-- Weekly Market Update for the Week Commencing 13th 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

A different look at the US yield curve

Summary of current thinking/positioning

1) Contrary to what we expected, the Dollar Index (DX) has broken out to the upside. Unless the breakout is quickly invalidated this should lead to significant additional US$ strength over the coming few weeks.

2) Upward reversals still have not been signaled in the gold and silver markets, leaving the door open to new 2018 lows prior to meaningful rallies getting underway. In fact, new 2018 lows probably will occur as soon as this week.

3) The gold-mining indices have extended their downward trends, 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 and last week the SPX again reversed course after touching its channel top. 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. Also, after being relatively strong for the bulk of the past 12 months the oil market looks set to be relatively weak for the next few 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.

Commodities

Is it time to bet against the oil price?

The short answer to the above question is yes, but a better opportunity would be created by a rebound to $70-$71.

Although it made a higher high in early-July, for all intents and purposes the price of oil (West Texas Intermediate Crude) has been in correction mode since late-May. However, the oil market correction has been mild while the industrial-metals markets have experienced substantial sell-offs. This opens up the possibility that the oil price will make a catch-up move to the downside within the coming few months. A daily close below $66 (roughly, the bottom of the channel drawn on the following daily chart) would warn that such a move had begun.



The futures curve indicates that the physical supply-demand situation (the fundamental backdrop) remains supportive of the oil price, albeit not as supportive as it was a few months ago. As long as physical supply is tight relative to demand there shouldn't be anything more bearish than a correction within a longer-term upward trend, but note that a bull-market correction could result in the price dropping as low as the mid-$50s. Furthermore, there is no guarantee that the fundamental backdrop will remain supportive.

In addition to oil's current high price relative to other industrial commodities there are currently two reasons to focus on oil's short-term downside potential. The first is that the "NonReportable" traders of oil futures (the proverbial dumb money) recently experienced a surge of bullish enthusiasm. As illustrated by the following chart, something similar happened near important price tops in 2011, 2012 and 2014. The second is that the Dollar Index has just broken out to the upside.



Further to the above, it could make sense for speculators to take a bearish oil position. As mentioned at the start of this discussion a better entry point would be established by a near-term rebound to $70-$71, but if the position is being averaged into the timing of the initial foray won't be critical.

We caution that it is always risky to bet against oil by purchasing a leveraged bear fund or shorting the futures. The reason is that this is a market that can always rocket higher in reaction to 'out of the blue' news such as a 'blow-up' in the Middle East. A protective stop may not help in such a situation.

We will be making the bet in our own account by purchasing USO January-2019 put options, and we possibly will add a USO January-2019 put option to the TSI List if the oil price rebounds to around $70 in the near future. Note that until the channel drawn on the above chart is breached there will be an outside chance of the oil price rebounding far enough to test its early-July high as part of a developing top.

A 26-year low for the natural gas price

In the US the natural gas (NG) price is very low by long-term historical standards, but it is nowhere near as low as it was in early-2016 and it has been gradually rising since intermediate-term support was tested in February of this year. In some parts of the world the NG price is actually high at the moment due to minimal local supply and surging demand. In Canada, however, the NG price hit a 26-year low during the second quarter of this year. Considering the huge monetary inflation that has occurred, it's extraordinary that the price of an increasingly-popular natural resource has just made a generational low in nominal currency terms.

Here is a long-term chart of the AECO (Alberta Energy Company) NG price, that is, the Canadian NG price. The chart ends at April-2018 and doesn't show the new multi-decade low that was achieved in May.


                                Chart source: http://economicdashboard.alberta.ca/NaturalGasPrice

Remarkably, some Canadian NG producers are still finding ways to be profitable in the current market environment. This is made possible by a low production cost, astute hedging and being able to sell some oil and/or NG liquids at relatively high prices. Peyto Energy (PEY.TO), which we mentioned in the 25th July Interim Update, is one such company.

PEY just reported its 54th consecutive quarter of profitability. Furthermore, during the first half of this year PEY managed to reduce its net debt by $62M while paying $67M of dividends to shareholders.

