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Week 17 Portfolio Update: Of Two Minds

My portfolio was up rather substantially last week, along with the rest of the stock market.  To be honest, I would not have expected it to happen that way.

My portfolio is constructed against what I see as an eventual calamity in Europe, and my expectation that as the dominos begin to fall, perhaps extending as far as Japan, that investors will reconsider the grand 40 year experiment with fiat currency , and with that they will reconsider gold.

(I’m really starting to sound like a gold bug, aren’t I?)

The market, on the other hand, looked at the plan (or plan of a plan depending on how exact you want to be with your language) that the EU laid out on thursday and apparently began to wave the all clear flag.

So what happened?  How did gold rally at the same time as the broad markets?  Isn’t this a conflicting signal?

Well it is and it isn’t.  I think you have to look that the situation through two lenses to truly understand the response of gold, of the stock market and of the bond market.

The first lens is reality. This is what the bond market and the gold market are telling you, and it is all about the inadequacy of the bailout.

The WSJ laid out a fact based piece on the front page of the Saturday Journal.  Sometimes the facts are as damning as any commentary.  While the market rallied on Thursday, the bond market hardly budged.  Sometimes a chart is worth a thousand words.

Worse, on Friday Italy held an auction and was forced to issue 10 year bonds at above 6%.

In Friday’s bond auction, Italy was forced to pay more than 6% interest on its new 10-year debt, approaching levels that some analysts said the country can’t afford for long.

Its actually somewhat surprising that the market has so far shrugged this off.  First, it is a pretty scathing critique by bond investors.  One day after the grand plan announcement and Italy is paying higher rates than it was even a few months ago.

Moreover, as the above quote alludes to, this crisis began in August when Italian bonds rose from 5% to 6%.  The reason that this seemingly innocuous move up was met with such fear by the market is because Italy is basically on the precipice of falling off the cliff of solvency and 1% can throw them over the edge.  While Italian government revenues can withstand a 5% interest payment, they cannot withstand 6%.

That is how thin the thread is that Europe hangs to right now.  Italy owes $1.9t of debt.  When you owe that much debt, over the long run (as that debt comes due) whether you are solvent is more a question of perception than anything else.

Right now the perception isn’t so good.

And let’s look at little closer at some of the details of the plan.  First, the EFSF.  Do you really think that the EFSF, which according to the same WSJ article is expected to guarantee only the first 10% of Italian and Spanish debt after default (I thought this was supposed to be 20%?) is going to appease investors at future Italian and Spanish bond auctions who have just watched Greece take a 50%+ haircut?

And do you really think that Greece is going to be able to live up to the forecasts laid out in the plan?  The recap agreed to will lead to a Greek debt load that will peak at 186% in 2013 and that will fall to 120% by 2020.   That alone is worth reading twice.  But it gets better.  This will take place if you presume their growth scenario of 1 1/4% by 2013 and 2 1/4% by 2015. Seriously.

Given the scenes I’ve seen from Greece the last few days I wouldn’t be betting my pennies that the country will be growing at 1.25% in a little over a year.  It looks like a country in collapse mode.  As the WSJ points out in another article on Saturday:

Greece is the canary in the euro zone’s coal mine. The bloc’s prescription for a crisis spurred by overborrowing and overspending is a dose of radical fiscal rectitude, delivered fast. To regain the confidence of skittish investors, countries are being asked to rip up paternalistic policies that provided stability and comfort to legions of citizens but left the state reeling from the bill. The question is, can it be done without igniting society into revolt?

Greece has youth unemployment of 43%.  They have total unemployment of 16% and rising at a pace that is beginning to look parabolic.  And they haven’t even begun to fire the civil servants that they need to in order to meet the austerity measures they have agreed to.  The country is being ripped up at the roots and it is supposed to grow again in a year?

Moreover, the one mechanism that could make Greece competitive is off limits.  They are stuck with the Euro, which means they are stuck playing on a level currency field with Germany even when they are clearly world’s apart.

