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Just a few years
ago, the junior resource stocks were hotter than the sun. The fact that the
accelerating commodities bull was secular in nature was finally starting to
sink in for mainstream traders. With a growing world in desperate need of
endless new supplies of natural resources, capital flooded into junior
resource stocks driving some truly epic gains.
Today that junior
golden age feels like a distant memory from a lifetime ago. The unmitigated
fury of the stock panic ravaged the junior resource stocks. Its monumental
carnage created a canyon-sized discontinuity in sentiment that's been nearly
impossible for traders to bridge and see beyond. Thus commodities juniors
have been largely forgotten, collateral damage left for dead in a war they
didn't start.
But with the stock
markets now gradually recovering from the worst of the panic, dim memories of
these tiny high-potential stocks are being rekindled. A small yet growing
fraction of traders has started wondering how the prospects for the junior
resource stocks look today. But in order to game their future, we first have
to understand where they have been.
Measuring this
unique sub-sector is certainly not easy. The ranks of commodities juniors are
highly fluid and very amorphous. The junior churn is relentless, with old
companies fading away into oblivion while new companies constantly form. This
makes it very difficult to follow junior resource stocks as an aggregate
group. How do you index them, pick key stocks to track, when their ranks are
in constant flux?
The Canadians have
made the best attempt yet at indexing this challenging sector. With Canada's vast
and incredibly natural-resource-rich geography, commodities production is a
major part of its economy. Mining is a very important sector up north, with
57% of the world's publicly-traded mining companies listing on Toronto's stock
exchanges. At the end of 2008, 1427 mining companies listed in Toronto. This dwarfs
the NYSE group's 116, the 216 listed in London,
and even the 684 in
Australia
combined!
All the larger
resource stocks list on the primary Toronto Stock Exchange. But the great
majority (75%) do not meet the listing requirements of the TSX. They trade on
the TSX Venture Exchange (CDNX), which is the busiest and most dynamic
junior-resource-stock exchange on the planet. Once known as the Vancouver
Stock Exchange, the CDNX has long been the Wild West of the commodities-stock
world.
An index now known
by the unwieldy name of S&P/TSX Venture Composite Index tracks the CDNX. But
most traders just call it the CDNX, as I do. From now on "CDNX"
refers to this index and not the broader exchange. This index's construction
is really ingenious, as it deftly captures the important junior resource
stocks while keeping its component list relevant in the face of this sector's
endless fluidity.
In order to be
included in the CDNX index, two key requirements must be met. First, a stock
has to have been listed for a minimum of 12 months. This keeps out the
shakiest new issues that soon fail. Second, a stock has to account for at
least 0.05% of the total market capitalization of all the stocks contained in
the CDNX index. This requirement is brilliant, it ensures only the
bigger and stronger juniors of this exchange will be indexed. Each calendar
quarter the CDNX component list is adjusted to reflect these bigger juniors.
Out of around 2000
stocks listing on the CDNX, today 475 meet these requirements. Only they are
included in the CDNX index. Of this elite group of juniors, 23% have the word
"Resource" in their name, 22% "Resources", 10%
"Energy", 8% "Gold", and 6% "Minerals". All
together just over 70% of these 475 juniors are involved in the
natural-resources sector! They also dominate by market cap, and this index is
market-cap weighted. The other 30% are involved in technology, bio-tech, and
other non-resource realms.
So while the CDNX is
not exclusively junior resource stocks, it is close enough. And there is
certainly no other index in the world that comes as close as the CDNX for
accurately tracking this amorphous sector anyway. If you want to understand
the fortunes of junior resource stocks as a whole, you have to follow the
CDNX.
And at first glance,
the CDNX has been doing quite well since the stock panic ended (VXO fell under 50 again) in mid-December. It is charted in blue below,
with the CCI underneath it in red. The Continuous Commodity Index, of course, is the premier measure of commodities
prices. And since small resource stocks produce or explore for commodities,
their ultimate success is governed by commodities prices.
As I'll discuss
further later, the CDNX fell to apocalyptic lows in the stock panic. Between
the plummeting general stock markets and plunging commodities prices, not
many traders had the courage to hold commodities juniors. But once the CCI
started to recover in late December, the CDNX shot up in a sharp initial
recovery. Since then it has been trending higher in a tight uptrend,
amplifying the CCI's gains.
The only time the
CDNX fell under this uptrend's support was in late February and early March
when economic despair set in. Despite all the data to the contrary, traders started again fearing a new depression as
stock prices plunged to fresh lows. Commodities were sold off too, which
makes sense in the framework of the then-popular neo-depression worldview. A
depression would definitely erode global commodities demand!
But we certainly
weren't facing a true economic depression, merely depressed sentiment driven
by depressed stock-market levels. And as soon as the stock markets started
recovering in March, so did sentiment. Traders started bidding up both
commodities and junior resource stocks, and the CDNX surged back up into its
previous uptrend. Just this month, the CCI surged to new post-panic highs
which the CDNX mirrored in a nice breakout surge of its own.
