<% 'pass = Request.Form("pass") IF ((Request.Form("pass") = 1) OR (Session("pass") = "pass")) THEN %> Speculative-Investor.com
   -- Weekly Market Update for the Week Commencing 29th October 2007

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)

Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

Outlook Summary

Market
Short-Term
(0-3 month)
Intermediate-Term
(3-12 month)
Long-Term
(1-5 Year)
Gold
Neutral
(15-Oct-07)
Neutral
(15-Aug-07)
Bullish

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

Bonds (US T-Bond)
Bullish
(22-Oct-07)
Neutral
(23-Jul-07)
Bearish
Stock Market (S&P500)
Neutral
(29-Oct-07)
Neutral
(26-Mar-07)
Bearish

Gold Stocks (HUI)
Neutral
(29-Oct-07)
Neutral
(15-Aug-07)
Bullish

OilBearish
(23-July-07)
Bearish
(22-Oct-07)
Bullish

Industrial Metals (GYX)
Bearish
(11-Jun-07)
Bearish
(09-July-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 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.

Fed Speculation

The strong 10-week rallies in gold, gold stocks, oil, the Hong Kong stock market, some NASDAQ100 components, emerging market equities and ocean shipping rates (the Baltic Dry Index) are all linked: to weakness in both the US$ and the Yen relative to the euro. The rubber band appears to have been stretched almost to the breaking point as representatives of the US Monetary Politburo (the Fed) get ready to meet. The official results of their meeting will be announced to the world on Wednesday afternoon.

A 0.25% rate cut is 'baked into the cake' in that almost everyone expects the official interest rate target to be reduced by at least this amount. If the markets that have been moving relentlessly higher over the past couple of months stay on their upward paths during the first half of this week then they will probably pull back if the Fed does no more than cut by the widely anticipated amount, but there really shouldn't be a big reaction to a 0.25% cut. However, there will almost certainly be a big reaction if the Fed does anything other than cut by 0.25%.

Given what has happened to the prices of gold and oil since the Fed last surprised the markets with a larger-than-expected rate cut we find it hard to believe that Bernanke and Co. will do the same again. Although a 0.50% rate cut might appear to be justified based on what's happening in the US housing market, cutting by this amount would be an act of monumental stupidity because it would be more likely to hurt than help this downtrodden sector of the US economy. The reason is that the resultant additional gains in gold and oil prices would put downward pressure on the bond market, thus pushing bond yields (and mortgage payments) upward.

We also find it hard to believe that Bernanke and Co. will leave the official interest rate unchanged because it should be clear to them that doing so would cause the stock market to plunge.

Our view is that the Fed will do the expected (cut by 0.25%), prompting sell-the-news pullbacks in the markets that have recently been strong.

The Stock Market

The Dichotomy

Valuations in the US stock market are generally nowhere near as stretched today as they were when the great 'NASDAQ bubble' was approaching its peak during the first quarter of 2000, but in one respect the current situation is similar in that there are huge disparities between the performances of different sectors of the market. Back in 1999-2000 a mania was underway in stocks related to tech, telecom and the internet (the so-called "new economy" stocks) while stocks considered representative of the "old economy" languished. This disparity was subsequently corrected in spectacular fashion between March of 2000 and October of 2002.

The current disparity involves the bidding-up of some stocks/sectors as if several years of rapid growth lay ahead of us, and the simultaneous shunning or selling of other stocks/sectors as if the economic future were guaranteed to be sub-par. For example, Research In Motion (RIMM), a maker of mobile communication devices, just became Canada's largest company by market capitalisation thanks to being valued at a mind-boggling 78-times earnings and 15-times revenue. It could reasonably be argued that RIMM should be valued far more highly than, say, loss-making homebuilders or companies heavily involved in the trouble-infested mortgage industry, but why should it trade at 5-times the valuation of Texas Instruments (TXN)? TXN recently announced financial results that were below the market's expectations, but TXN's profit margins are similar to those of RIMM. Furthermore, TXN makes the chips that go into mobile communication devices and is, in effect, serving the same consumer demand as RIMM.

