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   -- Weekly Market Update for the Week Commencing 28th March 2005

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. Bond prices will move considerably lower (long-term interest rates will move considerably higher) during 2005. (Last update: 29 November 2004)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000. The rally that began in October of 2002 will end during the first half of 2005 and the October-2002 bottom (775 for the S&P500) will be tested during 2006. (Last update: 29 November 2004)

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 during 1999-2001. The first major upward leg in this bull market ended in December of 2004, but a long-term peak won't occur until 2008-2010. (Last update: 28 March 2005)

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 first quarter of 2005, but a long-term peak won't occur until 2008-2010. (Last update: 28 March 2005)

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Outlook Summary

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Bearish
(23-Mar-05)
Neutral
(6-Dec-04)
Bullish

US$ (Dollar Index)
Bullish
(20-Dec-04)

Bullish
(31-May-04)
Bearish

Bonds (US T-Bond)
Bearish
(09-Mar-05)
Bearish
(20-Sep-04)
Bearish

Stock Market (S&P500)
Bearish
(05-Jan-05)

Bearish
(05-Jan-05)
Bearish

Gold Stocks (HUI)
Bearish
(23-Mar-05)

Bearish
(01-Dec-04)
Bullish

General Commodities (CRB)
Bearish
(23-Mar-05)

Bearish
(23-Mar-05)

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 on which way the market will move or that we expect the market to be trendless during 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.

Revisions to Big Picture Views

We've made the following small, but significant, alterations to the big picture views included at the top of every Weekly Market Update:

1. For the dollar we've changed "The first major downward leg in this bear market will end during the first half of 2005..." to "The first major downward leg in this bear market ended during the first quarter of 2005..."

2. For gold we've changed "The first major upward leg in this bull market will end during the first quarter of 2005..." to "The first major upward leg in this bull market ended in December of 2004..."

3. For commodities (the CRB Index) we've changed "The first major upward leg in this bull market will end during the first half of 2005..." to "The first major upward leg in this bull market ended during the first quarter of 2005..."

In other words, we've made a partial alteration to the tense of the wording for our US$, gold and commodities views to reflect the likelihood that an important low is in place for the dollar and that important highs are in place for gold and commodities.

Commodities

From the 28th February Weekly Market Update: "In our opinion, what is presently underway is a final blow-off to the upside in the prices of some commodities and many commodity-related equities. It's impossible for us to confidently predict how much further these moves will go before the inevitable downturn gets underway, although our guess is that major peaks will be in place before the end of March. What we can say with confidence is that the decline that follows the speculative blow-off will take back all gains achieved during the blow-off stage plus a lot more."

We'll deal with commodities in more detail in this week's Interim Update and at this time will simply note that last week's breakdown in the bond/dollar ratio (discussed later in today's report) suggests that an intermediate-term peak is now in place.

The Stock Market

The stock market versus the dollar

...if the US$ continues to move higher -- we think it will, perhaps after consolidating its recent gains -- then the head-wind facing the stock market will become increasingly strong due to a contraction in global liquidity.

As mentioned on several previous occasions, our view is that a US$ rally represents a much greater threat to the US stock market than does a continuing fall in the dollar. The reason is that over the past 2-3 years a falling dollar has been synonymous with rising financial-market liquidity, a result of which has been that global stock markets in general and the US stock market in particular have had an INVERSE correlation to the Dollar Index. Therefore, if the US$ continues to move higher -- we think it will, perhaps after consolidating its recent gains -- then the head-wind facing the stock market will become increasingly strong due to a contraction in global liquidity. It is reasonable to expect that almost all shares would be adversely affected by such an outcome, but the commodity-related shares that led the market higher between the second quarter of 2003 and the first quarter of 2005 are likely to be amongst the biggest losers. The homebuilders and REITs are also likely to suffer large declines because they have been primary beneficiaries of the rising-liquidity backdrop.

Zooming in on the commodity-related equities, in many previous commentaries we've noted the strong positive correlation between the bond/dollar ratio (the T-Bond price divided by the Dollar Index) and the shares of mining companies. In order to illustrate this correlation we have, in the past, often compared the stock price of copper producer Phelps Dodge (PD) with bond/dollar, but for the sake of variety (the spice of life, it is said) we've decided to use BHP Billiton (NYSE and ASX: BHP) in today's chart comparison (see below). BHP is the world's largest mining company so it is a good proxy for the sector.

