Brian Beamish FMA, FCSI
Macro Economic Analysis
Where we are, where we have been, where we are going.


Introduction


This is an introductory seminar on Macroeconomic Analysis. This information is intended for a basic understanding of the general concepts behind macroeconomic(largescale) conditions, pertaining to investing, and by no means represents a thorough examination. I strongly encourage feedback and hope to hear all of your questions, as all of these seminars are an ongoing work in progress. This is really two seminars in one. The first part is focused on the historical tendencies of financial and commodity related assets. We then move on to a detailed examination of the general trends in those assets going forward. The second part of this seminar is focused on the economic cycle, sector rotation and how you as an investor should approach the overall market. We follow this up with a look at various examples of investments that fall within the current sector rotation recommendation. These investments cover the entire spectrum (from very low risk/low reward, to potentially high risk/high reward) but all fall within one or two sectors of our economy. How you incorporate any of these products into your portfolio is covered in Professional Portfolio Management seminar.


17.5 year market cycles
Inflation & Deflation
Interest rate analysis
Hard & Soft Assets
US dollar fundamentals

Part 1. I have started this part of the seminar with a brief look at one long term cycle in equities markets. We then move on to study inflation vs. deflation and the current interest rate market. From there we look at market based proxies for confidence in financial and hard assets. Lastly we take a detailed look at the current fundamental situation for the world's financial asset proxy, the US dollar.


Economic cycles
Macro Growth Vs. Value
Sector Rotation
Examples of Investments
Part 2.This section begins with a macro look at economic cycles and investor preference for different types of assets during different phases of the economic cycle. We then move on the Sam Stoval's, Sector rotation model to help us determine what sectors we ought to be concentrating on given our current position within the economic cycle. We finish this seminar off with a detailed look at the entire investment spectrum (within a single sector) to illustrate just how wide your choices are (with regard to risk and potential reward) at any given time.


17.5 Year Market Cycles

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Markets move in cycles. Expansion through contraction, boom through bust, the market is in a constant state of change. political, economic and interest rate uncertainties are just a few of the issues investors need to take into consideration. But probably of most significance, investors need to be aware of where we currently are within the prevailing generational cycle. This section focuses on the 35 year generational cycle and its two primary components - greed and fear.


The above is a graphical representation of a long term cycle found in the Dow Jones Industrial average. The study suggests that the market moves in 35 year generational cycles that are broken into two distinct 17.5 year phases. there were three distinct 17.5 year expansion (or what I like to call greed) cycles in common-stock equities. Periods of economic expansion (1912 to 1929, 1948 to 1965 and 1983 to 2000) see rapidly appreciating equity prices. Periods of economic consolidation (1930 to 1947, 1965 to 1982, and probably 2001 to 2018) see increased volatility but little change in overall common equity prices. This 35 year generational cycle (of first greed then followed by fear) can be seen graphically below:


This notion of a rotating market is further validated when one looks at the Dow Jones Industrial Average as a financial (or 'soft') asset and compare its price to a classic commodity (or 'hard') asset like gold. Below is a graphic representation of this relationship over the better part of the 20th century. Notice the cycles mentioned in the first diagram are dramatically enhanced.


What causes this seemingly regular yet wild gyration in investment performance? The most logical answer arises when one looks at market performance from a money flow perspective. Money literally flows through a society and if there happens to be a bubble in a societies demographic curve, then those within the bubble carry enormous influence. Such has been the case in North America for the past 35 years as the 'baby-boomer' generation moves through its life cycle. Below are four diagrams, The first two are demographic curves for North America for 1980 and 2010. These illustrate the baby-boomer's influence on the demographic curve. At the beginning of this cycle (1980) there were many workers to support the retired and earnings were rising. Understandably, equity markets did quite well. The second two take the demographic data one step further. They are ratio charts showing the relationship between the working and non working populations and the working population and pensioners.






