In every bull market there are a few potential pivot points—points when the price and fundamentals are aligned in such a manner as to offer enticing value. Life is a risk, and when the odds favor your hand, you have to bet big if ever you intend to score big. I’ll pull no punches: I’m betting big on gold equities right now!
Nothing is more critical to gold equities than the relative price of the commodity itself, gold, compared to the cost of mining it. This gold bull market began at the turn of the century, and gold equities have been extremely cheap in comparison to gold on three occasions: (1) In 2000-2001 gold equities traded at absurdly low valuations because the cost of mining gold was very high relative to its price and because memories of the gold bear lingered fresh in investors’ minds; (2) During the 2008 financial crisis when all equities went on fire sale and the gold price nearly fell equivalent to the actual cost of mining gold; (3) At the present, when the gold price has spiked to a new high even while gold companies are greatly expanding their profit margins. The price of gold shares can remain depressed because they are a hybrid investment—part gold and part equity.
Source: StockCharts.com
As you can see from the above graph, the price of the miners has indeed appreciated relative to gold, but by no means in an even manner. Nobody claimed making money to be a smooth ride! Nevertheless, the main point is that since the onset of this gold bull, gold equities are slowly making headway against the metal itself. And today’s gold equities look particularly compelling. Certainly, gold equities have performed much better than general equities as seen below:
Source: StockCharts.com
What makes now the right time to buy gold equities? The price of the metal has been trading between 00-00 dollars per ounce while the all-in cost of mining gold is estimated to be 0-0 per ounce, leaving fat profit margins for gold producers. In the past, the rising price of oil, an important cost input for gold miners, pressured mining profits because the oil price had been escalating even faster than the price gold. Now, however, global growth is moderating due to the reliance of eastern economies on their over-indebted western trading partners. Consequently, the current price of gold relative to oil is now very expensive—a major bonus for the soon-to-be announced, fat profit margins of the gold producers. See the graph below:
Source: StockCharts.com
That does not mean that “all lights are green” for gold equities because, like any business investment, they entail great risk. If an improving economy—or worse yet, war—were to cause the price of oil to flare up, gold equities might not necessarily benefit from gold’s advance. To mitigate this risk, gold equities could be hedged by purchasing oil futures. Resource nationalization, too, remains a concern as evidenced by Hugo Chavez’s recent actions, but this is mostly a regional issue—at least thus far. Another worry is that gold’s mini-parabolic advance has defied the norm, displaying characteristics that appear frothy. Wouldn’t it be ironic if the low valuations of gold stocks were merely signaling a forthcoming reversal in gold’s fortunes?
It appears that the recent gold run-up is a statistical abnormality, somewhat similar to that of silver earlier this year. These types of rapid price movements are a rarity—a nearly three or four standard deviation event—and can sometimes set the stage for sharp price corrections. However, it can be misleading to read too much into a bell curve. These statistical measures only matter when the population sample (gold investors in this case) is static. Today’s universe of potential gold buyers is expanding dramatically, and this distorts the significance of these rare statistical price moves. If the new entrants stubbornly remain in the market, these price gains can stick. If the volatility of the gold bull bucks them off, the price corrections can be short and nasty! Either way, I expect the universe of gold investors to broaden substantially in the coming years and therefore would not try to time the moves caused by the whimsical hot money that ebbs and flows along the way.
One thing is certain—gold ETF holdings have been expanding since inception (see chart below). What’s interesting is that some of gold’s greatest gains have been made with only a modest increase in the ETF’s holdings, but this can be explained by a variety of reasons. Central banks are finally net buyers of gold, not net sellers as they had been for decades. Further, this gold bull is truly global—driven by hundreds of millions of Chinese, Indians, and Russians who demand to hold the physical metal.
Source: Bloomberg
The macro case for gold is still intact. Instead of addressing the structural problem of resource misallocation caused by poor macro and fiscal policy, central bankers choose to print money and further mask the imbalances created by a world gone mad. For this reason, I expect that any corrections in the price of gold will be nothing more than mere consolidations in a secular bull market. Just where will gold peak? Nobody knows for sure. Many like to compare this circumstance to that of the 1970s when gold reached parity with the Dow:
Source: Bloomberg
Clearly, during times of instability gold performs exceedingly well and general equities often suffer. The issue at hand is to determine just how high gold should appreciate relative to equities during times of resource misallocation. Mankind is certainly much more advanced today than in the 1970s—better able to feed itself, to communicate, and to produce goods with much less effort. Thus, it would seem that today’s society would be reluctant to pay as much as it had in the 1970s for a hedge like gold. Yet, the very buffer that man has achieved through technological progress and accumulated knowledge not only works to protect him, but also allows him to unwittingly continue on a misguided path of bad policy which adds fuel to gold. This can be seen in the balance sheets of many western nations, particularly that of the US where the total debt to GDP ratio now dwarfs that of the 1970s.
As I indicated earlier, every bull market has a few inflection points which offer enough compelling value to justify the risk. The gold mining equities will mint money even if the gold price merely treads water, just as long as oil and labor costs stay under control. If the marketplace accepts high gold prices to be more than an aberration, the price of gold equities should appreciate handsomely relative to the metal itself.
The beauty of rising markets is that they often create their own liquidity. A rising gold price creates high profit margins which should attract value investors and enable major gold producers to borrow more cheaply through bank credit lines and bond offerings instead of engaging in costly share offerings (dilutions). Furthermore, if the global economy remains weak and the gold mining shares are the only port in the storm, the momentum money might jump on board too. Appreciating share prices of the major gold producers can then be used as trade collateral to acquire accretive junior producers—companies that, thus far, have had to perpetually dilute their shares to meet the intensive capital demands of the gold mining business. The stage now appears to be set for the gold mining equities to catch fire.
Lastly, let’s not forget about gold’s monetary cousin—silver—which tends to do well during the money printing festivities of central bankers. During the 1970s, the Hunt Brothers cornered the silver market and squeezed the silver price to dizzying heights. Today’s world is replete with hedge funds who often act in concert and will likely squeeze silver for one reason—because they can! The gold to silver ratio has remained above 44:1 for a long time, but now that money printing is the way of the world that ratio has been breached in favor of silver, only to be retested yet again as industrial demand fades in a hemorrhaging global economy.
Source: Bloomberg
Once the next phase of QE is formally announced or silently recognized by the marketplace, I look for silver to gain relative to gold just as it had in the 1970s. What was formally resistance in the gold to silver ratio could now serve as support for silver. If I’m right, it could be a wild, wild ride for silver and gold equities. Are you prepared?
