-- Weekly Market Update for the Week Commencing 6th August 2018

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 mid-2016, but there will be many years of topping action in bond prices and bottoming action in bond yields before major new trends get underway. A major decline in government bond prices will unfold during the 2020s. (Last update: 11 September 2017)

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.), gold-denominated prices and inflation-adjusted prices. This secular trend will bottom in 2020 or later. (Last update: 11 September 2017)

A cyclical BEAR market in the US Dollar began in 2016-2017. (Last update: 11 September 2017)

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 in 2020 or later. (Last update: 11 September 2017)

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 2020 or later. (Last update: 11 September 2017)

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True Fundamentals Summary [Notes: 1) The date shown next to the current True Fundamentals Model (TFM) signal is when the most recent change occurred. 2) Charts of the Gold and Equity TFMs are included in the "Charts and Indicators" section of the TSI web site]

Last week's posts at the TSI Blog

Have the Chinese pegged the gold price?

Summary of current thinking/positioning

1) Despite numerous attempts, the Dollar Index (DX) has failed to close above resistance at 95. This leaves us expecting a DX decline to 92 and a euro rally to 1.20 within the next 1-2 months.

2) There is a good set-up for counter-trend rallies in the gold and silver markets, but upward reversals have not been signaled. This leaves the door open to new 2018 lows prior to meaningful rallies getting underway.

3) The gold-mining indices extended their downward trends into August, but are yet to experience a capitulation. This creates the risk that a speculative capitulation lies ahead. We have substantial exposure to the gold-mining sector and have hedged against this short-term risk via GDX put options.

4) There are numerous divergences within the US stock market. With monetary conditions tightening, the short-term downside risk appears to be high.

5) Most industrial commodities probably will remain in correction mode for another 1-3 months.

6) The T-Bond price should have an upward bias (meaning: the T-Bond yield should have a downward bias) for at least the next two months.

7) We are holding a cash reserve of around 30% and looking for opportunities to build up this reserve.

The Fed, the yield curve and "inflation"

The following chart shows that over the past fortnight the 10yr-2yr yield spread came within 0.24% of zero. This means that the US yield curve recently came within 0.24% of inverting. Based on speeches made over the past couple of months we know that senior Federal Reserve officials are worried that the yield curve will soon invert.



The Fed's senior people are obviously aware that the yield curve has inverted prior to recessions in the past and are concerned that an inversion would bring on the next recession. Therefore, at some point over the next few months the Fed may take actions designed to steepen the yield curve. If so, will this reduce the risk of recession?

The answer is yes and no. The Fed could reduce the risk that a recession will begin in 2019, but only by setting the stage for an even more painful economic decline to begin in 2020. Also, the Fed representatives who are concerned about the historical relationship between yield-curve inversion and recession are assuming that correlation implies causation. However, a yield curve inversion has never been the cause of a recession. A yield curve inversion is just a symptom that a credit-fueled boom is 'long in the tooth'. The boom itself is the cause of the bust and it's the reversal of the curve from flattening to steepening that signals the death of the boom.

That being said, at this point a reversal in the US yield curve from flattening to steepening would be a reliable signal that the boom is over only if it were driven by the market. If, instead, it were driven by the Fed, for example, by the Fed prematurely ending its rate-hiking due to fear of a yield-curve inversion, then it more likely would be a signal that the boom was going to enjoy a 'final fling'. In this case, the final fling would involve rising inflation expectations -- gradually at first and then rapidly.

When we look at the 10-year and 2-year T-Note yields individually it isn't hard for us to imagine the US yield curve becoming inverted within the next few months. In particular, the 10-year T-Note yield appears to be completing a short-term topping pattern on the chart (see below) at a time when speculators in 10-year T-Note futures have a record-high net-short position (meaning: there is presently a record-high speculative bet that the yield will rise). The combination of the chart and speculative positioning suggests the short-term potential for the 10-year yield to pull back to 2.5%-2.6%.



At the same time, the 2-year T-Note yield remains in a strong upward trend (see below), and with the Fed set to increase its targeted overnight interest rate to 2.00-2.25% in September there does not appear to be much short-term downside potential.



