Natural-resource-based industries are very capital intensive, and hence extremely cyclical. It is not unreasonable to say that as a natural-resource investor, you are either contrarian or you will be a victim. These markets are risky and volatile!

Why cyclicality?

Let’s talk about cyclicality first. Some of the cyclicality of these industries is a function of their being extraordinarily capital intensive. This lengthens the companies’ response times to market cycles. Strengthening copper prices, for example, do not immediately result in increased copper production in many market cycles, because the production cycle requires new deposits to be discovered, financed, and constructed—a process that can consume a decade.

Price declines—even declines below the industry’s total production costs—do not immediately cause massive production cuts. The “sunk capital” involved in discovery and construction of mining projects and attendant infrastructure (such as smelters, railways, and ports) causes the industry to produce down to, and sometimes below, their cash costs of production.

Producers often engage in a “last man standing” contest, to drive others to mothball productive assets, citing the high cost of shutdown and restart. They fail to mention their conflicts of interest as managers, whose compensation is linked to running operational mines.

Interest-rate cycles can raise or lower the cost and availability of capital, and the accompanying business cycles certainly influence demand. Given the “trapped” nature of the industry’s productive assets, local political and fiscal cycles can also influence outcomes in natural-resource investments.

Today, I believe that we are still in a resource “supercycle,” a long-term period of increasing commodity prices in both nominal and real terms. The market conditions of the past two years have made many observers doubt this assertion. But I believe the current cyclical decline is a normal and healthy part of the ongoing secular bull market.

Has this happened in the past?

The most striking analogy to the current situation occurred in the epic gold bull market in the 1970s. Many of you will recall that in that bull market, gold prices advanced from US$35 per ounce to $850 per ounce over the course of a decade. Fewer of you will recall that in the middle of that bull market, in 1975 and 1976, a cyclical decline saw the price of gold decline by 50%, from about $200 per ounce down to about $100 per ounce. It then rebounded over the next six years to $850 per ounce.

Investors who lacked the conviction to maintain their positions missed an 850% move over six short years. The current gold bull market, since its inception in 2000, has experienced eight declines of 10% or greater, and three declines—including the present one—of more than 20%.

This volatility need not threaten the investor who has the intellectual and financial resources to exploit it.

The natural-resources bull market lives…

The supercycle is a direct result of several factors. The most important of these is, ironically, the deep resource bear markets which lasted for almost two decades, commencing in 1982.

This period critically constrained investment in a capital-intensive industry where assets are depleted over time.

Productive capacity declined in every category; very little exploration took place; few new mines or oilfields replenished reserves; infrastructure and processing assets deteriorated. Critical human-resource capabilities suffered as well; as workers retired or got laid off, replacements were neither trained nor hired.

National oil companies (NOCs) exacerbated this decline in many nations by milking their oil and gas industries to subsidize domestic spending programs for political gain. This was done at the expense of sustaining capital investments. The worst examples are Mexico, Venezuela, Ecuador, Peru, Indonesia, and Iran. I believe 25% of world export crude capacity may be at risk from failure of NOCs to maintain and expand their productive assets.

Demands for social contributions in the form of taxes, royalties, carried equity interests, social or infrastructure contributions, and the like have increased. Voters are not concerned that producers need real returns to recover from two decades of underinvestment or to fund capital investments to offset depletion. Today this is actively constraining investment, and hence supply.

Poor people getting richer…

The supercycle is also driven by globalization and the social and political liberalization of emerging and frontier markets. As people become freer, they tend to become richer.

As poor countries become less poor, their purchases tend to be very commodity-centric, especially compared to Western consumers. For the 3.5 billion people at the bottom of the economic pyramid, the goods that provide the most utility are material goods and consumables, rather than the information services or “high value-added” goods.

A poor or very poor household is likely to increase its aggregate calorie consumption—both by eating more food and more energy-dense food like meat. They will likely consume more electrical power and motor fuel and upgrade their home from adobe or thatch to higher-quality building materials. As people’s incomes increase in developing and frontier markets, the goods they buy are commodity-intensive, which drives up demand per capita. And we are talking billions of “capitas.”

Rising incomes and savings among certain cultures in the Middle East, South Asia, and East Asia—places with a strong cultural affinity for bullion—have increased the demand for gold, silver, platinum, and palladium bullion. Bullion has been a store of value in these regions for generations, and rising incomes have generated physical bullion demand that has surprised many Western-centric analysts.

Competitive devaluation

The third important driver in this cycle has been the depreciation of currencies and the impact that has had on nominal pricing for resources and precious metals.

Most developed economies have consumed and borrowed at worrying levels. The United States federal government has on-balance-sheet liabilities of over $16 trillion, and off-balance-sheet liabilities estimated at around $70 trillion.

