Andrew Mickey: Are Markets Headed for a 25% Drop?

With anticipated GDP growth insufficient to sustain current market levels, Q1 Publishing's Founder and Chief Investment Strategist Andrew Mickey asserts that great expectations tend to lead to great disappointments. Although he's not foretelling a big crash, he tells Gold Report readers why it makes sense to expect the market to fall back to a fair-value level over the next six months to a year and there will still be plenty of opportunities for those in the right spot.

The Gold Report: In one of your recent articles, you suggest that even if good economic news continues coming out next year, the market is likely to drop 20% to 25%. Would you go through the logic that leads you to that conclusion?

Andrew Mickey: If we look back to the way the stock market has moved over the past 20 to 30 years, it has always been valued relative to earnings. The most common valuation for the market has 15 to 20 times the 10-year average annual earnings. That smooths out the up-and-down years and brings you to a fair valuation—with the S&P 500 between 800 and 1000.

Granted the stock market goes much higher and much lower than that—and can stay at an extreme for longer than most investors expect—but it always returns to its fair value.

Now that so many stocks have had a great run, the S&P is up to around 1050, which means it is overvalued. The market basically has a lot of positive expectations built in. Earnings estimates are starting to rise, although all CEOs are still trying to keep expectations low. Economic expectations are rising. Expectations for everything are rising and we've learned consistently throughout the years—great expectations usually lead to great disappointments.

So as long as GDP growth is low the market will fall right back to fair value. That's why, even with the big picture news getting better, the very real risk is that it's still insufficient to hold the S&P up at 1050, 1100, or wherever it eventually tops out.

We may not have an outright crash because everyone is still on watch, but probably a slow, steady fall over maybe six months to a year.

TGR: Are all sectors currently overpriced, or will some continue to appreciate?

AM: There will be some that will appreciate. But it won't be a case of great and greater returns like we've had. There is some great historical research done on the way stocks move. One important factor is the factors of market, sector, and stock. If you break it down, basically 50% of a stock's movement is usually tied the overall market. There's nothing you can do about that; it depends on the market. Another 30% of that stock's move depends on the sector. And the remaining 20% can be attributed to the individual company.

In other words, you can expect the initial impact across all sectors. We see it all the time when the markets go down. Just look at what happened last fall. Everything is very closely tied together. Over time though, there will be the divergence between the quality and value and all the speculative stuff.

TGR: How much focus should individual investors put on international investments versus North American-based investments in this environment?

AM: A lot of it depends on your time horizon. If you have five years or more, you can build a reasonable case for focusing 30% to 50% of your money in international stocks.

That's a very high concentration for any portfolio in any particular sector. If you're looking out that far, you definitely want to be in the emerging markets. In the short term, the falling dollar has been very helpful to some of the really large, high-quality U.S. companies.

But if we look at the massive U.S. dollar carry trade right now, we can see that is going to be driving everything. We watched the Yen carry trade last for about four years and then the credit crunch forcing the sudden unwinding of it. With the U.S. dollar carry trade, it is going be even bigger, could last even longer, and the when it is unwound, the volatility and fear even bigger.

TGR: In another of your recent articles, you said that junior gold stocks offer exceptional value because they're still in the relatively early stages of recovery. With gold up 30%, major gold stocks down 15%, and junior gold stocks down 60%, you asked, "Which one would you like to buy now?"

But with the greatest opportunities for appreciation, don't those juniors also present a correspondingly greater risk? If so, how do you minimize the risks of investing in juniors?

AM: There are two ways. The first is timing and picking the bottom, which is a very tough thing to do. The other is diversification; I'd recommend owning at least five to 10 across the board. In addition, you'd want to buy consistently. The way we see it, we'll be buying gold juniors for the next two years.

We don't want to exhaust all of our capital right away. It's a lot less stressful and you don't have to be exactly right to make a fortune.

Also, when they're still deeply undervalued on a relative basis, you don't have to risk nearly as much capital. So you could make 20% in big gold stocks, but you may have missed 50% to 100% in juniors. The juniors are riskier, but the amount of capital required to earn the equivalent nominal gains is less. Risk is always relative to a lot more factors than simple percentage moves, positions sizes are as equally important.

