This Could Be A Very Profitable Couple of Months

The second half of last year was slow torture for most stock market investors.

For investors in higher-risk stocks, like small-cap mining stocks, it was even worse.

The ASX200 may have lost 14% last year. But the ASX Emerging Companies Index (which mostly comprises small-cap miners) fell by 23%.

Then very quietly, with no announcement, the market turned up in December.

No bell was rung. The market didn't send out a memo warning you. And the mood at the time was so bad that few even considered a turnaround could even be on the cards.

But turn it did.

Since it bottomed, the ASX200 has clawed a modest 5% gain, while the ASX Emerging Companies Index has exploded by 18% in just a few months.

This is important because this index is a good bellwether for the Aussie mining stocks I cover in Diggers and Drillers. And this big bounce has been good for D&D readers.

In December, we sent out a free report on a shortlist of stocks I liked for 2012. Readers that subscribed at the time and invested in all of them are now sitting on an average gain of 28% in two months. The best performer is up 66%. The other gainers are up 62%, 44%, 7%, with the losers down just 4% and 6%.

Risk and Reward

The type of stocks I recommend are risky, and need a market with an appetite for risk to thrive. So after shunning risk in 2011, why is the market risky hungry now? I asked this question in my D&D weekly update on the 22nd of December:
'In most years the market has a run up leading into Christmas; the so-called "Santa rally".

'But this year Santa couldn't afford to feed his reindeer because of food price inflation, and his sled was repossessed due to non-payment on his vehicle loan.

'There's not much Christmas cheer out there in the markets as the year limps to a close. 2011 has been one long grind.

'Smaller companies fall faster than large companies. They are riskier investments as they often depend on capital to explore, develop their projects, or expand their operations. So while the ASX200 is down 15%, the XEC, which includes small mining stocks, is down 25% since the start of January.

'So why take the risk?

'Because the opposite is also true.

'When the market turns around, smaller companies rise faster than large companies.

'Small-cap miners did much better against the rest of the market from late 2008 to the start of this year. The small caps outperformed by more than four-fold: 85% for the ASX300 metals and mining index, compared to 20% for ASX200.

'So the 500 billion Euro question is - Which one is it to be in 2012?

'The market is truly in the hands of the politicians, so you'd have to ask them. There has never been more market intervention than there is today. No one knows which dial, lever, or button the central bankers, or nation's leaders, will push next to try and save the day. Trying to guess their next move is what passes for trading these days. The political headlines from Europe have been driving the market for most of this year.

'I've heard that if you put a chimpanzee in front of a typewriter and incentivised it to hit buttons at random, it may just take many years, but it is a matter of permutations and probability before it produces the complete works of Shakespeare.

'With this in mind, I'm starting to think we elect a chimpanzee into the ECB, to accelerate the progress made against the European debt crisis so far.

'I think we could all do with a break from hearing about Europe over the next few weeks. But I doubt that we will. And be prepared to hear about it right up to Christmas next year as well.

'The latest move has been for the European Central Bank (ECB) to offer unlimited loans to banks, for 1%, at 3 years.

'So where is that money coming from then?

'The ECB is printing it (although these days it is just done electronically with a key stroke).

'This is simply 'Quantitative Easing' by another name.

'The ECB can legally print this money - as long as it has collateral from the borrower. So to allow unlimited loans, the ECB has loosened the terms of what it considers 'collateral' to include just about anything.

'Government bonds, small business loans, antique hub caps, and Aunt Mildred's glass unicorn collection. It's all the same to the ECB. Just as long as they can find the price on eBay for your chosen collateral, they'll fix you up with an easy billion euros of cheap credit for three years...'
Since then, the sugar rush of half a billion euros of LTRO money has calmed the European bond markets. The barometer-of-the-moment, the Italian 10-year bond yield, has now fallen dramatically to less than 5%.

Italian 10-year bond yield at an 8-month low

Source: Bloomberg

Great, but what does this tell us? This tells us that the market thinks the chances of Italy going down the same road as Greece are less likely now. French and Spanish yields have also been falling fast.

The ECB have now decided to bet they can print their way out of the European debt crisis. Banks have just taken up another half a billion of LTRO loans. I think this is why the fall in Italian yields has accelerated in the last week.

Fighting debt with debt hasn't worked so far, so I don't think that it will work in the long run this time.

But, in the short term at least, I do think we will see more risk coming back into the market. The falling bond yields have made stock market investors more comfortable that a Euro crisis is on ice - for now anyway.

So I think the second LTRO will mean a continuation of the rally that is driving up small-cap mining stocks. The music will stop at some point. I think it could be at least a few months off, judging by the effect of the first LTRO. Until then...

Make Hay While the Sun Shines

Gold and silver small-cap stocks have had a huge turnaround. They are rallying on a 12% increase in the gold price and a 34% jump in the silver price - as well as the big jump in risk appetite.

The junior gold miners index (GDXJ) has bounced 20% since Christmas. This chart covers the smaller gold companies that are exploring for gold, or developing gold mines. The chart is looking much better, and I think the next leg up is brewing.

20% bounce in small gold stocks in two months

Source: stockcharts

Some small-cap gold and silver stocks have done much better than this.

An Aussie silver explorer I tipped for D&D readers in December, in just 3 months, has gained 103%. A gold explorer I tipped 11 months ago is now up 213%; with plenty left in the tank I reckon.

Precious metal stocks make up over half of the 19 stocks in the D&D portfolio, but in January I saw a rally brewing in oil. Demand for oil was growing steadily, but the supply side was falling to pieces. The problems around Iran were the catalyst for the whole thing to take off. So it made sense for me to shift my attention to oil stocks.

It wasn't just Iran though. Major oil exporters including Nigeria and Kazakhstan, who between them export more oil than Iran, were facing their own problems. Supply is also falling from other exporters.

Political chaos in Sudan and Yemen has caused a 500,000-barrel-a-day gap in the market. That may not sound like much when the world gets through 90 million barrels each day. But the market is so tight that it could be more than enough to move prices. Production from Syria is also falling on the back of sanctions from the European Union.

Brent crude oil is up 12% in a month, and the oil stock I tipped in January is now up 43%.

You just have to look around the market to see that we are back into a market where risk-tolerant investors can make good money on explosive moves.

It's not just gold, silver and oil stocks.

One copper explorer has jumped 109% in eight trading days. This was after spectacular drilling results of 231 metres of 4.49% copper. Put another way, this intersection contains more copper than the result that put Sandfire Resources on the map.

Even unglamorous sectors are rallying. Take uranium stocks for example. The two D&D uranium stocks are up 30% and 38% from their December lows. Another uranium stock, Alliance Resources (ASX:AGS) has soared over 196% since early December.

Apart from the likely effects of the ECB's money printing, one thing that told me the market could be turning in December was just how bearish everyone was. When everyone has truly had a gutful, that is often the time to go shopping.

As Lord Rothschild said, 'Buy on the sound of war cannons, and sell on the sound of victory trumpets'.

There's certainly no sound of victory trumpets just yet.

The mood in the market is still cautious and negative. Investors are disbelieving and untrusting of this rally.

With this mood prevalent, and the effects of the LTRO2 still to filter through in coming months, I think the small-cap rally has legs yet. Using sensible risk management, and picking the best stocks to ride the rally, it could be a very profitable couple of months ahead.

Dr. Alex Cowie
Editor, Diggers & Drillers


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