Junior Correction

By: Adam Hamilton | Fri, Feb 25, 2011
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Junior resource stocks are fickle little things. And most investors who dabble in this realm are fully aware of their capricious nature. One of the best ways to describe owning these stocks can be summed up by one of the most famous lines in literary history, "It was the best of times, it was the worst of times..."

Much like this opening line from Charles Dickens' A Tale of Two Cities, junior resource stocks can offer the best of times and the worst of times. These super-volatile tiny-cap stocks can indeed provide investors with legendary gains in the best of times. If the general stock markets are rising, underlying commodities prices are rising, and/or a junior scores a big find, it's not uncommon to see gains from the hundreds to thousands of percent in quick fashion.

But in the worst of times, junior investors can see their capital disappear in a flash. If the stock markets and commodities prices move against them, and/or they fail to deliver, these stocks can lose serious value in quick fashion. A fine example of the worst of times is what happened to junior resource stocks in 2008.

Any investor in the junior realm during 2008 felt some serious pain. Junior resource stocks had already been in decline since the second half of 2007, but 2008's infamous stock panic brought about wailing and gnashing of teeth. In the second half of the year the stock markets, measured by the S&P 500 (SPX), were crushed, commodities prices plummeted, and sentiment was at despairing lows.

On the year the SPX had fallen a staggering 48% to its November low. But this was nothing compared to how the juniors fared, with the average junior resource stock losing three-quarters of its value over this same span!

This junior carnage is best measured by the fortunes of the S&P/TSX Venture Composite Index (symbol CDNX, based on the original Canadian Venture Exchange). The CDNX is comprised of nearly 500 of the biggest and best stocks in the TSX Venture Exchange (TSX-V), which is home to the largest contingent of the world's junior resource stocks. Over 75% of the TSX-V's listed companies are in the business of natural-resources exploration and development.

This worst-of-times scenario resulted in a 2008 peak-to-trough CDNX decline of a whopping 76%. Losses like this obviously have a devastating effect on one's capital, and indeed the junior-stock sector forever lost a large contingent of investors as a result. But for the survivors and new investors onto the scene since, 2008's sobering plunge has ushered in a new era of protectionism. How does one protect his junior capital from future selloffs?

Investors trading in the junior arena obviously have a greater penchant for risk than the average investor. They embrace the risk this sector presents itself with in anticipation of huge rewards. But even these gun-slinging traders submit to the core market quintessence of buying low and selling high. And you can bet that if there was a way of increasing the probabilities of capturing gains at highs and buying back in at lows, better timing exit and entry points, they would jump all over this knowledge.

Well for tells on the directionality of the greater junior resource-stock sector, you need look no farther than the fortunes of the SPX. At Zeal we've done extensive analysis on the SPX's sphere of influence, and evidence continues to support this flagship index as the post-panic de-facto trailblazer of the global markets.

My business partner Adam Hamilton has written numerous essays over the past couple years highlighting this phenomenon. And in this work he clearly demonstrates how the post-panic SPX strongly colors the directionality of many other markets. It's simply amazing to see how the SPX drives deliberate movements in commodities and commodities stocks! And as you can see in the chart below, the CDNX is no exception.

SPX and CDNX Chart

Both the SPX and CDNX hit their panic lows around the same time in late 2008. Over the next several months the CDNX consolidated upward as it waited for the SPX to catch a bid. And finally in March 2009 when investors realized the world wasn't coming to an end, a new cyclical stock bull was born.

And this bull has been incredibly powerful. From its March 2009 low the SPX has nearly doubled to its recent highs. Even though it has been recovering from extremely oversold conditions, a +99% run over 23 months for the world's flagship stock index is stunning nonetheless.

And as the juniors leveraged the SPX to the downside, boy have they leveraged it to the upside. Like vultures drawn to carrion on a roadside, brave investors scooped up left-for-dead juniors to fill their larders. And those investors early to the game have experienced a best-of-times scenario. Over the exact-same cyclical-SPX-bull span, the CDNX is up a whopping 198% (+254% from its panic low in December 2008).

Independent of the SPX, this sharp CDNX rise has merits of its own. In addition to juniors being extremely oversold, commodities resumed their climbs higher amidst their ongoing secular bulls. And ultimately the fundamentals have been screaming for these juniors to hit the pavement and make some discoveries. Juniors represent vital components of the supply chains for oil, copper, gold, and all other hard commodities.

