-- Market Updates for 17th - 25th April 2011

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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)
Neutral
(07
-Mar-11)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(20-Sep
-10)
Bearish
(21-Mar-11)
Bearish
Stock Market (S&P500)
Neutral
(2
8-Mar-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)

Update #2, 24th April 2011

We began our travel-abbreviated 19th April market update by noting that there had been no evidence of changes in any short-term price trends since our preceding update. We could appropriately begin today's brief report the same way. However, while there is no evidence that any of the important trends have changed, the upward trend in the silver/gold ratio appears to be stretched to the breaking point. More on this below. 

As was the case with our 19th April note, we'll attempt to cover some of the recent significant developments and the current market situation in point form. Here we go:

1. Gold Bullion

In our 19th April posting we wrote:

"Gold's short-term price trend is still up and new highs are likely over the next couple of weeks, but our outlook for any market is determined by its upside potential relative to its downside risk, not by its likely future price direction. In our opinion, with its price having just reached $1500/oz gold's remaining short-term upside potential no longer exceeds its downside risk. We have therefore downgraded our short-term gold outlook from "bullish" to "neutral"."

Gold has since gained a little more ground. It is not yet 'overbought' and stands a good chance of moving to higher levels over the next couple of weeks, but we think that the remaining short-term upside potential is no more than $100 and that the short-term downside risk is now at least $100.

2. The Silver/Gold Ratio

Silver has continued its steep ascent relative to gold, enabling the silver/gold ratio to end last week at a new multi-decade high. The new high in the ratio means that new highs probably lie in the near future for both gold and silver. It also means that the ratio has become even more stretched to the upside. In fact, although the prices of silver and gold are still a long way below their January-1980 highs in real terms, by some momentum measures the silver/gold ratio is now almost as 'overbought' as it was in late 1979.

The final 2-3 weeks of the dramatic precious metals rally that ended in January of 1980 was characterised by strength in gold relative to silver, which created a bearish divergence between the silver/gold ratio and the gold price that signaled the imminent conclusion of the rally. As we've mentioned, the end of the current rally will likely be marked by either a sharp downward reversal in the silver/gold ratio or a bearish divergence lasting at least two weeks ("bearish divergence", here, means new highs in the gold price that are not accompanied by new highs in the silver/gold ratio).

By the way, we don't think that the current market situation is akin to the situation in late 1979. To put it another way, we don't think that either gold or silver is nearing the end of its long-term bull market. We'll deal with this in one of our next two commentaries, but gold's performance over the past two years relative to silver and commodities in general bears some resemblance to its relative performance during 1975-1977. If 2009-2011 can be likened to 1975-1977, then a massive advance in the gold price -- in nominal dollar terms and relative to most other commodities -- lies ahead.

Moving along, the direction of the silver/gold ratio over the past several months is consistent with the long-term relationship between this ratio and economic confidence (usually, silver does better than gold during periods when economic confidence is rising and the broad stock market is strong). However, the magnitude of the advance has gone beyond the bounds of normality due to silver becoming the focal point of inflation-induced speculation. In 1998-2000 it was the tech sector of the stock market, in 2004-2005 it was the homebuilding sector of the stock market, in 2007-2008 it was the oil market, and now it is the silver market.

We can be confident about HOW silver's parabolic advance will end (it will end in a spectacular decline), but we can't be confident about WHEN it will end. Our guess is that it will end by the middle of next month.

3. Gold Stocks

Gold stocks, as represented by the HUI, have continued to diverge bearishly from gold bullion. Of particular note, the move above $1500 in the gold price has not yet lifted the HUI above its highs of the past 6 months.

The recent bout of financial speculation has been focused almost exclusively on silver bullion. Gold has done quite well, but its advance has been methodical and mostly a reflection of the decline in the US dollar's foreign exchange value. Relative to currencies other than the US$, gold has generally been flat over the past 10 months. Moreover, there has recently been very little speculation in the shares of gold and silver miners. Even Silver Wheaton (SLW), a 'market darling' and one of the gold/silver sector's top performers over the past two years, has been flat in US$ terms since early December of last year and just hit a 52-week LOW in silver bullion terms.

The lacklustre price action of many gold and silver mining shares (especially gold mining shares) is causing the holders of these shares to become very frustrated. The frustration is understandable, but not useful. There is a chance that the speculative juices will soon begin to flow in the gold sector, leading to a large broad-based advance in share prices. However, given that the bullion rallies have gone as far as they have without generating widespread speculative enthusiasm for the associated mining stocks, it is a lot more likely that they will end before generating such enthusiasm. The mining stocks will undoubtedly have their 'day in the sun' within the next 12 months, but over the next three months they will probably continue to be unexciting except in cases where there is a very bullish company-specific development.

We have previously mentioned 670 as a short-term upside target for the HUI. This target still looks realistic, but it is only about 12% above the current price and probably now defines the HUI's maximum short-term upside potential. At the same time, we think that short- and intermediate-term downside risk is limited by support at 500-525. On a short-term basis, then, the risk and reward now appear to be roughly in balance. We have therefore downgraded our short-term gold stock outlook from "bullish" to "neutral".