On final point.  The bailout, and future bailouts, are all going to have to be be paid for by someone.  Those someones are Germany and France.  Neither of these countries are a fortress of debt virtue.  Both have debt to GDP ratios of around 80%.  This point seems to get forgotten.  The bailout-ers are really not in that much better shape then the bailout-ees.

I could go on.  But you get the point.  This is not over by a long shot.

But, having given my critique, I did say that I was of two minds right now.   What is the other?

Well I was re-reading The Big Short this weekend for perspective.  By the summer of 2007, when the two Bear Sterns hedge funds collapsed, pretty much everybody that mattered knew that sub-prime was a big problem.  By February 2008, when Bear Stearns collapsed, you would have had to be in a bubble to manage money and still not know anything about subprime mortgages.  Yet the market plodded along, rallying at times, until the fall of 2008.  And it wasn’t until after the shit hit the fan, after Lehmans went belly up and credit essentially ceased to flow, that the stock market actually began to plummet.

I think that what has to be remembered is that most money managers investing in the stock market are not really being paid to quantify the scenarios in Europe.  Its out of scope to have to account for that sort of risk.  They probably just want it to go away so that they can return to what they are paid for and go home when they are supposed to.

This deal appears to give them the out, for a while, that lets them do that.  What this deal has done is stave off the final denouement for another few months.  Enough time that the market can perhaps gleefully rally and pretend again that all is well.

And who am I to argue with that logic?  I’m certainly not going to go out and buy bank stocks based on it, but if the market is going to tread water for a while longer, there are a number of stocks out there that could benefit.

With that in mind, I bought some stock this week.  The first is I bought back some Equal Energy on the news of their property disposition.  As I have already written this is a good deal because it is a deleveraging one.  And Equal remains extremely cheap by any metric.  There was a very good post on IV that pointed out that Equal’s Mississippian land in Oklahoma is worth $60M to $75M alone at the going rate of recent transactions.

I also opened a new position in Midway Energy.  Again pointing to a post on IV, Midway is trading very cheaply based on its current production and cashflow.  As teh excerpt below points out, you aren’t even fully paying for the Garrington assets, let alone the potential in the Beaverhill Lake.

With the stock only trading at $3.61/share we believe the stock is not even fully reflecting the value of the Garrington Cardium assets let alone any value for the Swan Hills Beaverhill Lake play. Our base valuation reflecting the 2012 cash flow is $3.00 and the Garrington upside potential adds another $2.50. We therefore believe that investors are getting a free ride on the 40 net sections of Beaverhill Lake rights at Swan Hills with their investment in MEL.

As well I have sold down the extra shares I bought of Jaguar when it got into the low $4 range, and replaced them with shares of Aurizon Mines in the mid $5 range.  Jaguar, which was up 35% this week, is an enigma.  There was no reason for it to fall as much as it did two weeks ago, and there is no reason it rose last week.  I think its pure manipulation.  I decided to lighten up before the manipulators changed their stripe.

Finally, one stock that I have not yet bought (back), but that I plan to is Gramercy Capital.  The company is cheap, and it probably is going to sell itself sooner or later.  I will be buying on any significant correction downward.

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A Positive Step for Equal Energy

In a week that was littered with strong stock performance, one of the best stocks in my current ownership lot was Equal Energy.  Most of the outperformance came after the company released news that they were disposing of non-core assets.

Equal Energy Ltd. (“Equal” or the “Company”) (TSX: EQU): (NYSE: EQU) announces that it has entered into definitive agreements to sell several non-core properties in Canada for a total cash consideration of $49.35 million (the “Asset Dispositions”). The proceeds from the Asset Dispositions will be used to reduce outstanding debt.

Don Klapko, President and CEO commented, “ Equal will continue to develop its key oil plays in the Alliance Viking and Lochend Cardium in Canada, and its liquids-rich gas play in the Hunton formation of Oklahoma.”

The Asset Dispositions include properties in Alberta, Saskatchewan and British Columbia and compromise total current production of about 2,100 boe/day, of which 51% is natural gas. Upon closure of the transactions, Equal expects to realize lower operating costs and interest expense resulting in improved cash netbacks per unit of production on the remainder of its assets. Equal estimates that its net asset value will be approximately the same after the completion of the Asset Dispositions. The Company anticipates its second half 2011 production to range between 9,200 – 9,700 boe/day, after taking into consideration the Asset Dispositions.