With reference to the below chart, at this stage the recent pullback in the BHP stock price doesn't look any different to the other pullbacks that occurred within the up-trend that began in May of last year. However, there's a good chance it will evolve into much more than just a routine 'pause for breath' because a) it was preceded by an accelerated advance (an upside blow-off), and b) we have just had the most significant downward move in the bond/dollar ratio since the beginning of April last year.


Current Market Situation

The NASDAQ100 Index (NDX) closed below important support at the end of last week, but not far enough below that this support level is likely to act as significant resistance should a rally get started in the near future. In our opinion a rebound is likely to begin within the next few days, but we doubt that it will get very far. The other rebounds that have occurred since early January have failed near the 50-day moving average, so if we make the assumption that an intermediate-term decline is in progress (a reasonable assumption, in our opinion) then this moving average will probably continue to act as resistance.


The oil market continues to be one of the two biggest short-term influences on the stock market, the other being interest rates. The oil price, however, is probably close to an important high, which means that the oil market has the potential to change from being a negative influence to being a positive one. A sharp decline in the oil price could result in quite a feisty recovery in the stock market, but given the technical damage that has been done over the past few weeks we suspect that even a drop in the oil price to the mid-40s wouldn't be sufficient to push the senior stock indices to new highs for the year.


Below is a chart showing the percentage of NYSE stocks above their 200-day moving averages. Over the past several years the major lows in the stock market have coincided with this percentage dropping to around 20 whereas last year's intermediate-term low coincided with a drop to around 45. At the end of last week 64% of NYSE stocks were above their 200-day moving averages, so although the market looks oversold on a short-term basis it does not yet appear to be close to an intermediate-term low.


This week's important US economic events

Date Description
Monday Mar 28
No significant events
Tuesday Mar 29
Consumer Confidence
Wednesday Mar 30
Q4 2004 - Final GDP number
Thursday Mar 31
Personal Spending and Income
Factory Orders
Friday Apr 01
Employment Report
Construction Spending

Gold and the Dollar

Gold Stocks

Intermediate-term Outlook

...nothing has yet happened to make us doubt our intermediate-term bearish view on the gold sector. ...strength or weakness in the gold stocks relative to gold bullion might not be as significant over the next few years as it was over the past few years...

We are long-term bulls on the gold sector but over the past four months our intermediate-term outlook has differed markedly from the outlooks of most other long-term gold bulls, the main differences being:

a) None of the other long-term bulls we know of have been seriously considering the prospect of the HUI dropping below its May-2004 low (164) during 2005 whereas we have considered a decline of this magnitude to be one of the two most likely outcomes (the two outcomes are re-visited later in this section).

b) Over the past few weeks the majority view has been that the gold sector had embarked on a major new upward leg, but at no stage during the fairly predictable bounce that began during the first half of February did we believe that this was a probable outcome. For example, in the 9th March Interim Update, with the HUI trading in the mid-220s, we said "...if we were forced to come up with a number we'd say the probability that a major new upward leg is currently underway is no more than 10%."

But regardless of how confident we are we always need to consider the possibility that we are wrong because there is always a significant degree of uncertainty when it comes to the future. Furthermore, there is always the possibility that the facts will change (we will be quick to alter any of our views if the facts no longer support such a view). With this in mind we described, in the 9th March Interim Update, two things that would potentially constitute significant-enough changes in the facts to cause us to upgrade our intermediate-term outlook on the gold sector.

The first of these potential 'outlook changers' was described as "confirmation of a weekly trend reversal in the HUI/gold ratio where such confirmation was defined as the Price Momentum Oscillator (PMO) moving above its 10-week moving average." The below chart, however, shows that the HUI/gold's weekly PMO has just turned down without crossing above its 10-week MA. This is evidence that the intermediate-term downward trend is still in progress.


The second potential 'outlook changer' was described as follows:

"...a sizeable pullback in the HUI -- to the low-200s, for instance -- that does not result in the HUI/gold ratio moving decisively below its 40-day moving average. This would be a bullish development because, as the following chart shows, during the previous major upward legs every test of the HUI/gold's 40-day MA was successful with solid breaks below the 40-day MA only ever occurring at the very ends of upward legs and during the intermediate-term corrections. That is, if HUI/gold were able to hold at or above its 40-day MA during the next significant pullback the pattern would be consistent with what was seen during previous upward legs. By the same token, a solid break below the 40-day MA by this ratio would be a very clear signal that the correction that began in December of 2003 was still in progress."

The HUI has since experienced a sizeable pullback and the following chart shows that this pullback has resulted in the HUI/gold ratio making a solid break below its 40-day MA. In other words, the action is consistent with our intermediate-term bearish outlook.


