Verdmont Capital

Friday, July 31, 2015

Gold and Silver Fall into the Abyss / Gold Company All-in Production Costs ($/oz) / Gold Producers are in a Tough Spot (ABX.T:$9.37) / Now What?

Gold and Silver are Getting Creamed

We have been involved in the precious metals sector for many years. As personal investors, investors on behalf of our clients and in conjunction with Verdmont Capital’s corporate finance work. We have been staying clear of the sector for some time, and are happy to have avoided most of the onslaught.

Frequently, we can attribute a touch of luck to our successful investment calls. We come out with a thesis, and if everything aligns properly, we do ok. There is often a fortuitous event, or extraneous kicker, that helps push our call over the finish line. With our bearish call towards the gold sector, we can say that there was no luck involved.

We took a sober look at the sector, stripping out all the wild emotion that comes along with it, and saw that nothing was working in its favor. As active investors know, sometimes the best investments decisions are those associated with the investments that you do not make.

Our bearish long term stance, which was outlined in prior notes (http://www.verdmontlive.com.pa/2013/10/gold-sick-trade-gets-sicker-not-sick-as_12.html), was predicated on the belief that the gold trade was just not working. Inflation was non-existent and gold was not reacting positively to news that played into its crisis hedge status. When an investment or an asset class fails to respond to events that are typically bullish, it is a sign of a sick trade.

Further to this, all of the factors that had contributed to the bull market in gold, commencing in 1999, began to work against it. We have summarized these drivers below.

Table 1: Gold – What Happened?
1
The US dollar became increasingly attractive relative to the other major currencies.
2
Real interest rates in the US were beginning to reverse a multi-year slide.
3
Excessive monetary easing was not contributing to a pickup in inflation.
4
The Chinese miracle was not going to send commodities to the moon into perpetuity.
5
The limited supply theory regarding the commodity complex, bolstered by the “peak oil” theory, began to unravel.
6
Gold’s status as a crisis hedge was severely damaged by its inability to weather various systemic shocks.
7
The traditional stock market has continued to surprise to the upside.
Source: Verdmont Capital S.A., Bloomberg

Looking at the above drivers, it becomes clear that it has been difficult to muster up a bullish view on gold and related equities over the past few years.

Granted, from time-to-time, we traded various precious metal names to play swings in sentiment. Our trades were on both on the long and short side of the market. We would probably give our trading performance a “C” grade over the past few years. Winning more than we lost, but no doubt taking the odd hit.

One of the big trades in the precious metals sector, had been playing the bounce of both gold and silver off of well-established support levels. Support for gold was at ~$1,200/oz and the floor for silver had been ~$20/oz and then ~$15/oz. These support levels have been broken, only recently for gold, which has supercharged the selloff in the complex.

Gold Bullion – 5 Years
Source: Verdmont Capital S.A., Bloomberg

Silver Bullion – 5 Years
Source: Verdmont Capital S.A., Bloomberg

Gold Producers are in a Tough Spot

It is worth noting, that the $1,200/oz support level for gold was not just an arbitrary price point established by the market. The market hung onto $1,200/oz as a floor, because it was the widely accepted price where gold companies could remain profitable. In other words, if prices broke $1,200/oz, many gold producers would fail to breakeven, resulting in negative earnings and an inability to devote additional capital to the funding of new projects.

This has created a heighted degree of concern in the market about the ability of various companies to execute on their existing business plans and objectives. Looking at sustaining cash costs and total all-in costs, outlined below, it becomes evident that these fears are not unfounded.

All-in Sustaining Cash Costs ($/oz)
Source: Verdmont Capital S.A., Bloomberg

Senior Gold Stock Total All-in Costs – Trailing and Forecasts

We would imagine that there are a few management teams in the precious metals sector feeling the proverbial heat. At this point, it isn’t necessarily the share price they are the most concerned about. At current spot prices, the ability of various companies to service their debt obligations, and meet the various covenants often embedded within them, becomes increasingly more important.

