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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