Tuesday, March 27, 2012

Hidden Strength Showing in Small Mining Shares, Part 1

• But one might have to know where to look for it.
• CDNX outperforming the HUI a “tell?”    

HOUSTON (Got Gold Report) – From the Chart Book. Below is a kind of busy chart at first glance, but after a little study it opens a window into why we happen to believe that the smaller, less liquid and more speculative miners and explorers are beginning to show hidden strength, are at uncommonly low relative prices presently and therefore may be accumulated opportunistically.  Much more after the chart.

20120327-gold-HUI-CDNX

If any of the images are too small click on them for a larger version.

 
The Little Guys, as we refer to them, are represented in the comparison chart above by the Canadian Venture Exchange Index or CDNX (in pink tied to the left axis).  The larger, better funded and more liquid miners are represented by the AMEX Gold Bugs Index or HUI (in purple) and both indexes are compared to gold metal (black and red, tied to the right axis).

Great fear of worldwide banking collapse Armageddon in 2008 followed by even more fear of a European banking collapse and sovereign debt default in 2011 was enough of a one-two punch to bleed tons of liquidity out of the junior resource market, especially anything considered speculative or risky.  It’s tough to be a small resource company (SRC) stock these days.  Tough today, but our view is that it won’t be that way forever.

(This offering is in two parts. Part 2 will be added to the blog in the near future.)  

Part 1 continues…

 
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Beaten, Bloodied, Poised for Recovery

Over the past four years investors/speculators in the junior miners have seen the market endure the worst-ever plunge and liquidity purge ever (2008), followed by the second worst plunge and liquidity evaporation ever (2011).  It is therefore no wonder that people are loathe to take a chance with the small miners and explorers, but we intend to make the case that the terribly fearful crisis aftermath condition today is a huge argument that we should be accumulating our “Faves” in the junior space opportunistically.  Our view is (and we think should be) that it makes economic sense to be taking advantage of this protracted negative liquidity event (NLE) to build meaningful positions in a small collection of promising miners and explorers. (Provided one has the patience and tolerance for volatility required. More about that in Part 2.)

 
Remember when the smaller mining shares outperformed the big miners?  We can see that they did in the above graph right up to just before the Lehman bankruptcy in 2008, but they haven’t since.  There has been enough fear to keep SRC investors/speculators wary and on defense since then.  Apparently “all it took” to do that was the prospect of a worldwide banking collapse and maybe fear of end of the world as we know it.

Right, but the end of the world as we know it was at the very least postponed… 

Let’s make a few casual observations about the chart above. First, since the chart began in 2002 gold has advanced roughly 450% (performance indicator at top). The HUI has advanced about 380% (performance indicator at bottom).  The CDNX?  A dismal 32% higher than the beginning of the chart (performance indicator above the HUI).  Can we say that The Little Guys have underperformed both gold and the HUI? 
 

Yes, dramatically so. The CDNX is only marginally better than the S&P 500 Index over the same period (SPX +23%).   

Next, notice, please, that although there were periods of divergence and convergence (moving away from each other or toward each other), the action of the HUI and the CDNX were pretty well correlated from 2002 to 2007.  Generally speaking if one was rising, so was the other and vice versa.  During that period the CDNX was generally outperforming the HUI.  Now notice, please, that in late 2007, as the HUI moved higher strongly, the CDNX utterly and completely failed to “answer” the Big Miners.  By early 2008 the two indexes had converged just before going vertical, nearly straight down in the terrible, bone-crushing 2008 Panic.

We want to highlight and call attention to that failure of the CDNX to answer the HUI to the upside in 2007 as a blatant “tell.”  The CDNX was trying to send us a signal then, a warning.  As if saying, “Something isn’t right, I feel a great disturbance in The Force…” (with a nod to Obi-Wan Kenobi).   

That’s one of the reasons we track these indexes in ratios at Got Gold Report.  By doing so we can sometimes tune in to the signals the market is trying to send us.  Having said that, the signals are not always so crystal clear, and when there are obvious anomalous divergences it can be difficult to know which branch of the bifurcated signals to listen to. When there are two possible but opposite signals coming from a ratio divergence, we need more data or time (or both) to know which is the correct signal.  Sometimes the best we can say is that we know or suspect there is something a kilter, but we don’t know what exactly – yet.  

  
HUI Does not Confirm CDNX Drop in 2011

Now consider that we have kind of the opposite condition unfolding before us today.  Notice, please, that the terrible sell-down of The Little Guys in 2011 was not “answered” at all by the larger mining shares in the HUI. While the much more sensitive to fear/danger CDNX (pink) careened lower into its second worst correction ever (-47%) – while gold actually traded higher to new all time highs at one point, the bigger miners tracked more or less sideways.  Correlation be darned. From about February to October was one of the largest divergences (if not the largest) between the two indexes (HUI and CDNX) in their entire history. 

(For convenience here is the same chart so that folks don't have to scroll back and forth.)

20120327-gold-HUI-CDNX

We can visually see that there was a huge divergence between the CDNX and the HUI in 2011 just by looking at that chart above.  The Little Guys were getting tossed overboard with abandon but the larger miners were more or less holding their ground.  That led to some of us wondering which one of the indexes was “right?” They both couldn’t be right.  Either the CDNX was right in heralding a coming plunge in the Big Miners (and maybe gold), or else the Big Boys were telling us that The Little Guys were being irrationally sold off to extreme levels. Look at that chart! What is wrong with that picture? … he asked emphatically.

