Confirmation that GPR.TO is undervalued relative to other mining companies

GPR.TO ( Great Panther Silver ) has been followed on this blog for a while, and recently there has been an interesting development within this stock.

This massive triangle that began at the start of April. I would like to make a case of a break out of the triangle which will lead to a substantial gain in GPR.TO.  This gain may overshoot true valuation and have a pull back but I am expecting at least a 10% move.

Complicating this situation was the announcement of a $24 million Bought Deal which closed on April 12th, but was announced March 24th.  When this was announced, the stock quickly advanced to around 4.80 an all time high for this stock.  However, this began this triangle to find the true value of this stock.  The key here is, on April 12th, the underwriters instantly exercised the over-allotment option.  The stock price this bought deal was executed at was $4.20.

"We are very pleased with the strong investor support for the Company as evidenced by the over-subscription," said Robert Archer, President & CEO.

My last part of this case that this stock should at least be over the $4.20 mark comes from some analysis of three mining companies: GPR.TO (Great Panther Silver), FVI.TO (Fortuna Silver), AXR.TO (Alexco Resources).

Using a Canadian Silver ETF (HUZ.TO) to describe price movements in silver this graph shows that a convergence between the HUZ.TO and GPR.TO is likely.  Compared to all other mining companies GPR.TO has not kept up with the silver moves.  The right hand axis is the scale for Silver and the left hand axis is the scale for the mining companies.

Also some historical correlations from January 1st, 2010 to April 19th, 20th

Correlation GPR<->HUZ    0.610178314
Correlation GPR<->TSX    0.404853301
Correlation FVI<->HUZ    0.51851121
Correlation FVI<->TSX    0.416605769
Correlation AXR<->HUZ    0.559390905
Correlation AXR<->TSX    0.442104414
Correlation HUZ<->TSX    0.512571887

GPR.TO has the highest correlation with HUZ.TO, however in the past 10-20 days this correlation has broken down.  I expect that when investors have a signal that this stock is about to move, the move will be fast and furious, barring any collapse in silver.

GOLD ALL TIME HIGH - Above $1500 - Silver above $44

Well another historical moment in the metals market.  Gold breaks above the psychological level of $1500 for the first ever.  It happen just after 2am on April 20th, 2011.  Where does it go next?  Everyone seems to agree a correction is in order which could mean that the contrarian view of a continued push to say $1600 maybe in the cards. We will see how the North American markets react to gold around the $1500 mark.  One thing is for certain increased volatility is expected to continue as shakeouts and false break outs grip the metal markets. How high is two high? That is a good question.

Below is a live chart of silver:

Pick your poison: double-dip recession or run-away inflation

Before starting this article, I would like to briefly explain why the focus of this piece is on the United States economy and not the Canadian economy. Despite the obvious reasons, like the fact that the U.S. economy represents approximately 24% of the world’s GDP, 12.5% of the world’s imports/exports, and that the USD serves as the world’s reserve currency, Canada’s economy is very sensitive to the U.S. economy. For instance, Canada’s exports represent 30% of our GDP, of which, 73% head south of the border.

It is safe to assume then that negative economic growth in the U.S. will have a similar effect in Canada. I will not go further on this topic, but I would encourage all readers to follow the developments of the Canada-European Comprehensive Economic and Trade Agreement (CETA) as it has the potential to reduce some reliance on the United States as our main trading partner.

Remember the double-dip hype in the middle of 2010?

There is no globally accepted definition of the term “recession” let alone a “double-dip recession”. A general rule in defining a recession, created by Julius Shiskin in 1975, is “two down quarters of GDP”. A double-dip scenario simply means an initial recession followed by a brief period of growth followed by a potentially deeper recession. A mild case of this “w-shaped” recession occurred in the early ‘80s.

The U.S. economy was forced back into a recession when Paul Volcker in June 1981 raised interest rates to a peak of 20%. This was to fight inflation which hit 13.5% in 1981 and by 1983 was successfully lowered to 3.5%.

By looking at different aspects of the economy, it will be shown that rampant inflation could be just around the corner and that the tools to battle the potential surge in inflation have been effectively rendered useless. Furthermore, I will argue that if the Fed decides to implement a “Volcker Rule 2.0”, U.S. citizens could be in for a very bumpy future. 

How unemployment is calculated?

First, we need to examine the mandate of the Federal Reserve which states that it will “… promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. Unemployment is the first key to this puzzle, and therefore it is important to see how it is calculated. 

The United States Bureau of Labor Statistics (BLS) calculates six different unemployment numbers. Prior to 1994, the BLS used U-5 as the official unemployment number, which is defined as “total unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force”. Currently U-3 is the official unemployment number defined and it is defined as “total unemployed, as a percent of the civilian labor force”. 

