- Interim Update 29th March 2017

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New Charts

As part of our attempts to make the "Charts and Indicators" section of the TSI web site more interesting and useful, five new charts have been added. The new charts show the long-term inflation-adjusted (IA) performances of gold, silver, the Dow Industrials Index, oil and the GSCI Commodity Index (GNX).

These charts, which will be updated monthly (around the middle of each month based on data for the preceding month), are unique to TSI. This is because they are based on our own method of inflation-adjusting.

The market is definitely wrong about something

Although the yield on the US 2-year T-Note has been trending upward since the beginning of July last year, it is at an unrealistically-low level considering what the Fed is telegraphing. Specifically, based on the present level of the overnight rate on Federal Funds (the interest rate dictated by the Fed) and what the Fed has signaled it will do over the coming 15 months, the yield on the 2-year T-Note should be comfortably above 1.50%. However, it is below 1.30%. This means that either the market's expectations are wrong or the Fed's expectations are wrong. The thing is, the only way the market's low expectations regarding short-term interest rates could be right is if its high expectations regarding corporate earnings growth and equity performance are wrong. That is, the 'market' is definitely wrong about something important!

Putting it another way, there is no chance that the Fed will only hike its targeted interest rate twice between now and mid-next-year, which is roughly what the current yield of the 2-year T-Note implies, if the stock market continues to trend upward. Instead, the stock market will have to weaken substantially or at least persistently over the remainder of this year to bring the Fed into line with what traders of 2-year T-Notes are now collectively forecasting.

Alternatively, the market for short-term Treasury securities will have to adjust its interest-rate expectations upward over the next several months. This is something that it will be forced to do if the current stock-market optimism proves to be correct.

The financial markets are interconnected, so changes in interest rates don't just affect the prices of credit instruments such as 2-year T-Notes. Of particular relevance, changes in interest rates have dominated the currency market over the past 12 months and the combination of interest rates and currency exchange rates always has a big influence on the gold market. Actually, over the past 18 months the gold price has been strongly correlated with changes in the 2-year T-Note yield in isolation, which is unusual. This correlation is illustrated by the following chart on which the 2-year yield (the black line) is compared with the reciprocal of the gold price. We used the reciprocal of the gold price to make the intermarket link more visually clear, but keep in mind that the relationship we are illustrating is an inverse one -- the gold price falls when the 2-year yield rises, etc.



The above chart suggests that the gold price will come under irresistible downward pressure over the next couple of months if the 2-year T-Note yield rises to a new high for the year, which is something it will likely do if the stock market extends its rally. It also suggests that the gold price will come under irresistible upward pressure if the 2-year T-Note yield falls below its February low, which is something it will likely do if the stock market begins to trend downward with conviction.

The Stock Market

The US

Almost all of the reasons we have listed for being short- and intermediate-term bearish on the US stock market remain valid, but a beautifully-constructed thesis is of no positive consequence unless it is confirmed by the price action within a certain time-frame. The problem at the moment is that our 'beautifully-constructed thesis' is not being confirmed by the price action.

For example, as time goes by the decline in the S&P500 Index (SPX) from its 1st March peak looks increasingly like a bullish "flag" pattern -- a routine pullback within an upward trend.



For a second example, the Russell2000 Small Cap Index (RUT) has managed to hold above trend-defining support at 1340 to date.



For a third example, the Dow Transportation Average (TRAN) rebounded strongly enough during the first half of this week to suggest that last week's downside breakout was a false signal. It needs to end this week below 9000 to avoid negating last week's bearish signal.



Due to the increasing risk that our bearishness is premature (again) we may decide to exit our short-term bearish speculations before the end of this week. In fact, we will almost certainly do so unless TRAN moves back below 9000 before week's end.

If we do exit we will wait for a new opportunity to enter similar trades, the reason being that the probability is high that a substantial decline will happen at some time over the next few months. It's just a matter of not being too far out with the timing.

On a related matter, it occurs to us that the stock market is giving the Trump administration an extraordinary amount of leeway. Despite a series of what should have been confidence-sapping missteps by the new administration, equity-trader confidence in the Trump program remains sky-high.

The missteps we are referring to are the botched immigration ban, the running-down of the Treasury's cash reserve during the weeks leading up to the reinstatement of the government debt ceiling, and the failure to pass a bill that replaces "Obamacare". These demonstrations of incompetence had the potential to create widespread doubt regarding Team Trump's ability to fulfill the tax-cutting, infrastructure-spending and de-regulating promises on which the post-election stock market exuberance was based, but the market still seems to be assuming that all the 'good stuff' will happen as originally forecast.

Moreover, it's not like the stock market is insulated from unexpected negative developments by a low average valuation. Instead, it is priced for perfection.

We think that speculators betting on a continuation of the stock market's upward trend are effectively playing Russian roulette with a 6-shooter gun containing at least 3 bullets. Perhaps they will get lucky for a short while longer, but they are playing a very dangerous game.

Gold and the Dollar

Gold

The US$ gold price returned to its 200-day MA and its February peak during the first half of this week, but it hasn't yet broken out to the upside and the additional gold-price firmness received no validation from the gold-mining sector. We don't expect the gold price to make a sustained break above its February high anytime soon, but a short-lived spike to a new high for the year wouldn't surprise us.



We took advantage of the metals' price firmness during the first two days of this week to add to our gold hedge (via June GLD puts) and establish a silver hedge (via June SLV puts).

