From the July 17, 2017 HRA Journal: Issue 272
Things changed a lot in the past two weeks. The US Fed’s promises to keep tightening financial conditions look a lot shakier than they did at the start of the month, thanks to a series of weak economic readings in the US.
I still think we need to be wary of central bankers but with bond yields softening again and plenty of money flows into the major markets things look less dangerous than they did in June. Not safe, mind you. Overvaluation is and will continue to be a problem. Overvalued, complacent markets are always in greater danger of a larger fall but I don’t see a near term catalyst for one.
The other big change in the past two weeks is that gold prices appear to have found another bottom. As I note in the editorial, the technical set up of the gold market is as favourable as it has been at any time since late 2015. That set up led to some very good times in the resource space. While it’s too early to tell if we’ll get a literal repeat, the odds of a good run through the second half of the summer look much better. That is as much as we could hope for heading into the heaviest reporting season of the year for exploration results. Companies that don’t disappoint with the drill should get some traction under these conditions.
I’ll continue to provide more frequent but also shorter editions through the next couple of months.
In the last issue, I made the case that central banker’s real target these days is asset markets. They’re mumbling about inflation targets and getting laughed off by traders. Its clear markets are intent on pushing the envelop. Bullish sentiment is too high for traders to back off. They are going to call the central bank bluff. How well and how long that works depends on how intent central bankers really are.
This isn’t the first time we’ve seen this. There are famous past episodes of central bankers wagging their fingers and telling traders to settle down, sounding a bit like a testy grade three teacher.
Remember Alan Greenspan’s famous “irrational exuberance” comment back in the 1990s? These lectures usually work about as well as a teacher telling a group of sugar rushed eight-year-olds to hush. The current US Fed chair is, if anything, having even less impact than Greenspan did 20 years ago.
Recent events and data make me even more convinced that central bankers, and the US Fed in particular, are terrified by markets they are convinced will end badly.
The latest inflation data shows—again– that the “transitory” low inflation ain’t so temporary. Maybe that reading came as a surprise (again) to FOMC members and other central bankers. That’s not a comforting thought. It certainly doesn’t reflect well on their forecasting abilities if it did.
Maybe I give them too much credit but I’d prefer to think central bankers were not surprised. That implies, again, that inflation is not the real target of their threatened tightening of financial conditions. It’s really stemming from their concerns about overheating markets.
Central bankers, ultimately, “win” these fights when they tighten a bit too much and markets, and economies, roll over. It doesn’t feel like we’re very close to that outcome yet. It’s a danger sign we shouldn’t ignore but its more a “watch list” than a “to do list” item at the moment.
Those who remember Greenspan’s famous remark also remember that markets kept moving higher for a very long time after he made it. Bears could marshal plenty if arguments that agreed with Greenspan at the time of his remarks. That doesn't change the fact that acting on those remarks at the time was a bad trade.
We’re at a similar juncture in the markets now. With financial conditions very accommodative and the TINA trade in full force we could be setting up for another strong rally. However overvalued the main indices might seem, they’ll stay overvalued until a big enough percentage of traders decide its time to take their chips and go home. Keynes famous comment that “the market can stay irrational longer than you can stay solvent” is very much in play.
Not many people know Keynes, widely derided as “anti-market”, was actually a successful trader who made a lot of money ($40 million in today’s money) doing it. I’m sure he’d sympathise with our current conundrum. During his trading career, he moved from being a speculator to a value investor so I’m less sure he’d be long now if he was still around.
It’s too early to worry but not too early to recognize that the gulf between the economy and the market’s perception of if continues to widen. That can go on for a long time as long as the fund flows into equities continue. They haven't showed any signs of slowing yet.
We’re still in a very tradable bull market but need to stay on our toes. The further valuations stray from underlying earnings potential, the bigger the fall will be when things roll over. It’s not time to be pulling up stakes but we all need to be smart about taking some profits when they are offered and making sure there is some cash in our accounts.
My main concern with the latest wave of buying in the main indices is that so much comes from sources, like index funds and ETFs, that are designed not to carry a cash cushion. That’s fine for them but doesn’t mean we should emulate it. Being a bit defensive and making sure you have dry powder when everyone around you is being greedy is not a bad thing.
In the past few days we’ve seen fear wearing off and new highs reached again. This is partially due to more weak data and partially due to cracks appearing already in what looked like a united front for the FOMC a couple of weeks ago.
The 10-year Treasury yield chart above shows the TNX topping out a few days ago, after Yellen made comments in her semi-annual congressional testimony that bond traders interpreted as dovish. Weak inflation and spending numbers drove rates lower still.
The latest estimate of US Q2 growth shown on the GDPNow chart on this page takes most of the recent readings into account. After starting the quarter well above Wall St consensus, the Atlanta Fed estimate is now near the bottom of the Wall St. range at 2.4%. Most observers expected a good bounce after a weak Q1 performance but that doesn’t seem to be materializing.
The weak GDP estimate is reflected in consumer spending and inflation numbers. A couple of days after Yellen was telling the US Congress that weak inflation was transitory the Fed’s preferred inflation measure PCE, fell for the fourth straight month.
The PCE deflator touched the Fed’s 2% target briefly in Q1 but now stands at 1.4%. The drop was due to a wide variety of weakening prices, not just energy.
Weak growth and inflation numbers in the US coupled with strong readings in Europe and China generated further weakness in the US Dollar. All the post-Trump lift has dissipated, and then some, as you can see on the chart at the bottom of this page. The Bank of Canada raised rates as it threatened to. There will have to be some better US readings to get currency traders believing the Fed’s rhetoric. Right how there seems to be little reason to expect a rally.
Recent moves are finally helping the gold price. It bottomed a few sessions ago. The bounce off that bottom has been weak so far as the top chart on the next page shows. Sentiment has continued to worsen and there are plenty of recent articles about the smart money abandoning gold and silver in droves. This is a good thing.
The bottom chart below shows large swap/commercial positioning in the furfures market based on the latest CoT report. These traders are usually short by large amounts as they are hedging actual sales of physical metal. As the chart shows, these traders haven’t been this long since the gold price bottomed in late 2015.
The story is similar for large and small speculators who have unwound their long positions. The positioning is not quite as favorable as it was in late 2015 but it’s close. Hedge funds are all but completely out of the precious metals.
That may not make for happy reading by mainstream commentators but its a very bullish scenario. The Fed might still want to scare equity traders but even that might not be negative for the gold sector. There is a clear negative correlation between the SPX and gold prices on a very short-term basis. That may also be reflected in longer term trends if and when we see some weakness in equities.
Even without that, the gold market looks like its finally set up for a decent rally. It will have to move at least $70/oz higher to re-establish a longer-term uptrend but we should see at least some relief.
Base metals are still hanging in there thanks to the better readings from Europe and China. Zinc continues to look particularly well positioned to extend its Q1 rally. It dropped back a little after bouncing off $1.30 but I think that weakness is short term and technical.
Zinc warehouse inventories continue to drop. We are close to a tipping point in zinc supply that should generate a run to the $1.50/lb level. Hang onto those zinc names as there should be more good times soon.
There was little reporting since the last issue, though a couple of companies put out decent drill news. They did get some traction which is a good sign for the drill reporting season we’re entering now.
The weakened US dollar has been good for the commodity space in general, and good for emerging markets as it increases their local buying power. Ironically perhaps, it may also help US large caps that do so much selling overseas as the currency conversion helps their bottom line. That could extend the momo rally in NY.
All in all, I’m expecting the second half of summer to be much better than the first half was for the resource sector. Now we just need a few companies to deliver on their promise with some decent drill results.
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