Being very profitable and paying out sizable dividends (the current yield is almost 7%) hasn't done anything good for PEY's stock price, though. As illustrated by the chart displayed below, the price of a PEY share is languishing near an 8-year low and is down by almost 75% over the past two years. Not surprisingly, therefore, the past two years has also been a dismal time for the more marginal Canadian NG producers such as Petrus Resources (PRQ.TO), a TSI stock.

In a bearish market environment sometimes even the best companies get taken out back and shot, whereas in a bullish market environment it is not uncommon for turkeys to soar like eagles.



With Canadian and US natural gas storage levels at the low end of historical ranges, PEY's management expects a significant jump in prices heading into winter and has adjusted the company's hedging and drilling plans accordingly. If this expectation is correct then the beaten-down Canadian NG stocks stand a good chance of rebounding strongly over the next 6 months.

Cobalt turns volatile

The cobalt price ended the month of July at US$69,500/tonne and ended the 7th August LME trading session at US$54,500/tonne. This means that it dropped 20% during the first 5 trading days of August, an extremely fast move for this market. By 9th August it had recovered to $61,000/tonne. Therefore, it's fair to say that we are getting some wild swings in the cobalt price.



The amount of cobalt in EV batteries is being reduced to 10% or less, but due to the exponential growth in EV production over the years ahead there is still likely to be a large increase in the demand for cobalt. We therefore expect the cobalt price to make new highs within the next few years, regardless of whether the recent plunge and sharp rebound in the cobalt price marked the end of the correction that began in March.

The Stock Market

The US

Last week the SPX again reversed after rising to its channel top. The channel top now coincides with the January-2018 all-time high (2873). Closing a day above 2873 would be an important breakout and could/should be viewed as a signal to exit short-term bearish speculations.

A daily close below 2750 would take the SPX through the bottom of its channel and open the door to a fast decline to below the February low.



The NDX reversed course over the final two days of last week after rising for seven days in a row to slightly beneath its July high. A daily close below 7200 would signal that an 'interesting' decline had begun.



Last week's conclusion still applies: "...the US stock market has large short-term downside potential, but the potential is yet to be confirmed by the price action."

Europe

European financial stocks, as represented by the iShares MSCI Europe Financial ETF (EUFN), have been under pressure and trending downward since late-January. The downward trend was driven in part by the travails of Deutsche Bank (DB).

They were in recovery mode from late-June through to early-August, but last week there was a sudden increase in the downward pressure in response to the goings-on in Turkey and the crash of Turkey's currency. It looks like the downward trend is about to extend and that EUFN is a reasonable candidate for a short-term bearish speculation, especially if it rebounds to around $20.50.



The iShares Italy ETF (EWI) is an even better candidate for a short-term bearish speculation, ideally following a rebound to around $28.50. EWI captures Italian political risk in addition to a significant amount of European banking-sector risk. It also appears to have completed a major topping pattern.



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

Sentiment

Gold's COT situation continues to improve. It is not as bullish as it was at the late-2015 multi-year price bottom, but it is more bullish than at any time over the past 2.5 years. Furthermore, as mentioned in last week's Interim Update the Consensus-inc Bullish Sentiment Index for gold recently hit a 14-year low.

At the same time, silver's COT situation is slightly bearish. In the silver futures market the open interest has just risen to a 3-year high (important price lows tend to coincide with low open interest). Also, the gross speculative long position in silver futures is larger now than it was in mid-May, when the price was about $1 higher and important support levels were intact.

There's a strong tendency for the silver price to follow the gold price, so gold-market sentiment is more important than silver-market sentiment. However, silver's COT situation is muddying the waters.

The next major gold rally

During the first three quarters of 2016 we were open to the possibility that a new cyclical gold bull market got underway in December of 2015, but over the past 18 months we have been consistent in our opinion that the December-2015 upward reversal in the US$ gold price did NOT mark the start of a bull market. Since late-2016 there have been some interesting rallies in the gold price, but at no time has there been a good reason to believe that we were dealing with a bull market. That's still the case. The question is: what will it take to set a new cyclical gold bull market in motion?

The simple answer is that it will take a US equity bear market. However, this is not a practical answer because in real time there often will be no way of differentiating the first 6-9 months of an equity bear market from an intermediate-term bull-market correction. The most practical answer we can come up with is that it will take an upward reversal in the yield curve.