Gold Stocks

Current Market Situation

The US$ gold price moved up to its February high on Monday 27th March, but despite this bullion-market strength GDX (the Gold Miners ETF) was unable to close above its 50-day MA. GDX has now traded at or slightly above its 50-day MA on 6 of the past 10 trading days without managing a single daily close above it.



The gold sector's recent price action has been challenging with regard to both trading and commentary-writing. This is because it has not created any excellent buying or selling opportunities and because the narrow horizontal price range of the past two weeks has been sleep-inducing.

We continue to expect that the next excellent opportunity will be the buying kind, possibly as soon as early-May and almost certainly no later than end-July. Unfortunately, to get an excellent buying opportunity there will first have to be a clearing-of-the-decks decline.

A daily GDX close below $22.50 would be a warning that the aforementioned decline had begun, while a daily close above $23.50 would indicate that a return to the vicinity of the 200-day MA and the February peak (around $25.00) was likely to precede a substantial multi-week decline.

In the meantime, patience is required. When a market is not offering any clear-cut buying or selling opportunities it's important to do very little.

Ecuador versus Turkey

In the latest Weekly Update we wrote about Mariana Resources (MARL.V), a company that owns 30% of one of the world's best undeveloped gold projects (Hot Maden) in one of the world's highest-risk countries (Turkey). Today we wanted to quickly compare Turkey with Ecuador. This is because until recently Ecuador was widely considered to be too risky for mining investment, but gold-mining investors and speculators have been getting more optimistic about Ecuador at the same time as they have been getting more wary about Turkey. Is this reasonable? In other words, has the mining-investment environment in Ecuador improved to the point where it is now satisfactory in absolute terms and much better than the mining-investment environment in Turkey?

The answer is no. We get the impression that gold-mining investors/speculators are 'turning a blind eye' to the risks and costs of operating in Ecuador, and even though we view Turkey's political risk as unacceptably high we would actually prefer to invest in a mining project in Turkey than to invest in an identical mining project in Ecuador.

The turnaround in the perception of Ecuador as regards to mining probably began with the purchase by Lundin Gold (LUG.TO) of the Fruta del Norte (FDN) gold project a little more than two years ago. If Fruta del Norte is not the best gold discovery of the past 15 years it is definitely in the top 5. It is a truly exceptional deposit, but Kinross Gold (KGC) eventually sold it for peanuts because the company couldn't come to a reasonable agreement with the Ecuador government regarding the government's take (taxes, royalties, etc.). LUG subsequently came to an agreement with the government that enabled the FDN project to be moved towards a construction decision, and this, combined with encouraging words from the country's senior politicians, caused a large positive change in the Western perception of Ecuador as a place to have a mining business.

We are not qualified to assess the environmental, community-relations and political risks associated with getting a mine permitted and built in Ecuador, but we are capable of looking beyond the hype at the cold, hard numbers. The numbers to which we are referring are in the FDN project's Feasibility Study (FS).

One number in particular stands out, which is the 15.7% IRR (Internal Rate of Return) at a gold price of US$1250/oz. This tells us that the project is barely economic at $1250/oz. How could that be? How could such a phenomenal gold deposit have such a low IRR at $1250/oz?

The main part of the answer is that although LUG was able to negotiate a better deal with the Ecuador government than the one KGC balked at, the terms are still onerous for the mining company. Due to the combination of royalties, taxes and "profit-sharing", the government's take will be high enough to transform what should have been a very lucrative mining operation into a mediocre one (at $1250/oz the government's total take over the life of the mine is expected to be almost US$1B).

On a wider scale, the problem is that the terms of LUG's agreement with the government will be applied to all other projects that are progressed to the mine-construction phase. If these terms are such that one of the world's best gold deposits is barely economic at $1250/oz, then what are the economics going to be like for most other projects? The answer is that unless the government changes the rules* to allow mining companies to keep more of what they earn, almost all the projects that are currently being explored in Ecuador will be economically unattractive at $1250/oz regardless of the deposit's size and quality.

The situation in Turkey is different and arguably not quite as bad. In Turkey, the current rules that determine the government's take enable great deposits to have great economics. For example, at $1250/oz the economics of Mariana's Hot Maden project are almost 10-times better than the economics of LUG's FDN project. The problem in Turkey is the uncomfortably high risk that something will happen 'out of the blue' that wipes out all value for shareholders. That "something" could be a military coup or a rebellion or an arbitrary decision by the government to transfer ownership of the project.

The difference, in a nutshell, is that in Turkey it should be possible to make money from a high-quality deposit unless something disastrous happens on the political front, whereas in Ecuador it will be almost impossible to build a profitable mining operation unless there's a substantial change in the political environment.

    *Constructive rule changes could happen if the pro-business candidate (Lasso) wins Ecuador's Presidential election run-off on 2nd April, but at this time the more socialistic candidate (Moreno) has a slight lead in the polls.

The Currency Market

On Monday of this week the Dollar Index broke below lateral support at 99.25 and almost reached its 200-day MA at 98.5. It then quickly moved back above 99.25, opening up the possibility that a false downside breakout has marked the end of the dollar's multi-month correction.

The Dollar Index will have to break above 102 to confirm that its downward correction is over, so there is still a lot of work to be done. Also, Monday's low of 98.67 now becomes an important line in the sand. Closing below this level would definitely be a problem for our intermediate-term bullish outlook for the Dollar Index.



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

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html