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   -- Weekly Market Update for the Week Commencing 31st January 2011

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
(27-Oct-10)
Neutral
(24-Jan-11)
Bullish

US$ (Dollar Index)
Bullish
(19-Jan-11)
Bullish
(03-Jan-11)
Neutral
(19-Sep-07)

Bonds (US T-Bond)
Neutral
(20-Sep-10)
Neutral
(03-Jan-11)
Bearish
Stock Market (S&P500)
Bearish
(22-Dec-10)
Bearish
(11-Oct-10)
Bearish

Gold Stocks (HUI)
Bullish
(01-Sep-10)
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)


Notes:

1. In those cases where we have been able to identify the commentary in which the most recent outlook change occurred we've put the date of the commentary below the current outlook.


2. "Neutral", in the above table, means that we either don't have a firm opinion or that we think risk and reward are roughly in balance with respect to the timeframe in question.

3. Long-term views are determined almost completely by fundamentals, intermediate-term views by giving an approximately equal weighting to fundamental and technical factors, and short-term views almost completely by technicals.

Egypt's Revolution and Inflation

Unless you've been unconscious for the past few days you are probably aware that the situation in Egypt is becoming increasingly precarious. Increasingly precarious, that is, for Egypt's government (the dictatorship of Hosni Mubarak). Inspired by the fall of Tunisia's dictatorship two weeks ago, Egyptians have taken to the streets en masse in an effort to bring Mubarak's thirty-year rule to an end. Predictably, the Egyptian government's response to the protests has been draconian. For example, police have assaulted protestors with tear gas, water cannons and rubber bullets, the military has been deployed to assist the police and to help enforce a curfew, and the internet has effectively been shut down.

The financial markets yawned when Tunisia's government was overthrown and then ignored the signs of political upheaval in Egypt...until Friday, when the "safety trade" suddenly came back into vogue. In particular, gold, the US$ and the US T-Bond reversed upward on Friday, while the broad stock market reversed downward. Also, the oil price jumped as traders began to give more serious consideration to the possibilities of the Suez Canal being closed for business and the nascent revolutionary trend spreading to the Arab world's important oil-exporting nations.

As an aside, while the situation in Egypt certainly had some effect on global markets late last week and could have a bigger effect over the days/weeks immediately ahead, the safety theme had become so 'oversold' and the growth theme so 'overbought' of late that some sort of correction was well overdue prior to Friday. It was just a question of what the catalyst for a correction would be. If it hadn't been Egypt it would have been something else.

There will undoubtedly be a lot commentary about Egypt's political situation over the coming days, but we suspect that the bulk of this commentary will either not deal with inflation's role in the crisis or will incorrectly analyse inflation's role in the crisis. Therefore, this is the aspect that we will focus on.

A large proportion of Egypt's population is poor (we've read that about 40% of Egypt's people live in abject poverty). This not only means that there are a lot of people in Egypt who are desperate for a change, but also that there are a lot of people in Egypt who get adversely impacted in a big way by rising food prices (in general, the poorer the person the greater the percentage of their income that gets allocated to basic necessities such as food). As everyone knows, food prices have been rising sharply in terms of most currencies over the past 6 months. This means that for the average Egyptian, the increase in the cost of food probably came close to tipping the scales in favour of physical protest. Events in Tunisia earlier this month probably gave the final push by proving that major political change could be achieved if enough people forthrightly demanded it.

This prompts the question: what caused the so-called "food inflation"?

Most pundits will incorrectly cite grain supply issues, including the climate-related effects of volcanic eruptions and the effects of La Nina. A minority will correctly state that monetary issues are far more important than commodity-supply issues, although they will tend to make the mistake of pointing the finger of blame at the US Federal Reserve. While any story that has the Fed as the villain has some appeal to us, the reality is that the Fed is not to blame for inflation problems that occur outside the US.

The Fed has unlimited power to depreciate the US dollar, but it cannot bring about a reduction in the purchasing power of any other currency. Only the central banks and governments of other countries are capable of depreciating their own currencies. China is a classic example. Due to its shortsighted mercantilist trade policy, China's government chooses to purchase large quantities of US dollars using newly-created Yuan. The resultant rapid growth in the Yuan supply inevitably leads to rapid price rises within China, such as the double-digit rates of increase over the past year in the prices of food and housing. Our point is that China's policy-makers CHOOSE to import US inflation. They do this because of the misguided belief that it's good strategy to maximise the quantity of valuable goods that their countrymen exchange for pieces of paper created by a foreign bank.

