Negative divergences

Author Cam Hui

Posted: 06 May 2013

Further to my last post (see Sell in May?) I am seeing more negative divergences that create more concerns for the bull case. The recent rally, which has been led by the golds and deep cyclicals, have all the appearances of a dead cat bounce rather than the start of a sustainable advance.

Last week, I suggested that traders should watch the silver/gold ratio for signs of a sustainable rally (see Watch silver for the bottom in gold). The idea was that silver, being the more volatile poor man’s gold, should display positive relative strength against gold and lead a precious metal rally if these metals are in the process of making a sustainable bottom. Look at what’s happened to the silver/gold ratio since then:

We can see how the oversold rally developed by analyzing the price charts of the gold and silver ETFs. GLD has certainly staged a classic capitulation and rally pattern to fill in the gap left by its recent freefall:

But what about silver? Sure, this poor man’s gold rallied, but the rebound has been weak and the gap was not filled, which suggests to me that this advance is an oversold rally and the next major move in precious metals is likely to be down.

As confirmation of the bearish commodity trend, the entire industrial metals complex remains weak despite the rebound in gold and oil:

In my previous post, I also wrote about watching the AUDCAD currency cross rate, with the premise that the Australian Dollar is more sensitive to growth in China and the Canadian Dollar is more sensitive to growth in the American economy. A breach of the uptrend in this cross rate would would be a signal that the market’s belief that Chinese growth is slowing, which would be negative for the global growth outlook. The breakdown in this currency pair cannot be regarded as good news for the prospects of Chinese growth.

Another concern is the disappointing South Korean April exports, which were just released and missed expectations at 0.4% compared to estimates of 2.0%. The South Korean economy is regarded as cyclically sensitive as the country is highly exposed to trade with China and Japan.

In addition, Cullen Roche at Pragmatic Capitalism recently pointed out that the Citigroup Economic Surprise Index is turning down in every major region in the world. As a reminder, a economic surprise index reading below zero is indicative of more misses than beats on economic data. Falling surprise indices around the world suggests, therefore, that global economic growth is starting to stall.

As we wait for the decisions of the Federal Reserve and ECB this week, it will be a test of market psychology of whether bad news is good news, i.e. economic slowdown will lead to central bank stimulus, which is bullish, or bad news is bad news.

Non-confirmation of SPX new highs
Moreover, with the SPX making new marginal highs, I am not seeing the breadth confirmations from the 52-week highs and lows. While these kinds of breadth divergences can last for months, it nevertheless raises a red flag about the sustainability of this stock market rally.

Here’s another puzzle. If the stock market is making new highs, why is the VIX/VXV ratio (which I described in a previous post here and first pioneered by Bill Luby, see his original post) sitting at only 0.91, which is barely below my “sell signal” mark of 0.92? What is the term structure of the option market telling us?

This is not investment advice
One final point. I have outlined a number of negative divergences that suggest a bearish tone for stocks, but I have not outlined the timing of any trades. In my last post entitled Sell in May? I sketched out a number of likely triggers for to get more defensive. Since then, I have had a number of emails and other responses asking if and when I would write about when those events are triggered and, by extension, when it’s time to sell or short the market.

Let me make this very, very clear: Those triggers are just a set of suggested triggers. It will be up to each individual reader to make up his or her own mind as to what to do if and when each event is triggered. Don’t expect me to hold your hand and shout “sell” for you. You are responsible for your own portfolio and your own profit and loss statement.

For the readers who are waiting for me to tell when to buy or sell, I strongly suggest that you re-read my previous post about why the contents of this blog does not represent investment advice. This blog is a forum for discourse, not pre-digested investment or trading advice.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Goldman Doesn’t Know What’s Next Either

Author Larry Berman

Posted: 3 July 2012 re-posted from etfcm

It should be no surprise that the market jumped like a rocket and stopped the month and the quarter end rally right at the key retracement resistance of 1363, as well as the previous June high. This should only serve to prove the point we raised last week which is Goldman (or the person that made the now stopped out market call) does not know what is going to happen next either.