By taking a look at the last Annual Information Form released by the company (March 24th) its pretty clear that Equal sold off all its land outside of the 3 core areas of the Alliance Viking, Lochend Cardium in Canada, and the Hunton formation of Oklahoma.  Below is a list of other properties owned by Equal and producing totals for each area.  Together these properties add up to about 2,000boe/d.

So what are these properties?  Below I’ve copied the description of each from the AIF:

  • The Desan property is located 120 kilometres northeast of Fort Nelson, British Columbia in the gas producing greater Sierra area.  The primary producing zone is the Jean Marie formation.Daily average production in Desan for December 2010 was 2.6 mmcf/d of natural gas and 16 bbl/d of oil and NGLs.
  • The Clair property is located 20 kilometres north of Grande Prairie. The Corporation’s assets include a 100% working interest in 4,380 acres of land (1,340 net undeveloped acres), 15 producing wells, 6 water injection wells, and a profit sharing interest in an oil blending facility.  Oil and natural gas production is primarily from the Doe Creek (Dunvegan) formation. The Doe Creek oil pool produces light (41 API) oil along with solution gas and is currently under water flood to maximize oil recovery. There is also natural gas production from one Charlie Lake well. Average working interest production for December 2010 was 227 bbl/d of oil and 379 mcf/d of natural gas.
  • The primary production is crude oil (27 API) from the Pekisko formation. Much of the Corporation’s land is covered by 3D seismic with detailed geological and geophysical studies outlining new development drilling opportunities. Additionally, significant potential lies in the Bow Island and Sunburst formations. During 2010, Equal drilled two wells in the Princess area. At year-end, the Corporation had 25 producing wells in the Princess area with average working interest production of 303 bbl/d of crude oil and NGL and 817 mcf/d of natural gas. Net undeveloped acreage totalled 1,237 acres at year-end.
  • The Primate heavy oil field is the main producing asset in the Primate area and the Corporation holds a 100% working interest in this property. Oil and natural gas production comes primarily from the McLaren and Mannville formations respectively. Despite the oil’s gravity, 11 API, the gas saturation of the reservoir allows cold production of the oil under a primary recovery scheme.Average December 2010 production from the Primate area was 387 bbls/day of crude oil and 925 mcf/d of natural gas.
  • Natural gas production from the Liebenthal area comes from the Viking formation. The Corporation holds a 100% working interest in the pool. Seismic indicates that the pool is structurally controlled. Average December 2010 production from the Liebenthal area was 1,028 mcf/d of natural gas.

None of these properties strikes me as terribly interesting and the undeveloped land appears to be negligable.

Reduction of Debt is a Good Thing

The reason that this is such a good move for Equal is not because they scored a killing on the price.  They didn’t.  They received about $25,000/boe producing on the transaction.  This could be considered a bit low, but given the following facts, its not bad:

  • The amount (51%) of natural gas involved
  • The oil produced at Primate is 11 API
  • the oil produced at Pekisko is 27API and presumably requires a lot of water handling
  • There is almost no undeveloped land involved in the deal

The reason this is such a good move for the company is because it de-leverages them.  I think that the amount of leverage that Equal has is the primary reason that the company is trading so cheaply.  When you look at Equal’s debt compared to its production level, and compare that to the other juniors I follow in my universe its rather clear that Equal is quite leveraged up.


After this transaction Equal’s ratio drops to 16,300, which puts them more in line with their peers.

Onto the Mississippian!

The second positive that comes out of this transaction is that it should help to speed up the development of the Mississippian.  I was clearly too early when I bought Equal in the spring on the expectation they would begin exploiting their Mississippian prospects in Oklahoma soon.   But while the company has yet to spud a well or provide a firm development plan for the Mississippian, it is clearly on their radar.  Again from the news release:

Equal has amassed a significant acreage position on an exciting new Mississippian light oil play in Oklahoma that exists on acreage held by production from certain of its Hunton fields. The Company plans to continue consolidating acreage prospective for the Mississippian while it considers options to begin development of the play during 2012.

