-- Weekly Market Update for the Week Commencing 30th December 2019

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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

Accelerating Monetary Inflation

Summary of current thinking/positioning

1) The Dollar Index (DX) remains range-bound, needing a weekly close below 96.5 to signal an intermediate-term reversal to the downside or a weekly close above 99.5 to signal an intermediate-term rally. We are anticipating the former, but we are uncertain as to whether it will happen in the near future or during the first few months of next year.

2) Last week the conflict between the gold bullion market and the gold mining sector was resolved by the bullion market confirming the gold sector's bullish price action. We expect a multi-month top in January.

3) The senior US stock indices probably will make multi-month tops between late-December and mid-January. Sentiment indicators are flashing warning signs, but breadth indicators are saying that the coming decline will be limited to around 10%.

4) The T-Bond made a short-term bottom in early-November, but there is still risk of downward acceleration over the coming month or two. Regardless of what happens in the short-term, there's a good chance that major price weakness will be seen in 2020. In other words, it looks like higher interest rates are on the way.

5) Industrial commodities such as oil and copper should perform well over the next 12 months, but the stage is set for multi-month price highs early in the New Year.

6) We are holding a cash reserve of 25%-30% and are looking for opportunities to increase this reserve.

The Fed

The Fed's interest rate manipulations

According to the prices of Fed Funds Futures contracts, the majority view right now is that the Fed will make no change to its interest rate target in 2020. This means that the market currently is in synch with Jerome Powell's characterisation of 2019's three rate cuts as a mid-cycle correction along similar lines to the mid-cycle corrections that happened during the economic expansion of the 1990s. Consequently, a rate cut in 2020 would be a major event in that it would change the way that 2019's rate cuts are perceived.

To further explain, one more rate cut would indicate that the Fed's actions during July-October of 2019 marked the start of a 'loosening' cycle as opposed to a correction within a 'tightening' cycle. This shift in perception would have big implications for all the financial markets and especially the currency market. Specifically, it would lead to very significant weakness in the US dollar.

A catalyst for the Fed's next rate cut could arrive during the first quarter of 2020 in the form of a 10% decline in the S&P500 Index. While an SPX decline of this magnitude initially could boost the US$ and put irresistible downward pressure on the prices of almost all equities, the Fed's reaction probably would set in motion an intermediate-term rally in the commodity sector and an upward trend in inflation expectations.

Monetising the government deficit

A number of temporary factors came together during September to create the "repo crisis", but the underlying issue (the root cause) was not temporary. That's why the Fed felt the need to continue pumping money and reserves into the banking system after the initial crisis subsided and order was restored. The underlying issue is that the demand for the US Federal Government's debt is falling short of supply at current interest rates.

The Primary Dealers (PDs) are intermediaries in the Treasury market. When the Fed conducts its open market operations it deals through the PDs. For example, when the Fed wants to inject money into the banking system it buys Treasury securities from the PDs. Also, the PDs are obligated to place bids at the regular auctions of US government debt and they do this with the aim of quickly selling the debt at a profit. The Fed is a potential buyer of this debt.

Prior to mid-September the Fed was not doing any net buying of Treasuries, so Treasury debt purchased by the PDs at government debt auctions had to be sold to hedge funds, bond funds, pension funds, foreign central banks, etc. However, there wasn't sufficient demand at high-enough prices (low-enough yields) to enable the PDs to earn the desired profit, so they ended up with a much larger-than-normal amount of unsold Treasury inventory.

A knock-on effect was that the PDs, most of which are banks, had less ability than normal to offer short-term money to the "repo" market. At the same time, the demand from hedge funds for short-term money was ramping up.

During September, the elevated demand for short-term funding on the part of hedge funds and the reduced supply of short-term funding from PDs and the associated major banks collided with a substantial build-up of cash in the government's account at the Fed and a corporate tax payment. The result was a dramatic spike in the cost of short-term funding (a dramatic interest-rate spike) that the Fed addressed by providing the "repo market" with whatever additional 'liquidity' it needed.

By aggressively pumping money the Fed was able to bring the cost of short-term funding back into line with its target, but, as mentioned above, the underlying issue of excess Treasury supply remained. This meant that the Fed couldn't just switch on the money pumps for a short period and then turn them off. It had to keep pumping because the government kept emitting new debt at a rapid pace.