These numbers do not include state and local government liabilities, nor the likely liabilities from underfunded private pensions. Not to mention increased costs associated with more comprehensive health care and an aging population!

Many analysts are even more concerned about the debts and liabilities of other developed economies—Europe and Japan. In both places, debt-to-GDP ratios are greater than in the US. Europe and Japan are financing themselves through a combination of artificially low interest rates and more borrowing and money printing. This drives down the value of their currencies, helping their exports.

But which nations’ leaders will stand firm and allow their export industries to wither as their domestic producers suffer from cheap competing foreign goods? If Japan’s Abe is successful at increasing his country’s exports at the expense of its competitors like Taiwan, Korea, or China, then his policies could lead to competitive devaluation. And how will the European community react, for that matter?

Loss of purchasing power in fiat currencies increases the nominal pricing of commodities and drives demand for bullion as a preferred savings vehicle.

The factors that have driven this resource supercycle have not changed. Demand is increasing. Supplies are constrained. Currencies are weakening. Thus I believe we remain in a secular bull market for natural resources and precious metals.

With that in mind, I would call the current market for bullion and resource equities a sale.

Where to invest?

Let’s talk about a type of company most of us follow: mineral exploration companies, or “juniors.” We often confuse the minerals exploration business with an asset-based business. I would argue that is a mistake.

Entities that explore for minerals are actually more similar to “the research and development” space of the mining industry. They are knowledge-based businesses.

When I was in university, I learned that one in 3,000 “mineralized anomalies” (exploration targets) ended up becoming a mine. I doubt those odds have improved much in 40 years. So investors take a 1-in-3,000 chance in order to receive a 10-to-1 return.

These are not good odds. But understanding the industry improves them substantially.

Exploration companies are similar to outsourcing companies. Major mining companies today conduct relatively little exploration. Their competitive advantage lies in scale, financial stability, and engineering and construction expertise. Similar to how big companies in other sectors outsource certain tasks to smaller, more specialized shops, the big miners let the juniors take on exploration risk and reward the successful ones via acquisitions.

Major companies are punished rather than rewarded for exploration activities in the short term. Majors therefore tend to focus on the acquisition of successful juniors as a growth strategy.

Today, the junior model is broken. Many public exploration companies spend a majority of their capital on general and administrative expenses, including fundraising. Overlay a hefty administrative load on an activity with a slim probability of success, and these challenges become even more severe.

One response from the exploration and financial community has been to put less emphasis on exploration success and focus instead on “market success.” In this model, rather than “turning rocks into money,” the process becomes “turning rocks into paper, and paper into money.”

One manifestation of that is the juniors’ habit of recycling exploration targets that have failed repeatedly in the past but can be counted on to yield decent confirmation holes, and the tendency to acquire hyper-marginal deposits and promote the value of resources underground without mentioning the cost of actually extracting them.

The industry has been quite successful, during bull markets, at causing “sophisticated” investors to focus on exciting but meaningless criteria.

Being successful in natural-resource investing requires you to make choices. If your broker convinces you to buy the sector as a whole, they will have lived up to their moniker—you will become “broker” and “broker.”

We have already said that exploration is a knowledge-based business. The truth is that a small number of people involved in the sector generate the overwhelming majority of the successes. This realization is key to improving our odds of success.

“Pareto’s law” is the social scientists’ term for the so-called “80-20 rule,” which holds that 80% of the work is accomplished by 20% of the participants.

A substantial body of evidence exists that it is roughly true across a variety of disciplines. In a large enough sample, this remains true within that top 20%—meaning 20% of the top 20%, or 4% of the population, contributes in excess of 60% of the utility.

The key as investors is to judge management teams by their past success. I believe this is usually much more relevant than their current exploration project.

It is important as well that their past successes are directly relevant to the task at hand. A mining entrepreneur might have past success operating a gold mine in French-speaking Quebec. Very impressive, except that this same promoter now proposes to explore for copper, in young volcanic rocks, in Peru!

In my experience, more than half of the management teams you interview will have no history of success that shows that they are apt at executing their current project.

Management must be able to identify the most important unanswered question that can make or break the project. They must be able to say how that question or thesis was identified, explain the process by which the question will be answered, the time required to answer the question, how much money it will take. They also need to know how to recognize when they have answered the question. Many of the management teams you interview will be unable to address this sequence of questions, and therefore will have a very difficult time adding value.

The resource sector is capital intensive and highly cyclical, and we expect that the current pullback is a cyclical decline from an overheated bull market. The fundamental reasons to own natural resource and precious metals have not changed. Warren Buffett says, “Be brave when others are afraid, be afraid when others are brave.” We are still “gold bugs.” And even “gold bulls.”

