One Step Closer to BottomOne Step Closer to Bottom
By Ben Abelson
13 Jun 2006 at 08:41 PM EDT
NEW YORK (ResourceInvestor.com) -- This week’s market action in all sectors, but especially the precious metals, has been nothing short of a bloodbath. After closing last week above the 300 level, the Amex Gold Bugs Index (HUI) has plunged another 10%, trading as low as the 270 level. It’s worth noting that this is some 20% below the level where we warned investors not to buy the then rebounding market. The metal itself has lost more than $80 in about a week or so to trade down around $560 at last glance.
While the stars aren’t quite aligned for a full-fledged bottom in the precious metals sector – and weeks of agonizing consolidation could be in order – now looks like a great time to start quietly accumulating some of the cheaper gold stocks on the market.
Trading Indicators
As regular readers know, the Gold/XAU ratio is one of our favourite valuation indicators for mining stocks. (A higher number indicates that the miners are undervalued relative to gold. A number above 5 often shows extreme undervaluation.) After dipping down the lower 4 level in last month’s bounce, the ratio has started to creep up again – trading up towards the 4.8 range recently.
While gold stocks aren’t as cheap as we’d like them to be quite yet, their valuations are again going in the right direction. If we see the metal itself begin to stabilize, while mining stocks grind somewhat lower, it’s a fair bet that we’ll start to see very attractive valuations for mining stocks within a number of weeks.
Source: Stockcharts.com
Capitulation
The large scale declines we’ve seen in the HUI index over the past two days have come at the end of over one month of severe declines.
Fast and furious drops like we’ve seen this week are typically representative of investor capitulation – the kind that comes when no buyers are willing to step in, and everyone’s selling as fast as they can.
This kind of decline was to be expected after Joe Sixpack started to buy into the metals complex, but lucky for us it’s often a signal of a coming trend change.
Gold itself declined by $40 in Tuesday’s trading session (for the largest percentage decline in some 15 years), echoing another classic capitulation signal, and again suggesting that the declines are nearing their end.
While we can’t definitively guess where the bottom in mining stocks will be, it seems likely that the move downwards is 90% complete. In fact, the HUI’s decline of over 30% since the early May highs is fairly average when compared to previous corrections in the mining stocks.
At 270, the recent lows in the HUI are extremely close to the indexes highs in the previous bull cycle (around 250/260, which were hit in both late 2003 and late 2004). Over the past several years, the mining indexes (both the HUI and XAU) have tended to follow the fairly predictable pattern of bottoming near a prior bull-run’s highs – suggesting that we’re very close to a bottom.
Source: Stockcharts.com
Finally, the HUI has broken down below its 200 day moving average. Again, this is pretty standard trading action for consolidations in the mining sector.
While some of the past declines have ended very close to this average, others have gone below it by as much as 20%.
With the moving average currently in the 290 range, this would suggest a maximum downside in the HUI of about 230 – or 15% below current levels.
Of course, it’s worthwhile to remember that the HUI’s 200 day moving average is still rising – so it’s more likely that by the time that the HUI finally hits bottom, the moving average could be more like 240 or 250, the latter being only 10% below today’s level.
While these indicators are by no means guaranteed, at the current level of the mining stocks, it’s a fair bet that we’re within 10% - give or take - of at least an intermediate term bottom in the mining stocks.
That isn’t to say that this is an ultimate bottom. For example, when the HUI bottomed in spring 2004 at around 175, it spent the next year climbing back up to the 240 level, before again declining back to 170 or so. But in the interim period, nimble investors were able to cash in significantly.
Since it’s unlikely that we’ll ever catch a bottom exactly, now looks like a perfect time to start digging into some of the cheaper mining stocks on the market.
Undervalued Gold Portfolio Holds Up Through Declines
Regular readers know that we tend to favour those mining stocks that look especially undervalued. This logic has borne fruit lately – since we implemented our model portfolio in November 2005, our gains (including recommended profit taking) measure nearly 40%. This compares with only a 7% cumulative gain in the HUI to do. Through appropriate stock selection and judicious profit taking, our portfolio has fared quite nicely.
Several of the stocks in our portfolio are looking attractive yet again for new investment. While I’m not making many “formal” additions to the portfolio, newcomers can look to the follow stocks for a starting point. Investors looking for additional background on these companies would also do well to search our archives.
Where to Start Shopping
While Golden Star [AMEX:GSS; TSX:GSC] has been an almost perennial disappointer, this stock is probably one of the cheapest mid-tier producers currently on the market. If they can get their BIOX process off the ground at Bogoso/Prestea and costs come down, this could easily be a $5 stock again. In any event, Golden Star is not for the faint of heart – be sure you know what you’re getting into before you invest.
If Nevsun [AMEX:NSU; TSX:NSU] works its way down toward the $2 range, this stock will be a must-buy. The political situation in Eritrea has calmed down a bit, and Nevsun will probably pop on the Bisha feasibility study due out in Q3. This could be the last chance to get in on the cheap.
European Minerals [TSX:EPM; AIM:EUM; OTCPK:EPMCF] hasn’t been able to recover from a slump that started back in the winter when it announced contracting problems with MDM Ferroman. Those problems are behind it, construction at Varvarinskoye is proceeding, and it now looks like the mine will be in operation by early 2007. With hefty reserves and 15 year life, look for European Minerals to receive an upward valuation boost as that date approaches.
It seems likely that management will announce amended financing terms for the mine construction shortly – once that milestone is achieved, some of the uncertainty will also be removed from the stock. At 70 cents, European Minerals is a flat-out steal, and is trading near 52 week lows. I will actually make a formal recommendation here that followers of our ‘model portfolio’ double their original investment (on a dollar basis) in this stock.
Kinross Gold [TSX:K; NYSE:KGC] is currently one of the cheapest large-cap producers on the market on price/net asset valuation basis. The stock has worked its way down some 30% from its highs, and currently trades no higher than it did at a previous peak several years ago. With the bulk of its accounting issues behind it, Kinross is very attractive in the current $9 range.
In the past, I’ve written up both Alexis Minerals [TSX:AMC; OTCPK:AXSMF] and Committee Bay Resources [TSX:CBR; OTCPK:CBYRF]. Both of these explorers have great land positions, and are trading at slim multiples to their in situ valuations. It’s worth dipping a toe in these waters – but be careful, both are highly volatile.
Goldcorp [NYSE:GG; TSX:G] is quickly becoming a key piece in the ‘crown jewel’ of mining stocks. The stock has outperformed in the recent bull run, trading up to $41 before getting shaved nearly in half. Following its massive charge upwards, Goldcorp has been correcting more violently than most other miners. Given this, it seems like the stock could get a bit cheaper – but if it goes down anywhere near $22 or so, buy with both hands. An investment is a great way to buy a “best of breed” in large-cap gold stocks.
Finally, if you fancy yourself an indexer, check out the newly listed Market Vectors-Gold Miners ETF [AMEX:GDX]. This exchange traded funded tracks the Amex Gold Miners Index – which itself has traded almost lockstep with the Amex Gold Bugs Index (HUI) for the past several years. This ETF is the best way to gain almost direct exposure to the HUI. With luck, options will soon be listed on the index, providing an easy way to add leverage or hedge existing positions.
Conclusion
Obviously, there are a lot of other quality mining stocks on the market that are in the process of correcting to tantalizing buying levels. While mining stocks are legendary for their volatile corrections, various indicators suggest that we are getting close to an intermediate bottom. If you believe in the long-term power of the current gold bull, then now is one of the best times in recent memory to buy into some of the market’s undervalued stocks.