-- Weekly Market Update for the Week Commencing 12th February 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

No blog posts last week

Summary of current thinking/positioning

1) Thinking that the US$ gold price will remain in a downward trend for a few more weeks but will go on to make new highs for the year during the second quarter.

2) Expecting a 2-3 week stock market rebound followed by another fast decline that tests or breaches the early-February low. Although not the most likely outcome, there is a realistic chance that the SPX will trade as low as 2200 before the end of Q1.

3) Thinking that industrial commodities such as oil and copper are in short-term downward trends that will end in March.

4) Expecting the Dollar Index (DX) to maintain an overall upward bias for another month or so and then resume its longer-term downward trend.

5) Expecting that the T-Bond's downward trend will be interrupted over the coming 2-3 weeks by a rebound or consolidation.

6) Holding a cash reserve of 25%-30% and looking for opportunities to increase it.

Still no flight-to-safety bid for the T-Bond

Despite panic in the stock market there was more supply than demand for the 30-year T-Bond last week, hence the continuing decline in the T-Bond price. As illustrated by the following chart, the T-Bond price has now fallen 5 points since the stock market's late-January peak. This constitutes a very important change in the financial markets.

Rather than the T-Bond market rallying in response to significant stock-market weakness and selling-off in response to significant stock-market strength, it appears that the T-Bond is now 'in the driver's seat'. To get a rally in the stock market there may have to be a rally in the T-Bond.



It's likely that the T-Bond will soon commence a multi-week counter-trend rebound, enabling the stock market to partially recover from last week's shellacking.

The Stock Market

The incredible collapse of the short-volatility trade

In our 13th December commentary under the heading "The trade that is sure to NOT work in 2018", we wrote:

"The most consistently profitable trade since the stock-market bottom of February-2016 wasn't owning Bitcoin or one of the other 'cryptoassets'. The 'cryptos' achieved the largest and fastest price gains, but they experienced a few 30%+ crashes along the way. The most consistently profitable trade also wasn't being long the "FANGs". Taking into account the consistency of the trend, the most profitable trade over the past 21 months was being short volatility."

And:

"The belief in the short-volatility trade is now so strong that this trade is almost guaranteed NOT to work in 2018. By the same token, trades that are predicated on increased volatility should do much better in 2018 than they did in 2017."

The 'short volatility' trade blew up in a more spectacular fashion last week than any trade has ever blown up. And all it took to bring about a total collapse in this trade was a 5%-10% drop in the S&P500 Index from its all-time high.

Displayed below are pictures of the incredible 'blow-up' in the form of daily charts of two popular short-volatility ETNs (Exchange Traded Notes that are designed to rise in price when the VIX declines and fall in price when the VIX rises). The charts show that all gains delivered by the immensely-profitable short-volatility trade over the past 5-6 years were wiped out in the space of a couple of days last week.

An excellent explanation of what happened is contained in Kid Dynamite's 7th February blog post. Two points made in this post that bear repeating are:

1) The buying of VIX futures by the ETN issuer in its efforts to balance the price and the NAV of the ETN exacerbated the VIX's rise, which necessitated more buying of VIX futures to establish a balance, which pushed the VIX even higher, and so on. In effect, there was a positive feedback loop.

2) The decision by the issuer of XIV (one of the most popular short-volatility ETNs) to terminate the ETN did not cause or even add to the ETN's price collapse. It was the other way around: The 95% price collapse prompted the issuer to terminate the ETN. Those who hold the ETN at the termination date will receive a payment equal to the ETN's NAV on that date.

The short-volatility trade is dead, at least for the next 12 months. The reason is that having witnessed what can happen without warning to the prices of the products designed to profit from low/falling volatility, from now on nobody with significant money will be interested in buying these products.

This trade's demise removes a force that was supporting the longer-term upward trend, in that the large-scale betting on the continuation of the low-volatility environment was acting to suppress stock-market volatility and elevate stock prices.

Stocks and Bonds

A week ago we wrote:

"...last week's downside breakout in the bond market has increased the risk that something more bearish than a 5%-10% correction will occur in the stock market within the next couple of months.

There will be a further increase in the stock market's short-term risk if the downside breakout in the T-Bond price is confirmed by an upside breakout in the T-Bond yield. In fact, if the T-Bond yield breaks above 3.20% and continues to surge then the probability of something resembling a stock market crash will become uncomfortably -- or comfortably, depending on your perspective -- high."

Although multiple factors contributed to the recent stock market sell-off, there is no doubt that the decline in the T-Bond price played an important role. To put it another way, it wasn't a random coincidence that a mini stock-market panic got underway the day after the T-Bond signaled the completion of a long-term topping pattern by breaking below major support.

To further explain, the stock market can ignore a rising interest-rate trend for a considerable time (1-2 years is typical), but at some point the interest-rate trend shifts from being almost irrelevant to being almost the only thing that matters. We thought, well in advance of it happening, that this time around the point of recognition -- the point when the rising interest-rate trend suddenly goes from being unimportant to critical as far as the stock market is concerned -- would coincide with the T-Bond breaking below major support at 146-147. The T-Bond breakdown was confirmed by the weekly close on Friday 2nd February. On Monday 5th February, all hell started to break loose in the stock market.