Therefore, rather than saying that the US exports inflation, it is more appropriate to say that other countries deliberately import US inflation. In so doing, the governments of these other countries hope to gain a short-term advantage for their exporting industries. The problem is that this short-term advantage for one sector of the economy comes at the cost of a long-term inflation problem for the entire economy.

Just in case it isn't clear, there's an important distinction between the idea that the US exports inflation and the idea that other countries import US inflation. Advocates of the first idea generally portray the inflation importers as innocent, helpless victims, rather than the pro-active inflators (or pro-inflation blackguards) that they really are.

In support of our argument we present the following chart. This chart provides an indication of what the long-term food price trend would look like if food prices were denominated in a currency that was 100% backed by gold. In terms of such a currency the average price of food would have hit a 15-year low (perhaps even an all-time low) in June-2010. It would have bounced over the past 6 months, but there would certainly be no good reason for riots due to high food prices in a country using such a currency.


To sum up: rising food prices have probably helped bring about the political upheaval currently underway in Egypt, and the rising cost of food has been an effect of monetary inflation deliberately caused by Egypt's policy-makers.

Oil Update

In the 19th January 2011 Interim Update we noted the strong positive correlation between the oil price and the S&P500 Index, and stated: "...unless you expect war to break out in the Middle East (a Middle East war would cause a large rise in the oil price and a concurrent large decline in the S&P500 Index), your outlook for oil should be the same as your outlook for the US stock market."

The risk has increased that something will occur in the Middle East to crimp the flow of oil, potentially causing a significant divergence between oil and the stock market for the first time in more than two years. That's why we have upgraded our short-term oil outlook from "bearish" to "neutral".

We have upgraded our intermediate-term oil outlook from "bearish" to "neutral" for essentially the same reason. It's distinctly possible that recent events in Tunisia and Egypt constitute the start of a trend that will grow to encompass much of the Middle East within the next two years.

We think there's a lot of downside risk in the oil price, but there's also a lot of upside potential. When it comes to global oil supply, politics is much more important than geology.

Interesting quote(s) of the week

The first quote is from Barry Ritholtz's blog. It is included at the top of each page where readers post their own comments on the blog topics.

"Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data, ability to repeat discredited memes, and lack of respect for scientific knowledge. Also, be sure to create straw men and argue against things I have neither said nor even implied. Any irrelevancies you can mention will also be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous."

Perfect!

On a more serious note, the next quote comes from the 19th January article by Vijay Boyapati titled "The Politics of Deflation". This article makes the argument that when push comes to shove the Fed will act in the interests of the banking elite rather than the political elite, and that it is not in the interests of the banking elite to inflate to the extent that confidence in the currency collapses. The author's forecast, then, is for a "controlled deflation". Here is the article's conclusion:

"While the Federal Reserve has the theoretical power to force the resumption in credit expansion by monetizing enough public debt that the losses from the housing bust are wiped away, it is unlikely to do so. The Fed was created for the benefit of the banking class, and while it remains under the control of that class it will not pursue a policy that would lead to a breakdown in the monetary system from which the banking class profits.

However, the Fed is also unlikely to allow an untrammeled deflation to run its full course, given the risk of political unrest that might arise. Therefore, the Federal Reserve's most likely course of action is to keep the mortgage market, in which most of the losses are concentrated, in a sort of stasis where losses are acknowledged slowly over time. Such a policy, which might well be called "controlled deflation," would lead to a prolonged period of high unemployment and slow growth, as capital is only slowly reallocated to satisfy consumer preferences.

Further, the insufficient or barely sufficient creation of new credit to make up for debt paid down -- or defaulted on -- would cause a low growth in aggregate prices; in fact, these prices might occasionally become negative. Not until the losses of the housing boom are fully cleared -- which might take years under a policy of controlled deflation -- should we expect an inflationary credit expansion and a significant rise in prices."

Needless to say (but we'll say it anyway), we disagree. Here's why:

First, the Fed exists to support the expansion of the banking system AND the federal government, both of which benefit from controlled INFLATION. For example, the banks, as a group, are only able to generate outsized profits and grow as a percentage of the overall economy due to their special ability to create new money out of nothing (inflate the money supply, that is). The more they inflate in a 'controlled' manner, the more wealth gets transferred from other sectors of the economy to the banking sector.