One could argue that the North American economy hit a cycle peak with the dot.com and subsequent real estate bubbles. Coincidentally, this generation hit its' 'peak-earnings-years' right around this time too. The current 'fear' portion of the generational cycle began near the year 2000. From about 2005 on, 'boomers' that previously contributed to the growth of the economy were now entering retirement and thus becoming a drain. This part of the generational cycle is usually dominated by net government drains (in the form of retirement benefits), lower growth as employees retire from the work force (which leads to lower government revenues) and a general desire by retires to own less risky (or more 'hard') assets. In a very big picture way, the 17.5 year 'fear' cycle consolidates the 17.5 year 'greed' cycle. Unfortunately, this cycle's volatility may be exacerbated by unfunded government guaranteed retirement benefits. As boomers will be expected to dominate the demographic landscape for at least another decade, it is not surprising that the next cycle pivot isn't until around 2017.

While this, of course, isn't an exact science, one should take away from this study the idea that the markets never move in a straight line and that after periods of rapidly appreciating prices the market needs to take time to digest those gains. Should the current cycle continue, we ought to expect more economic consolidation before the next substantial move higher in the broader equity market can occur.


Inflation & Deflation

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There are many macro variables that go into making up a healthy economy. For example, political stability, the tax structure and confidence within the business community are variables that can greatly effect the ability of companies to consistantly grow earnings. Another key ingredient is the market's perception of the purchasing power of its money. Inflation and deflation are the market's vote on that purchasing power. During inflationary times the market believes money will have less purchasing power in the future (prices rising) and during deflationary times the market believes money will have greater purchasing power (prices falling). During times of crisis, these perception can move to dramatic extremes and greatly influence asset prices.

For example, in an effort to offset some of the wild gyrations seen in the interest rate and commodity markets, central banks began to guarantee rates early in the 20th century. While this action eased tensions in the short term, longer-term trends still dictate the general direction of inflation and deflation. Short-term interest rate manipulation was aggressively used by central bankers to halt a systematic buildup in inflation in the early 1980's. But that event is now over twenty years ago and unfortunately inflation is threatening once again. While long term trends still favor deflation, those trends are being tested.

Inflation and deflation directly effect prices of assets in the market place. More over, prices may be effected by which way the market thinks inflation or deflation is moving in. Here then is 1. A historical look at inflation and how the S&P 500 stock index reacts in the face of rising and falling inflation and 2. A magnified look at the current inflation picture within the US from a consumer price perspective.


US Inflation guage
Cdn Inflation guage
Inflation-Control Target

Operational Guide


Are there some basic conclusions we can draw from the above data? 1. Stocks tend to perform better during times of falling inflation than during times of rising inflation. 2. The uptrend in inflation seen in the 1970's was broken in the early 1980's. 3. After twenty years of falling inflation, that trend may be coming to an end. Specifically, inflation (as reflected in the CPI) has put in a noticeable bottom over the past ten years. For those who have taken the ChartPattern/Formation trading seminar you will notice a familiar trading pattern developing in the inflation trend.


Interest Rate Analysis

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Inflation benchmarks
One way to measure the market's inflation/deflation bias is through fixed income assets. Examples of a fixed income assets include government, municiple and corporate bonds. A bond is literally a loan. It is an agreement to lend an amount of money with a gaurantee that the money will be paid back at some point in the future. In consideration of that loan, interest is paid in the form of fixed payments annually to lenders. Since these payment are fixed the only way to properly reflect the rising or falling value of the payment is to either add a premium to or discount the underlying asset. Within a deflationary trend, investors believe the value of future payments will rise and as a result, fixed income assets do very well. Conversly, within an inflationary trend, investors believe the value of those payments will fall and as a result, fixed income assets do poorly.

Historical perspective
Before one can fully appreciate a short-term trend change in a benchmark like treasury bonds, one must understand where we sit in relation to how these index's act over long periods of time. Here is a look at US long-term interest rates over the past 200 years and then how rates have acted over the past 50 years:

source: Economagic.com

Are there any conclusions we can draw from this first chart? 1. Only looking at a very long term chart can one see how dramatic the move higher was in interest rates through the 1970's and early 1980's. 2. Based on the past 200 years, interest rates have actually averaged about 4.50% or roughly were we have returned to now. 3. Investors should draw from this study the basic idea that interest rates are not normally as volatile as they have been in the past 50 years and that from a yearly or quarterly perspective, the trend has been down since the early 1980's and continues to be so.


