-- Weekly Market Update for the Week Commencing 3rd October 2016

Big Picture View

Here is a summary of our big picture view of the markets. Note that our short-term views may differ from our big picture view.

The BULL market in US Treasury Bonds that began in the early 1980s ended in early-2015, but there will be many years of topping action in bond prices and bottoming action in bond yields before major new trends get underway. (Last update: 29 June 2015)

The stock market, as represented by the S&P500 Index, commenced a secular BEAR market during the first quarter of 2000, where "secular bear market" is defined as a long-term downward trend in valuations (P/E ratios, etc.) and gold-denominated prices. This secular trend will bottom sometime between 2018 and 2020. (Last update: 29 June 2015)

A secular BEAR market in the US Dollar began during the final quarter of 2000 and ended in July of 2008. This secular bear market will be followed by a multi-year period of range trading. (Last update: 09 February 2009)

Gold commenced a secular bull market relative to all fiat currencies, the CRB Index, bonds and most stock market indices during 1999-2001. This secular trend will peak sometime between 2018 and 2020. (Last update: 29 June 2015)

Commodities, as represented by the CRB Index, commenced a secular BULL market in 2001 in nominal dollar terms. The first major upward leg in this bull market ended during the first half of 2008, but a long-term peak won't occur until 2018-2020. (Last update: 29 June 2015)

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Outlook Summary

4. Long-term views are determined almost completely by fundamentals and intermediate-term views are determined by a combination of fundamentals, sentiment and technicals.

Last week's posts at the TSI Blog

Will the Fed be able to fight the next recession?

A strange sentiment conflict

Summary of current thinking/positioning

1) Hedged against short-term downside in gold and the associated mining stocks via GDX put options, GLD put options and a substantial cash reserve, while maintaining 'core' exposure in anticipation of large additional gains over the next two years. Planning to exit short-term hedges (put options) within the coming two weeks, either following breaches of support and accelerated declines or following evidence that support levels have held.

2) Gradually increasing exposure to non-gold commodity-related stocks during periods of price weakness in anticipation of 2017-2018 being a very bullish period for commodities.

3) Still betting (via options) on a near-term decline in the US stock market while continuing to acknowledge that October-2016 could produce a stock-market high (as per 2007) rather than the short-term low we are positioned for. Expecting the market to 'tip its hand' within the next few days.

4) Thinking that the Yen is topping, the British Pound is basing and the commodity currencies are still in consolidation mode.

5) Maintaining a large cash reserve in recognition of the downside risk in almost all equities (current cash percentage is around 50%), but looking for opportunities to reduce cash and add to gold/commodity exposure.

The markets are coiling

A number of financial markets are 'coiling'. To put it another way, in a number of financial markets the pressure has been steadily building via price fluctuations within narrowing ranges. Examples include gold bullion, the gold-mining indices, the Dollar Index, the Yen, the C$, the S&P500 Index and copper. Also, some markets are poised just below or just above intermediate-term demarcation levels. Examples include gold bullion, the Dow Transportation Average and the Shanghai Stock Exchange Composite Index. Most of these markets/indices are discussed below.

This sets the stage for interesting price action (sizable price moves) during October.

Commodity analysts often can't see the forest for the trees

If you fixate on the trees, that is, the day-to-day price fluctuations and the associated news, you will fail to see the forest, that is, the major price trends and the forces driving those trends. We'll explain what we mean using the example of the oil market.

In an effort to enlighten us on why the oil price did what it did on any day, commodity-market analysts, financial journalists and other pundits will often cite news of increasing supply (to explain a price fall) or decreasing supply (to explain a price rise). For instance, the popular view in the press was that the bounce in the oil price during the final three days of last week was due to news that OPEC was planning to cut production. The proximate cause of last week's bounce most likely was the OPEC news, but the important trends in the oil price rarely have anything to do with OPEC in particular or supply considerations in general. As evidence we provide the following chart comparison of the oil price and the S&P GSCI Commodity Index (GNX).

According to the Goldman Sachs blurb, the "S&P GSCI contains as many commodities as possible, with the rules excluding commodities only to retain liquidity and investability in the underlying futures markets. Currently, the S&P GSCI contains 24 commodities from all commodity sectors: six energy products, five industrial metals, eight agricultural products, three livestock products and two precious metals. This broad range of constituent commodities provides the S&P GSCI with a high level of diversification, both across sub-sectors and within each sub-sector."

In summary, GNX is designed to reflect the price performance of a broad range of commodities. And yet, the following chart shows that over the past 10 years GNX's performance (the blue line) has been almost identical to oil's performance (the black line).



To further make the point, here is a chart comparing the oil price with the S&P GSCI Agricultural Index (GKX). This chart shows several short-term divergences, but it also shows that the major price trends are the same. This is despite the fact that the supply situation for oil is very different from the supply situations of the agricultural commodities that comprise GKX.