It remains a waiting game.  Having held it this long, I will continue to hold Equal until these Mississippian wells begin to be drilled and the company hopefully gets revalued to a more reasonable level in anticipation.

Week 16 Portfolio Update

I can’t believe how weak the gold stocks have been.  While the price of gold has held up reasonably well, the stocks got pummelled yet again this week.  Gold stocks seem to be reacting to each tick up or down in the price of gold as if their business was operating on the slimmest of margins.  Yet nothing could be further from the truth.  The gold producers are pulling in record margins, and should report record cash flow for the third quarter.

With that in mind I “leveraged up” on the gold stocks this week, buying a position in Barrick Gold on Friday (as it hovers around its 52 week low), adding to my position in Newmont, and re-starting a position in OceanaGold.  I’m seriously considering trading out of Jaguar and into OceanaGold for no other reason than I am so sick of having the stock sitting on my watch list.  But we will see if cooler heads prevail there.

I’ve also been listening to a number of interviews with Kyle Bass this week.  I learned about Bass recently while reading an article about Michael Lewis’s new book Boomerang.  Bass was one of the few that predicted and then bet on the subprime debacle.  Lately Bass has had some very interesting things to say about what is taking place in Europe.

I’m happy to report that his views are not much different than what I’ve been saying since the beginning of August. That means that he also thinks the EU is unlikely to be able to deal with their debt issues in a sufficient manner.

Others agree.  William Buiter, the Chief Economist of Citigroup called the EFSF a “pea shooter earlier last week”.  Then on Friday night the European Commission released a report where they suggested private bondholders will be pushed to take 50 or 60 per cent haircuts on Greece.

All of the solutions being proposed right now are instances of the same basic idea.  Layer on more new debt to pay back the old debt.  How is this going to work?  How is it going to appease the market?

Its the type of world where I am not comfortable owning much of anything, but it is one where I still have to believe that owning gold is a reasonable choice.  Simply, how is it that we can have the second largest currency in the world under continued pressure and possible collapse, and it not be good for the asset class that is the “anti-currency”.

What’s more, it may be that the world’s third largest reserve currency is much closer to its own demise than anyone gives credit for.

Again, to the talented Mr. Bass (I just learned how to embed videos from CNBC so I’m all over that right now).

We might be on the verge of a far larger shift in the global reserve currency system than anyone imagines right now.

So I added a bit of Barrick at its 52 week low.  I don’t want to get crazy or anything.

The Total Cost of Producing Gold

Last month I wrote a post about the second quarter results from OceanaGold .  In that post I looked at the company’s assertion that the quarter was not as bad as it appeared on the surface because the total mining costs had not changed significantly.  What had changed was that more of the costs were being expensed and less of the costs were being capitalized.  Below was a chart I provided showing how OceanaGold’s capitalized mining costs had varied over the course of the last couple of years.

To generalize the point of that post, looking strictly at expensed costs (cash costs) as a judge of a company’s quarterly performance has its flaws.

So just to refresh, the difference between expensed and capital costs is as follows.  Expensed costs show up on the income statement and factor into the commonly evaluated cash cost number for a company.  Under most accounting methodologies these are the costs that can be directly attributed to the ore being mined.  Capitalized costs, on the other hand, are hidden on the cash flow statement under the Financial Activities, usually showing up as Property, Plant and Equipment.  They can be one time charges such as a new pinion bearing housing on the ball mill, or they can be pre-mining expenses such as the stripping away of overburden to get to ore that will be mined later.

While the expensed costs get all the headlines, the capitalized costs don’t get much attention at all.  Yet both types of costs are equal in the place where it really counts: how the company’s cash balance changes from quarter to quarter.

The work I did for OceanaGold led me to wonder what the same sort of analysis would look like for other gold companies.  What are the total costs of mining on a quarterly basis and how do they differ from the reported (expensed) cash costs that get so much attention from the brokerage community?  What we are really interested in with any company is how much free cash they can generate.  If a company is generating a lot of operating cash but is plowing that cash right back into the mine as sustaining capital, well then they are running on the spot.  So total costs is what matters, be they lumpier and messier than cash costs or not.