Are there any conclusions we can draw from this second chart? 1. We have just recently returned to the lows in interest rates seen in the 1960's but can still move lower into the range seen in the 1950's. 2. The market went into a virtual panic in the last 1970's sending rates up in an almost parabolic fashion (very indicative of the end of a market move). 3. From a medium term basis, we are now starting to see the beginnings of a bottom in interest rates.

What's happening now
Now that we understand where we sit historically we can now look at the shorter-term picture to gauge where we might be going in the near future. Here is a look at US long-term interest rates (and their corresponding trend channels) over the past decade:



Looking at this shorter-term perspective we can clearly see the deflationary trend channel we have been in for the past decade. Rates fell steadily throughout the 1990's but have tried to turn over the past few years. Indeed, the dramatic change in the US government's balance sheet has taken the wind out of the current deflation trend but it must be noted that we have not broken the downward pointing channel yet. Referring back to the 50-year chart, we can clearly see the significant downtrend line in rates that currently sits at about 6%. Should the 6% level be breached (consecutive monthly closes above), inflation will once again be the prevailing trend. There are hints that this will indeed happen (as we will discuss shortly) but it has not happened yet and keep in mind, rates bottomed in the 1950's near 2.5% so there is still plenty of room for them to fall more.

Are there and other tools we can use?
We can take our analysis one step further thanks to a relatively new tool, treasury inflation protected securities (TIPS). These are exactly the same fixed income instruments as regular government bonds except they have a built-in inflation protection component. Principle is repaid to the investor at maturity but calculated on the inflation-adjusted basis. Since they are very sensitive to any changes in inflationary or deflationary sentiment, a comparison (or spread) between regular government bonds (in this case TLT) and TIPS helps one determine the market's perception of conditions. Tips trading at a premium to regular bonds imply inflation and TIPS trading at a discount to regular bonds imply deflation. More importantly than the actual number is the direction the ratio is moving in, over time (or what technicians like to call the trend). Here then is a performance comparison of the two types of bonds over the past few years



Hard & Soft Asset

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Financial Asset Confidence Proxy
Since the largest economy by far is the United States (and with it the largest credit market) the market uses its currency as its proxy on the value of money. More specifically, an index of all the major world trading partners vs. the US dollar is an excellent tool for gauging the market's confidence (or lack there of) in money and financial assets. If we then compare it to a benchmark of safety (in this case, gold) we can see the trends more clearly. Since leaving the gold standard in 1971, the value of the US dollar has been trending lower. On a very long-term basis, investors would rather own gold then a 'FIAT' currency. Since there is no base floor for a value on the US dollar, it will rise or fall based purely on market sentiment. Therefore, a rising dollar implies confidence in the world's money supply and a falling US dollar implies a lack there-of.


source: US Federal Reserve Board

Sometimes there can be such a high demand for money that it gets very expensive. Conversely, sometimes there is such little demand for money that it is comparatively cheap. The above diagram illustrates this point well. During times of higher short-term rates (in relation to an inflation benchmark like the CPI) there is confidence in the financial system and strong demand for financial assets. During times of lower short-term rates (again in relation to CPI) there is a lack of confidence in financial system and a lower demand for financial assets. Federal Reserve rates are consistently below current CPI data and don't look to be improving. This implies a lack of confidence in financial and a preference for hard assets going forward.

For a little historical perspective, Here is an excerpt from this seminar from back in 2004. It is very interesting to see that yes the US dollar is much lower (as of 12/10 at .79) and yes the US fundamentals have gotten a lot worse.
From a dollar perspective, 2002 saw the end of our most recent deflationary trend (and US dollar bull market). Both long and short term interest rates traded at multi-decade lows and the deflationary rhetoric was rampant. The US Government was given a green light to spend as much as they could, and they did. Through a combination of both monetary and fiscal policy measures the United States broke this intermediate-term deflationary cycle, but at a substantial cost. Record budget, trade and current account deficits have left the US fundamentals in ruins and the dollar extremely vulnerable. While central bankers have suggested they will keep the cost of money low to help a failing economy, the effects of their actions can be clearly seen throughout the international marketplace. Demand for alternative assets in the form of raw materials and non-US denominated currencies has grown dramatically and leaves one to wonder if a major devaluation of the US dollar isn't around the corner.