The point is that regardless of what's happening on the oil-supply front, the oil price moves up and down with commodity prices in general. It's the same story with most commodities. There will be times when something out of the ordinary happens with the supply of a particular commodity, causing the price of that commodity to separate from the pack. For most commodities and for most of the time, however, prices trend up and down as a group.

The logical conclusion is that the important price trends in the commodity markets are driven by monetary forces rather than supply considerations. It must be so because money (the US$ in most cases) is the one thing that all commodity prices have in common. A follow-on conclusion is that there are no broad-based commodity bull markets driven by tightening supply, there are only periods when commodities are among the main beneficiaries of monetary inflation.

Copper Update

Our view since early this year has been that copper's bear market was essentially complete, but that there could be a test of the January-2016 low as part of a basing process.

The top of copper's base (or what we think is a base) is at US$2.25-$2.30. A daily close above $2.25 would be preliminary evidence that the basing process is complete while a weekly close above $2.30 would leave little doubt.



We will be surprised if the copper price breaks out to the upside in the near future. Considering the price action, the Commitments of Traders data and the performances of other markets, it's likely that the current multi-week rally will end near $2.25 and be followed by a multi-week decline to $2.10 or lower.

The Stock Market

The US

The S&P500 Index (SPX) went nowhere over the course of last week, but the path it took to get there provided a bit more information. As illustrated below, the intra-day lows on Tuesday and Thursday of last week have helped to define an upward-sloping trend-line from the September low. There is also a fairly-well defined downward-sloping trend-line from the August high. It will be difficult for the market to avoid breaking through one of these trend-lines within the coming two weeks.

If it's the upper (that is, downward-sloping) trend-line that gives way in the near future then the stage will be set for a quick move to a new all-time high. We suspect that such an upside breakout would prove to be false, as was the case with an upside breakout in the SPX at around the same time (early-October) in 2007. However, we would wait for evidence that the breakout was false before taking any action.

If it's the lower trend-line that gives way in the near future then the stage will be set for a quick decline to a multi-month bottom in October or November.



The Dow Transportation Average (TRAN) did relatively well last week and is now within spitting distance of intermediate-term resistance defined by its April-2016 high. An upside breakout would require a WEEKLY close above 8150.



An upside breakout by the TRAN would 'muddy the waters', but at this stage it looks like the US stock market will trade well below its current level within the next 6 weeks even if the SPX makes a new high during the first half of October.

Of potential significance to the stock market, the next iteration of the ISM Manufacturing New Orders Index (NOI) gets issued on Monday 3rd October. This index was close to generating a recession warning last month, so Monday's news could be important.

It would only take a small amount of additional weakness in the NOI to signal a recession and substantially increase the probability that an equity bear market is about to begin. Alternatively, a multi-point rise in the NOI would suggest that the start of the next recession was still at least a few months away.

The bottom line is that the US stock market's price action and the US economic data are set up to provide us with some useful clues over the coming fortnight.

The Global Banking Sector

Much is being written about Deutsche Bank (DB) and its possible imminent collapse.

The fear of a DB collapse has clearly been reflected in the price of DB's stock, but the financial markets currently do not appear to be concerned that DB's problems will cause a global banking crisis or even a European banking crisis. The general lack of concern about the potential knock-on effects of DB's troubles is evidenced by the following two charts.

The first chart shows that the Europe 600 Banks Index (FX7) has consolidated in a routine manner since rallying to resistance in early-September. The second chart compares the BKX/SPX ratio (the US Bank Index relative to the SPX) with the 30-year T-Bond yield to make the point that US bank stocks were relatively strong from early-July through to early-September and that the relative weakness since early-September is less than would be expected given the sharp pullback in the 30-year bond yield (the BKX/SPX ratio has been trending with the 30-year yield for years).

The financial markets could be grossly under-estimating the risk to the global banking industry posed by DB. If so, it wouldn't be the first time they've missed the signs of a developing major threat.

Our view is that DB's issues probably WON'T have severe global consequences, but that there's enough risk to justify maintaining a much greater-than-normal cash reserve.

China

The Shanghai Stock Exchange Composite Index (SSEC) plunged from a short-term high in December of last year to a low in January of this year. It then rebounded to a high in mid-August, but the 6.5-month rebound recouped less than half the loss incurred during the 5-week December-January plunge.

The SSEC's rebound from its January low is either a consolidation within a bear market or part of a drawn-out basing pattern. It is clearly not the first leg of a cyclical bull market. Furthermore, since hitting a short-term top in mid-August the index has pulled back to near a well-defined trend-line. Breaching this trend-line (by closing below 2940) would suggest that the index was on its way back to the January low.