Moreover I have to imagine that there is grey area when applying the criteria of what constitutes an expensed cost and what constitutes a capitalized cost.  The implementation whatever accounting methodology is used probably varies from company to company.  Simply looking at cash costs might ignore these discrepancies and paint a poor picture of what’s really going on in the operations.

To look at the effect of overall costs, what I have done is simply this.  I took the cash costs stated by each company for the last two quarters and added to those costs the additions to property, plant and equipment as reported on their cashflow statement.  Then I divided summation of these two costs by the ounces produced over the first two quarters.  Because PP&A is likely to be more variable, it might be worthwhile to do this over a longer time horizon, but for now this will have to suffice.


  This is an interesting result.  It is particularly interesting when you compare the list against the same list of companies sorted on the more traditional cast costs metric.

What you see is that the companies that are lowest on the cash cost scale are not necessarily the lowest on the total costs scale.

Now of course, like everything, these results have to be taken with a grain of salt.  One of the reasons that capitalized costs are not added to cash costs in for traditional analysis is because they are inherently lumpy.  One time purchases that should be capitalized could skew the picture of the quarterly performance of a company.  Brigus Gold is a good example of this.  They are ramping up their underground mine at Black Fox right now.  There are a lot of capitalized costs associated with that ramp up.

I went another step further by looking at costs for the full year 2010.  That graph is shown below.  Here a few of the companies (Lake Shore, Atna, Alacer, etc) drop off the list because they didn’t have comparable production for the period for one reason or another.

To make a few observations from the above graphs, the first being that OceanaGold does not look like such a high cost producer.  While their cash costs are higher than the norm, their capitalized costs have consistently been lower than normal.  I wonder how much this is caused by having a mature mine.

Another observation I would make is that Aurizon Mines truly is a (if not the) low cost producer.  Both OceanaGold and Aurizon Mine are cash generators, which should serve them well over the longer term as they develop their mines.

A final observation is that B2Gold is worth taking a closer look at.

Sigh…Gold Stocks

A couple of misses and a couple of really bad days for my gold stock holdings.  The fact that my portfolios are not down all that much is a testament to the power of cash (I am 55% cash at the moment), and shorts (while my banking short did not do well 2 days ago, they did quite well today, and I jumped on (off?) the Green Mountain Coffee bandwagon when I got a google alert yesterday morning about Einhorns presentation on the company (google alerts are invaluable tool in my opinion).  I am up a good chunk on that short right now.  Coastal has helped too.

But the gold stocks have been fairly distasterous.  First a miss by Argonaut Gold, followed by an even bigger miss by Jaguar Mining.   Aurizon Gold and Newmont didn’t miss anything but are respectively down 10% and 7%, presumably just for kicks.  And with gold down another $16 tonight so far, I am afraid the carnage isn’t over.

Let’s start with Argonaut.  I’m out!   Look, I like Argonauts prospects but I don’t like the cash flow they are going to generate this quarter from a little over 12,000oz of gold sales, which is 5,000oz less than last quarter.   With the stock being hardly down from its recent move up, I decided to break with the company for the moment.  I will look at the stock again when the dust clears.

Onto Jaguar.  I’ll admit that if Jaguar had been down 7-8% today I probably would have sold the whole thing and been done with it.  But at 20% down it just seemed to me to be a little overdone.

I sold half my position in Jaguar back in September but kept the other half because I trusted management too much and it did sound in August like they were having a good quarter.  So today was a bummer.  It was frustrating to see them fall so terribly flat.  The company has an “always something” complex.  Its always a one off problem but its always something.  However, I did buy back 1/3 of my original position today at the close.  The reasons I bought were:

  1. 21% is a lot to be down on a single day.  AEM shut a mine down today and it wasn’t down that much.
  2. They still are going to produce a lot of cash for the quarter.   They had 21.7M cashflow (0.25/share) from ops in Q2 on $60.6M of revenue.  In Q3 revenue was $70M and costs were roughly  $3.6M higher so cashflow from ops should be around $24-25M.  Of course its all the higher gold price but cash is still cash.
  3. While Paciencia sucked Caete looked like it finally turned around, and Turmalina looked fairly solid.
  4. The assets aren’t that bad (they haven’t had a grade type issue yet where the gold is actually not there) and with the right management I think someone might want to go in and buy the company at this price.  I mean you are getting total resource at less than $50/oz at this price.