Rick Rule is the chairman and founder of Sprott Global Resource Investments Ltd., a full-service brokerage firm located in Carlsbad, CA. He has dedicated his entire adult life to different aspects of natural-resource investing and has a worldwide network of contacts in the natural-resource and finance worlds.

Watch Rick and an all-star cast of natural-resource and investment experts—including Frank Giustra, Doug Casey, John Mauldin, and Ross Beaty—in the must-see video “Upturn Millionaires,” and discover how to play the turning tides in junior mining stocks, for potentially life-changing gains. Click here to watch.

A lot of investors are going to miss out on the huge bullmarket advance in the Precious Metals sector that is just starting as this is written, because they are frightened of the impact of the broad market on the sector, but as we will see, the sector itself is signaling that it is going up, big time.

If the broad market looks set to go up, then many investors think that the Precious Metals sector will be ignored and drift lower again, as the broad market continues to rise. If the broad market tanks, then they think that the PM will get dragged down with as in 2008.

Actually, the way that it is looking now is that the broad market will continue higher and higher and the PM sector will soar. Why would that happen? – continue reading HERE

In short: In our opinion short positions (half): gold, silver, and mining stocks are justified from the risk/reward perspective.

Gold, silver and mining stocks didn’t do much on Friday, so what we wrote in Friday’s alert is generally up-to-date. However, since the week is over, we have weekly closing prices and volume levels. One of the ratios that we monitor provides a very significant indication as far as weekly price changes are concerned. Let’s take a closer look (charts courtesy of http://stockcharts.com). 

This is the juniors to stock market ratio – more precisely, the GDXJ ETF (proxy for the junior mining stock sector) to the SPY ETF (proxy for the S&P 500 Index) ratio.

What does this have to do with gold?

Much more than one might expect. Let’s keep in mind the following about precious metals junior mining stocks and investors in general:

• Juniors are less likely to be held by institutional investors than individuals (mutual funds, for instance, often are allowed only to invest in big, senior companies, listed on major stock exchanges)
• Generally, individual investors tend to depend more on emotions than financial institutions do
• When the sentiment peaks, local tops are formed

Connecting the dots, we might expect juniors to perform particularly strongly right before local tops. Taking into account the fractal nature of the markets, we might also expect that this phenomenon to be present on a short- and long-term basis, but since large movements in sentiment are easier to detect from the long-term perspective, this type of analysis might be particularly useful in detecting more important tops.

Ok, but why divide juniors by other stocks?

Because that will allow to better focus on this sector’s performance with regard to precious metals’ price moves. In case there is a broad rally in the stock market, it could also lift mining stocks, including juniors, which could incorrectly make us draw conclusions about the precious metals sector. By dividing juniors by the stock market, we get the price of juniors without the impact of the general stock market. Technically, we get a ratio, but the above is a convenient way to think about it.

Moreover, the price is not the only thing that is divided. The above chart includes volume, but since a ratio is not traded by itself and doesn’t have volume of its own, it’s not a volume of ratio, but the ratio of volumes. Again, this will tell us when the volume in the junior sector was particularly significant but not because of huge volume across the board.

So, theoretically, if the juniors to stocks ratio rallies sharply then we might be looking at a local top. Does it work in practice?

There are no guarantees in any market, but it certainly looks this way. We included a 4-year chart and marked sharp rallies of the ratio – see for yourself. We put the ratio in the background (candlesticks) and we put the gold price (orange line) to make it easier for you to check the signals’ performance. There are actually two different ways to approach the ratio and they both seem to work. One of them is the ratio itself and the second comes from the analysis of volumes.

Rectangles mark situations when the ratio moved much higher in a short period and then at least paused. It’s easier to observe these phenomena using indicators: ROC (Rate of Change by definition should be very useful here) and Stochastic. We focused on the times when Stochastic was above the middle of its trading range (above 50) and in most cases, the ROC was above 10 as well. The only exception is the early 2012 top, which was included because the rallies in gold, ratio and indicators were clearly visible at that time.

Generally, all (7 out of 7) areas include either a relatively small or a significant decline. Prior to the 2011 top, the declines were local and after the 2011 top, the tops and following declines were major. 

The second way to examine the chart is to look at times when volume increased on a relative basis. This is another way to detect increased interest in the juniors sector. 

There were 4 cases in the past 4 years, which we marked with black ellipses. We didn’t mark the areas when volume was gradually increasing – only times when it increased quickly. Again, in call cases declines or pullbacks followed shortly after the volume had increased. 