Another good example of the current valuation dichotomy within the stock market can be found by comparing Amazon.com (AMZN) with Walmart (WMT). AMZN's valuation is MUCH lower today than it was back in 1999-2000, but it is still nonsensical. AMZN is a mid-sized low-margin retailer getting valued by the stock market as if it were a tech stock with Microsoft-like profit margins and market share. In fact, in valuation terms AMZN trades at a 500% premium to the world's leading retailer (WMT) despite having LOWER profit margins than the market leader. If WMT deserves to trade at a low valuation on the basis that high energy prices and the downturn in the housing market are going to crimp its growth, then so does AMZN.

Today's valuation dichotomy is more complicated than the one that existed near the peak of the NASDAQ bubble. Back then the market drew a clear line between the so-called "old economy" and "new economy" sectors, with moderate valuations automatically being assigned to the former and stratospheric valuations automatically being assigned to the latter. There's now a lot more inconsistency, with fewer stocks being assigned the stratospheric valuations and these speculative favourites being more unevenly spread through the market. As a result, some stocks look as risky now as they did back in the halcyon days of the tech/telecom/internet bubble, but the overall market risk appears to be a lot lower.

So, would we be looking to go 'short' the current speculative favourites -- stocks such as RIMM, AMZN and GOOG -- that have been bid-up to absurd levels? The answer is no; not unless we had good reason to believe that a stock priced for spectacular growth was about to report an unexpected decline in its growth rate. Something to bear in mind is that reality always wins-out in the long run, but in the short run it's the combination of perception and sentiment that matters most; and when the stock market gets the 'bit between its teeth' there's no telling how high is too high.

Instead of shorting the current speculative favourites we would be more inclined to look for opportunities to go 'long' the stocks with catch-up potential. We are thinking, here, of stocks such as MSFT and INTC -- stocks that are certainly not under-valued in absolute terms but are at bargain-basement levels relative to the current favourites.

Current Market Situation

In last week's Interim Update we noted that Wednesday's capitulation in response to Merrill Lynch's $8B write-down in the value of its mortgage-related securities had the look of a selling climax and, therefore, that the financial sector of the market was probably close to a short-term bottom. Friday's 8.5% rise in Merrill Lynch (MER) and 32% moon-shot in Countrywide Financial (CFC) lend some support to this idea. We are mindful of the fact that bear markets tend to be littered with very sharp 1-2 day rallies, but the stock market has spent the bulk of this year factoring the mortgage mess into the prices of financial stocks so unless the news backdrop quickly becomes even worse then the downward pressure on these stocks could abate for a while.

The financial sector's recent selling climax is one positive. Another is the marked improvement in the sentiment backdrop over the past two weeks, as evidenced by: 1) a substantial shift in the put/call situation (after generating a sell signal just two weeks ago our put/call indicator is already close to generating a buy signal); and 2) a plunge in the bull/bear ratio reported by the American Association of Individual Investors from a 6-month high to a 6-month low over just the past two weeks.

On the "risk" side of the ledger, the current market situation remains dicey because while the stocks that have been relatively weak -- the financial and homebuilding stocks, in particular -- are showing signs of bottoming, the relatively strong stocks and markets are extremely extended. Hong Kong's Hang Seng Index (HSI) and the Emerging Markets ETF (EEM) are good proxies for these relative strength leaders, and both closed at new all-time highs on Friday so the trends have clearly not YET reversed. However, the market action during the first two days of last week was indicative of how things can 'turn on a dime' in the leading equity sectors in response to fairly minor moves in the currency market (the HSI plunged 1000 points last Monday in conjunction with a bounce in the Yen and then shot upward to the tune of 1000 points on Tuesday in conjunction with Yen weakness).