Unfortunately, when you are boxed in by a collapsing market, your options become fewer and the decisions that need to be made become that much more difficult. If we don’t see a quick snapback in the price of gold, look for gold companies to take some drastic measures to stay in the game. In addition to ongoing cost cutting measures, and a likely dividend freeze, various companies might have to become more aggressive in an effort to shore up their balance sheets. This may involve equity sales, the shedding of assets and/or taking on additional debt.

Each of these options are what we like to call “dusty”, or, fraught with issues. Very simply, selling equity would involve diluting existing shareholders at prices close to 15 year lows, asset sales would be at done at fire sale prices (if at all) and the costs associated with issuing additional debt are becoming increasingly prohibitive.

Using Barrick Gold (ABX.T:$9.37) as an example, you can see that the numbers are moving in the wrong direction. The company has never had more debt in its capital structure, while at the same time, it is bleeding-out due to historically low profitability (or lack thereof). These numbers are setting up to be that much more troublesome given the recent collapse in gold.

Barrick Gold (ABX.T:$9.37) – Debt and Margins – 1989 to Present
Source: Verdmont Capital S.A., Bloomberg

The equity market has taken notice of Barrick’s predicament, which is of no surprise. What is surprising however, is that the stock is now trading where it was in 1990 (yes, 1990). This is despite the fact that we have just witnessed one of the strongest gold bull markets in recent memory.

Barrick (ABX.T:$9.37) – 1985 to Present
Source: Verdmont Capital S.A., Bloomberg

We have gone from watching the stocks, to following what is going on in the debt market. During times of heightened duress in any sector, equity stories typically become debt driven ones. The debt markets begin voting as to whether certain organizations will survive, and if so, how strong they will be coming out the other side.

Once again, using Barrick as an example, the debt markets are becoming concerned about the solvency of the company. This becomes evident when you look at value of Barrick’s bonds in the market, and the corresponding spike in yields. You can also see that the company’s credit default swaps, or the cost of insuring bond holders in the event of a default, have also jumped considerably.

ABXCN 4.1 5/01/23 - Yield and Spread to 10yr US Treasury – 1 Year
Source: Verdmont Capital S.A., Bloomberg

Barrick 5 Year Credit Default Swap – 5 Years
Source: Verdmont Capital S.A., Bloomberg

The issues facing Barrick are not specific to the company. If you pull up other names, such as Newmont’s debt for example, you are seeing a similar theme play out. By and large, all of these producers are getting caught with their shorts down. 

A couple of articles today in Bloomberg, highlight the problem facing natural resource related companies. The debt market is beginning to riot and various companies are due to begin writing down the book value of their assets.



So, to wrap things up, the gold trade remains sick and the producers are on the ropes. Without a quick bounce in the price of gold, expect more bad-to-shocking news from well-known companies.

Now What?

Looking at what drives physical gold and silver, which we outlined in Table 1 above, it is tough to make a fundamental argument on owning bullion at the present time. Granted, experience suggests that the time to buy something is when the market thinks there is no reason to own it. We get that. Right now though, let’s wait and see. Iron ore, oil, thermal coal, met coal, copper, nickel, etc., have all gone to levels unfathomable a couple of years ago. Why not gold and silver? We have not seen anything to suggest to us that the onslaught is over.

In terms of the large cap equities, there is no question that they are cheap – and have been getting cheaper. In terms of our view as an investment? We have a “you first” approach. Yeah, sentiment is low, and yeah, they are cheap. As we outline above however, this is deservingly so. There is no need to be a hero here. Remember, gold stocks represent a fraction of the investable equity market cap out there. Go where there is a reason to own something, other than hope. Hope has not worked with gold stocks for 5 years now. The one bright spot is that the strong US dollar, moderating sector labor costs and plunging energy costs should be good for producer profitability at some point.

Market Vectors Gold Miners (GDX:$13.64) – 5 Years
Source: Verdmont Capital S.A., Bloomberg

In terms of the juniors, as our friends at Stifel in Boston like to say, its OVAH. Once again, from a contrarian standpoint, that’s good. We are looking to trade the juniors before the year end. Luckily, we have been on the right side of the trade and have some powder dry. We imagine that the trade will show up in conjunction with a topping in the US dollar, a stabilization in the oil selloff, Chinese bubble fears subsiding and Canadian stocks in general catching a bid.