Since the CDNX
bottomed on December 8th, it has rallied 57.6% at best as of May 12th. Buying
interest in these junior resource stocks was naturally heavily dependent on
the CCI's fortunes. In this recovery, the CDNX index has had a correlation
r-square of 65% with the CCI. This means 2/3rds of the CDNX price action can
be statistically explained by the underlying activity in commodities prices.
Now a 58% run since
early December, straddling a considerably lower low in the general stock
markets, sounds pretty good at first glance. But it's really not. Compared to
the major resource stocks, this performance is pathetic. At best since the
panic, the HUI gold-stock index is up 134%! The major gold stocks' post-panic
performance has run circles around the junior gold stocks' performance so
far.
And as I look at the
stellar post-panic performance of the long-term investments in our Zeal Intelligence investment portfolio, the outperformance of the
large stocks is universal. There are not really any great large-cap
commodities-stock indexes either, but considering a few performances from
leaders within their respective sectors drives home the kinds of gains these
major resource stocks have seen.
BHP Billiton, the
world's largest diversified miner, has rallied 121% at best since the panic. Petrobras,
the elite Brazilian oil major, is up 168% at best. Chesapeake Energy, the
giant US
natural-gas producer, is up 111% at best despite much weaker
natural-gas prices after the stock panic. Freeport-McMoRan Copper, the elite
giant copper miner, is up 209% at best. Market-darling gold major Goldcorp
has rallied 132%, while the market-darling silver giant Silver Wheaton is up
a whopping 263% at best since the panic!
And these massive
gains are pretty representative of their respective sectors. Averaging 100%+
gains since the depths of the stock panic, the large-cap resource stocks have
trounced the CDNX's measly 58% post-panic run. There is no doubt that
investors and speculators have been better served by sticking with the big
boys rather than betting on the small juniors.
This massive
junior-resource underperformance is concerning many traders. As they perceive
this phenomenon, they grow even more reluctant to risk their scarce and
valuable capital in junior resource stocks. What is wrong with this once-hot
sector? Are the juniors doomed to never regain their former glory? In order
to address these questions, some critical perspective is necessary.
Junior resource
stocks are tiny in market-cap terms. As an example, my business
partner Scott Wright has done a vast amount of world-class research on gold juniors. He recently crunched the numbers and found that
82% of the entire universe of junior golds had market caps under $50m. Fully
50% had market caps under $10m! And since there are many more junior gold
companies than other commodities categories, these trivial market-cap levels
are representative of junior resource stocks in general.
At the end of 2008,
the 1071 mining stocks listed on the TSX Venture Exchange had a combined
market cap of just C$8.7b! A simple average yields a mean market cap for
these companies of just C$8m! This is so tiny it defies belief. And of course
there are a handful of larger juniors that really skew this average. The
great majority of CDNX companies probably have market caps under C$5m. This
has big implications.
These junior
resource stocks are so small that institutional investors like mutual funds
and hedge funds rarely bother with them. The reasons are many. If you run a
fund and your minimum allocation to any one stock is $10m, and juniors are
trading at $5m, then you simply can't buy them. Your buying alone would drive
the price stratospheric and prevent you from getting deployed near market. And
even if you could, you'd own so much of the company that it would be
impossible for you to exit later without killing the price.
But it is not just
juniors' tiny absolute sizes and meager trading volumes that are
institutional deterrents. In the US, most of these juniors trade
on the OTC Bulletin Board or Pink Sheets. Usually institutions will not
buy stocks not listed on the major exchanges. OTC-listed stocks do report to
the SEC quarterly, but stocks on the Pinks do not have to report to the SEC
at all! Thus you never know what is really going on with them. And most US funds only trade stocks in the US, they are
not willing to trade Canadian issues.
Thus institutions
are almost never major investors in junior resource stocks. The only group of
investors willing to overlook all these limitations is individual retail
investors. Retail traders are perpetually enamored with very cheap stocks
(they can own more shares) and they like the vast potential the successful
juniors have to soar. They are not swinging big-enough lines as individuals
to impact tiny-stock prices and they don't mind trading in Canada or on
the US Pink Sheets. So retail traders dominate the junior scene!
Since the stock
panic, nearly all of the recent stock buying has emerged from institutions. Professionals
run these funds, they study the markets and understand psychology. They
realize that fear was way overdone in the stock panic and resource-stock
prices fell far too low to reflect any reasonable economic future. So they've
been buying aggressively. But since the institutions only play in the
major-exchange-listed larger resource stocks, this post-panic professional
buying has not found its way into the juniors.
Meanwhile, as a
thundering herd individuals are highly emotional. Since the panic they
are generally sitting in cash, terrified at what the future might bring. Instead
of being contrarians who want to buy when everyone else is scared, they take
comfort in groupthink. Stocks will have to rally a long way, driven by institutional
players, before most retail investors muster the courage to buy back in. And
until retail commodities-stock traders return en masse, the junior resource
stocks they dominate will continue to lag the majors.