Second, neither the government nor the banks would benefit from an out-of-control inflation, but that has always been the case and has not prevented out-of-control inflations from erupting in the past. No government or central bank ever sets out to destroy the currency, and yet monetary collapses periodically occur. This happens because the government and the central bank set out to inflate in a controlled manner, and then lose control.

Third, the US experience of the past 50 years suggests that politics now trumps other influences when it comes to inflation/deflation. We note, for instance, that during the 1970s the Fed didn't take meaningful steps to slow the rate of money-supply growth until inflation was widely perceived as a major problem by the voting public.

In summary:

1. The government and the banking industry generally desire a "controlled inflation".

2. Contrary to the wishes of the government and the banking industry, controlled inflations sometimes evolve into uncontrolled inflations.

3. History suggests that aggressive attempts to use inflation to 'stimulate' a weak economy only end after unwelcome price rises become a major political issue. Only then does the central bank garner the political support it needs to curtail the inflation.

The Stock Market

The US stock market pulled back on Friday, but the market remains 'overbought' and sentiment indicators are still at levels that suggest meaningful short-term downside risk. In particular, the put/call situation remains decidedly bearish.

In order for us to become less bearish, the market will most likely have to drop by at least 10%. That's probably what it will take to bring short-term risk back into line with, or below, potential short-term reward.

Below are two charts that we think are interesting.

The first chart shows that EWZ, an ETF that tracks the Brazilian stock market in US$ terms, has spent the past four months oscillating within an 8-point horizontal range. It hasn't confirmed the new multi-year highs achieved by the senior US stock indices over the past two months, and tested the bottom of its 4-month range on Friday.

If EWZ were to break decisively below the bottom of its range then the short-term chart-based target would be the support that lies at around $64.


The second chart shows that the Baltic Dry Index (BDI) is approaching the 8-year lows it reached during the crescendo of the global financial crisis. It's just as well that there is so much economic growth happening in the world, because just imagine how low international shipping rates would now be if a recession were still underway.

Actually, we don't know if the BDI's current low level is related to the performance of the global economy. It could, for example, have more to do with the supply of shipping than with the level of international trade. We think it's interesting, though, that the BDI is now a lot lower than it was when the recession was officially still in progress.


This week's important US economic events

Date Description
Monday Jan 31
Personal Income and Spending
Chicago PMI
Tuesday Feb 01
ISM Manufacturing Index
Construction Spending
Motor Vehicle Sales
Wednesday Feb 02 No important events scheduled
Thursday Feb 03 Q4 Productivity and Costs
ISM Non-Manufacturing Index
Factory Orders
Friday Feb 04 Monthly Employment Report

Gold and the Dollar

Gold

The US$ gold price broke below support at $1320 on Thursday and traded as low as $1307 (basis the February contract) on Friday morning before reversing upward.

The situation in Egypt was the catalyst for Friday's reversal, but from a sentiment perspective the market was primed for a reversal prior to Friday's events. In fact, objective evidence suggests that sentiment in the gold market prior to last week's reversal was roughly the same as it was in mid July of 2010 -- just prior to the start of a relentless 2.5-month advance that resulted in a $200/oz addition to the gold price. The evidence we are referring to is the Commitments of Traders (COT) situation and the Market Vane sentiment survey. Near the short-term price bottom last July, the total speculative net-long position in COMEX gold futures dropped as low as 182K contracts and Market Vane's bullish percentage for gold dropped to 60. This is close to the levels reached last week.


Gains in the gold price that are made in response to geopolitical events are never sustained, but as noted above the stage was already set for a short-term trend reversal prior to the Egyptian news. It's therefore possible that Friday's reversal will be followed by a multi-week rally to new all-time highs.

We aren't forecasting a multi-week rally to new highs, but the potential for such an outcome intrigues us because it would surprise the maximum number of market participants and commentators. It currently seems that a vast majority of people, including a majority of long-term gold bulls, is resigned to seeing the gold price work its way down to significantly lower levels, but markets tend not to do what the vast majority expects them to do.

In our opinion, there isn't much downside risk in gold at this time. If the market were to quickly give back last Friday's gains and drop to a new multi-week low, the negativity would become almost palpable and the stage would again be set for an upward reversal. We therefore view a sustained break below last week's low as the least likely near-term outcome.

Gold Stocks

When the gold price broke below support at $1320 and hit a new correction low last Thursday, the HUI made a higher low. This was a positive divergence.

