Thanks, we needed that.
I'm breathing a sigh of relief at the selloff in energy and gold stocks. In the last few weeks, enthusiasm for the two sectors had risen to such a level that I couldn't find anybody with anything bad to say about these stocks. Everyone wanted to buy. And frankly, that had me worried.
I feel much better now that volatile small-cap oil-and-gas producer
has fallen 14% from Jan. 31 to Feb. 10. And with heavy-oil refiner and sector favorite
down nearly 19%. And with Canadian oil sands play
Canadian Natural Resources
down nearly 12%.
And now that gold stocks
have all dropped about 11% in the same two-week period.
No, I'm not some kind of investing masochist. I personally own shares of Glamis Gold and Goldcorp, and I don't like the pain of an 11% loss any more than the next investor does.
Bring On the Unconverted
But the simple truth is that stocks go up when doubting investors are converted into buyers. If everyone is a believer, there isn't a reservoir of potential buyers ready to increase demand for shares. You make more money investing in the trend when at least a sizable minority of investors doubts the trend -- or worries that it's about to come to an end -- and resists buying into the trend even while other investors are making money.
As long as the fundamental trend is intact -- and I believe it is in the energy and gold sectors -- I'm happy to see signs of skepticism. And I get positively giddy when I see a story like
Commodity Bubble's Burst Is Good for Stocks from
Bring me your worriers, your doubters, your shorts with a need to cover. In today's column, I'm going to take a look at the trend ahead for gold stocks.
The cliche says that bull markets climb a wall of worry. And like many cliches, this one became a cliche because it is so true. Let's take a look at the gold sector to see how it works for a sector that's trending upward.
Back in October 2000 you could have bought shares of gold-industry leader Newmont Mining for $13 a share. Thanks to a round-trip that had taken the stock from $15 in 1983 to $60 in 1994 and then back to $15 in 2000, volume had dried up.
In 1990, for example, the stock traded fewer than 200,000 shares on most days, and a big spike in trading would take daily volume up to 700,000 or 800,000 shares. That's a miniscule volume of trading for a stock like Newmont Mining, with 84.5 million shares outstanding in 1990.
Volume had picked up by the time 1998 rolled around, with 1 million to 2 million shares often trading daily. Volume spiked after the August bottom, as 4-million-share days became frequent and spikes took volume close to 6 million shares a day.
All that buying turned out to be premature, as earnings per share cratered in 1998, falling to 44 cents a share from $1.14 in 1997. The rally based on this higher volume petered out after the stock hit $30 in October 1998, and the stock began its descent toward the October 2000 lows near $13 a share.
This kind of misleading volume signal in 1998 is why I like to combine technical and fundamental analysis. At some point, the buyers buying on volume momentum have to give way to buyers buying on earnings momentum. Otherwise a stock's rally will stall. A huge drop in earnings at Newmont Mining in 1999 and 2000 scuppered this handoff and led to the stock's retreat.
As the stock rallied in 2001 -- finishing the year at $19 and change -- volume picked up, but it certainly didn't skyrocket. And the fundamentals were so strong that investors couldn't ignore this stock: Earnings had rebounded from a 6-cents-per-share loss in 2000 to a profit of 8 cents in 2001. But sales were still stagnant -- a trend, or lack of one, that would persist through 2002.
Why the Gold Bulls Will Win
By 2005, sales and earnings per share were up and -- best of all for investors riding the upward trend in Newmont -- trading volume was climbing along with the stock's price. You know the joke about stocks: They're the only thing people want to buy more of as the price goes up.
Well, that was exactly the case with Newmont. By February 2006, average daily volume had risen to 7.5 million shares, and the stock had hit a high of $63 a share.
But these two trends -- higher prices and heavier volume -- had hit a critical patch in December 2005. When gold broke $500 an ounce that month, two things happened.
First, the press treated us to a constant stream of stories about gold hitting an 18-year high. Each day that the metal nudged higher, the next day's headline hammered away at the fact that we'd just hit another 18-year high. The thrust of these stories was that gold was expensive and that investors might be looking at the end stages of the boom.
Second, the gold bulls came out of the woodwork predicting $800- or even $1,000-an-ounce gold. Yes, gold was near 20-year highs in nominal dollars, but if you corrected for inflation, the historical high was closer to $1,500 an ounce. It certainly didn't hurt the gold bulls' case that they could point to the 21% return on Newmont Mining in 2005 or the 2005 return of 50% for Goldcorp shares.
I think the battle between these two points of view was destined to be settled in the bulls' favor even before the pullback in gold prices this month. Gold is in short supply in the world -- physical demand for gold for jewelry in 2005, thanks to growing demand from India, amounted to 110% of global gold production. (Re-melting old jewelry and sales from the gold stockpiles of the world's central banks made up the difference.)
