The Next Mania
The following is an excerpt from commentary that originally appeared at Treasure Chests for the benefit of subscribers on Monday, March 31st, 2008.
As suggested in our last meeting, you can fool some of the people some of the time, but you apparently can't fool investors anymore, evidenced by the failure in attempting to engineer a dollar ($) rally. The question then arises however, is this week's failed $ rally the result of relative economic weakness in the States, where it's perceived an extended recession has commenced; or, is this just the result of continued 'party line talk' out of the European Central Bank (ECB)? You see European central bankers are simply doing their part in the expectations management game in talking hawkish, with fresh comments this week halting the $ rally in its tracks. In this respect it's obvious the international brotherhood of central bankers wish to manage the $ lower to relieve the key global consumer (the only people crazy enough to run up credit balances to the stars), but they may have gone too far this time, especially if they are serious about defending $1,000 gold.
Of course it could just be a case off not wanting to upset the apple cart prior to month / quarter end, where a great deal of potential damage in stock, commodity, currency, and debt markets could be the result if key reversals engineered last week were pushed into a crunch. (i.e. the sell stocks / dollar and buy commodities / precious metals trade.) Of course now master planners have a different problem, that being how to stop the $ slide before it turns into an accelerating panic. This would not be good for market(s) stability either. Certainly the stock market has been hinting in this respect over the past few days. But precious metal / commodity shares have been under-performing the underlying, so one should still be expecting some degree of a financials / index related 'jam job' consistent with the reversals witnessed last week into early next. Failure in this regard, which now looks likely based on last week's performance, would be very telling.
The big question after that however is 'how is a continued rally in the $ to be engineered past this?' In my opinion, the only way this can happen on a more permanent basis is if the ECB softens their stance on defending inflation somewhat, which is definitely a card central planners still have to play in an emergency. Even here however, just how effective and long lasting such a move would be is questionable, because remember, if the current sequence is to mirror that witnessed in 1978, where gold should not break below $900 on a lasting basis in the current correction, any rally in the $ should be fleeting. What's more, it's my firm belief that the States will continue to lead in currency debasement rates into the foreseeable future, where real money supply growth rates are poised to explode higher. Certainly if problem home equity credit lines, delinquent credit card debt / car loans, and soon to be troubled commercial real estate in the US come into focus, not too mention the derivatives related time bomb set to go off at some point, it's not difficult envisioning fresh credit crunch concerns reappearing quickly to trump any dovish tones emanating from the Euro-zone.
That being said, and in the meantime (meaning seeing a successful $ bounce engineered over the next month or so), could it be talk of joining Americans in monetizing mortgages out of the UK is a signal to expect the similar formal talk out of Europe soon too (as they are already doing so), having the effect of lifting the $ temporarily as a result. It's thought any mortgage crisis in Europe is not as profound as that of the US, however at the same time the banking system is still a shambles no matter how one chooses to add things up, so from this perspective it would not be surprising at all to see the Euro rally fail soon as well. And this would accomplish the very important job of killing the commodities rally, which would in turn put pressure on the precious metals complex temporarily. Of course even if the Euro were to continue rallying, sooner or later precious metals would stabilize and head higher anyway due to accelerating currency debasement rates on an international scale.
And it's this picture, one that allows for a $ rally and precious metals weakness over the next month or so that we will use to lead into our look at the juniors. Why? Because this is the picture sub-sector specific charts designed to measure their relative performance / attractiveness are telling us. They are telling us further bottoming price action should be expected in coming days in what can be termed a 'tradable bottom'. Let me show you what I mean.
A telling dichotomy exists between the larger universe of small cap opportunities and precious metals juniors (PMJ's) (the next mania) as measured by the S&P/TSX Venture Composite Index (CDNX) in that although the CDNX has only corrected a minimal Fibonacci retracement (38.2%) off the highs, PMJ's have been decimated, with many issues more than halved over the past few years, all the while gold and silver prices have made healthy gains. And many reasons can account for this divergence, including sector specific constraints such as rising costs and liquidity concerns associated with the broad stock market. At the same time however, if such worries are valid in relation to explaining the plight of PMJ's, one must wonder why the CDNX has not corrected more considering all small / micro cap issues will suffer in illiquid times, and this particular constraint would surely affect all illiquid stocks.
