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Junior Gold and Natural Resource Sector Report |
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Junior Gold - Backing Up the Truck
(Finding Value Amongst the Debris – Part 2)
StreetTracks Gold Trust (GLD-NYSE)
(The largest exchange-traded fund backed by bullion, holding 630 metric tons -- ¼ of annual global production)
“The Federal Reserve is totally out of it. They're destroying the currency and driving up inflation, which will result in higher interest rates and a worse economy. We now know the Fed doesn't understand markets or economics, but is just trying to bail out its friends on Wall Street at the expense of 300 million Americans; nay, of the whole world”. - Jimmy Rogers, former partner of George Soros, author of Investment Biker, etc.
The Return of Gold Fever?
Gold hit an all-time high on Friday, briefly touching US$900 per ounce. Gold is rallying strongly in practically every currency in the world. A stunning 55% gain in 2 years for American gold investors is now starting to get mainstream attention. Gold’s lengthy consolidation period that lasted for over a year and a half is decisively over.
In the general markets, the fallout from the credit crisis and the damage done to investors in August and the November - December market sell-off is considerably deeper than expected. Normally we see at least some hint of the usual January effect after so many months of losses – but so far nary a bounce.
Gold is viewed as a store of value when everything else seems risky – it’s been used as money for at least 3,500 years. The bigger drivers at this point includes a rapidly depreciating dollar and the prospect of negative US real interest rates. Like the central bankers before America dropped the gold standard, we need to stop looking at gold as a commodity. Gold is an alternative currency that is no one elses liability, in a world where the choices have become rather limited.
The dilution of all Western currencies, but specifically the US Dollar, is providing buying pressure for gold as an anti-inflationary safety valve. In the modern era, currencies ebb and flow with one or a few being sold off, offset by rallies in others. Right now, major currencies including the Yen, Dollar, Euro, Swiss, and Pound are all in a dilutive, over-printed state. Some still appear better than others but eventually real buying power will decline in these “premium” currencies as values match and mismatch among the group. Central banks are the great monetary adjusters as they raise and lower rates, and strain to compete with cheaper money to spark their flagging economies. The US is leading the world with the fallout of its loose money policies and is likely already in recession.
The Great Gold Bull of the 1970s ran from 1970 to early 1980, exactly one decade. Gold did not rise in every single year, but when you look at the long-term charts the secular bull market is unmistakable. Secular bulls in the financials, industrials and transportation markets tend to last even longer, usually two decades each, like the Great Stock Bull that started in the early 1980s.
Given that a secular bull or bear can easily run from a quarter to a half of an investor’s entire average investing life, it’s important to run with these primary trends. Getting even one wrong could cost investors half their investing life. The price for missing these secular trends is staggeringly high.
The primary difference between the 1970s gold bull and this one is today’s abuse of currencies, debt, credit, mortgages, bonds, and the Fed’s suppression of certain markets in favor of promoting others. And everything is accelerated via computing power.
An added dimension to what used to be a “Western”-centric world is the spread of capitalism to communist countries like Russia and China. These countries have unique hybrid systems of command dictatorship operating within semi-free economies. They want to be a part of the world economy, and have discovered the art of attracting western investment capital to develop their domestic projects. These new and growing semi-capitalists are draining global trillions to build themselves into modern societies, and the world’s resources have never been under more pressure.
So far, gold investors have focused on the big board gold miners trading near all-time highs. Barrick Gold, Kinross Gold, Agnico Eagle, Yamana Gold and Goldcorp have all benefited from the flow of money. International giants like Newmont, AngloGold Ashanti and Gold Fields are well-known alternatives. It’s been a rush to the obvious big names by the big money, and that leads us to where the opportunities lie – before investors start to scour the ranks where unknown names with little or no analyst coverage offer up compelling value.
What About a US Recession?
Worries about the US economy grow as the subprime mortgage mess continues to spread. The unemployment rate rose to 5% last month and Wall Street economists at Goldman Sachs and Morgan Stanley are now predicting an imminent recession.
