Bait and Switch
From the September 28th, 2016 HRA Journal: Issue 258
We didn’t have nearly the excitement I was hoping for during September. A few companies got big reactions to their drill results but they were negative more often than positive. Reporting also wasn't as quick as I’d hoped in many cases. The silver lining there is that we are still holding a number of lottery tickets and waiting to see if our numbers will come up.
The Fed ducked yet again, to the surprise of very few. That hasn’t helped gold prices as much as I would have expected. Traders in the larger markets seem to have gone “risk-on“ again very quickly That didn’t work too well the last couple of times. We’ll see if the third time is the charm.
Concerns held by many about the need for new free trading placement to be absorbed by the market has been borne out. Some of this is self-fulfilling prophesy. Traders worried about it have been selling ahead of it. There’s no simple way to tell how much of this selling we have gotten through but we ARE getting through it. There is no cure for the situation but time and trading volume.
For all the negativity, the sector is holding up fairly well after a very strong run. Gold seems to need a catalyst for its next move up. When it finds one I think we’ll see the market tone improve very rapidly. This is still a bull market. It’s just resting.
So far September hasn’t been the month in the markets that we hoped for. I’ve intentionally reproduced the same page one and two charts that I used in the past issue. We can see that the hoped for (and common) annual autumn lifts just haven’t happened in either the gold market or the Venture exchange.
Things aren’t terrible. As the chart below shows we’re dealing with a consolidation not a wholesale slaughter here. I think there are both top down (macro) and exchange specific issues that are creating this consolidation. I’ll touch on the big picture first then discuss some sector related issues.
The early part of the month was dominated by Fed fear and Fed joy, for gold traders at least. Volatility was high as traders tried to gauge the odds of a September rate hike. Markets had a rough ride up to mid month as bond yields spiked.
In the end of course it was yet another episode of bait and switch when the Fed finally met. The decision was put off until—probably—December. That cheered both the markets and gold, though the latter only briefly. Why hasn’t gold performed better coming out of the last Fed meeting? I think one important reason is that the odds of a December rate hike actually increased. Even though the FOMC ducked (again) members made a strong enough case that the bond market considers a December hike much more likely.
I agree with the bond market’s assessment, though I hasten to add that doesn’t mean a December hike will actually happen. Just that the market is more likely to think it will happen. Three FOMC members dissented at the last meeting, something that hasn’t happened in over a decade. And two of those dissenters that called for rate hikes are usually considered “doves”.
It was a bit surprising to see them vote for a hike. They both commented on inflation risks. Those seem low to me. I think the real reason is that they fear having no ammunition when the economy rolls over. That isn’t a point most Fed governors want to concede but its no secret many of them are worried about that. I am too but I think that ship has sailed. They waited too long and now they're stuck.
What made the dissents more surprising was the quarterly release of the FOMC “dot plots”. These showed that board members have again reduced their estimates of future growth, inflation and interest rates. It’s a bit strange to see that AND more FOMC members that think rates should rise at the same time. I won’t even pretend that I understand whatever logic underlies that combination.
You can see from the gold chat below that it spiked twice, after weak US metrics and the Fed meeting, but is having trouble holding those highs. The situation is far from critical, with gold still in the middle of the range its occupied since Brexit but traders are definitely less positive.
I think we can chalk much of this down to most markets being “risk on” again. Gold may have to consolidate for a while and give early buyers a chance to take profits before it can gain again.
I’m not that concerned about the gold market, though I would obviously like to see the gold price rising. I expect we’ll see more weak numbers from the US economy. The chart below of the Atlanta Fed GDPNow shows the current situation.
The estimate for Q3 GDP growth has fallen from 3.7% to 2.8%. I expect it to fall further as more September numbers are added. Its now falling below Wall St consensus which increases the odds of negative “surprises”.
In top of that, there is every indication we’ll see another quarter of declining earnings when those start to be reported next month. I’m not assuming that makes traders panic (it didn’t the last five quarters) but it could temper the enthusiasm a bit. I think that is all that should be required to stabilize the gold market since the underlying negative interest rate environment won’t be changing any time soon.
One thing that will still need to be factored into the equation is the OPEC agreement that just happened as this issue was being completed. Assuming that sticks and the production cuts are sufficient to push oil prices up meaningfully we could see a continuation of risk on trading. If Wall St assumes oil and gas sector earnings are going to “save” Q4 they could get braver.
Alternatively, a real move in oil prices could increase inflation readings. That should be a positive for the gold market but could have traders worried about an active Fed. Overall, oil’s a mixed blessing and we’ll have to see how other markets react if OPEC actually gets taken seriously this time.
That brings us back to the exploration sector itself. We didn't see the moves we were hoping for, for a couple of reasons. First, I think its fair to say that we haven't seen many companies deliver results that really made traders stand up and take notice. Some companies have been wins but that hasn’t translated into sector wide “risk on” buying yet within the sector.