I think we can all agree that the infrastructure of the global capital markets is weak at best. They can patch it up and maybe even fix it with massive money printing [said with an Austrian accent a la Dr. Marc Faber] over very long periods of time. But as Japan has aptly demonstrated, the longer-term QE does not work to fix the problem.

So the markets are about assessing the trading risks looking out for several weeks to months, and it appears that for now, the EU has come up with another band-aid. But also trust that Europe is not fixed and there is much more to go in the saga. Our trading bias is to lighten up positions into earnings season and if the market breaks out, stops should be trailed up to protect the gains.


Don’t lose sight of the medium term

Author Cam Hui

Posted: 18 June 2012

Rather than focus on Greece this weekend, I thought that I would write about the medium term path for equities and the global economy. I came upon this BIS paper entitled Characterising the financial cycle: don’t lose sight of the medium term! The BIS researchers break economic cycles into two components, a shorter business cycle and a longer financial cycle. Here is the abstract:

We characterise empirically the financial cycle using two approaches: analysis of turning points and frequency-based filters. We identify the financial cycle with the medium-term component in the joint fluctuations of credit and property prices; equity prices do not fit this picture well. We show that financial cycle peaks are very closely associated with financial crises and that the length and amplitude of the financial cycle have increased markedly since the mid-1980s. We argue that this reflects, in particular, financial liberalisation and changes in monetary policy frameworks. So defined, the financial cycle is much longer than the traditional business cycle. Business cycle recessions are much deeper when they coincide with the contraction phase of the financial cycle. We also draw attention to the “unfinished recession” phenomenon: policy responses that fail to take into account the length of the financial cycle may help contain recessions in the short run but at the expense of larger recessions down the road.

The financial cycle is turning down. Ray Dalio of Bridgewater explained the financial cycle using the Monopoly® game as an analogy in this note.

If you understand the game of Monopoly®, you can pretty well understand credit and economic cycles. Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players give them cash. So as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property with lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So early in the game, “property is king” and later in the game, “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.

Now imagine Monopoly® with financial leverage and you understand what is happening with the financial cycle:

Now, let’s imagine how this Monopoly® game would work if we changed the role of the bank so that it could make loans and take deposits. Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other giving each other credit (i.e., promises to give money and at a later date). If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. There would be more spending on hotels (that would be financed with promises to deliver money at a later date). The amount owed would quickly grow to multiples of the amount of money in existence, hotel prices would be higher, and the cash shortage for the debtors who hold hotels would become greater down the road. So, the cycles would become more pronounced. The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash.

What happened with Lehman in 2008 and in Greece, Spain and the other eurozone peripheral countries today are symptoms of the downturn in the financial cycle.

The business cycle turns down
There is no doubt that the financial cycle has been turning down since 2008. What about the business cycle? It’s turning down as well. Regular readers know that I use commodity prices as the “canaries in the coalmine” of global growth and inflationary expectations. Consider this chart of the negative divergence between US equities and commodities prices.

The market is also telling a similar story of an economic slowdown. Here is the relative performance of the Morgan Stanley Cyclicals Index against the market. It’s in a relative downtrend, indicating cyclical weakness.

Globally, air cargo traffic represents an important real-time indicator of the strength of the global economy (h/t Macronomics). This chart from Nomura shows the correlation of air cargo growth with global industrial production growth. Air cargo growth is headed south as well.

