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Overview

Below is a copy of the e-mail alert that we sent to subscribers in response to Tuesday's gyrations in the markets. We are reproducing it in full in today's report because it is a good summary of how we view the current situation.

We certainly didn't anticipate Tuesday's wild market action, but the moves were generally in line with our views. In particular:

a) The US$ moved sharply lower in line with our short-term bearish outlook while T-Bonds moved sharply higher in line with our short-term bullish outlook.

b) Over the past week we've reiterated short-term bullish views on the Yen and the Swiss Franc, two of the strongest currencies on Tuesday.

c) Although we are short-term bullish on gold and gold stocks, we have warned that a multi-week correction would probably soon begin.

d) We've been concerned about the failure of the NASDAQ100 Index (NDX) and the Broker/Dealer Index (XBD) to confirm the new highs in other stock market indices, but were waiting for more evidence before bringing our short-term stock market view into line with our bearish intermediate-term outlook.

That the US stock market and stock markets around the world have turned down prior to bullish confirmations from the NDX and the XBD suggests, to us, that stock market corrections of at least intermediate-term significance have commenced. Furthermore, it is quite possible that major peaks (the type that will hold for more than 12 months) have been put in place, but note that major peaks are usually tested before large multi-quarter declines get underway. In other words, if a major peak has just been put in place then we should expect the initial decline from the February high to be followed, within the next few months, by a rally that 'tests' the high.

The catalyst for Tuesday's sell-off was a plunge in China's stock market in response to additional steps being taken by Chinese authorities to curb the rampant credit-fueled speculation that caused the Shanghai Stock Exchange Index to 'go parabolic' over the past several months. This appears to have prompted a general downgrading of the 'China growth story' in the minds of speculators throughout the world, thus leading to a move away from risk and, perhaps, a partial unwinding of the Yen carry trade. (The Yen carry trade has been extensively used to finance speculations, so the exiting of these speculations might have prompted a partial unwinding of the associated financing arrangements. This is a potentially self-reinforcing trend in that Yen strength resulting from the unwinding of some carry trades makes the carry trade less appealing, causing the unwinding to accelerate. That is, increasing risk aversion leads to a shift away from the Yen carry trade, which leads to Yen strength, which prompts a further reduction in the overall extent of the carry trade, and so on.)

IF the unwinding of the carry trade picks up steam then the Yen will make large gains over the coming few months. This is a big 'if', but the Yen's short-term risk/reward continues to look attractive.

The market sectors and stocks that have recently done the best were generally the worst performers on Tuesday. Particularly hard hit were the emerging market ETFs and the commodity-related stocks -- investments that have been bid-up on the basis that global growth would remain strong. These investments were naturally hit hard when fears of a China-inspired growth slowdown suddenly moved to centre stage.

The financial backdrop became slightly more 'gold bullish' on Tuesday due to the modest widening of credit and yield spreads as well as the rapid pricing-in of a second 0.25% Fed rate cut (prior to Tuesday the Fed Funds Futures market had been anticipating a single 0.25% rate cut by year-end), but this didn't prevent gold and gold stocks from selling off along with growth-oriented investments. This is not unexpected, though, as we've previously warned that counter-cyclical gold would likely be taken down along with cyclical investments during the INITIAL phase of a market-wide sell-off.

If growth expectations continue to ramp down then the financial backdrop will become increasingly favourable for gold, so investors should take advantage of short-term weakness to build-up their exposure to the yellow metal. TSI's main focus will remain on the small-cap end of the gold share universe because this is where the most attractive long-term risk/reward ratios can be found.

It's too early to be buying gold stocks aggressively because the gold market is just one day into a correction that will probably last 3-6 weeks, but note that different stocks will hit appropriate levels for new buying at different times. The timing of new buying should therefore be determined on a stock-by-stock basis, not on the basis of what the gold stock indices happen to be doing. The approach we typically adopt in situations like this -- and are adopting now -- is to place below-the-market buy orders for the stocks we want to accumulate.