Market Vectors Junior Gold Miners (GDXJ:$19.25) – 5 Years
Source: Verdmont Capital S.A., Bloomberg

S&P/TSX Venture Composite – 5 Years
Source: Verdmont Capital S.A., Bloomberg

As always, please call your Verdmont Capital representative to discuss our in-house investment view across various segments of the market.


Monday, July 13, 2015

Bank of Canada Rate Decision this Wednesday - Look for a Cut

There is a rate decision by the Bank of Canada this week. To cut or not to cut, that is the question.

Here is a snapshot of some of the factors that the BoC will be incorporating into their decision:  


Economists are forecasting that the BoC will cut the overnight lending rate by 25bps, from the current level of 75bps.

BoC Overnight Lending Rate, Actual vs. Forecast – 10 Years
Source: Verdmont Capital S.A., Bloomberg

A cut makes sense, because it would ease lending costs for the over indebted consumer, reduce the debt burden for struggling energy companies and help the banks via a steeper yield curve. Additionally, one could argue that the BoC wants the loonie to go lower, as it would help the “phantom” recovery they are touting in the non-energy related manufacturing sector.

They may decide not to cut, as a decision to do so would have a negative signaling effect and curtail confidence towards the economy. Secondly, they are probably trying to figure out what the US is going to do with their short term rates. If the Fed raises rates over the next few months, it is essentially cutting rates for the Canadians, without them having to indicate they are witnessing significant slack in the local economy.

If we had to bet, we believe the case for cutting rates is more compelling than staying pat. The BoC will want to appear proactive and economic data has been quite soft as of late – not to mention that there has been a pretty steep correction in oil after its snapback rally.

A rate cut is bullish for our Canadian dollar short. Price action as of late suggests that the currency market is also betting on a cut. The loonie is trading like it wants to go to new multi-year lows.  

Canadian Dollar Sept 2015 Future – 1 Year
Source: Verdmont Capital S.A., Bloomberg

Friday, July 10, 2015

Copa Airlines (CPA:$84.35) - Setting up for a Short Squeeeeeeeeeeeze

We follow Copa Airlines (CPA:$84.35) closely and have been in-and-out of the name. A sagging share price as of late, along with a renewed bout of oil weakness, has us wondering if now is the time to get back on board.

The last time we took a significant position in CPA, back in December of 2014, we noted that the stock was due for a bounce as it had yet to react to a significant fall in oil prices. In addition to this, the broad equity market was on a tear and global airline stocks were going to new highs. Our thoughts were outlined in a previous post, which can be found here:  www.verdmontlive.com.pa/2014/12/copa-holdings-cpa9890-all-i-want-for.html .

CPA has now sold off rather significantly after having a decent run entering into 2015. The underperformance this year, has been that much more severe that CPA’s global peers.

Copa Airlines – 1 Year
Source: Verdmont Capital S.A., Bloomberg

Copa Airlines vs. NYSE Arca Global Airline Index – 1 Year
Source: Verdmont Capital S.A., Bloomberg

From a technical standpoint, CPA is bouncing off of support in the low 80’s and various indicators suggest to us that the selloff has become exhausted.

CPA Demark Indicator (weekly) – 2 Years
Source: R.F. Lafferty & Co., Inc.

There is also a significant short position in the stock. There is an aggregate short position in the market of 6 Mil shares, which represents 18% of the total float. This is quite significant.

Were CPA to experience a change in momentum on market related developments and/or a change in sentiment due to positive company specific news, we could see a nice pop in the name as the shorts look to cover.

CPA Short Interest – 5 Years
Source: Verdmont Capital S.A., Bloomberg

We recommend buying CPA for a bounce and employing a stop loss of $76/share.

CPA – 1 Year
Source: Verdmont Capital S.A., Bloomberg


Thursday, July 9, 2015

The Bond Market is in Uncharted Territory / Underfunded Pension Plans / Chicago is Broke / The Canadian Economy is Contracting

Below is a link to IceCap Asset Management’s monthly investment commentary for July 2015.