It has become popular to argue that due to extraordinary monetary policy the yield curve is not as important as it was in the past, but we strongly disagree. In our opinion the yield curve is, if anything, more important now -- in the face of extraordinary monetary policy -- than it has ever been.

The potential for the US yield curve to invert in the not-too-distant future is a red herring. Except to the extent that it influences the psychology of senior Fed officials, whether or not the curve inverts is neither here nor there. It's the reversal from 'flattening' to 'steepening' that matters, regardless of whether the reversal happens before or after the curve inverts.

If the next major reversal of the yield curve is driven primarily by falling short-term interest rates then it will signal the onset of an economic bust. An economic bust would naturally coincide with an equity bear market and the start of a gold bull market. On the other hand, if the next major reversal of the yield curve is driven primarily by rising long-term interest rates then it will signal the onset of an inflationary blow-off that likely would go hand-in-hand with a powerful 1-2 year rally in the gold price and the prices of most other commodities.

Last week the 10yr-2yr yield spread, a proxy for the US yield curve, fell to within 2 basis points of the 10-year low reached in mid-July. Therefore, at this time there is no sign of an upward reversal.

Current Market Situation

Last Friday's upside breakout in the Dollar Index didn't faze the gold market. That's because the US dollar's strength was driven by fear that European banks could be facing huge losses relating to their exposure to Turkey. However, as the days go by gold's performance since its 19th July bottom at $1210 is looking more like a consolidation and less like a base. This suggests that new lows for the year will be seen prior to the start of a tradable rally.

It's still the case that a daily close above $1240 will be required to signal a short-term trend reversal. However, the 20-day MA acted as a barrier last week so a daily close above this MA (presently at $1226) could be viewed as an early-warning signal that a reversal is in the works.



Silver

The silver price has moved sideways since breaking below an important lateral support level in mid-July. This price action suggests that silver will trade below its mid-July low before reaching a multi-month price bottom.

As previously advised, a daily close above $15.80 would confirm that a short-term price bottom is in place.



Gold Stocks

Some individual gold-mining stocks have suffered large price declines over the past few weeks, but for the sector as a whole, as represented by the most popular indices and ETFs, there has not yet been anything close to a capitulation.

For example, the following daily chart shows that GDX, which is probably the most important of the gold-mining ETFs, has drifted downward on low volume over the past few weeks. Even the break below obvious lateral support at $21.00 didn't lead to downward acceleration or a significant pick-up in volume.



For another example, here is a daily chart of the iShares S&P/TSX Global Gold Index ETF (XGD.TO), the Canadian equivalent of GDX. Over the past few weeks XGD has drifted downward on low volume from the top to the bottom of its narrow 6-month range. This is not what a gold-sector capitulation looks like.



What we've witnessed over the past few weeks is not a capitulation, but a gradual loss of interest.

As pointed out in last week's Interim Update, tradable rallies can start in the absence of capitulation. For example, all of the 1-2 month rebounds that happened over the past 18 months began without a preceding capitulation. It's just that if a 'deck-clearing' decline hasn't happened and the market hasn't signaled an upward reversal then there will be a risk that such a decline will happen in the near future. Also, a capitulation would set the stage for something more interesting on the upside than a 1-2 month rebound.

As to what a reversal signal would look like, we covered that in last week's Interim Update. Nothing of significance changed over the final two days of the week, so this comment still applies:

"Due to having breached obvious support at $21.00, to signal a reversal all GDX would have to do now is close a day at $21.50 or higher. Doing so would mark the preceding downside breakout as false. However, the downside breakout suggests a short-term target of $18.50 and the breakout should be respected until/unless it proves to be false."

With regard to the performance of the gold-mining sector relative to gold bullion, the following chart shows the unbroken sequence of declining tops and bottoms in the HUI/gold ratio since early last year. In mid-July we wrote that the HUI/gold ratio had to hold above its 150-day MA (the green line on the chart) to avoid perpetuating the pattern of the preceding 18 months, but it failed to do so. The pattern suggested that a decline to a new 2-year low would occur prior to the next meaningful rally.

A new 2-year low is almost in place, but note that a much better set-up for a rally would be created by a plunge to well below the March low than by a decline to a marginal new low.