Due to the likelihood of some stabilisation in the financial sector and the improved sentiment backdrop it is not appropriate for us to maintain a short-term bearish stance, but the significant on-going risk that an upward reversal in the Yen could bring about dramatic weakness in the sectors/markets that have led the rally from the August lows prevents us from being bullish. We have therefore shifted to the sidelines.

A reasonable risk management strategy for traders who are 'long' the leading stocks/sectors might be to remain long unless last week's lows -- 28,336 in the case of the HSI -- are taken out on a daily closing basis.

Update on the Airline Trade

The following chart compares the performances of the AMEX Airline Index (XAL) and the oil price over the past 12 months.

The most important determinant of the airline sector's trend is the inverse relationship between this sector and the oil price. We therefore sometimes refer to the XAL as the "anti-oil index". The XAL has been valiantly trying to establish an upward trend over the past few weeks, but the relentless strength in the oil market has kept a lid on it.


Given the extreme recent strength in the oil market, the XAL has held up fairly well. This is probably because the airline companies have been able to partially offset the effects of the higher oil price by raising the prices they charge for seats. However, for our suggested airline trade to be a success the oil price will soon have to embark on a downward trend.

In our own account we have taken positions in some airline stocks, but we won't add to these positions until/unless the XAL breaks above resistance at 48. A daily close above 48 would be a clear sign that an upward trend had begun.

We may mention some specific airline stocks at TSI if/when the XAL breaks above 48, but at this stage we are simply presenting a trading theme. Traders who are interested can review charts of the XAL's components and select 2-4 likely candidates.

The Semis

The stock market's dichotomy is exemplified by the performance of the Semiconductor Index (SOX) relative to the performance of the NASDAQ Composite Index in that the NASDAQ ended last week above its July high whereas the SOX has just broken below its August low. The SOX's recent weakness is quite strange considering the overall market environment.

As illustrated by the following chart, the SOX has been tracing out a large triangular consolidation pattern since the beginning of 2004. This pattern is potentially creating a launch pad for a large multi-quarter advance, but last week's break below the August low indicates that the bottom of the pattern (the low-400s) might have to be tested before a meaningful rally gets underway.

We had been contemplating some long exposure to the SOX, but last week's performance extinguished that idea. We will almost certainly take a long position in the semiconductor sector -- probably via SMH -- if the SOX drops below 420 at some point over the coming month, but failing that it will probably take a daily close above 510 to re-ignite our short-term optimism.  


This week's important US economic events

Date Description
Monday Oct 29
No important events scheduled
Tuesday Oct 30Consumer Confidence
Wednesday Oct 31 FOMC Statement
Employment Cost Index
Chicago PMI
Construction Spending
Thursday Nov 01 Personal Income and Spending
ISM Index
Friday Nov 02 Monthly Employment Report
Factory Orders

Gold and the Dollar

Gold Stocks

...the fact that the HUI has not corrected to a meaningful degree during October REDUCES the probability of the overall advance extending into next year.

With reference to the charts of the HUI and the HUI/gold ratio included below, Friday's surge into the 780s by the spot gold price took the HUI back to, but not beyond, its 11th October intra-day high. With the gold price now more than $30 above its 11th October level at the same time as the HUI is testing its 11th October high, the HUI/gold ratio is naturally well below the peak it reached earlier this month.

The failure of the HUI/gold ratio to confirm gold's surge to new multi-decade highs is a bearish divergence, but it doesn't necessarily mean much as far as the next few weeks are concerned. The reason is that bearish divergences such as this usually have to persist for longer and become more pronounced before they signal an important trend reversal. The current divergence is not particularly significant because it is only about two weeks old, but it could obviously evolve into something of significance over the coming month or so.