It's likely that another round of panicked selling in the stock market would be caused by the T-Bond yield breaking decisively above 3.20%. At the end of last week the yield was 3.14%.

Current US Market Situation

Last week, the S&P500 March futures contract bottomed on Tuesday at 2529. It then tested Tuesday's low on Friday before rebounding into the close.



The cash S&P500 Index, however, made a sequence of lower lows last week before reversing upward on Friday.



Tuesday's low for the March S&P500 futures and Friday's lows for both the cash S&P500 and the March futures were all within the 2529-2532 range. Also, we have the 50-week MA at 2512 and the 200-day MA at 2539, so it is fair to say that there is a confluence of important support within the 2510-2540 range.

The fact that this support range has been probed during the first downward leg of a correction makes it more likely that the support will be breached before the correction is over. If it is breached then a quick decline to the 200-week MA (near 2200) may follow.

Although last week's price action was more dramatic than envisaged, the expected pattern hasn't changed. The pattern was described as follows in our previous weekly commentary:

"Almost regardless of what's in store over the next two months, a multi-week bottom probably will be put in place this week. There should then be a rebound that recoups at least half of the loss from the January high followed by a drop to new lows for the move."

We suspect that a multi-week bottom was put in place last week and that a rebound will soon begin. Depending on its strength, a rebound over the coming 2-3 weeks could create a new opportunity to take a short-term bearish position in anticipation of a subsequent fast decline to a new low for the year.

Tesla (TSLA) Update

Every now and then TSLA reminds the market that it a) is hemorrhaging cash, b) will continue to hemorrhage cash indefinitely, c) is incapable of meeting its own production targets and d) has an astronomically-high valuation. The market then promptly forgets about these issues and chooses to dream about what the stock could be worth in the distant future.

We are betting against TSLA via the April-2018 $250 put options, which means that we are betting on a decisive breach of support at $300 happening within the next two months. The stock traded below $300 on Friday, but then rebounded with the broad market and managed to end the week above this critical support level.



$230 would be the short-term chart-based target following a break below $300. However, it would make sense to take profits on the above-mentioned put options following a drop to around $250 within the coming few weeks, because at that point the option price would be above $20 and there would be more to lose than gain by continuing to hold.

The STOX5E completes an intermediate-term topping pattern

Like its S&P500 Index, the EURO STOXX 50 Index (STOX5E) is very 'oversold' and likely to rebound over the coming 2-3 weeks. However, last week's decline appears to have completed an intermediate-term topping pattern.

Our guess is that the STOX5E will rebound to above 3400 within the coming fortnight but trade at 3100 or lower before the end of March.



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

Many people who are passionate about gold blindly assume that if there is panicked sell-off in the stock market then the fundamental backdrop is supportive for gold. Such assumptions are often wrong.

Instead of relying on 'gut feel' it is better to have an objective way of quantifying the extent to which the fundamental backdrop is bullish/bearish. That's why we developed the Gold True Fundamentals Model (GTFM). The GTFM quantifies the fundamental situation as it relates to gold by taking into account changes in interest-rate spreads, inflation expectations, the US dollar's exchange rate, the relative strength of the banking sector (an indicator of confidence in the financial system) and the general level of commodity prices.

The following chart shows the GTFM and the US$ gold price. Note that the fundamental backdrop as indicated by the GTFM was bearish over the past 5 weeks and remains so. In other words, the recent pullback in the gold price was in line with the true fundamentals.



Also, in general terms it should be understood that while it is normal for gold to benefit from an equity bear market, there is no good reason to expect gold to benefit from a short-term liquidity event in the stock market. For example, a sudden and generally-unexpected plunge in the stock market will prompt a scramble for cash, not gold. Of course, if a short-term liquidity event transmogrifies into a longer-term bearish trend then it would be normal for the resulting decline in economic and financial-system confidence to greatly increase the demand for gold and therefore the gold price.

The Price Action

The US$ gold price bounced off short-term support at $1309 last Thursday. With a bearish fundamental backdrop and a COT situation that is not close to indicating a 'wash out', there's no good reason to believe that this test of support marked the end of the decline that began in late January. However, it's certainly possible that a multi-week bottom was put in place last week.



Gold Stocks

With regard to the HUI's short-term prospects, a week ago we wrote: "...a Q1-2018 breach of the December-2017 low is now the short-term scenario with the highest probability." The most likely path at that time appeared to be a 1-3 week rebound followed by a decline that took the HUI below its December-2017 low and set the stage for a tradable rally. However, the HUI closed lower every day last week and on Friday traded below its December-2017 low.

The earlier-than-expected breach of the December-2017 low creates a more bullish short-term possibility. This is because it could be extending the sequence of marginal breaks to new multi-month lows that are immediately followed by upward reversals and 1-2 month rallies. These upward reversals occurred in May, July and December of last year and are indicated by arrows on the daily chart displayed below.