 

Expiration of the 99 week extension to unemployment benefits

In my opinion, this change to a tighter definition of unemployment was solely one of political intentions, distorting comparisons to past levels of high unemployment. For example, current U-5 level would approximately be 15%, which would be politically unacceptable if it was considered “official”.

The major difference between U-3 and U-5 is what is referred to as a “discouraged worker”, which is officially defined as “a person not in the labor force who wants and is available for a job, and who has looked for work sometime in the past 12 months, but is not currently looking because of real or perceived poor employment prospects”. The trouble with U-3 as the official unemployment number is that an able worker that has been unable to find work due to the economic situation and gives up will actually result in a decrease of the official unemployment rate. Proof of this phenomenon can be seen with the recent BLS report where unemployment dropped by 0.4% to 9.0%. The reason for the drop was not due to growth in the job market, but by an expiration of unemployment benefits that were extended to 99 weeks to help cushion the landing for workers laid off during the 2008-2009 recession.

This short term “positive” economic indicator is flawed since, if the economy does pick up, discouraged workers will become encouraged again. As they enter the labour force, pressure builds for the official unemployment number to rise. 

An additional suspicion of disinformation comes from past “initial jobless claims” revisions. The vast majority of recent “initial jobless claims” have been revised upwards. This understatement is a short-term positive indicator, as fewer jobs have been considered lost until revised upward a week later.

In regard to a double-dip recession, it appears on the surface that the unemployment rate is falling, implying that this scenario is less likely. However, consideration of stagnate job growth is required to draw a deeper conclusion of the current state of the economy.

 

The stock market recovery

Before exploring the “stable prices” portion of the Fed’s mandate, let’s turn our attention to the stock market. How can there be a double-dip recession if the stock market is reaching new highs since the lows of March 2009?

The simple answer is that we have successfully emerged from the recession. However, the real question is why the stock market is continuing to rally if unemployment is still at significantly high levels. Depending on whom you ask, one should expect to hear a wide variety of answers. My answer is strictly related to quantitative easing (QE), which refers to the Fed’s purchase of financial assets such as mortgage-backed securities and treasury bills.

QE1 commenced at the end of November 2008. The size of the program was tripled by mid-March 2009. This expansion set off the first strong rebound off the March 2009 lows. As the stimulus program came to an end, the market turned sideways. Fear of the double-dip recession laid the ground work for QE2 which was initially signaled on September 21st, 2010. This program is set to end in June 2011. If the economy has not responded to the stimulus as expected, removing this program could result in a severe correction in U.S. stock markets and potentially around the world. 

In the past, the traditional method for economic stimulus has been to lower interest rates and, thus, flooding the economy with “cheap” money. This encourages people and corporations to borrow to spend or invest, fueling a recovery. This is precisely what happened after the technology bubble burst. The result of lowering interest rates created a housing bubble which helped drag the U.S. economy out of a recession. During the recent crash of 2008-2009, interest rates were slashed to 0.25% and the Fed lost this tool to combat deflation.

The Fed argues that quantitative easing is not the same as printing money since it is a temporary action that will be reversed when the Fed sells the T-bills on the open market in the future. It is important to note that the Fed has recently become the largest holder of T-bills, surpassing Japan and China. The money the Fed gives to the primary dealers for the T-bills is then spent by the primary dealers as they see fit. This money is generally used to chase high returns by being pumped into the domestic and emerging stock markets. QE is viewed by many developing nations as a mechanism to devalue the USD and export inflation around the world.

Commodity inflation: food, energy, and metals

 

 

Cotton prices have surged over 100% in six months. Sugar prices are continuing to reach new five-year highs from lows in 2010 – a gain of over 100%. Wheat prices have climbed substantially in 2010, over 100% from the lows. Similarly, corn has risen over 80% in price since the middle of 2010, oil is back close to $100 per barrel, gold is holding above $1,350, and silver is holding its recent gain of over 50% since September. These spikes in food and commodity prices have contributed to riots around the world and partially played a part in the recent revolution in Egypt.

But where is the inflation in the West? If you look at the core CPI, it presents inflation at a very low figure. However, core CPI, the Fed’s preferred measure of inflation, does not incorporate food or energy prices as they are deemed too volatile. The food component of the regular CPI in the U.S. is the lowest percentage (7.8%) of any other country in the world; a staggering 10% lower than the world average excluding the U.S.

This weighting does make some sense as developed nations spend less on food as a percentage of overall income than emerging nations. However, for the millions of citizens living at the margin in the U.S., increasing food and energy prices are very noticeable and pose additional dangers to a recovering economy. A notable threat is the fact that citizens will have less disposable income to invest, save, and purchase non-essential goods and services. Since 70% of the U.S. GDP is based on personal consumption, this calls into question the status quo.

