Sunday, October 12, 2014

Warning: Market Correction This Week… Did You See the Opportunity?

1000 frank holmes
Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors, writes:

While stocks fell around the world this week amid growing concerns over global economic growth, Europe’s slowdown can’t stop emerging market population growth that drives long-term commodity demand. If the short-term market volatility concerns you, a solution is short-term tax-free municipal bonds. Check out the 5 Reasons Why.

Putting Capital to Work in Commodities for the Long Term

This week we saw a continued selloff in energy stocks and a slump in commodity prices, specifically oil. In light of this, I’ve highlighted some key points I made during last week’s webcast that might offer our investors some clarity and insight into our management strategy when such market nervousness occurs.

One of the main drivers of commodity demand, as I often point out, is PMI, or purchasing managers’ index:

PMI: Commodities’ Crystal Ball

You look at the stock market as a precursor to economic activity six months out. If you’re looking at commodities, you must be looking at PMIs.

JPMorgan-Global-Manufacturing-Purchasing-Managers-Index

What our research has shown is that there is a 60- to 80-percent probability of commodities and commodity stocks rising when the global PMI’s one-month reading is above the three-month trend. When its one-month is below the three-months, there is a high probability of these sectors and stocks falling over the next six months.

Commodities-and-Commodity-Stocks-Historically-Rose-Six-Months-After-PMI-CrossOver
click to enlarge

The global PMI reading is a composite of each country’s unique PMI. So we look at individual countries and try to gauge what their monetary and fiscal policies are going to be. These government policies have a high correlation to commodity demand, which is significant to resource investments.

 

Brian Hicks

 

Brian Hicks

Brian Hicks, portfolio manager of our Global Resources Fund (PSPFX),stepped in to share his thoughts on the resources sector, devoting special attention to the recent performance of crude oil.

Despite the recent selloff, I believe it's actually an excellent time to be looking at resource stocks and energy stocks in particular.




 

The Polarity of the Dollar and Crude Oil

The following chart mathematically depicts the oversold nature of crude oil:

Year-Over-Year-Percent-change-oscillator-SP1500-Energy-vs-US-Dollar
click to enlarge

The dollar is significantly overbought relative to crude oil. The dollar is up almost two standard deviations, crude oil down almost one standard deviation. History has shown, whether it’s in 2011 or 2012, that this has been a good time to buy crude oil.

Natural Resources Stocks Priced to Move

Another factor that gets me excited about these energy stocks and natural resource stocks is the metrics that we’re seeing from a fundamental standpoint. Looking at the top 50 holdings for our Global Resources Fund, what jumps out immediately is just how cheap these stocks are relative to their growth rate, trading at 20 times in the last quarter earnings. Sales were growing at over 20 percent.

Global-Resources-Fund-Portfolio-Construction
click to enlarge

These companies are very profitable, generating return on equity of 25 percent, paying a dividend yield on average—about 2.7 percent—and growing that dividend at about a 30-percent click. And as you can see, these stocks have outperformed the S&P 500 Index so far year-to-date (YTD), even with this pullback.

A Thirst for Oil

Looking at global oil demand, you can see it’s been unrelenting through recessions, through bull markets, bear markets, and it looks like it’s going to continue to go up at a fairly steady level based on latest data from the U.S. Energy Information Administration (EIA).

Global-Oil-Demand-Reaching-New-Highs
click to enlarge

Below is a very important point to consider. Where oil prices are now, we’re getting to the area where production could be cut off because prices are not high enough to incentivize new development, new production and new drilling.

Asset-Class-Returns
click to enlarge

If you look at crude oil price somewhere in the area of $80 to $90, we have about 650,000 barrels per day of production that need to be supported at that particular level. So we really can’t go too much lower in terms of pricing. Otherwise, we would see a significant drop in the supply of oil.

Just to give you a sense of the scale here, we’re expected to grow demand by one million barrels per day, and we have 650,000 barrels that need an oil price north of $80.

Pricing Black Gold to Stay in the Black

Another significant factor is the price that’s necessary for countries that produce crude oil or export crude oil out of the Organization of the Petroleum Exporting Countries (OPEC) or non-OPEC.

