-- Weekly Market Update for the Week Commencing 28th May 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

Incomplete silver COT analysis, revisited

Summary of current thinking/positioning

1) The Dollar Index and the euro are very close to critical levels that shouldn't be breached if the recent moves are counter-trend.

2) Gold has broken out to the upside in euro terms, but in US$ terms it has not yet negated the 15th May downside breakout. This creates uncertainty regarding the bullion market's short-term prospects.

3) The SPX likely will make a new all-time high by the end of next month. The risk/reward is not bullish, though, because a move to well above the January high is unlikely.

4) The multi-year upward trend in commodity prices that got underway in early-2016 appears to have resumed. If so, the Australian and Canadian dollars should be relatively strong over the next few months.

5) The oil market has made a price top that should hold for 1-2 months or longer.

6) There is no evidence that the Swiss Franc has bottomed against the US$, but taking a 3-6 month view this currency's risk/reward looks very attractive.

7) A multi-month bottom is in place for the T-Bond. New lows in bond prices (new highs in bond yields) are likely before year-end, but the T-Bond price should have an upward bias over the coming 2-3 months.

8) Holding a cash reserve of around 35%.

The T-Bond has bottomed

In the "Summary of current thinking/positioning" section of the preceding two Weekly Updates we wrote that the T-Bond was close to a multi-month bottom. It's too soon to know for sure, but there is now a high probability that the bottom was put in place on Friday 18th May. On that day, the nearest T-Bond futures (the June-2018 contract) made a new bear-market low and then recovered to end the day with a gain.

Also, due to the 18th May upward reversal and last week's price gain, the June T-Bond's 15th May drop below lateral support to a new multi-year low looks like a false downside breakout. Refer to the following chart for details.



Considering the extent to which speculators piled onto the short side of the Treasury market in the lead-up to the recent upward reversal, it's likely that the T-Bond will make significant additional price gains before resuming its longer-term bearish trend. We guess that it will rise to around 147 (resistance defined by the April high) within the next three months, but be aware that the mid-May low in the 140-141 range could be tested as part of a bottoming process.

If the T-Bond rebound continues it will have a positive effect on gold's true fundamentals. In fact, it has already had a positive effect, in that our gold model became a little less bearish last week.

Commodities

The copper market is coiling

The copper price is working its way into the apex of the triangle drawn on the following daily chart. For this coming week, a daily close above $3.15 or below $3.05 would be a breakout from this 'coiling' pattern.

A daily close above $3.15 would suggest that copper was on its way to new multi-year price highs. A daily close below $3.05 would point to a re-test of intermediate-term lateral support at $2.95, but triple bottoms are rare so it's likely that the next test of this support will fail. In other words, a daily close below $3.05 would suggest that a decline to well below $2.95 was on the cards.

We have been expecting an upside breakout in the copper price following a correction low in March or May, but at this point there's more to be lost than gained by trying to anticipate the direction of the coming breakout.



Oil Reversal

Last week the oil market signaled the start of a meaningful correction. Our reaction: It's about time!

Speculative enthusiasm for oil had become very elevated by late last year. This and some stock market turmoil led to a sharp pullback in the oil price from late-January to mid-February, but speculators remained committed to the upward trend (speculators retained most of their collective net-long exposure in the oil futures market). Also, the fundamental backdrop (as indicated by the futures curve) turned supportive last November and stayed so. With tight supply relative to demand and speculators resilient in their bullishness, the rally resumed in mid-February and continued until last Tuesday with only two minor corrections along the way. It was a 25% price rise in the space of only three months.

The oil futures curve is still downward-sloping, meaning that the market is still in 'backwardation' and that the supply situation remains tight relative to demand. However, the backwardation is not as pronounced as it was a few weeks ago and on Friday 25th May there was news that an OPEC supply increase was on the way. This news was the catalyst for a bout of speculative long liquidation.

Given that last week's plunge ended at the 50-day MA (the blue line on the following daily chart) and that no lateral support of significance has been breached to date, it's possible that we are dealing with a sharp 1-2 week correction within an on-going short-term upward trend. However, the fact that last week was both an outside-down and a key-reversal week suggests to us that a top that will hold for 1-2 months or longer is in place.

There could be a rebound this week, but we think that the largest oil-market correction since mid-2017 has begun. At this time the most plausible target for a correction low is lateral support near $58.



