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   -- Weekly Market Update for the Week Commencing 20th June 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 ended in December of 2008. In real (gold) terms, bonds commenced a secular BEAR market in 2001 that will continue until 2014-2020. (Last update: 4 April 2011)

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
(19-Apr-11)
Neutral
(24-Jan-11)
Bullish

US$ (Dollar Index)
Neutral
(07-Mar-11)
Bullish
(02-May-11)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(20-Sep-10)
Bearish
(21-Mar-11)
Bearish
Stock Market (S&P500)
Neutral
(13-Jun-11)
Bearish
(11-Oct-10)
Bearish

Gold Stocks (HUI)
Neutral
(24-Apr-11)
Bullish
(23-Jun-10)
Bullish

OilNeutral
(31-Jan-11)
Neutral
(31-Jan-11)
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.

Bank Reserves and Money Supply

The relationship between bank reserves and money supply is widely misunderstood. Some analysts believe that the Fed dictates the US money supply by controlling the reserves of the US banking system, but, as we'll explain, this is only partly correct. Other analysts believe that if commercial banks are collectively unable or unwilling to lend then the Fed won't be able to increase the economy-wide money supply, regardless of how much it increases bank reserves. As we'll explain, this view is completely wrong.

With regard to the relationship between US bank reserves and money supply, the period since 1990 can logically be split in two: September-2008 onwards and everything prior to September-2008. From the early 1990s up to and including August of 2008, changes in bank reserves had almost no influence on the money supply. We say this because there were large oscillations in the money-supply growth rate and a massive net increase in the economy-wide money supply during this period, and yet the total amount of reserves in the banking system barely moved (bank reserves were about $45B in August-1991, August 1998, and August 2008). However, from September-2008 onwards the change in bank reserves has been so important as to totally swamp all other influences on the money supply. The sudden shift in September-2008 is illustrated below.


We have a three-part explanation for what has transpired on the US monetary front since 1990. First, regulatory changes implemented by the Fed during the early-1990s effectively broke the link between bank reserves and bank lending. From then on the banks could use the practice known as "sweeping" to effectively enable any amount of bank reserves to support any amount of deposit money. Second, during the booms of the 1990s and 2000s there was huge private-sector demand for loans, which the commercial banks were willing and able to meet despite the fact that their reserves hadn't increased (due to the first part of our three-part explanation, reserves were no longer a limiting factor). The result was a large increase in the money supply driven by commercial bank lending. Third, whether it was due to the widespread impairment of bank balance sheets or a major trend change in private-sector loan demand or a combination of the two (our view is that it was a combination of the two), the banking system's collective loan book began to contract in late-2008. This would/should have resulted in deflation, except that the Fed stepped in and began creating new money at a rapid rate. Due to the way the Fed went about its money pumping, bank reserves and bank deposits were simultaneously boosted.

In summary, almost all the money created in the US from the early-1990s through to August of 2008 was created by the private banks, independently of changes in bank reserves. This, we suspect, is why some analysts concluded that the US would necessarily experience deflation once the private banks became unwilling to expand their loan books or private-sector borrowers became 'tapped out'. However, the world changed in September of 2008. From that time forward, the Fed has been solely responsible for net additions to the US money supply.

A secular trend change in the credit market

We disagree with the main conclusion of the analysts who are forecasting deflation for the US economy, but our assessment of the inflation/deflation situation also differs from that of most analysts who are forecasting more inflation.

As far as we can tell, most analysts who are convinced that a lot more inflation lies in store for the US economy believe that it's just a matter of time before the long-term upward trends in commercial bank lending and private sector indebtedness resume. Our view, however, is that the aforementioned long-term trends ended in 2008 and that future inflation will rely on the Fed's creation of new money.

Growth in the federal government's debt burden will probably ensure that the economy-wide volume of debt continues to increase, but in any case the Fed has proven beyond any doubt that it is capable of expanding the supply of money at a fast pace regardless of what is happening on the debt front. The fact is that while almost all new money is borrowed into existence during normal times (normal, that is, for the type of monetary system we have today), the Fed is able to create new money independently of demand for loans. It can do this because it is capable of monetising ANYTHING.

Evidence of a change in the US credit market's long-term trend is provided by the following chart of revolving credit. The post-2008 downturn does not look like an interruption to a long-term upward trend; it looks like the start of a new long-term downward trend.


