-- Weekly Market Update for 8th July 2019

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

There were no blog posts last week.

Summary of current thinking/positioning

1) The Dollar Index (DX) has commenced a downward trend, but it could be a few months before the new trend becomes consistent. In the meantime the price action could be choppy, possibly involving a test of the May high near 98.

2) The US$ gold price has broken out to the upside on a monthly basis. Significant additional gains are likely within the next three months -- after a correction has run its course. The correction was/is expected to result in a test of former resistance (now support) in the $1350-$1380 range. The US$ silver price stands a good chance of making a catch-up move over the months ahead.

3) The gold-mining indices/ETFs became extremely 'overbought' late last month and are now in correction mode. The correction most likely will end after either a decline to the 50-day MA or a few more weeks of sideways movement.

4) The SPX probably will commence a sizable multi-week decline within the next two weeks.

5) An upside blow-off has set the stage for a large T-Bond decline. If the decline didn't begin on Friday 5th July then it should begin very soon, although it could be September-October before the market starts trending downward with conviction.

6) Oil's correction is probably over, although there is still a risk that stock market weakness during July-August will push the oil price to a new multi-month low.

7) We are holding a cash reserve of 25%-30%.

US Recession Watch

A month ago we wrote that if commonsense did not prevail within the next few months then the Trump tariffs could be comparable to the Smoot-Hawley tariffs of 1930 in terms of their economic cost (one of the few things that almost all economists agree on is that the Smoot-Hawley tariffs exacerbated the Great Depression). Over the intervening period the tariff-related risk to the US economy was reduced by the withdrawal of the threats to a) impose a hefty tax on all imports from Mexico and b) add a tax to another $300B of imported Chinese products. In any case, regardless of whether the proximate catalyst for an economic contraction is the "trade war" or something else entirely, our favourite leading recession indicators should generate timely warning signals. These indicators are the ISM New Orders Index (NOI), Real Gross Private Domestic Investment (RGPDI) and the yield curve.

The latest monthly NOI was reported on Monday 1st July and revealed that there was a small but significant decline in this measure of manufacturing-industry strength in June. The index is now at 50, a new 2-year low.

50 is the official demarcation line between economic expansion and contraction, but interpreting a sub-50 NOI as a recession warning results in too many false signals. For example, it would have resulted in false recession signals in 2012, 2013, 2015 and 2016. Most of the false signals are eliminated without causing significant delays to genuine signals if we set the demarcation line at 48, which is why we define an NOI decline to below 48 (the red line on the following chart) as a recession warning.

The upshot is that the NOI hasn't issued a recession warning yet, but it is close to doing so.



The next quarterly RGPDI number will be published late this month, so by the time we do our next "US Recession Watch" we will have new RGPDI information.

The yield curve generates a recession warning when it 'flattens' to an extreme and then begins to steepen, regardless of whether or not the extreme entails an inversion.

The US yield curve is represented on the first of the following charts by the 10yr-2yr yield spread and on the second of the following charts by the 10yr-3mth yield spread. The 10yr-2yr spread has increased a little since bottoming late last year and recently made a failed break above its 200-day MA, whereas the 10yr-3mth spread remains in a clear-cut downward trend and close to an 11-year low.

As an aside, we require that a reversal in the yield curve be signaled by reversals in both the 10yr-2yr and 10yr-3mth spreads. This reduces the risk of being whipsawed. For example, if we had been focused on only the 10yr-2yr spread then we would have been whipsawed by this spread's recent non-sustained upward reversal.

The 10yr-3mth spread has dropped well into negative territory, meaning that this part of the yield curve is decisively inverted. The fact that it remains in a declining trend indicates that the boom has not ended yet, but the fact that it is well below zero indicates that the boom almost certainly will end within the next 12 months.

Based on the latest data, our rough estimates of recession start-time probabilities are:

  - Q3-2019: 10% (down from 15% a month ago)
  - Q4-2019: 30% (down from 35% a month ago)
  - 2020: 50% (not specified a month ago*)
  - Later than 2020: 10% (not specified a month ago*)

    *Last month we had a 50% probability of a recession starting later than 2019. That has increased to 60%.

