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Juniors - Performance and Timing
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Most gold and silver investors are aware of the fact that junior mining companies involve more leverage to the prices of precious metals than senior, big, liquid stocks. Sometimes investors purchase these small companies hoping that they will make significant discoveries which would cause the share price of these stocks to soar. However, it is unlikely to happen, so usually the best strategy is to spread out in the sector and sit tight, waiting for stocks’ appreciation. At ( www.SunshineProfits.com ) we use junior mining stocks (and respective warrants) both as a long term investment and as a trading vehicle. At times, we look at their performance in the search of specific trading signals. In this essay we will focus on juniors’ performance relative to gold as well as senior mining shares and speculate (as no one can say for certain why a particular sector moves in this way or the other) on the reasoning behind it.
Since financial institutions are usually not able to purchase junior mining stocks, prices of these equities are subject to change primarily due to the activities of individual investors. There are many exceptions from this rule, but generally individual investors, contrary to financial institutions, are not professionals when it comes to investing. Theregore individuals are more likely to make decisions based on emotions rather than econometric models, thorough fundamental analysis and/or advanced technical trading techniques. Institutions usually have many procedures and internal rules that they need to obey, so their emotional response to markets’ performance is limited. Individual investors are, on the other hand, most often free to change their investment decisions and remodel their portfolios up to 100% (sometimes even more) each day. This gives a host of opportunities, but also makes these investors more vulnerable to market’s wide swings.
To sum up:
- Juniors are less likely to be held by institutional investors than individuals
- Individual investors tend to depend more on emotions than financial institutions do
One might infer from the above statements that the stock prices of these small junior companies would be highly dependent on the emotional status of the individual precious metals investors. This finding has very important implications.
Firstly, juniors are more volatile than big, senior companies. Emotions cause big upswings to become even bigger, when people get euphoric and buy already overvalued stocks. On the other hand when stocks fall, juniors tend to fall harder as investors panic and dump even already undervalued companies. Bigger swings are therefore to be expected in this sector. This also means that timing entry and exit points is crucial, since it has enormous impact on the overall rate of return.
Secondly, most individual investors are likely to enter the market at the late stage of a particular upleg. Juniors follow seniors on the way up and then on the way down. However this kind of correlation is not crystal clear. Sometimes junior and senior mining companies trade very closely. At times juniors get ahead of themselves and soar virtually regardless of the situation in the most popular precious metals stocks. Finally, there are moments, when juniors seem to ignore the move in the underlying metal and bigger gold stocks and move in a rather lethargic fashion. It is also not uncommon for juniors not to follow big gold stocks immediately during a sell-off. They do fall, but not at the pace that one would expect them to, given their high leverage. They fall further, but not necessarily exactly at the same time as the senior gold stocks.
If we estimated when will juniors respond to changes in the big gold stocks in a given way, we would be able to rebalance our portfolios at the transition point and reap most profits from each type of these securities! Before digging deeper into analysis of this matter, we must choose appropriate proxy for the whole sector of juniors.
We created an index consisting of juniors especially for this essay. The index is an arithmetic average of the percentage gains of 14 juniors gold stocks. We have indexed these values, where Jan 2002 equals 100%. Finally, the scale of growth has been diminished five (!) times, to better fit charts with other gold-related assets. This means that the upswings (and sell-offs) were really five times bigger among the stocks that are included in our SP Junior Index. This does have other practical implications – it makes the price levels achieved by the Index more realistic.
Please note that we had the benefit of the hindsight when choosing gold juniors. In fact we were only able to choose stocks that are still in the business in order to create this Index. We agree that this situation is not very likely to occur, as no one can expect any individual or institutional investor to be right each and every time (and always choose companies that thrive). The final result is that realistic, average gains of a portfolio of juniors should be considerably smaller than those of our initial index.
