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   -- Weekly Market Update for the Week Commencing 23rd June 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
Neutral
(02-Jun-08)
Bullish
(12-May-08)
Bullish

US$ (Dollar Index)
Bullish
(16-Jun-08)
Bullish
(31-May-04)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(03-Mar-08)
Neutral
(19-May-08)
Bearish
Stock Market (S&P500)
Neutral
(02-Jun-08)
Bearish
(12-May-08)
Bearish

Gold Stocks (HUI)
Neutral
(02-Jun-08)
Bullish
(12-May-08)
Bullish

OilNeutral
(09-Jun-08)
Bearish
(22-Oct-07)
Bullish

Industrial Metals (GYX)
Neutral
(18-Jun-08)
Bearish
(09-Jul-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.

Newsletters

We hope that nobody expects TSI to be a 'one-stop shop' for all their investing/trading needs. For the $120/year ($2.30/week) that we charge it's not reasonable to expect us to provide coverage of everything, but even if we charged several thousand dollars per year, as some newsletters do, we still couldn't provide a service that fulfilled all needs.

In one respect, newsletter subscriptions are like stocks: you shouldn't put all of your eggs in one basket, but neither should you spread your eggs across a few dozen baskets. There is an optimum number of stocks to have in a portfolio, because: a) an investor should have a good understanding of the story behind each stock that he/she owns, so one limitation is the quantity of stocks that an investor is capable of understanding and closely following, b) the number of stocks should be large enough that a major problem with any single stock won't create a major problem for the overall portfolio, and c) the number of stocks should be small enough that a major success with a single stock will have a significant impact on the overall portfolio. This optimum number of stocks will vary depending on an investor's expertise and resources, but we suspect that for the average part-time non-professional investor the right number would be around 10, and certainly not more than 15.

In our opinion, when it comes to newsletter subscriptions the right number for the average part-time non-professional investor would be around 5, and certainly not more than 10. Different newsletters have different strengths and weaknesses (they all have some weaknesses) that should be taken into account during the selection process, but with 5-10 newsletter subscriptions an investor should be able to cover the bases that are most relevant to him/her. On the other hand, someone who subscribes to more than 10 services will probably end up with such a large amount of information, some of which will be conflicting, that the decision-making process will be made more difficult and prone to error. It has been demonstrated that once a certain information threshold is reached, getting more information becomes counter-productive. Furthermore, the information threshold is much lower than most people think.

By the way, when cutting back on your financial information intake the first thing you should consider doing is reduce the amount of time spent reading, viewing and/or listening to the mainstream financial news media. When you read newspapers or watch financial-news television you may feel like you are becoming better informed, but in reality you will usually be wasting your time. In general, the only value provided to the investor or trader by mainstream news services, be they in print form or some other form, is in assessing sentiment.

By selecting the right (relatively small) group of newsletters you should be able to obtain plenty of useful information in an efficient manner, but it's important to understand that even the best newsletters will never be anything more than resources for ideas. You can't reasonably expect to achieve excellent long-term returns by blindly following any newsletter; rather, it will always be totally up to you to take into account your own situation and to manage your own risk when deciding which ideas to act upon and the extent to which you act.

When going through the newsletter-selection process something to consider is whether a newsletter gives you ideas that you would never have come up with on your own and/or makes you see things in a different light. We get the impression that many people gravitate towards newsletters that reinforce their existing opinions, but a newsletter is of little value if it only tells you what you already THINK you know. For example, if you are absolutely convinced that the gold price is headed to the moon then the last thing you need is a newsletter that is forever bullish on gold.

With regard to specific newsletter suggestions, most of the ones we read and find useful are listed under "Newsletters and Market Advice" at http://www.speculative-investor.com/new/link.html.

Working off the excesses

Regardless of whether or not a huge run-up in price over a year or more constitutes a bubble, such run-ups are usually followed by bear markets, or periods of convalescence, lasting 1-3 years. The following set of charts shows two completed examples and one in-progress example of what we are talking about. The completed examples are the NASDAQ Composite Index, which peaked in March of 2000 and bottomed about 2.5 years later, and the homebuilding sector of the US stock market (represented on our chart by Toll Brothers (NYSE: TOL)), which peaked in July-August of 2005 and appears to have bottomed early this year. The in-progress example is China's stock market (represented on our chart by FXI), which peaked in October-November of last year.