Monetary Inflation Roundup

Here is our monthly update on what's happening on the monetary inflation front in a few different regions/countries.

Over the past three months the G2 (US plus euro-zone) monetary inflation rate moved sideways at a 10-year low of 4.3% and now has spent 21 months below the boom-bust threshold of 6%. Refer to the following chart for details.



The low rate of G2 monetary inflation stems from the very low rate of money-supply growth in the US. The year-over-year (YOY) rate of growth in US True Money Supply (TMS) is languishing at 2%, which is close to a 20-year low.

Despite the slow pace of growth in US money supply, US monetary conditions are still quite easy thanks to the reduced demand to hold cash. That's why the slow monetary inflation rate has not yet set in motion an economic bust and brought the bull market in US equities to an end.

It isn't possible to measure directly the demand to hold cash balances, but there are financial-market indicators of money demand relative money supply. The average credit spread is one of the best. Regardless of what's happening to the supply of money, when credit spreads across the economy are narrow by historical standards it means that monetary conditions are 'easy', and when credit spreads across the economy are wide by historical standards it means that monetary conditions are 'tight'. The following chart shows that credit spreads currently are near 20-year lows.



Australia's monetary inflation rate has picked up a little over the past few months, but the country remains on the verge of monetary deflation.

The very slow money-supply growth has taken a significant, albeit not yet substantial, toll on Australia's property market. There are signs that a post-election boost to sentiment is providing some price support, but house prices in Sydney and Melbourne, the two largest Australian cities, are down by an average of 15% and 11%, respectively, since their 2017 peaks.



Canada's monetary inflation rate bottomed at 2.8% (the lowest level in more than 15 years) 12 months ago. It has since rebounded to a little over 5%, which is still very low based on the standards of recent decades.

On a nationwide basis the effects of the relatively slow pace of money-supply growth have been minor to date. For example, house prices have leveled off over the past 6-12 months, but a sizable price correction has not occurred...yet.



The YOY rate of growth in Hong Kong's M2 money supply has languished near a 10-year low in the 1%-4% range over the past year. Remarkably, however, the low monetary inflation rate is yet to have a pronounced effect on the world's most expensive real estate (the average house price in HK is about 40% higher than the average house price in Singapore, the world's second most expensive city to buy a house, and approximately double the average house price in New York and London). Property prices dropped in HK during August-December of last year, but they have since made new all-time highs.

Due to the monetary backdrop we think there's a high risk of a double-digit decline in HK property prices over the next 12 months. That being said, it is notoriously difficult to predict when a major investment bubble will burst.



In summary, the pace at which new money is being created around the world remains unusually slow, but the effects of the monetary slow-down have been surprisingly 'uninteresting' to date. As mentioned in relation to the US, this could be due to a general decline in the desire to hold cash.

Interest Rates

What the market expects from the Fed

According to the prices of Fed Funds Futures (FFF) contracts, over the past 1-2 weeks the market has dialed back its expectations regarding Fed rate cuts.

Two weeks ago the market had priced in three-and-a-bit 0.25% rate cuts before year-end, but now the market is pricing in only two-and-a-half 0.25% rate cuts. Also, two weeks ago the market had assigned a probability of around 50% that the Fed would start its rate cutting with a 0.50% move at the end-July FOMC meeting, but thanks largely to a positive surprise in the US employment numbers reported on Friday 5th July the assigned probability of a 0.50% cut at the end of July has dropped to zero. The expectation, now, is that the Fed will cut by 0.25% at the end of this month and make 1-2 additional 0.25% cuts before the end of the year.

Our current guess is that the Fed will make two 0.25% rate cuts before the end of September and be on hold for the remainder of the year.

A potential T-Bond reversal

Tentative signs have emerged of a downward trend reversal in the bond market.