Oil Update

Last week's price action removes any remaining doubt that an intermediate-term peak was put in place in the oil market at the beginning of May. This, however, doesn't imply that the market has a lot of additional downside potential. Also of consideration is that while the attention of the financial world has drifted away from political instability in the Middle East and North Africa (MENA), the situation in that part of the world does not appear to have stabilised. It's likely just a matter of a few months until the next MENA-related oil supply scare.

The following daily chart shows that the July crude futures contract has support just below Friday's low. If this support gives way then a drop to $80-$85 is probably on the cards.

We expect to see plenty of evidence of a weakening global economy during the second half of this year and will not be surprised if the oil price drops to around $80/barrel in response, but given the geopolitical backdrop we will be surprised if drops much lower than that.


The coming crash in US municipal debt?

Late last year, banking analyst Meredith Whitney 'created a storm' by forecasting that there would be hundreds of billions of dollars of defaults in the US municipal bond market during 2011. Is there a chance that she could be right?

In a word: no. During the year to date there have been less than $1B of "muni" defaults, and the way things are going it is very unlikely that there will even be $10B of defaults this year (note that the worst year on record was 2008, when "muni" defaults totaled about $8B). This means that Whitney's default prediction is almost certainly going to be wrong by orders of magnitude.

At least, her timing is going to be wrong. It is possible that there will ultimately be hundreds of billions of dollars of defaults in "munis" spread over several years. We don't have a strong opinion on that, as we are not experts on the US municipal bond market.

In any case, the potential exists for large declines in municipal bond funds, as represented on the following chart by the Nuveen Municipal Closed-End ETF Index (NMUNI), almost regardless of how many actual defaults occur. The reason is that fear of default will probably mushroom once it becomes obvious to all that the US economy has moved back into recession. For example, fear of default, rather than actual default, was the main reason for the 40% peak-to-trough decline in NMUNI during 2007-2008. Also, fear of default was solely responsible for the 16% decline in NMUNI that occurred between September of 2010 and January of 2011.


Quotes of the week

"President Obama said he's not concerned about a double-dip recession. He's more concerned the recovery we're in is not creating enough jobs. Do you know what you call a recovery that isn't creating enough jobs? A recession."
 -- Jay Leno

"You have to be prepared and disciplined in order to trade right. Investors respond to volatility in predictable, but strange, ways. When the market goes up 30% for no reason other than volatility, investors tend to become aggressive and want to buy more. By contrast, they panic and sell when the market goes down 30%. Most investors respond to volatility by selling low and buying high, panicking the wrong way in both directions."
 -- Rick Rule (from the interview posted HERE)

The Stock Market

The following daily chart shows that the NASDAQ100 Index (NDX) declined a little further last week, but still hasn't broken below support defined by its March low. We'd prefer that it broke below this support before commencing a multi-week rebound, but the overall market is certainly 'oversold' enough to enable such a rebound to begin immediately. In particular, we note that the 10-day moving average of the equity put/call ratio ended last Friday at 0.90, which is close to the highs reached during the 2008 market crash. This is extraordinary considering that the senior stock indices have pulled back by less than 10% from their early-May highs.


Sentiment is now a definitive short-term positive, but it is not a positive beyond the short-term. In fact, that sentiment has become so pessimistic in response to such a small decline reveals a market with a strong tendency to panic at the first sign of trouble. This adds to the downside risk.

On an intermediate-term basis, the ONLY positive we can come up with is the continuing strong growth in the money supply. The supportive monetary backdrop means that a 2008 repeat is almost certainly not on the cards, but sizeable intermediate-term declines can occur in parallel with strong growth in the money supply.

The last point we'll make before leaving the stock market is that the price action of the past few weeks has constituted a marked divergence from the Presidential Cycle Model. According to this Model, the US stock market is supposed to be strong during the first three weeks of June in the third year of the cycle.

When a market is weak during a seasonally strong period, it should be taken as a 'warning shot across the bow'.

