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Gold: The Remonetisation of Gold?

Unemployment Cartoon

Two forces collided head-on. Hundreds of people spent more than 30 years looking for the answer. The Higgs boson discovery? No, gold. After experimenting with fiat currencies, this flawed premise has collided with an equally bigger truth: Gold is finite, paper isn't. Bankers now lie, even governments lie, and politicians always lie. Gold tells the truth. Gold is on the first step towards remonetisation. Gold is money, it is a currency. Without gold to bind the system together webelieve, like the Higgs boson, the financial universe will fall apart.

With the highest deficits since World War II, Mr. Obama and the Federal Reserve proved particularly adept at printing, borrowing and spending money creating one of the biggest financial bubbles ever. And the implications of the Fed's promise to keep interest rates ultra-low by extending "Operation Twist" (QEII ½) is a tidal wave of liquidity with money created out of thin air. Since 2008, the Fed expanded its balance sheet by 250 percent with nearly $2 trillion worth of toxic securities. After two rounds of quantitative easing, debt to GDP stands at 100 percent and deficits run at 9 percent GDP. And as in late 2008, the Fed's decision to keep interest rates artificially low has caused short term stock market volatility, runs on sovereign debts, bank bailouts and a dashfor cash.

Risk is back on again. In the eighties, government yields of 5 percent were considered low because they exceed both the inflation rate and equity returns. Today, the safe haven economies' yields are negative and returns are less than equity. Investors were prepared to lock up their cash for the next decade at a record low yield of 1.459 percent for 10 year US treasury notes, less than the S&P's 2.3 percent yield. As a consequence we believe that the forty year bond bubble peaked as investors in their quest for safety, flee crumbling Europe for government bonds backed by sovereign entities whose finances are similarly insolvent. Interest rates must eventually reflect this underlying fiscal insolvency and the quest for scarce capital will be accompanied this time by depreciating currencies, higher inflation and of course a collapse in overvalued bond prices. US bonds seem to be a good place to park funds for 30 days, not 30 years.

Meanwhile, at a time when markets and politicians are calling for the equality of tax rates, politicians naively ignore the role of capital in the production of wealth and of course jobs. A side effect is that investors have ignored risk as they seek safety of capital instead of the meager returns offered by central banks that collude to keep interest rates low. Higher returns are needed to assume risk today. Of course, one of the reasons that taxes are being raised is that cash strapped governments everywhere are desperate for new sources of revenues to close the financing gap. Some, like Australia, are soaking rich miners, and others their rich citizens. Even if America's top 1 percent paid more taxes it would not be enough to get America going. Higher tax rates also increases costs and in turn reduces the availability of investment capital. In Ontario, a surtax will see capital move towards lesser taxed provinces. In France, Mr. Hollande who just assumed office has already raised taxes on wealth and capital, increased the size of the public sector and lowered the retirement age pushing the debt to GDP ratio close to 90 percent. France's deficit will exceed 5 percent of gross domestic product and quickly assumes the have-not status of Spain or Greece leaving only Germany to shoulder the eurozone's burden.

Debt Hangover

The problem is that there is just simply too much debt in the world. Our deregulated world financial system is supported by debt and its surrogates, over the counter derivatives (OTC). In the past decade, the notational value of derivatives according to the Bank of International Settlements (BIS) has grown from $100 billion to almost $6 trillion or 10 times the world's GDP. Much of this is held by financial institutions, in particular, America's biggest investment banks. Derivatives were supposed to hedge risk but instead concentrated risk so that the world faces too many too big to fail institutions. Debt on debt does not work because it mortgages future generations' legacy. Governments eliminated the principles of moral hazard by rewarding the so-called risk takers in bailouts to Wall Street and Europe which recapitalized their underfunded banking systems with taxpayers' money. Bankers, the central banks' handmaidens, always seem to get the biggest bailouts and governments remain reluctant to nationalize the banks they have rescued. We seem more interested in coddling the banks than in fixing our banking system. In the United States, five banks, JP Morgan, Goldman Sachs, Morgan Stanley, Citigroup and Bank of America, hold assets more than half of America's economy. This crony capitalism is counterproductive. The previous bailouts only made a bad situation worse.