But in looking at this chart you can't miss seeing the striking similarities between the SPX and CDNX. Though the velocity of the flows and ebbs might not be the same between these two indices, the timing sure is. And this is apparent not only visually, but mathematically. From the March 2009 lows to current, the SPX and CDNX have sported a very high correlation r-square of 86.6%. This means that 87% of the daily CDNX price action over this span is directly explainable by the SPX's own.

Like it's been doing for so many other sectors, the SPX has guided the day-to-day, medium-term, and cyclical-bull-to-date movements of the CDNX. And this is readily apparent not only in the CDNX's tight uptrends mirroring the SPX's, but in the selloffs as well.

Notated in red are the results of the seven major SPX selloffs in this cyclical bull to date. In blue is the performance of the CDNX over the exact-same timeframes as the SPX selloffs. And in between these figures is the CDNX/SPX selloff leverage. As you can see, with one brief exception the CDNX neatly follows the SPX down when selloffs ensue.

One particularly-interesting observation is the fortitude of these high-risk junior companies during the SPX selloffs. Considering their risk it would seem logical for these little stocks to leverage to the downside. And we saw just this in 2008. With the CDNX down by 76% over the exact-same span where the SPX fell 48%, the CDNX exhibited downside leverage of 1.58x. But this same leverage hasn't been present in these post-panic selloffs.

Of the seven SPX selloffs six are categorized as pullbacks (less than 10% selloff), with one categorized as a correction (greater than 10% selloff). And you'll notice that in the smaller earlier pullbacks (2 and 3) the CDNX not only held its own, it actually fared better than the SPX. These two minor pullbacks lasted only 8 and 9 trading days respectively, and they instilled little fear into junior-resource-stock investors.

In the first two larger pullbacks prior to the correction (1 and 4), the CDNX did leverage a bit to the downside. This wasn't near the 1.58x leverage seen in 2008, but at 1.33x and 1.16x respectively the juniors did see more of a selloff. It should also be noted that in both of these pullbacks the CDNX actually bottomed two days before the SPX did. If we use the true CDNX bottoms instead of the prices from the corresponding SPX bottoms, this downside leverage gets bumped up to 1.48x and 1.23x respectively.

Moving on to this bull's only correction, the SPX saw a healthy 16.0% decline over 49 trading days in the second quarter of 2010. What did the CDNX do? It had a healthy correction of its own, shedding 17.1% over this exact-same span (down 19.5% to its true bottom the day after the SPX's). With downside leverage of only 1.07x (1.22x to true CDNX bottom), I'd say the juniors held up rather well over this prolonged selling period. Again, nowhere near 2008's 1.58x.

This brings us to the SPX's sixth selloff, a strong 7.1% pullback over 13 trading days last August. But provocatively the juniors didn't respond at all. The CDNX was actually flat over this exact-same span! Up to the point when this sixth SPX pullback commenced, the CDNX had moved near lockstep with this flagship index, sporting an incredibly-strong correlation r-square of 92.7%. But this tight 1.5-year positive correlation would be throttled over the next few weeks.

So what happened during this August anomaly? My best guess is the commodities strength at the time had greater influence over junior-investor sentiment than did the SPX's brief malaise. Interestingly only three days prior to this SPX pullback the Continuous Commodity Index (CCI) had achieved a new post-panic high, whereas the SPX was still well under its own post-panic high seen in April. With the CCI reveling in its new highs and only shedding 1.6% over these 13 SPX selling days, junior-resource-stock investors didn't fear the SPX pullback and held strong.

But this brief anomalous event quickly reverted back to normalcy, and ever since the CDNX has fallen back in lockstep with the SPX. From the bottom of this sixth SPX selloff to current, these two indices have a super-tight correlation r-square of 96.2%. And this includes the seventh and latest SPX pullback.

This brief November pullback saw the SPX fall 3.9%, with the CDNX pulling back 4.3% over this same timeframe (1.10x leverage). However if you use the CDNX's true pullback starting point a day later than the SPX's, it saw a 5.8% decline over 6 trading days. This 1.50x downside leverage is more in line with how one would expect juniors to react to SPX selling.

