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November 28, 2008

Juniors in Hell
by Scott Wright

Junior resources stocks reside in a realm that has long been considered the Wild West of the equity markets. And investors who speculate on the junior circuit are the consummate gamblers. Risks and rewards are realized in extreme fashion as juniors can either make you rich or rob you blind.

The allure of juniors will always captivate investors. It's exciting to own a portion of a company that is in effect a modern day treasure hunter. Whether it is searching for precious metals or petroleum, if a junior scores a find the owners of the company will be greatly rewarded. Speculating in juniors allows desk jockeys to become prospectors.

In the same fashion that investors long for the thrill of the hunt of the next big gold deposit or oil field, juniors long for the speculative capital investors bring to the table. For most juniors the only way to procure capital for their exploration endeavors is to offer up shares of their companies.

But since juniors are so hyper-risky and can't meet the liquidity and capital requirements of the big-board stock exchanges, their venue is not mainstream. In fact investors must go to Toronto, Canada to find the home of the juniors. And the breeding factory for junior commodities stocks is the TSX Venture Exchange (TSX-V).

The TSX-V is specifically designed to host an environment for junior companies to raise capital in the equity markets. In essence this exchange acts as a portal for venture capital to fund start-ups and project development. And since over 75% of the issuers on the TSX-V are resources stocks, this is the exchange we can look to in order to gauge the health of the junior resources sector.

Investors are able to tangibly measure the performance of the TSX-V via its real-time index. This index is called the S&P/TSX Venture Composite Index and goes by the symbol CDNX. The CDNX (acronym is based on the original Canadian Venture Exchange) is comprised of nearly 500 of the largest stocks that reside in the TSX-V.

Well if you are at all attuned to the markets these days, you are likely aware of the across-the-board carnage of virtually every asset class. And commodities and commodities stocks have not been excluded from the pain. The juniors in particular have been absolutely crushed.

Investors who have been riding the storm have seen their junior speculations simply obliterated. And the collective junior bloodbath is readily apparent in the performance of the CDNX. With history that dates back to December 2001, which was when the CDNX was acquired by the Toronto Stock Exchange, we can see the extreme nature of this obliteration.

From its 2002 low of 891 the CDNX entered into a powerful multi-year bull market. And because the CDNX is colored by the actions of the commodities markets, this index had spectacular gains that were far greater than most of the world's stock indexes over this period of time.

In the 4+ years in which the CDNX rocketed 278% higher, investors couldn't go wrong speculating in juniors. And some of the elite junior resources stocks had gains that greatly amplified the broader index. Those that made material discoveries and/or brought them into production had gains that were 5x to 10x greater than the CDNX.

Going into May 2007 all was fine and dandy in the junior world. After a steady run-up that included three sentiment-balancing corrections in 2004, 2005, and 2006, the CDNX reached the apex of this powerful bull run at 3370. But in most peculiar fashion this is where it stalled out. And I say peculiar because at that point the CDNX disconnected from the commodities markets.

This detachment was quite vexing to all junior traders. So much so that both myself and my business partner Adam Hamilton took to the pen in an attempt to analyze this disconnect, both from a gold stock perspective and a general commodities perspective.

Provocatively this disconnect was not slight. Measured by the CCI (Continuous Commodity Index), the juniors left the commodities party a full 14 months early. In fact, from the CDNX's May 2007 high the CCI tacked on a whopping 52% gain until it finally reached its own high in July 2008. Over this same period of time the CDNX fell by 23%.

With commodities remaining strong for well over a year after the CDNX petered out, this was indeed a major disconnect. There are many ideas for the reasoning behind this junior malaise, but since this is not the theme of this essay I'll move on.

Ultimately this CDNX/commodities disconnect was over the day after the CCI achieved its high. Since July 2, 2008 the CDNX has returned to stride with the commodities markets. It of course didn't change its ways, the greater commodities complex simply joined the CDNX in its downward spiral. And of course with physical commodities and headline commodities stocks now falling, the rate of descent for the CDNX accelerated to a blistering pace.

It was also about this time, July 2008, that the CDNX broke its two-year support around 2400 and began its dive to depths never before seen. By October 23 the CDNX had wiped out the gains from its entire bull market, and it didn't stop there. With its closing low of 692 last Thursday, the CDNX had fallen 73% in less than five months.

This next chart zooms in and shows the sickly action of the CDNX leading into this dreadful July decline. And it is apparent that the CDNX was already looking quite unhealthy. Even though commodities were on the rise, the juniors were exhibiting weakness as seen by the descending triangle that formed off the CDNX's May 2007 peak.

It is easy to look back on this descending triangle as a bearish signal, but with support holding strong and fundamentals bullish there was hope that the juniors would come back to life and rejoin the commodities party. Unfortunately this hope kept a lot of investors in the game, holding onto their junior resources stocks for dear life. But once support was broken, the subsequent five months that brings us to today would be pure hell for these investors.

