The US Stock Market

Current Market Situation

We always try to avoid reading explanations of why the markets did what they did on any given day, but we couldn't help notice the headlines following yesterday's modest recovery in the stock indices. Apparently, stocks rallied as a result of a rumour that Microsoft, the world's biggest supplier of PC software, was going to pre-announce higher profits for this quarter. We thought this was quite funny since a) 2 months ago MSFT surprised the market by lowering its guidance for the current quarter, and b) Intel, the world's biggest supplier of PC hardware, just lowered its guidance last week. If Intel's business is worse than it was 2 months ago, how could MSFT's possibly be better? Is MSFT now forcing the PC manufacturers to install 2 copies of Windows in every PC?

MSFT's balance sheet is so strong and accounting regulations are so flexible that the MSFT senior management will be able to report whatever profit they want to report. It's just ridiculous to think that there has been a significant improvement in the PC business since last week when Intel lowered its revenue and gross margin forecasts.

From a technical perspective things are now getting interesting for MSFT (see chart below). In the latest Weekly Update we said that a rebound to $55 would present another good opportunity to buy put options on this stock. The stock closed at $55.54 on Wednesday and the January-2003 $45 put options are now back below $3.00 (they closed at $2.85). The stock is selling at 10-times sales and 40-times earnings, so the downside risk is huge from a valuation perspective. Now is a reasonable time to buy (the put options, that is, not the stock).

In the latest Weekly Update we included a decisionpoint.com chart that compared the NASDAQ100 Index with the NASDAQ100 volatility index. The chart emphasised that although the NASDAQ100 had moved down to near last year's low, volatility had not spiked higher. 

The following chart comparing the S&P100 Index (OEX) with the OEX Volatility Index (VIX) tells a similar story. Volatility has remained at a fairly low level even though the OEX is getting perilously close to last September's low. This provides further confirmation of our view that a plunge below the September-21 low is going to occur before this decline is over.

We haven't yet seen the sort of spike in volatility that would be associated with a major bottom and put-option volumes remain low (put/call ratios have been high but this has resulted more from a lack of call buying than from heavy put buying). However, there are some signs that sentiment is approaching a bearish extreme. For example, the Rydex Ratio, which measures the amount of money in Rydex bear funds relative to the amount of money in Rydex bull funds, has moved up to 0.93 (see chart below). In other words, there is now almost as much money in bear funds as there is in bull funds. As recently as January of 2001 there was only 9c in bear funds for every dollar in bull funds.

We still don't know the answer to the question: Will the market plunge immediately or will we get an intervening rally before it plunges? What we do know is that the trend is down and there is no evidence that the trend is about to change.

Gold and the Dollar

A Comparison of Gold Stock Valuations

Below is a rough and ready comparison of eight of the world's largest gold producers ranked in order of PE ratio (lowest to highest). Note that:

a) We've estimated production, revenue and earnings for 2002 based on information provided by the companies or by annualising the results from the latest quarterly reports.

b) The figures for Kinross Gold assume that the takeovers of TVX and Echo Bay have already been completed, that is, we've assumed that TVX and Echo Bay will make a full year's contribution to KGC's results.

c) Estimates are based on a gold price of $300

d) Since AEM is expected to show a large increase in production and a large reduction in costs during 2003 we've used, in this comparison, the projected 2003 production and the consensus 2003 earnings estimate for AEM.

e) The "cash costs" reported by companies can be misleading. For example, most of the large NA producers have consistently reported much lower cash costs than their SA counterparts yet the major SA producers have been far more profitable. For example, ABX has, over the past two years, generally reported a "cash cost" to produce an ounce of gold that is much lower than the costs reported by Harmony and Gold Fields, yet ABX would have made no profit over this period without the help of its hedge program. Harmony and Gold Fields, on the other hand, have been able to generate healthy profits even though they have sold all of their gold at the spot price. To get around this difference in accounting we calculate a mining company's cost to produce an ounce of gold as follows: We subtract reported earnings from reported revenue to get a total, all-in cost figure. We then divide this total cost by the number of ounces produced to get a cost per ounce. 
 