The HGO (HUI/Gold Oscillator) sell signal generated on 20th September hasn't yet worked in that such a signal is supposed to be followed by a drop in the HUI/gold ratio to at least a few percent below its 40-day moving average. The operative word, here, is "yet", in that we continue to anticipate such a decline. Note, though, that due to the increase in the gold price over the past couple of weeks the HGO's criteria could now be met by the HUI dropping back to around 390 while the gold price stays within about $20 of Friday's peak.




The recent action suggests that more gains will be seen over the coming month. Also, the improved short-term outlook for the broad stock market reduces the short-term downside risk for the gold sector. Our guess, now, is that any pullback over the coming 1-2 weeks -- perhaps a sell-the-news pullback in response to the Fed doing what everyone expects it to do -- will take the HUI back to around 390 (at worst) and will be followed by a move to new highs.

However, the fact that the HUI has not corrected to a meaningful degree during October REDUCES the probability of the overall advance extending into next year. Sharp 2-3 week declines in gold and gold stocks during October in parallel with a US$ rebound could have set the stage for multi-month extensions of the current trends, but, instead, the trends that began in mid August have remained over-stretched.

A characteristic of the strong rally in the gold sector from its mid-August low has been its narrowness, so much so that the rally probably hasn't felt strong to many gold-stock investors. The rally has resulted in large gains for a relatively small number of stocks, and despite the new highs in the gold-stock indices most gold stocks have remained well below their 2006 or early-2007 highs.

Had the gold-stock indices corrected sharply during October then the subsequent advance would probably have had much broader participation, but note that even if the gold-stock indices reach intermediate-term peaks over the coming 6 weeks we could still see some interest return to the speculative end of the market during the first quarter of next year. Those who have been involved with junior gold stocks over the past several years might recall, for instance, that even though the HUI reached intermediate-term peaks in early-December of 2003 and late-November of 2004, plenty of exploration-stage gold stocks went on to make new highs during the first quarters of 2004 and 2005.

The point is: the longer this rally goes the greater the chance that it will result in rampant speculation amongst the sorts of gold stocks that we tend to focus on, but even after it ends there could be a 2-3 month period when the exploration-stage stocks do well while the majors trend downward.

The HUI ended last week at a new closing high, but due to the continuing narrowness of the rally only one of the many large and mid-tier gold stocks we follow made a decisive move into new-high territory. The stock that we are referring to is Kinross Gold (NYSE: KGC, TSX: K). In fact, not only did the US$-denominated shares of Kinross build on the upside breakout achieved early this month, the following chart shows that the C$-denominated shares also ended the week at a new high.

There has been considerable speculation this year about Barrick Gold making a takeover bid for Newmont Mining, but the price action has us wondering if Kinross is Barrick's target.


Silver

The following daily chart shows that the December silver contract has broken out to the upside. This breakout suggests that December silver will, at a minimum, test resistance at around 15.25 at some point over the coming two months. Interestingly, this upside breakout by silver coincided with an upward reversal in the Bank Index (refer to last week's Interim Update for a discussion about why this might be significant).

The set-up for a long trade in silver-related investments is not ideal because gold and the gold-stock indices are so 'overbought', but silver is not extended in terms of either price action or sentiment so we will respect the breakout.


The simplest and lowest-risk way to obtain long exposure to silver is via the silver ETF (SLV), but more 'bang for the buck' (and more downside risk) can be obtained by purchasing stocks of silver miners. In this respect, Hecla Mining (NYSE: HL) currently looks like a reasonable trading vehicle in that the consolidation pattern traced out by the stock over the past 6 months would be capable of supporting a 30% up-move. Note that about half of HL's revenue comes from mining gold, but almost all of its profit comes from mining silver.

First Majestic Silver (TSXV: FR), one of our core holdings, should also do well if silver follows through on last week's breakout, although FR is better suited to being a longer-term investment than a short-term trade.


Currency Market Update

We are going to quickly re-visit a relationship we first addressed several weeks ago.

