If you are investing in precious metals juniors, either through the Market Vectors Gold Junior Miners ETF (NYSEARCA:GDXJ) or through individual stocks, then undoubtedly you are investing in juniors listed on the TSX Venture.
The high risk, high reward profile in Canada is dominated by companies listed in the TSX Venture exchange - in particular, the junior mining sector with its higher-risk, less liquid, and more speculative member companies.
Under the current global economic and political environment, there will undoubtedly be periods of volatility leading to downside pressures.
While the first few months of 2011 were strong, the performance of the TSX Venture has been under extreme pressure since early March. It has been severely battered as risk aversion has strangled the equity markets. When flight to safety is the number one priority, the Venture is always going to get hit the hardest. In a market where liquidity has always been a concern, things can go real bad when money is pulled out.
But does that mean you should stay away?
Gauging the TSX Venture
Generally, the gauge for investor sentiment is the strength of an exchanges' daily trading volumes; in other words, liquidity. In the case of the junior mining sector, the strength of the TSX Venture volumes have been dwindling at an extreme pace.
In January 2011, the S&P/TSX Venture set a new record for daily-traded volumes - reaching a yearly and all-time high of over 600 million shares traded per day. Since then, volume has tumbled averaging below 200 million shares per day in the last few months. I consider this number to be the absolute minimum level of liquidity support for the TSX Venture. If the average traded volumes continue to dip below this number, we are going to see some rock bottom prices soon.
To get a better grasp of what's going on, let's look back at the Venture's history.
Predicting the Future by Looking at the Past
Over the last 10 years - but excluding the 2008 crash - typical corrections on the TSX Venture have ranged from 17-31%, with the longest correction lasting over a 19-week period. Based on rolling 52-week highs and lows, the Venture has seen a decline of 47% from March 7, 2011 to October 4, 2011 - a range of 28 weeks. This clearly shows us that this is not a typical correction.
The TSX Venture in its current state is now back to levels not seen for 8 years, when gold was trading just over $400/oz and the TSX Venture exchange was barely nearing its second anniversary.
To put the crash of 2008 into perspective, let's look at the previous bear runs of other junior exchanges in Canada, including the Vancouver Stock Exchange (VSE), the Canadian Venture Exchange (CDNX), and the TSX-Venture (TSX-V) since 1983.
The Venture's 80% drop in 2008 is the single largest decline ever in the 25 year history of any of the past Canadian junior exchanges. The biggest drop in the junior exchanges aside from 2008 was during the crash of 1987 when the junior market in Canada dropped 54% over a one-year period. So far this year, we have declined 47% over a 7-month period.
In 1987, the market was under pressure for nearly four years before a new upward trend was established. In 1996, following the Bre-X scandal, the market was under pressure for three and a half years. Luckily, in most other cycles of corrections, the markets recovered in just over one year.
Regardless, those numbers can be daunting. However, there is a bright side.
While additional market pressures are still on the table and Europe remains a mystery, there is a strong possibility that we could have a recovery in the junior sector despite the negative sentiment.
First of all, current low interest rates offer very few alternatives for deployment of capital. Just last week, I talked about how badly the world's largest bond fund has performed in this low interest rate environment (see Prepare for Upside).
Second, metal prices remain significantly above average historical prices. That means many mineral projects can be developed into high margin operations. As such, many of the juniors remain well funded, opening the potential for exploration spending to create speculative interest in new discoveries.
Third, balance sheets of the majors continue to strengthen and that means more potential for M&A activity, including takeovers of exploration and development companies. We have already seen it over this past year including last week's takeover announcement of Hathor by Rio Tinto - just one of many takeovers and consolidation attempts this year. I fully expect this trend to continue - especially given the current major decline in share prices for many of the juniors.
Last, but certainly not least, exploration capital continues to flow - unlike the climate in 2008 when a junior explorer couldn't even raise a few pennies to put something into production.
Last month, Metals Economics Group indicated that 2011 non-ferrous exploration budgets would exceed US$17 billion on expenditures related to precious and base metals, diamonds, uranium, and some industrial minerals; the focus of these expenditures on gold exploration with copper being second. According to MEG, this represents an increase of about 50% from the 2010 - setting a new all-time high. That means there is a lot of smart money being risked.
Record levels of exploration spending should drive new discoveries and strong reserve/resource growth over the next year, which should improve the equity valuations in the junior sector. This, along with high metal prices, should lead to a rebound in mining equities in the coming months if the overall equities market turns around.
What to Expect
For the rest of 2011, I will be adding my exposure to juniors that are associated with strong management and that have active exploration and development programs on top-quality targets/assets over the next 6-12 months.
Risk tolerance will continue to be a major factor in determining the junior mining sector market valuations. That means we should be aware of the potential macroeconomic factors (Europe, politics, China etc.) that help to shape broad investor risk tolerance.
That being said, I still believe that strong overall fundamentals (metal prices, low interest rate) underline the junior mining sector. If you have an iron-clad stomach, accumulating positions during corrective market phases could prove very rewarding.
Many of the stocks listed on the Venture have lost bid support. In cases and scenarios such as this, strong companies have been hit based purely on liquidity of the markets, as opposed to the business itself. When people pull their bids, stocks can drop really fast - but that also means that stocks can bounce back just as fast.
Until next week,
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I own stocks listed on the TSX Venture