Gas stocks follow oil stocks

There were tentative signs of life in US natural gas (NG) futures market last week, although in the grand scheme nothing has changed. NG's price action since early-2017 has been almost as uninspiring as the gold-mining sector's price action over the same period.



It is notable that even though the NG price gained about 4% last week and ended the week near a 3-month high, the First Trust Natural Gas ETF (FCG), a proxy for the NG sector of the stock market, fell by almost 5%. It is clear that NG stocks sold off in sympathy with oil stocks last week.

It's actually not unusual for NG stocks to be influenced more by oil stocks than the NG price. NG's strength relative to oil will tend to determine whether NG stocks are strong or weak relative to oil stocks, but usually these two equity sectors trend in the same direction.

The tendency of NG stocks to trend with oil stocks can be seen by comparing the two charts displayed below. The charts show that XOP, a proxy for oil stocks, has been much stronger than FCG since early-February of this year, but that the ETFs consistently moved in the same direction over the past 2.5 years.

Due to last week's price action, traders who purchased FCG for a short-term trade should look for an opportunity to exit. However, it would be reasonable to retain intermediate-term positions.

The Stock Market

There was a 2-3 week period of excitement spanning late-January and early-February when the 'short volatility' trade blew up in spectacular fashion. Apart from that, the US stock market has been uneventful so far this year, with most stock indices spending almost all of their time between the late-January high and the early-February low. This is surprising considering what has happened on the interest rate and political fronts. However, at the start of this year we thought that the largest decline would occur during the second half and that is still the case.

Over the next two months we expect that the stock market will be helped by a pullback in interest rates (the Fed will hike its targeted rates again in June, but the Fed is well behind the market). However, we also expect that the upside will be limited to marginal new highs in the senior indices. The upside appears to be limited because the monetary backdrop is tight, especially compared to the monetary conditions that prevailed over the past several years, and likely to get tighter as the Fed ramps up the pace of its balance-sheet reduction (its QT program).

The Fed's QT program is happening via the non-replacement of maturing debt securities. Consequently, it doesn't involve a steady decline in the balance sheet. Instead, step changes (sudden reductions) will occur on the dates when a large dollar amount of the Fed's bond holdings is due to mature. For more information refer to the article posted HERE and the Fed's portfolio HERE.

The idea is that an immediate impact of the Fed's QT program, in the form of lower prices for stocks and bonds, should be felt on the days when a large quantity of the Fed's holdings are scheduled to mature. The last such date was 15th May, when there was a sharp decline in the T-Bond and a 20-point decline in the SPX. The next such date is 31st May (this coming Thursday). It will be interesting to see if there is a similar effect.

Turning to the charts we see that the NDX, the strongest of the three senior US stock indices (the SPX, the NDX and the Dow Industrials), is not far from its high for the year. We won't be surprised if the NDX tests its 2018 high during the first two trading days of this week, but we will be surprised if it makes a solid break into new-high territory within the next two weeks. Our guess is that more choppiness lies in store over the coming fortnight.



The most significant price action that we noticed over the past week was the upside breakout by the Dow Transportation Average (TRAN).



Lastly, it's worth mentioning that some of the world's most iconic packaged-food companies have been pummeled on the stock market over the past 12 months or so. Below are charts showing two of the best examples. The first chart shows that Kraft-Heinz (KHC) is down from $90 to the mid-$50s and the second chart shows that Campbell Soup (CPB) is down from $60 to $34.

The packaged-food companies have "inflation" risk (the risk that their costs will rise faster than they are able to increase their selling prices) and tend to have high debt levels, implying that they are vulnerable to rising interest rates. At the same time, they are essentially recession proof and now have decent dividend yields.

These stocks may be worth buying for a 2-4 month trade, but we don't know enough about their balance sheets or earnings prospects to have an opinion on their investment merits.

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 price rebounded to the vicinity of its breakdown level ($1309) last Thursday. The validity and sustainability of this rebound is called into question by it being at least partly a reaction to Trump's decision to cancel the planned summit with North Korea's dictator (Kim Jong-un). As we have pointed out countless times in the past, gold never sustains price gains that are made on the back of military conflict or fear of military conflict.

In any case, at this stage the rebound hasn't taken the gold price above any resistance of significance. At the end of last week it was below the 20-day MA, the 200-day MA and lateral resistance at $1309.

