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   -- Weekly Market Update for the Week Commencing 24th May 2010

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
Bullish
(12-Apr-10)
Bullish
(12-May-08)
Bullish

US$ (Dollar Index)
Bearish
(19-May-10)
Bullish
(02-Nov-09)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(17-May-10)
Bearish
(14-Dec-09)
Bearish
Stock Market (S&P500)
Neutral
(09-May-10)
Bearish
(11-May-09)
Bearish

Gold Stocks (HUI)
Neutral
(19-Apr-10)
Neutral
(16-Sep-09)
Bullish

OilNeutral
(28-Oct-09)
Bearish
(01-Mar-10)
Bullish

Industrial Metals (GYX)
Bearish
(21-Sep-09)
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.

The post-bubble recriminations ramp up

Apart from the tiny fraction of the US population that understands economics, everyone was content while the private-sector credit bubble was inflating. The Fed chairman was hailed as a "maestro" for keeping interest rates at artificially low levels and thus ensuring that the prices of most investments -- especially high-risk investments -- remained on upward paths, while politicians of all stripes were happy that the market for home mortgages was the greatest 'beneficiary' of the Fed-sponsored inflation of money and credit. Actually, politicians didn't leave much to chance, in that regulations were passed to encourage the provision of mortgage-related credit to anyone with a pulse and government-sponsored enterprises (Fannie Mae, etc.) worked tenaciously to increase both the supply of and the demand for mortgages. The banking industry played its part to the hilt by inventing new ways to expand credit (think: Residential Mortgage-Backed Securities and Collateralised Debt Obligations), but it is important to understand that the banks would not have had an incentive to create these new credit-related products unless there existed huge demand for such products. The demand came from large investors -- hedge, bond and pension funds, for example -- that were desperately searching for yield in a world where yields had been kept artificially low by various central bank and government manipulations.

The main problem with credit bubbles is that they result in a massive transfer of resources to activities that would not be economically viable in the absence of the artificially low interest rates and the monetary inflation. Consequently, although they temporarily create the feeling of prosperity, they deplete real savings and lessen the economy's long-term growth potential. The recession or depression that inevitably follows the bursting of a credit bubble is caused by the ill-conceived investments made during the bubble rather than by the bursting of the bubble itself. Think of it this way: once the bubble bursts and the supply of new credit is curtailed, a light is suddenly shone upon the terrible mistakes that were made during the bubble.

During the giant credit bubble that ended in 2007, the banking industry made more than its fair share of investing errors and was thus eventually left with enormous holes in its collective balance sheet. Some of the largest US banks should have gone under, which would have resulted in the holders of bank equity losing all of their money and the holders of bank bonds losing most of their money. It would NOT, however, have resulted in bank depositors losing any of their money or in the cessation of the traditional banking businesses (the taking of deposits and the making of loans). Unfortunately, the government deemed that the banks were "too big to fail", and arranged for hundreds of billions of dollars to be siphoned from the rest of the economy to prevent the large banks from collapsing. Note that the banks were not actually "too big to fail". They should have failed, and the US economy would be in far better shape today if they had.

Further to the above, the banks certainly played a role in creating the current mess, but it was a supporting role. The lead roles were played by the government and the Fed. However, now we have the ridiculous situation of US policy-makers passing legislation that grants themselves greater power and crimps the activities of the banks, with the stated aims of mitigating the risk of another financial crisis and preventing banks from becoming "too big to fail". If they are serious about mitigating the risk of another financial crisis then they should pass legislation that abolishes the Fed and severely crimps the activities of the government.

The attacks on the banks are nothing if not predictable. Throughout history the ends of giant credit bubbles have invariably been followed by periods of recrimination, when politicians looked around for someone other than themselves to blame. In the current case the banking industry is the most logical target because it is blatantly obvious that the large banks have profited handsomely at the expense of taxpayers over the past 18 months. But isn't it bizarre that the finger of blame is being self-righteously pointed at the banks by the very same people who arranged or approved the gargantuan wealth transfer from taxpayers to banks?

Copper

In the 19th April Weekly Update, we wrote:

"Over the past year we have grossly under-estimated the upside potential of the industrial metals markets in general and the copper market in particular. We correctly anticipated strong post-crash rebounds, but the rebounds have gone on much longer and reached much higher levels than we thought they would.

After the fact it is usually easy for us to figure out why we under-estimated a market's upside or downside potential, but this isn't the case when it comes to the performances of copper and the industrial metals over the past 9 months. The reason is that prices have been rising in apparent defiance of bearish supply/demand fundamentals. In particular, the prices of these commodities have been rising in parallel with large increases in inventory levels."

We went on to suggest that the increasing supply of physical copper had been more than offset by increasing demand for copper futures, which, in turn, was likely linked to surging optimism about the global economy's growth prospects. We concluded as follows:

"We think that this optimism [about global economic growth] is misplaced, and, by extension, that there is large downside potential in the industrial metals markets. As things currently stand, however, we are lacking price-related evidence that this potential energy is about to be transformed into kinetic energy."