Next is Aurizon, my as-it-turns-out-not-so-safe safe gold play.  I used some of the proceeds from Argonaut to increase my position in Aurizon.  Unfortunately it was a day or two too soon.  I bought most of my position in the $5.40-5.50 range.  Today the stock closed at $5.25.  Sigh…  I decided to go with Aurizon because they are really trading quite cheaply, they have around $1/share of cash on their balance sheet and no debt, and they should generate very strong cash flow in the 3rd quarter and going forward.  The theory is that this will somehow help the stock during these take downs.  Ha!  Not today, Aurizon was down 7%.

As for Newmont, its just another instance of trying to keep some exposure to gold stocks (which may be the essence of my mistake here) while not taking too much risk (which is beginning to look like an absurd statement in this market).  The stock has behaved pretty well, and low and behold it was down a mere 5% today.  Sheesh.

I guess the reality the market is telling us is that in a banking crisis, you are much better off owning banking stocks then gold stocks.  Clearly the losers of the collapse of fiat currency are the company’s who mine for the hard asset alternative.

Excuse the sarcasm.

Look, I am not going to get dogmatic here, and certainly not about gold.  The market is saying what its saying, as insane as it might seem.  I have raised more and more cash on every move back up (although never as much as I wished I would have raised in retrospect).  I’ve tried to take advantage of the moves down to make trades like I did today in Jaguar and earlier this week in Aurizon.  But its getting incredibly stressful to time these moves and deal with the volatility. Its wearing me down.

Probably the most frustrating part is how little time you have to get out when there is a move up.  I swear that on Friday afternoon the gold stocks peaked within the last 15 minutes of trading.  I pragmatically took money off the table.  Problem is, usually I do this in stage.  A little bit today, a little more tomorrow, gradually reducing the position down to a comfortable level.  No such thing in this market.  Friday afternoon the gold stocks peaked and on Monday morning most were down 5% within a few minutes of the open.  Same with Tuesday when Jaguar moved up.  I took a little off the table, but you have to do it all or nothing is this market, because as today is evidence, you just don’t get a second chance.

Week 15 Portfolio Update: Scratching Back to Even (again…)


My portfolio gained along with the rest of the market last week.  The rollercoast on either side of par continues.  The good news is, as the relative performance chart below shows, I have been outperforming the major indexes since inception.

Unfortunately the bad news is that I am still down 1% since I started the portfolio on July 1st.  I’ve said on a number of occasions in the past couple of months that the best position to have in this market may be a cash one.  Thus far that has turned out to be the case.  Even though I have picked stocks and sectors that have generally outperformed the market, the fact remains that it is very hard to make money in a bear market without being short.

Speaking of shorts, I do want to point out once again that while I am not allowed to short stocks in the practice account that I post on this blog, I am short a number of stocks in my actual account.  These stocks are entirely in the banking sector.  Right now I am short BAC (Bank of America), UBS, and HBC (HSBC).  I have been short HCG.to (Home Capital Group) but covered that recently on the suspicion that the market was going to rally.  These banking shorts amount to about 1/3 of my longs, and they are there entirely as a hedge against the possibility of a systemic collapse brought on by some European catastrophe.

Also of note is that while I mentioned that I had began to buy Newmont this week, exchanging some of my gold junior shares for the shares of the gold senior, you will note there are no Newmont shares in the account displayed.  I’m not entirely sure what happened here; I think I may have put the USD limit price for Newmont on the CDN dollar share order.  At any rate, I didn’t get the shares I thought I got, and I didn’t realize that until I checked my portfolio this weekend.  I’m not entirely sure what I am going to do about this now, as Newmont is a good 5% higher than when I had anticipated buying the shares. I think I will just sit in cash until the opportunity arises to buy the stock at the price where I actually bought it in my real accounts.