So, knowing this, the question remains, 'why is this divergence occurring?' Obviously the answer to this question is more complex than just the above considerations - that's for sure - as it only makes sense that if rising costs and liquidity concerns were the central issues, which affect all sectors either directly or indirectly, then the CDNX should have corrected more, as denoted in the Figure 1 below. What's more, and in looking at this chart in more detail, we discover that based on investor sentiment, as measured by the accumulation / distribution pattern (which has been straight up), despite the risk of liquidity related concerns being genuine, investors are sanguine about this risk, where in spite of deteriorating on balance volume (OBV) characteristics in the trade (which has caused prices to fall), they continue to accumulate. (See Figure 1)
What's worse, and in terms of the reality of the situation, is that liquidity concerns are in fact 'for real' because of a now contracting credit cycle. And from this point moving forward, this condition should act as drag on the larger group of illiquid small and micro cap companies, which in the final analysis then, puts the small investor (dumb money) sentiment on the wrong side of trade in being 'bullish', as usual. In fact, where you may know this from previous conversations on the subject, it's likely worse than this - that being investors are inappropriately bullish on prospects for the larger group of venture companies for an even worse reason. In my view, what is worse is that an increasingly desperate small investor, whose available cash to invest is getting smaller all the time, is putting money into these things and then 'hoping' for a miracle.
And as mentioned previously, it's the fact 'hopers' don't pull their money out of the stock market that keeps prices at unjustifiably lofty levels, as they have lost fear of risk due to accelerating inflation throughout the years. In what may appear to be an irony in relation to this knowledge however, now that general price levels are rising, is investors may finally be forced to face up to reality. Moreover, this, combined with the fact that in the larger picture, demand for gold and silver will continue to rise as increasing numbers catch on to the inflation game, along with contracting production (think political risk, environmental, energy cost / availability), in my opinion at some point (after prices have already begun to move higher) the public will notice PMJ's, if not for their relative value, as they start to move higher in a sector where everything else is already perceived to be 'sky high'.
Does the above capture the essence of why PMJ's have been held back thus far in the precious metals bull market, along with why prospects should improve moving forward? Largely, if I may say so myself, but there is more to talk about as well. Above I opine that hedge funds (on mass) will never play the juniors. Certainly Eric Sprott may have something to say about such a sentiment, and in thinking about how these hedge fund types like to control the markets they play, perhaps I am wrong in making such an assumption. Here, as liquidity dries up, characterized by a bursting hedge fund bubble, drastic measures by the survivors will have then searching for smaller and controllable markets with a good story, where PMJ's fit this bill to a 'T'. This could cause current valuations to treble against aggregate measures once momentum gets rolling. (i.e. precious metals stocks should be 12 to 15 percent of aggregate stock market measures at the pinnacle of their manic blow-off.)
This possibility is certainly borne out by key indicator diamonds (denoting pressure cooker conditions internally) in precious metal stock to commodity ratios, with this snapshot of the weekly Amex Gold Bugs Index (HUI) / Gold Ratio attached here a shining example in this regard. And while the diamonds might break to the downside first, which would likely occur with a lasting break in gold below the larger round number at $900, we know that because the real price of gold (see Figure 2) is far in excess of $2,000 using even official inflation measures, that at some point such a break would be proven false, and reverse to the upside through the four-digit barrier at $1,000 on a lasting basis.
Then, once this occurs, which will act as an inflation signal to a sleepy investment community (focusing on hedge funds for now), not only will tightening liquidity conditions force investors to take another look at PMJ's; but more, the pack-like predators that have their attention(s) focused in other sectors should show up here as well. John Lee describes the process in relation to silver in his latest attached here for your convenience. This should get momentum rolling, which in turn will bring in the small investors (in addition to hedge funds) who are also not afraid to pay up once prices start to run. So, the key then, or trigger if you prefer, is to watch for gold surpassing the $1000 mark, which could be sooner than most people think with lease rates now negative. (This means central banks will now pay you to lease gold.) A reversal in this regard would assure gold reading through the $1,000 as rising lease rates are always accompanied by rising commodity prices.
In total then, and in reaffirming the primary reason we are here today, which is to determine if we are at or near a bottom in the dangerous but potentially lucrative PMJ market, it should be understood that sentiment is key in this regard, with factors like rising costs and liquidity conditions acting as triggers to first draw in the smart money (sophisticated speculators like us that watch the indicators), and then the momentum players (hedge funds and small investors) who will turn the larger move into a mania in due process. This is of course the process by which all manias are essentially derived, where a mania in precious metals will simply prey on people's fears of system failure and inflation as opposed to greed.