As noted in the most recent two TSI commentaries, preliminary evidence that gold has made a sustainable turn to the upside would be a daily close above the 200-day MA while decisive evidence of such a turn would be a weekly close above the 200-day MA. If this happens during the coming week then the market will be performing in a similar fashion to how it performed following last year's breaks below the 200-day MA and back in line with the 1985-1987 Model.



In US$ terms gold didn't do anything significant last week, but in euro terms it did. As illustrated below, on Friday the euro-denominated gold price broke above well-defined lateral resistance at 1110 and made an 8-month high. This should mean that if the US$ gold price manages to move back above its 200-day MA then gold will have a bullish short-term posture in terms of both senior currencies.



The fundamental backdrop remains gold-bearish, but as discussed above in our T-Bond comment it has begun to improve (move in gold's favour) and should continue to do so if the T-Bond extends its rebound. The sentiment situation is slightly bullish for gold.

Gold Stocks

Due to having substantial exposure to gold-mining stocks our biggest concern right now is that we are dealing with another in a long line of short-term, counter-trend rebounds.

The channel drawn on the following daily chart is not particularly well defined. Its sole purpose is to make the point that the HUI could move up to 190-200 without changing anything. An up-move of that magnitude would simply create another in a sequence of declining tops.



The pattern of the past 16 months has involved 1-2 month up-moves followed by declines to marginal new lows. There have been no large rallies and no dramatic sell-offs. As mentioned in last week's Interim Update, the simplest and most reliable way for this tedious pattern to end would be via a sharp decline that 'clears the decks'.

Alternatively, the HUI could change the pattern by showing more strength than it has shown during the other rallies of the past 16 months and the current rally to date. This would involve an upward burst relative to gold. Note that the slow upward drift of the HUI/gold ratio over the past two months is not indicative of substantial rally in its early stage.

The Currency Market

The euro approaches a critical level

This is getting interesting. From last week's Interim Update:

"During the first quarter of this year we wrote that once the euro reached a short-term top the ensuing decline could extend as far as long-term support (the previous major upside breakout level) near 1.16 and still be a correction within a cyclical advance. The corollary is that if the euro were to break solidly below 1.16 on a weekly closing basis then doubt would be cast upon the idea that last year's upside breakout marked the beginning of a cyclical (multi-year) advance."

The euro was about one point away from critical support at 1.16 when we posted the Interim Update. It subsequently dropped a little further and is now about half a point away.



We'll now take a step back. In early-February of this year (in the 5th February Weekly Update) we presented a chart to make the point that the euro had just tested the top of the channel that had limited its intermediate-term trends over the past 10 years. This implied that the euro was close to a very important psychological resistance area. We also pointed out that even if an upside breakout was destined to occur eventually, the test of long-term resistance combined with the stretched sentiment and momentum situations paved the way for a significant correction.

Here is an updated version of the chart included in the above-mentioned early-February commentary. The channel lines have not been moved.



The correction took longer than expected to get underway, but, as noted above, it has now gone almost as far as it can go and still be classed as a correction. Putting it another way, the euro will have to end a week only a point or so below its present level to signal that the rally from the December-2016 bottom was the bear market variety.

The euro is now very 'oversold' and should soon rebound, but the fundamental backdrop remains decisively euro-bearish and sentiment is not yet close to being supportive (speculators, as a group, are stubbornly maintaining a large net-long position in euro futures). Therefore, although the euro holding critical support and then resuming its 1-2 year upward trend would be a better fit with our current overall market view (e.g., expecting commodity prices to trend upward during the second half of this year), the risk is increasing that the euro's 2017 rally was an intermediate-term upward trend within the context of a long-term downward trend.

The world's weakest currencies

Not counting countries that are complete basket-cases (e.g. Venezuela), Argentina and Turkey are the countries with the weakest currencies at this time. The following charts show the performances of each of these currencies (the Argentine Peso and the Turkish Lira) relative to the US$ over the past 12 months.

The Peso is down by about 35% and the Lira is down by about 25% over the past 12 months, so Argentina has been the leader in the race to zero. However, the chart of the Peso/Lira exchange rate displayed below shows that there was a significant change over the past two weeks. The Peso/Lira rate has reversed upward in dramatic fashion, not due to strength in the Argentine Peso but due to the rapid weakening of the Turkish Lira.


                            (The above charts are from the Pacific Exchange Rate Service)

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 he will have greater influence over the actions of the central bank.

