Junior Miners Rise from the Ashes

The Gold Report: In retrospect, investors should have been short mining equities and exchange-traded funds (ETFs) in early 2013. You have the opposite view for 2014. Please outline your strategy for us.

Michael Ballanger: The physical bullion silver and gold markets bottomed in the middle of last year and we thought mining shares would catch a bid soon after the physical market turned. As it would turn out, the mining shares hit new lows in December as they were caught in tax-loss selling and rebalancing. That set up a generational buying opportunity.

Additionally, I’ve never seen such black bearish sentiment numbers for gold — and I’ve been in the business 38 years. In contrast, tech darlings like Facebook, Twitter and Netflix are trading at price-to-revenue levels that would take 30 years of optimum performance to come within these valuations. That is an opposite extreme of what’s happening in the metals.

In November, I came up with a strategy for 2014 that is a very conservative equal-weighting basis to short the S&P through the SPDR S&P 500 ETF Trust (SPY:NYSE.Arca), but to go long the Market Vectors Gold Miners ETF (GDX:NYSE.Arca). It didn’t really matter to me which way the S&P or the markets went — I would see outperformance of the miners.

TGR: And the biggest advantage of that trade is?

MB: It insulates from market risk. It’s a market-neutral strategy in a hyperinflationary spiral where stocks actually do quite well. You can never underestimate the replacement value of stocks in an inflationary spiral. Warren Buffett is a great example: When he got worried about inflation a few years back he bought a big stake in Burlington Northern Santa Fe. Why? Because rails on the ground are a hard asset.

TGR: You suggest there are two ways of controlling the risk in this particular trade. Take us through those.

MB: It goes back to physical bullion. We had a double-bottom at $1,180/ounce ($1,180/oz) on bullion in June and December. That level is the first risk control. If there is a two-day close with gold below $1,180/oz, the double-bottom has aborted and it’s a new down leg for bullion. You’ve got to exit the trade. The second risk control is related to portfolio management risk. Set a stop-loss point of 15%. If you violate that point, you’re gone.

TGR: You’ve been quoted as saying, “I tried several times in 2013 to pick the top via the VIX [volatility index] only to watch in amazement as that invisible hand saves stocks every single time they looked ready to correct.” The Federal Reserve recently lowered its monthly bond-buying program to $65 billion per month. How long can this go on?

MB: I’ve been monitoring investor sentiment numbers in Barron’s magazine since I was a young broker in 1983. If there are four or five weeks where sentiment is above 65% bullish, I’d know it was time to start being conservative, raising cash. Last year, there were six consecutive months ABOVE 70%.

How long do I think this can last? It can last until the market decides that it’s not working anymore, which I believe is going to be 2014.

But the magic hand still continues. It’s called the Plunge Protection Team — the working group on capital markets established under President Ronald Reagan in the 1980s. After the crash of 1987, the government put together a group to prevent market crashes, which is against the free market philosophy that I’ve lived all my life. It has continually — day in, day out — made sure that that market stayed well bid. I have never seen a market that has hugged the 50- and 200-day moving averages with such amazing symmetry as it has 2013. It sets up the trade for January.

TGR: Juniors have performed well in January, a rebound from tax-loss selling season. Is it a seasonal bump or the turn of a corner?

MB: Juniors are turning a corner, but there is also a great seasonal effect. Look at the volume in the Market Vectors Junior Gold Miners ETF (GDXJ:NYSE.Arca) for November, December and January, compared to the last 18–24 months. There’s a great expression: Volume precedes price. Those volumes, evidenced by the Market Vectors Junior Gold Miners ETF, are massive. That spells big, sophisticated money entering a trade. This was taking profits out of the blue chips and moving it into the massively depressed miners.

If you ask me where we’re going to be at the end of the year, I think we entered into a new bull market in the junior mining sector in December at tax-loss selling. I think that bull market was artificially delayed by tax-loss selling and year-end portfolio rebalancing. I’m looking for an up for the junior miners — one that could be quite substantial — but one that demands selectivity and discipline.

TGR: What’s your advice on how to navigate the illiquidity of many gold and silver stocks?

MB: Clients that need to maintain liquidity in taking large positions should consider ETFs. They usually won’t have the $0.20 stock that goes to $3 or $4 because the junior mining company that gets included in an ETF is usually one that has already been recognized. Put the bulk of your assets in ETFs and reserve a little capital for one or two specific junior companies. It’s a rifle approach as opposed to a shotgun approach.

TGR: What are some juniors that you’re following?

MB: Rather than “follow” any particular name, for 2014 I have chosen to look at the junior miners in the context of sector versus specific company. And after a three-year, brutal bear market, the greater challenge will be to be proven correct in moving into the sector — period — rather then picking the individual name. Through the Market Vectors Junior Gold Miners ETF you own exposure to a basket of the most-advanced juniors while getting the liquidity of the ETF.

There are two companies that are currently recommended by our wealth managers. One isEldorado Gold Corp. (ELD:TSX; EGO:NYSE), trading around $7.35, which recently received a $40 million equity injection for a 20% interest in the Eastern Dragon mine in China. This removes the logjam that has impeded Eastern Dragons’ development and advancement. GMP’s analyst has a $12.25 target price in his Feb. 24 report.

The other is Rio Alto Mining Ltd. (RIO:TSX.V; RIO:BVL) that trades around $2.30. With the release of the revised resource estimate of 1.08 million ounces for La Arena in Peru, the stock looks undervalued. GMP has a $4.90 target as of Feb. 24.

MB: After the three-year bear market, the good guys are coming out of the ashes. You’re going to be surprised how well some of these gold companies perform. Manage your portfolios so you have liquidity and diversification. The Market Vectors Junior Gold Miners ETF is an excellent way to put together a balanced portfolio in that area.

TGR: Is that your top pick for 2014?

MB: If I’m going to do an unhedged trade, 75% would be an equity combination of the Market Vectors Gold Miners ETF, which is the senior miners, and the Market Vectors Junior Gold Miners ETF, which is the junior miners, leaving 25% for other special situations.

TGR: Parting thoughts for us, Michael?

MB: As a wealth manager, my job is balance risk versus reward potential. The most important thing for 2014 is going to be risk management. It’s going to be a rollercoaster year if I’m correct in my assessment. Going long on miners and short on the S&P 500 is an excellent augmentation to the balanced portfolio approach.

TGR: Thanks, Michael. I’ve enjoyed speaking with you today.

---

COMPANIES MENTIONED:

ELDORADO GOLD CORP. : RIO ALTO MINING LTD.