Some of the companies that we would have chosen at the beginning of 2002, would probably cease to exist, in spite of increasing gold price. Particular companies might have entered contracts in which they pledge to sell gold at a price, which was based on past gold prices or which were indexed perhaps on a yearly basis. Costs are not likely to be paid in this way, so companies might temporarily suffer when all commodities (including crude oil) go up. As time goes by, gold price increases and those contracts might be fulfilled economically by more and more companies. Those, which did not manage to achieve the break-even point regarding their gold business have disappeared and those, which did, experienced a windfall of profits. Like stated before, our Index consists of companies that existed before 2002 and are still in the business.
For this essay’s purposes, we have diminished the scale of the appreciation five times – in the full version of this article (available on our Website in the Research section) we deal with the issue of the hindsight in a different way.
Having established the SP JUNIOR INDEX as a proxy for juniors, let’s see how it performed during the whole bull market with emphasis on its performance relative to the HUI index. The chart below features indexed SP JUNIOR INDEX, HUI and the price of gold (Jan 1st 2002 = 100%).
Naturally price of all of the above gold investments has been rising since 2002, despite temporary consolidation periods. Similarity in the shape of each upswing in these assets is a little lower. The performance during each upleg of this bull market is different for gold (which is quite stable its growth from a long term perspective), HUI (where profits are magnified by the leverage the stocks offer) and juniors (usually stable, but catch up with a vengeance at the end of each upleg).
Summing up - the emotions of market participants have bigger influence on juniors than on bigger companies and when juniors start to move, they move fast and far. This sector may be metaphorically compared to the work of a collapsed spring. The fundamentals are one end of the spring. The other end represents emotions. As the fundamentals (for following analysis we will assume that the main fundamental factor is the price of gold) improve, the spring gets more and more collapsed, unless the emotions follow the price of gold. That is mostly - but not always - the case. If the emotions are in tune with the price of gold, the spring does not shrink and in fact does not seem to matter much. However if - for any reason - fear prevails despite improving fundamentals, the spring gets really tight, ready to blast. Unless fundamentals deteriorate, once the fear is removed, we would expect juniors to go ballistic in no time! The longer and the harder this spring gets squeezed, the bigger move will follow. We’ve already established what is the main fundamental factor, but we still need to determine what might cause the excessive fear to take advantage of the above "spring theory".
Whether one considers the reason for this fear the aversion towards paper investments, concerns regarding credit crunch or any other reasons, the end result should be visible not only in the junior stocks market, but should apply to the broad market. Generally, market’s participants often share similar emotions. Of course different sectors have different specific reasoning, but the general tendencies remain the same. In short term it is not uncommon to witness all markets plummet exactly at the same time.
Could it be that the reason for distinctions between senior and junior gold mining shares was in front of our eyes for the whole time? Can we really use general stock market to look for specific signals regarding junior and senior gold stocks? You don’t have to take our word on that - take a look at the following chart and see for yourself if there indeed is a correlation between SP JUNIOR INDEX to HUI ratio and the general stock market, measured by the S&P Index.
The chart above seems to confirm the initial assumptions. Generally the stock market rises along with the above junior/senior ratio. R - square coefficient of 52.6% indicates that 52.6% of the moves in the ratio can be explained by the moves in the general stock market. That is not really outstanding performance, but as we claimed before we did choose juniors with the benefit of hindsight, which probably distorted the R-square value in the chart above. It’s impossible to tell what stocks we would have been chosen six years prior to the moment of writing this essay. Besides - what we are really interested in, is the local, temporary emotional influence of the general sentiment, not the long term relationship between juniors and SPX. We would not recommend making LONG TERM investment decisions in the juniors sector basing exclusively on the SPX. We have dealt with this issue in a different manner in the full version of this essay, and the findings are identical to those mentioned here – the junior to senior ratio does seem to be influenced by the general stock market.
We might be wrong as almost all asset classes rise in an inflationary environment (which is the case at the moment of writing this article), and the relation might seem to exist simply because both variables are in an uptrend for their own, different reasons (so called spurious regression). However, we gave our reasoning prior to posting this chart and we are quite convinced that general stock market really has a major impact on this ratio. On the next featured chart you can see how this analysis can be put into practice.
