Profiting From the Wall of Worry
In this article, I want to address what stage of the market cycle resource stocks are in, why, what’s likely next, and what you should do about it.
For pretty much all my adult life, I’ve been a speculator. That is to say, someone with an appreciation for the relationship between risk and reward, an appreciation far too many people clearly don’t share.
Take for example, ostensibly conservative investments such as money market funds and T-bills. To my worldview, these are just bad jokes being played on the masses. Piling all your assets into increasingly worthless paper paying next to no interest is the financial equivalent of a death of a thousand cuts, guaranteeing that a large swath of the nation’s senior citizens will spend their golden years sporting paper caps while tossing fries. My view is that, certainly in today’s world, it’s much more prudent to risk 10% of your capital with a prospect of getting a 1,000% return than risk 100% of your capital for the prospect of a 10% (or less) return.
This brings me to the current market in natural resource stocks, a sector in which I have been an active investor for almost 30 years. That’s enough time to have witnessed all manner of cycles and market action. As is to be expected, especially in the early years, I made mistakes, most of them attributable to the hubris of youth. On one memorable occasion, the error was serious enough that I felt the need to spend a day in bed pondering the magnitude of my losses.
But most humans (politicians and most economists being the exceptions) learn from their mistakes, and I learned from mine. As a direct consequence, I have made considerable money in the resource sector. Certainly enough to retire and hang out in upscale locales for the rest of my life, if that were my want. (It’s not…as you read this, I’ve just returned from a rock-kicking expedition to a developing gold play in the boondocks of Panama).
Further, I’m convinced that if I were wiped out tomorrow, I could start with a small grubstake and recoup most of my losses in a few years’ time. In fact, I believe I could do it even if I was airdropped into the Congo, with no money at all. And so could anyone with an entrepreneurial spirit, who knows the difference between something’s price and its value, and understands how to balance risk and reward.
But there’s no need to do anything exotic, like starting with nothing. A relatively small amount of money, skillfully deployed in the right market at the right time, can compound quickly.
With that in mind, perhaps the most critical thing for people now in resource stocks is to examine the nature of bull markets. Many believe that, since resource stocks have had such a big move since their absolute bottoms in the 2000-2002 period, the bull market is, if not over, at least long in the tooth.
I don’t think so. And the reason goes back to an understanding of the way bull markets work — at least major, secular bull markets. They generally have three stages: 1) Stealth, 2) Wall of Worry, and 3) Mania.
The Stealth Phase
The best time to buy in any market is when shares can be purchased on the basis of value alone. Of course, that’s generally only possible when nobody wants to own them because they’ve been so beaten up in the previous bear market. It’s then, when people are most bearish, that new bull markets are born — quietly, unbeknownst to almost anyone. That’s why I term the first stage the Stealth phase: It’s there, but nobody can see it.
In the case of mining stocks, the bottom came between early 2000 and mid-2002, when few investors were even aware that a market in resource stocks existed any longer. It was so beat up that many companies were selling for less than their cash in the bank. Every week, several would change their names, roll back their stock, and make themselves over as dot-coms, or China telecom parts distributors, or some other then fashionable fad business.
In March 2002, for instance, when the risk-averse investing masses wanted nothing to do with precious metals stocks, I wrote this in the International Speculator (Vol. XXIII, No. 3), complete with the uncharacteristically hyperbolic punctuation:
“Junior gold stocks are the most volatile securities on the planet, with the possible exception of lately minted Internet stocks, and the market is still off about 95% from its previous peak. THIS CONTINUES TO BE THE TIME TO BACK UP THE TRUCK. If I could call your broker for you, I would.
“What we’re looking at is a rare opportunity, perhaps twice a decade in the resource stocks, to make a real killing. The last time it was this good was January 1993. In fact, now is actually the best time to buy gold stocks (and they’re usually terrible things to hold) since 1971, when the dollar was devalued. Gold is now, in real terms, almost as cheap as it was at $35 back then; silver is considerably cheaper than it was at $1.29.”
Attentive subscribers joined me in making a lot of money by buying solid resource stocks while they were almost being given away. Another term I use for the Stealth phase is the “Easy Money” phase, because almost anything you buy in this stage will make you a lot of money, with little actual risk — although perceived risk is very high.
Then, as is the nature of things, word got around and investors began rediscovering the resource stocks. Two things happened, as they always do.
One, a new wave of investors started pouring into the sector, eager to join in the fun and willing to throw money at any good story (and most are good stories…whether those stories are fact or fiction is another matter).
Two, a new wave of resource companies was launched to meet the demand. Conference halls previously suitable for yodel practice filled up with clamoring hordes of cash-waving investors, who were met in force by resource company executives happy to relieve them of that cash.
Predictably, the tsunami of money — which started hitting the market in the second half of 2003 — floated all boats, pretty much regardless of merit. The new money, however, put an end to the Stealth market. Early investors looked like financial geniuses and began to believe trees grow to the moon. Actually, they will — but not until the third stage of the bull market.
The flood of money also did one more thing: It provided the juice needed by the well-run companies to lock up new properties and fund the exploration required to come up with a mineral discovery.
Wall of Worry
The approximate C$12.8 billion of IPO and private placement money that materialized over the last two years acted like a rainstorm in the desert, causing stock prices to blossom. There were quite a few that went up 1,000% and more. But stocks — especially mining exploration stocks — aren’t heirlooms, they’re highly volatile trading vehicles. Seeing momentum diminish, speculators with (sometimes) huge profits started selling to realize them. This led to the second stage of a bull market, commonly called the Wall of Worry stage. That’s where we’ve been for a little more than two years.