TGR: When you're looking at juniors, do you differentiate between current producers and near-term producers? Or JV models versus royalty companies?

AM: Most of our valuations are based on traditional metrics such as net present value of future cash flows for producers. Of course, once a company is producing and we know much gold it is producing, there's a clear way to value it through the cash flow model. That's how the big money values things, so that's how you have to do it.

If you really want to swing for something with just a little bit more upside potential, maybe you select a near-term producer. There's a lot more room to value them differently because as the big money managers continue to look at gold, they're going to have to come up with ways to value those stocks.

Think of it like the dot-com days. If a company had earnings, there was a way to value it traditionally. But if a company didn't even have a chance of being profitable, traders and investors would come up with all kinds of ridiculous ways to justify lofty prices and bid them up even more. That's why the worse a company was fundamentally, the better it actually did.

That happens in all euphoric bubbles. And when it does, it will feel great, but that's also the time to start taking money off the table.

TGR: Are any of those on your radar?

AM: One junior gold company I really like right now is in that larger junior tier, and that's Nevsun (NSU). The first two years it produces it will produce mostly gold, and then it becomes basically a copper-zinc mine in the out years. It's fully financed now with debt from European and South African lenders, and Nevsun is comfortable with building a mine in Eritrea, Africa.

So, that one really makes sense to me, and it's really doing well. The stock is $3 now, and the biggest risk I see to it, aside from commodity price risk, is that it gets taken out at around $5 or $6 before it realizes its full potential. In a market like this, that's a risk worth taking.

TGR: Most of those you follow are really exploration companies. Would you share some of those with us?

AM: One that has me really interested is Otis Gold Corp. It has a unique kind of deposit at its Kilgore Gold Project in Idaho. The early exploration results have been good mixed in with the occasional high-grade greatness, but I don't think the market completely understands what it may have at this point.

It's similar to past discoveries in Nevada in that it has small pockets of high-grade gold. Otis has discovered just one of those pockets so far, but that pocket has maybe 500,000 to 750,000 ounces of gold—and that justifies the current market cap of around $15 million excluding everything else.

It's fairly valued at that point if the company stopped all exploration right now and did nothing else. But if this is like the Round Mountain mine in Nevada, which also has pockets of very high grade gold in a large low-grade deposit, has already produced 10 million ounces and with almost 2 million ounces of reserves left.

You never know, of course, but at this point, the company is really cheap based on what is known and there's all kinds of potential. Since we start looking at things with a risk-first approach, we like the low downside mixed with the truly unlimited upside. The company's drilling. The results will be coming out over the next few months. And we'll soon have a better picture, which, at this point, can only add value to the company. It just seems like the right time.

TGR: So the market's basically only valuing the current pocket and there may be several more?

AM: That's what it seems like. There's no premium at all built into the exploration upside at this point.

TGR: You mentioned copper a bit earlier. We always hear about copper as the leading indicator of the market expansion, because building, construction, housing, electricity and durable goods are all very copper-intensive. Timber is apparently emerging as another such indicator, and not long ago, you referred to timber as "the next silver" in terms of its appreciation potential. Do you see timber's prospects greater than copper's?

AM: Copper demand and timber demand are both driven fundamentally by population growth, plain and simple. Where there are more people, they want more things—more copper demand. More people need more houses—more timber demand.

Over the long run, it really is that basic. During the housing bubble, timber shot up to $450 per 1000 board feet, and when the bubble burst, it fell two-thirds to about $150 just like almost every other commodity.

Now it's back up to the $180-$190 level now and still I can't find too many people remotely interested in timber.

It's not that I expect a housing bubble to return. I don't. But 660,000 houses are currently under construction in the United States. But just to keep up with average population growth, housing growth is pegged at 1.2% per year over the next 40 years. That means we need about 1.3 million more houses per year just to meet basic demand for new houses and replacement of old ones. That rebound would justify a lumber price of $250 to $300 per 1000 board feet. That's kind of the long-run average for timber and it'll rebound there over time.

But what timber has over copper is a supply problem that's potentially much more severe. This is caused in large part by the pine beetle infestation in North America. Over the last decade, the pine beetle has decimated the forests in British Columbia, and is now hitting the U.S., as far down as Colorado. Basically, the pine beetle has taken 20% of the future world timber supply off the market. Think about that in terms of other commodities such as copper or oil. If one-fifth of the supply went away, you know we'd see a big surge of demand. Once people start to figure that out, timber assets will really be worth something again.