If the 2-year yield stays where it is and the 10-year yield achieves the objective suggested by its short-term topping pattern, then the US yield curve will invert. This could happen within two months.

Based on what has been said by several Fed officials, an inversion of the yield curve likely would provoke some panic within the halls of the central bank that would manifest initially as a temporary cessation of the rate-hiking program. Therefore, it's very possible that the September rate hike will be the last rate hike for many months.

If the Fed signals the temporary cessation of its rate-hiking program within the next two months the likely consequences would include a small decline in rates at the short end of the curve and, in response to higher inflation expectations, the start of a multi-quarter upward trend in rates at the long end of the curve. In other words, it's likely that the Fed would set in motion a substantial steepening of the yield curve driven by rising inflation expectations.

The metals 'correction' continues

Only the commodity markets will be adversely affected by the reduction of international trading and economic growth that will result from the protectionist measures and counter-measures that have been implemented or are under consideration. At least, that's the message from the market action of the past two months. During this period the industrial metals markets were pummeled while stock markets were calm.

For example, the copper market completed a deceptive intermediate-term topping pattern in early-June and then tanked. It appears to be on its way to major support near US$2.50, with or without an intervening rebound to test resistance in the mid-$2.90s.



For another example, the cobalt price ran up to a high in March, leveled off for about three months and then plunged over the past two months. It is now down by about 30% from its Q1 high.



We think that this year's price declines in copper, cobalt and most of the other important industrial metals are intermediate-term corrections within major bullish trends that will resume before year-end. The major bullish trends are powered by a very compelling fundamental story in the form of exponential growth in EV production and by the likelihood that the Fed will veer off its monetary tightening course at early signs of trouble. Until recently we thought that it would be a sizable stock market decline that pushed the Fed off its tightening course, but it is beginning to look more like a yield curve inversion will be the disruptive force.

The Stock Market

Tesla Update

When it comes to Tesla (TSLA), the bad news is always the actual results of the business while the good news is always what the company's CEO promises the business will achieve in the future. In the minds of the many diehard TSLA bulls, it's irrelevant that these promises have usually amounted to nothing in the past.

It was the same story last week. The company announced that it had made a record-breaking quarterly loss of US$717M and burned through about $700M of cash during the latest quarter, but the stock price rocketed upward following this news because Elon Musk was polite to analysts on the conference call and promised that future quarters would be profitable.

Perhaps TSLA will be able to report positive net earnings for a quarter or two, but it will take a lot more than a shift to nominal profitability to justify the company's $64B enterprise value. Also, even if TSLA is able to sort out its manufacturing issues and begin producing more cars at a lower cost per car, it is about to a) lose the benefit of the tax credit that encouraged a lot of the early Model 3 purchases and b) face a rapid rise in competition from the likes of Volkswagen, BMW, Mercedes, Jaguar, Audi and Porsche.

It's extremely improbable that TSLA will ever sell enough vehicles with a sufficient profit margin to justify its current market valuation. Bankruptcy is a far more likely outcome. However, a large herd of investors remains committed to the TSLA story and prepared buy/hold regardless of valuation. At the same time, the stock's downside risk is well known and, as a result, TSLA is the most 'shorted' stock in the US market.

Due to the large number of shares sold short there are periodic bursts in the stock price fueled by short covering. As illustrated by the following weekly chart, such a burst occurred last week. Almost all of last week's 17% gain occurred on the day after the announcement of the record quarterly loss.

We may attempt another bearish TSLA speculation in the future, but at the moment we have this stock in the 'too hard basket'.



Current Market Situation

The S&P500 Index (SPX) reversed course after touching its channel top during the week before last, but last week it returned to the vicinity of its July high. The top of its rising channel now coincides with the January high, meaning that there is now a confluence of resistance at around 2875. This resistance may be tested within the next few days, but it shouldn't be exceeded on a daily closing basis and mustn't be exceeded on a weekly closing basis if we our overarching market view is correct.