Producer-Country-Budget-Breakeven-Prices
click to enlarge

On average, you need to see $95-per-barrel prices in order for these countries to balance their budgets—their fiscal budgets. What really sticks out is Russia and Saudi Arabia. They’re the two largest exporters of crude oil and, as you can see above, Russia requires an oil price north of $100, Saudi Arabia right at about $95 per barrel on a Brent basis, and we’re below that number now.

The next OPEC meeting is in November. I would be surprised if we did not see another production cut if oil prices remain at these levels. I think that OPEC and the Saudis need to come in and support prices even more so than they already have following the cut in August.

U.S. Gushing Oil

One area that’s been very topical and interesting as of late is the growth in U.S. crude oil production. It’s at a new 25-year high.

US-crude-oil-production-at-25-year-high
click to enlarge

We’ve gone from basically 4.5 million barrels in 2008 to 8.5 million barrels. Energy stocks are no longer just the commodity play. They’re also a volume growth play.

You can see this paradigm shift in that many of these shale producers have gone out and invested a lot of capital over the years and now, over the next two years or so, we’re going to start to see a free cash flow payback on that initial investment and infrastructure in fracking and developing their resource.

US-Oilfield-Cash-Flow-and-Capital-Expenditure
click to enlarge

Because they’re going to start seeing free cash flow, I think there’s the potential we could get a rerating in multiples to that cash flow. Instead of trading four to six times, maybe we trade higher, somewhere between seven or eight times due to that positive free cash flow metric.

Commodities: A Value Play

Commodities have way underperformed other asset classes, bonds, U.S. equity, and we feel like this is where the value is at. This is the area where you can put capital to work for the long term and outperform, whereas some of the other areas such as in bonds or U.S. stocks may not perform as well.

Asset-Class-Returns
click to enlarge

 

There are pockets of strength within the commodity sector where I think we will see companies profit and do well. On the whole, given this pullback, I’m very optimistic about resources going forward.


No Faith in the G20 Central Bankers

Frank-Holmes-New-Orleans

This weekend the finance ministers and central bank governors of the world’s top 20 economies will meet in Washington to discuss, among other issues, Europe’s weak economic performance. The region, whose sluggishness has negatively affected the global market, is at risk of dipping into its third recession since 2008.

I have no confidence that this body can persuade Europe to act sooner rather than later to dig itself out of further economic hardship. As I’ve observed in my global travels, the G20 central bankers are not interested in promoting and facilitating trade among nations. Instead, they’re interested foremost in levying more taxes and imposing more regulations that actually impede international trade.

It’s Economics 101: Capital cannot be spurred or created with high taxes and strangulating regulations.

European Central Bank President Mario Draghi assures the media that the eurozone will recover soon, but as we wait, the region continues to underperform and drag the rest of the markets down with it. European growth in the second quarter was flat, and this quarter doesn’t look as if it will fare much better. France’s manufacturing sector has steadily contracted. Over the last 12 months, it’s seen only two PMI scores above 50, which would indicate expansion. Even usually-reliable Germany, the eurozone’s largest economy, is in the midst of a downturn.

The U.S. has been gradually recovering from its worst economic period since the Great Depression, and to continue this progress, we need strong trading partners. Investors have become impatient waiting for Europe to get its fiscal act together and stop trying to rationalize even more taxes and regulations.

If it weren’t for the U.S. and Canada propping up the rest of the world, Europe would likely be in a more depressed state than it already is. 

Speaking of Canada: I want to wish all of my fellow Canadians a Happy Thanksgiving!

Gold Market

For the week, spot gold closed at $1,223.09, up $31.74 per ounce, or 2.66 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 0.24 percent. The U.S. Trade-Weighted Dollar Index fell 0.90 percent for the week.