This week's significant US economic events [Notes: 1) The most important events (to the markets) are shown in bold. 2) A list of global economic events can be found HERE]

Gold and the Dollar

Gold

The US$ gold price fell about $25 last week, but there has been no change in the overall chart pattern. To breakout to the downside and indicate that a quick decline to the 200-day MA was underway the price will have to CLOSE below $1308.

We emphasised the word "close" in the above sentence because an intra-day spike below $1308 would not constitute a bearish breakout. In fact, an intra-day decline to well below $1308 followed by a rebound to end the day above $1308 would be a short-term bullish signal.



The speculative net-long position in gold futures continues to be a risk. It has dropped a little from its July peak, but at 315K contracts it remains in rarefied territory.

We have been anticipating a sharp decline to the 200-day MA (or lower) to end the correction, but the ability of the gold market to hold above support at $1308 despite repeated tests suggests two other possibilities. One is that an intermediate-term top is not yet in place, in which case there would likely be an October-November rally into the $1400s prior to such a top. The other is that the correction will be longer and shallower than expected. In this case there would likely be a rebound to test the July peak within the next few weeks as part of a flat correction that would extend into the first quarter of next year.

A near-term break below support and a quick decline to the vicinity of the 200-day MA would be the easiest scenario to trade, because it would soon create a low-risk opportunity for new buying. However, the market is obviously under no obligation to make things easy for us.

Like the US$ gold price, at the end of last week the euro gold price (gold/euro) was near a virtual precipice. In fact, gold/euro ended the week right at the edge of the precipice.



The US$ gold price and the euro gold price are in the same position now as they were two weeks ago, at which time they commenced 1-week rebounds. We have no opinion on whether this week will bring a rebound or a breakdown.

Gold Stocks

The HUI is one of the many markets/indexes that is coiling. As illustrated below, since reaching a short-term bottom on the first trading day of September it has been oscillating within a narrowing range. To break out of this range it must close below 225 or above 250.

A close below 225 would probably be followed by a quick decline to the 190s. This would be the easiest outcome to trade because such a decline would result in a low-risk buying opportunity. Alternatively, a close above 250 would suggest that the HUI was going to test its August peak as part of a longer correction than we were expecting.



The HUI/gold ratio is in a similar position to the HUI. The solid break below the 40-day MA (the blue line on the following chart) during the second half of August indicates that an intermediate-term correction is in progress, but performance since the end of August has been non-committal. In particular, there has been no positive or negative divergence between the HUI/gold ratio and the HUI.



Finally, here is an update of our chart comparing the rally in the HUI from its January-2016 bottom (the blue line) with the rally in the Barrons Gold Mining Index (BGMI) from its 1982 bottom. Despite the blatant fundamental differences between 1982-1983 and 2016, the rally from the 2016 low has been more similar to the 1982-1983 rally than to any other gold-sector rally from a multi-year low.

For what it's worth, this chart comparison points to a tradable bottom being put in place during the second half of October.



The Currency Market

The Dollar Index

The Dollar Index is in a similar position to the SPX, except that whereas it will be difficult for the SPX to avoid breaking out one way or the other within the next two weeks it will be difficult for the Dollar Index to avoid breaking out this week. Unfortunately, the chart pattern does not suggest a likely direction for the coming breakout.

As previously advised, a downside breakout would probably be followed by a quick decline to major support at 92.5-93.0. The target following an upside breakout is less obvious, although 96.5-97.0 would be a minimum short-term objective.



When we refer to US$ fundamentals being strong we are referring to strength in US equities relative to European equities or global equities. This is because 1) intermediate-term trends in the Dollar Index usually go hand-in-hand with trends in the SPX relative to global equities as represented by the MSCI World (ex USA) Index (MSWORLD), and 2) intermediate-term trends in the US$/euro exchange rate usually go hand-in-hand with trends in the SPX relative to European equities as represented by the iShares MSCI Eurozone ETF (EZU).

The following chart illustrates the positive long-term correlation between the Dollar Index and the SPX/MSWORLD ratio. Notice that during the period since late last year (the period inside the rectangle) the SPX/MSWORLD ratio has continued to trend upward, meaning that the US dollar's fundamentals have continued to strengthen, but the Dollar Index has fallen. This is a divergence that will have to be closed over the months ahead via either substantial relative weakness in the US stock market or a rally to new multi-year highs in the Dollar Index.



The Canadian Dollar (C$)

The C$ continues to drift with a slight downward bias. A close above 78 would suggest that a substantial 3-6 month rally had begun, whereas a close below 75 would suggest that a decline to 72 or lower had begun.

Our view is that the C$ made a major bottom along with the commodity indices early this year but that it could test its January-2016 low as part of a basing process.