The NASDAQ100 Index (NDX) has been stronger than the SPX over the past few months, but, as mentioned in last week's Interim Update, is closer than the SPX to confirming a downward reversal. That's because it would have to do no more than close below last Monday's low of 7158 to suffer a potentially significant downside breakout.



The upshot is that the US stock market has large short-term downside potential, but the potential is yet to be confirmed by the price action.

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 Fundamentals

When most market analysts state whether the fundamental backdrop is bullish or bearish for gold, they are stating their opinion and their opinion is most likely based on gut feel. They have no way of objectively quantifying the fundamental situation. Instead, they look around and come to a conclusion based on what they see.

The most obvious problem with this approach is that any conclusions will be strongly influenced by personal biases. Another problem is that the fundamental drivers of the gold price aren't statistics such as the money supply and the amount of government debt, but the general PERCEPTIONS of what these statistics mean for economic growth, the financial system, "inflation" and interest rates in the future.

Our Gold True Fundamentals Model (GTFM) is not influenced by our personal biases. The Model's output is what it is, regardless of what we think of the economic and financial-market situations. Also, the Model's inputs are largely based on how market participants collectively view the economic and financial-market situations. For example, we may very well think that the economy is 'skating on thin ice', but if credit spreads are very narrow then we know that our view is an outlier and that economic perceptions are not supportive of the gold price.

When constructing the GTFM we considered -- based on the general idea that gold's value is the reciprocal of confidence in the financial system and the economy -- what should be the main influences on the gold price. This gave us a list of potential price drivers. We then tested each of these potential drivers against the price data to confirm that there was a significant correlation. For example, it can be shown that there is a strong and consistent relationship between the TIPS yield and the US$ gold price and between credit spreads and the US$ gold price, but no consistent relationship between the US$ gold price and either the CPI or the level of federal government debt. The result was a list of seven factors whose inclusion in a gold model was justified both logically and empirically.

The GTFM is sensitive to shifts in the fundamental backdrop. This makes it quick to signal significant new trends, but also makes it susceptible to being 'whipsawed'. For example, it got whipsawed between late-June and mid-July of this year when it went from bearish to bullish and back to bearish. It will continue to get whipsawed from time to time, but over the past 15 years the intermediate-term trends in the gold price have always been consistent with where the GTFM has spent the bulk of its time.

The GTFM remained in bearish territory last week.



In the short term, the most likely cause of a positive shift (from gold's perspective) in the fundamental backdrop is a T-Bond rally combined with a decline of at least a few percent in the S&P500 Index. However, looking beyond the next few months we can envisage a very gold-bullish fundamental backdrop emerging on the back of rising US inflation expectations. Rising inflation expectations are bullish for gold to the extent that they reduce real interest rates, steepen the yield curve and weaken the US$.

A substantial rise in inflation expectations probably won't be a factor in the financial markets over the remainder of this year, but it could be the most important factor during 2019-2020.

Sentiment

There won't be something more than a short-term rebound in the gold price until the GTFM makes a sustained shift into bullish territory. However, the sentiment backdrop is now very supportive of the gold price, so the next short-term rebound should be strong.

A week ago we wrote: "The COT situation is supportive, but not decisively so because the open interest in gold futures is too high. Important lows in the gold price tend to go with relatively low open interest."

As illustrated by the green bars in the bottom section of the following chart, there was a significant decline in the gold futures open interest (OI) last week. We now have OI in the bottom third of its 3-year range and the total speculative net-long position at its lowest level since early-2016. Consequently, for the first time this year the COT situation is decisively supportive of the gold price.



As illustrated by the chart included in last week's Interim Update, the Consensus-inc sentiment survey is also decisively supportive.

The upshot is that sentiment is now a strong tail-wind for the gold price.

The Price Action

The US$ gold price tested its July low last Friday and then rebounded. The price action was slightly bullish, but a reversal has not been signaled yet.

The following paragraph from last week's commentary remains applicable:

"Until an upward reversal is signaled via a daily close above $1240 there will be a risk of a final decline to a new 12-month low. As illustrated by the following daily chart, no upward reversal has been signaled yet. A decline to a new low probably would take the form of a downward spike to the $1190s, but there's a risk of a larger decline. The most likely catalyst for a larger decline would be an upside breakout in the Dollar Index."



