-- Weekly Market Update for the Week Commencing 26th 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

Gold Leads Silver

Summary of current thinking/positioning

1) Thinking that the US$ gold price will work its way downward over the next few weeks but will go on to make new highs for the year during the second quarter.

2) Still favouring a drop in the stock market to test the early-February low during March, but now assigning a very low probability that the decline from the January peak is something more bearish than a short-term correction.

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

4) Expecting the rebound in the Dollar Index (DX) to continue for a few more weeks before the longer-term downward trend resumes.

5) Thinking that the T-Bond's short-term risk and reward are now in balance, meaning that the best place for short-term traders to be is on the sidelines.

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

Commodities

EV (Electric Vehicle) Metals Update

What we call "EV Metals" are the metals for which demand would be given a substantial boost by the proliferation of electric vehicles. That's due to the use of these metals in the batteries or the motors or the wiring for electric cars, trucks and buses. The members of the EV Metals group are copper, nickel, cobalt, lithium and the rare earth elements (REEs).

With regard to potential price performance over the coming 1-5 years, the EV metals collectively have a better risk/reward than any other commodity group that we track. In particular, the risk/reward of the EV Metals group is superior to that of the precious metals group (gold, silver and platinum) and vastly superior to that of the traditional energy-commodities group (oil, thermal coal, natural gas and uranium). However, within the EV Metals group there are widely varying supply/demand prospects and therefore different risk/reward ratios, largely dependent upon the extent to which the overall demand for each metal will be affected by the shift from ICE (internal combustion engine) to electric.

For example, due to its widespread use in electrical cabling and plumbing throughout the world, the proliferation of electric vehicles will not result in a large percentage increase in the global consumption of copper. For a second example, nickel demand will continue to be dominated by the steel industry for at least the next three years (65%-70% of all nickel production goes into stainless steel and another 20% goes into other metal alloys). Even in the cases of copper and nickel, though, by early next decade the EV-related addition to demand should be enough to have a significant price effect. Actually, due to speculative buying in anticipation of increasing commercial demand, the price effect is already being seen.

Price wise, the metals that appear to be the most levered to the EV trend are cobalt and the REEs. Lithium is obviously a critical component of the lithium-ion battery and as a result is experiencing a large increase in demand, but in the lithium market there is much greater scope to boost supply to meet rising demand than there is in the markets for cobalt and some of the REEs.

Cobalt has regularly been in the news of late due to the intersection of rising demand and a precarious supply situation. The supply situation is precarious because more than 60% of the world's production comes from the DRC and the DRC is not becoming less risky. On the contrary, as if in an effort to underline the risk of investing in its country the DRC parliament recently approved unexpected law changes that will lead to much higher mining costs. Mining companies operating in the DRC are lobbying to prevent these changes from being signed-off by President Kabila.

Due to the risk of a major supply disruption in the cobalt market, end users of the metal have taken the unusual step of dealing directly with mining companies. For example, Apple is now negotiating directly with miners to make sure that it will have the cobalt it needs for the batteries that go into iPhones. Currently, about a quarter of global cobalt production is used in smartphones.

The combination of cobalt's precarious supply situation and the potential ramp-up in cobalt demand due to the increasing popularity of EVs may lead to a doubling or even tripling of the cobalt price over the coming 1-2 years. At the same time, the extreme difficulty of increasing the cobalt supply in response to greater demand will prompt battery makers to seek out alternatives. The search for alternatives will have to be successful, otherwise the entire EV trend will be dramatically slowed by lack of reasonably-priced cobalt. The only question is the timing. In other words, cobalt's risk/reward is very attractive, but it isn't a one-way bet. Cobalt will eventually price itself out of the market and then the price will drop back to earth.

How to profit from the EV trend

There are plenty of mining stocks that offer exposure to cobalt, usually with the cobalt resource being a relatively small part of a nickel or copper project. Some of these mining stocks, especially those within the ranks of exploration/development-stage juniors, will provide their owners with spectacular gains over the next few years, but the best way for most investors to gain exposure to cobalt is via the shares of Cobalt 27 (TSXV: KBLT). KBLT was added to the TSI Stocks List about three weeks ago.