It's possible that Friday's marginal and short-lived break below the December-2017 low has set the scene for a rally lasting at least one month.



While being more bullish than a continuing short-term downward trend, another rally that fizzles out after several weeks is not exactly an exciting prospect. However, there is a reason that the next gold-stock rally may be stronger than the rallies of the past 12 months, regardless of whether it begins immediately or following some additional downward movement. The reason is the magnitude of the recent weakness in the HUI/gold ratio.

Weakness in the HUI/gold ratio is bearish until it becomes extreme relative to certain moving averages, at which point it indicates that a bearish trend has almost run its course. The current level of the HUI/gold ratio is not extreme on a long-term basis, but the following chart indicates that it is almost as stretched to the downside relative to its 40-day MA as it has been at any time over the past 2 years. Paradoxically, this is good news for the bulls.



Friday's intra-day low (170.9 for the HUI) is now an important demarcation level. A daily close below this level at some point over the next few weeks would eliminate the similarity with the May, July and December-2017 lows and suggest that the December-2016 low (160) will be tested or breached before a tradable rally gets underway. However, last week's price action ushers in the possibility that a multi-month price bottom has occurred earlier than expected.

We are not doing any short-term trades in the gold-mining sector at this time, but it would be reasonable for a short-term trader to buy a gold-mining ETF near the current price and place an initial protective stop slightly below Friday's intra-day low.

The Currency Market

The Dollar Index (DX) has rebounded over the past two weeks. We expect the rebound to continue until resistance at 91.0-92.5 has been tested.



We see two equally-likely paths for the DX over the coming 1-2 months. The first path entails a multi-week top very soon followed by a 1-3 week minor pullback or consolidation and then a move up to the ultimate rebound high in the 91.0-92.5 range. The second path also entails a multi-week top very soon, but with an ensuing pullback that tests or breaches the January low. The stage would then be set for a rally to 92 or above.

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 9th February 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%, P&P = Proven and Probable, PEA = Preliminary Economic Assessment, PFS = Pre-Feasibility Study]

  *Africa Oil Corp. (AOI.TO) issued a press release containing an update on its progress.

The development-stage Lokichar Basin in Kenya is a JV between AOI (25%), Tullow Oil (50%) and Maersk (25%). The JV has proposed to the Government of Kenya that two fields (Amosing and Ngamia) be put into production as the initial stage of the South Lokichar development.

The initial stage is planned to include 280 wells through 25 well pads, with a planned plateau rate of 60,000 to 80,000 bopd. Additional stages of development are expected to increase plateau production to 100,000 bopd or greater. It is anticipated that Front End Engineering and Design (FEED) for the initial stage will commence this year, with a Final Investment Decision (FID) targeted for 2019 and first oil production targeted for 2021-22.

We are comfortable with the rate of progress at the Lokichar Basin -- AOI's flagship asset. We are not so comfortable with the minority investments that AOI's management is making in other Africa-focused oil companies, partly because these investments are consuming cash that may be needed over the coming few years to fund AOI's portion of the Lokichar development expense and partly because the stock market tends to apply a substantial discount to such assets.

The latest investment was announced last week. It involves the purchase of a 25% stake in Impact Oil and Gas Limited, a private UK company with exploration assets in South and West Africa, at a cost of US$15M cash plus 14M AOI shares.

AOI now holds significant minority interests in three other companies: 20% of Eco (Atlantic) Oil and Gas (EOG.V), an oil-exploration company focused on Namibia and Guyana, 28% of Africa Energy Corp. (AFE.V) and 25% of Impact Oil and Gas (private). These investments increase AOI's exposure to the oil price and to Africa.

  *Blackham Resources (BLK.AX) advised that during the month of January it had record-high gold production of 6.5K ounces at a record-low AISC of A$1158/oz (US$915/oz). This enabled it to be cash-flow positive for the month and is evidence that a turnaround is in progress for this beleaguered company.

The company expects to produce 40K-45K ounces at an AISC of A$1100-$1200/oz (US$870-$950/oz) during the first half of the 2018 calendar year. If this guidance is achieved it will constitute a vast improvement over last year's efforts and put BLK in a solid financial position for the first time in a long time.

BLK's Entitlement Issue (EI) ends on Monday 12th February, so eligible shareholders who haven't yet exercised their rights under the EI (the right to buy 5 new shares at A$0.04 for every 2 existing shares) and wish to do so must act quickly. Exercising the rights makes sense. Other investors could consider buying shares on the market at up to A$0.06, bearing in mind that the risk will remain high until the company has proved that it can operate profitably with consistency.

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$0.86)

2) ALK.AX (last Friday's closing price: A$0.29)

3) KBLT.V (last Friday's closing price: C$11.23)

4) PG.TO (last Friday's closing price: C$3.34)

5) PRQ.TO (last Friday's closing price: C$1.24)

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.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.barchart.com/