4. This week's Fed meeting

As it turned out, Standard and Poor's decision to downgrade its outlook for US Federal government debt roiled the financial markets for about three hours, which in our opinion was about three hours longer than appropriate given the obvious incompetence and perennial tardiness of the senior credit ratings agencies. Who cares what S&P thinks?

Of greater significance, some Federal Reserve representatives have recently dropped hints that Quantitative Easing (QE) could be extended beyond June. These hints contradict the earlier hints from other Fed reps that QE would soon end. Therefore, the markets currently aren't sure what Fed actions they should be discounting. This means that the Monetary Policy statement due to be issued by the Fed on 27th April could provoke a sizable market reaction.

Will the master price fixers warn about the end of QE, or will they hint at the extension of QE? We continue to expect the former, but we wouldn't bet a lot of money on the outcome.

5. The tightening continues in China

The People's Bank of China (PBOC) continues to slowly, but relentlessly, tighten the monetary screws via increases in reserve requirements and interest rates. This tightening will eventually have a big effect on China's economy and on global financial markets, although it should be noted that China's money supply is still expanding at a rapid rate. Furthermore, the 16% year-over-year growth rate in China's M2 money supply dwarfs the current official deposit rate of 3.25%, meaning that real interest rates in China are still a long way into negative territory. In other words, monetary conditions in China are not as 'loose' as they were, but they are a long way from being 'tight'.

The tightening process will almost certainly continue...until something breaks.

6. The US Dollar

The dollar's downward trend extended through to the end of last week. The US currency is probably close to a bottom in terms of both time and price, but at this stage neither a bottom nor the start of a bottoming process has been signaled. The signal that we are waiting for: a downward reversal in the silver/gold ratio. 

7. JAG: The end of the disappointments?

Brazil-based gold producer Jaguar Mining (JAG) announced last week that its mines operated more efficiently during the March quarter and that it was on track to achieve its 2011 production forecast. This could mean that the company has finally 'turned the corner' from an operational perspective, although it will naturally take more than a single quarter of improvement to verify that this is, indeed, the case.

News of the improved operating performance prompted a quick-fire 20% gain in JAG's stock price. However, the valuation remains attractive and at Friday's closing price of US$5.94 the stock was still in the bottom quintile of its 2-year price range.

We think that JAG has a lot of upside potential as far as the coming 2 years are concerned, but it will probably take one or two more quarters of confirmed operational improvement to break the stock above resistance at US$7.50-US$8.00. Also, at current prices we think that Golden Star Resources (GSS) is better value than JAG.

Update #1, 19th April 2011

The short-term price trends that were in progress when we posted last week's Interim Update are still in progress. At least, there is no evidence that they have changed. There are, however, a few things worth commenting on. Here they are, in point form:

1. Gold Bullion

In last week's Interim Update we noted that the June gold futures contract had pulled back over the first three days of the week to 'test' the preceding week's upside breakout. This, we said, was normal price action. We also said that to avoid doing any damage to the technical picture, June gold should hold above $1440 on a daily closing basis.

As it turned out, support in the $1440s held and gold subsequently moved well into new-high territory. Last week's low of $1445 (basis the June contract) can now be used as a demarcation level, in that a daily close below this level would now confirm a trend change.

Gold's short-term price trend is still up and new highs are likely over the next couple of weeks, but our outlook for any market is determined by its upside potential relative to its downside risk, not by its likely future price direction. In our opinion, with its price having just reached $1500/oz gold's remaining short-term upside potential no longer exceeds its downside risk. We have therefore downgraded our short-term gold outlook from "bullish" to "neutral".

2. The Silver/Gold Ratio

The silver/gold ratio has continued its surge. In doing so it has reached a new 'overbought' extreme, but the fact that it is still making new highs almost every day means that new price highs for both gold and silver probably lie in the near future.

As we've said many times, the silver/gold ratio will likely provide us with the most reliable signal of a downward trend reversal -- by diverging bearishly from the gold price over a period of at least 2 weeks or by quickly declining by at least 7%. Such a signal hasn't yet been generated, but we suspect that it will be generated by mid May.

3. Gold Stocks

Over the past several trading days the gold and silver shares have generally been weak relative to the metals. We can only speculate as to the causes of this weakness.

We'll first note that the recent decline in the HUI/gold ratio is no greater than a routine fluctuation. In itself, it doesn't look meaningful. What lends it significance is that it was caused by the HUI consolidating below its high while the gold price moved well above its previous high.

Second, the bearish divergence in the gold-stock indices could be eliminated very quickly -- via a 2-3 day surge. In other words, it could turn out to be nothing more than a short-lived aberration.

Third, it should be noted that in many parts of the world the gold price has not recently made a new all-time high. For example, in Australian Dollar terms the gold price has been in consolidation for more than two years and in euro terms it has been in consolidation for about 10 months. At the same time, the cost of producing gold has been in an upward trend. To put it another way, the profit margins of gold producers in many parts of the world are currently well below their highs of the past two years.

