Market Overview Week 08

Financial markets are efficiently inefficient. They will never reach absolute efficiency because market participants are more irrational than rational. The (almost) equal access to information and its instantaneous dissemination increases efficiency in the context of inefficiency.

The narrative has swung between extremes for the past two weeks - the eternal bulls and the ubiquitous bears vying for attention. And in the end, both sides find themselves on the wrong side more often than they'd like.

I think MAG7 stocks are expensive. So what? Who determines the stock price, me or the market? The market, of course. My opinion is entirely my problem.

In a few charts, I will argue why I think the current bull trend still has potential. The first chart compares the spreads of high-yield corporate bonds and US Treasuries against the VIX Index.

Rising spreads are a leading indicator of market volatility. The higher the spreads, the higher the probability of market turbulence. Spreads continue to fall, indicating that the probability of rising volatility is relatively low. As a reminder, low probability does not mean zero probability.

Having looked at the financial system, let's turn to the US Treasury. The rise in interest rates has significantly increased the Treasury's interest payment costs. On the other hand, taxes have remained unchanged. Defense spending and social expenses are gradually rising, resulting in an ever-growing budget deficit.

Is the Treasury's revenue sufficient to cover the government's spending and reduce the deficit growth rate?

Let's start with the Treasury's primary revenue source - taxes. The following chart shows tax revenue (individuals and corporations).

Tax revenues depend on tax rates, the number of taxpayers, and the tax base. In recent years, U.S. tax rates have remained flat. At the same time, the US has the best demographics of any G20 country. That is to say, the number of taxpayers is still rising, evidenced by the rising tax revenues.

Let us now look at the budget deficit (the blue line), interest expenditure (the green line), and tax revenue (the red line).

Even so, we cannot understand how bad or good the US economy is. We need context. To do this, I will compare these three variables against US GDP.

The graph tells us a few things. First, interest payments relative to GDP are not record high. For reference, the period 1990-1996. Second, the budget deficit to GDP is also below its peak. And last but not least, tax revenues relative to GDP are far from their lowest levels.

What is the conclusion? The US is not as troubled as the mainstream fearmongers say. At the same time, the US is not as strong as supposed to be in the past. The budget deficit can not grow ad infinitum, nor can debt to GDP. With the above three charts, I am not arguing that rising budget deficits and interest payments are not a problem.

The purpose of the charts is to remind us that the utility of a hypothesis is a function of time. The constant flow of US demise predictions carries no informational and predictive value. One day, they will be correct. In the meantime, the doom and gloom prophets are no different than a clock stopped at 06 am, correct twice a day.

Let's see how extreme the expectations of market participants are.

Both the Investor's Intelligence and AAII indicators are far from their averages. At the same time, they are below their peak levels. Markets are driven by three dominant forces - trend, reversion to the mean, and momentum. It wouldn't surprise me if the market goes through a correction in the coming months.

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ICE cars are an endangered species. Electric cars are the present and the future. I somewhat agree with the latter. However, with the first, I don't. And the facts bear it out.

Fossil fuel-consuming vehicles have not only not been left in museums, but they continue to be in increasing demand. What does this mean? Growing demand for platinum and palladium. Toyota has a sensible approach to the transition to clean energy, betting on hybrids and improving ICEs.

Both metals have been digging new lows in recent months. The majors, Anglo American Platinum, Impala Platinum, and Sibanye, are laying off staff. What will this lead to?

Low commodity prices lead to shortages, and shortages lead to high prices. High prices lead to surplus, and surplus leads to low prices. PGM miners are at the bottom of the CAPEX cycle, with almost nonexistent capital investments and reduced mining output. The implications are straightforward: constrained PGM supply in a growing demand environment.

Short positions in palladium have reached epic extremes.

Long/Short ratio is 0.2, which is extremely low. The reversion to the mean, sooner than later, will reappear.

More than 90% of PGMs supply depends on two countries, Russia and South Africa. Russia produces 45% of the world's palladium and about 15% of the world's platinum. 80% of platinum and over 50% of palladium reserves are in South Africa, a country torn by problems. South Africa's presidential election is in May 2024. In my view, this is the most significant election for the country since Mandela.

As tradition dictates, Friday is the time for important news once the markets close. A set of new sanctions against Russia was published. The PGMs are not affected for now. However, that can change at any time. From platinum and palladium, let's move on to uranium. In recent weeks, many investors have been disappointed. Volatility has squeezed "weak" hands who expected the uranium price to move upward in a straight line.

Cameco "disappointed" market participants with less bad news, which provoked the initial sell-off. The company published unchanged expectations for 2024. At the same time, Cameco failed to meet its 2023 targets. The market is an expectation discounting machine. The reaction of market participants following Cameco's report is further proof of the validity of this principle.

Uranium shortages continue to grow. A few days ago, the US published its last quarter's uranium production figures.

You're not alone if you're struggling to see the tiny bar for 3Q2023. The U.S. mined 12,365 lbs of uranium during that period. At the same time, they are the largest consumer of uranium. The US consumes about 40 million lbs of uranium per year.

The conflict between Armenia and Azerbaijan can impact further uranium supply. How is that possible? The Armenians make cognac, and the Azeris extract oil. However, let us look at the map below.

Kazakhstan is the largest producer of uranium and is landlocked. Kazakh uranium passes through Azerbaijan to reach Poti or Batumi in Georgia, then to be exported to Europe and the US. A growing conflict in the Caucasus would directly affect transport links and uranium exports.

The US is planning to impose sanctions on Russian uranium. The sanctions will likely become a fact. Rosatom subsidiaries are included in the last set. In the meantime, Russia could act first and stop exports to the US as retaliation.

Speaking of geopolitics, let’s move on to the defense industry. Brazil is one of the pioneering countries in aviation and the home of Alberto Santos Dumont. The following chart shows Embraer's (ERJ) stock price.

The company manufactures aviation equipment for the civil and military segments. 63% of revenues come from the US, 19% from Europe and 11% from Brazil. The chart provides an opportunity for a speculative position with a close stop loss around $16.0-$16.5 and a $25.00 take profit.