Junior Mining Stock Crisis

Adam Hamilton
Archives
Sep 19, 2008

Commodities investors were treated to an extraordinary event this week when gold skyrocketed 11.1% in a single trading day! This was all the more impressive since everything non-commodities was getting crushed. That same day the SPX plunged 4.7%, erasing 1/20th of the US stock markets' value, for the second time in 3 days.

Having just weathered the biggest and meanest commodities correction of this entire secular bull, this week's surge was wonderfully refreshing. I suspect it will prove to be the vanguard of a major new upleg. But even if it is, a disturbing problem continues to vex the commodities realm. Small miners and explorers, the junior stocks, have long ceased participating at all in this bull market.

Their horrible performance, even prior to this latest correction when commodities and large miners were still rallying nicely, is weighing down confidence. Stock investors and speculators, who have long gravitated to the high-risk high-reward junior-mining realm, are getting wiped out. Allocating too much capital to one's favorite juniors, or even too much to juniors in general, has proven lethal.

And this plague decimating junior commodity stocks has really shown no favoritism. Small producers of or explorers for gold, silver, copper, oil, gas, uranium, and virtually any other major commodity you can think of have been scourged in equal measure. While this carnage is probably apparent to most in precious-metals stocks, they have not been singled out. Almost no small mining/exploration stocks have been spared.

This junior crisis is serious, and has all kinds of sentimental and fundamental implications. On the former front, will stock traders wholesale abandon junior mining since it continues to obliterate their capital without respite? If they do, exploration companies will fold. And without exploration, the world will not have enough commodities in the future to supply ever-growing global demand. Commodities prices will skyrocket if the critical pipeline of new discoveries freezes up.

Measuring junior mining stocks as an aggregate is not easy. We all have our favorites that have been sold down to gut-wrenching levels unimaginable a couple years ago. But how do we quantify the performance of this sector as a whole? Ideally, there would be some broad index encompassing this entire highly fluid realm. We could track it like any other stock index and understand sector performance free of individual-company biases.

Unfortunately I haven't found such an index yet. But the closest one today to that ideal is probably the CDNX. Still sporting the symbol from its previous name, the Canadian Venture Exchange, today the CDNX is known by its unwieldy formal name of S&P/TSX Venture Composite Index. Don't you love branding? To me, and most long-time commodities-stock traders, it will always be Vancouver or the CDNX.

Giant resource-rich Canada, of course, is a mining powerhouse. And unlike the US, its securities listing laws are actually reasonable. So the majority of the world's publicly-traded mining companies gravitate to the Canadian stock markets. Last year, the Toronto Stock Exchange claimed it held 57% of all the world's mining-company listings! Something like 3/4ths of these trade on the CDNX.

Thus no other stock index in the world has more broad junior-mining exposure than the CDNX. But the CDNX is for venture companies of all types, not just commodities. There are plenty of small tech stocks too, for example. Last spring my business partner Scott Wright waded through the entire CDNX roster and estimated that about 60% of the CDNX listings and market capitalization are pure mining companies.

So for lack of a better way to track junior mining, the CDNX is our best bet. It is riddled with small producers and explorers, it attracts most of the world's new commodities-stock listings, and its component stocks are widely traded among commodities-stocks enthusiasts in the US and Canada. Looking at a CDNX chart, the unbelievably bad mass exodus of capital from junior miners is nothing short of astounding.

In general, stocks that produce commodities rise with the prices of the commodities they produce. If it costs a miner $2 a pound to mine copper, and the metal trades at $3, it earns a $1 profit. But if copper only rallies 33% to $4, profits rocket up 100% to $2. So all things being equal in a secular bull driving rising commodities prices, mining profits and hence stock prices should rise too. This is even true with soaring input costs as long as profits rise faster than the costs of producing them.

So in order to understand this junior stock crisis in context, I rendered the CDNX on top of the CCI in these charts. The Continuous Commodity Index is the premier way of tracking general-commodities price levels. Over multi-month and multi-year time horizons, the preponderance of junior miners in the CDNX should lead it to track and amplify the CCI's gains. But ominously this is no longer happening, the CDNX has completely decoupled from the underlying commodities bull.

Now you'd be hard-pressed to find a riskier sector than commodities exploration. Most companies claiming to be involved in this are garbage, they are created solely to mine investors' pockets. Even of the remaining sincere and earnest explorers, the great majority won't prove successful in finding a big deposit. The odds are stacked against them. Only a small percentage of exceptionally talented and lucky juniors will score the massive 100x returns speculators have flocked to this arena to chase.

I'd have no problem with juniors if only the junk stocks were falling. But even the biggest and best of the juniors, elite explorers with some of the best proven deposits the world has ever seen, have been trapped in the downward spiral rendered above. Quality has been no refuge, and fundamentals have been ignored no matter how exceptional any particular company's operations or explorations happened to be.