Some price-related evidence in support of our bearish outlook has since emerged, in that the copper price has quickly moved down from the $3.70s to the $2.90s. Refer to the following daily chart for details. This, we think, will prove to be the first leg of a downward trend that will continue until the final quarter of this year, at which time we may be presented with a good opportunity to buy copper and the stocks of copper miners.



FCX is the world's largest listed copper producer and is a good proxy for the copper-mining sector of the stock market. We mentioned FCX as a good put-option candidate when it was trading in the mid-$80s, and we continue to believe that it will be a leader to the downside over the months ahead. It is presently 'oversold' and will probably rebound over the next few weeks, but our thinking at this stage is that a recovery to the mid-$70s would create another good opportunity to buy FCX puts for hedging purposes.


The Stock Market

In the email alert sent in response to last Thursday's market action, we said: "With regard to the broad stock market, some technical indicators have returned to the extremes of 6th-7th May, which, in turn, were similar to the extremes reached between October of 2008 and March of 2009. This means that there should be an upward reversal within the coming three trading days."

The technical indicators we had in mind were the NYSE McClellan Oscillator (MO) and the percentage of S&P500 stocks trading above their respective 50-day moving averages. Charts of these indicators are displayed below. It is also worth mentioning that the VIX has surged to the mid-40s. This is well below its October-2008 peak, but prior to 2008 a rise in the VIX to near its current level usually coincided with a significant price low.




One thing we have sensed over the past 12 months is declining interest in the stock market on the part of the average non-professional investor. It seems that the sudden and dramatic changes of 2007-2008 caused many members of the investing public to realise that holding stocks "for the long run" could be a bad idea. Consequently, people who as recently as two years ago viewed the stock market as one of the surest ways to build wealth now view it with suspicion. Rather than looking for opportunities to invest more money in stocks, they are focused on increasing their cash savings. This, we think, could explain why the stock market now becomes so 'oversold' so quickly. Long-term 'buy-and-holders' have a diminishing presence, leaving short-term traders with greater influence.

Our expectation since the beginning of this year has been that 2010 would roughly adhere to the average for the second year of the Presidential Cycle, meaning an upward bias through to April followed by a downward trend through to early October and then a rebound into year-end. Such a pattern appealed to us because it meshed with the idea that by the second quarter of this year there would be undeniable evidence that the economic rebound had ended.

Up until now the US stock market has followed the Presidential Cycle pattern as closely as could reasonably be expected, and we see no good reason to believe that it won't continue to do so. The fact that the S&P500 traded below its 6th May intra-day low on Friday supports this view by confirming that there was more to the spectacular 6th May plunge than a simple error. Note, though, that even if the market is destined to make an important low in October, it could get from here to there via a number of very different routes. One possibility is that the market will 'stair-step' its way downward via a sequence of lower highs and lower lows over the coming 4-5 months, while a less straight-forward possibility is that the next rebound (the one that follows the current phase of the decline) will take the indices all the way back to their April highs. The market is certainly 'oversold' enough to enable a substantial rebound.

This week's important US economic events

Date Description
Monday May 24
Existing Home Sales
Tuesday May 25Case-Shiller Housing Price Index
Consumer Confidence
Wednesday May 26 Durable Goods Orders
New Home Sales
Thursday May 27 Q1 GDP (revised)
Friday May 28 Personal Income and Spending
Chicago PMI
Consumer Sentiment

Gold and the Dollar

Gold

The June gold futures contract tested support at $1160-$1170 on Friday. This is as low as it should go IF the short-term upward trend is intact.


In A$ terms, gold hasn't made a new high this year. However, the following chart suggests that gold/A$ remains in a long-term bull market. We expect that it will make a new high before year-end, courtesy, in part, to weakness in the A$.


Since 1990 (the period covered by the following chart), the gold/silver ratio has generally reflected the central-bank-driven boom/bust cycle. Specifically, the ratio has worked its way downward (gold has under-performed silver) during the booms and worked its way upward (gold has outperformed silver) during the busts.


We hope that things don't get bad enough over the years ahead to push the gold/silver ratio into triple digits, but they could. A triple-digit gold/silver ratio isn't probable, but it is possible. This is why we continue to advocate -- as we have consistently done over the past decade -- that investors substantially overweight gold relative to silver in their portfolios.

The argument in silver's favour is that it is a much smaller market than gold and at some point should therefore benefit to an even greater extent than gold from the general flight away from paper money. Of particular importance is the fact that the monetary value of silver's aboveground supply (in readily saleable form) is a tiny fraction of the monetary value of gold's aboveground supply.

Under certain conditions, however, the relatively small size of its market could work against silver. By way of further explanation, consider that if John Smith, a successful plumber, wants to buy $10,000 of precious metal as a store of value then he could opt for either gold or silver, but if John Paulson, a successful large speculator, wants to buy $10,000,000,000 ($10B) of precious metal as store of value then he must opt for gold (because gold is the only precious-metal market of sufficient size to handle such large changes in demand). Regardless of what happens there will always be some speculators with massive amounts of money to invest.

