- Interim Update 15th November 2017

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The T-Bond extends its rebound

A week ago we wrote:

"The iShares 20+ Year Treasury Fund (TLT) tested important support near $123 in late-October and has since rebounded. We suspect that this rebound is forming the 'right shoulder' of a 'head and shoulders' topping pattern. If so, the rebound should end at or below $128.

Although the rebound is probably almost complete in terms of price, we won't be surprised if it takes TLT a few weeks to roll over into its next downward trend."

TLT subsequently pulled back and then returned to last week's high. As a result, it is roughly unchanged over the past week. However, there's now a higher probability of a rise to $128 prior to a rebound peak.



Quote of the Week

On Wednesday of this week Chicago Fed President Charles Evans said things that rival the stupidest statements ever made by a senior central banker. As outlined in the Bloomberg article posted HERE, Evans expressed concerns Wednesday that the public was losing faith in policy makers' commitment to bring inflation back up to their 2 percent target. In particular, he said: "I...worry that giving too much prominence to financial stability considerations in discussions of monetary policy could erode the public's confidence in our commitment to our 2 percent inflation objective."

Is even a single member of the US public worried that the Fed will not be able to cause enough "inflation"? To put it another way, is there anyone out there who is worried that their cost of living is not increasing fast enough?

The Stock Market

Over the past three weeks we've been anticipating the start of a correction in the US stock market. Based on historical performance following the sort of upside momentum extreme achieved during the second half of October the most likely outcome was a routine 1-3 month pullback or sideways consolidation followed by another surge to new highs. However, the historical record also indicated the possibility -- with a less than 20% probability -- that a crash pattern would develop once a short-term high was in place. Note that if a crash pattern were to develop then early next year would be the most likely time for the actual crash.

The correction appears to have begun. The evidence is that on Wednesday 15th November the SPX closed below its 20-day MA (the black line on the following chart) for the first time since late-August.

If a meaningful downward correction has, indeed, begun, then the 20-day MA should act as resistance during any attempted rebounds over the coming few days.



The EURO STOXX 50 Index (STOX5E), the European equivalent of the Dow Industrials Index, has just dropped for 8 days in a row and suffered a quick peak-to-trough decline of about 5%. There's a good chance of a rebound over the next few days, but it's likely that the 2017 peak is in place and that a 1-3 month (or longer) correction is underway.



Over the past few days Japan's Nikkei225 Index also signaled that it has entered correction mode and has most likely topped for the year. We expect the Nikkei to do no worse than drop to around 21,000 to test its long-term upside breakout before resuming its bullish trend.



Gold and the Dollar

Gold

Due to a federal holiday the COT numbers for last week weren't published until Monday of this week. We covered these numbers for gold, silver, the C$ and the Yen in a blog post on Tuesday, although there was no significant change. In particular, the COT numbers for gold and silver suggest that the flushing out of leveraged speculators that usually precedes a strong rally has not yet happened. This is currently our biggest concern about gold's short-term prospects.

On Wednesday 15th November the gold price initially gained about $8 to $1290 before reversing course and ending the day with a $5 loss. This could be viewed as slightly bearish price action, although such intra-day reversals are unreliable indicators of the future. For example, the opposite happened a day earlier and it meant nothing.

All we can really say about Wednesday's price action is that it continued the pattern of the past three weeks. More specifically, over the past 14 trading days the US$ gold price has drifted in a narrow range with a slight upward bias. This pattern leaves open the possibility of a spike below support near $1260 prior to a short-term bottom.



Gold Stocks

Current Market Situation

The HUI tested its 3rd November intra-day low on Tuesday of this week without closing below it. Consequently, the possibility remains that a 2-month cycle low was put in place almost two weeks ago.



However, there have been no signs of strength since the 3rd November low. On the contrary, the HUI/gold ratio made a new low for the year on Tuesday of this week and is now testing its December-2016 low.



GDX (the Gold Miners ETF) is positioned to be the first gold-mining ETF or index to signal an upward reversal. This is firstly because GDX has been relatively strong of late and secondly because nearby resistance is defined more clearly for GDX than for any of the other important gold-mining ETFs/indices.

GDX could generate a definitive signal of an upward reversal by closing above its 200-day MA (the red line on the following chart, presently at $23.04), which is only 1.7% above the current price. Also, it would take only a daily close above $22.75 to generate a preliminary warning of an upward reversal. The reason is that a daily close above $22.75 would break GDX above its 20-day MA and the top of the downward-sloping 'wedge' in which it has traded since the early-September peak.

On the downside, the support levels that could come into play if the 3rd November low is breached are the bottom of the 'wedge' at around $21.90 and the July low at $21.00.



Eldorado Gold (EGO) and the boom-bust cycle

EGO is a mid-tier gold producer with current production of around 300K ounces/year. Its balance sheet is in reasonable shape, with $593M of long-term debt more than offset by $700M of working capital. It also has undrawn credit of $250M, so the company will not run short of cash anytime soon. However, with the stock having lost about two-thirds of its value over the past 6 months and about 95% of its value over the past 6 years (the stock price peaked near $22 in 2011) the shares are trading as if the company is on its way to bankruptcy. Is it a bargain and therefore worth a punt near its current price?



Sorry, we don't know. It isn't an obvious bargain, because the market is still assigning it a sizable enterprise value of around US$700M. If it were an obvious bargain it would be trading near cash value, meaning that new buyers would be effectively getting the mining assets for free. US$700M, however, is not unusually cheap in the current market for a 300K-oz/year gold producer. To know whether it is a bargain we would therefore have to spend considerable time assessing the values of the company's various assets and quantifying the risks it faces, which we aren't inclined to do.