Periodically in 2004, and intensively in 2005 and 2006, prices of most resource companies have been driven down, casting a dark cloud over the psychology of most investors and market observers.
People are worried for a number of reasons. Technicians fret about the huge run-ups and subsequent losses of momentum; they wonder if the mining stocks aren’t about to go right back where they came from. Fundamentalists are concerned that (inevitably) higher interest rates will cause people to buy fewer new houses, cars, and other consumer goods; as demand falls, so would commodity prices. They worry that the boom in China will soon come off the rails. They worry that all the money that’s been raised will result in gigantic new supplies of metal, depressing prices. They worry that environmentalists will make it impossible to develop new properties at any price. They worry that feckless and bankrupt governments might nationalize good-looking discoveries, or tax them into unprofitability. They worry that new technologies will radically reduce the use of some metals, collapsing their prices. They worry that anything that can go wrong will go wrong. And they’re right — but their timing is wrong.
As a consequence, even good news out of a resource company is often met with selling as investors decide to use any volume to liquidate positions in order to “watch from the sidelines.”
But in this stage, despite all the fear and sharp sell-offs, the market slowly climbs the Wall of Worry. It eventually digests selling from the profit-takers and the timid, as new buyers overwhelm them.
As a speculator, this phase of the market is almost as good as the Stealth phase, because while the easy money has been made, the big money is still ahead. It will come once the market enters the next phase, the Mania stage. That’s when the broad base of individual and institutional investors becomes convinced the market is going to the moon, pile in, and drive it halfway to that destination. By positioning yourself in the right companies before the mania phase begins — and then having the intestinal fortitude to stay invested, and even buy more, through any periods of weakness — your investments can make you rich.
But you may be asking: Casey, what makes you so sure that this actually is a major secular bull market for the resource stocks?
There are lots of reasons. Enough that even a cursory discussion of them will take another article. But in brief, to refute some of the current worries: We’re coming off the longest and deepest secular commodity bear market since the Depression of the ’30s. Commodity prices are still far below their historic highs, at least in “constant” dollars, which is what counts. The world economy is evolving away from the debt-burdened U.S. and toward China, India, and numerous smaller countries; their growth will be volatile, but it’s for real, and they’ll consume unbelievable amounts of raw materials in the coming years. There’s been very little mineral exploration for a full generation, the industry has come nowhere near replacing reserves, and a historic supply crunch in many commodities is in the making. Governments will always act stupidly, but the long-term trend is inevitably toward freer markets, higher standards of living — and higher resource consumption.
If I’m right about these things, and I’m confident that I am, then the current Wall of Worry will be followed by a mania.
The fundamentals — although of a much different sort than we saw in the Stealth stage — will drive these stocks much, much higher when the third, the Mania, stage hits. And thanks to the 1980-2000 bull market in the general stock market, everybody (probably even including most homeless people) now has a stock account. They know little about stocks except to get on board anything that seems to be headed up; they’re trend followers. The commodity story tells well, and a whole generation of investors are going to hear it for the first time. Remember, even during the secular resource bear market of 1980-2000, there were three spectacular cyclical bull markets in exploration stocks that took them up an average of 1,000% each time. The power behind the coming Mania phase will drive the resource stocks we are currently covering up like the contents of Hoover Dam trying to fit through a garden hose.
I expect the Mania stage to resemble what we saw with the Internet stocks in the late ‘90s.
What to Do Now
If you are going to be successful as an investor in this phase of the market, you are going to have to suppress your fight-or-flight response and take the time to identify those companies with the goods: adequate financing, great management, realistic market capitalization, and solid properties in the right locations.
How long will you have to wait for your payoff? Not long. The typical exploration cycle lasts about two-three years, and we’ve already started seeing some important discoveries in 2006 and early 2007. That stream of news should pick up momentum as a result of all that money raised in 2003-2006 — and it is already delivering the goods. Consider the table below, of recommendations made in June 2006 and their results as of June 2007 (note that we would not necessarily recommend the same set of companies today, so please don’t rush out and buy these stocks):
*We sold XRC because of a political setback with its then-flagship project in Mendoza, not because anything is wrong with the rocks or with management performance.
As far as the Mania stage, that will make mere 80% gains in a year look like chump change. It will begin once people get over the Wall of Worry, likely triggered by a resumption of the downward trajectory of the U.S. dollar. I’d be surprised if it didn’t start materializing within the next year.
In the final analysis, it is the worrisome aspects of the current market — when you and everyone else are feeling on edge about the risk — that make this such a good time to invest. People do dumb things when they are scared. Like sell great companies. Or sit on the sidelines, keeping their powder dry for a brighter day. And when the brighter day comes, they will do even dumber things, like spend twice, or 10 times, the current ask for the same shares. They’ll be buying those shares from me. The key, if you agree with me that the long bear market of 1980-2000 is over and the new bull market has only gone through its first stage, is to buy when everyone is afraid (like now, while the market climbs the Wall of Worry) and sell when everyone is confident (in the coming Mania).
Finally, for the record, let me emphasize that if you don’t have a tolerance for risk, or a willingness to do enough homework to reduce the risk of falling for a good story without substance, you really shouldn’t be investing in this sector — any more than you should invest with money you can’t afford to lose. By definition, any investment that can turn dimes into dollars can also turn dollars into dimes if you aren’t attentive. This isn’t an arena for amateurs. Although I expect millions of complete amateurs will be in it over the next few years.
But if you can handle the risk, there is a very serious opportunity — and maybe the last in this cycle — for you to get well positioned in this “Wall of Worry” stage. Don’t miss it.
August 9, 2007