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The market for metals and the ghost of Bre-X

Not much is going the way it’s supposed to in the markets these days, says this advisory, so where does that leave junior mining stocks?

Nothing in the markets is quite what it seems — or what many commentators insist it must be. In a time when uncertainty rules, all kinds of forecasts that seem to make sense keep skidding off in odd directions.

For Mr. John Kaiser the greatest frustration is the unfair punishment meted out to junior mining stocks, his area of interest. And this leads him to some penetrating comments on the markets in general.

Mr. Kaiser’s Bottom-Fish Action Report comes to us from California, but the editor himself was born and raised in Canada and keeps his eye firmly on Canadian junior mining stocks.

As he reviews recent events and looks ahead in the markets, Mr. Kaiser finds some changes taking place that run contrary to many so-called expert forecasts. But his first concern is that the juniors have not been reaping the benefits of the commodity boom. Far from it.

The juniors do nothing

“There is a serious disconnect between metal prices and the behaviour of the resource juniors,” writes Mr. Kaiser. With precious metals such as gold and platinum reaching record highs, and base metals like copper heading for prices six times the level of five years ago, you would think that capital would be pouring into resource juniors … at least into advanced projects with promising prospects.

“But what do we have instead?” asks Mr. Kaiser in exasperation. “Whenever metal prices push higher, the juniors do nothing. When metal prices pull back again, the juniors lurch lower. But when metal prices recover, the juniors do nothing. And when metal prices once again retreat, the juniors lurch lower again.”

And where are metal prices headed now? They may not move much higher unless the U.S. dollar collapses against other currencies, explains Mr. Kaiser, but they should remain high. We have come to a point where investment capital is actively seeking “hard assets” like copper. This is tempered by anxiety about the impact a U.S. slowdown on the demand for raw materials at home and across the globe. But that anxiety is exaggerated on both counts.

The home front is a red herring, says the editor. The house construction boom in the U.S. effectively ended in 2006. The copper market already absorbed a hit from sluggish demand in the housing market, and prices are near all-time highs. “All the hand wringing about the end of the home construction boom and its impact on metal demand is about water under the bridge.”

Bre-X is chump change

The end of the home construction boom is just a symptom of a much bigger seismic shift, according to the “cyclical bears.” It is nothing less than this: the post-World War II era of debt-fuelled consumption is over. The wealth created by the real estate bubble of 1998-2007, pumped into the system by consumer loans and dispersed throughout investment portfolios by means of securitized mortgage paper, has dried up.

“It doesn’t matter what reforms the government introduces,” states Mr. Kaiser flatly. “Investors have been taken to the cleaners on a scale that makes the Bre-X fiasco look smaller than chump change,” he adds with reference to the most notorious junior mining scandal in Canadian history.

But if the American consumption boom is over, does this mean that all of those refrigerators, plasma televisions and the like being manufactured in China won’t be wanted anymore? Will this “rip the rug out from underneath the urbanization of Asia?”

Let’s not be too hasty to connect those dots either, says Mr. Kaiser. Yes, the U.S. consumption boom may well be over as we know it. Indeed, it is altogether possible that Americans will renew themselves through renewable energy. Instead of replacing today’s stuff with newer and better versions, they will start to insist on quality, durability and efficiency while reducing their collective “ecological footprint.”

Not catching pneumonia

But Asia will not turn into an industrial ghost town. “At the same time as Americans work to reduce their per capita footprint, Asians are working very hard to expand their relatively tiny per capita footprint,” says the editor. Over the past few years, China has already shifted much of its emphasis away from dependence on the American business cycle. It is building infrastructure for its emerging middle class and expanding its economic reach across Asia, Australia and South America.

“The dreaded collapse of raw material in the form of China catching pneumonia because American has come down with a cold has not yet happened,” adds Mr. Kaiser, “which is why warehouse inventories remain low and metal prices remain high.”

That brings us full circle, back to the problem of the gap between metal prices and the performance of the juniors. As commentators carry on about the commodities boom and when it might end, they have succeeded only in talking down the resource juniors, while metal prices remain high and dry.

Road kill of Wall Street

The juniors, complains Mr. Kaiser, “are road kill in the path of a train wreck created by the greed and stupidity of Wall Street and the White House.” The bull cycle of 2003-2007 was fuelled by institutional money, but much of that money, and the people who manage it, has been caught in the gears of the credit crisis.

Fund managers have been dumping everything they can from their portfolios, to the dismay of retail investors who had banked (correctly) on the long run of high metal prices and who have seen their stocks tossed out like the baby with the bathwater.

But it would be a mistake to bail out, says Mr. Kaiser, because somewhere along the line the market will realize that metal prices are due to remain at very high levels compared to five years ago. All of a sudden, the half-empty glass will be half-full. When that happens, he says, you want to be long, not short, on the juniors, because they will snap back to pre-credit crisis levels and then start climbing.

A classic example of a stock that should benefit when the glass fills up is Lithic Resources (TSX/V-LTH), which is currently drilling in an advanced zinc project in western Utah. The company is finding high grades of zinc. It has also discovered unusually high grades of indium, which is prized for flat panel displays. The price of indium has fallen in the past year, but it may be gearing up for a major boost.

Lithic was a “no-brainer buy at current levels,” said Mr. Kaiser two weeks ago. That level was $0.25. It has been recommended as a top priority bottom-fish buy in the $0.20-$0.29 range since 2003. It is also tabbed as a good speculative buy as high as $0.67, adds the editor (that’s fairly high in a bottom-fishing world swamped by adverse conditions). It currently trades at $0.37.

Not every investor will want to dive into the world of bottom fish. But every investor should look carefully behind all the confident predictions about the economy and the markets. Hot air may keep balloons afloat, but it can only push stocks up so far.