We have known IceCap’s Founder, Keith Dicker, for many years. We have always appreciated Keith’s insights, and more importantly, he always acts in the best interests of his clients.

Some timely topics in this piece, which we tend to agree with, are:

  • After a multi-decade bull market in bonds, the market has no idea what a prolonged slump in fixed income securities would look like. 
  • If you analyze the expected (theoretical) returns embedded in various pension plans, it becomes evident that they are living on borrowed time. 
  • Chicago is broke (good thing we have the former Senator from Illinois doing the same thing in Washington). 
  • Economists are seldom right and have called none of the past 7 recessions. 
  • The Canadian economy missed economic forecasts by a wide margin in the first quarter of 2015. This suggests that economists are zigging when they should be zagging.

Wednesday, July 8, 2015

Look for the Loonie to Follow the Australian Dollar to New Lows

The Australian dollar has broken new lows, which bodes well for our Canadian dollar short position.

The two have had a tight trading relationship in the past.

AUD vs. CAD – 5 years
Source: Verdmont Capital S.A., Bloomberg

A chart of the loonie provides little confidence that it can hold recent lows. The loonie continues to breakdown, against what we believe are deteriorating economic fundamentals in Canada.

Canadian Dollar Future (Sept 15) – 1 Year
Source: Verdmont Capital S.A., Bloomberg

Look for the loonie to follow the Australian dollar lower.

Monday, July 6, 2015

Shorting the Loonie Again - "Oh-O" Canada

We are shorting the Canadian dollar (CAD) as it is due for another leg down.

If you are long CAD positions, in a US dollar (USD) focused investment account, our call is even that much more relevant.

We believe that the Canadian economy, and by extension the market, is in a tough spot. Our view has not changed since we came out with our call to short the Royal Bank of Canada (RY.T:$76.21). A summation of our view can be found in previous posts to our news site, Verdmont Live.



It is worth noting that we have been bearish on the Canadian dollar for some time, which was outlined in prior notes, where we suggested that the loonie was heading into a period of prolonged weakness.


Now is probably a good time to reload on the short side. We think a short position in US dollar focused investment accounts that hold CAD positions is even that much more compelling.

We remember an investment commentary piece way-back-when by Eric Sprott where he wrote, “weakness begets weakness.” We believe that the sentiment of that statement applies directly to the current state of the Canadian economy, and by extension, the loonie.

The CAD has sold off rather significantly vs. the USD, which has some contrarians believing that shorting the loonie is an exhausted trade. That would be the wrong position to take, as it is going to get worse before it gets better. Weakness begets weakness as the smart guys say.

Recent news and events coming across the wire indicate to us that now is the time to go short again. The oil rally off of its lows has become tired, the US dollar is setting up to go higher once again, Canadian economic data is due to surprise to the downside and there is increasing chatter of a rate cut to prop up growth. These deteriorating fundamentals continue to be matched by horrific household debt dynamics, which continue to go the wrong way. Note: For a detailed summary on Canadian household debt levels, please view the Royal Bank note from Jan 2015 (above).

From a technical standpoint, the loonie is breaking down again. When the charts jive with our view on the fundamentals, we pay attention. We pay even more attention when a currency is on the cusp of breaking to new lows, which tends to supercharge the price action.

Canadian Dollar – 1 Year
Source: Verdmont Capital S.A., Bloomberg

The pop in oil off of its lows, and corresponding weakness in the US dollar, has become tired. The positive momentum, and the associated hope for the Canadian economy, is fading. A weaker oil price has not been fully discounted by the market in our opinion. We continue to see far too many articles discounting the importance of oil on the Canadian economy. Remember, when the oil price was rocketing higher, it was being trumpeted as a bullish development for Canada. We believe the inverse must be true.

The rally in oil, has been a bullish CAD factor, given the importance of natural resources to the Canadian economy. Regardless of your view on oil, it isn’t a stretch to assume that the snapback rally has largely run its course, and any upside from here will be measured at best.

The Canadian Dollar vs. WTI Oil – 1 Year
Source: Verdmont Capital S.A., Bloomberg

Those who follow the oil market will know, that supply/demand fundamentals have been taking a backseat to USD price action as of late. The selloff in oil, and subsequent rally this year, directly coincided with the fortunes of the US dollar.