Gold Stocks

In the email sent to subscribers following last Thursday's plunge in the gold sector, we wrote:

"It's amazing what a difference four trading days can make. In the latest Weekly Update we noted that the HUI was 'overbought' (it was at the very top of its moving-average envelope and its daily RSI had just turned down from a high level), but just four trading days later it is already close to being 'oversold' on a short-term basis. This is thanks to a quick 12% decline.
 
This week's action confirms that the gold sector made an important peak earlier this month and is consistent with our expectation that the intermediate-term correction that got underway on 2nd December of 2009 will continue until October of this year. Of course, it won't continue in a straight line, and as noted above the HUI is almost 'oversold' on a short-term basis."

The following daily chart shows the HUI's rapid decline from the 490s to support in the 420s. It also shows that the daily RSI, which was above 70 during the week before last, has dropped to 40.

Friday's downward spike to 420 probably created a low that will hold for at least 1-2 weeks.


The gold sector's correction probably won't end until October, but the speed of the recent downturn opens up the possibility that the correction's price low will be put in place as soon as next month. Under this scenario, the October low would be a test of the June-July low, which would, itself, quite likely be a test of the February low.

The next chart shows the big picture. Specifically, it shows the HUI's progress on a weekly basis since the beginning of its long-term bull market.

Charts tell you what has happened in the past, not what will happen in the future. Future performance will be determined by fundamental factors and the extent to which those factors are discounted by current prices. For example, if we thought that governments and central banks were going to stop implementing policies that destroyed savings and the purchasing power of money, or that the likely extent of future policy-related damage had been fully discounted by the financial markets, then we would interpret the HUI's long-term chart as a giant "double top". However, what we actually think is that the policies of governments and central banks will get worse before they get better, and that the financial markets haven't yet come close to discounting the likely policy-related damage. We therefore interpret the HUI's price action from early-2008 through to the present as a giant base formation. Our best guess, at this time, is that the HUI will break upward from its base during the first half of 2011.

Finally, the RSI at the bottom of the following weekly chart suggests that the HUI is still some distance from being 'oversold' on an intermediate-term basis. We expect that the weekly RSI will drop to 40 or lower before the end of the correction.


Currency Market Update

The Euro

The anti-euro trade became extremely overcrowded, so now the euro is rebounding as speculators lock-in gains. This rebound could last 1-2 months and take the euro back to resistance in the low-1.30s, but we doubt that it will do any more than that.


The Australian Dollar

From the 8th March 2010 Weekly Update:

"...we think this currency [the A$] has almost as much downside risk today as it had two years ago, for the same reason (it has been pushed up to a dangerously high level by speculative/investment demand prompted by a rally in commodity prices). Perhaps it will do what it did during 2008 and continue to grind upward for a few more months before succumbing to the weight of its over-valuation, but we wouldn't bet on it.

The following chart shows that the A$ has had a slight downward bias since peaking late last year. If industrial commodity prices remain firm and the US stock market moves to a new 52-week high over the next few weeks then the A$ could move up to around 0.95, but there's a good chance that it will be trading a long way below its current level by the final quarter of this year."

The A$ ended up peaking at around 0.93 last month and has since dropped to 0.82 (see chart below). It could rebound over the next few weeks in parallel with rebounds in the prices of equities and industrial commodities, but is likely to trade much lower before year-end.

As an aside, gold mining companies with operations in Australia will benefit from a decline in the A$.


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)

Buying Opportunities

A good opportunity to buy gold-stock ETFs such as GDX and GDXJ hasn't yet arrived, but it is not too early for cash-rich speculators to be thinking about accumulating individual gold and silver stocks at the junior end of market. To mitigate risk, the buying should be spread over the several months.

As a general guideline, buying should be focused on stocks that are near, or below, their 200-day moving averages. In alphabetical order, some TSI stocks to consider at this time are: CAH.AX, CFO.V, DOM.AX, EDV.TO (or the EDV warrants - EDV.WT.A), FVI.TO, MFN, NXG, PEZ.TO, and RSG.AX.

    Khan Resources (TSX: KRI). Recent price: C$0.23

CNNC withdrew its bid for KRI late last week, causing KRI's stock price to plummet on Friday. Although this wasn't the reason cited, the actual reason for the withdrawal of CNNC's bid was most likely the uncertainty regarding KRI's ownership of the Dornod uranium project in Mongolia. This uncertainty has been caused by the blatant attempts of a Russian company to gain control of the project by political means.

There has been a surprisingly large reduction in KRI's cash position over the past 6 months, but the amount of cash on the balance sheet still amounts to about C$0.24/share. The value of a KRI share is now equal to this cash plus an option on the efforts of KRI's management to either re-establish rights to the Dornod project or obtain compensation for losing these rights. At the current stock price speculators would essentially be getting the aforementioned option for free.

If this situation had arisen a few weeks ago we would have suggested buying KRI at or below cash value as a gamble on the likelihood that there will end up being some monetary compensation for loss of its Dornod stake, but thanks to recent market action there is now more speculative merit to be found elsewhere. In particular, it doesn't make sense to deploy new capital in a high-risk uranium venture when relatively low-risk gold mining companies are going on sale.

Lastly, KRI's predicament underlines the risk of doing business in Mongolia. We will take this into account before buying or recommending any other mining stocks with substantial assets in Mongolia.

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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