This sounds
discouraging, but it's really not. Retail investors are manic-depressive. They
always return to stocks, but not until the markets convince them it is safe
again (by rallying far off the lows). So once big commodities stocks, and
commodities prices, travel high enough to eliminate the residual post-panic
fear, retail traders are going to flood in aggressively. Their buying
will spark huge surges in the tiny juniors and eventually lead to rampant
greed as usual. Of course the gains and greed will feed on itself driving
even more buying.
With the return of
the juniors' core investing constituency inevitable, the last question is
whether they have room to run higher technically and fundamentally. Do junior
resource stocks deserve to be trading where they are today for
commodities-price reasons? As this long-term CDNX and CCI chart reveals,
juniors remain dirt cheap today relative to every conceivable measuring
stick. Their
prospects are very bright!
While the
commodities correction started before the stock panic, the CCI's terminal
plunge driven by it resulted in a massive 46.7% loss between early July and
early December. Such a wild swing is unprecedented, as the CCI usually moves
gradually due to its geometrically-averaged index construction. Meanwhile,
from late May to early December, the CDNX plummeted a mind-blowing 74.8%! Ouch!
Like the CCI, its terminal plunge was driven by the general-stock panic.
At worst at its
panic lows, the CCI itself briefly fell back to November 2005 levels. But the
plummet in the CDNX was so unbelievably precipitous that its entire bull
market was more than erased! Despite commodities prices remaining much
higher, at worst the CDNX was trading well below where it did all the way
back in 2002! The devastating impact of the stock panic on
junior-resource-stock prices could not have been more radical.
But fundamentally
this made no sense at all. Scared retail traders panicked and totally
abandoned the juniors. There was little buying to offset their relentless
selling so junior stock prices fell to levels that didn't make any sense
unless the world was truly ending. But the Apocalypse was not drawing nigh.
There are several different ways this truth can be illustrated technically
using the CDNX and CCI chart above.
Even at its panic
low, the CCI merely descended to 327. This was a similar level to Q4 2005,
where the CCI averaged 335 on close. Yet in that very quarter, the CDNX
averaged 2075. This was literally 3x its panic low of December 2008! So using
the CCI as a measure, even in the very darkest days the junior
resource stocks were only trading at a third of where
commodities-price fundamentals demanded.
Since the stock
panic, the CCI has traded between 327 and 404. As you can see in this chart,
these were the same levels this index traded at for the 19 months between
November 2005 and May 2007. Yet over this very span, the CDNX averaged 2725!
But since the panic it has only averaged 890, once again about a
third of where commodities prices suggest it should be. Clearly these junior
stocks remain an epic bargain fundamentally.
Of course in 2006
and early 2007 retail investors were getting greedy, driving the surge in the
CDNX evident in this chart. So if you want to be really conservative,
consider extending the CDNX's pre-surge uptrend rendered above. During
the last long period of time where the CCI traded in the same range it has
been in since the stock panic, the midpoint in the CDNX's secular uptrend
ascended from 2000 to 2250 or so. So even by this conservative measure,
today's CDNX near 1050 still looks ridiculously oversold.
Junior resource
stocks, because they were driven so extremely low in the panic, have
awesomely bullish prospects today. Even if commodities prices flatline going
forward, juniors should at least double from here. And with
commodities prices highly likely to rise in the coming years, the embattled juniors should do far better. Retail
investors' return is inevitable, and when they come back they will bid these
stocks back up to more reasonable prices based on their underlying
commodities' fundamentals.
At Zeal, we've been
buying elite junior resource stocks to game this unsustainable anomaly. In
our Zeal Intelligence newsletter trading portfolio, we've bought and
recommended elite gold, oil, and copper juniors. While they've done quite
well already, the best gains are yet to come. As retail-investor confidence
returns, the oversold junior sector is going to soar. Subscribe today to our acclaimed monthly newsletter and ride this
coming junior surge higher with us!
With so many juniors
yet so few truly great junior stocks, it takes an incredible amount of
research to uncover the gems. So periodically we research the entire universe
of juniors in a particular sector to find our favorites to trade going
forward. Our latest detailed fundamental report, on junior golds, has been very popular. While
these elite stocks are gradually rising, their best gains by far are yet to
come when retail investors get excited about gold stocks again. Buy our report today and get deployed for this coming rally!
The bottom line is
junior resource stocks' prospects are extraordinarily bullish today! Panicking
retail investors drove their prices far too low relative to commodities
fundamentals during the recent fear bubble. Because of this anomaly, today
you can buy many elite juniors for bargain prices not seen since the early
days of this secular commodities bull. Yet today's prevailing commodities
prices are over twice as high.
Our big world still
consumes vast amounts of raw materials, even in these troubled times. And
juniors remain critically important in the global commodities-supply pipeline
since they take the big risks to explore for new deposits. Just as in the
past, the juniors successful in this realm will yield legendary returns for
their owners. At such crazy low prices today, if you ever wanted junior
exposure now is the time to add it.
Adam
Hamilton, CPA
Zealllc.com
May 15,
2009
Read
all articles published by Adam Hamilton
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