I have written about the Axis of Growth, namely the US, Europe and China and at least two of the three are slowing. Hale Stewart at The Bonddad Blog went around the world and explained why the global economy is slowing:

[T]here are no areas of the world economy that are demonstrating a pure growth environment; everybody is dealing with a fairly serious negative environment. Let’s break the world down into geographic blocks:

1.) China is located at the center of Asian economic activity. Recently, they lowered their lending rate largely as result of weakening internal numbers. While these numbers still appear strong to a western observer (growth just over 8%), remember that China is trying to help over a billion people become middle class. To accomplish that goal, the economy needs to have a strong growth rate. Also consider that the news out of India has become darker over the last few months as well. A recent set of articles in the Economist highlighted the issues: a political system that is more or less unable to lead, thereby preventing the action on structural roadblocks to growth. The fact that two of the Asian tigers are slowing is rippling into other regions of the world, which leads to point number 2.

2.) The countries that supply the raw materials to these regions are now slowing. Australia recently lowered its interest rate by 25 BP in response to the slowing in Asia. A contributing factor to Brazil’s slowdown is the decrease in exports to China. Other Asian economies that have a trade relationship with China are all experiencing a degree of slowdown, but not recession. Some of these countries (such as Brazil) were also experiencing strong price increases. The price increases are are starting to slow, but they are still above comfort levels.

3.) Russia has dropped off the news map of late. However, it emerged from the recession in far worse shape; it’s annual growth rate for the duration of the recovery has been between 3.8% and 5%, which is a full 3% below its growth rate preceding the recession. This slower rate of growth makes Russia a far less impressive member of the BRIC list.

4.) The entire European continent is caught up in the debt story — underneath which we’re seeing some terrible economic numbers emerge. PMIs are now in recession territory, unemployment is increasing and interest rates for less than credit-worthy borrowers are rising. And, the overall credit situation is casting a pall over the continent, freezing expansion plans.

5.) The US economy has experienced 2-3 months of declining numbers. While we’re not in recession territory yet, we are clearly in a slowdown with growth probably hovering around the 0% mark.

In addition, I have documented warning signs of rising tail risk in China (see Focus on China, Not Europe, Ominous signs from China and The ultimate contrarian sell signal for China?)In last week’s analysis, John Hussman said that the US is in recession now and blamed it on the financial cycle:

By our analysis, the U.S. economy is presently entering a recession. Not next year; not later this year; but now. We expect this to become increasingly evident in the coming months, but through a constant process of denial in which every deterioration is dismissed as transitory, and every positive outlier is celebrated as a resumption of growth. To a large extent, this downturn is a “boomerang” from the credit crisis we experienced several years ago.

Regardless of the outcome of the Greek election, my inner investor tells me that the fundamentals of the economic outlook is negative. When the financial cycle and the business cycle both turning down in unison, that’s bad news.

As for how much of the negative news has been discounted by the markets, I don’t know. What can change the trajectory of the outlook in the next few months is intervention, either by the central banks (which was rumored late last week), an announcement of more QE by the FOMC, or the news of some deal cooked up by the European governments, IMF, etc.

My inner trader tells me that fundamentals don’t matter and the markets will react to short term headline news.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Focus on China, not Europe

Author Cam Hui

Posted: 30 May 2012

While everyone is focused and worried about the news flow from Europe, I am less concerned about the prospects for Greece and the eurozone. As I wrote in my last post (see Draghi, the last domino, falls), Germany is becoming increasingly isolated and expect her to start to bend on the issue of eurobonds. While they may not be eurobonds in the strictest sense, we are likely to see some sort of typical European compromise on Pan-European infrastructure bonds.

I am more concerned about the news flow out of China, which is likely to deteriorate over the next few months – and none of the negative news has been discounted by the market.

The consensus on China
Currently, the consensus view on China is that while the economy is weakening, the authorities are aware of the problem and they are taking steps to remedy the situation. Indeed, Bloomberg reported that Premier Wen Jaibao made some remarks on May 20 suggesting that more stimulus was on the way:

Chinese Premier Wen Jiabao said the government will focus more on bolstering economic growth, indicating policies may be loosened further as inflation moderates.

“The country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations,” Wen said during a tour of Wuhan, the capital of China’s Hubei province, from Friday to Sunday.