TGR: Any other areas that interest you at the moment?

AM: As you may know, about 80% of manganese is used in steel production, but there's a new demand for it now in hybrid car batteries. If you like lithium and rare earths, you should look into manganese could be a big opportunity in manganese as well.

In that space, your readers may be interested in a company called Wildcat Silver Corporation. Some of the same people are behind one of our top-performing picks we found February, Ventana Gold Corp. (VENGF.PK). Ventana was actually spun out of Wildcat, which owns 80% of what is basically a silver/manganese deposit in Arizona.

There's plenty of exploration upside there, and Wildcat's net present value is about four to five times higher than its market cap. It's something with the right mix to do well, but it's not going to be one the biggest gold discoveries of the decade, so it will take a little bit of time.

DISCLOSURE: Andrew Mickey

I personally and/or my family own the following companies mentioned in this interview: Nevsun Resources, Otis Gold, and Wildcat Silver. I personally own shares in all of the mentioned companies. You've got to eat your own cooking.

I personally and/or my family am paid by the following companies mentioned in this interview: None.

Comments

[jrainspe]

As is every other comparison analysis, this one is based on someone's anticipation of what GDP will be in the future. NO ONE KNOWS, but historically, the government and 99% of all economists are very conservative when predicting recovery and future growth. And, the more serious was the previous downturn, the more conservative and doomsday all economists are. Really, a useless article.

2009 Nov 11 06:49 AM

[Ray Winter]

Thinking through scenarios offering potentially great returns is a worthy exercise but most people are looking for the more immediate opportunities.
The International Press reports that the H1N1 epidemic is now gaining a serious foothold in The Ukraine, India and Turkey and it will not be long before our own few cases become a full blown epidemic.
So buying stock in the vaccine producing companies has to be a near term no-brainer. Major producers, such as Glaxo Smith Kline and the other global players are always worthy of an investment consideration.

2009 Nov 11 08:49 AM

[User 283977]

I like the investment logic discussion... They are releasing a Jr Gold Mining ETF today.... that works right into the discussion about risk. Of course, you can't predict markets, but you can put yourself in a favourable position.

I think Ray Winter is absolutely correct. Swine Flu is a play that is happening now. Once again, knowledge in a category puts you in a favourable position. There is an investment group here on SA that actively tracks the Swine Flu play.

2009 Nov 11 09:57 AM

[tripleblack]

I would agree as to his estimate of the size of the correction coming, 20-30% (and 25% is right in the middle) has been my working idea for a while now.

2009 Nov 11 10:05 AM

[Mark Bern]

My favorite quote from the article:

"We've learned consistently throughout the years—great expectations usually lead to great disappointments."

We are just now beginning to hear a little negative here and there, but usually most data reported is still being spun with extremely positive expectations, IMHO.

2009 Nov 11 10:38 AM

[Mark Bern]

This quote from the article sort of sums up some of my greatest fears for the future:

"With the U.S. dollar carry trade, it is going be even bigger, could last even longer, and the when it is unwound, the volatility and fear even bigger."

The trigger will be interest rate fluctuations, IMO. The US is amassing a huge debt burden which it needs to financed. When the Fed begins to raise interest rates to continue attracting additional investment in Treasuries, the carry trade will begin to unwind. When will that happen? Well, no one knows for sure. But, the US is not the only developed country using debt to stimulate their economy and the competition for additional investment into sovereign debt could become intense. If that becomes the case, the pressure on interest rates will naturally be upward.

The Fed has been talking about not changing its stance until sometime next year, when the economy strengthens more. What happens if the economy doesn't strengthen adequately without additional stimulus? More debt? What does that do to the demand side for Treasuries? Too much supply of sovereign debt worldwide could push interest rates up. If it does, the carry trade will necessarily have to be unwound. And then the really scary part unfolds.

2009 Nov 11 11:53 AM

[FIFOkid]

AM I agree with your comments on Nevsun. Not too many large projects can generate enough cash flow to pay off the debt within one year.

2009 Nov 17 04:23 PM