For the upcoming week, I would like to pare back some of my positions further if given the chance.  D-day in Europe is coming up quickly, and god only knows what that day has in store for us.  I have seen the market turn downwards on a dime too many times in the past couple of months to have any faith in the sustainability of this rally.  If Europe actually comes to a workable solution, I will buy back stocks with a vengence, but until that time has clearly arisen, I will continue to exercise extreme caution.

The one stock that I might look at adding to is Atna Resources.  I did a lot of work this weekend with another, more familiar, gold producer called San Gold.  San Gold is an interesting story and I will try to write up a short piece on the company some time soon.  I don’t anticipate buying and SanGold in the near term though; while the production and exploration potential of the company is interesting, it seems to be that a lot of this upside is already in the stock.  Which brings me to Atna.  What Atna has at Pinson seems fairly analogous to what SanGold had at Rice Lake before they began to ramp up production.  Lots of high grade underground gold and a  mill that was mostly commissioned and ready to go.  The difference between the two companies is that Atna has a market capitalization of less than $100M, whereas Sangold at one time was a $1B company, and even now with recent production disappointments (which I have to say are not as disappointing as the share price performance would suggest) is a $600M company.  There are differences to be sure, but nevertheless $500M is a lot of wiggle room to play with.

Not Buying this Rally

While I have been happily taking part in the rally this week I remain skeptical in its sustainability.  The positives right now are all in the “price action”.  If you look beyond the improving prices of the stocks, there is not very much positive to be said about the underlying conditions.

Lets take, as our first exhibit, Europe.  The market rally seemed to get kicked off this week with the news out of Brussels that Sarkozy and Merkel had a plan.  Or the makings of a plan.  Or a plan of a plan.  They had talked anyways, and the market deemed this to be significant and positive.

It is worthwhile here to look at some of the details of what was said by the two leaders.  In particular, the emphasis that they made that changes were needed to the actual constitutional treaty that underlies the EU.  Here is what Dennis Gartman said on the matter:

We continue… perhaps too dramatically… to dwell upon the statement by Ms. Merkel that France and Germany “will make proposals in a comprehensive package… that will include changes to [the] treaties” that established the European monetary and political unions. Ms. Merkel went out of her way Sunday and again yesterday to reiterate that “treaty” statement so that no one anywhere would misunderstand the seriousness of the situation. Changes to the treaties of Maastricht, Amsterdam, Lisbon and Nice require passage by either public referenda or by vote of the parliament in individual nations… that is left to the nations themselves… and importantly the votes must be unanimous. Not one… not a single nation in the “unions” in question… can vote against such changes. They are not passed by mere majorities of the member nations, nor by super-majorities, but by unanimity. Essentially, Slovakia must agree with Germany and Germany must agree with Ireland and Ireland must agree with Austria and so on to unanimity… Unless Ms. Merkel was lying openly and often in the past two days regarding the need to revise these seminal treaties at the core of the political and monetary unions, we find it difficult if not wholly impossible to believe that this unanimity can be achieved within anything less than one year…

The situation in Europe is far from resolved.  I would even argue that given the difficult nature of what it looks like they are now trying to accomplish, things just got a bit worse.

Meanwhile, one of my most trusted gauges of economic forecasting, the ECRI, has been getting more and more negative on the outlook for the US economy, and last week they tipped officially into the recession camp.  Now these guys are no David Rosenberg; they are not making a recession call based on a theory or the historical precedent of credit contractions elsewhere, no the ECRI is looking at the long leading indicators that have traditionally foretold economic strength and weakness and these indicators are, right now, pointing solidly downward.

I think its worth mentioning that during the sharper but shorter downturn in the index that occured in the spring of 2010, the ECRI was adamant that this did not signal a recession.  A lot of other bears did, I remember reading Rosenberg at the time and he conveniently used the WLI data to foretell a recession that never came.  But the ECRI did not.  I think they key difference is the “persistance” of the current move down.  The index has been moving down steadily since March.

