Editor's note: Our friend and well-known resource trader Rick Rule likes to say about commodity investing, "you're either a contrarian or a victim." He's talking about cyclicality.
Natural resources are famous for their volatility. If a resource is in the early stages of a boom, you can make a fortune. If it's busting, it doesn't matter which stock you buy... you will lose money. Our resource specialist Matt Badiali has developed a great system for identifying cyclicality in the resource sector for his new S&A Junior Resource Trader. We'll let him tell you more about it...
There's one aspect to the junior resource sector that is so important, if you don't master it, nothing else you can possibly do will help. You will lose every cent you put in the sector.
This aspect is called "cyclicality."
Cyclicality might sound like industry-speak, but it's actually a simple concept...
An asset with cyclicality is simply one that booms and busts like crazy. One year it will skyrocket 200%, the next year it will plunge by 50%. After plunging, it might drift sideways for a year and then rise 300%.
Contrast this to a "noncyclical" asset, like shares of Johnson & Johnson (JNJ)...
JNJ is the world's largest health care and consumer products company. It sells everyday items like Listerine, Tylenol, and Band-Aids. Demand for these products is relatively constant. Even recessions do little to dent mouthwash and Band-Aid sales. This makes JNJ shares noncyclical. They don't go through wild booms and busts.
But, natural resources do... Consider the case of uranium from 2000 to 2008. Uranium is a natural resource whose chief use is fueling nuclear-power reactors. For much of the 1990s, uranium prices were mired in a bear market. Excess supplies from years before depressed prices and investment in new uranium deposits. There simply wasn't any money in it.
For example, in 2003, it cost miners $20 per pound to mine uranium, but they were selling it for $15 per pound. That meant miners were losing about $5 per pound. Mines closed and no new ones opened. It was grim – a classic "bust."
Then... after years of "bust," the lack of investment in new uranium projects and the increased demand for the cheap fuel started driving prices higher and higher.
As you can see from the chart below, prices climbed from $20 per pound to $80 per pound in about three years:
In response to this new uranium boom, exploration companies went wild. You can see from the table below of uranium exploration spending in Canada (a major uranium producing country) how fast the industry increased spending:
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That's an incredible 5,484% increase in uranium exploration investment in just four years.
This shows you how, when a commodity goes into a "boom" cycle, it attracts huge amounts of money. Uranium eventually climbed to $140 per pound... a more than 10-fold increase from 2001's depressed levels.
You can imagine what that kind of rise does to the share price of companies in the sector...
Consider junior uranium explorer Mega Uranium (MGA.TO). Its ride from 2003 to 2007 was spectacular. Shares went from $0.04 each in September 2003 to $7.41 in April 2007. That's an amazing 18,425% increase.
Now... remember, in a given resource sector, the cure for high prices is high prices. Every "boom" eventually turns to "bust."
When huge amounts of money flow into a sector, it creates tons of new companies, bloated values, increased supplies, and eventually, plunging prices.
Hundreds of new uranium exploration companies were created from 2004-2007 to capitalize on the new uranium boom... many with no real assets or even a hope of becoming a real company.
As you can see from the "updated" chart of uranium (below), the boom turned to bust. Uranium prices collapsed from $140 per pound to $40 per pound. Most uranium stocks lost more than 90% of their value.
Shares of Mega Uranium peaked at $7.41 in April 2007 and fell to $0.37 by June 2010. That's a 95% decline in three years. Investors lost $0.95 of every dollar they invested if they followed the crowd, bought at the top, and didn't cut their losses.
This example is no isolated case. Oil, natural gas, nickel, copper, and uranium go through booms and busts all the time.
When "bust" periods of excess supply depress prices, people find new uses for the cheap resource. At the same time, producers of that resource can't make much money, so they stop investing in new projects to bring on supplies.
This "increased demand, decreased supply" situation creates a crunch that drives prices up by hundreds of percent... and causes incredible stock gains in the companies that focus on that resource.
Then, after prices rise, increased supplies come online... producers of that resource invest heavily in new projects to cash in on the "boom" times.
Meanwhile, users of the now-expensive resource look for alternatives. This decreases demand. The "decreased demand, increased supply" situation can crush the price of the commodity... and send the share prices of commodities that focus on that resource down more than 90%. This is the kind of "bust" you MUST avoid.
All commodities are highly cyclical. And while these big cycles chew up most investors, you can use them to make incredible profits in junior miners by getting in the booms early... and exiting right before the bust begins.
To succeed with junior resource stocks, you must ride booms higher and stand aside during busts by always minding the "big trend" in our sectors.
You see, the fact is... No matter how good a value a company's stock appears... no matter how solid its deposits are... or how smart the management is... if the price of the commodity that company produces or explores for plummets, that company's share price will collapse with it.
If oil drops by 30% in a few months, it's perfectly reasonable to expect oil stocks to fall 40% or 60%. Same goes for gold, uranium, or copper. Even the best junior gold mining companies fell by more than 50% during the mining stock selloff of late 2008.
On the other side of the coin, in a commodity bull market, almost all commodity stocks rise. Old traders put it this way, "When the wind is blowing, even turkeys can fly."
Let's go back to Mega Uranium, the uranium junior that rose so rapidly along side the uranium price. Mega was a classic "flying turkey." Look back at its stock chart for 2003-2007... That 18,425% rise came despite the fact that Mega Uranium had no mines and no high-quality projects... just exploration potential.
To gauge the big trends, I use a simple, reliable tool that "smoothes" out market price daily volatility. When a market is trading above this trend line, it's in a bull market. When a market is trading below its trend line, it's in a bear market.
When the trend tells us the bulls are in charge... that's the time to go long certain junior resource companies... when they have the wind at their backs.
Conversely, when a commodity's trend is down... that's the time to pass on stocks in that given commodity sector.
You see, the force of a big commodity bear market is just too great for a long-side trader to fight. Sure, a few mining stocks will be able to buck a big downtrend in the commodity they are focused on, but it's too much risk for us to take on.
Buying junior resource stocks in the face of a big downtrend is like trying to swim up Niagara Falls.
For the Junior Resource Trader, we're tracking the big trend these major commodities: copper, gold, crude oil, and uranium.
This gives us a perspective on base metals, precious metals, and energy. In addition, we're tracking the TSX Venture Index to gauge various resource stocks that don't fall neatly into one of the other four sectors.
We'll use the ever-present "boom and bust" cycle to our advantage.
Now that you know the general conditions that are favorable to making 5,000% on a single resource stock, tomorrow we'll discuss "buy zones" – the system I use to know exactly when to buy and sell a certain resource.
New high: Keyera Facilities Income Trust (KEY-UN.TO).
In today's mailbag... One subscriber's asking for more on Matt's system for trading junior resource stocks... Any more? feedback@stansberryresearch.com.
"Can you once again provide me with subscription information. Thanks." – Paid-up subscriber Roland
Goldsmith comment: We hope to have Matt's new service ready by the end of the month, but no guarantees. We're still working on pricing and a few other final details. Digest readers will be the first to know when S&A Junior Resource Trader is available.
Regards,
Sean Goldsmith and Matt Badiali
Zurich, Switzerland
November 17, 2010