Name	Symbol	Recent Price (US$)	Market Cap (US$M)	2002 Prod (Koz)	2002 Rev ($M)	2002 Earnings ($M)	Cost per oz prod (US$)	Reserves (M oz)	Mkt Cap $ per oz reserves	Price/ Sales	Price/ Earnings
Harmony Gold	HGMCY	14.38	2,416	3,000	900	212	229	42	58	2.7	11.4
Gold Fields	GFI	12.48	5,866	4,324	1,350	392	222	83	71	4.3	15.0
Anglogold	AU	29.40	6,350	5,500	1,500	356	208	59	108	4.2	17.8
Kinross Gold	KGC	2.32	2,102	2,000	600	80	260	19	111	3.5	26.3
Goldcorp	GG	10.38	2,221	600	164	75	148	5	444	13.5	29.6
Agnico Eagle	AEM	15.33	1,272	400	120	40	200	4	318	10.6	31.8
Newmont	NEM	29.00	9,860	7,500	2,500	170	311	97	102	3.9	58.0
Barrick Gold	ABX	20.24	10,909	5,500	1,912	188	313	82	133	5.7	58.0

Below is the same comparison, but this time the estimates have been based on a gold price of $400. Once again the companies have been ranked in order of PE ratio. Note that we haven't accounted for the adverse effects that hedging will have on the earnings of ABX, AU and NEM if the gold price rises to $400. ABX's hedge book in particular will be a major detractor from earnings during a substantial gold rally. We also haven't accounted for the increase in reserves that would occur due to a higher gold price.
 

Name	Symbol	Recent Price (US$)	Market Cap (US$M)	2002 Prod (Koz)	2002 Rev ($M)	2002 Earnings ($M)	Cost per oz prod (US$)	Reserves (M oz)	Mkt Cap $ per oz reserves	Price/ Sales	Price/ Earnings
Harmony Gold	HGMCY	14.38	2,416	3,000	1,197	420				2.0	5.8
Gold Fields	GFI	12.48	5,866	4,324	1,796	704				3.3	8.3
Anglogold	AU	29.40	6,350	5,500	1,995	703				3.2	9.0
Kinross Gold	KGC	2.32	2,102	2,000	798	219				2.6	9.6
Newmont	NEM	29.00	9,860	7,500	3,325	748				3.0	13.2
Barrick Gold	ABX	20.24	10,909	5,500	2,543	630				4.3	17.3
Agnico Eagle	AEM	15.33	1,272	400	160	68				8.0	18.8
Goldcorp	GG	10.38	2,221	600	218	113				10.2	19.7

In both of the above comparisons Harmony is the clear winner. In fact, it offers the best value in terms of market cap relative to production, market cap relative to reserves, price relative to sales and price relative to earnings. This doesn't guarantee that the Harmony stock price will out-perform the stock prices of the other major gold producers over the coming 6 months, but it sure doesn't hurt.

The 1970s Road Map

There is no point in looking at what happened over the past 20 years as a guide to what is going to happen over the remainder of this decade. The secular bull market in financial assets that dominated the markets during the 1980s and 1990s has ended and new secular trends are emerging. Based on evidence gathered over the past two years these new trends will encompass a strengthening gold price and a weakening US$. As a result of the massive inflation that has occurred over the past few years and the requirement of the world's monetary authorities to keep the supply of fiat currency expanding at all costs, two other trends that will almost certainly become apparent as the current decade progresses are the trends towards higher interest rates and commodity prices. So, we think it is fair to say that the first decade of this century will have a lot more in common with the 1970s than with either the 1980s or 1990s. As such, in an attempt to develop some sort of road map regarding what we should expect to happen over the next few years it makes some sense to look at what happened during the 1970s. With this concept in mind we have, over the past several weeks, done a couple of comparisons between the rally in gold stocks that began at the major bottom in November of 2000 and the gold stock rally that began at the major bottom in January of 1972. 

The below chart shows how the current rally in the HUI (AMEX Gold BUGS Index) is proceeding relative to the great gold stock rally of 1972-1974. 

At this stage of the 72-74 rally there was a 3 month correction followed by an almost vertical rise. If a similar situation developed now we would see gold stocks drift lower into late-August and then rocket higher during the September-November period. Since gold stocks have been traveling in the opposite direction to both the US$ and the overall stock market a 3-month correction in gold stocks would be unlikely to occur unless there was a 3-month recovery in the Dollar and the stock market.