US Dollar Fundamentals

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US dollar demand


There are several negative market forces putting downward pressure on demand for US dollars going forward. These include competition for reserve currency status, a preference for hard assets over financial assets and a preference for a safe-havens in the face of new global threats.

A new reserve currency?
Upon compliance with Maastricht treaty requirements and a subsequent introduction period, the Euro Currency will celebrate its 5th birthday of active use this year. Initially the currency was tested and lost forty percent of its value. Since 2001, it has appreciated back to its introduction level and beyond. If the current spread between European and US short-term interest rates continues so too will the shift in money away from the greenback and towards Europe.

source: futuresource.com

International demand for hard assets
Asia has recovered from its monetary problems of the late 1990's. Furthermore, China has publicly stated it is gearing up the country for an international debute at the 2008 Olympics, in Bejing. Demand for raw materials from this area and other parts of the world is expanding and putting upward pressure on prices as seen here in the Commodity Research Bureau (CRB) index.

source: futuresource.com

Dollar vs. Gold
As a perceived safe-haven, gold has moved from an oversold level back above $400 recently. Since 2000, fear has overtaken greed as investors have moved away from financial assets (specifically US dollar denominated growth stocks) towards hard assets. Weather it is in the commodities in general, commodity-related currencies or perceived safe-havens, such as gold, the market has spoken clearly. Of interest to equity investors; after many years of lack luster performance bullion prices can now justify exploration and development activity and may be one cause for small cap out-performance of late.

source: futuresource.com

Trends going forward
Just because gold has moved in recent years does in no way indicate it is near a top relative to financial assets. This chart details the intricate relationship between the value of gold and the value of the Dow Jones Industrial Average. Notice the wide channel this ratio moves in. The middle support line suggests that the market could realistically move to a ratio of 10:1 (i.e. Dow 6000: Gold $600 or Dow 8000: Gold $800). Regardless, from its current level near $400, gold has a lot of upside potential from a historical perspective.


US dollar supply


There are several negative market forces that are now putting upward pressure on the supply of US dollars going forward. These trends include historical consumer debt levels, historical government debt levels, current budget deficits, current trade deficits and current account deficits. The net result is not only record levels but also very strong trends that may take decades to resolve.

Debt: Total US consumer debt throughout past decades has been rising and a general concern to economists. This trend accelerated into the new century as personal income fell while spending accelerated. While buffeted by lower interest rates, the potential for trouble is looming should rates start to climb again. Total government debt was trending flat to down through the 1990's but has changed dramatically since. An abrupt turn has taken place over the past three years as the pace of indebtedness has increased dramatically. To put the current situation into historical perspective, throughout the nineteenth century the ratio of debt to GDP hovered between 120% and 160%. In 1929 debt rose to 260%. Currently the ratio of debt to GDP is at or near 300%.


Trade & Budget Deficits: As you can see from the above diagram, after a brief period in surplus, total US government budget deficits are once again negative and have accelerated to historic levels. This is most troubling for the market, as it is indicative of a government treasury that is quite literally ‘out-of-control’.


Current Account Defict: Total US current account deficits have been trending negative since leaving the gold standard. This, in itself, would not guarantee additional weakness in the dollar or strength in hard assets as long as the US is able to attract enough new investment to offset the massive outflow. The current account deficit of the USA is now about 5% of GDP, and according to a study done by the Federal Reserve, EVERY country that has seen a current account deficit of greater than 4% has seen its currency devalued. Now add the huge deficits created by the spending spree of the current administration, the possible repatriation of assets by foreign investors in the US markets, and it seems certain that the USD will head lower in value.

This then summarizes the current fundamental situation within the United States. The world's capitalist benchmark and most indebted nation is completely dependent on foreign investors and foreign capital. At the same time, government expenditures are far surpassing revenue and are expected to continue to do so for some time to come. The future does not lend support either. Un-funded military obligations have yet to be factored into current budgets and new government debt will be needed to fund 'baby-boomer' retirement obligations.


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BREAK


The Economic Cycle

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All stocks are, to a certain degree, driven by the economic cycle. Some companies will do better during different periods of the cycle and some won't. Here then is a simple diagram illustrating the economic cycle in a circular format. The economy moves through expansion to contraction and back again in the never ending patterns. Through each phase of the cycle both specific sectors of the economy and different types of investments will benefit while others wont.