And the price of bailouts keeps going up. Contagion has hit debt-ravaged Europe. However as always, the devil is in the details. In the fourth bailout, Spain was to receive a €100 billion credit line to recapitalize its banks which added 10 percent to its national debt already at 69 percent of GDP. Like Wall Street, it is all about the banks. The point of absurdity is that Italy is responsible for almost 20 percent of that €100 billion promise but must borrow those funds at almost 7 percent to lend to Spain who is paying 3 percent. This Lehman-like bailout, like the others, keeps getting bigger and will not work. Spain not Greece is the dividing line. To date, one quarter of the seventeen eurozone members have required a bailout. Moody's, the credit rating agency left Spain's bonds just above "junk" status. Nonetheless, the market will focus on the next domino, Italy for the next little while. Italy's public debt of €2.3 trillion makes it too big to fail and too large for the ECB. Needed is a fiscal union not a political union nor the savings of Germans.

America Approaches the Tax Cliff

Despite the recent coordinated round of interest rate cuts, there is no question that another QEIII or IV is just around the corner both in Europe and in the United States. But like a drug, governments keep printing more and more money to keep their economies solvent but like an addict, they need more and more since the interest cuts and bailouts only bought time. And the latest cuts brought rates down to near zero anyway. If cheap money was the solution, our economies would be roaring.

A bigger problem is that Mr. Obama's debt addiction has already racked up $5 trillion of debt in his first term, more than all the presidents before him. America is destined to pile up another trillion dollar deficit for the fifth year in a row regardless of who wins in November. With a $1.3 trillion deficit this year and almost $16 trillion national debt, the numbers are scary. If we add state and municipal bond debt plus the debt of Fannie Mae and Freddie Mac, the debt to GDP ratio in the United States easily exceeds the 100 percent danger zone when solvency risks mount. Federal spending as a share of the economy is higher than at any year since World War II. Of most concern is that the United States approaches a "tax cliff", a yearend combination of tax increases and spending cuts equivalent to a fiscal squeeze of 5 percent of GDP. Amazingly both parties are not talking about the likelihood of a fiscal stalemate at yearend. Debt resolution should be a major plank of the presidential election campaign. It is about debt, stupid. Too often brinkmanship, the politics of blame and legislative gridlock has undermined confidence in our policymakers ability to make the necessary decisions to steer our economies. The lessons of history shows that profligacy eventually leads to economic chaos, capital controls, and devaluations and of course eventually hyperinflation. The world is charging to disaster like the Light Brigade, led by America's addiction to debt.

Fiat Currencies Experiment Has Failed

The origin of today's problems date back to the termination of the Bretton Woods Agreement when America, Japan and Germany agreed that their currencies would float against each other with the dollar replacing gold as the benchmark. This 30 year experiment with faith based currencies has now fallen apart. The 10 year decline in the dollar and the collapsed euro has raised the prospect of a currency war. The Americans continue to blame the Chinese for currency manipulation while America's mounting debt has undermined the value of thedollar - even the Swiss are manipulating their currency.

The deepening problems of the eurozone and Europe's experiment with a faith-based euro reveals the vulnerability of the fiat currency system. We believe that the dollar's position as the world's reserve currency and source of America's financial power is being challenged. The dollar's day as a faith based currency will be tested again this fall when America faces the fiscal cliff of big tax cuts and the made-in-Congress austerity cuts. History is littered with examples of broken currencies that failed to work, such as the Zimbabwe dollar, Russianrouble or the Weimar mark.

Who Can We Trust?

The decline in the market is no surprise. Nor is the decline in public trust in the "masters of the universe" or its institutions in the wake of Wall Street's mortgage debacle, JP Morgan's whale-like losses, Facebook's implosion, MF Global's demise, or Europe's debt woes. That decline intensified when Britain's largest bank, Barclays admitted that it rigged Libor, the benchmark rate for some $350 trillion worth of derivative financial products. And as the rate scandal deepens, it implicates as much as eleven other global banks, including the Bank of England. So too, has central banks' credibility fallen as they have become the greedy creators of money, monetizing deficits to subsidize the spending of their respective debt ridden governments. Central banks were at one time independent stewards of taxpayers' money. Today they are the alchemists, the creator of money. Fed Chairman Bernanke once said that under a fiat system, "the US government has a printing press that allows it to provide as many dollar as it wishes". Theprinting presses are working overtime.