It's beginning to look as if the non-Fed demand for Treasury securities will continue to fall short of Treasury supply at the Fed's desired interest rates until/unless there is a financial shock of sufficient magnitude to provoke a large-scale flight to safety. In other words, in the absence of a widespread shift away from risk it seems that the Fed will have to keep filling-in the gap between Treasury supply and Treasury demand with its own buying of Treasury debt. This means that for all intents and purposes, the Fed is now monetising the government deficit.

In the 21st October Weekly Update we explained why this is potentially very important. At that time we wrote:

"The Fed has emphasised that the new asset monetisation program should not be called "QE" because it does not constitute a shift in monetary policy. Technically this is correct, but in a way it's worse than a shift towards easier monetary policy. The Fed's new program is actually a thinly-disguised attempt to help the Primary Dealers absorb an increasing supply of US Treasury debt. To put it another way, the Fed is now monetising assets for the purpose of financing the US federal government, albeit in a surreptitious manner."

And:

"...when the central bank is perceived to be financing the government, as opposed to implementing monetary policy to achieve economic (non-political) objectives such as "price stability", there is a heightened risk that a large decline in monetary confidence will be set in motion. One effect of this would be an increase in what most people think of as "inflation"."

As well as leading to an increase in what most people think of as "inflation", the spreading realisation that the Fed is monetising assets for the express purpose of financing the US federal government should lead to weakness in the US dollar on the foreign exchange market.

Oil

Flawed Forecasts

Most forecasts are extrapolations of the recent past and as a result will be wildly inaccurate around major turning points or trend accelerations. The forecasts made by the U.S. Energy Information Administration (EIA) a decade ago are great examples, in that there are big differences between the actual US energy situation today and what the EIA projected 10 years ago. Some of the most important differences are illustrated in the following charts, which were taken from the article posted HERE.

The first chart shows that US oil production today is approximately double the projection that was made by the EIA in 2009.



The next chart shows that it's a similar story with natural gas production.



In 2009 the net amount of oil imported by the US was expected to remain at around 8M barrels/day over the ensuing decade. Instead, the chart displayed below shows that the US has become a net exporter of oil. In addition to having economic consequences, this has foreign policy implications. In particular, it removes the main excuse for US military intervention in the Middle East.



The popular assumption now is that US production of oil and gas will continue to trend upward, but this line of thinking could turn out to be as 'off-the mark' as the projections made by the EIA in 2009. We don't have the information or the expertise to have a strong opinion on the matter, but we do know that it is dangerous to assume that the future will be a linear extrapolation of the recent past.

Current Market Situation

We have been expecting a December-February (most likely January) turning point in the oil price. Prior to the past fortnight a turn from down to up was the more likely scenario, but that's no longer the case. Due to an extension of the stock market's short-term upward trend and the positive correlation between the oil and stock markets, there's a good chance of a multi-month top in the oil price during January-2020.

A January-2020 top for the oil price would, we think, prove to be similar to the January-2018 top, meaning that it would be followed by a sharp multi-week pullback.



The Oil Services ETF (OIH) is consolidating after reaching its 200-day MA. We expect big things from OIH during 2020, but the short-term risk/reward is neutral. We won't be surprised if the ETF gains another 10% before topping on a short-term (1-3 month) basis, but we also won't be surprised if there is a correction of up to 10% prior to the upward trend resuming.



The Stock Market

Sentiment Alert, Part 2

A week ago we wrote that there had just been a surge in optimism that constituted a loud warning signal. This was evidenced by an upward spike in the TSI Index of Bullish Sentiment (TIBS). Well, the warning signal got even louder over the past week.

At around this time last year, the Smart-Money/Dumb-Money Confidence Spread calculated by Sentimentrader.com was near a 5-year high, meaning that the confidence of the Smart Money (institutional traders) was extremely high relative to the confidence of the Dumb Money (retail traders). This was a buy signal.

The current signal is the opposite. As illustrated by the following chart, the Smart-Money/Dumb-Money Confidence Spread has just reached a 6-year low. Rarely has the Dumb Money been so confident relative to the Smart Money.



Current Market Situation

Sentiment isn't the only reason to suspect that a sizable correction will get underway in the near future. Another reason is the extent to which the senior US stock indices and many other stock indices are stretched to the upside in momentum terms. For example, the following chart shows that the daily RSI(14) of the NASDAQ100 Index (NDX) has just risen to near a multi-year high and that the previous two times that the NDX's RSI reached a similar extreme there was a quick decline of around 10%.