As illustrated by the following daily chart, the 20+ Year Treasury ETF (TLT) made a new high for the year on Wednesday 3rd July and then dropped sharply on Friday 5th July (the market was closed on Thursday). In addition, the higher highs achieved by TLT since the end of May have gone with a downward trend in the daily RSI shown at the bottom of the following chart. This is a potentially bearish momentum divergence.

A daily close below last week's low would be preliminary evidence that a top of at least short-term importance is in place.



The Stock Market

Current Market Situation

At this time last week the outcome of the Trump-Xi meeting had just become known, prompting us to write: "Although the meeting outcome appears to be in line with what most market participants were expecting, the removal of a near-term source of uncertainty could give sentiment a sufficient boost to push the senior US stock indices to new all-time highs this week."

It turned out that sentiment was, indeed, given a sufficient boost by the temporary winding-down of US-China government conflict to push the SPX into new-high territory, with the breakout confirmed and led by the Advance-Decline Line (ADL).



However, at this stage the S&P500 (SPX) is the only important US stock index to break out to the upside on a weekly closing basis. Some indices are testing their highs and therefore are close to breaking out to the upside, while other indices are not remotely close to their all-time highs. The following daily charts show an example of the former (the NASDAQ100 - NDX) and the latter (the Dow Transports - TRAN). The NDX is testing its April-2019 all-time. The TRAN, however, is well below its April-2019 high, which, in turn, is well below the 2018 all-time high.

Given the TRAN's tendency to be a leader to the downside around important stock market peaks, this index's relative weakness should be viewed as a significant bearish divergence.

The on-going strength in the ADL indicates that a major decline is NOT about to begin, but the combination of the recent put/call sell signal and the divergences between the stock indices is a reason to think that a tradable 1-2 month decline will get underway soon.

The tendency of the US stock market to make an intermediate-term top during the first half of July is also noteworthy. For example, intermediate-term tops occurred at this time of the year in 1990, 1998, 1999, 2007, 2011 and 2015.

With regard to speculating ideas, over the past 1-2 weeks we wrote that a boost from trade-related optimism would present an opportunity to establish or add to short-term bearish speculations, with risk then managed by placing an initial 'stop' slightly above whatever high is in place by mid-July. We also mentioned an alternative tactic, which was to wait for a downward reversal before entering or adding to a bearish speculation. Specifically, we wrote that if the SPX closed at a new all-time high (above 2964), then a subsequent daily close below 2940 could be viewed as a reversal signal.

The SPX has closed at a new all-time high, so a daily close below 2940 could now be viewed as a reversal signal.

In summary, we think that the long-term bull market is intact, but we are expecting that a tradable 1-2 month decline will start by the middle of this month.

A brief comment on the banking sector

On the following weekly chart there is a note to the effect that the current position of the US Bank Index (BKX) is similar to the position of this index at this time (early July) three years ago. If the similarity persists then the BKX will perform very well over the next 6 months.

One of the keys to how the banking sector performs over the next several months will be the performance of the bond market. In particular, if the T-Bond is about to embark on an intermediate-term decline, which it was at this time three years ago, then the BKX will be helped by an interest-rate tail-wind (bank stocks tend to do relatively well when long-term interest rates are rising).



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 market was volatile last week. The price oscillated wildly between the high-$1380s and the low-$1440s before settling at $1400 -- down by $13 over the course of the week. We think that the volatile price action is happening within the context of a multi-week correction that could result in a drop to as low as $1350.

To maintain the potential to extend the rally over the months ahead, gold should not end a week below $1350.



Credit spreads generally trend in the opposite direction to economic confidence, as does the gold/commodity ratio. For example, when economic confidence is on the decline then credit spreads usually will widen and gold usually will perform well relative to the average commodity. That's why the following chart shows a strong positive correlation between the IEF/HYG ratio, a credit spread indicator, and the gold/GNX ratio (the gold price divided by the GSCI Spot Commodity Index).

We suspect that it would take more stock market weakness than we are bargaining on over the months ahead to widen credit spreads beyond where they were at the height of the Q4-2018 panic. That's part of the reason we expect the average commodity to perform better than gold over the remainder of this year, although we won't be surprised if gold maintains its leadership for a couple more months.