Summing up, in the gold market we have unequivocally bearish fundamentals, unequivocally bullish sentiment, and price action that could be either a base (an upward reversal in the making) or a consolidation within an on-going decline. The sentiment situation could enable a sizable ($100+) short-term rebound even if the fundamentals remain bearish, but until an upward reversal is signaled there will be a high risk of a decline to new 12-month price lows.

Silver

Relative to support/resistance, the US$ silver price is in a very similar position to the US$ gold price. Like gold, silver recently broke below intermediate-term support defined by its December-2017 low. Also like gold, silver tested its July low last Friday and then rebounded.



Unlike the situation in the gold market, current sentiment in the silver market does not constitute a strong tail-wind for the price. In fact, thanks to persistent optimism on the part of the dumbest money (the "NonReportable" traders) and the relatively high open interest in silver futures, silver's current COT situation is no better than neutral. However, the silver price almost certainly will rebound when the gold price rebounds.

Gold Stocks

Both the HUI and GDX (the Gold Miners ETF) ended the week before last at major support levels, prompting us to write:

"The gold-mining sector has reached a critical juncture. The indices/ETFs will either hold support near their current levels and soon commence 2-4 month rallies OR break below support and accelerate downward. The former outcome has the higher probability, but due to last week's decline in the HUI/gold ratio and the fact that the bullion market hasn't generated any evidence of a bottom we should be prepared for the possibility that the latter outcome will happen."

Last week support held, but there was no rebound to speak of so the situation is virtually unchanged. The gold-mining sector remains at a critical juncture.

The following daily chart shows that the lateral support level currently being tested by GDX has been tested numerous times over the past 18 months. When a support level has been tested this many times it usually will have to be breached prior to the start of a substantial rally. This is because the capitulation that happens in reaction to the violation of the obvious support 'clears the decks'. Therefore, ideally there will be a brief plunge by GDX to well below $21 in the near future.

In the absence of a 'deck clearing' plunge the best that we probably will get from GDX is a 1-3 month rebound to $23-$25.



The Currency Market

Perhaps not surprisingly, the Dollar Index (DX) is in the opposite situation to gold. Whereas the gold market is facing bearish fundamentals and bullish sentiment, the DX is facing bullish fundamentals and bearish (dangerously optimistic) sentiment.

The bullish fundamental backdrop for the DX is due to the strength in US equities relative to European equities and the expanding gap between US and European interest rates (specifically, the increase in the US 10-year government bond yield relative to the German 10-year government bond yield).

Regarding sentiment, the following chart shows that over the past 10 years all of the major peaks in the Consensus-inc bullish sentiment for the DX were in the 75%-80% range and that at the end of the week before last the DX's bullish sentiment was 75%.



Last week the DX stayed inside its "rising wedge" and again failed to achieve a weekly close above lateral resistance at 95. For details refer to the daily chart displayed below. This week it could trade as high as 95.5 while remaining within its "wedge", but it shouldn't give a weekly close above 95 if we are dealing with a topping pattern rather than a mid-trend consolidation.



Interestingly, the following weekly chart shows that over the past 10 weeks the DX has repeatedly risen to its 200-week MA (the blue line) without managing to achieve a weekly close above this MA. It should continue to hold below its 200-week MA if we are dealing with a topping pattern.



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 3rd August 2018:

[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%, NSR = Net Smelter Return, P&P = Proven and Probable, PEA = Preliminary Economic Assessment, PFS = Pre-Feasibility Study]

  *Blackham Resources (BLK.AX) published its quarterly activities and cash-flow reports for the June quarter. Given that the company had announced its production results and net debt level about two weeks earlier, the most important information in these reports was already known.

