…Chicken, Egg, Chicken…

From the HRA Journal: Issue 298

This issue contains the first part of my start of the year editorial, focused on the equity markets, with a gold kicker at the end. Wall St, barely, avoided falling into a bear market late last month. I don't think we'll get through 2019 without a drop into Bear Market territory getting completed. I'm still not sure whether that will happen early or late in the year, though bear markets that start in Q1 are admittedly pretty rare.

The delay getting lab results and engineering studies continue. There is only a short list of updates this issue because so few companies reported anything. With a couple of important conferences dead ahead, I'm still hopeful the reporting situation improves through the next couple of weeks.

While I'm negative on how the large indices will turn out this year, I'm considerably more positive about the prospects for the gold and silver resource and exploration sectors. In large part because I am negative about the bigger markets. I think odds are high we see our little corner of the market outperforming, something that hasn't happened for three years.

While I like gold's prospects, the broader markets will be treacherous and volatility will be much higher going forward. In that sort of backdrop, using gains to harvest some funds and keeping a higher cash balance wouldn't be the worst idea ever.

Eric Coffin
January 9, 2019


…Chicken, Egg, Chicken…

This is the first part of the traditional "how big an idiot can I look like" start of the year editorial. I'll go into metals and oil in the next issue but, this year, the equity market will be driving the bus so I'll look at that first, with a bit of gold tacked on.

Markets have endured incredible volatility in the past month. The S&P, pictured below, had a huge dive followed by a huge bounce in the past few sessions. Traders are getting bullish again.

I see several possible scenarios. Most of them are not positive for New York and other major bourses, at least not right away. I think Wall St goes lower in the short to medium term (over the next few months). What I'm not yet sure of is the precise order events unfold in. That is likely to determine whether Wall St and its followers close 2019 higher or lower than it started.

I feel pretty confident it's going to go below the December lows in 2019. In other words, we get a bear market this year. How bad a market we get will be largely determined by what happens with the economy in the US and, to a lesser extent, China. That, in turn, appears largely dependent on politics, sentiment, and Fed.

One of the enduring mysteries, and debates, in the stock market is centered on whether it moves, or just reacts to, the economy. I think the answer is definitely "both". Compensation, reputation and planning at large companies is so tied up with market valuation that it can't help but affect decision-making.

The market itself gets impacted by actors that are trading based on technical patterns (charts), fundamentals, and sentiment.

Technicians (most, anyway) argue that the market prices all available information, seen and unseen. The implication is that if the market moves strongly enough in one direction or another it's pricing in new information, even if that information isn't known to you. The market is telling you there is really good, or bad, news coming. You just don't know what it is yet. I think there is truth to that, though I wouldn't be as dogmatic about it as some chartists are.

Fundamentalists consider the market efficient at pricing in known information, and assumptions about future profit streams based on it. Because some fundamentalists, especially "old school" ones, underpin their views with the Efficient Market Hypothesis, they tend not to believe in "beating the market" at all.

Fundamentals can change and alter investor outlooks and hence price levels but future changes are random and unpredictable. I don't buy into this fully either, but plenty of others seem to, even if they don't admit to it. I don't see why passive investing would be as popular as it is if people don't hold to this idea.

Technicians might seem to believe future events are unknowable, superficially, except that they also believe there are patterns to price changes that can help predict which way they will move and/or detect momentum shifts (up or down) with enough confidence that they can be traded. They reject the "random walk" theory of the market.

I certainly find charts helpful, but I've never spent a lot of time trying to learn TA and make no claims to deep understanding of it. I know a few technical traders who are successful at it. The most successful ones trade very short term and they trade a lot.

Technicians tend to react faster to chart signals, assuming information to explain the price change will follow or, more likely, not caring if it does since they are trading the pattern. A strict fundamentalist is more likely to want to see some sort of supporting data, no matter how obscure, before taking the plunge.

I'm definitely at the fundamentalist end of the spectrum. I find charts useful but with junior resource stocks, the biggest short- and medium-term drivers are exploration data that I do not think gets represented in advance of its arrival in a chart.

Fundamental information- new projects, exploration results, etc., have by far the largest impact on a junior resource stock. I don't think staring at a chart can tell you when a company will drill a discovery hole. Fundamentals are the main driver for a given company, but TA still helps gauge entry and exit points. And then, of course, there's sentiment.