Shouldn’t slowing economic activity pull down commodity prices? Historically, US economic growth has been the world’s greatest driver of demand for raw materials and thus the engine behind commodity price increases. This is no longer the case.
Commodity bulls like Hong Kong-based investment adviser Marc Faber argue that the current boom is different because growth in China and other developing nations, coupled with shrinking global supplies, has created a "supercycle" that will push up prices for years to come.
According to Gary Gorton, a finance professor at the University of Pennsylvania's Wharton School. “The US economy may go into a recession but that will not change demand from China … even if China goes into a recession it's not clear that inventories could quickly replenish.” He likens the current environment to the early 1970s, when droughts and low inventories kept commodity prices on the rise even when the US economy hit the skids.
Globalization has also diluted the impact of a US recession on commodity prices, Duke University professor Cam Harvey notes. "Extreme caution needs to be exercised in comparing historical growth episodes … the strong correlation between the commodity prices and the US business cycle has been diminished by the rise of key emerging markets."
US Federal Reserve Board chair Ben Bernanke sent a strong signal this week that the central bank will lower interest rates again this month as it attempts to stave off a recession. In charge of maintaining the soundness of American money, he nonetheless reassured a Washington D.C. audience that he will print more money to make things better. “Helicopter” Ben is setting the stage for the next great money drop.
Bernanke said the downturn in the credit and housing markets posed substantial risks to economic health and predicted that consumer spending and overall growth would slow in 2008. Calling monetary policy the "Fed's best tool" for regulating the economy, he wants to maintain growth levels while consumer spending and home values face a steep decline over the next year. The implication is that Fed officials will lower the overnight lending rate by as much as half a point at their next policy meeting late January and another quarter point in February.
Evans-Pritchard of the Telegraph says Bernanke is just the dull tip of a long US-policy spear - a spear in the hands of the President's Working Group on Financial markets, the so-called “Plunge Protection Team”. The Plunge Protection Team - long kept secret - was last mobilized to calm the markets after 9/11. It then went into hibernation during the long boom. He writes “on Friday [Jan. 4], Mr. Bush convened the so-called Plunge Protection Team for its first known meeting in the Oval Office … the New Deal of 2008 is in the works. The US Treasury is about to shower households with rebate cheques to head off a full-blown slump, and save the Bush presidency.”
Let’s look a little deeper …
The arguments for further gains in the gold price are compelling. It looks cheap, despite climbing from a low of about $250 a troy ounce in 1999, when central banks were busy aggressively selling their reserves. The UK’s decision back then to sell 60 per cent of its official holdings was particularly noteworthy. Central banks see gold as a threat to their fragile fiat-paper currencies, so they tend to act irrationally. Rather than buying low and selling high like a private investor, central banks buy and sell at the wrong times, thereby amplifying secular trends.
Prices have a long way to go before they approach the inflation-adjusted record touched in 1980 when Soviet tanks invaded Afghanistan. An ounce of gold at $875 in 1980 would be worth $2,200 today. It could top $1,000 tomorrow and still be at the lower end of what some analysts argue is a safe haven range.
Gold is also benefiting from diversification away from equities. Commodities have emerged as a distinct asset class, with billions of dollars poured into exchange traded funds. Physical demand for jewellery may have slowed in Asia, but consumption remains strong in the Middle East, and declining output in South Africa will help support spot prices.
But it is the relationship between the dollar and the reaction of the world’s central banks to the credit squeeze that some bulls would say really makes gold an attractive bet. Banks are hoarding money, and some banks are literally left begging for working capital. The Wall Street Journal reported this week that both Citigroup and Merrill Lynch are again in talks with investors in the Middle East for more cash infusions. Merrill is in the market for about $4 billion, while Citi is looking for a more substantial $10-11 billion. Some of America's biggest investment banks and lenders have gone from lending capital to investors and businesses … to borrowing it and transferring ownership to foreign governments. This is known as recapitalization, and is a powerful motivator for central bank involvement. This is the strongest gold bull market confirmation yet, with gold acting as a currency of last resort for funds seeking a safe haven in an uncertain environment.