Just as an aside in this regard, and pictured just below for your benefit, watch the Gold / Crude Oil Ratio as the primary trigger for PMJ's to begin making a move, where although perhaps rooted in fiction due to the fact crude prices could still rise, it will be perceived gold (and silver) are making gains on the aggregate cost structure, which will help bottom line(s), particularly of emerging producers like Novagold (NG:AMEX & TSX), Etruscan (EET:TSX), etc. (I will have more to say on specific company prospects later in the week.) It should be noted such a breakout is expected in associated with a break in gold above $1,000, not necessarily with crude breaking lower. Remember, a mania in precious metals will not be borne out of greed during 'good times' characterized by rapidly growing credit, but rather in the opposite, when money is attempting to secure enduring value and safety. (See Figure 2)
Moreover, and also in the not commonly understood department, based on this assessment then, it's quite possible such a move doesn't necessarily require broad liquidity conditions to improve materially before value oriented speculators / investors begin to seek out the better opportunities in the PMJ's, where it could be argued based on what I am about to present below that time is right about now, with 'optimal pricing' having just passed or only a few weeks away. Again, let me show you what I mean below in reviewing the charts that measure relative value in PMJ's first presented to you some weeks back in a study entitled Finding Value In Precious Metals Shares. You will remember at the time we envisioned further consolidation in the sector, which of course has proven to be the case.
Moving onto the charts now, and remaining consistent with the attached study above, in attempting to expand upon a simple look at the CDNX as the definer for Canadian based PMJ's, selective ratio related analysis is key in not only arriving well-timed value based buy points for the group; but more, we also gain perspective on where the market is in terms of the 'big picture' within what appears to be an increasingly confusing backdrop. And for those who do not think knowing where we are in the big picture is important, just ask investors who have been invested in PMJ's for the past few years what it's like watching commodity prices continue to rise moderately, while share prices decline precipitously in far too many cases. Obviously, the answer here would be, 'it's not much fun, and something I would like to avoid in the future'.
And that's what these ongoing studies attempt to accomplish in measuring where we are in the 'big picture'; finding interested parties optimal accumulation points, thereby attempting to avoid prolonged periods of under-performance and potential negative returns. Of course, this job has been getting harder these days with multi-layered degrees of complexity being heaped on the pile with every intervention master planners engineer. Why? Because this causes delays in natural process (sentiment, intermarket influences, etc.), where it can be argued ultimate outcomes could be altered permanently. Be that as it may, one thing is for sure with respect to PMJ's, while liquidity conditions could be negatively affected by a contracting credit cycle / broad market conditions, they remain undervalued and devoid of generalized speculation levels that one would expect to see if the larger cycle has topped. No mania has run its course in PMJ's thus far in the larger cycle as far as pricing is concerned.
What's more, we know the larger cycle for precious metals has not topped for a growing number of reasons these days, not the least of which is prominently displayed for you above in Figure 2. And as mentioned, there are more reasons to remain bullish on gold at this time, with negative lease rates and significant recent declines in COMEX gold open interest, meaning the stars are becoming aligned in bullish fashion on both the physical and paper related fronts simultaneously at present. But as far as trigger pints are concerned, the Gold / Crude Oil Ratio remains prominent in my opinion for the reasons outlined above, where although it appears more downside may be in the cards in coming weeks, which of course is no surprise to us, ultimately, a breakout to the upside as summer approaches is shaping up as an increasingly probable outcome with the global economy / credit cycle slowing (reducing oil demand), which will need to be countered by accelerating currency debasement rates.
This is the formula one would expect to be present in sponsoring a breakout in the Gold / Crude Oil Ratio, and then gold above significant resistance at $1,000; where again, it appears the stars are becoming aligned in this regard. Indeed, it's likely not a stretch speculating perceptions (and sentiment) will change markedly once gold is above four-digit resistance amongst both knowledgeable investors (focused on bottom line considerations associated with a breakout in the Gold / Crude Oil Ratio) and newcomers alike (waking up to pricing implications associated a lasting break above $1,000). Here, it can be argued that finally increasing fears associated with disintegrating fiat currency regimes and inflation could spark a rush into the relatively tiny precious metals sector in an asset allocation play that trumps liquidity concerns, which is the big fear holding many back from buying PMJ's right now, as can be seen here in the CDNX / S&P/TSX Global Gold Index (SPTGD) Ratio. (See Figure 3)
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Good investing in 2008 all.