“We should continue to implement a proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth,” Wen said.

The market interpreted his comments as being growth friendly:

Wen’s remarks cited in the report, which didn’t mention concern about inflation, indicate the government might take more aggressive steps to support the economy after April data showed the slowdown may be sharper than expected. The central bank this month cut banks’ reserve requirement ratio for the third time since November to boost liquidity.

Take a look at the Shanghai Composite, which reflects this ambiguity about China’s near-term growth outlook. The index is currently testing the downside of an unresolved wedge formation, which indicates indecision. A breakout to the upside of the wedge would be interpreted bullishly while a downside breakdown would be bearish.

Turmoil beneath the surface
While the picture of the Shanghai Composite reflects this consensus view, a tour of secondary market indicators suggest that not all is well with the Chinese economy. First of all, the flash PMI release showed contraction.

Signs of economic weakness are everywhere, this analysis shows a a tight correlation between Macau gaming revenues and Chinese growth – and gaming revenues are falling.

Next door in Hong Kong, the Hang Seng Index is not behaving quite as well as the Shanghai Composite. The index rallied in February to fill the downside gap that occurred in August 2011, but the rally couldn’t overcome resistance. The index has now violated an important support zone and weakening rapidly.

Further north from Hong Kong, South Korea is an economy that is highly sensitive to global economic cycle. In particular, the South Koreans export a lot of capital equipment and other goods to China. That country’s stock market isn’t behaving well either. In fact, it’s cratering.

China has been an enormous consumer of commodities. Commodity prices have also been weakening as the CRB Index is in a downtrend and has violated an important support level.

Australia is not only a major commodity exporter, it is highly sensitive to Chinese commodity demand because of its geography. The AUDUSD exchange rate is falling rapidly.

Just to show how bad things are, the Canadian economy is similar in characteristic to Australia’s. Both are industrialized countries that are large commodity exporters. The only difference is that Australia is more levered to China, whereas Canada is more sensitive to US growth. Take a look at the AUDCAD cross rate as a measure of the forward expectations between the level of change in Chinese and American growth.

Is the shadow banking system unraveling?
The story that I have outlined so far is the story of economic deceleration in China. There is another risk that the market doesn’t seem to be focusing on – the risk of a Lehman-like catastrophe in China’s financial system. Patrick Chovanec, a professor at Tsinghua University’s School of Economics and Management in Beijing, writes:

There really are two related but distinct things people have in mind when they talk about a “hard landing” for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we’re already seeing some signs of the first, and the second is a bigger risk than most people appreciate.

He went on to detail an incident of how the shadow banking system is unraveling in China:

In early April, Caixin magazine ran an article titled “Fool’s Gold Behind Beijing Loan Guarantees”, which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China’s capital. “What’s a credit guarantee company?” you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China’s “shadow banking” system. If the risky trust products and wealth funds that Caixin documented last July are China’s equivalent to CDOs, then credit guarantee companies are China’s version of AIG.

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans. State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy. Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default. Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make). In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.

OK, so China has a bunch of little AIGs. The story gets better, you have leverage on top of leverage [emphasis added]:

Zhongdan, the company in the Caixin article, took these risks one step further. It persuaded borrowers to take out bank loans based on guarantees from Zhongdan, and then hand some or all of that money back to Zhongdan to invest in Zhongdan’s own “wealth management” products:

Under the arrangement, a participating company would take out a bank loan and give some of the money to Zhongdan for investing in high interest-paying wealth management products for a month or more.

The firm then apparently put those funds to work by buying stakes in small companies such as pawnshops and investment consulting firms, according to the sources. Some of the funds went toward a U.S. consultancy that later failed.

When excesses occurred in the US with subprime lending and “liar loans”, rules were skirted. It’s no different in China.