The bulk of KBLT's current value is associated with physical cobalt stored in LME warehouses, which means that there is almost no political/country risk and that the stock is close to being a pure play on the cobalt price. The rest of the current value is associated with royalties on cobalt and nickel production in North America. Moreover, the company will be doing cobalt streaming deals in the future.

There is currently no nickel exposure in the TSI Stocks List, although there is some in the Small Stocks Watch List via Cassini Resources (CZI.AX). CZI is a reasonable speculation based on the likelihood that within the next few years the economics of the company's large-but-low-grade West Musgrave project will shift from marginal to robust due to higher metal prices, prompting CZI's well-funded JV partner (Oz Minerals) to make a takeover bid.

If we were going to add nickel exposure to the TSI Stocks List we would probably opt for JJN, an ETN designed to track the nickel price. However, we are in no hurry to do anything with JJN.

There is also currently no exposure to lithium in the TSI List. We will be on the lookout for an opportunity to add a lithium stock or the Global X Lithium ETF (LIT) to the TSI List, but the lithium sector is intermediate-term 'overbought' following a 2-year rally and most lithium stocks look expensive.

The Dubbo Project of Alkane Resources (ALK.AX) provides the TSI Stocks List with exposure to REEs as well as a few other interesting commodities, but we have suggested Arafura Resources (ARU.AX) as a focused play on the specific REEs needed to make the permanent magnets that go into EV motors. A brief write-up on ARU was included in the 17th January Interim Update.

Copper exposure is easy to obtain, as there are numerous listed copper producers/explorers and many copper-mining stocks are reasonably priced at this time. Furthermore, copper exposure often comes with gold exposure, or vice versa, which is not a bad thing when selecting a long-term holding because one metal hedges the other.

The TSI Stocks List currently has exposure to copper via Sandfire Resources (SFR.AX), a mid-tier Australia-based copper-gold producer, Nevsun Resources (NSU), a company with a zinc-copper mine in Eritrea and a large undeveloped copper project in Serbia, and Euro Sun Mining (ESM.TO), an exploration-stage junior with a gold-copper project in Romania.

Lastly, bear in mind that even if our current bullish outlook is in the right ballpark, the EV trend will take up to 10 years to play out. Therefore, don't be in a rush to accumulate exposure to the trend and don't buy for a short-term trade.

COT Extremes

Like all sentiment indicators, the Commitments of Traders (COT) numbers only provide actionable information at extremes or when they diverge in a big way from the market price. Most of the time they can be safely ignored.

Currently, four of the markets we follow have COT situations that are near extremes, or that appear to be near extremes based on the data of the past decade. One of these is the 10-year T-Note futures market, where speculators, as a group, have built-up an unusually-large short position. We covered the T-Note market's COT situation last week and it is not significantly different now. The three other futures markets that have comparatively extreme COT situations are oil, silver and the euro.

In the oil market the total speculative net-long position (the equivalent of the commercial net-short position, which is indicated by the blue bars in the middle section of the following chart) has shrunk a little over the past two weeks, but it remains close to the all-time high reached three weeks ago. This should be taken as a bearish sentiment warning, although, as we've previously noted, the short-term downside risk in the oil price is mitigated by bullish fundamentals (demand in the physical market remains strong relative to supply).



In the silver market the total speculative net position has shrunk to a level that would be consistent with at least a short-term low. At the same time, however, the open interest in silver futures (indicated by the green bars in the bottom section of the following chart) is much larger than would normally occur at an intermediate-term price bottom.

Silver's COT situation suggests that a) the price could be close to a short-term bottom and b) a rally that began from near the current level would be of similar magnitude and duration to the rebounds that started from short-term lows in July and December of 2017. In other words, the rally would not be substantial.

A decline in open interest to 160K contracts or less would set the stage for a much larger rally.



