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   -- Weekly Market Update for the Week Commencing 26th October 2009

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
(02-Sep-09)
Bullish
(12-May-08)
Bullish

US$ (Dollar Index)
Neutral
(28-Sep-09)
Neutral
(02-Sep-09)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(28-Sep-09)
Neutral
(09-Sep-09)
Bearish
Stock Market (S&P500)
Bearish
(21-Sep-09)
Bearish
(11-May-09)
Bearish

Gold Stocks (HUI)
Neutral
(20-May-09)
Neutral
(16-Sep-09)
Bullish

OilBullish
(14-Oct-09)
Neutral
(14-Oct-09)
Bullish

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

A mixture of inflation and deflation?

Despite what many analysts/journalists seem to believe, an economy cannot simultaneously experience inflation and deflation. And that's regardless of whether inflation and deflation are defined in terms of money supply, credit supply or purchasing power (the general price level). Saying that the economy can simultaneously experience inflation and deflation is akin to saying that the economy can grow at the same time as it is shrinking. It is, in our opinion, the most illogical stance a person could possibly take on the inflation/deflation issue.

People have undoubtedly been drawn to the idea that there is a mixture of inflation and deflation by the reality that some prices are rising while other prices are falling. However, regardless of whether the overall economy is experiencing inflation or deflation it will almost always be the case that some prices will be rising and other prices will be falling. For example, regardless of whether inflation is correctly defined as an increase in money supply or incorrectly defined as a decrease in money purchasing power, there has been a lot of inflation within the US economy over the past 15 years; and yet, computer prices in the US have been in a downward trend throughout this period. This doesn't mean that the US computer industry is experiencing deflation; it means that the rate of productivity growth within the computer industry has been high enough to more than offset the upward pressure on prices stemming from inflation.

Our point, in a nutshell, is that inflation and deflation are mutually exclusive economy-wide phenomena.

On a related matter, there will sometimes be a mixture of inflationary and deflationary FORCES within the economy. An example of a deflationary force is excessive debt and the associated potential for credit contraction. In fact, this is the only deflationary force of real importance. An example of something that is NOT a deflationary force, although it is often portrayed as such, is the downward pressure on the prices of some goods resulting from increased productivity (including the increased productivity of China's manufacturing industry). The inflationary forces are private-sector debt expansion via the banking industry, government-sector debt expansion via the private banks and/or the central bank, central bank manipulation of interest rates, the central bank's direct monetisation of assets, and the actions taken by central banks to 'manage' currency exchange rates.

Over the past 15 months a battle has been raging between the deflationary force of private-sector credit contraction and the inflationary forces of government-sector credit expansion and central bank monetisation. The inflationary forces are currently ascendant, and, in our estimation, will remain so.

The Stock Market

There probably won't be a large decline in the US stock market within the next 6 months. Both the 1937-1942 Model and the Early-1980s Model discussed in last week's Interim Update suggest that the upside potential from here is small, but that the market will spend many months forming a top before it establishes a clear downward trend. Also of significance is the monetary backdrop. Having learnt the wrong lessons from both the early-1930s collapse and the late-1930s relapse, Bernanke has all but guaranteed that monetary conditions will remain accommodative -- meaning a near-zero funds rate target and the continuing monetisation of debt securities -- for several more months.

The reason we are short- and intermediate-term bearish on the US stock market isn't that we think a large decline is likely and imminent; it's that we perceive small upside potential relative to downside risk. The stock market has risen on the back of expectations that the worst is behind the US economy and that global growth will be quite strong over the years ahead, led by the "emerging markets". In our opinion, these expectations will prove to be as wrong as they could possibly be, resulting in most equity and industrial-commodity markets eventually dropping back to their 2008-2009 lows in nominal currency terms and plunging to new multi-decade lows in gold terms. This is the downside potential; and although we don't expect that this downside potential will come to the fore prior to the second half of next year, the risk is that things will happen earlier/faster than we expect. It therefore makes sense to be very cautious and to avoid getting caught up in the 'economic recovery illusion', but we don't think it makes sense to bet heavily against the broad stock market at this time. To put it another way: hedging is appropriate, but large speculative bearish bets are not.

There's a good chance that the economic recovery theme will fall apart shortly after the Fed and its central banking cohorts begin to remove monetary support, which prompts the question: Why won't the Fed maintain monetary support indefinitely?