To magnify the fear and carnage gripping the CDNX, I included the new lows percentages. From the 2007 high to the recent July breakdown things weren't too bad. Only about 2.3% of the stocks traded on the TSX-V each day would achieve new 52-week lows. But as you can see once the selling pressure accelerated beginning in July, a much higher percentage of these juniors were finding new lows.

The global financial-market crisis that has had a stranglehold on the world's stock markets wreaked havoc on the TSX-V. By October 6, one in three juniors traded would hit new 52-week lows. And I suspect this one-in-three extreme doesn't tell the full story of how bad things truly are.

It is important to understand how small the TSX-V really is. As of the end of October its total market capitalization was only $20.1b, less than one-quarter of one percent the size of the S&P 500. And with over 2400 stocks on this exchange, the average market cap per stock is only about $8m. As you can probably guess many of these stocks are very illiquid. In fact, only about half even have trading volume on any given day.

Provocatively during the panic selling in recent months many of the stocks trading on the TSX-V didn't have any buyers. If new lows were captured from the bids on many of the stocks that didn't trade or those with extremely low volume that didn't have any later-in-the-day trades, I suspect the new lows percentages would be a lot higher.

Another anecdotal example of these junior travails was a recent announcement by the TSX-V that it was introducing measures to grant temporary relief on some of its listing and maintenance requirements. The head of equities at the exchange states the obvious, "We are very aware of the difficult market environment currently facing many of the companies listed on our equity exchanges..."

And a "difficult market environment" is an understatement. Year-over-year through the end of October, even with new issues this anemic exchange has seen its market cap drop by 68%, the value of its monthly trading volume drop by 41%, and a 43% drop in equity financings.

When it comes down to it, the precipitous decline and horrendous fundamentals of the CDNX points to a major structural problem with the junior resources sector. Not only are these markets unhealthy, they are in critical condition and perhaps even on life support. And regardless of the cause, I believe the effects of this junior stock crisis will be felt for some time to come.

With junior resources stocks currently trading at an average of twenty-five cents on the dollar from just five months ago, a complete loss of investor confidence, and the inability to raise capital in the midst of these seizing financial markets, I suspect many juniors will not survive this storm.

And many of the stocks that comprise the TSX-V are in the midst of a perfect storm. To start with the prices of most of the commodities they either explore for or produce have plummeted. For the producers this translates into much lower margins and cash flows, and this can be catastrophic for the majority of juniors that run small-scale operations and have thin cash balances.

And for not only the producers but the explorers, falling commodities prices translate into falling project valuations. This makes these companies less attractive to potential suitors. But even if projects remain promising at these depressed prices, the ripple caused by the global credit crisis will hit the juniors with the force of a powerful tsunami. Buyouts are a junior's best friend, but when the entire commodities supply chain is infected with these credit woes, M&A activity grinds to a halt.

Coincidentally I'm currently in the final stages of completing a comprehensive report on Zeal's favorite gold-producing stocks. And in sifting through the pool of candidates I've noticed a recurring theme that goes all the way to the top of the food chain, preservation of capital. And not surprisingly this theme extends well outside the gold producers. Preservation of capital has become modus operandi for the entire commodities industry.

Thanks to the depressed commodities prices and illiquidity in the credit markets, companies are clamping down on capital expenditures. This means exploration budgets are tightened, development projects are placed on hold, and growing cash becomes priority.

With so much uncertainty in today's markets most larger commodities producers have radically altered their spending habits. And this means much less flexibility for acquisitions. Again, this is devastating for the juniors.

So with falling commodities prices and decreasing prospects for joint ventures or buyouts from the senior companies, juniors must look to investors for a vote of confidence and infusion of capital. But things don't get any easier here. In fact finding investors now may be about as easy as finding ice cream in hell.

Investors must have an incentive to speculate in juniors. When commodities prices rise, the stocks of their producers/explorers should positively leverage their gains. This is the nature of accepting individual company risk and simple profits leverage. And this leverage should be especially prevalent for the juniors.

But not only were the juniors lagging in the latter part of the latest commodities upleg, they were declining. And this was readily apparent in the gold stock arena. There was wailing and gnashing of teeth when gold launched to $1000 in early 2008 and the juniors merely ground sideways. Investors were just not seeing their risks being rewarded.

In fact the only leverage the juniors have seen recently is to the downside. In the downward spiral since July, the mass exodus out of the juniors has showcased extreme capitulation. Those that stayed in own a portfolio of juniors with staggering unrealized losses. And those who sold out on the decline have yelped all the way home with their tails lodged well in between their legs.

I have personally heard from countless investors who swear they will never speculate in juniors again. And those who do venture to return to this arena will do so ever so gingerly after an extended period of mourning for their losses. The fact of the matter is there is a complete lack of confidence in junior resources stocks. And investors are nowhere to be found.

This lack of investor confidence is a huge problem for the juniors. Often times confidence, exuberance, and promise is all juniors can cling to in rallying investors to buy their shares and bid up their stocks. But this cheerleading doesn't work for banks. Banks won't even think about funding a junior until it's defined an economically feasible project. And most juniors have no such asset.

