Bursting Asset Bubbles In Equities And Bonds Boost PM Sector Values

by: Emmet Kodesh

Rob Arnott has won six Graham-Dodd awards (named for Benjamin Graham and David L. Dodd) for excellence and innovation in Financial Analysis. He is chairman and CEO of Research Affiliates, which manages $150 billion. He recently suggested that last week's drop in the indices denotes systemic flaws rather than a pause in a cyclical bull run.

On June 18 Arnott made some points that I have been stressing for months: for one thing, the markets are addicted to debt. A sign of their fragility is that even a hint of ending "credit expansion" jolts trading from New York to Tokyo. Emerging markets and their currencies have been staggered in recent weeks by fears that QE will be reduced leading to rising bond yields and borrowing costs. The markets are "addicted to debt," Arnott adds, and disordered markets can push a stumbling economy into recession this year, not only in 2014.

Even when Fed comments give mixed messages, as occurred at the FOMC meeting June 18-19, commentators have fastened on the narrative of "tapering." This led to profit-taking and panic selling. Part of the sell-down the week of June 17 was due to fund managers locking in quarterly gains. Moreover, asset prices partly have been supported by share buy-backs funded with borrowed money. Now that borrowing costs are rising, debt-financed corporate buy-back of shares is dwindling. Still, despite all these factors there has not been a major correction since last November's 9.9% drop. This means the indices may have a harsher plunge ahead.

Market behavior during the week of June 17-21 saw asset bubbles leaking while rising bond yields threaten real estate and expose the dead-end of Fed policy. Doug Short writes of a "long overdue price discovery" process and correction in the markets. He points out that 3Q 2010 saw a 15.9% correction in the cyclical bull and 3Q 2011 a 19.3% correction. The 9.9% drop in May 2012 was double the 4.85% sell-off since the indices peaked May 21. Steadily increasing sovereign and individual debt and increasing ex-USD trade agreements suggest that a 7.6% drop like that or last November, or worse, is likely.

Most classes of bonds, high yield (NYSEARCA:JNK), short (NASDAQ:VCSH), long (NASDAQ:VCLT) and intermediate term (NASDAQ:VCIT) investment grade made their 52-week lows a year ago between June 21-6, 2012, a year ago. Looking at charts since 3Q 2010 show that we are at an important annual inflection point. If you have not already pared your bond holdings, do so unless their asset prices hold. If they begin to recover you might find the rise in yields appealing. Dr. Marc Faber believes that bonds, like gold are "very oversold." But stability in bonds is unlikely given the vagaries and scale of Fed involvement in this sector and because foreign sovereigns are selling off T-Bills. We are about to reap the whirlwind sown by massive Federal debt creation (QE).

Each of the past three months have seen smashes in the PM sector, bullion and the miners and streaming companies, like Silver Wheaton (SLW) tied to them. Both SLW and gold royalty company Franco Nevada (NYSE:FNV) made 52-week lows Friday before recovering to end green. Indeed, nearly every significant PM miner, large cap like Goldcorp (NYSE:GG), mid-tier like Eldorado Gold (NYSE:EGO) or small cap like Vista Gold (NYSEMKT:VGZ) touched new 52-week bottoms Friday. Short positions have been covered and banks and major players now have large net long positions as discussed by Tekoa da Silva here. Trading strategies trump fundamentals but the PM (precious metals) market seems poised for a meaningful uptick.

Award-winning geologist and investment strategist Keith Barron urges people not to be shaken out of their PM holdings. A divergent case is made by Carl Swenlin who notes that the moving averages for spot gold are in a "negative stack" with the 20-day average below the 50-day, which in turn is below the 200-day moving average. With strong hands active in this sector and trends looking negative, it is difficult to call a bottom above $1000 though values are compelling and systemic fiscal and economic problems suggest that the move toward a new world reserve system is underway. The PM sector is as oversold as equities are overbought even after last week's decline. For example, Dr. Marc Faber says that "the S&P could drop 20-30% from its recent high, easily." The 3Q 2010 correction is a recent precedent for his assessment. Conversely, PM buying in Asia was still at record levels as June began and U.S. retail demand is high.

I hope you have not panic sold your PM miners because on the other side of their YTD collapse is significant upside. Many people may not be able or willing to add to holdings in this sector: if they have been investing in it for the past 10 months or more they may have had enough and are hard-put simply to wait out the storm. This is why I have suggested that a significant portion of one's PM mining holdings should be used as trading vehicles. But for newcomers, those who consider themselves underweighted or those who have ample income streams a chance to buy SLW at $20, Barrick Gold (NYSE:ABX) below $18 and Goldcorp below $26 is inviting. They pay dividends ranging from 2.41% to 4.82 and the reserves of ABX and GG insure dividend continuance. GG has no short term debt and a tiny debt/equity of .1. It is rated "Strong Buy" at nasdaq.com with a target consensus of $38.25, 60% above its current price.