Because the Fed's job is to inflate the money supply whilst keeping inflation expectations in check. The second part of this job is very important, the reason being that if inflation expectations get out of hand then monetary inflation will become counter-productive (monetary inflation always acts counter to real economic progress, but we are referring, here, to the perspective of policymakers). Monetary inflation can be used to fund promises, buy votes and channel wealth to supporters up until the time that the masses wake up to what's happening, at which point the monetary injections start to cause immediate and disproportionately large increases in the WRONG prices (the prices of gold and credit, for example). The central bank must avoid this situation for as long as possible and at almost any cost.

This week's important US economic events

Date Description
Monday Oct 26
No important events scheduled
Tuesday Oct 27Case-Shiller Home Price Index
Consumer Confidence
Wednesday Oct 28 Durable Goods Orders
New Home Sales
Thursday Oct 29 Q3 GDP (prelim)
Friday Oct 30 Personal Income and Spending
Employment Cost Index
Chicago PMI
Consumer Sentiment

Gold and the Dollar

Gold

Gold's Fair Value

A well known gold-market analyst likes to calculate a "fair value" for gold by assuming that the percentage change in the gold price should approximate the percentage change in the money supply, which amounts to applying the simplistic "Quantity Theory of Money" (QTM) to the gold price. The reality, though, is that QTM creates a misleading picture of how changes in the money supply affect prices. It should not be applied to anything, including (especially) the gold market.

It is vitally important to understand that an X% increase in the money supply will NOT lead to an across-the-board X% increase in prices. The reason is that new money does not get evenly spread throughout the economy; rather, it enters the economy at specific points and benefits the first recipients at the expense of everyone else. Monetary inflation is, in effect, a means for stealing and redistributing wealth as opposed to a means for raising the average price level.

Due to the way it works, monetary inflation will lead to dramatic increases in some prices while other prices barely rise or perhaps even decline. The distortion of relative prices will, in turn, create major economic problems, and once these problems start becoming evident to the masses (including policymakers) the response will tend to be twofold. First, policymakers will try to mitigate the problems caused by monetary inflation by promoting even more monetary inflation. Second, the public will attempt to increase its savings, but due to the blatant efforts of policymakers to inflate their way out of the economic morass created by prior inflation it will begin to dawn on people that it is no longer prudent to save in terms of the official currency. At this point gold could become the focal point of the public's collective desire to save, resulting in a gold price that bears absolutely no relationship to the growth in the money supply.

A "fair value" for gold can't be determined based on changes in money supply, but the more general point is that there is no such thing as a fair value for gold. The whole concept of a fair value for gold is nonsensical, because value is subjective. If we had enough data we could perhaps conclude that over extremely long periods of time the gold price had tended to oscillate around a number determined by the difference between the change in money supply and the change in gold supply, but because the gold price has only been 'untethered' since 1971 we don't have anywhere near enough data to do such an analysis. Furthermore, even if we had enough data to do the aforementioned analysis it wouldn't lead us to a "fair value" for gold and it may not tell us anything about gold's future (since the future is not just an extrapolation of the past).

Although we shouldn't kid ourselves that it is somehow possible to calculate gold's "fair value", history does give us some clues as to what we can expect from gold over the coming decade. For example, the previous two secular bear markets in US equities have taken the Dow/Gold ratio down to 1, versus its current level of around 10. Financial-market history therefore suggests that gold has additional long-term upside potential of around 900% relative to the Dow Industrials Index. For another example, the following chart shows that the gold/TMS ratio (gold relative to the True Money Supply) was about 5-times higher at its January-1980 extreme than it is today.


Current Market Situation

Over the past 8 trading days the gold market has been consolidating in bullish fashion in the $1045-$1070 range. It appears to be readying itself for a move up to $1100.

Short-term support in the December contract lies at $1025.


On a short-term basis, silver is in a similar position to gold and will probably soon resume its advance.

Gold Stocks

Like gold bullion, the AMEX Gold BUGS Index (HUI) has spent the past 8 trading days consolidating in bullish fashion. Our guess is that the HUI will move up to around 475 within the next few weeks.


As we've mentioned numerous times, the rallies in gold and gold stocks over the past several months have had a lot more to do with US$ weakness than real strength. This is evidenced by the fact that gold bullion and most of the major gold stocks are yet to exceed their January-February highs in terms of currencies other than the US$. For example, the following chart of the C$-denominated shares of Kinross Gold reveals a February-2009 peak followed by about 8 months of consolidation.

The Kinross pattern is typical of what has occurred throughout the gold sector when performance is measured in C$ terms. The gold sector is yet to break out to the upside in terms of the Canadian currency, but the chart looks bullish because the post-February price action appears to be a base. The chart will retain a bullish tinge as long as K holds above C$20.