The Yuan

The following chart shows that China's currency, the Yuan, was in a strong downward (weakening) trend relative to the US$ throughout 2015-2016, but that since the beginning of 2017 it has recouped a substantial portion of its 2015-2016 loss. What were the main causes of this performance?



China's government was blamed by some, most notably Donald Trump, for the Yuan's weakening trend in 2015-2016. According to this line of thinking, China's government was manipulating the currency downward relative to the US$ to gain an international trade advantage. However, we know by looking at the change in China's foreign currency reserves that this was not the case. In fact, China's government intervened aggressively during 2015-2016 in an effort to prop-up the Yuan.

The Yuan's weakness during 2015-2016 was a reaction to a) US$ strength (the US$ trended upward against most currencies during that period), b) capital flight from China and c) the Yuan being over-valued due to a decade of relatively fast monetary inflation. It would have weakened a lot more if not for China's government spending about a trillion dollars of its reserves as part of a Yuan support effort that also involved imposing stricter limits on sending money out of China.

The upward trend in Yuan/US$ over the past 17 months is largely a mirage created by weakness in the US$. This is evidenced by the following chart, which shows that there was no meaningful strengthening of the Yuan relative to the euro prior to the past two months.



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 25th May 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]

  *Cobalt 27 Capital Corp. (KBLT.V) has completed its first streaming deal, and a good deal it appears to be.

The streaming deal is associated with the 11.3% stake owned by Highlands Pacific (HIG.AX) in the fully-operational, long-life Ramu nickel/cobalt project in Papua New Guinea (PNG). The project is majority-owned and operated by Metallurgical Corporation of China (MCC), a large Chinese company listed in Hong Kong.

KBLT has purchased 55% and 27.5%, respectively, of HIG's share of Ramu's cobalt and nickel production. This is expected to result in annual production to KBLT's account of 450K pounds of cobalt and 2.25M pounds of nickel. The cost to KBLT is an upfront payment of US$113M plus $4 for each pound of cobalt and $1 for each pound of nickel.

In addition, KBLT has purchased 13% of HIG via a private placement priced at A$0.105/share, giving HIG's treasury an A$15M boost. HIG will use this money to fund the repurchase, at a cost of US$15M, of part of the cobalt/nickel stream sold to KBLT.

The net result of the aforementioned transactions is that KBLT will be paying about US$110M to get:

1) 390K pounds/year of cobalt production at a cost of $4/pound.

2) 2M pounds/year of nickel production at a cost of $1/pound.

3) 13% of HIG.

At current metal prices of around $40/pound for cobalt and $6.50/pound for nickel, the stream would generate about US$25M/year of gross profit for KBLT. Applying a fairly conservative multiple of 10 to this gross profit figure gives us a rough valuation of US$250M for the stream. Adding US$15M for the current market value of the 142M HIG shares to be owned by KBLT, we get a total value of US$265M.

In summary, for a cost of US$110M we estimate that KBLT has obtained something worth about US$265M.

If our calculations are in the right ballpark then KBLT has just done a deal that adds about US$155M, or about US$3.00 (C$3.80) per share, to the company's value.

In other positive KBLT news:

1) The company is in advanced discussions with two local PNG stakeholders in Ramu to purchase another cobalt/nickel metal stream on the project on the same terms as the deal with HIG. The deal with the local stakeholders is expected to be about 77% the size of HIG deal and cost US$87M. If so, it would add another US$100M (C$2.40/share) of value to the company.

2) The company "anticipates paying a quarterly dividend equal to a meaningful portion of free cash flow from future streaming and royalty investments."

At current metal prices and taking into account the HIG deal, our estimate of KBLT's net asset value (NAV) is C$14.50-$15.00. Our estimated NAV will rise to C$17.00-C$17.50 if the deal with the two local Ramu stakeholders is completed as mentioned above.

The lack of a positive stock market reaction to the news of KBLT's streaming deal could be related to the PNG location of the Ramu project. The market undoubtedly would have preferred a deal linked to a project in a lower-risk location, but if Ramu was in Australia or North America then KBLT would get a lot less metal for the same payment.

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$0.29)

2) EGD.V (last Friday's closing price: C$0.39)

3) GRG.V (last Friday's closing price: C$0.45)

4) KBLT.V (last Friday's closing price: C$11.78)

5) PG.TO (last Friday's closing price: C$2.78)

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/