for another -- and quite likely final -- multi-week advance.

While the odds favour at least one more rise to new highs for the year, a number of things are happening to suggest that the post-crash rebound is nearing its conclusion. These things include the decline in the Baltic Dry Index, the tentative signs of a US$ bottom, the relatively high level of bullish sentiment, and the potential topping action of the Shanghai Stock Exchange Composite Index (SSEC) as depicted below. An intermediate-term peak for the SSEC would be confirmed by a rebound to a lower high followed by a decline that takes out the August low.


Another development with potentially bearish implications is the recent performance of Wal-Mart's stock price. Wal-Mart is one of the few non-gold companies that would likely grow its earnings, or at least maintain its earnings, during a lengthy period of economic contraction. This probably explains why it has moved counter to the broad stock market over much of the past three years. For example, the following chart shows that WMT did nothing during the final year of the global equity bull market (Oct-2006 through to Oct-2007), trended upward during the first 11 months of the equity bear market, and went nowhere while the broad stock market rallied between March and July of this year. On this basis, last week's upside breakout by WMT should be construed as a bearish omen for equities in general.


This week's important US economic events

Date Description
Monday Aug 17
Treasury International Capital (TIC)
Housing Market Index
Tuesday Aug 18Housing Starts
Producer Price Index
Wednesday Aug 19 No important events scheduled
Thursday Aug 20 Leading Economic Indicators
Friday Aug 21 Existing Home Sales
Expiry of Equity Options

Gold and the Dollar

Gold

Gold Seasonality

From the 20th May Interim Update: "Since the beginning of its long-term bull market gold has tended to be flat from late May through to mid August. In fact, during the 7-year period from 2001 through to 2007 the average change in the gold price between 21st May and 15th August was only 3% and the maximum change was only 6%. Last year was an outlier in that it produced a 15.6% decline during the aforementioned period."
 
Here are the details, updated to include this year's performance:

Year:        Net Change in Spot Gold Price Between 21st May and 15th Aug:

2001                -2.8%
2002                -0.3%
2003                -2.4%
2004                +3.9%
2005                +6.0%
2006                -5.2%
2007                +0.9%
2008                -15.6%
2009                -1.0%

Clearly, gold followed its seasonal pattern over the past 12 weeks. Let's now look at what we can expect if gold follows its seasonal pattern over the remainder of the year.

Since the beginning of its long-term bull market gold has ALWAYS risen between mid August and the final trading day of the year. The gain over this period has ranged from 1.1% to 24.7%, with an average of 11.4%. Moreover, even last year's September-November crash failed to prevent gold from keeping this perfect record intact. Here are the details:

Year:        Net Change in Spot Gold Price Between 15th Aug and 31st Dec:

2001                +1.1%
2002                +10.5%
2003                +14.4%
2004                +9.6%
2005                +17.0%
2006                +2.1%
2007                +24.7%
2008                +12.0%

In other words, the seasonal pattern represents a tailwind for gold over the remainder of the year.

Current Market Situation

The following daily chart of December gold futures shows the pattern of falling highs and rising lows that has been forming since February. If the pattern continues then the gold price will make its way down to the $920s over the coming fortnight.

A daily close ABOVE the early-June high or BELOW the early-July low would break the pattern and project significant additional movement in the direction of the breakout.


Based on the assumption that the pattern will continue in the immediate-term and ultimately conclude via an upside breakout, traders should consider taking a long position IF the gold price drops to the $920s within the next three weeks. Risk could then be managed by placing a sell stop just below $900.

Silver versus Gold

As discussed many times in TSI commentaries over the years, the silver/gold ratio tends to function as an indicator of financial and/or economic confidence in that silver tends to out-perform gold when confidence is rising and under-perform gold when confidence is falling. As a result, we expect that silver will do well relative to gold until the stock market reaches an intermediate-term peak, after which it will become relatively weak. For this reason, SLV (the silver ETF) put options would provide a means of hedging a portfolio heavily laden with gold- and silver-related investments.

This is just something to bear in mind. The best way for most people to hedge is by maintaining a large cash reserve, but it could also make sense over the next couple of months to average into out-of-the-money SLV puts, with expiry dates of January-2010 or later, during periods when silver is firm.

Gold Stocks

It's possible that a good short-term buying opportunity will evolve in the gold sector over the coming 1-2 weeks. The opportunity would be created by gold bullion dropping back to the $920s while the HUI dropped back to near support in the 330s or the 310s. We suspect that it would take simultaneous weakness in the broad stock market and the bullion market to push the HUI down to lower of these support areas.


Although we don't have a financial interest in the stock, we always keep a close eye on Royal Gold (RGLD) because it tends to be a leading indicator for gold stocks in general.

The following chart shows that RGLD peaked on the first trading day of this year and has since established a sequence of declining tops. A daily close above $48 would break this sequence and indicate that the overall sector had commenced, or was about to commence, its next intermediate-term upward trend.

On a very short-term basis, a quick decline to around $35 would create a buying opportunity for traders.


Currency Market Update

We think that the Dollar Index has been going through a bottoming process over the past three months. The early-August low was slightly below the early-June low, but the drop to new lows for the year near the beginning of this month was not confirmed by the momentum indicators displayed at the bottom of the following chart, or by the Baltic Dry Index, or by the Swiss Franc, or by the gold market, or by the oil market.

Preliminary price-related confirmation of a Dollar Index bottom would be consecutive daily closes above 80, as this would break the Dollar Index above its 50-day moving average and its downward-sloping channel. More conclusive evidence of a bottom would be provided by a solid daily close above resistance at 81.5.


Update on Stock Selections

(Note: 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)

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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