Take ABX as an example of value since sentiment toward it has been singularly negative all year. Barrick's reserves in Nevada, Montana and at Pueblo Viejo in the Dominican, where issues were contractually resolved six weeks ago, are immense: 59.5 million oz proven and probable gold reserves with 3 million oz produced / year in Nevada alone where ABX has eight sites. Even assuming a depressed gold price of $1000/oz Barrick's North American reserves alone amount to $60 billion, three times its current, depressed market cap. Its producing sites at Lagunas Norte in Peru and Veladero in Argentina add another 16 million oz proven and probable reserves or $16 billion at $1000/oz estimate for gold. The all-in sustaining cash costs at the North American ABX sites are about $750/oz while in South American they are about $900/oz. This is the context in which to consider its $14 billion total debt. One also might note that Barrick's debt to equity at .64 is less than a fourth that of General Electric (NYSE:GE). The sectors and scale of operations are incommensurate but the comparison helps reveal the extent of Barrick's under-valuation. Major firms at nasdaq.com give ABX a consensus price target of $29, nearly 80% above the June 21 close at $16.89.

Estimating Barrick's Western Hemisphere reserves at $76 billion (on gold at $1000/oz) assumes zero income from the Chilean side of Pascua Lama. I believe operations there will go forward in 2015 after environmental issues are addressed as the new on-site Chilean management team irons things out with the government. Still, the relative strength and reserves of its North American operations invite suggestions from some fund managers for Barrick to split itself along regional lines. ABX does not favor this recent suggestion though it is interested in divesting some of its Australian mines.

In the junior space, acquiring shares in McEwen Mining's (NYSE:MUX) sites in Mexico and in Argentina for under $2.10/share is like getting a new Subaru Outback for $5k. MUX has a high quick ratio (3.2) and no debt. On Friday it was one of very few companies in the PM sector that remained well above its 52-week low before rebounding 9.14%. Eldorado Gold, a mid-tier with excellent properties has no short term debt, cash and cash equivalents 35% greater than its long term debt and a quick ratio at 3.8. In late trading it recovered 1.49% off its June 21 morning low.

When there is a bounce back from last week's sell-off, increase your allocation to cash. If Consumer Staples (NYSEARCA:VDC) and Health Care (NYSEARCA:VHT) continue to slip until they have re-traced 10% from May 21 highs, next quarter you might re-enter them a bit. If you have not yet done so, pare your bond holdings: you always can re-enter after plunging net asset values stabilize. The next 12-18 months are likely to be volatile and potentially disastrous: with foreign sovereigns dumping T-bills the Fed is losing some control of bond markets.

Bear in mind Dr. Philippa Malmgren's warning that the relation between the governed and their governors is being re-fashioned. If you do not wish to be managed for the benefit of the strong hands, consider buying a mixed-use farm or a company that invests in these basic goods. Like Marc Faber, Dr. Malmgren also suggests that it is prudent to buy physical gold (NYSEARCA:PHYS). "A gold-backed yuan" she remarked June 5, "is increasingly a sensible idea." Her view complements the formal policy proposal of the Official Monetary and Financial Institution Forum for a multi-currency reserve system pegged to gold.

To achieve all these goals consider Sprott Resource (OTCPK:SCPZF) managed by billionaire asset manager and bullion magnate Eric Sprott. SCPZF owns 9-94% rights in four oil & gas production, drilling and exploration companies, two agriculture and two crop nutrient (phosphate and potash) properties plus its wholly owned $75 million in gold bullion, about 20% of its total holdings. SCPZF, bullion prices and most PM miners recovered a bit June 21 while nearly all commodity, basic material and industrials again were hammered. Its 11% dividend is paid monthly and at $3.50 it offers an attractive entry point.

Those with a positive income stream should consider the major industrial commodity silver which YTD is the heaviest hit and best value in the sector. Having been crushed below $20/oz. for reasons tied to monetary and geopolitical issues, now is a time many could enter via physical-metal vehicles like Sprott Physical Silver (NYSEARCA:PSLV). Those who buy cautiously and are patient are likely to be rewarded, perhaps very richly rewarded as Drs. Faber and Malmgren suggest.

Disclosure: I am long EGO, GG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I own PM shares in two mutual funds.

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