We could still see that. One reasonable concern is that a great deal of money has been expended on northern projects, with Colorado Resources being the poster boy for that. We’ve seen some extreme negative market reactions as traders start to worry about seasonality in a region with a seven-month winter. There isn’t much we can do about that but hope some of the other players in the region have better experiences. They may. Most have barely started reporting. One other danger in that region is work programs getting curtailed prematurely.
Many traders new to resource stocks have been blasé about this but more experienced hands realize that when you get to late September in the Golden Triangle anything can happen with weather. I was surprised how late some companies were starting drill programs up there.
That is a common early bull market problem however. It takes time to raise money and get projects when the bull market is young and shareholders are not patient. They want the company to be drilling right away, so management feels committed to try even if they know it might be a bad idea. Hopefully the weather cooperates so there is plenty of good reporting from the region.
The other issue that is plaguing the junior sector is the vast amount of private placement stock that is coming free trading. Added to that is the “warrant issue” that many traders are upset about. They think companies have issued too many.
Those two issues are obviously connected, and are connected with a third issue; that retail investors feel left out of the private placement arena.
I should start off by saying that I completely agree with retail frustration about being locked out of private placements. Even though I know it’s a hassle for management (and it is) to use the recently added “existing shareholder” exemption I think companies should. The exemption gives a much larger pool of shareholders’ access to a placement. I think management would get kudos from smaller shareholders for at least making the attempt to be inclusive.
The simpler solution would be to do away with the Accredited Investor rules all together. These were brought in for investor protection, or at least that is the “official” reason for them. I’ve never really believed that. I think the main rationale for these rules is litigation protection for issuers and for the regulators themselves.
If the concern is investor protection I can think of some more useful solutions. How about if the provincial securities commissions put together some sort of course that investors have to complete? Its not a bad idea anyway. You can have chapters on how the market functions, how the placements themselves work, how to spot scams, etc. Its not going to be comprehensive but it would be a good start. Investors who wanted in would have to prove they had taken and passed the course. You could still have everyone signing forms saying the understand the risk of loss, etc.
The current system doesn’t protect investors anyway. It just means they don’t get to take part in placements that may have better pricing and probably have attached warrants. Traders large and small are still free to buy in the market and lose as much as they want to, without the warrant.
And what of warrants? Yes, they are part of the short term problem. There are a lot of them around right now. There are several companies on the HRA list with significant numbers of warrants outstanding. I try to factor those in and I recognise them as a potential issue. How big the issue is depends on who holds them.
The company featured in this issue, for instance, has a large outstanding warrant balance. Half of those are held by the two largest institutional shareholders or management. There are other companies on the list that have a similar situation. In most cases I either have comfort that the owners won’t blow off shares to
exercise them or see enough liquidity that I think selling can be absorbed anyway.
I like getting warrants but understand why others hate them. They tend to be an early cycle issue in any case. Take a look at the five-year venture chart above. When companies were raising money early this year there weren't many lining up to buy them. The market was coming out of a four year brutal bear market. The list of reliable buyers was short indeed. Companies were offering full warrants because money was hard to raise and they wanted the built in financing a warrant can provide.
Lots of people are pointing back to early year placements and grousing about how good a deal those buyers got. Well, hindsight is 20/20. Many of those companies struggled to close those financings. The people grousing now could have been calling those companies in February and getting welcomed with open arms.
Companies also recognise that if its raising money for a drill program or other near term significant event, the placement buyers probably won’t be able to trade their stock when results start to arrive. I’ve been in THAT situation when poor results arrived plenty of times. It’s a risk you accept as a placement buyer but it’s nice to get the warrant to compensate.
As the market improves and money is easier to come by, warrant terms get tougher. That’s how it works. It’s a problem that takes care of itself as bull markets mature but will take time and trading volume to work through.
I have no problem with forced warrant exercise and personally think the terms should be shorter. The five year warrants so beloved by some market participants should either not exist or carry automatic forced exercise terms.
Even without warrants there is always going to be some selling if share prices move enough. This is one of the reasons corrections are common on the way up. We’re going through one of those now. If the gold price has a strong upward move or if a couple of companies make big discoveries that bring back the greed you’ll see the situation reverse soon enough.
Any experienced investor relations person will tell you that in order for any stock to have and sustain a large price move the share float will have to turn over several times. Everyone has their own comfort level and preferred entry point. They also have preferred exit points based on ether price gains or the company’s stage of development.
This isn’t something any of us should be taking personally. I’m constantly telling you to make sure you zero out your costs when the market lets you. I’m not going to be offended when others do the same. If you believe we’re still in a bull market you should be using periods like this to your advantage. Decide which companies you really like. If you think a pull back in that company’s stock is just due to “the market” and not some new fundamental negative, put in a stink bid.
As we move into October major markets will be tested by what promises to be another weak earnings quarter. We may see more volatility centered on New York markets if the US election is close. There are plenty of reasons to expect more uncertainty but the resource sector should come through it alright. We’re dealing with fairly normal corrective action here. I don’t think the world or the opportunities, are coming to an end.
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