The way we see it on the above chart, we’ve had three major situations which are worth mentioning (the first two rectangles and the last two rectangles each count as one), where juniors outperformed the HUI index during uplegs. There are few visible upswings in the ratio that we did not mark e.g. the upswing in the middle of 2002 and the single spikes around the beginning of 2005. These examples are the results of corrections in the HUI, rather than the effect of juniors surpassing seniors on a percentage basis during an upleg in the gold and gold stocks.
Each rectangle marks the time frame when you would like to hold juniors instead of the big gold companies, or at least switch a part of your portfolio from these senior mining companies to their smaller counterparts. Notice that it never occurred without rising prices in the general stock market. In fact it almost always took place at the last part of a particular upswing. There is an exception – the part of the upswing that took place on May 2006 did materialize as SPX fell, but that was exactly the part when HUI fell hard too. Generally this ratio increases along as S&P Index rises, because that is exactly when the general public (which – of course - consists of individual investors) enters the market! Before a particular market tops we can see signs of redistribution of shares, where smart money, often institutional investors, sell their stocks to people, who enter the market at this point. When this is done, it does not take too much time (depending on the scale of the whole upleg) before the top materialize, as some investors try to secure their profit. Buying power dries up and price begins to fall. Other investors start to panic and they also sell adding more fuel to the fire.
How can you use this information? You are free to use it in any way you find appropriate, of course, at your own responsibility. Here, at (www.SunshineProfits.com), we tend to use it in the following ways (depending on various factors):
- Switching a part (or all) of your gold stock portfolio into juniors, when you find that general stock market’s rally is nearing its end
- The same as aforementioned but switching physical gold or silver for juniors
- Keeping your big gold companies and observing juniors to see, when a particular upleg matures (juniors thrive relative to your portfolio of senior mining companies) – improving your chance of selling near the top
- Looking at junior outperformance as a sign of temporary overvaluation in the general stock market – improving your chance of selling near the top
The results of this analysis can also answer the question "why don’t juniors skyrocket yet?". Well - are we now nearing an end of an upleg in the general stock market? It’s not always easy to tell in which part of the upleg we are (there are some subtle clues, though, but that is a subject for another essay), but at times we may indeed say that we are NOT in an upleg at all. If that is the case at the moment of reading this essay, then you might consider your question answered.
We fully acknowledge that the SP JUNIOR INDEX may be overoptimistic about the junior sector performance due to the survivorship bias. We address this issue in the full version of this essay. You can check it out on ( www.SunshineProfits.com) in the Research section.
P. Radomski
March 31-st 2008
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All essays, research and information found above represent analyses and opinions of Mr.Radomski and Sunshine Profits' associates only. As such, it may prove wrong and be a subject to change without notice. Opinions and analyses were based on data available to authors of respective essays at the time of writing. Although the information provided above is based on careful research and sources that are believed to be accurate, Mr. Radomski and his associates do not guarantee the accuracy or thoroughness of the data or information reported. The opinions published above belong to Mr. Radomski or respective associates and are neither an offer nor a recommendation to purchase or sell securities. Mr. Radomski is not a Registered Securities Advisor. Mr. Radomski does not recommend services, products, business or investment in any company mentioned in any of his essays or reports. Materials published above have been prepared for your private use and their sole purpose is to educate readers about various investments.
By reading Mr. Radomski's essays or reports you fully agree that he will not be held responsible or liable for any decisions you make regarding any information provided in these essays or reports. Investing, trading and speculation in any financial markets may involve high risk of loss. We strongly advise that you consult a certified investment advisor and we encourage you to do your own research before making any investment decision. Mr. Radomski, Sunshine Profits' employees and affiliates as well as members of their families may have a short or long position in any securities, including those mentioned in any of the reports or essays, and may make additional purchases and/or sales of those securities without notice.
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