DateEventSurveyActualPrior
Oct 09

US Initial Jobless Claims

295K 287K 288K
Oct 15 Germany CPI YoY 0.8% -- 0.8%
Oct 15 US PPI Final Demand YoY 1.8% -- 1.8%
Oct 16 Eurozone CPI Core YoY 0.7% -- 0.7%
Oct 16 US Initial Jobless Claims 290K -- 287K
Oct 17 US Housing Starts 1005K -- 956K

Strengths

Despite Dollar Strength, Gold Market Appears To Have Strong Support at $1,200
click to enlarge

  • After the one-week holiday, Chinese consumers returned to the gold markets. Gold futures rose this week as many anticipate the Chinese will take advantage of lower gold prices. Indeed, gold seemed to withstand recent decreases in oil prices as well as increases in the dollar, implying that many investors are taking advantage of the bargain prices. On Friday, the Bank Credit Analyst highlighted that gold prices are unlikely to break down after successfully bouncing off support at $1,200 and are poised to stage a relief rally into the end of the year.
  • Franco-Nevada Corp. has entered into an agreement with Lundin Mining Corp. to acquire a gold-silver stream. Lundin recently purchased an 80-percent interest in Freeport-McMoRan’s Candelario/Ojos del Salado mining complex in Chile.
  • There was a significant amount of positive news from many companies this week. Balmoral Resources Ltd. reported that its drill results revealed a higher-grade potential at its Martiniere property. Romarco Minerals, Inc. received its awaited 401 Water Quality Certification for its Haile project. Lastly, Richmont Mines raised its gold output view to 85,000-90,000 ounces, claiming strong performance from Island Gold mine.

Weaknesses

  • This week, Deutsche Bank recommended shorting gold due to the strong dollar environment. 
  • A continuation of the prevailing socialist model in South America, Chile’s Supreme Court granted a petition by the Diaguita communities to overturn a resolution to develop the El Morro gold-copper project joint venture (JV) in Chile. This is the third time Goldcorp’s El Morro project has been suspended in three years.
  • This week Luna Gold established a special committee of independent board members to look into strategic alternatives. The stock tumbled as much as 30 percent on the news.

Opportunities

  • Multiple opportunities relating to the Swiss National Bank Gold Initiative:
  • Switzerland has decided to hold a vote on the initiative, which would force the central bank to hold at least 20 percent of its assets in gold. The initiative, scheduled for a November 30 vote, would forbid the sale of any holdings and require them to be held in Switzerland.

Despite Dollar Strength, Gold Market Appears To Have Strong Support at $1,200
click to enlarge

  • If passed, the Swiss National Bank would have to buy roughly 1,500 tonnes of gold over five years to meet the 20-percent requirement. Since 1993, the Bank has reduced its gold holdings by 1,550 tonnes, the largest liquidation by any central bank. Changing from the largest seller to a rapid buyer should create serious tailwinds for gold.

Despite Dollar Strength, Gold Market Appears To Have Strong Support at $1,200
click to enlarge

  • The initiative put forth in Switzerland is part of a larger theme relating to increased gold purchases by central banks. Global central bank reserve holdings had been declining without interruption since 1989 until the financial crisis. Since 2008, there has been a steady rise in central bank gold holdings. With the possibility of substantial purchases from the Swiss National Bank, this rise should continue.

Threats

  • This week, BMO Capital Markets, Morgan Stanley and ANZ all reinforced their negative outlook for gold prices. While this consensus is negative, such wide consensus agreement usually coincides with a reversal in the going trend.
  • The World Gold Council is calling on India to mobilize and monetize its household savings imbedded in physical gold stocks. If the Indian government decides to use the idle gold from households and temples, it would reduce the need for future imports, which would be negative for global gold demand.
  • Uncertainty from residents of the Mokopane area in the northern Limpopo province of South Africa is threatening to hold up Robert Friedland’s platinum project. The billionaire promised the residents a 20-percent stake in the project, but the residents remain unsure of the exact method of repayment for the project.

October 10, 2014 (U. S. Global Investors)

http://www.usfunds.com/investor-library/investor-alert/#.VDqj4PldXYg


Comments



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..."

Brien Lundin, CEO, Jefferson Financial, Host of the annual New Orleans Investment Conference and Publisher of Gold Newsletter


Contact Us