Fourth, plenty of gold producers have failed to achieve their own production forecasts over the past year, so perhaps there are many situations where disgruntled shareholders are viewing any strength as a selling opportunity.

There are other possibilities, one of the least plausible of which is that short-sellers are to blame.

Whatever the reason for the weakness, if it persists -- and especially if it becomes more pronounced -- it should not be ignored. Rather than trying to explain it away, if such a divergence persists it would be prudent to view it as a legitimate warning sign until/unless proven otherwise. It should not be viewed as a warning that a 2008-style crash lies in the near future (the current monetary backdrop all but precludes such an outcome), but as a warning that gold and silver bullion are within a few weeks of intermediate-term peaks.

As things currently stand, the HUI has held support at 575-580 (on a daily closing basis) and many gold stocks are at levels where some buying would be appropriate for anyone who hasn't yet built a core position. Some of the best candidates for new buying amongst the stocks we follow are: GSS, CFO.V, PVG.TO, and RSG.AX.

On both a short- and intermediate-term basis, we are now more bullish on gold stocks than on gold bullion.

4. The Stock Market

The US stock market was very weak during the early going on Monday, but recouped enough of its losses by the end of the day to enable the S&P500 Index to hold above support at 1300.

There is no evidence yet of a trend change, but credit spreads have begun to widen and if they continue to do so it would be a clear warning that the broad stock market's upward trend was about to end.

5. A credit ratings agency becomes concerned about the US budget deficit

There was an announcement on Monday that one of the largest credit ratings agencies had changed its outlook on US federal government debt from "stable" to "negative". Despite the way it was played-up by the mainstream press, we don't think this outlook change is important. First, we doubt that any of the large investors in government bonds rely on the advice of ratings agencies. Second, it's likely that all large bond investors are well aware of the US government's financial situation.

In our opinion, relying on the ratings agencies to warn you about a debt problem would be akin to relying on the NBER (National Bureau of Economic Research) to warn you about a recession (the NBER typically announces recessions about 12 months after they start). 

6. Hathor Exploration (TSXV: HAT) buying Terra Ventures (TSXV: TAS)

HAT and TAS have agreed to merge, thus bringing 100% of the high-grade Roughrider uranium deposit under one roof (the Roughrider project is currently owned 90% by HAT and 10% by TAS). TAS shareholders will receive 0.20 HAT shares for each of their TAS shares, which represents a small premium based on pre-bid prices. 

This deal makes sense for the shareholders of both companies. It also makes HAT a more likely takeover target.

7. The lack of commitment to smaller government

We didn't say anything in TSI commentaries about the recent budget-related haggling between the two dominant US political parties, because we didn't think it was important. The amount of money being argued over was trivial compared to the Federal government's overall spending and liability levels, and it is obvious that neither party is in favour of reducing the size or reach of the government.

A related issue is that the the US voting public isn't really in favour of cutting back on government spending. To put it more aptly, most voters are only in favour of reducing the deficit as long as doing so doesn't shrink the major entitlement programs or boost their own taxes, which is the same as not really being in favour of reducing government liabilities by a meaningful amount. For example, consider these recent polling results from Bruce Bartlett at www.thefiscaltimes.com (with a tip of the hat to Barry Ritholtz at http://www.ritholtz.com/):

"An April 6 NBC News/Wall Street Journal poll found that 61% of people favor a balanced budget amendment to the Constitution, down from 71% in 1995. Support falls to 27% when people are told that this would require a 20% cut in entitlement programs."

"An April 4 YouGov poll found that an overwhelming majority of people favor large budget cuts. However, majorities also favor increased spending for education and medical research, and a strong plurality favor increased spending on clean energy technology."

"On March 9, the Harris poll found strong opposition to cutting Social Security or Medicare benefits to deal with the budgetary problems of those programs. People are also opposed to raising taxes to fund them."

"On March 2, a NBC News/Wall Street Journal poll found strong opposition to cutting spending for Social Security, Medicare, Medicaid, K-12 education, heating assistance for the poor, college student loans, Head Start, and unemployment insurance. There was majority support only for cutting nuclear power subsidies, aid to state and local governments, the EPA budget, and spending on transportation and infrastructure projects. The poll also found that 81% of people would support a surtax on millionaires to help reduce the budget deficit, and 68% would support eliminating the Bush tax cuts for those earning more than $250,000."

"On March 1, the Tarrance Group issued a poll which found that 63% of voters incorrectly believe that the federal government spends more on national defense and foreign aid than it does on Medicare and Social Security. Also, three-fifths of voters believe that the budget can be fixed just by eliminating waste, fraud and abuse."


Why would politicians be committed to substantially improving the fiscal position of the US Federal government when most of the people they represent aren't genuinely committed to this goal?

8. Unless something dramatic and unexpected happens in the financial markets within the coming three trading days, we will post our next brief market update on Sunday.

 



 
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