Overall market, and stock specific sentiment has a huge impact on traders, obviously. I don't need to tell you that when a sector is out of favor it takes far better news to generate a positive impact. In fact, it usually takes a bona fide surprise­-like a discovery drill hole­-to do it. The same thing applies on a broader scale to the major bourses and, indeed, the economy as a whole.

I've touched on this in the past, talking about "hard" versus "soft" data, as the latter is heavily influenced by, and really a measure of, sentiment. I think it will be critical to keep that distinction in mind for the next few months. The market seems to be driving the economy in the US. Sentiment shifts won't just be felt on Wall St if it is.

Take a look at the chart below. This is an updated version of one you've seen before. There has been a huge and growing divergence between "hard" (measurement based) and "soft" (opinion based) economic data for a few years now. The recent divergence is among the largest ever measured. The US economy did pretty well in 2018, but nowhere near as respondents think it did. The US economy would have had to be growing at 8-9% to match the soft survey numbers.

Of course, sentiment is a two-way street, as the two charts below show. The December 2018 US ISM survey was a big shocker for the marker. The manufacturing PMI dropped by five points, one of the biggest drops on record. There's little doubt in my mind that the market and political mayhem of December figured largely into that drop.

Interestingly, and importantly, it wasn't just the "soft" parts of the ISM survey accounting for the drop. The "new orders" part of the survey fared far worse, dropping twice as much as the overall measure. I'm taking it on faith that the survey respondents actually checked their order books. Keep in mind, new orders are one of the more forward-looking parts of the survey.

This is where the "egg…chicken…egg" part comes in, and it's important. There is little doubt that the cascading markets through December and bad news on trade talks and revenue/profit warnings from the likes of FedEx had a big impact on the ISM survey. Most, including me, would view the ISM number as "soft" data since its survey based. But I consider the new orders number both telling and potentially ominous.

While we're on the subject of ominous, the results of the latest CFO Survey give me food for thought. This survey of Fortune 500 CFOs also falls into the category of soft data, but it could foretell more slowing on the corporate side.

In the latest survey, almost 50% of CFOs said they expect the next recession to start this year, and virtually all of them expect it to start no later than next year. That is a significant dimming of the future views of CFOs in the space of three months. Yes., it's just a survey. But I can't help but wonder if that new, darker view of the 2019 and 2020 economy will change the spending plans of these large corporations.

I'd expect them to become more cautious, at a minimum. Indeed, the large drops in the latest ISM survey are probably related to budget decision makers getting more negative about growth prospects. Things like this can become self-fulfilling prophesies if sentiment doesn't get turned around.

To add one more piece to the puzzle going forward, let's spend a moment on the yield curve. That has been getting a lot of press recently, as the curve continued to flatten and then slightly invert through the middle part of the curve.

The chart below shows the current yield curve (January 4th), a week earlier and a year earlier. You can see how yields increase, very slightly, until one year out on the curve then dip, again very slightly, before starting to rise again as you near the seven-year maturity point. The curve is inverted from about 1 year out to 7 years out, but only barely. Probably more accurate to call the curve "flat".

Why does this matter? I noted in the last issue that inverted yield curves are one of the most accurate recession predictors. A study that came out a few days ago from the Federal Reserve Bank of St Louis takes it a step further, positing that inverted yield curves don't just predict recessions, they help cause them.

The chart above from that study, shows the difference between the yield on the 10- and 2-year Treasury notes plotted against the percentage of US banks tightening lending standards, something the Fed surveys regularly. The graph shows whenever the net "10 minus 2" yield approached or dipped below zero, indicating a flat or inverted yield curve, banks ratcheted up their lending standards.

This makes sense when you think about it. Banks are in the business of "borrowing short and lending long" in terms of duration. The steeper the yield curve is, the bigger the potential margin between the interest they pat for short term borrowing and deposits and the interest they receive on longer term funds they lend out.

As the yield curve flattens banks' margins get squeezed and the risk of them losing money on any given loan increases. Banks respond by making lending standards tougher and ultimately, if the yield curve inverts enough, refusing to lend at all. You can see from the chart that lending standards tightened ahead of the last two recessions, and appeared to be slightly led by drops in the 10-minus-2 net yield.