Silver

The silver market continues to be sluggish. This is a little frustrating, but it isn't unusual for silver to lag gold in a big way in the early stages of a substantial upward trend and to subsequently make a catch-up move.

As we mentioned last week, if the silver price ends a week above US$15.60 it will generate evidence that an intermediate-term rally has begun. In the meantime, weakness in the silver price should be viewed as a buying opportunity.



Gold Stocks

The HUI peaked almost two weeks ago and has since oscillated in a narrow range near its high. The most likely scenario is that this is a mid-trend correction that will continue until the daily RSI(14) drops to 50 or the price reaches the rising 50-day MA.

Note that the daily RSI could drop to 50 as the result of 2-3 weeks of additional sideways movement near the June high, that is, the most likely scenario doesn't have to involve meaningful price weakness.

Ideally (from a bull's perspective), the HUI will 'chop around' for 2-4 more weeks while holding above support at 180. That would fully 'correct' the rapid May-June advance without doing any technical damage to the chart pattern.



However, there are always multiple realistic scenarios. Another is that a 1-3 week sideways consolidation is almost complete and there will soon be a rise to a new high for the year. From a bull's perspective this scenario would be less appealing because it would involve a break to a new high with the market still stretched to the upside, increasing the risk of a breakout failure.

Furthermore, a break to a new high for the year by the gold-mining sector (as represented by the HUI and GDX) that was not accompanied by a break to a new high for the year by the US$ gold price would constitute a potentially bearish divergence. It wouldn't be seen that way by the vast majority of market analysts/commentators, since most people assume that strength in gold-mining stocks relative to gold bullion is always bullish. However, when the gold market is stretched to the downside a divergence of any kind between the bullion and the mining sector will tend to have bullish implications and when the gold market is stretched to the upside a divergence of any kind between the bullion and the mining sector will tend to have bearish implications. For example, the big rallies in gold and the gold-mining sector that unfolded during January-August of 2016 kicked off with a supposedly BEARISH divergence (a new multi-year low in the HUI in parallel with a much higher low in the US$ gold price) and ended with a supposedly BULLISH divergence (a new high for the year in the HUI combined with a lower high for the year in the US$ gold price).

Finally, it's worth mentioning that the HUI/gold ratio's performance over the past three weeks continues to look like its performance during the first few weeks of the 2016 rally.



The Currency Market

Christine Lagarde, the current head of the IMF, has been nominated to replace Mario Draghi when his tenure as ECB chief ends on 31st October. We doubt that Lagarde could do a worse job than Draghi, since Draghi presided over the most destructive monetary policy implemented by any major central bank over the past 100 years. However, Lagarde believes in the efficacy of QE and Negative Interest Rate Policy (NIRP), so she may well be just as bad.

Prior to last week's news the Dollar Index (DX) was 'oversold' and already set to rebound (in the 1st July Weekly Update we guessed that a counter-trend rebound would begin in the next week or so). However, the news that Mario Draghi will be replaced by someone of similar incompetence hurt the euro and therefore enabled a sharper rebound in the DX than otherwise would have occurred.

As illustrated below, last week the DX shot up to its 50-day MA and in doing so moved back above its 200-day MA and the bottom of the 'wedge' that formed over the past year. The rebound probably isn't over.

Based on the information we have today we would view a rise in the DX to 97.7-98.0 as an opportunity to establish a bearish US$ trade.



Late last month the Yen traded marginally above its early-January high and then entered correction mode. It bounced off support on Friday, but we suspect that the correction is no more than half complete in terms of both price and time.

Due to the strong positive correlation between the Yen and the US$ gold price, the likelihood of the Yen falling further before reaching a correction low is a reason to expect additional weakness in the gold market.