Additional note: The stocks of base metal producers/explorers were hammered, but the base metals themselves were generally unfazed by Tuesday's market shakeout. This is potentially important because it suggests that there is little speculative premium in current base metal prices and that the emerging markets theme is now the focal point of speculation. This doesn't mean that there is minimal downside risk in the base metals, but probably does mean that a large price decline will have to be driven by a significant fall in commercial demand relative to mine supply rather than by the liquidation of speculative positions.

The Stock Market

Current Market Situation

...there appears to be a lot more short-term downside risk at this time in the emerging markets than in the US. ...a sharp decline in emerging market equities not confirmed by a significant widening of emerging market credit spreads...will be suspect.

We doubt that Tuesday's stock market plunge will prove to be a 'one-day wonder' because the failure of leading indices (the NDX and the XBD mentioned above) to confirm February's new highs in other stock indices was already sounding a warning that something was wrong. We are therefore shifting our short-term view on the US stock market from "neutral" to "bearish". We wouldn't be surprised if the rebound that began on Wednesday continued for a few more days, but would be very surprised if the highs of the past two weeks were exceeded anytime soon.

Although the US stock market is in a secular downward trend while the stock markets of many "emerging" economies are in secular upward trends, there appears to be a lot more short-term downside risk at this time in the emerging markets than in the US. The reason is that over the past two years the emerging markets have benefited to a far greater extent than the US market from the liquidity deluge and are thus more vulnerable to being adversely affected by a liquidity contraction. Putting it another way: while market participants are moderately optimistic about the prospects for US equities they are absolutely euphoric about the prospects for emerging market equities, and have placed their bets accordingly. This leaves little room for a positive surprise and a lot of room for the negative variety.

The vulnerability of the emerging markets to a negative surprise was evident in Tuesday's intra-day decline of more than 10% in the iShares MCSI Emerging Markets fund (NYSE: EEM). EEM rebounded a little on Wednesday and could rebound some more over the coming days, but we think Tuesday's drubbing will prove to have been the proverbial "warning shot across the bow".

Now, one thing about emerging market equities is that they routinely make big counter-trend swings that don't mean anything beyond the very short-term. For example, EEM lost 27% of its value within the space of only 5 weeks during May-June of last year and then resumed its upward trend as if nothing had happened. How, then, could we tell the difference between a sharp pullback within an on-going upward trend and the first downward leg in a cyclical bear market?

The best way, we think, is to follow what's happening to emerging market bonds. A lot of 'dumb money' (the public's money) flows into and out of emerging market equities, causing big swings that often don't have longer-term significance. However, the trading of emerging market bonds tends to be dominated by the 'not-so-dumb money' (investment banks and hedge funds). Therefore, a sharp decline in emerging market equities not confirmed by a significant widening of emerging market credit spreads (spreads between the yields on emerging market bonds and US Government bonds) will be suspect. For example, we noted at the time that the failure of emerging market credit spreads to widen by much in parallel with last year's plunge in emerging market equities was a significant bullish divergence.

A convenient way of monitoring emerging market credit spreads is via the EMD/USB ratio (the Emerging Markets Income Fund divided by the US T-Bond). EMD/USB should fall when credit spreads are widening and rise when credit spreads are falling. The idea, therefore, is that a major downward trend reversal in the emerging markets won't be signaled until there is a sharp decline in EMD/USB.

With reference to the following chart, there has clearly been a pullback in EMD/USB over the past two months but the pullback is not YET of sufficient size to signal a trend reversal. If we have just witnessed the start of a major equity market correction then there should be a lot more weakness in EMD/USB over the coming month or so.

By the way, the NASDAQ100 Index has been included on the EMD/USB chart to make the point that the 4-year rally in the US stock market and the increasing investment demand for emerging market debt are part and parcel of the same trend.

Gold and the Dollar

Currency Market Update

As evidenced by the following daily chart, the March Swiss Franc futures contract has decisively broken above the top of a 5-week basing pattern. At some point within the next two months we think the SF will test its December-2006 high, but we don't think this currency has much upside potential beyond that.