WTI Oil vs. Trade Weighted US Dollar – 5 Years
Source: Verdmont Capital S.A., Bloomberg

There are reasons to believe that recent US dollar weakness has run its course. With a relatively strong US economy and the Fed under the gun to raise rates, as other countries remain in full on easing mode, the US dollar should remain sticky to the upside.

The rally probably got ahead of itself, resulting in a correction, which has arguably led to short term capitulation. You don’t have to like US dollar strength, but it should continue to surprise the market, however flawed people believe it is.

The Trade Weighted USD vs. JPM Capitulation Index (30 Years)
Source: BCA Research

Economic data in Canada is also setting up to disappoint the market. The country has had four consecutive months of negative GDP growth, with the last month surprising every economist by a wide margin to the downside. We continue to believe that the market is underestimating the impact of the commodity correction on the Canadian economy.  Here are some recent articles that underscore our view.



Further to the above, The Citi Canadian Economic Surprise Index has rolled over. The index measures those economic data points that are beating/missing estimates. A rollover in the index is consistent with economic expectations, and sentiment, becoming overly rosy. When the Index tops out, it has been a pretty good leading indicator for CAD weakness.

The Canadian Dollar vs. The Citi Economic Surprise Index – 3 Years
Source: Verdmont Capital S.A., Bloomberg

Seasonality is also working in favor of a CAD short trade. The Canadian dollar typically has a rough time during the summer months, as is illustrated by its average 10 year seasonal performance below.

Canadian Dollar vs. 10 Year Average Seasonal Performance
Source: Verdmont Capital S.A., Bloomberg

Relative interest rate spreads are also due to put pressure on the Canadian dollar. With increasing chatter of a rate cut in Canada, the policy rate spread of CAD over USD will in all likelihood come in.

The below chart by BCA (third panel), illustrates the policy-rate spread in Canada versus the US. It is also worth noting that BCA’s intermediate-term CAD indicator is in bearish territory.

BCA, Canadian Dollar Data Points – 10 Years

Look for the entire yield curve in Canada to come in versus the US, where economic growth is relatively strong and policy makers are under the gun to raise rates. You will see that the relative yield of Canadian 10 year government debt is breaking to new lows when compared to US 10 year treasuries.

Canada 10 Year Govt Yields vs. US 10 Year Govt Yields – 5 Years
Source: Verdmont Capital S.A., Bloomberg

In summary, we believe that now is a good time to go short the Canadian dollar. You have the economy, commodities, interest rates, consumer debt levels and banking sector health (soon to be seen) working against it. If you hold a significant amount of CAD denominated investments, where your daily liabilities are in US dollars, this positions makes that much more sense.

We are selling Canadian dollar (Sept 15) futures contracts to express our view. We have a stop in at $82 to exit the trade if it goes the other way on us.

Sept 15 Canadian Dollar Future – 1 Year
Source: Verdmont Capital S.A., Bloomberg

Monday, June 29, 2015

Commodities - Back to the Future - For Now

We have been overweighting commodities in our managed accounts, to the expense of equities. 

The thought process is pretty simple - one asset class is priced for perfection and the other is priced realistically. If strength in the equity market over the past 5 years is legit, then global growth and commodities will have to follow stocks higher. If the rally has been artificial, commodities have already priced in slower growth, and will outperform on the downside.

MSCI (Green), Chinese H Shares (Purple), Bonds (Red), Commodities (White) – 5 Years
Source: Verdmont Capital S.A., Bloomberg

If you oversee a mandate that requires you to be fully invested, then commodities make a lot of sense in here. Our least favorite segment is the base metal complex, which we believe is still lofty, particularly copper. Focus on agribusiness, energy infrastructure and gold plays.

Check out wheat and corn over the past week – no concerns about Greece or overstretched equity markets here.

Wheat 3M Future – 1 Year
Source: Verdmont Capital S.A., Bloomberg

Corn 3M Future – 1 Year
Source: Verdmont Capital S.A., Bloomberg