The US stock market's saving grace is that breadth remains strong. This suggests that while a correction of up to 10% may well be likely, a bear market is not about to begin.

The only bearish divergence or non-confirmation we can identify right now is the obvious lack of strength in the Dow Transportation Average (TRAN). As illustrated below, the TRAN remains below its early-November high.



It isn't only the US stock market that is stretched to the upside and due for a sizable correction. On a short-term basis the Emerging Markets ETF (EEM) is in a similar position to the NDX, having 'gone vertical' over the past few weeks.

We expect that due to the combination of US$ weakness and relatively attractive valuations, Emerging Market equities will outperform US equities over the coming 12 months.



It would be reasonable to accumulate new or add to existing bearish speculations over the coming fortnight. These speculations could take the form of put options with expiry dates of March-2020 or later that are 5%-10% out of the money, or bear funds such as QID.

At some point over the next week we may add one or two new bearish option trades to the TSI List. The ones we have in mind are the SPY March-2020 $290 Put Option and the IYT (Transportation ETF) March-2020 $180 Put Option.

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

Our Gold True Fundamentals Model (GTFM) has been 'whipsawed' over the past few weeks, flipping from bullish to bearish and back again. As explained in each of the previous two Weekly Updates, this is due to four of the GTFM's seven inputs being very close to their tipping points. Consequently, it's best to view the current fundamental backdrop as finely balanced.

Anyhow, the fundamental backdrop isn't the main issue at the moment. As has been the case for about four months now, speculator sentiment is the biggest obstacle facing the gold price.

Prior to last week the total speculator net-long position in Comex gold futures was not far from the all-time high reached during August-September of this year, despite the downward drift in the gold price since early-September. Due to the Christmas break the updated COT data was not published last Friday, but given that the gold futures open interest (OI) ended the week at an all-time high it is safe to assume that the total speculator net-long position has returned to the vicinity of its August-September extreme.

As noted a week ago, the sentiment situation doesn't preclude a rally that tests the 2019 high. In fact, the chart pattern suggests that a test of the 2019 high probably will happen in the near future and that a spike to as high as $1600 is possible. However, it reduces the scope for additional net buying on the part of speculators and thus makes it unlikely that the rally will continue beyond the next few weeks. It also creates downside risk.

Turning to the price action, the following daily chart shows that the US$ gold price broke out to the upside early last week. There is some resistance in the $1520s that could limit the rally for a few days, but, as mentioned above, the chart suggests that a test of the 2019 high is coming.



Silver

As was the case with the US$ gold price, the US$ silver price broke out to the upside early last week. There is some resistance in the low-$18 area that could limit the rally temporarily, but a near-term rise to the $19.00-$19.50 area looks likely.

Note that silver has a smaller chance than gold of exceeding its 2019 high prior to the next multi-month price top.



Gold Stocks

A week ago we wrote: "The HUI, a proxy for the gold-mining sector, managed to draw-out its coiling pattern for an additional week by pulling back to near its 20-day MA. The HUI looks like it is preparing to accelerate upward to a new multi-year high...".

The first of the following daily charts shows that the HUI did accelerate upward last week to a new multi-year high (last week's high for the HUI was the highest level since Q3-2016).

Thanks to strength in copper relative to gold, recently the XAU has been stronger than the HUI. Whereas the HUI made a marginal new multi-year high last week, the second of the following daily charts shows that the XAU broke decisively into new multi-year high territory.

GDX, on the other hand, has been relatively weak of late and remains a few percent below its 2019 high. Refer to the third of the following daily charts.

In terms of time the gold mining sector probably isn't far from an intermediate-term top, but there is the potential for a continuing strong advance over the weeks immediately ahead.

As illustrated below, a top in January would keep the HUI on a similar path to the one traveled by the Barrons Gold Mining Index (BGMI) in the 1980s.

Our comparison with the 1980s points to a January-2020 high followed by a large decline to a March-2020 low. This is just something to be aware of. The current market eventually will deviate from our 1980s model, but as long as the model is consistent with the recent price action we will continue to pay heed to it.