Growth vs. Value
In terms of the economic cycle

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The economic cycle plays a dramatic role in investor psychology and perceived 'value' in the market place. During times of economic prosperity, investors will chase areas of high growth in believing earnings increases will be infinite. Conversely, during economic downturns investors seek places of shelter in the form of high dividends and consistent earnings. Since much of the broader market direction is driven by emotion which in turn leads to momentum; once a change in bias from either growth to value (or vise versa) has been established the trend can last many months or even years. For example, growth out-favored value through much of the nineties as inflation fell, war tensions eased and new industries dominated the landscape. That market psychology and trend slowly reversed with the demise of internet stocks, the collapse in the US$ giving rise to inflation fears and a return to a war mentality.


Sector Rotation

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An investor can quickly determine the appropriate sectors of the market to be in based on where we are in the economic cycle. This theoretical model is based on Sam Stovall's, S&P's Guide to Sector Rotation and states that different sectors are stronger at different points in the economic cycle.

Think of it as surfing the sectors or catching the next crest of the wave. It's an attempt to improve returns by anticipating which part of the investment spectrum will benefit the most from the current economic conditions. This strategy is not focused on individual stocks but rather on sectors of the market, such as technology, oil and gas, manufacturing and utilities.

One popular rotation strategy of late has been the tech/blue chip rotation: when blue chips go up, technology stocks go down. You're undoubtedly aware of it -- when investors get nervous they take money out of high-risk categories, like technology, and put it in the safer blue chips. When they feel secure again, they move from the blue chips to the technology issues.

If you want to try this strategy, you need to track both individual sectors of the market as well as economic and business cycles. This link, Economic Cycle, shows the current economic and business cycles and the relative order in which the various sectors should get a boost from the economy. As well, it neatly displays the current performance of each sector relative to each other. While keeping investors focused on stocks that are in the sweet spot of the cycle, it also helps us avoid areas of potential weakness. Below is an example of that data for the summer of 2004.




The Investment Spectrum

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As mentioned previously, different investors will have different investment needs. Conservative investors will look for capital preservation as their main objective while more liberal investors will employ more risky strategies. Regardless, proper asset allocation should be employed by both. Once a basic financial planning framework has been established one can start to review the various investment products available to fit your individual needs. Below is a list (from least risky to most risky) of assets that may be employed as a hedge against the effects of either inflation or deflation.


Conservative - Fixed Income

GOC Real Return Bonds
This is a bond that pays a rate interest that is adjusted in relation to the Consumer Price Index (CPI). Interest on the bonds consists of both an inflation compensation component and a cash entitlement. Coupon interest is payable in semiannual installments on the dates specified for each series of bonds in each year. The market will trade at a discount if the market believes there is a deflationary threat and trade at a premium if the market believes there is an inflation threat.

Equity Linked Notes
Strategic return notes, linked to the oil and natural gas index are due in March 2007 and pay regular interest payments. These notes are issued so that a conservative investor can participate in equity market returns while at the same time ensuring that their principle will be repaid at maturity regardless of the equity market's performance. This feature eliminates the risk of losing principal that is inherent in traditional stock and mutual fund investments.

Convertible Bonds
(ex: Freeport-McMoran C&G 7% due 02/11/11). Convertible into common stock at the purchasers request, these notes are issued so that a conservative investor can participate in FCX returns while at the same time ensuring that their principle will be repaid at maturity regardless of the equity market's performance. They pay a fixed amount yearly there is little risk of losing principal.

Aggressive - Fixed Income

Income Funds
Aberdeen Asia-Pacific Income Fund is a closed end, non-diversified management investment company. The Fund's investment objective is to seek current income. It may also achieve incidental capital appreciation. The Fund seeks to achieve its investment objective though investment in Australian and Asian debt securities. Current yield 7.18%

Conservative - Equity

IGold Fund
Is an Exchange Traded Fund (ETF) which seeks to provide long-term capital growth by investing in shares of the companies that make up the S&P/TSX Capped Gold Index in the same proportion as they are reflected in the index. IGold is an open-ended mutual fund trust, units of which are listed and traded on the TSX just like individual stocks.