Central banks around the world have no other option but to print money and this will lead to a further depreciation in the value of paper money against precious metals. Still, nothing goes up in a straight line and, so investors need to be aware that gold could still correct to around $750 or so. But when we consider the up-side potential of gold compared to its downside risk the biggest mistake an investor could make is not to own any gold at all. There are a lot of gold bulls who have recently sold their positions at the old trading resistance levels, now hoping for a significant correction in order to re-establish long positions.
The US Federal Reserve’s aggressive, rate-cutting response to the credit squeeze has obviously created the risk of a sharp rise in American inflation. That in turn creates the risk of a precipitous fall in the dollar and so makes gold more attractive as a hedge. At this point the Fed can’t raise rates to shore up the dollar. The dollar will be sacrificed as necessary, over time. If gold is a finite currency, its value against not just the dollar, but sterling and the euro too, should rise.
Moreover, a sharp decline in US real interest rates means that the low yield on gold matters less. It may have been a poor hedge against inflation in the past but the combination of rising consumer prices and economic stagnation may make it a better store of value.
As a key barometer of confidence, gold’s rise shows investors are nervous. That is an important message for central banks contemplating interest rate cuts. The Fed must show it is not prepared to allow inflation to take off. Big gold companies have made respectable advances, but their valuations have increased as well. They appear to be fairly valued at today's precious metals prices.
Junior Mining Companies Depressed
Meanwhile, valuation levels for junior gold, silver and base metal exploration and development companies are ridiculously low. Volatility and distress headlines in 2007 forced a lot of the smaller investors out of the picture. Similar to the Nasdaq 100 where Google, Apple and Research In Motion have contributed to most of the gains in 2007, a few larger players like Barrick Gold, Newmont Mining and Goldcorp are pushing the indices higher in precious metals mining. Mid-caps are languishing and the small and micro caps have practically been forgotten.
The historic record of gold bull markets shows that small gold and silver stocks become major beneficiaries in the later stages of precious metals rallies. Investors start looking for better value as big cap mining stocks become expensive. As the crisis of confidence gets fully factored in (we’re probably there now) positive press releases should start to surprise, and investors will stream in as the cup looks to be half full once again.
Even as the economic slowdown is met head on by a rapid reduction in interest rates, production and development cost pressures should ease and the crisis of confidence will begin to fade away into the past. One of the first signals suggesting that this process has already begun is the spectacular recovery of Novagold after its late-December swoon following its Galore Creek construction suspension, with a double off the low in a couple of weeks.
The small cap gold and silver stocks are certainly less liquid and have a higher perceived risk, but their significantly better value suggests lower to negligible downside, and historically they almost always rally dramatically in the later stages of the sector upturn.
The psychological effect of gold trading and staying above $900 should not be underestimated. Investors will hold their noses and dive in and gold shares will really take off to the upside. With an average mining cost to produce gold of around $400 per ounce, gold mining is a profitable business, but not easily met with new supplies – the easy stuff’s been found, a lot of it is in non-friendly hands, and it takes years to put a mine into production.
Similar to the base metal juniors, investors don't believe these higher gold prices are sustainable, and have therefore not been willing to pay up for metal in the ground and future cash flow. That fear will eventually be resolved. It’s been 28 years since gold hit a record high of $850 back in January 1980. With this old high now bettered the most exciting part of the gold bull market should lie ahead.
If you are convinced of gold's future then these are the times to increase gold share positions. Junior gold shares are selling at fire sale prices. In 2005 and 2006 respectively, with breakouts through $500 and $600, the gold sector rallied dramatically – and on much lower prices. Yes, costs are also rising, but this provides the basis for a higher support level. The most exciting rewards will come from junior mining companies making new discoveries and transitioning to developers and potential takeover candidates. That’s where the leverage is found. Downside risk is exceptionally low today.