Back in 2003, 2004, and 2005, the relationship between commodities prices and the junior miners worked as expected. Commodities prices were gradually rising on balance, increasing incentives to explore and produce, so capital flowed in to steadily bid up the junior mining stocks of the CDNX.

And in early 2006, we actually started to see some excitement in the junior realm as these stocks began to grow sexy to contrarians. From October 2005 to May 2006, the CDNX blasted 67.7% higher. It was the best of times for the junior miners and fortunes were won by us and our subscribers. While gold and silver stocks led this particular upleg, all kinds of small commodities stocks soared higher in concert.

Now there is no doubt at all that junior miners became radically overbought by that May 2006 peak. They needed to correct hard, and they did. By mid-2006, the CDNX was back down to the uptrend channel it had carved over the preceding several years. Unfortunately, which was certainly not apparent at the time, the bull market in junior mining stocks had essentially stalled in May 2006. It would surge again in late 2006 and early 2007, but the resulting highs only marginally eclipsed May 2006's (2.3% higher).

The CDNX had entered a grinding high consolidation, between roughly 2400 and 3300. And if you take a representative sample of your favorite junior mining stocks, odds are their chart patterns looked very similar over this period of time. Despite a few rare exceptions, pretty much every small commodities explorer or producer was trapped in this giant trading range. It naturally started to wear on sentiment as all consolidations are wont to do.

By the CDNX's technical apex in May 2007, it had soared 278.4% higher since October 2002. Meanwhile the underlying CCI was only up 78.9% over this same period of time. Up until this point, the junior mining stocks were doing what they are supposed to do. Capital was bidding them up to chase the higher profits certain to come from finding and producing commodities at their new higher prevailing price levels.

Interestingly, even by that point all the major CDNX corrections had been driven by concurrent selloffs in commodities reflected by the CCI. Of course the geometrically-smoothed CCI corrected far less sharply than the leveraged and highly-sentiment-dependent CDNX, but there is no doubt that periodic commodities selloffs drove the sharp CDNX selloffs. This model worked fine until Q3 2007.

In July 2007, both the CDNX and CCI were near their bull highs. Late in the month, they both started grinding lower but it was unimpressive and gradual. Typical summer-doldrums behavior. But on August 16th, the CCI plunged 3.5% in a serious selloff. Over three days surrounding this commodities selloff, the CDNX plunged 15.3%. This sharp decline was almost crash-like in its intensity, certainly the most physiologically-damaging of its bull to that point.

You probably remember August 2007 best through the lens of gold and silver stocks. The HUI gold-stock index plummeted 14% in just over one trading day! Many of the best gold and silver juniors fell on the order of 20% per day. It was such an extraordinary panic event that it damaged sentiment to such a great degree that I don't think it has yet recovered. Within a month of that selloff the CCI was again hitting new all-time highs, but the CDNX couldn't manage to bounce back.

I'll continue this sad journey of junior mining stocks below after the next chart. But first, there are some more points from this secular chart to ponder. First, note that 2400 or so was multi-year panic support in the CDNX since 2006. No matter how bad things got in the juniors, you could expect them to bounce near this level since they had done it 5 times before. Countless traders watched 2400 this year as the critical line in the sand.

Second, after 2400 failed in July 2008 the selling floodgates opened and the entire junior mining sector plummeted. The carnage was just incredible, I've never seen anything like it. As a result, by this week the CDNX was driven back down to October 2003 levels. I'll discuss this more below, but you really have to see it on the long-term chart above to fully appreciate it. This selloff was so brutal it wiped out the great majority of the juniors' gains over this entire commodities bull!

But juniors were already weak well before the dire events of the past couple months. When the CCI hit its all-time high of 615 in early July 2008, up 228.8% since early 2002, the CDNX was only up 132.8%. Even with commodities firing on all cylinders and powering higher, junior mining stocks were anemically grinding lower. The sharp CCI correction off these highs, coupled with already weak CDNX levels, was the lethal catalyst that triggered the total failure of the CDNX's multi-year support.

Early July's critical support failure is much more apparent at this scale. Prior to it, every sharp selloff in the CCI was really amplified by the CDNX. This is fine given juniors' risk and extreme leverage, but it wasn't fine when these stocks could not subsequently recover even later when commodities were powering to new highs. And starting late last year, we even saw juniors start falling during periods of CCI strength. This was a big warning flag of devastated sentiment, a dire omen of things to come.

Technically the CDNX was in a tightening wedge defined by that multi-year panic support line near 2400 and falling resistance. It couldn't break out even during the big commodities surges of February and June. Over the several days after the CCI's early July high, it plunged 5.1% and really spooked already fragile junior sentiment. On July 9th the CDNX fell 3.2% to 2400, right on the precipice. Even though the CCI initially bounced over the next couple days, the selling continued driving the juniors below critical support.

Once that long-time CDNX support level failed, the floodgates opened. Junior commodities stocks became radioactive and traders rushed to liquidate them at any price. As the CCI continued lower after that, the CDNX amplified each sharp decline. The resulting carnage in junior miners was just sickening and led to the crisis we face today. At these price levels this entire sector is in danger of losing most trader interest.