GS Natural Resources IShares
are an ETF which seeks investment results that correspond generally to the prices and yield performance of the Goldman Sachs Natural Resources Sector Index. The index has been developed by GS as an equity benchmark for US Traded natural resource-related stocks. The index includes companies in the following categories: extractive industries, energy companies, owners of timber tracts, forestry services, producers of pulp and paper and owners of plantations.

Materials Select Sector SPDR
This fund seeks to correspond generally to the performance of the materials economic sector. The fund invests at least 95% of assets in companies of the materials sector as classified by the S&P Composite Stock Index. The fund's sector includes companies from the following industries: chemical, construction materials, containers and packaging, materials and mining and paper and forest products.

Intermediate - Equity

Pan American Silver
The company is principally engaged in the exploration for, and the acquisition, development and operation of, silver properties. The Company owns and operates the producing Quiruvilca silver mine in Peru, a 99.85% interest in the Huaron silver mine in Peru and the producing La Colorada property (a silver mine and development project located on the site of a formerly producing silver mine in Mexico). Pan American was operating La Colorada under a limited production plan, pending completion of construction of an oxide mill, which was completed in June 2003. The Company mines and sells silver-rich pyrite stockpiles at a small-scale operation in central Peru.

Bema Gold Corp.
Bema Gold is an intermediate gold producer with key assets in Russia, South Africa, Chile and Canada. In 2003, Bema will be actively exploring six projects with over 150,000 meters of drilling planned. The Company is engaged in the mining and production of gold and silver, and the acquisition, exploration and development of precious metal properties in Latin America, the Russian Federation, South Africa, Ontario and Manitoba, Canada, as well as the western United States.

North American Palladium
This company owns and operates an open-pit mine known as the Lac des Iles Mine and a processing plant with a design capacity of 15,000 tons per day in Thunder Bay, Ontario. The mining and processing operation produces a flotation palladium-rich concentrate, which also contains platinum, gold, copper and nickel. The concentrate is delivered to the Sudbury operations of Falconbridge Limited and Inco Limited for smelting, and further processed at their respective European operations for refining. The Lac des Iles Mine property consists of four mining leases from the Government of Ontario numbered 104108 to 104111, inclusive, comprised of 85 single unit mining claims and covering an aggregate of 1,465 hectares.

Minco Mining
The company is involved in the acquisition, exploration and development of base and precious metal properties in China. In just few years, Minco has built up a portfolio of high-quality properties, strong operating expertise, and has established strong strategic alliances in becoming major force in China’s mining industry. .

Junior Equity & Derivatives

Cross Lake Minerals
Cross Lake Minerals Ltd. is in the business of acquiring, exploring and developing natural resource properties, and holds interests in 14 properties totalling over 29,420 hectares in Ontario and British Columbia. The properties host base metals including copper, zinc and lead; precious metals including gold and silver; strategic metals such as tantalum and niobium; and rare earth elements such as cerium, lanthanum and neodymium.

Beartooth Platinum Corp.
(formerly known as Idaho Consolidated Metals) is a Canadian company that explores for Platinum Group Metals (PGM) in the Stillwater Igneous Complex of Montana and for gold in Idaho, USA. The Company's core asset is a significant land holding of over 14,000 acres in the Stillwater Complex of Montana. Within this land package exists numerous untested PGM zones with excellent near term discovery potential and several advanced stage exploration targets.

Gold Stock Warrents
The merger of Kinross Gold Corporation with Amax Gold Inc. that became effective June 1, 1998 has brought Kinross to a new status as the fourth largest North American based gold producer with annualized gold production estimated at more than one million ounces. The combination of Kinross' mines and strong balance sheet with Amax Gold's efficient new open pit mines has created a well-financed senior gold producer with estimated cash costs in the lower quartile of world production. Kinross Warrants K.WT – TSX Cusip: 496902-191 Outstanding: 25 million Expire: December 5, 2007 Conversion: 3 warrants + Cdn $15.00 = 1 Kinross common share .

Gold Index ETF Call Options
Give the purchaser the right but not the obligation to purchase a preset amount of shares of the underlying asset for a given period of time at a stated price. For a fraction of whole ownership an investor can reap the benefits of an assets move without the entire risk. As well, with one purchase an investor can totaly hedge their portfolio for any given amount of time.