Supply from the world's gold mines, J.P. Morgan calculates, peaked in 2001, and the low prices of the 1990s resulted in underinvestment in new production that should keep supply constrained until new projects come into production in 2008 or 2009.
And that's just the physical supply-and-demand story. The world's investors are putting gold back into their asset-allocation mix. You can track the effect in the growth of exchange-traded funds (ETFs) that specialize in gold.
The first fund,
, was listed only in March 2003, but gold demand from ETFs has climbed to 145 tonnes in 2005 from 39 tonnes in 2003. (A tonne is a metric ton of 1,000 kilograms, or about 2,204 pounds.)
But the drop in February gold prices swings the battle between these two opinions even more toward the gold bulls' position. The drop in price takes the sting out of the "gold hits historic highs" camp and the argument that gold is too high. Instead, for those who have noticed the returns reaped by investors in gold in 2005, the drop creates a buying opportunity. Investors who are itching to get into the sector but hesitating because of gold's price now have the perfect "reason" to buy.
Wall Street Doubles Down
You can even find this logic reflected in the opinions of Wall Street analysts. In any drop like the one gold has suffered recently, investors should check out Wall Street's reaction.
If analysts react to a decline in the prices of the stock they cover by cutting target prices and slashing recommendations to hold (almost no one ever says "sell") from buy, it puts more downward pressure on stocks already tumbling in price. (This is classic "Close the barn door after the horse has run away" logic.)
If, on the other hand, analysts use the drop as an occasion to raise targets and recommendations, it proves that they believe they see this drop as a chance to make money for clients. And, of course, by recommending that clients buy these shares, they increase buying volume, pushing up prices and generating exactly the effect they predicted. Examples:
Citigroup has raised its gold forecast to $540 an ounce for 2006 from $470 an ounce.
Merrill Lynch has raised its gold forecast to $500 an ounce from $400 an ounce.
I think all this turns the recent selloff in gold and gold stocks into one of those declines that provides a rally with fresh fuel by bringing in new buyers who have been hanging on the sidelines into the market.
I can't say how long any gold-sector decline will run -- the price of gold on a daily basis is set by speculation on such imponderables as whether the Japanese will buy more or less gold as their economy recovers.
But the turn in the gold sector will come. When it does, the move up will be strongly fueled by the big buildup in short positions in the sector. (In a short position, a trader sells borrowed shares of a stock, betting the stock will go down in price and that he'll be able to buy shares at a lower price to replace those he borrowed.)
According to Prudential Equity Group, in January, investors added $183 million in Newmont Mining to their existing short positions (total $1.2 billion), $470 million to existing short positions in
and $137 million to existing short positions in
Freeport-McMoRan Copper and Gold
. Any rally that makes shorts nervous enough to buy shares in order to cover their positions will get a boost from that fuel.
New Developments on Past Columns
Stocks for the 2006 Commodities Crunch: It's hard to imagine how earnings growth of 140% could cause disappointed investors to sell your shares, but that's exactly what happened to
( GRP) when it reported earnings before the market opened on Feb. 8. By the close on Feb. 9, the shares were down 14% from the $51.15 close on Feb. 6.
Exactly what was so disappointing? Not fourth-quarter earnings: The company beat Wall Street estimates by 3 cents a share. Not record revenue of $390 million, an increase in operating margin to 24%, or another 10% jump in order backlog of $814 million. No, chalk up the disappointment to the company's guidance for 2006. Wall Street prefers its managements to be optimistic boosters. Grant Prideco instead played it close to the vest, projecting 2006 earnings of $2.40 to $2.60 a share. That was well below the Wall Street consensus of $2.56.
But before you get your knickers in a knot like Wall Street investors, consider this: Grant Prideco started 2005 the same way with a projection of full-year earnings of 95 cents to $1.05 and then proceeded to produce earnings of $1.75. The company's projected rig count for 2006 -- a big deal for a company that sells cutting-edge technology to oil drillers -- is lower than industry forecasts, so the company based its earnings projections for 2006 on a very modest increase in drill-pipe production capacity of 17%.
I'd also like to point out that even the company's conservative projections call for 37% to 49% earnings growth in 2006. Not bad for a stock that, after the selloff, is priced at 17 to 18.4 times the company's projected 2006 earnings per share. As of Feb. 14, I'm raising my target price on Grant Prideco to $54 a share by December 2006.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: Glamis Gold, Goldcorp and Grant Prideco. He does not own short positions in any stock mentioned in this column.
Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;
to send him an email.