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   -- Weekly Market Update for the Week Commencing 21st January 2008

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. (Last update: 22 August 2005)

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)

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 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 CRB Index, commenced a secular BULL market in 2001. The first major upward leg in this bull market ended during the second quarter of 2006, but a long-term peak won't occur until at least 2008-2010. (Last update: 08 January 2007)

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Outlook Summary

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Bullish
(19-Nov-07)
Bullish
(12-Nov-07)
Bullish

US$ (Dollar Index)
Bullish
(11-Jun-07)
Bullish
(31-May-04)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(02-Jan-08)
Neutral
(23-Jul-07)
Bearish
Stock Market (S&P500)
Neutral
(02-Jan-08)
Neutral
(26-Mar-07)
Bearish

Gold Stocks (HUI)
Bullish
(14-Jan-08)
Bullish
(14-Jan-08)
Bullish

OilBearish
(14-Jan-08)
Bearish
(22-Oct-07)
Bullish

Industrial Metals (GYX)
Neutral
(28-Nov-07)
Bearish
(09-July-07)
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.

Yearly Forecast

Included in TSI commentaries over the past two weeks were our 2008 forecasts for stocks, bonds, the US$, gold and gold stocks. We've consolidated these forecasts into a single document and posted it at http://www.speculative-investor.com/new/yearly.asp.

Bad Economics

...the smaller the eventual stimulus package the better because the less harm it will do

There's a lot of talk about trying to stave off a recession using a combination of monetary and fiscal stimulus, but you can't stave off a recession that began months ago. And in any case, how could a recession possibly be avoided, or even postponed, by creating more money out of thin air? (Regardless of whether the stimulus comes in the form of tax cuts or increased government spending or lower interest rates, it boils down to creating money out of thin air since there isn't an existing supply of spare money at the disposal of the monetary authorities). If it were possible to do so then no country would ever have to experience a recession since officialdom always has the power to increase the money supply.

The idea that the government and the central bank should take steps to increase the supply of money to counteract an economic slowdown is based on the Keynesian fallacy that recessions are caused by insufficient aggregate demand. Nothing could be further from the truth.

Recessions occur because the inflationary policies of the government and the central bank lead to the misdirection of investment, which, in turn, results in a lot of the wrong stuff being produced. Putting it another way, the problem revolves around the fact that inflation distorts price signals, thus causing investment to be directed in ways that would not be justified in the absence of the inflation. You can't fix this problem by creating more inflation, and yet more inflation is the solution being advocated by almost everyone!

All the central bank and government can reasonably hope to achieve by a so-called "stimulus package" is a reduction in the purchasing power of the currency. This may hoodwink some people into believing that things are getting better, but actually things will be getting worse because the new inflation will lead to another round of misdirected investment.

Strangely, considering the almost universal acceptance of the idea that a stimulus package is needed, the sorts of proposals that are being advocated to address the current downturn have been tested and fallen flat on their faces many times in the past. That is, it's not like there isn't a mountain of empirical evidence to back-up the theory that fiscal/monetary "stimulus" hurts more than it helps. In fact, we only have to look back to the early years of this decade to see just how 'effective' the combination of massive monetary and fiscal stimulus can be.

Massive stimulus in the form of slashed interest rates, substantial tax cuts and a dramatic increase in government spending was implemented during 2001 in reaction to the economic downturn that began with the bursting of the NASDAQ bubble the year before, but the US economy remained in recession until mid-2003 (the US Government claims that the recession ended in November of 2001, but real-world observations tell us that recession-like conditions remained until at least the middle of 2003). Furthermore, the strong downward trend in the US stock market persisted for almost two years following the implementation of the combined monetary and fiscal stimulus. The stimulus measures put in place to address the economic downturn that began in 2000 were, however, largely responsible for inflating the gigantic mortgage-lending bubble. And we can see how well that turned out!

Creating a lot of money out of thin air will always have the effect of pushing-up prices somewhere in the economy, but it can't stimulate real growth. As a result, the downturns in the stock market and the economy will run their natural courses regardless of whether or not a stimulus package is implemented. Actually, the smaller the eventual stimulus package the better because the less harm it will do.