The COT situation in the market for euro futures is similar to the COT situation in the market for oil futures, in that the total speculative net-long position has reduced a little but remains close to its all-time high. This should be taken as a bearish sentiment warning, especially since the euro's fundamentals are bearish.



The Stock Market

At the beginning of last week we expected 1-2 weeks of additional consolidation in the US stock market prior to a sharp decline that resulted in a test and possibly a breach of the 9th February low (2530 for the SPX). Last week's price action hasn't changed what we consider to be the most likely near-term scenario, although it's fair to say that the US stock market ended the week on a stronger note than we expected.

Thanks to its 43-point rise on Friday 23rd February the SPX has achieved the first solid close above its 50-day MA since the rebound from the 9th February low got underway. However, it wasn't able to close above its 16th February intra-day high.



The NASDAQ100 Index (NDX) has been much stronger than the SPX and has moved up to within 2% of its January peak.



And then there's Amazon.com (AMZN), the most important stock in the US market at the moment. AMZN did no more than spike down to its 50-day MA during the early-February market-wide plunge and has since returned to its January high. In fact, it made a marginal new all-time high last week on a daily-closing basis and an intra-day basis. It ended the week exactly at $1500.



Amazon is a great company, but its stock market capitalisation is absurdly high relative to its revenue and earnings. That being said, AMZN looks downright cheap compared to Tesla (TSLA). Tesla is a classic bubble story -- a massively-unprofitable enterprise that probably shouldn't exist but that continues to attract substantial investment due to counter-productive central bank and government policies.

TSLA has one thing going for it, though: its over-valuation is so egregious and so obvious that there is consistently a large short position in the shares. Covering by the short sellers periodically fuels rebounds in the stock price.

After plunging to major support at $300 in sympathy with the early-February market-wide weakness, TSLA has returned to the vicinity of its January high. However, this strong rebound hasn't altered the longer-term chart pattern. TSLA still appears to be tracing out a major top.



As stated at the start of this section, last week's price action hasn't changed what we consider to be the most likely near-term scenario. We continue to anticipate a sharp decline that results in a test and possibly a breach of the 9th February low, although if the anticipated decline hasn't begun by this time next week then the probability of it happening at all will have plummeted. Also, with the SPX having managed to break above its 50-day MA and with the NDX positioned to challenge its January high within the next few days, a successful test of the 9th February low has a much higher probability than a breach of the low.

Further to a comment we made in last week's Interim Update, it would be reasonable for traders to use a daily SPX close above 2750 as a 'stop' for short-term bearish positions. A stopped-out trader can always return to the fray following evidence of a reversal.

Lastly, it is clear that the US stock market has become very sensitive to rising bond yields. There are early signs that bond yields have begun to consolidate below their recent highs, but when 10-year T-Note and 30-year T-bond yields eventually break above 3.00% and 3.22%, respectively, a likely ramification will be another gut-wrenching stock market decline.

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

Last week's pullback in the gold price to below its 20-day MA confirmed that the market has completed another successful test of resistance in the low-$1360s. We continue to expect that this resistance will be breached in the second quarter of this year.



There continues to be a good chance that the gold price will drop back to the $1250-$1300 range before making a sustained break above resistance. There are three reasons for this:

1) The fundamental backdrop remains gold-bearish.

2) Sentiment, as indicated by the COT data, is no better than neutral.

3) There has been an unusually-strong negative correlation between the US$ gold price and the Dollar Index over the past few months, and the Dollar Index is more likely to rise than fall over the next few weeks.

Once gold breaks through resistance in the $1360s the situation will be more bullish for silver and gold-mining stocks than for gold itself. This is because gold bullion is expensive relative to silver bullion and the average gold-mining stock, and because gold's breakout will prompt speculative buying of the related investments that have historically provided more 'bang for the buck' during upward trends.

Silver

Silver's price chart looks similar to that of the HUI. Like the HUI, the US$ silver price has been choppy and trendless over the past 12 months.