Sentiment-wise, the HUI appears to be in a similar position to gold bullion. Specifically, if it dropped to a new multi-week low, the negativity would become so great that an upward reversal would probably soon follow. We therefore view a sustained break below last week's low as an unlikely near-term outcome.


Many gold-stock investors are no doubt worried at this time about the potential for gold stocks to be hurt by a sharp decline in the broad stock market. In fact, they are almost always worried about this possibility, even though general equity bear markets are the lifeblood of gold and gold-stock bull markets.

If the broad stock market falls far enough and fast enough then the gold sector will naturally take a hit, but the gold sector's vulnerability to a general stock market decline has been greatly reduced by the downward move that has already happened. Also, any damage incurred by the gold sector due to a general stock market decline would be temporary and quickly eliminated during the ensuing stock market rebound.

Finally, we want to stress that there is no urgency to do anything in the gold sector at this time. In fact, there should never be any urgency to do anything in any market. There were many opportunities to do some selling into the strength that occurred in the gold sector during the fourth quarter of last year, and there will be many opportunities to do some buying over the months ahead. Both selling and buying should be gradual, methodical processes.

Currency Market Update

When the March euro closed marginally above resistance at 1.37 last Thursday it had risen for 13 trading days in a row. Thursday's high could turn out to be important, although it is obviously way too early to draw any conclusions.

A daily close below 1.34 would be the first definitive sign that an important euro top was in place.


Update on Stock Selections

(Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html)

Chesapeake Gold (TSXV: CKG). Shares: 38M issued, 45M fully diluted. Recent price: C$14.70

CKG has been remarkably strong over the past two months and ended last week at a new all-time high. Since early December the stock has gained about 40% while the HUI has lost about 16%.

There has been no news to explain CKG's relative strength. The strength could be the result of the recommendation of one or more other newsletter writers, or the anticipation of a takeover bid, or the market's belated realisation that the stock is under-valued, or something else entirely. We have no way of knowing.

CKG has good management and, despite its recent surge, still offers good value. However, we are going to take advantage of the stock's current strength by removing it from the TSI List and recording a profit of around 320% (based on our 2006 entry price of C$3.49 and Friday's closing price of C$14.70). CKG still has plenty of upside potential and we certainly wouldn't criticise anyone for maintaining a position in the stock, but in many ways it is similar to Pretium Resources (TSX: PVG) and at current prices we much prefer PVG. We also prefer International Tower Hill (THM), another company sitting on an elephant-sized gold deposit. THM probably has less upside potential than CKG, but also less downside risk.


    Duoyuan Global Water (NYSE: DGW). Shares: 25M. Recent price: US$10.81

In the second installment of the Barrons Roundtable, Felix Zulauf said: "It takes about six kilos of grain to produce one kilo of beef. It also takes 4,000 gallons of water. If I had a good water play, I would discuss it here."

In our opinion, DGW is a good water play. DGW manufactures equipment for waste-water treatment, water purification and water conservation, and its business is based in a country (China) that has a worsening shortage of quality water. The company has benefited from government regulation and from strong growth in genuine demand, and should continue to do so.

The stock has been weighed down over the past few months by fears that its accounting cannot be trusted. These fears are most likely unfounded, but will remain a significant factor as far as the stock's performance is concerned until the currently-in-progress independent accounting audit is complete. We don't know when this audit will be complete, but we understand that it is not unusual for these things to take several months.

When we added DGW to the TSI List in early November we placed a protective 'stop' at $10.50 due to the risk that an accounting problem would be uncovered. We had planned to include a note in today's update to the effect that we were removing this 'stop', because a) the main source of downside pressure on the stock price in the short-term was more likely to be related to broad-based stock market weakness than a company-specific issue, and b) we would view a price decline to $10.50 or lower as a buying opportunity as long as it wasn't associated with a deterioration in the company's fundamentals. However, the stock price fell quickly late last week and hit our sell stop during Friday's trading session. As a consequence, the record will show that we exited DGW on Friday at $10.50 at a loss of 15.9% and immediately returned it to the List at Friday's closing price of US$10.81.

We think that DGW is a reasonable candidate for new buying near its current price.


    Uranium Stocks

A sizeable downdraft in the broad stock market would probably create good opportunities for new buying in the uranium sector. In our opinion, EFR.TO, HAT.V and UEX.TO would be strong candidates for new buying in the C$0.70s, the C$2.50s and the C$1.70s, respectively.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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



 
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