We’re certainly not suggesting gold itself will just keep going higher in the short term. A corrective sell-off could easily follow this latest move, but any corrections must be seen as opportunities to acquire or increase exposure at this point. One simply needs exposure to the continuing bull market in the resource sector, and gold just broke out to new highs. And of course, don’t count on a correction actually happening short term either.
With gold, and indeed most other investments, the demand curve is not normal. In the investment world the higher the price of an investment climbs the greater demand becomes. Virtually no one wanted anything to do with gold near $250 a few years ago, but once gold soars to $2,000 everyone will want a piece of it. In the financial world higher prices don’t dampen demand, they increase it.
Conclusion
The ongoing debasement of the US dollar and the seize-up of a huge part of the US credit market leaves the Fed between a rock and a hard place. Inflation is on the rise and homeowners are defaulting at an alarming rate. But while a serious threat, inflation takes some time to fully develop. It is not the priority except through lip-service. Meanwhile, the system faces huge write-downs – it’s really only getting started.
According to BMO’s Don Coxe, Citigroup alone is estimated to have a $22 billion problem. Bill Gross estimates there are $45 trillion in derivatives at risk – representing the shadow banking system of off-balance sheet conduits designed to get around the Basel Accord rules. Effectively there are no reserves behind these instruments like in the banking system, and these are non-transparent markets.
The popular Greenspan-brand of Fed-style monetary assistance has the potential to make these problems worse, perhaps leading to a Volcker-type solution in the future a la 1980. The very instruments used to conduct Greenspan-era ‘bailouts’ are what set up tomorrow’s blowups. But for now we find ourselves heading into a presidential election year with all its not-so-subtle temptations to do something to keep things at least muddling through.
While it is likely that the US as a whole will only suffer a mild recession in the near term, financial stocks are nowhere near a bottom and are likely already in a depression. Two years from now, it could be a very different story, but that won’t make us money today.
The US obviously cannot stomach either extreme -- hyper-inflation through the unabated printing of money to save extended homeowners, or a 1930’s style depression through overly tight monetary policy designed to wring out inflation, cleanse the built-up excesses, and save the bond market. That really just leaves a balancing act -- to engineer an easing a la 1990s Japan and 2001-2003 Greenspan.
As supporting evidence, one just needs to see last week’s reaction when Fed Chairman Ben Bernanke all but threw in the towel in a moment of extreme candor. He essentially conceded the US requires decisive and substantive additional easing. Futures expectations moved to 88% for a cut of 50 basis points at the FOMC’s next meeting at the end of the month, with an 88% probability of a further quarter-point cut in March, up from zero a week before. Gold obviously liked what it heard as it set off on a succession of new highs.
A gradual devaluation of the US dollar as the world’s reserve currency would seem an inevitable outcome of US policy. This will result in a continued re-pricing of gold upward, as the only liquid store of value “to get to the other side” without counter-party risk. It will also benefit resource stocks in general as lower rates lead to anticipation of a recovery and excess money finds its way into commodities and related stocks. The final bubble blow off phase, when it does come, will be seen in commodities and probably Asian stock markets. The junior precious metals sector in particular has explosive upside from here, mainly as a consequence of an extremely oversold environment and gold’s long consolidation phase through 2007, now clearly being left behind.
Action
Our trading strategy tries to incorporate buying fear and selling greed. Trading on emotional extremes is the highest-probability-for-success paradigm for buying low and selling high. We can never know in advance when irrational fear will suddenly give way to a buying surge, and so we may buy in too early and suffer some downside, or too late and miss the majority of the fast profits off the real fear bottom. These risks are balanced by averaging in on fear, buying a position over time. This is challenging psychologically since we have to buy when we do not really feel like it, but over time it tilts the odds for success way in our favor. The junior golds still mostly suffer from the fear fallout, and so have pretty well ignored this move in the price of gold. Happy hunting.
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