The above charts show markets that were clearly in 'bubble territory' when they peaked. Working off the excesses that develop during a stock market bubble typically takes years of time and a price decline of at least 70%, but even when a huge run-up in price occurs within the context of a continuing bull market it often takes years of 'corrective activity' before the stage is set for the next major upward leg. A good example is provided by the junior end of the gold/silver sector as represented on the following chart by First Majestic Silver (TSX: FR).

We don't think FR was close to being in 'bubble territory' when it peaked in May of 2006, but the spectacular run-up to the peak set the scene for a very lengthy correction. While FR's stock price has been consolidating within a large contracting triangle over the past two years the company has been steadily increasing its production and in-ground resources, so much so that there is a lot more real value underlying an FR share today than there was at the May-2006 peak even though the stock price is now more than 30% lower. The correction could last a few more months, but the price pattern and the value accretion have put the foundations in place for the next major rally.



Currently, the oil market and the coal and fertiliser sectors of the stock market are likely in the late stages of price run-ups that will be followed by bear markets or very lengthy corrections.

Bond Market Update

The following daily chart shows that T-Bond futures have had a downward bias since mid January and have been trending lower within a well-defined channel since mid March. There isn't yet any chart-related evidence of a bottom, but the Commitments of Traders (COT) data have become decidedly bullish.



There is currently upward pressure on the T-Bond price (downward pressure on the T-Bond yield) due to the credit crisis, the stock market downturn and the economic slowdown, and downward pressure due to the inflation fears spawned by the gains in the prices of oil and some other commodities. The perceived inflation threat will probably outweigh the positive factors until evidence emerges that the oil market's upward trend has come to an end.

With the sentiment backdrop now clearly supportive of bonds it will be time to turn short-term bullish on this market as soon as resistance at 115 (basis the September T-Bond futures) is overcome or the oil price confirms a reversal of its trend by closing below $120.

The Stock Market

As evidenced by the following charts, the Dow Industrials Index and the NASDAQ100 Index (NDX) are in very different positions. Whereas the Dow has given back almost all the gains achieved since the mid-March collapse of Bear Stearns (the Dow ended last week within 1% of its March low), the NDX has experienced only a modest pullback from its recent high. The Dow's relative weakness is largely due to its exposure to financial companies (the NDX contains non-financial companies only).




Regardless of whether or not the Dow breaks to new lows for the year over the coming days, the US stock market is probably within a week or so of a short-term bottom. The reason is that sentiment is now very supportive. In particular, sentiment surveys and put/call ratios, while not yet at the extremes reached during the first quarter of this year, are now at levels typically associated with intermediate-term bottoms. Furthermore, the quantity of shares sold short by the public is higher now than it was at the March bottom.

The sentiment situation means that a short-term bottom is probably close in terms of time, although it doesn't necessarily mean that a bottom is close in terms of price. In other words, there's still sufficient downside risk to warrant a cautious stance.

This coming week should be very interesting because the Fed will be issuing its new monetary policy statement with the Dow near critical support, oil near its all-time high, and the gold price close to an upside breakout. The high oil price is the biggest short-term problem facing the stock market, so anything that takes the wind out of the oil market will probably be taken positively by the stock market. This means that an interest rate hike at this time will potentially give the stock market a boost as long as it prompts a rally in the US$ and a significant decline in the oil price. However, the Fed may not see it that way. This is a difficult situation for the price fixers at the Fed, but price fixers always end up in difficult situations so there's nothing untoward about that.

Before leaving the stock market it's worth mentioning that the HYG/LQD ratio has reversed sharply lower from the vicinity of last year's peak (refer to the following chart for details). As regular TSI readers would know, the HYG/LQD ratio is an indicator of what's happening to credit spreads (with a rising ratio being indicative of narrowing credit spreads) and tends to reverse direction a few weeks ahead of the stock market. That HYG/LQD made a new high for the year during the week before last suggests that the next downward leg in the equity bear market has not yet begun, but if credit spreads have returned to a widening trend (as indicated by a downward trend in HYG/LQD) then the next downward leg will probably begin a few weeks from now.