So, last week's confirmation of our intermediate-term bearish view means that the two scenarios outlined in previous commentaries continue to be the two most likely outcomes. The below chart, which was originally included in the 28th February Weekly Market Update, illustrates these scenarios. In both cases the correction extends well into the second half of this year, the difference being that under the "red scenario" the HUI remains within a wide range bounded by its May-2004 low and its Nov-2004 high while the "blue scenario" involves a drop to well below the May-2004 low.


The bottom line is that nothing has yet happened to make us doubt our intermediate-term bearish view on the gold sector. This doesn't mean, though, that we are necessarily going to be right (when it comes to the future we are always dealing in probabilities). What it does mean is that if we are right, and assuming we are correct to be long-term bulls, then our readers will hopefully be emotionally and financially prepared for what's in store. On the other hand, if it turns out that we are wrong to be intermediate-term bearish then anyone who pays attention to us will probably suffer an opportunity cost (they will make less money than if they'd remained fully exposed to the gold sector). The opportunity cost shouldn't be that great, however, because we won't stay bearish if the facts change.

On a side note, over the 3+ years that we've used the HUI/gold ratio it has proven to be a very good (the best, in our opinion) leading indicator of trends in gold stocks and gold bullion, and as long as it continues to work well we will continue to use it. It has worked so well because gold stocks have invariably demonstrated strength relative to the metal throughout the intermediate-term advances and relative weakness throughout the intermediate-term declines; however, if the current secular bull market in gold follows roughly the same pattern as the secular bull market of the 1960s and 1970s then this indicator's usefulness will decline over the coming years. To show what we mean by this we've included, below, a chart showing the BGMI/gold ratio (the Barrons Gold Mining Index divided by the gold price) from the beginning of 1964 through to the end of 1980. Notice that the major gold stocks represented by the BGMI dramatically out-performed the metal prior to 1968 and dramatically under-performed thereafter (the major gold stocks trended LOWER relative to gold during the great bull run of the 1970s). And notice, in particular, that during the final 3 years of the gold bull market (1977-1980) the BGMI fell by 50% relative to gold bullion.


We can think of a few reasons why the major gold stocks under-performed gold bullion during the 1970s. For one thing, by 1968 the stocks had been bid up to very high levels in anticipation of a large upward move in the gold price. For another thing, the supply of shares can be increased quickly and cheaply to take advantage of a bull market whereas increasing the supply of physical gold is a slow and costly process. Lastly, the general shift away from financial assets and towards tangible assets that occurred during the 70s would have favoured gold bullion over gold shares. The point is, it is not difficult for us to imagine something similar happening over the next few years because a) gold stocks were bid up to very high levels relative to the gold price during 2001-2003, b) brokerage houses and promoters will almost certainly be just as quick in the future as they have been in the past to increase the supply of shares to meet increasing demand, and c) there could well be another shift towards the added safety provided by bullion. Therefore, strength or weakness in the gold stocks relative to gold bullion might not be as significant over the next few years as it was over the past few years and investors who currently have a lot more invested in gold shares than in gold bullion should perhaps consider some re-balancing.

Current Market Situation

...even if NEM is headed towards new lows for the year (we think it is) a counter-trend rebound is likely to begin within the next few days.

In the Market Alert e-mail sent to subscribers after the close of trading last Tuesday we said "...there have been some convincing signals that the counter-trend rallies in gold and gold stocks that began during the first half of February have ended. In particular, the popular gold stock indices have broken support and the HUI/gold ratio has closed below its 40-day moving average. We are therefore going to change our short-term views on gold and gold stocks from "neutral" to "bearish". As far as the intermediate-term is concerned we remain bearish on gold stocks and neutral on gold (the stocks, in our opinion, have more downside risk than the bullion)." The e-mail has been archived at http://www.speculative-investor.com/new/email.asp.

The below chart shows that the Newmont Mining (NEM) stock price has dropped in almost a straight line over the past 11 trading days. However, markets almost never get from where they are to where they are going in a straight line so even if NEM is headed towards new lows for the year (we think it is) a counter-trend rebound is likely to begin within the next few days. Notice, for instance, that the decline from the mid-November peak was interrupted by two multi-week consolidations. A similar consolidation over the coming 2-3 weeks -- a likely outcome, in our opinion -- would result in the stock rebounding to $43-$44 before resuming its decline.


Current Market Situation (Gold and the Dollar)

With gold and silver having ended last week poised just above their respective 200-day moving averages it's likely that rebounds will begin very soon. However, we expect that both metals will move to new lows for the year at some point over the coming 2 months.