This week's important US economic events

Date Description
Monday Jun 20
No important events scheduled
Tuesday Jun 21
Existing Home Sales
Wednesday Jun 22 FOMC Announcement
Thursday Jun 23 New Home Sales
Friday Jun 24 Durable Goods orders
Q1 GDP

Gold and the Dollar

Gold and Silver

Silver's decline: a normal reaction to the preceding advance

When a major commodity market experiences a parabolic rise of the magnitude experienced by the silver market during the final four months of last year and the first four months of this year, the result is always a crash. Students of financial market history know how such episodes inevitably end, but they generally can't pinpoint the timing of the ending.

When the inevitable happens there is never a good reason to look for explanations that involve nefarious antics, but this hasn't prevented Eric Sprott from doing exactly that. As discussed in the article posted HERE, the Canadian billionaire claims that market manipulation caused the early-May crash in the silver price. Naturally, he offers no evidence to support his claim.

In the above-linked article, Mr. Sprott also claims that the introduction of "QE3" would quickly send silver back to $50/oz. This is probably a correct assessment, but it is not reasonable to expect that "QE3" will be introduced within the next few months given that a) "QE2" has been an obvious failure and b) the Fed would justifiably be attacked from almost all directions if it instituted a new round of aggressive money pumping in the near future. There will probably have to be a lot more evidence of economic weakness and an intervening deflation scare before "QE3" -- or something similar under a different name -- becomes politically feasible, which could mean that silver visits the low-$20s before resuming its long-term upward trend.

Current Market Situation

Not much happened in the gold and silver markets last week. For example, the following daily chart shows that the July silver futures contract lost about $1.50 last Monday and then spent the rest of the week recouping these losses. The net effect was that it went nowhere over the course of the week.

July silver has resistance just below $40 and support at around $33. We suspect that a break below $33 would be quickly followed by a decline to $28 or lower.


If gold and silver futures can continue to hold above support ($1520 for gold, $33 for silver) this week then the risk of a sharp near-term decline will subside. As mentioned in the last two TSI commentaries, the most likely alternative to a sharp near-term decline is several more weeks of 'choppy' range trading. We suspect that this extended period of range trading would be followed by declines to below the May lows for both gold and silver.

Displayed below are charts showing gold in euro terms (gold/euro) and gold in A$ terms (gold/A$).

Gold/euro is testing its all-time high and is roughly in the middle of its long-term upward-sloping channel. We are bullish on gold/euro over all timeframes, as we expect that any decline in the US$ gold price over the months ahead will at least be matched by a decline in the EUR/USD exchange rate.

For a similar reason, we are also bullish on gold/A$ over all timeframes.




Gold Stocks

Unlike the HUI, the XAU failed to make a new high in April of this year. Consequently, the XAU's chart pattern makes it clearer that the gold sector of the stock market has been in correction mode since early December of last year.

The following daily chart shows that the XAU made a new low for the year late last week, so at this stage there is obviously no evidence that the intermediate-term correction is complete.


Even if the overall correction is not complete, at the end of last week the gold-stock indices were at important support levels and were sufficiently 'oversold' in both nominal currency terms and gold terms to enable a multi-week rebound. There's a good chance that such a rebound will begin within the next seven trading days.

In our opinion, investors and longer-term speculators should be gradually averaging into high-potential gold and silver stocks. However, the idea of 'going long' for a short-term trade doesn't appeal to us at this time. The potential short-term reward is simply not attractive enough relative to the downside risk.

Currency Market Update

The Dollar Index moved to a new 2-month high last week before pulling back on Friday. As noted on the following daily chart, this is similar to what happened in June of 2008.

If the dollar's current bottoming process evolves in similar fashion to its 2008 bottoming process then we will see a pullback to around 74 over the next few weeks. That being said, there is no assurance that today's market will continue to track the 2008 pattern.

One alternative to the 2008 pattern is that the bottoming process is already complete. This would be signaled by consecutive daily closes above the 200-day moving average. Another alternative is that the Dollar Index's early-May low was only the short-term variety. This, we think, has the lowest probability of the three possibilities and would be signaled by consecutive daily closes below the May low.


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)

Clifton Star Resources (TSXV: CFO). Shares: 36M issued, 40M fully diluted. Recent price: C$2.13

In last week's Interim Update we said that the questions surrounding OSK's continuing involvement in the Duparquet project joint venture (JV) with CFO would be resolved, one way or the other, within the next four weeks. As it turned out, CFO's management brought the situation to a head by halting the stock last Thursday pending clarification of OSK's intentions. This essentially forced OSK's hand. The result: it was announced on Friday that OSK had terminated the JV agreement, thus removing the uncertainty that has been swirling around CFO.