This week's important US economic events

Date Description
Monday Jun 23
No important events scheduled
Tuesday Jun 24
Consumer Confidence
Wednesday Jun 25 FOMC Policy Statement
Durable Goods Orders
New Home Sales
Thursday Jun 26 Q1 GDP (final)
Existing Home Sales
Friday Jun 27 Personal Income and Spending

Gold and the Dollar

Currency Market Update

Last week the Dollar Index retraced a bit more than half the gains it had made during the preceding week. It ended last week right at its 20-week moving average, meaning that things are delicately balanced as we head into a week that includes a Fed monetary policy statement.

According to the Fed Funds Futures market, which is almost always correct this close to a scheduled interest rate decision, there is almost no chance of the Fed altering its targeted rate at this week's meeting. However, we don't agree that a 25 basis-point rate hike is out of the question. Our view is that Bernanke and Co. may decide to go with a small hike at this time to demonstrate willingness to back-up their words with deeds. A 25 basis-point hike would only be a symbolic gesture because it would constitute a trivial increase in the price of bank credit, but as far as symbolic gestures go it would be quite effective. This is especially so because the market is not expecting it.

The Australian Dollar remains the one major currency not to show any real weakness relative to the US$. Even though the A$ won't signal a top until the September futures contract, a daily chart of which is displayed herewith, closes below 0.92, we think that a bearish A$ position is now a reasonable speculation. This is because the currency has risen for six days in succession and is poised just below resistance at 0.95. Either the US$ is about to resume its rebound, leading to significant weakness in commodity prices and a catch-up move to the downside by the A$, or the US dollar's rebound from its March low is over, in which case the A$ will soon move to new highs for the year. We think the former outcome is the more likely, but the main reason we are interested in speculating against the A$ at this time is that it wouldn't take much additional strength to prove us wrong (a daily close above 0.95 by the September contract would do it).

FXA put options can be used to speculate on an A$ decline, although these options are too thinly traded to be added to the TSI Stocks List.

Gold

Gold vs. Industrial Commodities

Gold trended higher against almost all industrial commodities during the liquidity contraction that extended from the final quarter of 2000 through to the third quarter of 2003, and then trended lower against almost all industrial commodities from the final quarter of 2003 through to the third quarter of 2005. Since September of 2005 an interesting pattern has emerged in that gold's trend relative to industrial metals has been the opposite of its trend relative to oil. The situation is illustrated by the following charts of the gold/oil and gold/GYX ratios (GYX is the Industrial Metals Index).




Gold is currently in an intermediate-term downward trend relative to oil and an intermediate-term upward trend relative to the industrial metals. The intermediate-term downward trend in the gold/oil ratio has led to the increasing popularity of the idea that oil is the new "anti-dollar" since this trend has occurred alongside a downward trend in the US dollar's exchange value. We think this idea will prove to be a passing fad, but in any case it has always been inaccurate to think of gold as the "anti-dollar". It is more correct to think of gold as the "anti-fiat-currency" because there will never be a large increase in the investment demand for gold as long as a high level of confidence is maintained in at least one of the world's two senior currencies. As things stand right now there is a general belief in the marketplace that the ECB will act to maintain the euro's purchasing power, which, we think, goes a long way towards explaining why gold is presently near an all-time low relative to oil.

The bottom line is that there will be no good reason for investors to shift en masse towards the only monetary commodity as long as the euro is perceived to be a high-quality alternative to the US$.

The current difference between gold's situation relative to oil and its situation relative to the industrial metals sector probably relates to the market's perception of supply constraints. Gold is never supply-constrained in the normal sense of the term in that new mine supply is always a trivial component of total supply. Furthermore, commercial consumption of gold is always a trivial component of total demand. As a result, gold's price is determined almost solely by changes in investment demand. The oil and industrial metals markets, however, tend to live from "hand to mouth" in that today's new supply is needed to satisfy current consumption. Over the past 1-2 years the general perception has taken root that oil is, and will remain, severely supply constrained (that its current supply is, and will remain, barely sufficient to satisfy immediate demand), whereas the perception has been that the supply of industrial metals is in an upward trend relative to the demand for these metals.