What about the current situation? The volume first increased in January, and in the past 2 weeks it was simply huge. As far as the first approach is concerned, we have both indicators at their previous highs and the ROC indicator has already declined slightly. The Stochastic indicator hasn’t flashed a sell signal yet, but if gold at least pauses or declines next week, we will likely see one and then the analogy to previous local tops based on the GDXJ:SPY ratio will be very strong. It’s already strong but a sell signal from Stochastic could actually trigger a decline on its own in the current state of the market.

What does it all mean? Most importantly, it means that not all is as bullish in the precious metals sector as one might think. It seems that the recent rally caused investor sentiment to be too optimistic and this is likely to cause at least a correction. 

To summarize:

Trading capital (our opinion): Short position (half): gold, silver, and mining stocks.

Stop-loss details:

• Gold: $1,346
• Silver: $22.36
• GDX ETF: $27.9

Long-term capital (our opinion): No positions.

As always, we’ll keep our subscribers updated should our views on the market change. We will continue to send them our Gold & Silver Trading Alerts on each trading day and we will send additional ones whenever appropriate. If you’d like to receive them, please subscribe today.

Thank you.

Przemyslaw Radomski, CFA

Founder, Editor-in-chief

Tools for Effective Gold & Silver Investments – SunshineProfits.com

Tools für Effektives Gold- und Silber-Investment – SunshineProfits.DE

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Disclaimer

All essays, research and information found above represent analyses and opinions of Przemyslaw Radomski, CFA and Sunshine Profits’ associates only. As such, it may prove wrong and be a subject to change without notice. Opinions and analyses were based on data available to authors of respective essays at the time of writing. Although the information provided above is based on careful research and sources that are believed to be accurate, Przemyslaw Radomski, CFA and his associates do not guarantee the accuracy or thoroughness of the data or information reported. The opinions published above are neither an offer nor a recommendation to purchase or sell any securities. Mr. Radomski is not a Registered Securities Advisor. By reading Przemyslaw Radomski’s, CFA reports you fully agree that he will not be held responsible or liable for any decisions you make regarding any information provided in these reports. Investing, trading and speculation in any financial markets may involve high risk of loss. Przemyslaw Radomski, CFA, Sunshine Profits’ employees and affiliates as well as members of their families may have a short or long position in any securities, including those mentioned in any of the reports or essays, and may make additional purchases and/or sales of those securities without notice.

Dave Lutz of Stifel, Nicolaus talks about the big things traders are talking about today:

Good Morning!    US Futures are slightly higher, but off best levels as E-Minis failed 1840 overnight.   Headlines from the G20 are equity supportive over the weekend, as they shift from Austerity to growth, while blessing the BOJ’s easing operations as ECB’s Draghi sparks a dovish tone into their next meeting.   Focus remains on EM, where Ukraine is in rally mode on bailout indications – which has CDS dropping for all the EM markets on my monitor.   UK/European markets are mixed this AM, with the FTSE under pressure as HSBC is hit (#s) – The DAX is off small, but volumes there are almost 30% below recent averages.   The EU fins are in rally mode, as Spain is upgraded by Moody’s, and Soros indicates he’s a buyer of the sector.    In Asia, Japan was off small – but Shanghai posts it’s biggest loss in 2 months as concerns about a cooling property market weighed.   While ever sector in China was under pressure, globally Banks staged a decent overnight, Industrials in Germany outperformed (better Ifo), and the miners down under continue their recent outperformance.

The 10YY is lower in the US, and back below the 100dma, despite headlines from FT and Barron’s about the “cooling” sentiment towards the bond market.   While the Yen has a slight bid, the $ is in rally mode against € (Draghi Comments as EU’s CPI prints weak).   With the DXY flat, no impact on commodities- but fresh “polar vortex” headlines has Nat Gas surging 5% into Wednesday’s expiry as traders scramble to get inventory for March delivery.   The G20 growth headers have a bid under metals – with Silver adding 1.4% and gold hitting 4month peaks.   Copper is having it’s worst day in a month on headlines from China talking reduced credit for housing.   Coffee remains in moonshot, adding another 3% (up 55% over the last week) as Brazil drought continues the upward momentum.     Scheduled Catalysts today include Chicago and Dallas Fed at 8:30, Greenspan Speaks at 8:45, a decent size POMO at 11 – and EM eyes will be on Brazil’s Trade Balance at 1.   This week brings Multiple Fed Speakers, including Yellen at Senate; Heavy Japan Data – PMI, Employment, CPI, Retail, IP, Housing; Housing Data – Case Shiller, New and Pending Home Sales; the Monthly Russell Rebalance, and the MSCI Quarterly Review on Friday, ahead of China Manufacturing late Friday night