Political paralysis has shifted the responsibility of growth to the central banks which are using every available monetary tool in their toolbox. Even China has lowered its benchmark rate for the second time in a month emulating Bernanke's zero interest policy. In printing record amounts of currencies in order to pay for their respective governments' spending, central banks have been complicit, building the global monetary system foundation with debt. Central banks' assets have grown much faster than their capital with the European Central Bank's balance sheet topping $4 trillion, surpassing the Federal Reserve's bloated $3 trillion balance sheet. Where does the central bank go to get its funding? The printing press of course. That's the debasement of currencies. Since the collapse of Lehman Brothers, base money has more than tripled. It is no coincidence that after finding out that Libor could be rigged, so can currencies. As part of its dollar policy, Washington had the big derivative banks short bullion and other rival currencies in a last ditch effort to buoythe dollar. Crony capitalism is very much alive today.

However, history shows that without public trust, neither the governments nor our financial institutions can prosper.

Indeed with central banks' balance sheets laden with the toxic paper of the world's banking system, it is no surprise that gold has become a significant and important reserve asset that is both convertible and protects purchasing power. Gold has made new highs for eleven years in a row. Today central banks are the single largest holders of gold with the US, Germany and France among the largest holders along with the International Monetary Fund (IMF) and ECB. The International Monetary Fund reported that official reserves jumped from $2.2 trillion in 2001 to $10.8 trillion by October 2011. China's reserves alone jumped 15 times from $0.2 trillion to $3.3 trillion. At the end of 2011, 22 percent of those reserves were in gold which could be used as collateral. Goldis becoming too important to the central bankers to be left aside.

Funding For Votes

Today, Europe is borrowing heavily from the IMF. The IMF was created in 1947 and recently Christine Lagarde passed the hat around, raising another $540 billion to replace funds mostly for Europe. The Europeans are pressing for another round looking to Canada and Asia's deep pockets this time. However, any contributions must be in proportion to their respective voting blocs. China recently contributed $43 billion but is reluctant to contribute more without being allocated additional votes and a say in the decision making progress. Herein, politics has raised its head because the United States and the west are reluctant to give up their votes or dilute even for more funding. Ironically, America too has borrowed heavily but not from the IMF, but from China. Therein lays the next battle as we believe the IMF's archaic quota system will giveway to more funding but for votes.

America's policymakers are slowly losing control over their institutions and their indebtedness will reshape that control. If the decisions are to be made by the IMF, will majority rule or will the west again insist upon its solutions. The second problem is the contributions themselves. Can America maintain its proportionate share if there is no political will to maintain their stake in this important institution. What if for example the IMF's other members insist on a new currency to replace the greenback, backed by gold? Or what if the IMF decides to revalue gold upward? (The dollar, euro, and yen value wouldthus decline in value). Can America stop this?

The Remonetisation of Gold

Although we expect significant volatility ahead as policymakers continue to look for quick fixes, the markets will discover that bailouts are unsustainable. We believe the road map to fixing our problems is based upon gold. There are two ways to ease the world's debt woes. The first is for deflation which would lead to widespread failures and asset devaluation. The second option and most likely is inflation which devalues wealth, paying down debt with devalued dollars - a lessor evil. There is another way. For some time we have said gold is the antidote to our problems because we believe it is simply the default solutionwhen faith in fiat currencies such as the dollar or euro disappears.

The solution is not outlandish nor the ravings of a very old gold bug. The solution actually builds upon existing arrangements and institutions. The IMF is the world's third largest holder currently holding 3,217 tonnes of gold. Gold has always remained a key component of its official reserves. The IMF gold is owned by its member nations, some who are in trouble and revaluinggold upward would leave fiat currencies like the dollar or euro in the dark.

The proposal would involve linking currencies to the IMF's own currency, the special drawing unit (SDR). The SDR consists of a basket of currency and gold. The second step then is a move to convertibility to the SDR and gold and the formation of a basket of currencies like a petrodollar, Asian yuan, a muchweaker euro and diminished dollar.