The Currency Market

The biggest news last week was the crash in the Turkish Lira (TRY). As illustrated by the following chart, Turkey's currency has lost about 30% of its value against the US$ since the end of July (a rising line on the chart indicates a weakening Lira).



In the 28th May Weekly Update, we wrote:

"If we had to place a bet today on which globally-significant currency would be the world's weakest over the coming 12 months we would pick the Turkish Lira. The main reason relates to governance.

Recep Erdogan, Turkey's president, is aggressively consolidating power and clearly is striving to be the country's dictator. He is very much against the actions that would have to be taken to rein-in inflation and stabilise the currency, and if he is successful in the elections scheduled for 24th June [it turned out that he was successful] he will have greater influence over the actions of the central bank."

'Erdogan risk' (with a healthy dose of 'Trump risk') moved to centre stage last week, prompting the currency collapse illustrated above. However, the primary concern of the major financial markets wasn't the brewing crisis in Turkey per se but the potential effect of this crisis on Europe's banks. Some European banks have loaned substantial sums to Turkey-based businesses and will have major problems if the tanking TRY leads to large-scale loan defaults. That, in essence, is why the euro plunged and the Dollar Index (DX) surged on Friday 10th August.

As evidenced by the daily chart displayed below, on Friday the DX broke above the top of its rising wedge and also achieved a solid weekly close above intermediate-term lateral resistance at 95.



As is always the case in such situations, there's a chance that last Friday's breakout will prove to be a false signal. But as is also always the case, it's prudent to assume that the breakout will be sustainable until it proves otherwise. Proving otherwise would require a daily close below 95 for the DX or a daily close above 1.16 for the euro.

If Friday's breakout was the 'real thing' then there could be a sharp rise in the DX over the coming 3-5 weeks -- similar to what happened between late-April and late-May. Also, unless the breakout is quickly invalidated it will be evidence that the DX's bull market did not end last year.

The Australian Dollar (A$) and the Swiss Franc (SF) are the currencies we have focused on for anti-US$ short-term trades. This was on the expectation that the DX would not do what it has just done, which is break above resistance. The A$ broke out to the downside along with the euro on Friday, but the following chart shows that the SF's double bottom is intact. The SF is benefiting from a flight away from the euro and from the unwinding of carry trades.



Due to last Friday's market action, most anti-US$ short-term trades should be exited. A reasonable argument can be made for retaining long SF positions, but only if tight stops are used.

Note that when speculating on market outcomes by purchasing out-of-the-money options, by the time there is clear evidence that the position is wrong there often won't be much value left to salvage by selling the position. That's certainly the case with regard to the FXA (A$) September $80 call options that we added to the TSI List a few months ago.

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 10th 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]

  *Almaden Minerals (AAU) published its financial statements for the June-2018 quarter, revealing that the company had C$11.3M of working capital at 30th June. Although this is only about C$1M less than it had at the end of the preceding quarter, during the intervening period the company raised about C$9M via a private placement at C$1.00/share. This means that the company consumed about C$10M of cash during the latest quarter.

The high quarterly cash burn was due to the company making its final payment on the second-hand mill it agreed to purchase three years ago. This payment accounted for C$6.1M of the quarter's cash expenditure.

The aforementioned working capital amount should be enough to fund AAU through FS completion and submission of the Environmental Impact Assessment for the company's flagship Ixtaca gold-silver project in Puebla State, Mexico. Both of these milestones are expected to happen before year-end.

We continue to expect that AAU will receive a takeover bid soon after completion of the FS and environmental permitting.

  *Continental Gold (CNL.TO) published its financial results for the June-2018 quarter.

At 31st March the company had working capital of US$41M (down from $69M at 31st December and $45M at 31st March), long-term debt of US$120M (up from $48M at 31st December and $73M at 31st March) and undrawn credit of US$125M.

The company has available financing (working capital plus undrawn credit) of $166M. Although this should be enough to cover the remaining mine capex and working capital requirements, we expect that for risk management purposes a US$20M-$40M equity financing will be done within the next 6 months.