The index also seems to be a very good indicator of stock market turns.  It turned almost co-incidentally with the market during the March 2009 bottom.  As you can see from the chart above, this year it turned down almost at the same time as the market topped.  I would have somewhat more faith in this rally if the index was not foretelling more economic weakness ahead.

This week I sold out of Gramercy Capital.  Gramercy was the last of my US real estate related holdings, as I have already sold out of Oneida Financial and Home Federal Bank of Louisiana.  With the US economy slowing, this doesn’t seem like a particularly good time to be making long bets on real estate. FT Alphaville posted an interesting article on the state of prime mortgages in the US.  It seems that a number of the prime mortgage indexes have fallen off preciptiously in the last few weeks.

Now these indexes only represent a sampling of the outstanding MBS, and it very could be that they are skewed to areas of the country (ie. Califronia) that are currently experiencing more weakness then the country as a whole.  Still its a sobering thought to contemplate that the housing downturn has another leg left in it.

Tying this back to Gramercy, while the company remains in a much better position than it has been in for the last few years, being no longer overly leveraged and generating significant cash flow, the lifeblood of that cash flow is still tied to the US economy, and so Gramercy is not going to be immune to a US recession.  You saw that this was the case last week when news came out that CDO-2005 failed its overcollateralization test for September.  When the company released their delayed 10-Q’s, they had this to say about CDO-2005:

“We expect that the overcollateralization test for the 2005 CDO will fail at the October 2011 distribution date”

Now this is not the end of the world for the company.  Indeed, Plan Maestro pointed out on one of the boards that it likely gives Gramercy more chances to buy the CDO bonds at distressed prices.  CDO-2006 is still generating lots of cash flow.  My point is that in an environment of a deteriorating economy, and in a world where the collapse of the second largest reserve currency is still very much a possibility, one needs to err on the side of caution.

I suspect that absent some sort of private equity take-over of the company, I will be able to buy Gramercy back at a cheaper price than I sold it at.  Just a couple weeks ago the stock was trading in the $2.60’s.  I sold at $3.20.  I suspect I will be able to pick it back up in the $2.60’s once the dust settles and Europe is found to be still wearing no clothes.

Some last bits of news, again of the positive sort, was, first of all, that Crescent Point participated rather significantly in Arcan’s recent financing.  So while retail was selling stock at sub $4, Crescent Point was buying it at $5.45.  The market is somewhat ridiculous, isn’t it?  I picked up a few shares of Arcan during the “panic”.  I’ve been contemplating reducing my position back to its normal size now that the stock has moved up, but I haven’t done so yet.  But I will; I want to use this rally lower risk in my portfolio right now, and so scaling back on everything is prudent I think.

Last night Coastal Energy released what looks like some very good news.  The hope has always been that the Bua Ban North A and B reservoirs were actually a single, larger reservoir.  The latest well seemes to confirm this:

“We are extremely pleased with the results of the A-08 well, which further supports the conclusion that Bua Ban North A & B are likely in communication in the western fault closure of the structure. We now plan to drill an additional delineation well halfway between the A & B fields on the western side of the structure to further confirm this. This well will spud by this weekend.

Coastal was another stock that I bought a bit more of on fire sale.  I don’t think I’m going to sell any of this one.  Its too cheap and the results remain too good.

The last thing I have been doing this week is paring my positions in my junior miners in favor of a position in Newmont. Why Newmont, you might say.  A couple reasons.  First, as the below snapshot from BMO illustrates, Newmont is not expensive.  In fact the stock is trading as cheaply now as it ever has.

Second, if you look at the price performance of Newmont through the recent downturn, it has performed admirably well.  While the juniors got decimated during the two week downturn, Newmont did not.  An while I still really like the idea of gold stocks, I don’t totally trust that if Euope goes into freefall again that they won’t put in a repeat performance of this themselves.  I’d rather own a little bit less of the volatility provided by Jaguar and OceanaGold and a little bit more of the stability (and dividends!) provided by Newmont.