Commodities

Base Metals Update

The LME copper inventory has begun to decline, perhaps due to re-stocking by China. Also, the copper market looks like it is about to return to a 'backwardated' state (the spot price has begun to increase relative to the 3-month futures price, indicating a tightening near-term supply/demand situation). These factors, along with the price action, make us short-term bullish on copper. However, the other base metals do not look as good. There are preliminary indications that the nickel market is turning the corner (becoming more bullish), but zinc and lead still look bearish.

Natural Gas Update

The natural gas (NG) price has perked up over the past few weeks on the back of a larger-than-expected reduction in the amount of NG in storage. According to the EIA's latest Weekly Natural Gas Storage Report, the current inventory level is 8.7% below last year's level. However, it remains 6.7% above the 5-year average for this time of the year.

If the NG inventory in the US falls even slightly more than expected over the next few weeks then a substantial price rise would be the likely outcome. This is due to the current structure of the NG futures market, as highlighted by the following sharelynx.com chart. The chart shows that the speculative net-short position in NG futures has just hit an all-time high, leaving the market acutely vulnerable to any bullish news and mitigating short-term downside risk.



We featured Daylight Resources (TSX: DAY.UN), one of the Canadian 'gassy' trusts in the TSI Energy Trust Index (TETI), as a buy in the 19th November 2007 Weekly Update when it was trading at C$6.55. Our conclusion, at that time, was that the trust's distribution yield of 18.3% was unreasonably high given that there didn't appear to be much risk of a distribution cut. DAY.UN has since risen to C$7.53, reducing its yield to 15.9%. This, however, still appears to be an unreasonably high yield considering that the trust's payout ratio is a very low 43% (a low payout ratio reduces the risk of a distribution cut).

When we compare DAY with other trusts we come to the conclusion that its yield should be around 14%, meaning that its price should be around C$8.50. It therefore still looks like a strong buy in the C$7.50s or lower.

Palladium

The palladium market is an enigma in so much as the main use of palladium is the same as the main use of platinum (the demand for both metals is driven primarily by their use in auto catalysts), and yet palladium is currently priced at only $375/ounce while platinum trades at more than $1500/ounce. This huge price discrepancy is strange, to say the least, and suggests huge upside potential for palladium, but there's no telling how long it will take for this upside potential to be realised.

The price discrepancy between palladium and platinum appears to be related to the Russian stockpile of palladium in that the continuing release of metal from this stockpile is keeping the market in surplus. Unfortunately, the size of the stockpile is a well-kept secret, as is the plan of the Russian insiders who control the release of the metal into the world market.

That having been said, palladium's weekly price chart (see below) has a bullish tinge courtesy of a sequence of rising lows within the context of very lengthy consolidation pattern. More often than not, patterns such as this end via upside breakouts.



One way to 'play' the potential for an upside breakout in the palladium price is via North American Palladium (AMEX: PAL, TSX: PDL), a stock that we mentioned as a trading opportunity in the 2nd January Interim Update. PAL is still at roughly the same price (US$3.70-3.80) and still looks like a reasonable trade.

Also, those willing to take-on more risk in exchange for a potentially greater reward could consider the PAL warrants (AMEX: PAL.WT, TSX: PDL.WT). These warrants have a strike price of US$5.05 and an expiry date of 13th December 2009. At the current stock price of US$3.76 we estimate the fair value of the warrants to be US$0.65-0.75 (they closed at US$0.65 on Friday).



Uranium

The uranium price has been steady at around $90/pound for more than two months. By historical standards this is a very high price and should be supportive for the stocks of uranium-mining companies, but this hasn't been the case as most uranium stocks have remained under pressure. For example, the following chart shows that the stock price Uranium One (TSX: UUU), a fast-growing mid-tier uranium producer, has dropped back to near its lows of the past two years.



We have been anticipating a strong rebound in the uranium sector from a Q4-2007 low to around April of 2008 due to a) the resilience of the underlying commodity market, b) the fact that the huge decline in this sector from its Q2-2007 peak has created significant value and caused most uranium stocks to become dramatically oversold, and c) the cyclical/seasonal tendencies of the sector. The start of this rebound has been delayed by the weakness in the broad stock market and the associated market-wide increase in risk aversion, but with the overall market now primed for a rebound of its own we will hopefully get some strength in the uranium stocks over the coming 1-2 months.

As far as new buying is concerned, our preferences at this time are Uranium One (TSX: UUU) and Energy Fuels (TSX: EFR).

