-- Weekly Market Update for the Week Commencing 30th April 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

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Summary of current thinking/positioning

1) The Dollar Index has broken upward from its trading range, but the remaining short-term upside could be less than one point.

2) The US$ gold price looks set to test the bottom of its $1309-$1363 trading range. A downside breakout from this range is a realistic possibility, but a large price decline is not likely.

3) The SPX is about to either end its correction or escalate the significance of the January-2018 top by breaking to a new low for the year. The former outcome is the more likely, but mainly due to rising interest rates there remains the threat of a trend-ending plunge to a new low for the year.

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 T-Bond came close to a downside breakout last week and is at risk of breaking out to the downside in the near future. This could lead to a rapid additional decline, but in terms of time the bond market is probably close to a multi-month bottom.

6) Holding a cash reserve of around 30%.

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, three of the markets we follow have COT situations that are worth highlighting.

The first is the 10-year T-Note futures market, where the total speculative net-short position (the mathematical equivalent of the commercial net-long position, which is indicated by the blue bars in the middle section of the following chart) just hit an all-time high. This suggests that speculators, as a group, are now more bearish on the 10-year T-Note (more bullish on the 10-year interest rate) than they have been in decades.

As a consequence, there is now a lot of 'short-covering fuel' to power a rally in the 10-year T-Note. This doesn't mean that a rally will begin soon, but it's the main reason that we are not interested in placing a new bet against the T-Note at this time.



The second COT situation worth highlighting is in the US oil futures market, where the total speculative net-long position reached an all-time high late last year and has since remained at an extreme level. This warns of downside price risk, although, as we've warned numerous times over the past 5 months, the downside risk in the oil price is mitigated by bullish fundamentals (demand in the physical market remains strong relative to supply).

The evolution of oil's COT situation illustrates one of the weaknesses of sentiment as a market timing tool. Due largely to the supportive fundamental backdrop, the upward trend in the oil price continued over the past several months despite relentless optimism on the part of the speculating community.

At some point the unwinding of the massive speculative net-long position in oil futures will fuel a large decline in the oil price. That most likely will happen after the oil market shifts out of backwardation.



Turning to the silver market, the recent focus of many analysts was on the reductions in the net positions of commercial traders and large speculators to the point where both of these groups were effectively net-flat. This was an unusual development that, at a superficial level, pointed to the sentiment backdrop being very bullish for the silver price. However, as pointed out in multiple TSI commentaries, deeper analysis of silver's COT situation revealed two reasons to be cautious. One reason was the high level of open interest. The other reason was the vigorous optimism on the part of small speculators (the proverbial 'dumb money') as evidenced by the rise in the net-long position of "NonReportable" traders to a 9-year high.

The following chart indicates the net position of small speculators in silver futures. It shows that the dumb money remains very optimistic about the prospects for a rally in the silver price.



Interest Rates and Bonds

During the first three days of last week the 10-year T-Note yield broke above the psychologically-important 3% level and the price of the 30-year T-Bond broke below its February-2018 low to a new multi-year low. However, neither breakout was confirmed by the weekly close. Also, at no time last week did the 30-year T-Bond yield move above resistance defined by its 2016, 2017 and early-2018 highs.

The first of the following daily charts shows last week's failed attempt by the 10-year T-Note yield to break above the big round number (3.0%). The second chart shows the 30-year T-Bond yield's long-term resistance near 3.2%.

The rise in the nominal 10-year T-Note yield from its July-2016 major bottom and from its September-2017 secondary bottom was partly a response to rising inflation expectations, but higher inflation expectations were only half the story. We know that this is the case because the above chart reveals a roughly 1.6% increase in the nominal 10-year yield since the July-2016 bottom while the chart displayed below reveals a roughly 0.8% increase in the 'real' 10-year T-Note yield over the same period. In other words, interest rates have been trending upward in both nominal and real terms. (On a side note, the upward trend in the real interest rate has been a source of downward pressure on the gold price).