As mentioned earlier in today's report, silver's COT situation is now supportive. However, the COT situation also suggests that if a rally were to begin immediately it would be an uninspiring 1-2 month bounce.

To set the stage for a much stronger rally there may have to be a selling squall that quickly takes the price down to the $14.50-$15.50 range.

Gold Stocks

The HUI lost about 4% last week. A one-week change of 4% would be a lot for some stock indices, but for the HUI it is not out of the ordinary. In this instance it is also not significant, since the 4% decline left the HUI above its early-February low.



Last week's price action in the gold-mining sector wasn't devoid of significance, though, because the HUI fell far enough relative to gold to push the HUI/gold ratio to a new low for the year. In fact, last Thursday the HUI/gold ratio dropped to its lowest level in almost two years.



The on-going weakness in the gold-mining sector relative to gold bullion must be frustrating for many gold-stock investors, but it is setting the stage for a strong rally. Unfortunately, we haven't yet seen the sort of 'wash-out' decline that 'clears the decks'.

Considering the HUI's current chart pattern, within the next three weeks we may get the sort of capitulation that tends to precede a powerful rally. Let's hope so.

In any case, we will consider an intermediate-term gold-mining buy signal to have been generated when either of the following happens:

1) The US$ gold price closes above $1363.

2) The HUI closes above its 50-day moving average AFTER first breaking below its December-2016 low of 160.

The Currency Market

In last week's Interim Update we wrote that the market action had provided additional evidence that the Dollar Index (DX) successfully tested its late-January low on Friday 16th February and that the reversal should lead to the DX moving above its early-February high within the next few weeks.

We continue to have the 91.0-92.5 resistance range in mind as a likely target for the DX's rebound, but we also see the possibility that a stronger rebound could be in progress. The possibility of a stronger rebound is suggested by the magnitude of the speculative long position in euro futures. It is also suggested by the very US$-bullish interest rate backdrop and the relative strength of the US equity market.

Note that the DX's short-term rebound could go as high as 95 without affecting the longer-term downward trend.



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 23rd 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%, NSR = Net Smelter Return, P&P = Proven and Probable, PEA = Preliminary Economic Assessment, PFS = Pre-Feasibility Study]

  *Almaden Minerals (AAU) reported a high-grade intercept (29m grading 5.6-g/t gold) from a hole drilled immediately below the PFS pit at its Ixtaca gold-silver project. This is good news as it suggests the potential to expand the PFS mine plan.

  *Alio Gold (ALO) provided 2017 financial results and 2018 guidance.

The overall performance in 2017 was satisfactory, but the second half of the year was much worse than the first half mainly due to a large investment in mine stripping at the San Francisco (SF) gold mine (Mexico). This investment reduced production and added to costs, with one of the effects being a US$11M reduction in working capital during the final quarter. However, the balance sheet remains strong (the company ended the year with about US$62M of working capital) and the aforementioned investment paves the way for improved performance during 2018. In 2018 the SF mine is expected to produce 90K-100K ounces, or 7K-17K more ounces than in 2017, with production of 18K-20K ounces in Q1 and average production of 24K-27K ounces over the remaining three quarters.

The above information about the past and expected future performance of the SF mine should not have surprised anyone, but the company did provide some surprising new information about its other project: the development-stage Ana Paula project, also located in Mexico.

The high-grade breccia system that forms the core of Ana Paula's open-pit gold reserve extends well below the currently-proposed pit. Due to location and geometry, the open pit cannot be deepened in order to access this additional high-grade gold. It could make sense, however, to incorporate an underground mining operation into the overall mine plan to take advantage of the breccia extension. Doing so could substantially improve the project's already-robust economics.

All of the above was known before last week. In fact, in an effort to better define the high-grade mineralisation that lies below the proposed pit, prior to last week ALO had begun drilling deep holes from the surface and had started to construct a 1200m decline to facilitate extensive underground drilling during the second half of the year.

The plan that was outlined by ALO's management prior to last week involved completing the FS during Q2-2018 based on an open-pit-only operation and subsequently updating the FS to include an underground mining component if this year's exploration work pointed in that direction. However, the plan has changed.