Since this use of funds completely violated banking rules, Zhongdan forged documents indicating the money was being borrowed to pay fictitious suppliers:

To nail one loan, [an executive for a building materials manufacturer] said, Zhongdan formed a shell building materials supplier and wrote a fake contract between the supplier and his company. The document was presented to the bank, which approved the loan. Zhongdan later de-registered the phony supplier.

It all unraveled in the end.

The whole thing started to unravel in January when banks “reacted to rumors of a liquidity crunch” at Zhongdan:

At that point, regulators stepped in and told everybody to freeze — and to keep all the assets as “good” on everyone’s balance sheets while they figured out what to do next. Zhongdan had over 300 clients, and guaranteed RMB 3.3 billion (US$ 521 million) in loans from at least 18 banks. The only liquid assets that the guarantee company appears to have available to pay banks is RMB 210 million (US$ 33 million) in margin accounts deposited with the banks themselves. Good luck finding the rest:

Several banks that cooperated with Zhongdan smelled trouble and started calling loans they had issued to companies backed by the firm … The next domino fell when the creditor companies, seeking to appease the banks, turned to Zhongdan for help repaying the called loans. But Zhongdan executives balked, and the domino effect accelerated as companies teetered under bank pressure and the city’s business community shuddered with credit freeze fears.

When I hear stories like this, I think of the cockroach theory. If you see one cockroach, there are sure to be more.

Reuters recently reported a story that Chinese buyers were defaulting on coal and iron ore shipments. While this story may be an indication of a slowing economy in China and slackening commodity demand, it might have stopped there. But the story gets worse as it exposes the cracks in the shadow banking system. It turns out that Chinese buyers have been buying commodities and using them as collateral to obtain financing. When the economy and commodity prices turned down, they were caught. This type of financing is highly prevalent in the copper market, as Reuters reported that Chinese warehouse were so full that copper inventory was the red metal was being stored in car parks.

Watching the shadow banking system
I have no idea what all this means. China’s economy is highly opaque and we have no reliable statistics. How big is the shadow banking system and how much leverage is involved? We know that there are problems, but I have no way of quantifying it.

Could this result in a crash landing, i.e. negative GDP growth, in China? I have no idea. Certainly, the unraveling of excessive leverage has seen that kind of result before.

Here is one offbeat way that I am watching for signs of stress in China’s shadow banking system. I am watching the share price of HSBC. While HSBC is a global bank, it has deep roots in Hong Kong and Asia. For newbies, HSBC stands for Hongkong Shanghai Banking Company. It is a bank that was firmly established in Hong Kong. As a child, I can remember driving by the bank’s headquarters in downtown Hong Kong in the 1960’s.

Stresses in the Chinese financial system is likely to show up in the share price of major financials that have exposure to China and Asia, like HSBC. The stock has been falling rapidly in the past couple of weeks, which is not a good sign.

To put the stock performance into context, I charted the performance of the stock relative to the BKX, or the index of US bank stocks. HSBC has been in a relative downtrend, but the lows of 2009 have not been violated. I interpret this as the market signaling that while there may be signs of trouble, it is not panicking.

Chinese elite losing confidence
To add to China’s troubles, the Chinese business elite is starting to lose confidence in China’s long-term outlook. FT Alphaville highlighted a survey by the Committee of 100, an international, non-profit, non-partisan membership organization that brings a Chinese American perspective to issues concerning Asian Americans and U.S.-China relations. The results of this key question asks American and Chinese business leaders their outlook for China. While Americans believe that Chinese growth will continue long into the future, the Chinese are far less optimistic and their outlook has deteriorated rapidly since 2007.

China’s outlook in 20 years

Putting it all together, we have signs of a weakening economy, a shadow banking system that is teetering and a loss of confidence by China’s business elite. While the government is taking steps to address the problems, none of these risks have been discounted by the market.