Even if the oil market remains supply constrained, two things are likely to happen. First, even the most solidly underpinned long-term bull markets periodically experience large corrections simply because the market goes too far towards discounting the bullish case, so a large oil-price correction will begin in the not-too-distant future. Second, cracks will begin to appear in the euro's bullish veneer. The euro is very over-valued relative to the US$, but fundamentally it is no better than the dollar.

Current Market Situation

The following daily chart shows that August gold ended last week at the top of its downward-sloping channel, meaning that any additional strength from here will generate an upside breakout. The AMEX Gold BUGS Index (HUI) is in a similar position.


Upside breakouts by gold and the HUI over the coming days would be 'buyable' signals given that the bullion and the major gold stocks are not close to being overbought, but how a speculator reacts to such signals should be determined by his/her current positioning. As mentioned in previous commentaries, our own portfolio has close to its maximum planned exposure to gold stocks in line with our bullish long- and intermediate-term views. We've also mentioned that shorter-term trading positions have not yet been established.

We don't intend to add shorter-term trading positions at this time unless there's a sharp sell-off. In other words, we probably won't take any action if an upside breakout occurs this week. However, if we did not already have substantial exposure to the gold sector then we probably would do some buying in response to a near-term upside breakout.

Gold Stocks

As we've noted in many previous commentaries, over the past couple of years Royal Gold (RGLD) has been a much better indicator of the overall gold sector than popular gold-stock indices such as the HUI and the XAU. The following chart shows that RGLD has been in consolidation since the first half of 2006. It also shows that within the long-term triangular consolidation pattern a shorter-term triangular pattern has been developing since the October of last year.

A daily close above $32 would break RGLD out to the upside from its shorter-term pattern and suggest that the longer-term pattern was coming to an end.

 

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)

Fortuna Silver (TSXV: FVI). Shares: 81M issued, 104M fully diluted. Recent price: C$1.92

At current prices FVI is one of the most obvious candidates for new buying in the world of junior gold/silver stocks. It has a lot of cash in the bank, a small silver and base metals mining operation in Peru that generates significant cash flow, and a much larger exploration-stage silver/gold project in Mexico (the San Jose project).

There should be positive news in the form of a scoping study and an updated resource estimate from the San Jose project within the next month or so, although the stock's near-term upside will probably be limited by the 10M warrants that expire in July (the exercise price of the warrants is C$2.30, so a move above 2.30 would likely prompt a substantial amount of selling).

Our view is that the downside risk is limited by support at around C$1.50 (see chart below). This support might be tested if there's a steep sector-wide sell-off over the next few weeks, but we wouldn't rely on being able to take an initial position at such a low level. Near Friday's closing price of C$1.92 it already has a very attractive risk/reward ratio.


    Red Hill Energy (TSXV: RH). Shares: 47M issued, 58M fully diluted. Recent price: C$0.62

As per the email sent to subscribers on Friday, we have exited Patriot Coal at a profit of 330%. This means that RH is now our sole exposure to coal.

RH has over 100 BILLION dollars of in-ground coal and a market capitalisation of only US$35M, so in a coal bull market it should be a good performer. As evidenced by the following chart it has, however, been a lousy performer.

We don't know of anything that RH's management could have done differently to create a more buoyant market for the stock. The main problem, we suspect, is that RH's coal is located in Mongolia. The Mongolian Government has done its utmost over the past year to discourage foreign investment in the country's mining industry, so much so that even Ivanhoe Mines (IVN.TO), a Mongolia-focused mining company led by one of the world's best stock promoters, has seen its stock price cut in half.

Due to its enormous upside potential we are going to persevere with RH. It's likely that the investment climate in Mongolia will improve, simply because if it doesn't there won't be any more investment.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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