After twenty years of selling gold, central banks have become net buyers. We believe that recent central bank purchases are a major step towards the remonetisation of gold particularly as they lose confidence in paper currencies. China, Saudi Arabia, Russia, India and Mexico bought gold recently to diversify their reserves, which are largely denominated in US dollar. China has recently slowed its purchases of US treasuries and has less than 2 percent of its foreign exchange reserves in gold. If China were to bring this proportion in line with the western average of 10 percent, it would have to buy more than two years of gold production. The euro today has a 12 percent gold backing, not enough.We believe the global monetary order is about to change.

To unwind the huge build-up of debt or deleverage, the solution is not austerity or more growth. Instead of shouldering the debt of the weaker European economics, Germany for example has proposed mobilizing the eurozone's vast gold reserves in order to back or use that gold as collateral to recapitalise some $2 trillion of loans to desperate euro nations. Similarly we believe that the issuance of new sovereign bonds backed this time by revalued gold (aka Giscard d'Estaing bonds) would prevent the financial meltdown and eliminate much of the world's debt - not dissimilar to the time when FDR went off the gold standard to wipe out their huge debt through the devaluation of the dollar. Central banks could mobilize their huge gold reserves as an alternative reserve asset. We believe by revaluing gold upward and linking the value of currencies to gold, it betterutilizes the world's massive precious gold reserves.

The US holds 261 million fine troy ounces in its reserves valued today at $42.22 an ounce or $11 billion. On the other hand, revaluing those reserves at $1,500 an ounce, US holdings would be worth some $391.5 billion. With total public outstanding debt at about $16 trillion, a gold price of $41,000 would pay off US indebtedness. America could issue new bonds backed by their gold reserves, valued at the higher price and the debt problem would disappear as the dollar would be backed by gold. Noteworthy is that gold as a percentage of US foreign reserves stands at 74 percent and ironically among the highest but behind Portugal at 81 percent and Greece at 79 percent. While gold as percentage of foreign reserves is not necessarily a useful determinant of solvency, a revaluation would certainly help those insolvent economies, including the United States.

In effect gold would replace currencies. To restore confidence then gold becomes the default currency of the world. Gold is liquid and provides better returns than the debt of the governments that run the printing presses. Gold is simply the antidote to our problems.


We continue to believe that gold stocks are not only a terrific buy at current levels but their reserves in the ground will be the reason for their phoenix-like rise. The average market cap per ounce of in-situ reserves is less than $400 an ounce. Despite the dismal performance of the group, we believe that there is terrific upside in investing in gold companies with particular emphasis on those gold companies that could show the highest production growth ratesand possess quality reserves located in stable geographic jurisdictions.

Yet the losing streak of gold equities continues thanks to heavily weighted Barrick's plunge following the firing of Aaron Regent and Goldcorp's production problems. Second quarter earnings are likely to be disappointing due to rising costs, production shortfalls and lower gold prices. Gold stocks have been hit in the downdraft as the European debt woes caused a dash for cash as investors are concerned about a global downturn. Of concern, is that the gold stocks have lost their premium multiples and are trading more in line with the basemetals. Exogenous factors have also hurt gold stocks.

Operational risk has become a big factor as the new multi-billion projects run into start-up problems. In addition there has been rising geo-political risk in line with the shrinking number of world class discoveries. Simply there is a scarcity of world class gold projects. In addition the rising geo-political risk has evolved into tougher tax regimes and even confiscation. Capital risk is also a factor as the new resource projects face inflated costs such as Kinross's experiment with Tasiast mine. Newmont's $4.8 billion Conga gold mining project is stuck in a political local battle and the replacement for the Yanacochawill unlikely begin until after 2014.

The latter point is particularly relevant. Indonesia has threatened to grab 51 percent of deposits. Venezuela and Bolivia are expropriating 100 percent of deposits and recently Guatemala floated a 40 percent ownership benchmark. Traditional mining friendly jurisdictions like Peru or Chile are threatening tax hikes. Even existing contracts are being renegotiated. Centerra shares were hard hit by Kyrgyzstan's parliamentary moves. And it is not only the emerging countries grabbing more, but Australia recently brought in a hefty surtax on miners. Investors may be shunning gold equities but governments are pluckingthis golden goose.