Via annotations on the following Bloomberg.com chart of the Baltic Dry Index (BDI -- an index of ocean freight rates) we have attempted to show that intermediate-term peaks in the BDI tend to coincide with intermediate-term bottoms in the US$, and vice versa. Therefore, when the US$ eventually reverses upward 'for real' we should get confirmation in the form of a downward reversal in the BDI.


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)

The Venezuela Gold Play

At the beginning of this month we added Gold Reserve (AMEX: GRZ) to the TSI Stocks List as a trade at US$4.38/share. As far as we can tell, GRZ is the cheapest way for stock speculators to gain exposure to a development-stage gold deposit with more than 10M ounces of P&P reserves in that the stock market is presently valuing these reserves at only US$26/ounce. One reason for the low valuation is the low grade of GRZ's Brisas gold project, but this is not the main reason because the significant copper by-product should allow the gold to be extracted from the ground at a cost of only US$250/ounce.

The main reasons for GRZ's low valuation are country risk (Venezuela) and the extraordinarily long time it is taking for the Venezuelan Ministry of the Environment to issue the full mining permit (GRZ's current permit only allows them to do some preparatory infrastructure development).

GRZ's Brisas deposit adjoins the Las Cristinas deposit owned by Crystallex (AMEX: KRY). In fact, the two deposits are just different sections of the same ore body. The stock market is valuing KRY's reserves at almost double the amount at which it is valuing GRZ's reserves, but KRY's valuation premium is probably justified given that it controls the largest and highest-grade portion of the ore body. In any case, KRY's valuation is still very low relative to industry standards as a consequence of the risks mentioned above.

After KRY dropped back to the 2.50s last Thursday we decided to feature it in today's Weekly Update because US$2.50 has acted as a solid floor over the past two years and because at Thursday's closing prices the KRY/GRZ ratio had dropped to near its lows of the past two years. Unfortunately, news on Friday morning that additional pressure had been put on Venezuela's Ministry of the Environment to grant the relevant mining licence/permit caused KRY to jump 17%, but we still thought it was worth presenting the idea of buying it for a trade.

We aren't going to add KRY to the Stocks List, but anyone interested in the Venezuela play will probably be best served by buying equal dollar amounts of GRZ and KRY (with the total amount risked across both stocks being the equivalent of a single position). If we were forced to choose just one we'd choose GRZ, but the following charts show that the two stocks tend to move in unison. Also, owning both stocks would cover a speculator against the risk that one of the companies receives the relevant permit well in advance of the other.

The Venezuela play, by the way, is based the following combination of factors:

a) The likelihood that receipt of full mining permits will result in substantial upward re-ratings of GRZ and KRY, almost regardless of what is happening to the price of gold

b) The distinct possibility that if the gold rally continues then GRZ and KRY will make sizeable gains due to the enormous gold-price leverage they offer, almost regardless of whether the required mining permits have been issued

c) The outside chance that KRY and/or GRZ will receive takeover bids (we doubt that any large North American or South African gold miner would be interested in investing a lot of money in Venezuela, but a large Russian miner might be interested).

Note that a daily close above US$3.25 by KRY would create a short-term chart-based target of US$4.00 and that a daily close above US$5.00 by GRZ would create a short-term target of US$6.00.


    Keegan Resources (TSXV: KGN). Shares: 23M issued, 30M fully diluted. Recent price: C$4.27

Last Thursday KGN reported an initial resource estimate of 1.7M ounces of gold at its Esaase project in Ghana. This initial estimate is based on just the first year of drilling at the project and can reasonably be described as a good start.

We expect the Esaase resource to expand considerably over the coming year in response to additional in-fill and step-out drilling, leading to a much higher stock price and, eventually, to a takeover bid from a mid-tier gold miner. However, with the stock having run up from the 2.70s to the low-4.00 area during the three weeks prior to Thursday's news and then jumping to the 4.70s in the hours following the news it was not surprising that profit taking occurred on Friday. The stock's close proximity to the lateral resistance shown on the following chart also made a period of consolidation a likely outcome in the aftermath of Thursday's strong up-move.