Well, what is “wrong” is that the CDNX blew out its correlation to the HUI, that’s what.  And, forgive us for being adamant about it, but take a good look at what is happening just since that October 2011 “bottom” for the CDNX.  The enormous divergence between the HUI and the CDNX is beginning to contract or converge.

Yes, the HUI has been moving a little lower but the CDNX has been moving up to meet it at a faster relative pace.  (See it in the chart above and own it, before moving on.)  

It may not feel like the smaller miners are outperforming – yet – but we don’t have to rely merely on a visual reference to confirm what our eyes can see in the cart above.  We can chart the relationship itself as shown in the chart below.  This is a performance comparison ratio of the CDNX and the HUI.  When it is rising the smaller miners in the CDNX are outperforming their larger cousins in the HUI on a relative basis.  Conversely, when this ratio is falling The Little Guys are weaker than the Big Boys. 

20120327-CDNX-HUI-Ratio
  
(CDNX:HUI Ratio)    

There is no question, looking at the graph above, whether the two indexes have been converging or diverging.  There is no question that from about February of 2011 to October, that the CDNX was underperforming the HUI in dramatic, historic fashion. 

But now hear this:  There is also no question that in October that underperformance paused and since December the CDNX has actually been outperforming the HUI.  Yes, we could “see” that in the first chart, but here we can quantify and measure it with little doubt. 

 
And that brings us back to the important part.  What does it mean? 

Well, one thing it might mean is that the sell down for the smaller miners in 2011 was indeed irrational or unwarranted, and now the market is in the beginning stages of correcting that imbalance.  The other side of that gold or silver coin is that it also might mean that the HUI has more downside “work” to do in the short term in order to square the CDNX:HUI relationship books, so to speak. 

Here at Got Gold Report we find ourselves leaning heavily in favor of the former (the 2011 sell-down for the CDNX was irrational, motivated by fear), and we will make one important point (of several we could offer) why we think so.  That is simply that today the CDNX is trading at about the same level it did back in 2003; back when gold was struggling to get up to and through USD $450 and silver was trading below $5 an ounce. 

The chart just below is the CDNX by itself, monthly, going back to the beginning of the Great Gold Bull market in 2002. Notice, please, just a couple of points (this time).  See the circle on the right hand side and the black horizontal line going across to another circle on the left hand side, in 2003?  The line marks the 1,575 level, about where the CDNX closed on Tuesday, March 27, 2012.  Notice that the CDNX first crossed that line in 2003, nearly nine years ago.  Nine years ago!  Gold was more than $1,200 the ounce cheaper and silver about $27 the ounce cheaper then.   What is wrong with this picture? 

20120327-CDNX-longterm

(CDNX since 2002, monthly.)

 
So in summary, one reason we lean toward the idea that the CDNX is more likely to converge with the HUI by moving higher, is because the CDNX selloff was very likely irrational and unwarranted.  Motivated by fear and reinforced by the cascade effect, the CDNX has had a tremendous amount of liquidity squeezed out of it.  So much so that the CDNX is trading at a fear-discounted bargain level. 

Could it go lower still?  Sure, you bet it could, but should it go a lot lower from here?

 
We don’t think so, not with gold sporting a $1600 handle and silver in the $30s. To the contrary; the charts above suggest that the CDNX is quietly beginning to close the gap with the HUI, even if that gap-closing convergence has not caught on with the fearful SRC gamers – yet.  As of now the latent strength of the smaller miners is hidden except in relative comparisons. 

The fact that the HUI failed to “answer” the CDNX by moving strongly lower in late 2011 is, in our view, the best argument that the CDNX will now correct back up toward the HUI more than the opposite.  And, we could also make a pretty good case for the HUI not only continuing to hold its ground but advancing itself (with perhaps another bear trap like the one in 2007 first – just to keep us all guessing)  … but that’s another story, for another time. 

Is it just too simple a notion to be true?  Is it too simple to say that The Little Guys ought not to be trading at the same level they did with $450 gold?

 


Is it too simple to suggest that most of the liquidity than can be wrung from the small miners has already been so wrung? 

 
And does that mean that the nasty, fearful negative liquidity event (NLE) of 2011 really has already come to an end, now, in 2012? 

We think so, give or take, say a 5% to 10% contingency absent some exogenous surprise, of course.  We’ll see soon enough.


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(End of Part 1, stay tuned for Part 2, which will be posted in these pages in the near future.) 

Part 2 now available at this link:  http://www.gotgoldreport.com/2012/03/hidden-strength-showing-in-small-mining-shares-part-2.html 

Edit to add the current HUI daily chart showing the Falling Wedge break attempt and possible bear trap unfolding. 

20120327-HUI-1yr

To continue reading Part 2 of Hidden Strength Showing in Small Mining Shares click here

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The Original
Vulture Speculator

Trading gold, silver and mining shares since 1980 with a focus on taking advantage of volatility extremes, Gene Arensberg analyses the markets through a basket of technical and fundamental indicators and shares his findings from time to time here at Got Gold Report. Mr. Arensberg has been quoted in the Wall Street Journal, Dow Jones MarketWatch, USA Today and dozens of other news organizations.

"I've been a huge fan of Gene and his amazing work for years..."

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