There are three ways for gold companies to attract investor interest. The first is that the market will reward production growth. A second is that in a yield hungry world, players will look to those companies that pay dividends in excess of 3 percent. Gold companies currently pay less than 20 percent of their cash flow out in dividends thus there is ample room to boost that to a minimum of 30 percent which would raise yields close to the 4 percent level. One route that has met investor favour is tying the dividend to the gold price as Newmont and Eldorado have done. Alternatively paying that dividend in kind, would, in our view differentiate the gold miners from their much popular competitors, the gold ETFs whose trading volume matches the senior miners. ETFs provide investors a low cost and liquid way to play gold exposure without the operational risk.

The third way to revive interest is that gold miners should buy back those shares that were issued for everything from hedging mistakes to takeovers to mine development. Gold might be finite but gold miners became infinite paper pushers. Share buybacks are thus accretive and provide both downside protection as well as boosting earnings per share. Buybacks also sends a bullish signal on valuation. This industry ironically has seen too much capital wasted on multi-billion follies. Shrinking their capitalization would also impose discipline on an industry that issued too much paper with so little results.

With the senior gold miners possessing little near term prospects and shrinking margins, we believe the mid-caps possess superior production growth prospects as well as exploration pipelines. Equity markets reward growth, per share growth. The junior explorers are usually the exciting part of the market but the bear market in gold equities has hurt this group, in particular because of the lack of financing needed to support drill programs. We believe that until the intermediate and senior stocks move up, the pure junior exploration vehicles will be laggards. We would recommend the mid-tier players such as Agnico-Eagle, Eldorado and New Gold. Barrick has been so beaten up that our expectation for a dividend increase and a super buyback would be the catalyst to turn investors around and thus Barrick shares could be bought here.

Agnico-Eagle Mines Ltd.

Agnico recorded a strong second quarter from its five mines. Agnico spent $43 million in the first part of the year with good news from Meliadine in Nunavut, converting resources into reserves. Agnico is slated to spend $150 million this year and we believe the shares have discounted their short term operating problems. We also expect some news from recently shuttered Goldex which caused a $2 billion write-down earlier this year. Agnico shares have traditionally traded at a premium to its peers and now trades at a discount. We do not expect this discount to last as Agnico regains market credibility. Buy.

Barrick Gold

Barrick surprised the Street by dumping Aaron Regent presumably because of the lack of share performance. If that was the case, the entire gold mining industry ought to fire their CEOs. More likely, Mr. Regent's departure was linked to a variety of reasons rather than the much publicized Equinox purchase which will bring $1 billion of cash flow. Nonetheless Barrick has little near term financial flexibility because it is in the midst of mega-spending program on Pascua Lama and finishing Pueblo Viejo. To regain investor support, Barrick is likely to boost shareholder returns, the old fashioned way. The company has room to increase dividends significantly and we would not be surprised to see a super share buyback. A share buyback would be accretive since Barrick's shares are particularly cheap at present and earlier issues shares higher up when the company took a $6 billion hedging loss. Barrick's founder Peter Munk will not settle for his shares to remain in a funk, so we expect Barrick to be particularly active in the next little while. Buy.

Continental Gold Ltd.

We visited Continental Gold in Columbia in the spring. Continental recently reported high grade drill results outside the envelope as the company ambitiously plans to drill more than 60,000 metres using 10 drills as part of its development program. Continental will begin to expand underground development in the fall when it can sink an adit. The underground drilling program will expand the vertical extent at its 100 percent owned Buritica project, 75 kilometres northwest of Medellin in Columbia. Unlike others, Columbia is a mining friendly jurisdiction. Continental has two main veins, the Yaragua and the Veta Sur systems, which are comprised of multiple steeply dipping veins stacked on top of each other. Continental will release a resource update (likely 4 - 4.5 million ounces) in the early fall which could support 200,000 ounces a year at a $400 cashcost. We like the shares here.

Eldorado Gold Corp.

We continue to recommend Eldorado for its growing production and reserve profile. Following the acquisition of European Goldfields, the company plans five new mines and production of 1.7 million ounces by 2016. While ambitious, the new mines in Greece and Romania were acquired at an attractive price. Eldorado plans to spend $1 billion in Greece making it one of the largest projects there. The assets in Greece have long lives and the technical quality derisks the project. However, local problems with tree cutting is a reminder of the difficulties of mining. Nonetheless, we like Eldorado's management team and with major assets in Turkey and China, the company is well positioned to achieve its ambitiousmine schedule. Eldorado also links its dividend to the price of gold. Buy.

Goldcorp Inc.