A solid daily close above C$25 would create a measured objective of C$33-C$34.


Thanks to the introduction of a new ETF, it will soon be possible for investors to obtain diversified exposure to the junior end of the gold mining universe without going to the trouble of selecting and following individual companies. The junior gold mining ETF will be managed by Van Eck Global and will trade in the US under the symbol GDXJ. The initial 38 components of GDXJ are listed HERE.

GDXJ will probably begin to trade within the coming two months. It should be of interest to investors who want exposure to the part of the stock market with the greatest long-term upside potential, but have neither the time nor the expertise to analyse individual stocks. It could also be a good trading vehicle, especially because it should be liquid enough to enable the effective use of protective stops.

Whether or not it will be appropriate to purchase GDXJ as soon as it begins to trade will be determined by the market situation at the time. 

Currency Market Update

The following chart shows that the Dollar Index is now almost as 'oversold' as it ever gets. In particular, the chart shows that:

a) The Dollar Index has reached the bottom of a moving-average envelope (the blue lines on the chart), and that every other time over the past 20 years when it reached a similar level it was close to at least a short-term low.

b) The Dollar Index's 250-day rate-of-change (ROC) (the green line in the bottom section of the chart) is about 2% from an extreme that, with one exception, has always marked an intermediate-term bottom. The exception was early-2003, when a drop by the 250-day ROC to -15% marked only a short-term bottom.


As noted in an earlier commentary, the main missing ingredient for a US$ bottom is a stock market peak. The following chart shows the strong positive correlation between the S&P500 Index and the euro, and thus reflects the strong inverse relationship that presently exists between the broad stock market and the Dollar Index.


It is quite possible that a multi-month topping process in the broad stock market will coincide with a multi-month bottoming process in the Dollar Index.

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)

Endeavour Financial (TSX: EDV). Shares: 96M issued, 131M fully diluted. Recent price: C$2.01

EDV gained 13% on Friday on high volume and is in the process of breaking out from the base that has formed over the past 12 months. As far as we can tell, Friday's surge was driven by news that the previously-announced deal to acquire 54% of Etruscan Resources had been completed.


Near Friday's closing price of C$2.01, EDV is still a good candidate for new buying because it remains very under-valued and is not technically 'overbought' on even a short-term basis. We estimate that the company's net asset value now exceeds C$3.00/share, so the stock is trading at a large discount to the underlying assets. Moreover, EDV will still have almost $100M in cash after paying for its Etruscan stake and is planning to use this cash to do similar value-enhancing deals over the months ahead.

    The Canadian 'Gassy' Trusts

In the 16th September Interim Update we said that the Canadian natgas-focused energy trusts included in the TSI Stocks List looked like they had completed, or were about to complete, major bottoming patterns. These bottoming patterns are now complete, thanks in part to news last Thursday that state-owned Korea National Oil had agreed to purchase Harvest Energy Trust (TSX: HTE.UN) at a 37% premium to its market price at the time. This news lit a fire under the energy-trust sector of the Canadian stock market.

We expect that the natural gas market will be very strong during the first half of next year, mainly because by that time the large decline in drilling activity that has occurred over the past year should be having its maximum effect on production. However, we know from the experience of the past 2 years that natgas producers are capable of quickly boosting supply in response to rising prices. Also, we expect that by mid-2010 the artificial economic rebound will have come to an end. Our current plan is therefore to make a complete exit from our 'gassy' trusts and other natural gas positions by around May of next year.

If the recent rally continues then an opportunity to begin the scaling-out process, or to do some selling with the aim of buying back following a pullback, could actually present itself within the next few weeks. In particular, we would make partial exits from trusts that rise sharply over the weeks ahead to near intermediate-term resistance levels. For example, the following charts of Peyto Energy (TSX: PEY.UN) and Penn West Energy (TSX: PWT.UN, NYSE: PWE) illustrate the recent upside breakouts achieved by these trusts and the intermediate-term resistance levels that lie at C$16 and C$24, respectively. Some selling would be appropriate if these resistance levels were approached within the next few weeks.




The one member of the TSI Energy Trust Index (TETI) that looks suitable for new buying at this time is Daylight Resources (TSX: DAY.UN). The following chart shows that DAY has only just broken above the top of its base and is a long way below intermediate-term resistance. Also of note is that DAY is trading at a comparatively low valuation (we estimate that DAY is presently being valued by the market at around $53,000 per BOE/d of production, versus the $77,000 paid by Korea National for HTE) and has a relatively secure yield of 10.4%.


Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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