Gold

$660 is proving to be a very important support level for April gold. Notice, with reference to the following chart, that the one-day plunge in mid-February halted at $660, as did this week's sharp decline.  If $660 gives way then the channel bottom and the 200-day moving average, both of which presently reside around $640, would become near-term objectives.

Our upside target range, as far as the coming two months are concerned, remains $700-$760 (basis the April contract). The bottom of this range was almost reached late last week and we seriously considered downgrading our short-term outlook from "bullish" to "neutral" at that time; but we decided to maintain our short-term bullish view because the upside potential still appeared to slightly outweigh the downside risk. This week's decline has marginally improved the short-term risk/reward.

Below is a chart-based comparison of gold and the PAAS/Silver ratio (the stock price of Pan American Silver divided by the gold price). The reason this strange comparison has relevance is that downward reversals in PAAS/Silver have occurred 1-3 months prior to each of the last three intermediate-term peaks in the gold price (the shaded areas on the chart highlight the periods between intermediate-term peaks in PAAS/Silver and the subsequent intermediate-term peaks in gold). Given that PAAS/Silver has either just peaked or has not yet peaked, the chart's message is that we are still at least 1-3 months away from the next intermediate-term peak in the gold price.

Gold Stocks

In last Sunday's Weekly Market Update we wrote:

"Our guess is that if short-term peaks are not already in place for gold and the gold stock indices then they will be put in place within the next week or so. However, we expect that any pullback over the coming few weeks will be followed by a move to new multi-month highs."

Due to the severity of Tuesday's decline it is clear that a short-term peak was put in place on Monday. In price terms it's quite possible that the bulk of the anticipated pullback is already out of the way, but we suspect that there will be a few weeks of consolidation and at least a marginal new low for the move before the next tradable rally gets underway. Sentiment has undoubtedly taken a hit and it will, we think, take some time for the market to recover from this hit.

With the gold sector now just two days into a correction that will probably last a few weeks there should be no urgency to buy, but as noted in the e-mail alert sent earlier this week it might make sense for investors desiring to build positions in small-cap gold stocks to place some below-the-market buy orders at this time. This approach can pay dividends because the lack of liquidity in the smaller stocks will sometimes result in quick downward spikes due to inexperienced traders/investors attempting to get out at any price.

We will do our best to identify buying opportunities as they occur. For example, later in today's report we mention a gold stock that is already at a sufficiently depressed level to be a candidate for new buying; and in the latest Weekly Update we featured a gold stock (Gryphon Gold) that, due to its lack of movement during the recent rally, was a candidate for new buying prior to Tuesday's shakeout.

We will also attempt to highlight potential buying opportunities in advance in those cases where we are able to ascertain logical downside targets for individual stocks. In general, though, for stocks that offer good long-term value but became over-extended on a short-term basis during the recent rally it probably makes sense to anticipate pullbacks to near the respective 50-day moving averages; that is, it probably makes sense to place below-the-market buy orders in the vicinity of this moving average.

Suggested Reading

Over the years we've read plenty of books on investment, but very few of them have had much impact on us. Some of the ones that have had an impact are noted below.

One thing that the following books have in common is that they contain very little specific advice on how to be a better investor. They have, however, helped to shape the way we view the financial markets and the business of investing.

1. "Fooled By Randomness -- The Hidden Role of Chance in the Markets and in Life" by Nassim Taleb

2. "The Education of a Speculator" by Victor Niederhoffer

3. "Practical Speculation" by Victor Niederhoffer

4. "Reminiscences of a Stock Operator" by Edwin Lefevre

5. "Against the Gods -- The Remarkable Story of Risk" by Peter Bernstein

If you are interested in reading about economic issues such as inflation, a good source is www.mises.org. Use the search function at this web site to look for articles written by Ludwig von Mises, Murray Rothbard and/or Frank Shostak on your specific topic of interest.