Retail stores are combating higher raw material prices by reducing sizing of packaging rather than increasing prices. A study conducted in January by the Consumer Report on this topic showed that packaging of specific items tracked decreased by 7.8% to 20%. Comparably, a report by the Associated Press recently warned of a 10% increase in price for clothing starting in the second half of this year as cotton prices continue to rise dramatically.    

 

Housing market and interest rates

Finally, the last part of the Fed’s mandate is to “moderate long-term interest rates”. From the above analysis, it can be seen that due to loose monetary policy, inflationary pressure has started to build around the world. Now, one might say that inflation is under control and if it starts to become an issue, the Fed can start raising interest rates. The flaw in that argument is the assumption that the Fed can raise interest rates without causing great harm to the population.

Housing is the main wealth generator for the middle class in United States and Canada. In the recent housing bust, prices drastically fell across the U.S. leaving many with mortgages that were substantially higher than the underlying value of their home. This led to the considerable increase in foreclosures over the past two years. 

By the second half of 2010, new housing starts began to plunge as housing prices continued to slide. The reason for the continued decline in housing prices is oversupply. Banks are holding large quantities of foreclosed homes that are slowly being placed on the market. In addition, a stimulus program called “first-time home buyers tax credit” ended in April 2010 reducing the incentive to purchase homes at current price levels.

As previously mentioned, the housing bubble was fueled by the lowering of interest rates to help grow the U.S. economy out of the technology bust in the early 2000s. Raising interest rates has the opposite effect, making it harder for people to obtain a mortgage as borrowing costs increase. Furthermore, home owners that are currently in a mortgage with a variable rate will face more financial pressure as interest payments become higher which, in turn, will continue to erode disposable income.

The worst case scenario is continued increases in foreclosures, leading to increases in housing supply, leading to larger declines in property values across the board, resulting in nationwide middle class wealth destruction. In addition, rising interest rates would also make it extremely difficult for the U.S. government to service its debt obligations, which currently stand at an unprecedented $14 trillion. 

 

What is the end game?

So is there going to be a double-dip recession? The question no longer matters. It is evident that the U.S. economy is stuck between a rock and hard place. It should be clear as well the economy is heading for a state of stagflation. As inflation starts to creep over the next couple of years, U.S. lawmakers and the Fed will have to make tough decisions. 

Scenario 1: pull a Paul Volcker and increase interest rates to kill inflationary pressures, but risk a deep second dip in this recession. This will result in a fundamental re-evaluation of the U.S. housing market and a severe correction in the stock market.

Scenario 2: allow inflation to run its course. Even though this scenario goes directly against the Fed’s price stability mandate, it could be considered the most advantageous option for the U.S. government with its $14 trillion dollar debt. Inflation benefits the debtor, since “new” money is less valuable and can be used to pay down “old” money. The only way this works is if interest rates are not adjusted to offset the loss in value of the “old” money. In this case, asset prices from commodities to housing to stock markets will surge. However, relative buying power of the USD would plummet.

These scenarios assume that the Fed will still be in relative control to determine the best course of action. There are less likely scenarios where either the loss of the USD currency reserve status or bond vigilantes start driving up T-bill yields as the world becomes less certain of the United States’ ability to pay down its growing debt.

If the U.S. government and the Fed can navigate an extremely narrow road to short-term stabilization and moderate growth of the economy, one major unknown remains: an exit strategy.

The Fed’s balance sheet before the 2008-2009 recession was steady at $800 billion dollars. Currently, the balance sheet stands at almost $2.5 trillion, including $1.1 trillion in U.S. treasury holdings. If quantitative easing is a temporary measure, it must be unwound at some point. It is hard to imagine the bond market holding up with a constant flow of treasuries from the Fed. It would be therefore understandable if the dollar index continues its decline from the 2001 highs.

Digital Copy of Original Print:
 
http://www.insidermediagroup.com/

CIENA Chart - Future Expectations, indebtness, and raising interest payments

Quick look at Ciena (CIEN).
This stock appears to be rolling over, the MACD looks like it will cross this week, if it can't hold the 0 level, it could indicate longer term trend change to bearish.  The Slow stoch also shows a roll over and If you plan on buying this stock it would only make sense to wait until the Slow Stoch is back closer to the 20 level.  However, My expectations are that the stock will head back to the 200 MA which should be closer to the $20 mark. This level corresponds to a pivot high in May 2010 as well so should be decent resistance.  This means close to 20% drop in the stock over the next couple of months, especially if the markets roll over which they appear they might be again.

While the US has been shook by S&P credit watch, I look at highly leveraged companies such as CIENA as at the whim of debt markets.

Here are some ratios to be worried about.  These are from Reuters.