Lending activity has a direct impact on economic activity. If businesses can't borrow, they may have to put off capital spending, expansions or hiring. At the time of writing, the slow between two- and ten-year yields is still positive, though not very positive, with the 10-year yield only 16 basis points above the two year.

Based on the chart above, we're not at the point yet where banks have tightened standards, though the latest survey in the chart is early October, before the yield curve really flattened. I wouldn't say this indicator is flashing red, but it's certainly yellow and bears watching.

Most recently, the markets have bounced again, hard. It already seems that Wall St is full on bullish again, which is one reason I distrust the rally. At a minimum we should expect recent lows to get retested.

Markets recovered through the past week for three main reasons; China, the Fed, and Jobs. China indicated it will cut the bank reserve ratio again, allowing more lending, and talked of plans for new stimulus spending. That started the bounce. Traders have been rightly concerned about slowing growth in China, worsened by the trade fight. I doubt China is out of the woods yet but a heavily oversold market was looking for anything positive. China is of course critical to demand for many materials. I hope Beijing does pull the proverbial rabbit out of the hat. I think they can goose the economy as they have many times before but I expect its growth rate to remain tepid.

Next up was a non-farm payroll report for December that blew away expectations with the 312k job gain. I didn't like the high number of "second" (i.e. part time) jobs in the number, nor the large number of "self-employed" jobs that may or may not be paying much of anything. The one thing that was good news was a larger year over year wage gain of 3.2%.

It was a good report despite the shortcomings noted above. It's important to remember that employment reports are lagging indicators though. I don't think we should expect better Q1 growth based on this job report and I'm highly skeptical we see a number anywhere near this good for January.

The biggest impact came from an interview given by Fed chair Powell. Wall St loved Powell's comments, but I find myself less enthusiastic. I think Powell has seriously damaged the credibility of the Fed, which wasn't great to begin with.

It's painfully obvious the Fed will let Wall St call the shots. Powell backpedaled on how many, if any, rate increases we'll see in 2019, and said he may back off on QT as well. I'm not saying that higher rates and more balance sheet reduction is a good thing. But having ammunition for the next real slowdown is.

Although the news out of China may be the most significant in real terms, it's the Fed comments that had the biggest positive impact on sentiment. It remains to be seen whether that will be enough to turn things and extend the Wall St bull market significantly. Short term it certainly has.

Maybe I'm being too bearish. I readily acknowledge that. But the overall tenor of the major markets feels different to me, notwithstanding the current rally. Most risk measures have dropped right back to where they were before the Q4 correction. Yields have moved up, though not a lot. Traders are again confident there is a "Fed Put".

If this is a bear market rally (and, remember, those tend to be the most impressive) it should top out fairly soon. There are several political issues like the Washington shutdown and a potential China-US trade agreement that are likely to come to a head this month. The trade deal is by far the most important to the market. There have been several optimistic comments out of Washington on the deal. A positive outcome is getting priced into the market. Whether an actual deal keeps the bull alive will depend on how good the agreement is.

Earnings season starts in a couple of weeks. Bullish traders have already decided December was a blip. It will be important that large companies reporting earnings say nice things about their future prospects. The bullish narrative will falter if they don't. That is especially true for tech and FAANG stocks. Those have bounced with everything else but lost on their leadership position.

Gold and gold stocks have been one of the main beneficiaries of increased market tension. Gold continues to hold up very well, even though yields ticked up again during the current rally.

The combination of higher risk, followed by the Fed Put, has kept a bid under the gold price. Gold held up even the face of a stronger $US during the worst of last month's pullback. There are signs the US Dollar is rolling over, though it's too early to call it a big downtrend. If traders really buy into the idea the Fed will stand pat, or even cut rates this year, the USD could fall a lot further. That could generate the move through $1300, and more importantly $1350, I'm hoping for. Gold topped out at $1350 three times in the past couple of years. If bullion breaks higher than that, things will really get interesting for gold stocks.

I think the SPX rolls over again soon. If it holds, the next Fed meeting at the end of January will be very important. Traders have pinned their hopes on the Fed Put. The FOMC will have to release a statement that convinced traders the Fed loves them. If not, look out.

The big markets look sketchy, but the hope for a 2016 repeat for the gold sector is still alive and well.

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