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)

Over the past week we made specific profit-taking suggestions in relation to three of our stocks (FR, GRS and SBB) when they were near their highs, and two weeks ago we gave a specific profit-taking target for another stock (IVW) that was subsequently reached.

In the TSI commentaries we identify opportunities to take partial profits whenever we can, but it's important that holders of junior resource stocks never become totally dependent on any newsletter for advice on when to take money off the table. The main reason is that the decision to take partial profits in a stock should, in most cases, be based on individual money management considerations. That is, an individual's decision to take partial profits in a stock for which the long-term outlook remains bullish will usually be based on considerations such as that individual's overall market exposure, the relative weighting of the stock in question within their portfolio (a large rise in the price of a stock can result in that stock achieving an excessive weighting within the portfolio), and the effect -- both financial and psychological -- that a pullback would likely have on them.

Speculators in small-cap resource stocks need to continuously perform a sort of balancing act because the initial decline from the top in these stocks can be dramatic, meaning that technical confirmation of a top will often come too late to be of practical use. On the other hand, doing a lot of selling at an early stage can be hazardous to a speculator's financial health because these types of stocks routinely make their largest gains during the final few weeks of a sector-wide rally.

In our own account we almost always take money off the table in stages, which usually means that the first one or two sales we make prove to be premature. However, our goal is not to make a once-in-a-lifetime 'killing' by maintaining full exposure to any stock or any market until the ultimate high is reached (such a goal is the impossible dream of investment novices and gamblers). Rather, our goal is to generate good real returns, on both an absolute and relative basis, year after year after year. The process we go through to achieve this goal involves a) sticking to those markets or market sectors whose long-term trends are bullish, b) maintaining an overriding focus on value when selecting individual stocks, and c) maintaining a sizeable cash reserve that never falls below 20% of portfolio value and gets adjusted upward in response to increasing intermediate-term market risk.

    Chesapeake Gold (TSXV: CKG). Shares: 29M issued, 43M fully diluted. Recent price: C$6.97

The merger between American Gold Capital (TSXV: AAU) and Chesapeake Gold (TSXV: CKG) has been completed and AAU has been de-listed. We've therefore replaced AAU with CKG in the TSI Stocks List. In determining the original price for CKG in the Stock Selections table we have assumed that the profit percentage for CKG at the close of trading on 23rd February (the date on which the merger was completed) was the same as the profit we had on AAU at that time.

We will also add the CKG warrants -- the ones issued to AAU shareholders as part of the merger -- to the TSI Stocks List as soon as they begin to trade. At this stage the symbol and listing date for the warrants are not known.

Lastly, it is not yet known whether the Class A shares will be eligible to trade on the stock market. If CKG isn't able to arrange a stock market listing for these shares within the next two months then they will become slightly more valuable in that they will be convertible into more CKG shares than would otherwise be the case. However, if they aren't listed then it obviously won't be possible to trade them and it won't make sense for us to include them in the TSI Stocks List.

    Ivernia Inc. (TSX: IVW). Shares: 134M issued, 143M fully diluted. Recent price: C$1.71

We featured IVW as a buy at C$1.46 in the 12th February Weekly Market Update on the basis that it looked under-valued and appeared to be about to breakout to the upside. At that time we also said: "It would be reasonable, we think, to take partial profits on IVW at around $2.00 if given the opportunity to do so within the next two months, and to retain the balance as part of a core industrial metals position."

The stock subsequently moved sideways for a few days before breaking-out to the upside. It traded as high as C$2.05 on Monday, providing an opportunity to take partial profits, before pulling back in response to technically-oriented selling later on Monday and the general stock market shakeout on Tuesday. It is very unusual for a stock to drop back to an area where new buying would be appropriate just one day after reaching a reasonable profit-taking level, but due to this week's extreme volatility that's exactly what happened to IVW.