Multi-month counter-trend moves in the gold, stock and currency markets at this time would mesh almost perfectly with our original forecasts for this year (we forecast that the biggest downward moves in the Dollar and stocks and the biggest upward move in the gold price would occur during the final few months of the year). However, although a prolonged correction in the gold market would not be unusual given the preceding strength and the huge speculative long positions that will need to be unwound at some point, we can't envisage the stock market or the US$ beginning multi-month recoveries from current levels. As such, the odds favour the current correction in the gold market being considerably shorter than 3 months.

It is probably going to be over much sooner but we suggest keeping late-August in mind as a worst case end-date for the current correction in the gold market. This is a correction in an on-going bull market, but bull markets never make it easy for investors to hang on for the ride. Peter Lynch, one of the most successful mutual fund managers of all time, said that during the period when he managed Fidelity's Magellan Fund more people lost money investing in this fund than made money despite the fund's exceptional performance. This is because a lot of people would always jump into the fund after a period of high returns and exit after experiencing a significant draw-down.

Current Market Situation

Because it recently achieved a major upside breakout the silver market is currently a good gauge of the underlying strength in the precious metals market. In particular, if the current pullback in the silver price finds support at, or above, the previous resistance in the 4.75-4.80 range (we think it will), then all we are seeing is a normal breakout pullback that will soon be followed by a run-up to 5.80. 

The major gold stocks might have bottomed on Tuesday morning, but even if they did it is not reasonable to expect them to surge straight back to their late-May highs. The stocks were pushed sharply higher by momentum traders, most of whom would have been washed-out during the decline of the past 2 weeks. A period of what is commonly referred to as "backing and filling" is probably now required before the next rally begins.

Harmony Gold Mining traded as low as $12.15 on Tuesday and closed at $13.27 yesterday. This means that buyers at the current price are paying about 10-times earnings for one of the best-managed, fastest-growing companies in a growth industry. Although there are no guarantees that it won't become even better value in the short-term, investors who want to buy it but are waiting for even lower prices are really pushing their luck.

Update on Stock Selections

Below are charts of HGMCY and GFI. Both stocks tested their short-term up-trends earlier this week.

We were stopped out of 2 of our commodity stocks over the past few days, OXY for a 16% profit and CRU for a 23% loss. CRU's exit from the Portfolio is unfortunate because the company is probably going to report some good news relating to its Nalunaq gold project at some point over the next few weeks. C'est la vis.

Bob Moriarty at www.321gold.com recently posted an article that includes a few paragraphs about American Bonanza (TSX: BZA), a speculative gold stock that was added to the Portfolio last month. Here is the link to Bob's article: http://www.321gold.com/editorials/moriarty/moriarty060902.html
BZA is a highly leveraged play on the gold price, but anyone who wants even more leverage can buy the BZA warrants that began trading earlier this week (BZA.WT). The warrants expire in 2 years and the exercise price is C$0.15 during the first year and C$0.17 during the second year. With BZA trading at $C0.20 the warrants are worth around C$0.09. BZA can be likened to a call option on the gold price, so these warrants are like a call option on a call option on the gold price!

We've previously mentioned the Resolute Mining options that trade on the ASX under the symbol RSGO. They have 3 years to expiry, have an exercise price of A$0.80 and are a reasonable speculation at the current price of A$0.27.

Apex Silver continues to look good from both fundamental and technical perspectives.

LightPath Technologies (LPTH) looks horrible from a technical perspective, but looks great from a fundamental valuation perspective. The stock market is 100% about value, but over the short and even the medium-term there is often a large gap between objective value (what a company should be worth based on its earnings, cashflow, assets, management, etc.) and subjective value (what investors are willing to pay for the company). These gaps are always closed...eventually. LPTH will remain under pressure as long as the downtrend in the optical communications sector continues, but we expect the trend in this sector to reverse sharply higher at some point over the next few months. 

By the way, in order to take full advantage of the bull market in gold stocks you will need to be able to trade on the Canadian stock exchanges. Canadian stocks can be bought/sold from most countries, but not every broker provides such a service.