Below are daily charts of gold and silver futures. It looks like silver's failure to confirm gold's upside breakout in March was just as significant as its failure to confirm gold's downside breakout in February. Specifically, the ability of silver to remain above its January low when gold broke to new lows for the year in early February was a significant bullish divergence whereas the inability of silver to trade above its February high during the first half of March has proved to be a significant bearish divergence.


With gold and silver having ended last week poised just above their respective 200-day moving averages it's likely that rebounds will begin very soon. However, we expect that both metals will move to new lows for the year at some point over the coming 2 months.

Silver has more intermediate-term downside risk than gold and it will probably under-perform gold over the coming 12 months. However, it also has greater long-term upside potential. The key to successful trading and investing in silver is to NEVER buy during periods of strength. Instead, if you are a trader you should scale-in during the periodic sharp declines and scale-out during the sharp rallies. If you are an investor you should scale-in during the periodic sharp declines and just hold on for the ride. Our thinking has been, and continues to be, that silver will test its May-2004 low ($5.50) before this year is out, but that any price below $6.50 represents a reasonable entry level for long-term investors.

Below is a chart of the Dollar Index. The dollar closed decisively above its 50-day moving average and its early-March high at the end of last week, thus providing solid evidence that a secondary low is now in place. This doesn't mean that it will be onwards and upwards for the dollar over the coming weeks because following such a strong 5-day advance some consolidation would be normal. However, if the next leg of the dollar's advance has begun then the Dollar Index should not trade below its March low over the coming weeks/months.


In the 9th March Interim Update we said that a downturn in the A$ lasting at least one year and potentially as long as two years would likely soon begin, but that one final surge was possible. Last week's action suggests that a final surge is not going to occur and that a major peak is already in place.

Update on Stock Selections


  In our opinion, the best strategy to have at this time is one that involves gradually scaling into small-cap gold and silver stocks over the remainder of this year. We would focus on the small-caps because a lot more value can be found in this area of the market and, as a result, many of these stocks are likely to out-perform the bullion by a wide margin during the next multi-year upward leg in the secular bull market. On the other hand, large-caps such as NEM, as well as the stocks of popular mid-tier companies such as Goldcorp, Glamis Gold and Pan American Silver, are very expensive relative to current metal prices. As a result they might not out-perform bullion during the next multi-year advance. Therefore, rather than buy over-valued large- and mid-cap stocks investors who are uncomfortable owning the small-caps could consider focusing on exchange-traded bullion funds such as StreetTRACKS Gold Shares (NYSE: GLD), which is designed to track the bullion price, and Central Fund of Canada* (AMEX: CEF), a fund that owns gold and silver bullion. The major unhedged South African gold stocks -- Gold Fields Ltd and Harmony Gold -- are also worth accumulating on weakness because they offer substantial leverage to the gold price, but bear in mind that additional leverage is invariably associated with additional risk.

Getting back to the small-cap stocks, it is likely that most of these stocks will trade below their current prices before the next bull market gets underway. This is not a concern, however, if your plan is to average into positions over many months. In fact, after you've purchased an initial stake in a company you have positioned yourself in such a way that you have some coverage in case the stock price takes off but are hoping for additional weakness in order to reduce your average purchase cost. Remember, the idea isn't to buy at the absolute bottom because nobody knows, in advance, where the bottom is going to be. Rather, the idea is to accumulate stock when the risk/reward is very favourable and to build-up cash reserves when it is not. If you average into fundamentally-sound stocks when the risk/reward is favourable then you will often be doing your buying on either side of the ultimate bottom and will end up with an average purchase cost that gives you a good chance of achieving large gains.

Buying the stocks of those companies that have a lot of cash in their coffers can mitigate the risk associated with small-caps. As far as the exploration/development-stage gold and silver stocks in the TSI List are concerned, the ones that are 'cashed up' and are therefore going to be under no pressure to raise additional funds over the coming 12 months are CLG, DSM, FR (assuming its recently-announced financing is successfully completed), MRB, MVG, NG, and NSU.

Our guess is that the next tradable low (equivalent to the 8th Feb low) in the gold sector will occur during May. In anticipation of this event we will, over the next couple of weeks, mention some under-the-market buy levels for several of our favourite gold/silver stocks based on technical factors.

    *We like CEF because it provides exposure to silver as well as gold, but note that it sometimes trades at a large premium to its net asset value (NAV). If you are interested in building up a position in this fund then make sure you don't pay more than 3% above NAV. The premium/discount to NAV can be found at http://www.etfconnect.com/select/fundPages/sectors.asp?MFID=3653

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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