  *Cobalt 27 Capital (KBLT.V) has been hit hard in the stock market over the past two months, as have most other cobalt plays. This is primarily a reaction to the downward correction in the cobalt price, although in KBLT's case the decline was helped along by a large, discounted equity financing.

We have updated our KBLT valuation to reflect the change in the cobalt price. Our previous valuation (refer to the 18th June Weekly Update) of C$17.80/share was based on a cobalt price of US$88,000/tonne (US$40/pound). At US$65,000/tonne for cobalt our estimate of fair value for KBLT drops to C$13.80/share.

Currently, cobalt is trading at around US$61,000/tonne. We haven't re-done our valuation at this lower price, but it would be in the C$12.50-C$13.00 range.

Although the fundamental value of a KBLT share has dropped significantly, the share price has dropped a lot more. By our reckoning, at Friday's closing price of C$6.35 the shares are trading at about half of their underlying value.

  *Premier Gold (PG.TO) published its quarterly financial results for the June quarter.

PG's quarterly financial performance tends to be lumpy, meaning that there tend to be large swings in cash flow and earnings from one quarter to the next. This is the nature of its business. The company has two operating gold mines, only one of which (Mercedes) has steady production. The other (South Arturo) sometimes produces a lot and sometimes produces almost nothing, all in accordance with the long-term mine plan. Also, the company makes a significant investment in its portfolio of exploration-stage projects every quarter.

For the June quarter PG reported a loss of US$7.7M. More importantly, its net cash position (working capital minus long-term debt) decreased by about US$11M.

At US$56M the net cash position remains very healthy, though, and the contribution of the Mercedes mine is expected to be far more positive during the second half of the year than it was during the first half.

Due to the costs associated with the ramp-up of new small-scale mines at South Arturo we expect that the company will be cash-flow negative over the remainder of this year, but not sufficiently so to put a large dent in its net cash position. The company should be strongly cash-flow positive during 2019.

In addition to being affected by sector-wide weakness, PG's stock price may have been pressured downward recently by the major change to the Vanguard Precious Metals Fund (VGPMX). VGPMX is a $2.3B fund that until about two weeks ago was focused on precious metals (PM) stocks. As explained at https://investor.vanguard.com/mutual-funds/precious-metals-changes, the fund is changing its name, coming under new management and shifting its focus away from PM stocks. We understand that Vanguard holds or held several million PG shares, so PG could be one of the PM stocks that is being unloaded by the new manager of the fund formerly known as VGPMX.

Stock price declines caused by the forced liquidation of an ETF or a mutual fund never concern us, because such declines are invariably retraced. Also, as is probably the case with the VGPMX change, they can be evidence that market sentiment is close to bottoming out. The declines that concern us are the ones that happen in reaction to worsening company-specific fundamentals. For example, Alio Gold (ALO) was down by 17% on Friday in reaction to a disastrous quarterly report.

  *Petrus Resources (PRQ.TO) published its financial results for the June quarter and the first half of 2018.

During the quarter the company's net debt (long-term debt minus working capital) dropped from C$144M to C$143M, meaning that the company added about C$1M of cash to its balance sheet. Net debt was C$146M at the start of the year, so C$3M of cash was added to the balance sheet during the first half. Quarterly production averaged about 9,200 boe/day, which was about 1,400 boe/d lower than the March quarter. The lower production was a planned response to the extremely low natural gas price in Canada.

The company's book value at 30th June was C$2.76/share. This is down from C$3.08/share at the end of last year.

Considering the commodity-price environment, PRQ's financial performance was satisfactory over the first half of this year. However, the company will struggle to do more than tread water until there is a substantial rebound in the Canadian natural gas price.

  *US Gold Corp. (USAU) has been very quiet over the past few months, both in the stock market and in terms of company news. However, assay results from step-out drilling currently underway at the company's Copper King gold-copper project in Wyoming should be available next month.

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$0.65)

2) CNL.TO (last Friday's closing price: C$3.64)

3) PG.TO (last Friday's closing price: C$2.12)

4) PRQ.TO (last Friday's closing price: C$0.85)

5) SBB.TO (last Friday's closing price: C$1.38)

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:

https://stockcharts.com/
http://www.goldchartsrus.com/
https://www.lme.com/
Pacific Exchange Rate Service