The only new information of real interest to us was the section titled "Controlled Placement Agreement". This section contained the following:

"During July 2018, the Company entered into a Controlled Placement Agreement (CPA) with Acuity Capital. The CPA provides BLK with up to $10 million of standby equity capital over the coming 29 month-period. Importantly, Blackham retains full control of all aspects of the placement process, having sole discretion as to whether or not to utilise the CPA, the quantum of shares issued, the minimum issue price of shares and the timing of each placement tranche (if any). There are no requirements on Blackham to utilise the CPA and Blackham may terminate the CPA at any time, without cost or penalty. If Blackham does decide to utilise the CPA, Blackham is able to set a floor price (at its sole discretion) and the final issue price will be calculated as the greater of that floor price set by Blackham and a 10% discount to a Volume Weighted Average Price over a period of Blackham's choosing (again at the sole discretion of Blackham)."

This means that BLK's management has given itself the flexibility to raise money (up to A$10M) by selling new BLK shares in the stock market over the next 29 months at whatever price it deems appropriate.

We view this news as negative, because the "CPA" makes it easy for BLK's management to dilute the stock.

  *Premier Gold (PG.TO) reported drilling results from the Rey de Oro deposit (a zone that will be brought into production this year) at its Mercedes gold-silver mine in Mexico. The drilling confirmed the extension of a high-grade vein system and included some excellent intercepts, with the best one being 36.65 g/t Au and 171.30 g/t Ag across 21.95 metres in Hole UG-R018-006.

This is obviously good news.

Also in the good news department, PG advised that after a poor first half production performance by the Mercedes mine, production is now increasing as planned with July being the best month so far in 2018.

  *Tinka Resources (TK.V) reported drilling results that extend the high-grade zinc mineralisation at the company's Ayawilca project in Peru. It appears that there are substantial widths of high-grade zinc below the currently-defined resource and also that it will be possible to connect the 200m+ gap between mineral resources at the West and Central Ayawilca deposits.

This is good news. The Ayawilca deposit is already of sufficient size and grade to be of interest to a large industrial-metals mining company and looks set to get even better.

List of candidates for new buying

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

1) AAU (last Friday's closing price: US$0.66)

2) CNL.TO (last Friday's closing price: C$3.74)

3) PG.TO (last Friday's closing price: C$2.50)

4) PRQ.TO (last Friday's closing price: C$0.93)

5) SBB.TO (last Friday's closing price: C$1.46)

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.

Osisko Gold Royalties Warrants (TSX: OR.WT) added to the TSI List at C$1.05

Osisko Gold Royalties (OR, OR.TO) is like a hedge fund that invests in gold/silver royalties, gold/silver streaming deals and junior gold/silver mining stocks. Its current market cap is around C$1.9B, as is its book value.

We previously wrote that the OR warrants (OR.WT on the TSX) would be added to the TSI List if they traded at C$1.05. They traded at this price last week.

The warrants have an exercise price of C$36.50, meaning that they are a very long way out of the money (OR ended last week at C$11.92, which is close to the bottom of its 3-year range). However, they don't expire until 18th February 2022, so there is a lot of time for the sort of increase in the stock price that would inject substantial value into the warrants.

Note that our interest in these warrants isn't based on a belief that OR shares will trade well above C$36.50 by February-2022. It's possible that they will, but that's not a bet we would make. Our bet is simply that there will be a large-enough rally in the stock price at some point over the coming year or two to cause the warrants to trade at least 200% above their current price. A 50% gain in the stock price probably would be enough if it happened within the next 12 months.



Update to TSI Small Stocks Watch List (SSWL)

Northern Empire Resources (NM.V) is a small, exploration-stage gold miner that was added to the SSWL in May of last year. Its speculative merits were subsequently discussed four times in TSI commentaries, most recently in the 11th December 2017 Weekly Update.

Last Thursday it was announced that NM had agreed to be acquired by Coeur Mining (CDE) in an all-stock transaction that initially valued NM at C$1.64/share. Due to a post-announcement pullback in CDE's stock price, NM shares ended the week at C$1.52.

At last week's closing price NM was up by almost 200% from the time it was added to the SSWL. This is a good result considering that the HUI was down by about 10% over the same period.

If you own NM shares you should take your profit by selling into the market unless you want to own CDE shares. We don't want to own CDE shares.

NM has been removed from the SSWL.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.goldchartsrus.com/
http://www.lme.com/