Goldcorp reported another production shortfall which was disappointing and lower than what the Street expected. Particularly disappointing was the lower than anticipated production from the important multi-billion dollar Penasquito mine in Mexico plus continuing problems at the flagship Red Lake mine in Ontario (ground control issues) that will result in a loss of at least 200,000 ounces of production. Teething and production challenges (high pressure grinding roll circuit to lack of water to SAG mill) caused a shortfall in output at Penasquito. Lower guidance is becoming a habit. With yet another quarter of disappointment, Goldcorp is losing its so called premium growth multiple. Goldcorp has estimated a doubling in production by 2015, but that target too is illusive particular since Red Lake, Porcupine and Musselwhite are short life mines. We would switch Goldcorp into Barrick.

Kinross Gold Corp.

Kinross has ten mines located in four regions but its quest for growth has been problematic. Kinross shares continue to languish while investors wait for a new mine plan and more details from trouble prone Tasiast project in Mauritania. Declining production from its second leg, the Russian Kupol gold/silver project in Russia also weighed heavily on Kinross. Kinross will spend $220 million on exploration of which $80 million is allocated for Tasiast, where everything from a new mill plan, final cost and production plans are still unknown. Those dollars have so far shown little results. Speculation that Barrick is interested in Kinross is just that. We believe Barrick would not want to acquire the open-ended liabilities of Tasiast nor Russian assets.

Higher than expected capex together with delays over an agreement with Ecuador and Fruta del Norte suggests that Kinross still has downside from here. Sell.

McEwen Mining

McEwen Mining continues to aggressively develop the El Gallo deposit in Sinaloa, Mexico and is scheduled to begin production in the third quarter. El Gallo was developed in two phases with the first phase production planned at about 30,000 ounces of gold. The second phase will include the Palmerito nearby deposit which will significantly increase production. A feasibility study is expected by the fall. Meanwhile exploration continues and the Company keeps on building reserves. McEwen Mining however has been hard hit by Argentina's nationalistic moves which has hurt McEwen's Los Azules and San Jose (49 percent owned) operations. Nonetheless we believe the pullback provides an excellent purchase opportunityand McEwen Mining shares are cheap here.

Osisko Mining Corp.

Osisko has developed teething problems at its 100 percent owned Canadian Malartic gold project in northwestern Quebec. Osisko is operating a large scale open pit bulk tonnage which holds almost 11 million ounces of proven and probable reserves. A fire in the mill and problems with core crusher resulted in a disruption of production. However, the second quarter production was a record 92,003 suggesting that they have turned the corner and the company will produce about 430,000 ounces rather the 600,000 forecasted in its guidance. A second crusher was installed and we believe that the major teething problems are behind it, although cash cost have increased to $825 an ounce. Osisko shares have fallen sharply from its highs and we believe that the shares are attractively priced at these levels. Until Detour Lake comes in, Osisko will be Canada's largest gold mine with low political risk and now low operational risk. Nothing is priced infor Hammond Reef which has almost 2 million ounce of reserves. Buy.

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Analyst Disclosure
Company Name Trading Symbol *Exchange Disclosure code
Agnico-Eagle Ltd AEM T 1
Barrick GoldCorp ABX T 1
Centerra Gold Ltd CG T 1
Continental Gold CNL V 1,6
Eldorado Gold Corp ELD T 1
Disclosure Key: 1=The Analyst, Associate or member of their household owns the securities of the subject issuer. 2=Maison Placements Canada Inc. and/or affiliated companies beneficially own more than 1% of any class of common equity of the issuers. 3=<Employee name> who is an officer or director of Maison Placements Canada Inc. or it's affiliated companies serves as a director or advisory Board Member of the issuer. 4=In the previous 12 months a Maison Analyst received compensation from the subject company. 5=Maison Placements Canada Inc. has managed co-managed or participated in an offering of securities by the issuer in the past 12 months. 6=Maison Placements Canada Inc. has received compensation for investment banking and related services from the issuer in the past 12 months. 7=Maison is making a market in an equity or equity related security of the subject issuer. 8=The analyst has recently paid a visit to review the material operations of the issuer. 9=The analyst has received payment or reimbursement from the issuer regarding a recent visit. T-Toronto; V-TSX Venture; NQ-NASDAQ; NY-New York Stock Exchange


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