Expectations of stronger global economic growth were probably behind the rise in the real T-Note yield during the second half of 2016, but it's likely that the rise in the real T-Note yield over the past 7 months was mostly driven by expectations of increased bond supply.

The increase in US government bond supply may be less than feared over the remainder of this year, though, due to the huge increase over the past few months in the US Treasury's cash balance. The increase is illustrated by the following weekly chart of the Treasury General Account (the US federal government's bank account at the Fed). The chart shows that the cash balance grew from below $100B late last year to a little over $400B on 25th April.

The Treasury probably needs a cash float of only $50B-$100B, so there is currently $300B-$350B sitting in the Treasury General Account that will in all likelihood be injected into the economy within the coming 6 months. To put it another way, $300B-$350B of the deficit spending that will be done by the US government over the next several months can be funded without tapping the bond market.



One-off corporate tax payments on money held outside the US is likely the main cause of the large increase in the Treasury's cash reserve over the past few months, but whatever the reason for the cash build-up the drawing-down of the cash will reduce the most important recent source of upward pressure on the 'real' T-Note yield. As a consequence, we think that the real 10-year T-Note yield is close to its high for the year.

Productivity of Debt

In the latest Quarterly Review and Outlook by Hoisington Investment Management (HIM) there's a discussion about the falling productivity of debt. According to HIM, this is evidenced by the rising trend in the amount of additional debt required to generate an additional unit of GDP. There are some serious flaws in this analysis, but before we get to these flaws here is the relevant excerpt from HIM's report:

"The law of diminishing returns is already evident in all major economies as well as on a global scale (Table 1). Global GDP generated per dollar of total global public and private debt dropped from 36 cents in 2007 to just 31 cents in 2017. Diminishing returns is even more apparent in the case of China's public and private debt, largely internally owned. In terms of each dollar of debt, China generated 61 cents of GDP growth in 2007 and only 33 cents last year. In other words, in the past ten years the efficiency of China's debt fell 45%. Thus, even in a command and control economy, the law of diminishing returns prevails. The most advanced sign of diminishing returns is in Japan, the most heavily indebted major country, where a dollar of debt in the last year produced only 22 cents of GDP growth. This economic principle applies equally to businesses.

All economies rely heavily on the business sector to lead the growth process. Yet, a sharp decline in GDP per dollar of business debt occurred in the U.S. during the past nine years, reinforcing the underlying trend since the early 1950's. In 1952, $3.42 of GDP was generated for every dollar of business debt, compared with only $1.39 in 2017. In the corporate sector, where capital as well as technology is most readily available, GDP generated per dollar of debt fell from $4.50 in 1952 to $2.50 in 2007 to $2.21 last year. The dismal trend in productivity confirms this conclusion. The percent change for productivity in the last five years (2017-2012) was equal to the lowest of all five-year spans since 1952. It was also less than half the average growth over that period."

There are three big problems with the whole "it takes X$ of debt to generate Y$ of GDP" concept, the first being that GDP is not a good indicator of the economy's size or progress.

For one thing, GDP is a measure of spending, not a measure of wealth creation. It's possible, for example, for GDP to grow rapidly during a period when wealth is being destroyed on a grand scale. This could happen during war-time and it could also happen as the result of massive government spending on make-work projects. It's also possible for GDP to grow slowly at a time when the rate of economic progress is high. This can happen because GDP is dominated by consumption. It omits all business-to-business expenditure and misses a lot of value-adding investment.

For another thing, GDP is strongly influenced by changes in the money supply. Of particular concern, even though an increase in the money supply cannot possibly cause a sustainable increase in economy-wide wealth, it will usually boost GDP.

Therefore, comparing anything with GDP is problematic.

The second flaw in the "it takes X$ of debt to generate Y$ of GDP" concept is that it involves comparing a flow (annual GDP) to a stock (the cumulative total of debt). There are times when it can make sense to compare a stock to a flow, but care must be taken when doing so. We'll use a hypothetical example to show one of the pitfalls.