CFO's stock price dropped on heavy volume following this news, but the magnitude of Friday's reaction was clearly mitigated by the weakness that had already occurred in anticipation of the news. Also, Friday's heavy volume and rebound from an intra-day low of C$1.86 indicates that the panicked liquidation of some traders was largely offset by the accumulation of others.

OSK's decision to exit the project is a short-term negative and a longer-term positive for CFO. The short-term negative is the damage to market sentiment stemming from the event. This damage is now fully reflected in the stock price. The longer-term positive is that CFO picks up a few million ounces of gold in Quebec at a cost of $10-$15 per ounce, by virtue of the fact that it ends up with 100% of the asset but has to fund future exploration.

Also of note is that even though OSK has decided to exit the JV, it is still obligated to provide CFO (at CFO's option) with up to $22.5M of unsecured debt financing on favourable terms. With this financing commitment and about $15M in the bank, CFO is well positioned to advance the project on its own.

Whether it will advance the project on its own or seek a new JV partner is unknown at this time. Our preference would be for CFO to 'go it alone' unless offered an attractive JV deal by Agnico Eagle.

With regard to CFO's valuation, here are our 'back of the envelope' calculations (the only type of value calculation feasible for exploration-stage miners):

  - Based on the current 5.2M-oz resource and drilling results, there is almost no doubt that CFO will establish a total resource of at least 7M ounces for the Duparquet project by this time next year. A 7M-oz resource in Quebec would typically be valued by the market at more than $100/oz, but due to the deposit's complexity we will assume that it attracts a valuation of only $50/oz. Assuming an increase in the share count to 45M and allowing $50M for payments to the original project vendors, we arrive at a valuation of $6.70 per CFO share. This, we think, is the moderately pessimistic case.

  - Allowing for an increase in the resource to 8M ounces and assigning $75 to each of these ounces results in a valuation of $12.20 per CFO share. This could be classified as the moderately optimistic case.

When a stock plunges in response to news, the stock price will often rebound and then decline to test or breach the news-related low. A test of last Friday's low is therefore a possibility, but we think it's more likely that the bottom is already in place.

    Candidates for new buying

Due to the market action of the past several weeks, every gold and silver stock that we follow at TSI is now at a level where new buying could be appropriate. However, in the current financial-market environment it makes sense for most new buying to be directed towards relatively low-risk situations. Along these lines, two TSI stocks that spring to mind are Northgate Minerals (NXG) and Orvana Minerals (TSX: ORV).

NXG should generate significant cash flow from its Australian operations during the second half of this year and will be bringing its Canada-based Young-Davidson project into production next year. It is now testing support near the bottom of its 20-month price range, which is a reasonable area for new buying.


ORV is in the process of commissioning a 100K-oz/yr mine in Spain and a 20K-oz/yr mine in Bolivia. Unforeseen problems often emerge during the first few months of a mine's life, but in ORV's case the risk is mitigated by management's track record of successfully bringing new mines into production. ORV ended last week at support.


    Energy Fuels Inc. (TSX: EFR). Shares: 124M issued, 142M fully diluted. Recent price: C$0.34

Due to the size, location and uncommonly-high grade of its deposit, Hathor Exploration (TSX: HAT) provides the lowest-risk exposure to in-ground uranium within the world of junior uranium stocks. However, HAT's price has moved back to where it was prior to the Fukushima disaster, so it is now expensive relative to many other junior uranium stocks.

At current prices, the best value that we know of within the ranks of junior uranium miners is offered by EFR. Due partly to negative sentiment associated with a legal challenge to the license for its proposed Pinon Ridge uranium mill, but mostly due to a general decline in demand for uranium-mining shares, EFR has continued to trend downward over the past two months and has now given back almost all of the gains made during the powerful 7-month rally that culminated in February.

With the exception of the aforementioned legal issue, the EFR story is progressing well on the ground. The stock should eventually reflect this progress, but a lot of patience is obviously required.

If you currently don't own any EFR shares then it would be reasonable to take an initial position near Friday's closing price of C$0.34.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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