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 5th July 2019:

[Note: AISC = All-In Sustaining Cost, EBITDA = Earnings Before Interest, Tax, Depreciation and Amortisation (a measure of cash flow), EV = Enterprise Value or Electric Vehicle, FS = Feasibility Study, FY = Financial Year, IRR = Internal Rate of Return, ISR = In-Situ Recovery, JV = Joint Venture, 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 or Net Smelter Royalty, P&P = Proven and Probable, PEA = Preliminary Economic Assessment, PFS = Pre-Feasibility Study]

  *Arafura Resources (ARU.AX) is developing the feasibility-stage, fully-permitted Nolans REE (Rare Earth Elements) project in the Northern Territory (NT), Australia. It is not a member of the TSI Stocks List, but it is part of the TSI Small Stocks Watch List (SSWL). Our most recent comments on the stock were in the 10th June 2019 Weekly Update.

The only reason we are mentioning ARU today is to point out that existing shareholders with registered addresses in Australia or New Zealand have an opportunity to buy new shares (7 new shares for every 20 existing shares) at a significant discount to the current market price via a rights issue that ends on 12th July. This is a good deal for existing shareholders wanting to boost their stakes.

Applications for new shares under the rights issue can be made at https://events.miraqle.com/ARU-Rights/Rights-Issue/.

  *Tinka Resources (TK.V) went on a rollercoaster ride in the stock market over the past 1.5 weeks, first rising from C$0.26 to C$0.33, then plunging to C$0.21, then rebounding to C$0.28 before settling at C$0.24. The cause of the volatility was anticipation of and then reaction to the PEA for the company's 100%-owned Ayawilca zinc project in Peru.

According to the PEA, at a cost of US$262M the project could be developed into an underground mine with average annual production of 220M pounds of zinc and 0.9M ounces of silver over a 21-year life. At a zinc price of US$1.20/pound the after-tax NPV(8%) and IRR are estimated to be US$363M and 27%, respectively, but changes in the assumed zinc price result in relatively large changes in the economics. In rough terms, a 10% change in the zinc price changes the after-tax NPV(8%) by about US$130M. For example, according to the PEA the NPV would be about US$490M at a zinc price of US$1.32/pound and about US$230M at a zinc price of US$1.08/pound. The current zinc price is US$1.10/pound and over the past two years the price has ranged from US$1.05/pound to US$1.65/pound. We are intermediate-term and long-term bullish on zinc, so we view the Ayawilca project's leverage to the zinc price as a plus.

Another plus is TK's market cap relative to the project's estimated NPV. TK has about 265M shares outstanding, so the market cap at Friday's closing price of C$0.26 is C$64M (US$48M). This means that at the "base case" zinc price of US$1.20/pound, the market cap plus the initial capex (US$262M) is well below the NPV. This is what we like to see, as it implies that the company offers good value from the perspective of a potential acquirer.

On the negative side of the ledger, 78% of the resource included in the PEA is defined as "Inferred". Inferred resources can be included in a PEA (a PEA is called "Preliminary" for a reason) but can't be included in the more advanced engineering studies (PFS and FS). Therefore, TK will have to fund a lot of drilling over the coming 12 months to get to the point where the bulk of the resource is in the M&I category. That being said, the company had C$10.5M of working capital at 31st March and probably has about C$8M of working capital right now, so there should be no short-term need for an equity financing.

Taking into account the current zinc market environment and applying a 50% risk-related discount to the figures in the PEA, we arrive at a very rough valuation for TK of C$0.57/share. At a zinc price of US$1.32/pound our TK valuation increases to C$1.20/share. That is, in rough terms we think that a 20% increase in the zinc price would double the value of a TK share. Consequently, due to our bullish outlook for the zinc market we view TK as a good intermediate-term speculation near its current price.

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) A40.AX (last Friday's closing price: A$0.14)

2) AAU at around US$0.55 (last Friday's closing price: US$0.61)

3) ECS.V (last Friday's closing price: C$0.23)

4) PG.TO near C$2.00 (last Friday's closing price: C$2.16)

5) PPLT (last Friday's closing price: US$76.56)

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

Chart Sources

Charts appearing in today's commentary are courtesy of:

https://stockcharts.com/
https://research.stlouisfed.org/