Assume that over the course of a year an economy goes from a GDP of $10T and a total debt of $50T to a GDP of $10.4T and a total debt of $52T. This could prompt the claim that it took $2T of additional debt to boost GDP by $0.4T, or that $5 of additional debt was needed for every $1 of additional GDP. However, it could also be said that a 4% increase in debt was associated with a 4% increase in GDP. The second way of expressing the same change seems far less worrisome.

In any case, the above two flaws in the typical productivity-of-debt analysis pale in comparison with the third flaw, which is that the entire concept of debt productivity is meaningless. The fact is that debt doesn't cause economic growth and 'excessive debt' (whatever that is) doesn't inhibit economic growth.

An economy can grow with or without an increase in debt, because per-capita economic growth is caused by savings and capital investment. An increase in debt can accelerate the pace of real growth by acting as a means by which savings are channeled to where they can be invested to the best effect, but the transfer of savings can also occur via the exchange of money for equity. For example, most exploration-stage mining companies and most technology start-ups are equity-financed not debt-financed. There is, of course, debt that is used to finance consumption rather than investment, but that type of debt can't grow the economy over the long term because it necessarily involves a present-future trade-off -- more spending in the present leads to less spending in the future.

The central problem is unsound money, not excessive debt. More specifically, the problem is that when banks make loans they create money out of nothing. It's this creation of money out of nothing and the subsequent exchange of nothing for something, not the build-up of debt, that leads to reduced productivity. If all debt involved the lending/borrowing of real savings then no amount of debt could ever make the overall economy less efficient. Of course, if all debt involved the lending/borrowing of real savings then the total amount of debt would be a small fraction of what it is today.

The Stock Market

Cutting directly to the chase, if there's a modicum of strength in the US stock indices early this week we probably will re-establish a short-term bearish speculation via the purchase of some QQQ June-2018 put options. It will be a small position that most likely will be exited if new signs of weakness haven't emerged by mid-May.

There are two reasons for our interest in buying some short-dated puts, the first being that the most important US stock indices bounced from critical support over the final three days of last week and remain in precarious positions.

This situation was discussed in last week's Interim Update with regard to the S&P500 Index (SPX). When we wrote the Interim Update the SPX had just bounced from the vicinity of its 200-day MA and trend-line support. The bounce continued over the final two days of the week, but it wasn't strong enough to significantly reduce the danger of a downside breakout.

Below are three charts containing other examples of indices or ETFs that are within spitting distance of critical support. The first chart shows that the Dow Transportation Average is close to the bottom of a well-defined channel that dates back to the early-2016 low. The second chart shows that QQQ bounced off its intermediate-term channel bottom last week and rebounded to, but not through, its 50-day MA. The third chart shows that the Dow Industrials Index ended last week about 3.5% from the edge of a virtual cliff (the 'cliff edge' lies at 23500).

The second reason for our interest in buying some short-dated puts is the risk of a rapid additional decline in the bond market. There are good reasons to expect that US government bond prices are close to multi-month lows in terms of time, but a trend-ending plunge is a realistic threat.

A trend-ending plunge in the bond market would result in a few weeks of turmoil in the stock market.

Just to be clear, the most likely outcome is that the US stock indices do NOT experience solid breaks below their critical support levels within the next few weeks. However, it wouldn't take much additional weakness from here to breach these levels and breaching them could precipitate a panic.

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 gold market was interesting last week for what it did NOT do. It didn't confirm the upside breakout in the Dollar Index. Considering that the fundamental backdrop is unequivocally gold-bearish and that gold market sentiment is not yet supportive, gold's failure to confirm the DX's upside breakout is surprising.

To confirm the DX's upside breakout the US$ gold price must close below $1309, which could happen this week. We expect that support at $1309 will soon be challenged, but if the DX is destined to do little more on the upside than test its 200-day MA (as discussed below) then even if gold breaks below $1309 it probably won't lead to much additional weakness.