Since our last write-up the company released its latest quarterly results and provided some guidance for 2007. The December results were very good and the guidance provided by the company regarding this year's production and costs supports our view that the stock offers plenty of value near its current price. Production and costs will be adversely affected during the first half of this year by a low-grade ore test during the first quarter and the commissioning of a new pressure filter during the second quarter, but the company still expects to produce 85,000 tonnes of lead this year -- about 35% more than last year -- at a cash operating cost of US$0.36/pound. Assuming an average lead price of US$0.76/pound this would mean that IVW would have a cash operating margin of US$0.40/pound and would generate pre-tax cash flow of around US$75M. Using a fairly conservative valuation of 5-times pre-tax cash flow would then yield a market capitalisation of US$375M (C$436M), or C$3.11/share based on a share count of 140M.

The biggest assumption here is that the lead price will average US$0.76/pound during 2007. With reference to the following chart, the current lead price is US$0.87/pound so we are not being particularly aggressive in our metal price assumption. However, a substantial slowdown in the rate of global economic growth could certainly push the average lead price down to a much lower level. We view this as the main risk, but if you buy the stock in the 1.50s or low-1.60s then you will have a hefty margin of safety.

Technically, IVW has good support in the 1.50s and resistance at around C$2.00 (see chart below). The stock unfortunately rebounded 9% on Wednesday -- we would have preferred to feature it at Tuesday's closing price of C$1.57 rather than at Wednesday's closing price of C$1.71 -- but could again become available in the C$1.50s at some point over the next few weeks.

Note that we would no longer view a move up to around C$2.00 as a short-term profit-taking opportunity because the next time this resistance is challenged there will be a greater chance of it being breached.

    The Laggards: Richmont Mines (AMEX: RIC) and Nevsun Resources (AMEX: NSU)

RIC has always been a turnaround story for us. It doesn't have the sort of assets that are ever likely to generate much excitement in the stock market, but our view was that if it could come close to achieving the production gains that the company's management was planning then the market would be forced to price the stock at a much higher level.

It remains an under-valued turnaround story but the pace of the turnaround has been much slower than we had originally expected/hoped; and based on the latest information issued by the company there appears to be no good reason to anticipate a more rapid rate of improvement over the coming 6 months. We've therefore decided to exit RIC and book a loss of 22% based on Wednesday's closing price of US$2.59 and our original entry (12 months ago) at US$3.32.

Note that we aren't particularly concerned about RIC's downside risk. In fact, because very low expectations are already built into RIC's price the stock probably has less downside risk than most other gold stocks of similar size. Our main concern is the lack of upside potential.

There are limits on the number of stocks we can follow at TSI and there are other stocks that currently aren't in the TSI List that we think have better risk/reward ratios than RIC. Exiting RIC now will make it possible for us to add a new stock, preferably in a few weeks time following more corrective activity in the sector.

Unlike RIC, NSU certainly has mineral assets with the potential to excite the stock market. Furthermore, these assets are currently trading for a lot less than they appear to be worth.

There are always reasons for extreme under-valuation, and in NSU's case one of the reasons is perceived political risk (Eritrea). However, we've come to the conclusion that the main factor weighing on the stock is the market's perception of the company's management.

Years ago when NSU was doing nothing other than drill holes in the ground the management seemed capable enough, but they began to look much less capable and lost a lot of credibility once the company changed from being purely an explorer to being a mine builder/operator. Unfortunately, management's bad experiences (huge delays and cost overruns) with the development of the Tabakoto gold mine in Mali haven't dissuaded it from trying to take the much larger poly-metallic Bisha project in Eritrea through to production. Clearly, the management team doesn't understand its own limitations.

Despite the management problem we are going to retain the stock for now because we think NSU's assets are too good to languish near current valuations for much longer. In our opinion, either the market will re-rate the stock or another mining company will make a hostile takeover bid (hostile to management, that is, but not to shareholders). In fact, with the stock approaching intermediate-term support (see chart below) some 'nibbling' might be appropriate at this time.

We wouldn't be surprised to see NSU trade as low at US$1.75 in parallel with more corrective activity in the gold sector over the next few weeks, but that's probably the worst case barring a political blow-up in Eritrea.

Chart Sources

Charts appearing in today's commentary are courtesy of:

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