So since equity financings are the only option for most juniors to raise capital, and investors are nowhere to be found, this presents quite the dilemma. On the TSX-V thousands of juniors vie for a limited pool of capital even in a friendly environment for commodities. They need to continually release shares to the markets to build the working capital necessary to advance their projects.

But with no credit, lower commodities prices, vastly lower stock prices, and a lack of investor confidence, many juniors are likely to be in a period where it will be impossible to raise capital. Not only will there be less demand for junior equity, but many of their share prices are so low now that they do not have enough shares shelved to acquire material-enough proceeds from an offering to make a dent in their capital requirements.

No equity financings mean insufficient capital for marketing and promotions, insufficient capital for meaningful exploration programs, and insufficient capital for overhead expenses. And for many companies an environment like this can quickly lead to the end of the road.

Only those juniors that have the ability to remain flexible on the capital front will survive. A handful of elite juniors that own top-shelf projects will retain the ability to raise capital in the equity markets. But the rest will have to rely on the savvy management of working capital that is already in the books.

Some juniors may have the necessary capital to continue business as usual for many quarters into the future. Some juniors may be able to survive by throttling back on their exploration and/or development programs. Some may survive by outright halting capex and riding out the storm. But without the ability to procure financing many will fall by the wayside and outright fail.

So what is the point of this bleak outlook for the juniors? Well other than pointing out that these extraordinary and unprecedented markets have placed many juniors on the precipice of catastrophe, I believe an extreme cleansing of the junior landscape will create opportunities in the coming months and years.

Even with a major shakeup it doesn't mean the junior trade will cease to exist. Yes, there may be a rough go as this global recession plays out, but I don't believe that the unfortunate circumstances of a once-in-a-lifetime financial market crisis has the moxie to put an end to this secular commodities bull.

Extraordinary pressure has been placed on the interim fundamentals of the commodities markets. And a rebalance will cause significant collateral damage on the junior front. But for a variety of reasons I explained in my last essay, I believe commodities will continue to be the best-performing asset class in the decade to come.

And juniors have and will always play a vital role in the commodities markets. They are the mavericks of this industry that scour for resources on every corner of the earth. Many juniors are led by some of sharpest and most innovative technicians and managers in the industry. Some of the most experienced and successful exploration geologists are guiding their small companies in search of the next great mineral deposit or oil field.

What drives these juniors is the same thing that drives investors, the opportunity to score vast riches. When discoveries are made and advanced toward economic development junior stocks skyrocket. The principals of these juniors often have large equity interests in their companies, and it is to their incentive to drive their stock higher. And this all leads into the symbiotic relationship between the larger producer companies and the career explorationists.

Juniors play an instrumental role in feeding the commodities supply chain either directly or indirectly. Sometimes a junior will actually become a producer itself. But more often than not juniors serve to provide the larger producer companies with fresh new projects. Interestingly many juniors have no interest in seeing a project all the way through to production. Many would prefer to take the spoils from their finds and go back out to look for a new one.

As the junior markets reshape and rebuild, there will eventually be a revival. The strong juniors that were able to survive mixed with the new ones that emerge to take advantage of the next commodities upleg will again offer investors vast opportunities. And it may take a whole new generation of investors willing to risk their capital, but the juniors will again find the financial resources to rejoin the supply chain.

Until this time comes I suspect the junior markets will continue to exhibit gut-wrenching volatility. It is a shame that even the premier juniors that have excellent projects and sound financials will suffer until this market finds its balance. But when a balance is found and growth returns, there will be unbelievable buying opportunities.

At Zeal we look forward to the time when we can again confidently recommend junior speculations in our newsletters. Thankfully we grew leery of the juniors when they were nowhere to be found in gold's upleg in the first part of this year so we completely stayed away from them in the second half of this year.

In today's markets we prefer flight to quality until things settle down. In fact we recently took the opportunity to add to our long-term investments by recommending buying some of our favorite commodities giants that we believe are way oversold. If you are interested in cutting-edge market analysis and high-potential trade recommendations please subscribe to our acclaimed monthly and/or weekly newsletters today.

The bottom line is this crazy financial-market crisis is likely to have such a devastating impact on the juniors that what many people thought was a junior bubble might just turn into a double-bubble. If the global commodities bull carries on like I expect, this junior crash is nothing more than a premature reactionary event to extreme market conditions. And this will be followed by yet another bubble-type atmosphere when confidence returns to this arena.

Like reptile ecdysis, the carnage we see today will shed a thick layer of skin as many juniors fail in these tough markets. But once the skin is shed, a new junior market will emerge that could be stronger than ever. Now it might take some time for fundamentals to shift and for a new generation of investors to emerge, but juniors will again have their day in the sun.

Scott Wright
Zeal LLC.com

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Thoughts, comments, or flames? Fire away at scottq@zealllc.com. Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!

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