The FOMC announcement scheduled for this Wednesday probably won't have a significant effect on the gold market or any other financial market. It is widely expected and very probable that the Fed will take no action this week. There is a high probability of a rate hike in June, but this is also widely expected and therefore factored into current prices.

Silver

With apologies for mixing our metaphors, to get a tradable silver rally it isn't necessary for all the ducks to be in a row but the best rallies begin when all the important pieces of the puzzle are in place. The three pieces are fundamentals, sentiment and price action. The fundamental backdrop should be bullish, speculative sentiment should be very pessimistic or totally disinterested, and momentum indicators should be screaming "oversold". At no time over the past 3.5 months was even one of these pieces in place for either gold or silver.

By the way, we don't have a way of determining the fundamental backdrop for silver separately from the fundamental backdrop for gold. In any case, there is no good reason to do a separate assessment of silver fundamentals because intermediate-term bullish trends in silver almost always follow intermediate-term bullish trends in gold, with the emphasis being on the word "follow".

We covered the sentiment backdrop as it relates to silver in the "COT Extremes" section earlier in today's report. In summary, we view silver-market sentiment as mixed, with the bullish implication of the relatively small net-long position of large speculators offset by the bearish implication of the relatively big net-long position of small traders.

Turning to the price action, during the week before last the silver price broke above the top of its multi-month price range, but last week it negated the breakout and is now close to the middle of the aforementioned range. There is support at $16.10-$16.20 and then at $15.60. The higher of these support levels probably will be tested and the lower support level could be tested prior to a sustainable price low.



Gold Stocks

Revisiting the 1985-1987 Model

Over the past several years, central banks have acted differently and have intervened in the financial markets far more aggressively than they have in the past. It's reasonable to surmise that this intervention has caused markets to perform differently than they have in the past, but, while there are certainly some recent cases of markets performing in unprecedented ways and reaching unheard-of extremes, if you go back far enough you'll find that most things that are happening in the markets today have happened before. Gold and the gold-mining sector, for example, have performed similarly over the past 2 years to how they performed during the mid-1980s. That's why we have been tracking the 1985-1987 Model.

The 1985-1987 Model is illustrated by the following chart comparison of the US$ gold price and the XAU. Notice that after gold's 8-year cycle low in early-1985 the XAU experienced a 1-2 month rebound and then a sideways-to-downward drift until August-1986, despite the gold price trending upward during this period. It wasn't until the gold price broke out to a new 12-month high in August-1986 that the gold-mining sector embarked on a strong rally.



The next chart shows the current situation, using the HUI instead of the XAU as our gold-mining proxy. Notice that after gold's 8-year cycle low the HUI experienced a 1-2 month rebound and then a long downward drift, despite the gold price trending upward.



According to a literal interpretation of the 1985-1987 Model, gold bullion's upcoming break to a new 12-month high (the expected catalyst for a big rally in the gold-mining sector) will happen in May-2018. However, a more sensible interpretation is simply that the gold-mining sector won't do anything interesting on the upside until the US$ gold price breaks above its high of the past 12 months, and that until the US$ gold price breaks to a new 12-month high there will be a risk of the HUI moving below its December-2016 low (in the same way that the XAU broke below its early-1985 low during 1986).

The comparison with the price action of 1985-1987 is far from perfect. For example, there has been greater gold-price volatility following the December-2016 cycle low than there was following the February-1985 cycle low and the gold-mining sector has been stronger during 2018 than it was during the first 7 months of 1986. However, as things currently stand the similarities outweigh the differences.

Current Market Situation

The HUI's year-to-date low was during the second half of March. Since then it has been working its way higher within a well-defined channel.



Since the March low the HUI has also been strengthening relative to gold, but neither the strength in nominal dollar terms nor the strength in gold terms is sufficient to indicate that we are dealing with something more bullish than a counter-trend rebound.