Since it isn't an obvious bargain we aren't interested in buying it, but we wanted to highlight it as an excellent example of wealth destruction stemming from the boom-bust cycle in the mining sector. An exploration-stage junior could potentially lose 95% of its value due solely to negative stock-market sentiment, but a mid-tier producer losing 95% of its value requires some major strategic errors by the company's management. In the inflation-fueled boom-bust cycle, the bad investments are made during the boom phase in response to misleading price signals (price signals that make the future seem much brighter than is actually the case) and exposed for what they are during the ensuing bust phase.

The gold-mining sector tends to suffer the wealth destruction wrought by the boom-bust cycle to a greater extent than any other part of the economy. It's just that the gold-mining cycle tends to be 180-degrees out of phase with the cycle of the broad economy, meaning that peaks in one coincide with troughs in the other, and vice versa. Here is a picture of two waves that are 180-degrees out of phase.



For most gold-mining companies the 'troughing' part of the cycle began in 2015, but for some, including EGO, the declining/bust phase hasn't yet ended.

The Currency Market

The Canadian dollar (C$) made a multi-week bottom in late-October. It is currently in the midst of a rebound that could extend as far as 80, but there's a good chance that it hasn't completed its downward correction. The main reason is sentiment, as indicated by the COT data. As is the case with the gold and silver markets, up until now the C$'s decline from its early-September peak hasn't prompted enough bullish speculators to 'throw in the towel'.

The C$ has both lateral support and moving-average support at 77, which is only half a point below the late-October low. This support could limit the downside, but a final bottom at 75-76 now looks more likely.



Updates 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

Updates to the TSI Small Stocks Watch List (SSWL)

The SSWL is a list of stocks that are too risky and/or illiquid to be considered for the TSI Stocks List. We don't track these stocks closely in the TSI commentaries, but they have favourable risk/reward ratios (high risk versus much higher potential reward) and could be of interest to speculators who are able to do their own due diligence. Brief updates on the progress of two members of this list were included in our latest weekly report. Here are updates on two others:

1) Cassini Resources (CZI.AX). Shares: 277M. Recent price: A$0.075. Cash: about A$3M (including upcoming $1.9M payment from OZL). Current enterprise value: about A$18M

CZI's flagship asset is the West Musgrave Project (WMP) in Western Australia, a project that contains a large, low-grade nickel-copper resource. The WMP is a JV between CZI and Oz Minerals (OZL.AX), a mid-tier copper producer. OZL can earn up to 70% of the project by spending A$36M in stages and advancing the project to the point where there is a completed FS.

On Tuesday of this week CZI reported the results of a Scoping Study (that is, a PEA) for the WMP. The Scoping Study (SS) was done by OZL as part of its earn-in obligations.

The SS is based on the development of a mine with average annual production of 44M-55M pounds of nickel plus 55M-66M pounds of copper plus 1.5M-2.2M pounds of cobalt over an initial mine life of 8 years. The pre-production capex is estimated to be A$730M-$800M.

The headline economics indicated in the SS look good. In particular, the post-tax IRR is estimated to be 20%-25%. These headline numbers prompted a flurry of buying in the immediate aftermath of the news and pushed CZI's stock price up 25% to A$0.125, but when a closer look was taken at the SS details it became apparent that the robust IRR was based on very aggressive assumptions and the stock sold off.

The 20%-25% IRR was calculated assuming a copper price of US$2.95/pound, a nickel price of US$7.13/pound and an A$/US$ rate of 0.74. The copper price assumption is justifiable given that the current price is around US$3.00, but the nickel price assumption is unreasonably high given that the price is currently around US$5.20 and hasn't been above $7.00 since 2014. Also, the assumed A$/US$ rate is unreasonably low given that the current rate is around 0.76 (the lower the assumed A$/US$ rate, the better the economics will appear to be).

Unfortunately, CZI hasn't yet provided information on what the economics would be under more conservative/realistic price assumptions, but we suspect that the project would look economically marginal at today's metal prices and exchange rate.

That's the bad news. The good news is that OZL has committed to continue with its earn-in. The larger company could have 'pulled the plug' having spent only A$3M, but it has opted to spend another $19M over the next 18 months to boost its stake in the WMP to 51%. It wouldn't be doing this if it didn't believe that the WMP could be developed into a profitable mining operation.

Given that the forecast production costs are low (bottom 1/3 for nickel and bottom 1/4 for copper), the marginal-economics problem is most likely caused by the pre-production capex being too high relative to the mine size or mine life. It may be possible to resolve this problem by expanding the mineable resource.

The bottom line is that CZI is still an interesting speculation. The keys are that its market cap is very low and that it is being free-carried by OZL to the point where a decision is made to build a mine.

2) Emmerson Resources (ERM.AX). Shares: 402M. Recent price: A$0.081. Cash: about A$5M. Current enterprise value: about A$27M

ERM's flagship asset is the Tenant Creek Mineral Field (TCMF) in Australia's Northern Territory. The TCMF is being explored/developed as part of a JV with Evolution Mining (EVN.AX), a mid-tier gold producer and a member of the TSI Stocks List.

At the end of next month (December-2017) EVN will have earned 65% of the TCMF by spending A$15M and will have to make a decision to either remain at 65% or increase its stake to 75% by sole funding an additional A$10M of work by December-2019. EVN could also opt to make a takeover bid for ERM and thus gain 100% ownership of the TCMF.

Our speculation has been that EVN would make a takeover bid for ERM rather than pay $10M to obtain an additional 10% of the TCMF, but up until now there probably hasn't been a discovery of sufficient magnitude at the TCMF to interest a company of EVN's size. The odds are therefore against a takeover happening in the near future, but ERM should have positive news flow over the next several months due to the start of small-scale mining and a new drilling program at the TCMF, as well as a drilling program at a prospect that the company owns in NSW.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html