Sunday, February 27, 2011

Phases of a market move

originally posted 2-24-11

Most people say there are 3 phases in a market move: 
1.  Pioneering investors begin buying
2.  Steady accumulation by progressively savvy investors
3.  Parabolic mania phase
This might be true.  The longer I am in the business of risking capital the more I believe there are 5 phases in market moves.  What has led me to this is being forced to head into battle with virtually no outside direction.
So, through my experience I have come to believe that psychology is so present in markets and decisions that it could be 80% of what I do.  I am going to lay out what I believe are the 5 phases of a move and then apply them to one sector that I believe is currently well positioned in phase 3 of 5.
1.  Unawareness
2.  Awareness
3.  Denial
4.  Acceptance
There has been some press lately about Rare Earth Elements.  I must inform you that most of this press is dangerously untethered to the truth, or reality.  To make money you need to be in sync with reality.
Phase 1 was in place for maybe 10 years.  Unocal was in the news in the early 2000’s as China made a bid for it.  Luckily someone in the state department was awake and blocked the sale.  Unocal owned Mountain Pass which is now the primary asset of Molycorp NYSE:MCP, America’s only near term rare earth element project.  This qualifies as phase 1 because once I lay out the importance of REEs to the modern society you will see that people should have been protesting in the streets as China would have controlled 100% instead of 97% of world production!  (They control an estimated 35% of world supply)
Phase 2 arguably began in the summer of 2010 when China drastically cut export quotas on the elements.  Also, I thought we may have teetered back into Phase 1 when the fishing boat incident was reported as such when really Japanese mafia smuggling is one of the biggest threats to China’s 100% lock up of these elements.
Phase 3 is where we are today.  I have seen numerous stories about these elements not being rare, substitutes being available, recycling programs being designed, new products in development that do not require the elements.  ALL of these assertions are false and a cunning attempt to keep you from being properly positioned in this trend. 
Phase 4 will arrive at some point, I suspect sooner rather than later.  China has cut export quotas so furiously that I suspect the effect of this action will shove us forcefully into this phase.  Just to illustrate the importance of these elements, every military fighter, smart bomb, fuel cell, windmill turbine, iPhone and television needs these materials to exist.  It is possible to make them without rare earths but to do so would take away the ability to make them smaller and more efficient.  For example, rare earths make magnets that are many times stronger than traditional designs and heat resistant which allow the small fins in guided munitions to function.  This phase, acceptance of the reality, will cause the equity value of companies with viable projects to soar to currently unimaginable heights as governments will pay any price to secure these vital elements.
Phase 5 THE PLUNGE!  Time for you to sell!  When you are in a Shoney’s and you hear a guy next to you with a Bluetooth in his ear talking about a new rare earth company watch out.  If you can quickly determine that he was day trading in 1999, flipping condos in 2007, selling his scrap gold in 2010, and yield hunting using the Etrade municipal bond screener in 2011, immediately get in touch with your broker and sell every holding related to the sector and take a mental vacation.  You have just participated in one of the best bull market moves of your lifetime.
How do you pick a good stock?  Well, the world uses 100,000 tons a year of this material today and 97,000 of those tons are supplied by China and if you haven’t noticed we are at war with China.  They have slashed the quotas, some say down to 30,000 tons a year.  This is not a typical war but a very sophisticated power struggle between a debtor and a creditor.  The creditor wants to acquire as many hard assets as possible and challenge the debtor on many fronts.  The debtor is dreaming that he has the power that existed before he levered himself many times over in exchange for plastic toys and cheap television sets.  If you were the creditor and you controlled 97% of the current supply of a critical element, think of how you would behave.  Then you will have some clue as to what their next moves might be.
Now assume that the demand will increase at 10% per annum which is reasonable as new technologies are being created constantly that require these elements.  Then make a timeline of expected projects, their cost and estimated time to market.  Next pick the projects with the best deposits (i.e. there are 17 elements some more valuable than others see prices here and notice price trends!  Also, be aware that you are wading into the mining business so do your best to avoid guys standing over a hole with a laptop making press releases and doing share offerings.  Finally, understand that you will want to sell sometime in phase 5 because at some point in the future new supply will meet and exceed demand and valuations will collapse.   That is not an immediate concern though.
Good luck, you will need it! 

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