Growth Stocks Weekly
Junior Gold and Natural
Resource Sector Report
Junior Golds - Backing
Up the Truck
(Finding Value Amongst
the Debris - Part 2)
Richard Reinhard
rreinhard@shaw.ca
Jan 16, 2008
StreetTracks Gold Trust
(GLD-NYSE)
(The largest exchange-traded
fund backed by bullion, holding 630 metric tons - 1/4 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.
Richard Reinhard
email: rreinhard@shaw.ca
website: http://www.gsweekly.com
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