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

Company news/developments for the week ending Friday 30th September 2016:

[Note: AISC = All-In Sustaining Cost, FS = Feasibility Study, FY = Financial Year, IRR = Internal Rate of Return, ISR = In-Situ Recovery, MD&A = Management Discussion and Analysis, M&I = Measured and Indicated, NAV = Net Asset Value, NPV(X%) = Net Present Value using a discount rate of X%, P&P = Proven and Probable, PEA = Preliminary Economic Assessment, PFS = Pre-Feasibility Study]

  *Ramelius Resources (RMS.AX) issued its 2016 Resources and Reserves Statement last week. Total resources are estimated to be 2.2M ounces and total reserves are estimated to be 400K ounces. These figures are little changed from the preceding year as mining depletion was mostly offset by resources added via exploration.

RMS only has enough reserves to sustain its current rate of production for 3-4 years, which explains why the company has a low stock market valuation relative to most other 100K-oz/year gold producers. However, RMS consistently identifies or acquires sufficient additional in-ground gold to ensure that its reserve life never drops below 3 years. At some point the stock market will probably figure this out.

List of candidates for new buying

This section was a regular feature of the Weekly Update until a few months ago, when it was removed because the stocks on which we were most bullish from a long-term perspective had all become very 'overbought' on a short-term basis. It is making a comeback because some of our favourite stocks are now only one moderate multi-day decline away from reaching price levels at which new buying could be appropriate.

From within the ranks of TSI stock selections the best candidates for new buying at this time, listed in alphabetical order, are:

1) AAU near US$1.00 (last Friday's closing price: US$1.40)

2) ESM.TO near C$1.00 (last Friday's closing price: C$1.22)

3) EVN.AX near A$2.00 (last Friday's closing price: A$2.51)

3) PG.TO in the C$3.50s (last Friday's closing price: C$4.04)

4) PRQ.TO (last Friday's closing price: C$1.91)

Note that the above list is limited to five stocks. It will sometimes contain less than five, but it will never contain more than five regardless of how many stocks are attractively priced for new buying.

Introducing Oz Minerals (ASX: OZL). Shares: 302M. Recent price: A$6.08

OZL is an Australian mid-tier copper producer that also produces a significant quantity of gold (gold production will amount to about 23% of total production over the next 12 months). All current production comes from the 100%-owned Prominent Hill mine in South Australia, but it's likely that at least one of the company's exploration-stage projects will be developed into an operating mine within the next few years.

Accounting for gold as a byproduct, OZL's copper production is low cost. For example, over the most recent half-year the AISC was only US$1.20/pound. Consequently, OZL doesn't need a rise in the copper price to become profitable, that is, to become a viable business. It has a healthy profit margin at current metal prices, as evidenced by the fact that during the most recent half year the company generated A$178M of EBITDA and A$55M of NPAT (net profit after-tax).

Based on the latest half-year NPAT figure, the stock is currently being valued at around 17-times earnings. If we are now near the bottom of the base-metal price cycle then this is an attractive valuation.

With regard to valuation it is also worth mentioning that the book value is around A$7.60/share (about 25% above the current share price), the dividend yield is around 3% (the company has been paying an annual dividend of A$0.20/share), and the balance sheet is rock solid (no debt and A$560M of cash at 30th June 2016).

Production guidance is for 240M pounds of copper plus 130K ounces of gold in 2017, 198M pounds of copper plus 145K ounces of gold in 2018, and 154M pounds of copper plus 155K ounces of gold in 2019. That is, copper production is expected to taper off and gold production is expected to increase over the next three years. At current metal prices, the company's guidance implies that gold production will be 37% of total production in 2019.

From a speculator's perspective there is a pro and a con to owning the shares of a cashed-up, low-cost metal producer. The pro is that there is less risk of suffering a large loss. The con is that there is less leverage to upside in metal prices. However, OZL has enough leverage to metal prices to pique our interest.

The leverage doesn't come primarily from OZL's current production, but from its portfolio of undeveloped mineral deposits. Of particular significance are the Carrapateena copper project in South Australia and the West Musgrave nickel-copper project in Western Australia.

There's a good chance that within the next three years the 100%-owned Carrapateena project will be developed into a mine with annual production of more than 100M pounds of copper and 70K ounces of gold. A PFS is currently underway.

The West Musgrave project is at a much earlier stage of development, but it is massive (the global resource contains about 3.8B pounds of copper and 1.8B pounds of nickel). OZL recently inked a deal with Cassini Resources, the project's current owner, whereby OZL can earn 70% over the coming few years by spending A$36M and completing a feasibility study.

With its strong balance sheet and cash-flow, OZL should be able to comfortably fund the construction of a mine at Carrapateena and the planned exploration/engineering work at earlier-stage projects including West Musgrave.

OZL's valuation is low enough to justify buying at this time, but taking into account the price chart (see below) the optimum place to buy would be in the low-A$5 area. Our current plan is therefore to add OZL to the TSI List if it drops to A$5.00-A$5.20, although for our own account an initial position has already been established.



Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://bigcharts.marketwatch.com/