The Currency Market

If we are dealing with a bear-market rebound in the Dollar Index (DX) then the most likely place for the rebound to end is at or slightly above the 200-day MA, while a solid break above the 200-day MA will suggest that the rebound will extend to lateral resistance at 95. The following daily chart shows that the 200-day MA was almost reached on Friday.

If the 200-day MA is going to limit the DX's rebound then the most likely time for a rebound peak is the first half of May.



But what if instead of a bear-market rebound to around 92 or 95, the DX has just commenced a new bull market?

This possibility can't be ruled out, especially since the fundamental backdrop in general and the interest-rate backdrop in particular are DX-bullish right now and have been supportive for the past few months. Based solely on the interest-rate backdrop, the DX should be a lot higher than it is today.

We assign a low probability to the 'new DX bull market' scenario, though, because the historical record indicates that once the DX confirms a new cyclical bullish or bearish trend the trend continues for several years.

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 27th April 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]

  *Alkane Resources (ALK.AX) published its quarterly activities and cash-flow reports for the March-2018 quarter.

The combined amount of cash, cash equivalents and bullion increased by A$11.2M during the quarter and the balance sheet remains solid. At the end of March ALK had no debt and about A$69M of liquid financial assets.

Gold production during the quarter from the company's Tomingley Gold Operation (TGO) was on plan and the production guidance for the current Financial Year (1st July 2017 to 30th June 2018) has been narrowed from 70K-80K ounces to 75K-80K ounces. Importantly, the AISC guidance has improved from A$1000-A$1100/oz to A$975-A$1050 (US$740-US$800).

The TGO should continue to add cash to the company's balance sheet.

An underground mining study for the TGO was originally scheduled to be completed during the March-2018 quarter but is now scheduled for completion in May. This study has the potential to be a positive, market-moving piece of news.

For the fully-permitted Dubbo Project (DP), which is slated to produce zirconium, hafnium, niobium and REEs, the company advised that a project execution and financial model incorporating the results of the modularised build study (MBS) has been further delayed while the financial assumptions are reviewed by the board. May-2018 is the new ETA.

We've been eagerly awaiting the financial results of the MBS, because we expect them to highlight the extreme under-valuation of ALK shares. However, the delay in providing the information is a cause for concern. When a junior mining company is late in publishing the results of an economic study it generally isn't because the numbers turned out to be better than expected.

  *Nevsun Resources (NSU) reported very good performance during the March quarter. Of particular significance, there were substantial improvements in zinc and copper recovery at the company's Bisha mine in Eritrea, enabling above-plan quarterly production comprising 72M pounds of zinc plus 9M pounds of copper. Even more importantly, this positive result on the production front led to good financial performance, with the company adding about US$25M of working capital to its balance sheet during the quarter. NSU now has about US$188M of working capital and no long-term debt.

The most important news for this company over the coming few months should be the initial resource estimate for the Timok Lower Zone copper project in Serbia. The deposit is huge and the initial resource estimate will potentially comprise many billions of pounds of copper.

Our medium-term NSU trade got off to a bad start, but it has recently begun to work the way it was originally expected to work and for the reasons it was originally expected to work.



  *Sandfire Resources (SFR.AX), an Australian mid-tier copper producer, reported that it produced 34M pounds of copper and 10.9K ounces of gold during the March-2018 quarter (the third quarter of the 2018 FY). Accounting for gold as a byproduct, the cash cost of the copper production was US$0.97/pound.

This was a good result. The company is maintaining its FY2018 copper production guidance of 138M-145M pounds and reducing its cash cost guidance to US$0.95-$1.00/pound.

SFR has a solid balance sheet and is strongly cash-flow positive at the current copper price. We continue to have in mind a valuation-based target of A$10.

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$0.81)

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

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

4) KBLT.V (last Friday's closing price: C$11.65)

5) PRQ.TO (last Friday's closing price: C$1.10)

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/
http://research.stlouisfed.org/