The Stock Market

Considerable technical damage has occurred in stock markets throughout the world. For example, the following chart shows that France's stock market has clearly broken a multi-year upward trend and is now trading at its lowest level since September of 2006.


The downside breakout in France's CAC40 Index creates a technically-based target in the low-4000s, or almost 20% below the current level. There are other markets, however, that could be much closer to their ultimate correction (or bear market) lows. For example, we noted in last week's Interim Update that as a result of its recent plunge the downward move in Hong Kong's Hang Seng Index was very likely at least two-thirds complete. There is also a reasonable chance that Japan's stock market is close to its ultimate correction low.

Unlike many other stock markets, which only entered correction mode over the past few months, the following chart of EWJ (iShares Japan) reveals that the Japanese stock market has been consolidating since May of 2006. In other words, the correction (or cyclical bear market) in Japanese equities is already quite 'long in the tooth'. Furthermore, there was an impressive upward reversal in the Nikkei225 Index on Friday and EWJ has just rebounded from near long-term support.

It will be difficult for Japan's stock market to make much headway until after the US stock market reaches an intermediate-term bottom, but for valuation and technical reasons we think the Japanese market will end the year with a solid gain.


As far as the US stock market is concerned, sentiment continues to hit the sorts of pessimistic extremes that are seldom seen. For instance:

1. The 10-day moving average of the equity put/call ratio ended last week at 0.85, which is the highest reading since Feb-2003 and is only slightly lower than it was near the major bear market bottom of Oct-2002. In fact, over the past 10 years the 10-day moving average of the equity put/call ratio has only been significantly above its current level on two occasions -- Feb-2003 (a few weeks prior to the start of a multi-year bull market) and Sep-2001 (at the completion of the terrorism-related market collapse).

2. The proportion of NYSE stocks above their 200-day moving averages has dropped to within a few percent of where it was at the bottom of the 2000-2002 bear market.

3. The proportion of NASDAQ stocks above their 200-day moving averages is now as low as it was at the bottom of the 2000-2002 bear market.

Given the news backdrop and the likelihood that the news will become even worse it is very easy to be bearish at this time. However, sentiment indicators warn that a large proportion of market participants have already acted in anticipation of worse news. This leaves the market vulnerable to a positive surprise and creates a certain amount of immunity to additional negative developments in the short-term.

We continue to think that a multi-week rebound will soon begin in order to alleviate the extremely oversold condition that now prevails, after which there will probably be a decline to new lows. It's possible that the ultimate correction low will not be far below the current level, but the risk of a much larger decline prevents our short- and intermediate-term outlooks for the US stock market from being any better than "neutral" despite the oversold extreme currently being registered. The risk is that we are now at the equivalent of mid-March 2001, and that a 1-2 month rebound will be followed by a much larger decline.

Note that there will almost certainly be a 50-basis-point official rate cut in the US within the next several days. For the reasons discussed earlier in today's report this won't have a significant REAL effect on the US economy, but it could be the catalyst for the multi-week rebound we are anticipating.

A favourite leading indicator outlives its usefulness

For many years the NDX/Dow ratio (the NASDAQ100 Index divided by the Dow Industrials Index) was our favourite indicator of the US stock market's intermediate-term trend. What we liked so much about this indicator was its uncanny ability to reverse direction well in advance of a trend change in the broad market.

Unfortunately, NDX/Dow appears to have outlived its usefulness as a LEADING indicator. We say this because, as evidenced by the following weekly Decisionpoint.com chart, it has only just confirmed a downward reversal. In years gone by this type of signal would have occurred 1-3 months PRIOR to an intermediate-term peak in the S&P500 Index, but in this case the signal has been generated well into an intermediate-term decline.


NDX/Dow used to be such a good leading indicator because large-cap tech stocks -- the types of stocks that dominate the NDX -- were widely considered to be more risky than large-cap stocks in general. This meant that when market participants started to become more risk averse, which is something that almost always happens prior to the end of an intermediate-term advance in the broad stock market, the NDX would start to weaken relative to the Dow. Now, however, large-cap tech stocks are widely considered to offer relative safety, while financial stocks such as banks are considered to be high-risk (there are no financial stocks in the NDX). As a result, the first few months of the stock market downturn that began last July were characterised by STRENGTH in the NDX relative to the Dow.