While I expect the news flow from Europe to improve in the days to come, which is bullish, I also expect further stories of deterioration out of China, which has the potential to be extremely bearish. All this points to further choppiness in stocks and risky assets with a downward bias.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Bond Market Bounces Back as Equities Stumble

Author Larry Berman

Posted: 1 May 2012 re-posted from etfcm

AGG: A few weeks ago many were calling for the end of the treasury bull market. The economy was recovering and yields were heading higher. Since that false start, Bernanke and the FOMC has reiterated the need to keep rates low through 2014 and that more QE is on the backburner if needed. And viola, the bond market has bounced back to near all-time highs as equities start to stumble. Investors can get used to this behaviour as we still see it lasting for years.

Emerging market debt (EMB) is somewhat overvalued given the inflation risks (real returns are extremely low), which suggests currency risks are rising. Peripheral Europe (IGOV) remains a basket case and currency risk is extremely high. High yield (JNK, ZHY) is more correlated to equity market risk and is showing strong evidence that we would want to avoid it for now. The global deleveraging that needs to take place will likely cause stress for the next decade. Significant defaults are likely before it ends and there is flight to safety value in the Treasury markets of Germany and the US. Japan may see some stress in bond yields, but QE will persist.


Gold: Stocks vs Bullion

There’s a curious phenomena in the gold market right now. After many months of out performance, bullion is still outperforming stocks. In previous years, bullion and stocks see-sawed in performance, as one led strongly, the other followed in turn. Not so this time. Bullion has been the overwhelming winner in asset class whereas stocks have done little better than to just preserve wealth.

Note the bottom red line of the range represents how inexpensive stocks are to gold and the top red line represents how expensive stocks are to gold bullion. In late 2008, gold stocks hit their all time low relative to the price of bullion and although gold stocks have had a good rally, relatively, they are still at 50 year lows of relative value.

I think its due to a few factors including the lack of buying… With advent and popularity of gold ETFs, the difficulty in owning bullion has never been easier. As well, the management volatility quotient prevalent in gold companies is just not a factor in bullion. In bullion there is no exploration risk, no fraud, no mine salting, no lack of liquidity, no cheap management below market options there to reward management who has little or no stake in the company etc etc. With bullion there is a benign management bias – ie no net present value of a managements ability to deliver results. Just the metal…

With bullion, for example GLD the most popular gold etf, there is immense liquidity. A hedge fund, mutual fund, institution etc can make a relatively massive stake without impacting the near $72B market capitalization of GLD. In previous years, most stake holders would have gotten their gold exposure through gold stocks – now there is competition.

That being said, if you look at gold stocks through the lens of a value investor, this asset class is starting to look quite appealing. I think, on average one can guesstimate cash costs per once of gold around $500 and with gold at $1000/oz they would be quite profitable. At $1800/oz most gold companies, quite literally, are printing money. And they now are in a conundrum that most successful companies can find find themselves in. And that is, what to do with all that cash…

Classic cash flow analysis will tell you theres only a few things management can do with the cash: pay down debt, buy back stock, pay out dividends, expand capital expenditures or look for opportunities.

My thesis is that what we’re about to see is a cascade of merger and acquisition type of activity. Gold companies have a poor record of paying out dividends as the earnings volatility is too high. Most companies typically dont have alot of debt as banks find them difficult to finance and equity markets have been eager to finance via issuing stock. ergo not alot of debt to pay down.

Buying back your stock is a question of metrics and the best use of your capital. If your company trades at a higher valuation multiple than a competitor in the marketplace and there is potential economies of scale then it makes good investment sense to purchase your competitor. If you trade at a discount to industry metrics then it makes sense to buy back your own stock.

Right now, there is a disparity between the valuations producers are getting the marketplace  versus the explorers. I’m guessing that smart management of a typical producing gold company would look at leveraging their overvalued metrics and utilizing the cash at purchasing an undervalued close to production/significant proven reserve type company.

It is this series of event that i think will spark the coming rally in junior golds. See our upcoming  newsletter for our picks in this sector!

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