Overall the six mirroring SPX and CDNX selloffs have had a simple average leverage of 1.00x (one-to-one). And if you include the anomalous August event in which the CDNX brushed off the SPX pullback, not only was there no downside leverage on average, the juniors actually fared better than the SPX during the selloff periods in this bull to date. These are definitely not the results I expected before I ran the numbers.

There appears to be two major reasons for this overall junior parity with the SPX during selloffs. First is the SPX hasn't really given the CDNX a reason to sell off. Other than a single correction by definition, which was not sharp measured by average loss per day, the SPX has been resolute during this bull. Its short pullbacks over short durations have yet to stoke fear in junior investors.

The other big reason for this junior resilience is the incredible strength in commodities. The venerable CCI has not only recovered its entire panic losses, it has blown through its all-time highs and continues to roll on. Many key commodities are at record levels, and this has given an extra boost to commodities stocks. Junior-level stocks naturally thrive in this environment.

Regardless of the velocity differentials between SPX selloffs and CDNX selloffs, there is no denying that the CDNX's directionality is indeed driven by the fortunes of the SPX. Other than a single anomaly in August, this chart clearly demonstrates that when the SPX sells off, the CDNX sells off. And until the super-high correlation between these two indices abates, there is no reason to game the CDNX's future without first looking to the SPX.

As per the title of this essay and our chart focus on SPX selloffs, you may surmise that here at Zeal we hold the extremely contrarian view that the SPX is overdue for a major correction. I encourage you to read some of our current work that details the myriad of reasons why the SPX needs to correct from here.

When this SPX correction indeed plays out, such associated markets as the CDNX will suffer the same fate. Juniors have had a spectacular run-up, but a correction in this hot sector would be healthy. Not only is sentiment in the junior realm currently too heavily weighted on the greed side of things, the CDNX is technically overbought (30%+ above its 200-day moving average).

So when the SPX corrects, and the CDNX follows suit, the question at hand is will we see downside leverage of the likes we saw in 2008, or losses at par or less than the SPX as we've seen on average in this bull so far? Only time will tell of course, but I wouldn't be surprised if we see big downside leverage if commodities also experience material selloffs.

Not only are commodities due for corrections of their own for technical and sentimental reasons, they could see additional selling pressure if a big SPX correction sparks a big US dollar rally. As Adam detailed in his essay just last week, there's much historical precedent for SPX selloffs igniting dollar rallies.

So should junior investors adjust their trading strategies if an SPX correction looms on the horizon? You bet! The last thing you want is to be caught in a worst-of-times scenario if a strong junior correction develops. At Zeal we've recently been layering out of the junior trades in our newsletters in anticipation of a coming correction. Not only has this allowed us to capture some awesome gains, it allows us to build up capital for the next major buying opportunity.

Corrections should not be feared, they should be embraced. In any bull market, corrections offer excellent entry points to add new trades and reload core positions. I can hardly wait to redeploy my cash in high-potential juniors that are well-positioned to capitalize on the ongoing commodities bulls!

In our acclaimed weekly and monthly newsletters we plan on accumulating positions in some of our favorite juniors, hopefully for much cheaper than where they are today, when the SPX correction matures and everybody else is running for the hills. Subscribe today if you hunger for expert guidance in these exciting markets, and also to find out which juniors we'll be buying when the time is right.

For a comprehensive look at the elite pool of juniors we'll be pulling from in our newsletter trades, consider buying our research reports at recently-discounted prices. In 2010 we published three popular reports with in-depth fundamental profiles on our favorite early-stage, advanced-stage, and producing gold juniors. We also recently published a report on our favorite silver stocks, which includes several high-potential juniors.

The bottom line is junior resource stocks offer investors the best of times, but can also offer the worst of times. Lately we've enjoyed a big dose of best-of-times returns, with the CDNX soaring ahead of SPX and commodities tailwinds. But with an SPX correction looming, junior investors should not be complacent.

While the CDNX is soaring higher on fundamental merits of its own, its tight post-panic positive correlation with the SPX ultimately makes it slave to the SPX's directionality. As clearly demonstrated in the chart above, as goes the SPX so go the juniors. Prudent investors ought to heed the call of an SPX correction, build up cash, and get ready to buy once prices fall lower.

 


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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