This week's important US economic events

Date Description
Monday Jan 21
US markets closed for MLK Day
Tuesday Jan 22No important events scheduled
Wednesday Jan 23 No important events scheduled
Thursday Jan 24 Existing Home Sales
Friday Jan 25 No important events scheduled

Gold and the Dollar

Gold

We wouldn't have a care in the world with regard to gold's prospects over any timeframe if not for the current absurd euro optimism. The euro's fundamentals are no better than those of the US$, yet the euro trades at a huge premium to the US$. This creates a short-term risk for the gold market in that many speculative long positions in gold are predicated on the belief that the US$ will continue its relentless decline against the euro. So even though a US$ rebound against the euro SHOULDN'T be a significant negative for gold if it is driven by euro weakness rather than genuine US$ strength, it probably would be a significant negative due to current market psychology.

Below is a picture of gold's bull market in euro terms. Based on the way the market traded once it broke out to the upside in 2005, the extent of any pullback in the near future should be limited by support defined by the November peak (575 euros) and the 50-day moving average (566 euros and rising). That is, in euro terms the short-term downside risk appears to be no more than 3-4%.


In US$ terms, we've previously noted that short-term downside risk should be limited by support at $850-$860 (basis the February futures contract). This also implies short-term downside risk of 3-4%.

Gold Stocks

We had expected that a break by the HUI above resistance at 463 would be followed by a surge to 480-500 and then a pullback to the 450s. However, the gold sector has continued on its extra-volatile way and actually traded as low as 423 on Friday morning after trading as high as 489 just 4 days earlier. Friday's low might have to be tested at some point over the coming fortnight, but in price terms the pullback could essentially be complete even though it only commenced last Monday.


A significant plus for the gold sector over the past two weeks has been the emergence of more evidence that gold has embarked on a new intermediate-term advance relative to oil. The evidence we are referring to is the break above resistance illustrated by the following chart of the gold/oil ratio. Oil is a major cost to gold-producing companies so a higher gold/oil ratio means higher profit margins for gold producers.


The following chart tells a story that we wouldn't have thought possible had we not watched it unfold with our own eyes. The chart reveals that Gold Fields Ltd. (NYSE: GFI), the best-managed and most under-valued of the major South African gold stocks, has trended LOWER since May of 2006 in parallel with a powerful UPWARD trend in the Rand-denominated gold price. In fact, since May of 2006 there has been a 42% rise in the Rand gold price and a 37% FALL in the Gold Fields stock price.


It will be interesting to see GFI's Q4-2007 financial results, due at the end of this month, and the Q1-2008 results, due to be reported at the end of April. Based on what has happened to the Rand gold price, the Q4-2007 results should reveal strong profit growth and the Q1-2008 results should be much better again. If this does not prove to be the case then we will probably give up on GFI.

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)

Australian Gold Stocks

We remain comfortable with our two Australian-listed gold stocks, even though neither of them has done very much as of yet.

Resolute Ltd. (ASX: RSG) is the most under-valued soon-to-be mid-tier gold producer we know of. Its annual gold production is expected to double from 250K to 500K ounces once the Mali-based Syama gold project comes on line towards the end of this year, meaning that at Friday's closing price of A$2.03 it is being valued by the stock market at less than US$1000 per ounce of production. This is less than one-third the industry average.

Investors are obviously sceptical regarding RSG's ability to achieve the planned production and cost figures for Syama. This means that the most likely catalyst for a major upward re-rating of the stock is evidence that Syama is performing as planned, or the removal of the risk-related discount as Syama gets closer to production.

In addition to the growth potential offered by Syama, RSG has stakes in a number of very interesting exploration-stage projects for which it currently gets almost no credit.

From a technical perspective (see chart below), the stock has short-term resistance at around A$2.10 and solid support in the A$1.60s.


Lion Selection (ASX: LST) is a company that owns stakes in several small-cap miners and also owns 30% of the Cracow gold mine in Queensland. At Friday's closing price of A$1.61 it was trading at a discount of more than 20% to its net asset value (NAV).

Although its current discount is excessive, it is quite common for investment companies such as LST to trade at discounts to their NAVs. It's possible, however, that early this year LST will have the opportunity of evolving into an operating company by purchasing the remaining 70% of the Cracow gold mine. We are not relying on this opportunity coming to fruition, but if it does then the market will be forced to change the way it values LST and the stock should experience a substantial upward re-rating (profitable gold-mining companies tend to trade at sizeable premiums to NAV).

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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