With the gold mining indices and the broad stock market (represented by the S&P500 Index) having just made new multi-year highs together, the gold mining sector is far more vulnerable than usual to weakness in the broad market. That is, don't assume that the gold mining sector will benefit from significant stock market weakness in the near future. Instead, due to the gold sector having just rallied with the broad market it's more likely that gold mining stocks would be dragged down by significant short-term stock market weakness.

The Currency Market

The Dollar Index (DX) ended last week slightly above important support at 96.5. A weekly close or consecutive daily closes below this support probably would be followed by a multi-week decline to 94.5 or lower.

As mentioned early in today's report, the DX initially could be boosted by a 'flight to safety' during the next sizable stock market decline. However, if the Fed's reaction to the stock market decline involves a rate cut it would, we think, lead to persistent weakness in the DX.



The following chart shows that gold and the Yen have diverged over the past several weeks, with gold beginning to trend upward and the Yen continuing to drift downward. Based on the historical relationship between these markets it is reasonable to expect that the divergence will be closed within the coming month via a surge in the Yen or a plunge in the gold price. We think that the former is more likely, but it's a virtual coin toss.



The Yen's decline since its August-2019 peak has traced out a wedge pattern. Refer to the following daily chart for the details. A daily close above 92 would break the Yen out of its wedge and suggest that the gold-Yen divergence mentioned above was going to be resolved via a surge in the Yen.



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 20th December 2019:

[Note: AISC = All-In Sustaining Cost, EBITDA = Earnings Before Interest, Tax, Depreciation and Amortisation (a measure of cash flow), EV = Enterprise Value or Electric Vehicle, FS = Feasibility Study, FY = Financial Year, IRR = Internal Rate of Return, ISR = In-Situ Recovery, JV = Joint Venture, 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 or Net Smelter Royalty, P&P = Proven and Probable, PEA = Preliminary Economic Assessment, PFS = Pre-Feasibility Study]

  *Premier Gold (PG.TO) advised that it is involved in a legal dispute with Centerra Gold (CG.TO), its JV partner at the feasibility-stage Hardrock gold project in Ontario. According to PG, the project meets the requirements defined in the 2015 partnership agreement for mine construction to proceed. According to CG, it does not. In other words, PG wants to begin the process of putting the project into production, but CG wants to wait.

CG could resolve this dispute by purchasing PG's 50% stake in the project or making a takeover bid for PG. We doubt that it will do this in the near future, but it's a realistic possibility.

Regardless of how the current PG-CG dispute is resolved, we would prefer that PG was NOT involved in moving the Hardrock project through the construction phase. The reason is that given the US$1B estimated construction cost, doing so would entail PG taking on a lot of debt and a lot of risk.

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$0.55)

2) AOI.TO (last Friday's closing price: C$1.19)

3) PG.TO (last Friday's closing price: C$2.01)

4) PRQ.TO (last Friday's closing price: C$0.24)

5) TGB (last Friday's closing price: US$0.46)

The above list is limited to five stocks. It sometimes will contain less than five, but it never will contain more than five regardless of how many stocks are attractively priced for new buying.

The Fortuna Silver Mines (FSM) Trade

FSM was added to the TSI List during the week before last with an initial daily-closing stop at US$3.15. It was expected to either start working or get stopped out right away.

It has started working and is up by 16% to date. As a result it makes sense to lift the sell stop.

From now on we will use a 10% trailing stop. For example, the high to date (since the start of the trade) is US$4.07, so the current sell stop is US$3.66.



Tax Trade Update

Three weeks ago we mentioned five candidates for a tax-loss trade that we planned to track as a group, with each stock being added to the group if/when it became available at a targeted entry price. The aim was to average into the group over the remainder of this year and exit at a profit during the first month of the New Year.

At the moment our tax trade group contains three stocks: AAL.V, TGB and TK.V. The other two potential inclusions (CGT.TO and GRG.V) didn't quite make it to their stipulated entry prices before beginning to rebound. Consequently, they have been ruled out.

We were considering a few other stocks for inclusion in the tax trade group, but each has enjoyed a significant bounce over the past two weeks. Clearly, the post-tax-loss-selling rebound started early this season.

Here is a table showing the performance to date of our tax trade group. The entire group will be exited within the coming three weeks and any member of the group will be automatically removed if it trades at least 100% above its entry price.



Chart Sources

Charts appearing in today's commentary are courtesy of:

https://stockcharts.com/
https://www.barchart.com/