Financial Strength

	Company	Industry	Sector	S&P 500
Quick Ratio (MRQ)	2.42	1.72	1.57	0.68
Current Ratio (MRQ)	2.99	2.07	2.63	1.00
LT Debt to Equity (MRQ)	1,516.52	20.42	14.36	113.76
Total Debt to Equity (MRQ)	1,516.52	30.62	39.19	161.87
Interest Coverage (TTM)	-74.37	2.32	0.60	17.35

I question the LT DEBT to Equity as it appears extremely high however, I do know that Ciena on all accounts is much more indebted than competitors.  With Ciena's acquisition of Nortel's MEN division required substantial debt instruments to fund it (mainly convertible notes).

A couple of interesting parts from the Annual report (2010).

Outstanding indebtedness under our convertible notes may adversely affect our business.

     At October 31, 2010, indebtedness on our outstanding convertible notes totaled approximately $1.4 billion in aggregate principal. Our indebtedness could have important negative consequences, including:

	•		increasing our vulnerability to adverse economic and industry conditions;
	•		limiting our ability to obtain additional financing, particularly in light of unfavorable conditions in the credit markets;
	•		reducing the availability of cash resources for other purposes, including capital expenditures;
	•		limiting our flexibility in planning for, or reacting to, changes in our business and the markets in which we compete; and
	•		placing us at a possible competitive disadvantage to competitors that have better access to capital resources.

     We may also add additional indebtedness such as equipment loans, working capital lines of credit and other long-term debt. 

Below is the interest payments per quarter from Q1 2009 up to Q1 2011.  Remember that the MEN acquisition occurred officially in Q1 or Q2 2010, hence an increase in Debt payments.  The trend, however based on 9 quarters, is troubling especially with the above warnings included above from the company.  

Mainly this point should be highlighted:

"Limiting our ability to obtain additional financing, particularly in light of unfavorable conditions in the credit markets"

  

Lastly, I note found in Ciena's Annual report (2010) which is a failed logical flow.

Failure to maintain effective internal controls over financial reporting could have a material adverse effect on our business, operating results and stock price.

     Section 404 of the Sarbanes-Oxley Act of 2002 requires that we include in our annual report a report containing management’s assessment of the effectiveness of our internal controls over financial reporting as of the end of our fiscal year and a statement as to whether or not such internal controls are effective. Compliance with these requirements has resulted in, and is likely to continue to result in, significant costs and the commitment of time and operational resources. Changes in our business, including the MEN Acquisition, will necessitate modifications to our internal control systems, processes and information systems. Our increased global operations and expansion into new regions could pose additional challenges to our internal control systems. We cannot be certain that our current design for internal control over financial reporting, or any additional changes to be made during fiscal 2011, will be sufficient to enable management to determine that our internal controls are effective for any period, or on an ongoing basis. If we are unable to assert that our internal controls over financial reporting are effective, our business may be harmed. Market perception of our financial condition and the trading price of our stock may be adversely affected, and customer perception of our business may suffer.

Assertion 1: Failure to maintain effective controls over financial reporting could have material consequences

Assertion 2: Compliance to Section 404 of the Sarbanes-Oxley Act of 2002, costs the company time and money

Assertion 3: Business changes and the acquisition of Nortel's MEN will require changes (posing additional challenges) to internal controls

Assertion 4: Management doubts current design for internal controls will be sufficient to enable management to determine internal controls are effective for "any period"

Assertion 5: If they cannot assert that the internal controls are effective, the business maybe harmed

Assertion 6: Market perception of the financial condition may be adversely affected (stock price drop).

A1 -> create a need for effective controls

A2 -> a complaint that adhering to the law will cost the company money

A3 -> an admission that internal controls do in fact require a change

A4 -> an admission that the current internal controls cannot be trusted as they may not be effective over "any period"

A5, A6 -> This indicates that just lacking the ability to assert that their controls are effect will harm business leading to a stock correction / financial difficulty.

Very convoluted way of saying that they really don't know if their projections can be trusted and admitting that this will hurt them at some point.

Why hold a short position in the S&P 500: Part 2

On March 28th, 2011, a post entitled: Why hold a short position in the S&P 500

I was about 9 days early on the call, however, since April 6th,  the markets have been rolling over.  Today, we go a strong drop in the morning as S&P put United States AAA debt rating on Watch with negative implications. 

With its mounting debt / deficit, the US economy requires a lot of fixing, however,  the threatened government shut down two weeks ago, a lot with the larger debt ceiling argument coming down the pipe, S&P determined there is potential for additional risk associated with US debt. 

If you couple the political risk with QE programs, and the dollar decline the past year, it is obvious the world is changing dramatically around us. 

Have a look at Gold, being ever so close to the 1500 level.  The number of stops (for Shorts) that are placed above this level is likely massive.  Breaks about this will send gold to 1525 /1550 in short order.