The new plan is for the FS that was previously scheduled for completion in Q2-2018 to be based on a combination of open pit and underground mining. Since most of the information needed to properly define the below-pit mineralisation won't be available until the second half of the year, this means that completion of the FS will be delayed by at least 6 months (the FS now won't be finished until the end of this year at the earliest). This, in turn, means a significant delay to the start of mine construction. That's why the stock price was down sharply in reaction to the company's press release.

There are good efficiency-related reasons for the change in the Ana Paula schedule, but the market reaction to the news was understandable.

We are disappointed that the schedule change has happened. In our opinion it would be better to have followed the original plan even though doing so would be less efficient.

The Ana Paula FS was going to be the main company-specific catalyst for a rise in the ALO stock price in 2018, but ALO is now more of an exploration play. There will be a steady stream of drilling news throughout the year, especially during the second and third quarters, as the company gathers information about the high-grade below-pit mineralisation.

ALO's intermediate-term downward trend was extended by the reaction to last week's news. The stock is now very under-valued, 'oversold' and close to an area of important support on the chart. Based on the chart (see below) the US$2.30-$2.50 range would be the optimum place for new buying, but it would be reasonable for someone with no exposure to take an initial position near the current price.



  *Blackham Resources (BLK.AX) options began trading on the ASX last Tuesday (20th February) under the symbol BLKOA and have been added to the TSI List. The options have an exercise price of A$0.08 and an expiry date of 31st January 2019. They traded as low as A$0.006 and ended the week at A$0.008. This means that they are priced at almost zero, but "almost zero" is what they are worth with the stock trading at only A$0.045.

The options are a high-risk speculation, but they are also a reasonable speculation at the current price if implemented on a scale small enough that a loss of 100% could be easily taken in stride.

  *Cobalt 27 (KBLT.V) has purchased a 1.75% NSR royalty from RNC Minerals (RNX.TO) on all future production from the Dumont nickel-cobalt project in Quebec.

Dumont is a huge project. It contains the largest undeveloped nickel and cobalt reserves in the world and is planned to have initial annual production of 73 million pounds of nickel and 2.3M pounds of cobalt. Also, it is planned that production will be expanded in year five to an annual average of 113 million pounds of nickel and 4.3 million pounds of cobalt, and that the mine life will be at least 33 years.

At current metal prices the initial production rate would result in annual payments of about US$9M to KBLT, so on the surface this appears to be a very valuable royalty. However, in its press release KBLT did not disclose the cost of the royalty and noted that it would not have to raise additional capital to fund the purchase. This implies that the purchase price was very low.

It's likely that the purchase price is low due to the high risk that the project will never get put into production, given that about $1B will have to be raised to build the mine and that the project is probably not close to being economic at the current nickel price. It is therefore best to view this NSR royalty as a low-cost nickel call option of unlimited duration.

  *Sandfire Resources (SFR.AX) published its half-year financial report. The most important information in the report was the change in the company's balance sheet, with the net working capital position (working capital minus long-term debt) increasing from A$111M to A$156M. In effect, SFR generated free cash-flow of about A$45M during the first half of FY2018, which is a good result.

Also, SFR announced an interim dividend of A$0.08/share, payable in March.

Based on the company's historical final/interim dividend ratio, SFR's final dividend (payable in September) is likely to be A$0.18-$0.20, making a total FY2018 dividend of A$0.26-$0.28. This implies that SFR has a dividend yield of about 3.5% at its current stock price of A$7.65.

SFR's relatively high dividend yield (for a mining company) should provide support to the stock price and limit the downside during corrective periods.

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) ALK.AX (last Friday's closing price: A$0.28)

2) ALO (last Friday's closing price: US$2.61)

3) EGD.V (last Friday's closing price: C$0.41)

4) PG.TO (last Friday's closing price: C$3.23)

5) QID (last Friday's closing price: US$11.29)

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.goldchartsrus.com/