As noted in the 23rd August Interim Update, we think KGN has the right stuff to be a "core" gold/silver holding (along with CKG.V, FR.V, GGN.TO, GOZ.V, LST.AX, MFN, MRB and SBB.V). The positions that we consider to be "core" aren't necessarily the ones that we expect to deliver the greatest short-term gains; rather, they are the ones we are most comfortable sitting with during the market's upward AND downward swings.

We think a pullback to around C$3.80 would create a new opportunity to buy some KGN.


    Red Hill Energy (TSXV: RH). Shares: 47M issued, 57M fully diluted. Recent price: C$1.21

In the 23rd August Interim Update we described RH as a steal at its then price of C$0.60. Due mostly to a new coal discovery reported last Thursday the stock price of this Mongolia-based exploration-stage coal miner has since doubled, but in our opinion RH offers even better value now at around C$1.20 than it did at C$0.60 in August. This is because the new discovery has increased RH's M&I coal resource by 180% (from 350M tonnes to 1B tonnes) and total coal resource by 290% (from 386M tonnes to 1.5B tonnes).

The value of RH's in-ground coal resource is now so large relative to the stock's market capitalisation that additional growth in the resource is probably not going to do much. What we really need now in order to obtain the large gains that this stock is capable of delivering is increased speculation in the coal mining sector of the stock market and/or a deal between RH and a major coal producer.

The Mongolian Government continues to be the biggest risk, but this risk can be mitigated by limiting one's combined exposure to Mongolia-related plays.

RH can be accumulated from near its current level down to around C$1.00 (we doubt that it will trade significantly lower than 1.00).


    Kinross Gold Warrants (TSX: K.WT.B). Exercise price C$10.00, expiry date Sep-2011, 2.2487 warrants per share. Recent price: C$2.55

Warrants on Canadian resource shares regularly trade considerable distances from their fair values. More often than not they trade at premiums to fair value, especially during the latter stages of intermediate-term market advances when the speculative juices are flowing freely, but occasionally they trade at significant discounts. We were therefore not surprised when we discovered, a few months ago, that the Kinross Gold warrants (K.WT.B) were trading at a significant discount to fair value. We WERE surprised, however, when the discount seemed to increase as the underlying stock moved sharply higher over the past few weeks. This caused us to question the assumptions we made when doing the original valuation.

What we've found is that we have made a basic error in our calculations. We have been assuming that 2.2487 warrants could converted into one share at a cost of C$10.00, but in actuality the total amount that would have to be paid per share when exercising the warrants is C$22.487 (2.2487*$10). In other words, the effective exercise price of these warrants is around $22.50. As a result, we now realise that they were significantly over-valued when we originally added them to the TSI List, and are now, thanks to the gains in the Kinross stock price, roughly at fair value.

This will hopefully be a case of "no harm no foul", because as noted earlier in today's report the Kinross stock price has broken out to the upside from a lengthy consolidation. The stock is overbought and likely to pause for breath in the near future, but last week's breakout suggests an upside target of around C$23; and if Kinross trades at C$23 within the next few months then our Series B warrants will probably move up to around C$4.00. That is, an additional 30% increase in the stock price over the next few months should lead to an increase of at least 50% in the price of K.WT.B.

It is, of course, possible that Friday's upside breakout by Kinross will prove to be a 'head fake' and that the stock will quickly drop back into its lengthy consolidation range. The best thing about these warrants, though, is that their expiry date is almost 4 years into the future; so although further short-term gains in Kinross shares would be welcome, our warrant position does not require them.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
Copyright 2000-2007 speculative-investor.com
<% Session("pass") = "pass" Session.Timeout = 480 ELSE Response.Redirect "market_logon.asp" END IF %>