While the CCI plunged 26.4% between early July and this week, the worst correction of its bull by far, the CDNX fared far worse with a concurrent 43.8% loss. The CDNX was down an astounding 56.7% from its all-time high in May 2007! If you ever wondered what serious fear looks like, when a sector is cast off and nearly abandoned, this is it. Seeing juniors trade at October 2003 levels was like a living nightmare.

The last time the CDNX traded at this week's low, the CCI was running in the 240s. This week it was in the 450s! So even though commodities are trading at 88% higher levels, the junior mining stocks are now dead flat over 5 years. To me at least, this stunning development is every bit as astounding as the massive dislocations in the big financial stocks. Something is desperately out of whack in junior commodities stocks. It can't be sustainable.

Our growing world, in which more than half (Asia) is now industrializing, desperately needs commodities. Unlike intangible financial instruments, real physical commodities can't just be wished into existence. It requires many years of hard work to scour the earth, find raw deposits, design and permit and build mines, and finally bring commodities to market. This commodities supply pipeline begins with junior explorers.

The shareholders that fund juniors take huge risks. If they are not rewarded from time to time with big gains in the best and most successful juniors, they will exit this sector in disgust and deploy their capital elsewhere. No fair returns proportional to risk in juniors ultimately results in no capital to fund exploration. And without exploration, new commodities deposits won't be found. As existing mines are depleted, commodities prices will skyrocket without a healthy and robust exploration pipeline.

For this simple fundamental reason, I absolutely believe this junior mining stock carnage is not sustainable. Someone has to fund exploration, and these investors and speculators have to be paid for their risk. Even though this doesn't seem to be the case in today's sentiment wasteland, sooner or later rationality will return and the junior miners will be bid up to reflect the value of the scarce commodities they bring to market.

From a trading standpoint, the best elite juniors have to be at or near incredible buying opportunities. To have them trading at October 2003 levels while general commodities have nearly doubled since is just ridiculous. At Zeal we actually quit trading and recommending junior miners in our subscription newsletters last spring. Why? They were lagging rather than leading major miners even in strong commodities environments which was a big warning flag. We didn't want our subscribers to get hurt.

But now, after this brutal selloff, I am really getting interested in buying the best juniors again. While prices could always go lower, when they get to such excessively oversold levels the odds start to wildly favor a big rally to return some rationality to this sector. The bargains that exist today in the fundamentally-strongest juniors, which have been detailed in our various comprehensive reports, are staggering.

Yet today juniors face a challenge like never before, leveraged commodities ETFs and ETNs. These new trading vehicles offer stock traders leveraged exposure directly to commodities without the myriad of geological, operational, and geopolitical mining risks. Traders traditionally bought juniors to leverage a bull run in a particular commodity. But now they can leverage the commodity directly in their stock accounts for vastly less risk, which will compete for some of the capital pool that traditionally chases juniors. And what's bad for miners is great for commodities, since lower production means higher prices.

We've been trading these new leveraged commodities ETFs and ETNs a lot at Zeal this summer, which have been rallying at times even when commodities stocks are being crushed. We also spent months researching commodities ETFs and ETNs and have written a comprehensive new report on our favorites. We expect this highly-anticipated report to be finished and available for purchase early next week. No commodities enthusiast should ignore the great opportunities in these neat new trading vehicles.

The relationship between leveraged ETFs/ETNs and junior mining stocks should only get more interesting as these new vehicles become more widely accepted. If juniors continue to be starved for capital, exploration will dry up. As existing deposits are depleted but insufficient new ones are in the pipeline because explorers can't get equity financing, commodities prices will soar. This will lead to great gains in the hybrid trading vehicles as well as renewed interest by investors in junior explorers.

However this all plays out, we'll be ready to trade it at Zeal. We have spent countless months over the years researching junior commodities stocks, winnowing out the chaff to find the highest-potential companies. We'll be ready to buy them when sentiment finally shifts back in their favor. We are also actively trading the new ETF/ETN world to leverage commodities directly. Subscribe today to our acclaimed monthly newsletter and ride these commodities bulls higher with us, in both traditional and innovative trading vehicles.

The bottom line is junior mining stocks have been utterly devastated over the past year and a third. Pessimistic sentiment has fed on itself driving a vicious circle that culminated in a wasteland riddled with 5-year lows this week. This is highly irrational though given the much higher general commodities price levels. These prices are signaling the need for new deposits that juniors have to go out and discover.

But until investors and speculators are rewarded for the great risks inherent in owning juniors, exploration will be crippled. Low stock prices mean juniors can't finance exploration through equity offerings, which is the only way available to them. Ultimately this will drive much higher commodities prices as the pipeline of new deposits dries up. Sooner or later these high prices will finally get traders interested in the junior mining sector again.

Adam Hamilton, CPA

September 19, 2008

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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